FX Risk Management

Transaction Exposure
 Overview
• The three major foreign exchange exposures
• Foreign exchange transaction exposure
• Pros and cons of hedging foreign exchange transaction
exposure
• Alternatives of managing significant transaction
exposure
• Practices and concerns of foreign exchange risk
management

Slide 1
 Foreign Exchange Exposure
 Types of foreign exchange exposure
• Transaction Exposure – measures changes in the value of
outstanding financial obligations due to exchange rate changes
• Operating Exposure – also called economic exposure, measures
the change in the present value of the firm resulting from any
change in expected future operating cash flows caused by an
unexpected change in exchange rates
• Translation Exposure – also called accounting exposure, is the
changes in owner’s equity because of the need to “translate”
financial statements of foreign subsidiaries into a single
reporting currency for consolidated financial statements
• Tax Exposure – as a general rule only realized foreign losses are
deductible for purposes of calculating income taxes

Slide 2
 Foreign Exchange Exposure
Moment in time when exchange rate changes

Accounting exposure Operating exposure

Changes in reported owners’ equity Change in expected future cash flows
in consolidated financial statements arising from an unexpected change in
caused by a change in exchange rates exchange rates

Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates

Time

Slide 3
 Why Hedge - the Pros & Cons
 Opponents of hedging give the following reasons:
• Shareholders are more capable of diversifying risk than the
management of a firm
• Currency risk management does not increase the expected cash
flows of a firm
• Management often conducts hedging activities that benefit
management at the expense of shareholders
• Managers cannot outguess the market
• Management’s motivation to reduce variability is sometimes
driven by accounting reasons
• Efficient market theorists believe that investors can see through
the “accounting veil” and therefore have already factored the
foreign exchange effect into a firm’s market valuation

Slide 4
 Why Hedge - the Pros & Cons
 Proponents of hedging give the following reasons:
• Reduction in the risk of future cash flows improves the
planning capability of the firm
• Reduction of risk in future cash flows reduces the
likelihood that the firm’s cash flows will fall below a
necessary minimum – avoiding bankruptcy costs
• Management has a comparative advantage over the
individual investor in knowing the actual currency risk
of the firm
• Markets are usually in disequilibirum because of
structural and institutional imperfections
• Reduction in variability of income reduces a firm’s
overall tax burden
Slide 5
 Why Hedge - the Pros & Cons
Hedged

Unhedged

NCF Net Cash Flow (NCF)

Expected Value, E(V)
Hedging reduces the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk, but who benefits from it.

Slide 6
 Measurement of Transaction
Exposure
 Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations, namely
• Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
• Borrowing or lending funds when repayment is to be
made in a foreign currency
• Being a party to an unperformed forward contract and
• Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies

Slide 7
Purchasing or Selling on Open Account
 Suppose Trident Corporation sells merchandise on open
account to a Belgian buyer for €1,800,000 payable in 60 days
 Further assume that the spot rate is $0.9000/€ and Trident
expects to exchange the euros for €1,800,000 x $0.9000/€ =
$1,620,000 when payment is received (assuming no change in
exchange rate)
• Transaction exposure arises because of the risk that Trident will
receive something other than $1,620,000 expected
• If the euro weakens to $0.8500/€, then Trident will receive
$1,530,000
• If the euro strengthens to $0.9600/€, then Trident will receive
$1,728,000

Slide 8
Purchasing or Selling on Open Account
 Trident might have avoided transaction exposure by
invoicing the Belgian buyer in US dollars, but this
might have caused Trident not being able to book the
sale
 Even if the Belgian buyer agrees to pay in dollars,
however, Trident has not eliminated transaction
exposure, instead it has transferred it to the Belgian
buyer whose dollar account payable has an unknown
euro value in 60 days

Slide 9
Purchasing or Selling on Open Account
Life Span of a Transaction Exposure

t1 t2 t3 t4
Seller quotes a Buyer places Seller ships Buyer settles
price to buyer firm order with product and A/R with cash
seller at bills buyer in amount of
offered price currency
quoted at t1

Quotation Exposure Backlog Exposure Billing Exposure

Time between quoting Time it takes to fill the Time it takes to get
a price and reaching a order after contract is paid in cash after A/R
contractual sale signed is issued

Slide 10
 Borrowing and Lending
 A second example of transaction exposure arises
when funds are loaned or borrowed
 Example: PepsiCo’s largest bottler outside the US is
located in Mexico, Grupo Embotellador de Mexico
(Gemex)
• On 12/94, Gemex had US dollar denominated debt of
$264 million
• The Mexican peso (Ps) was pegged at Ps3.45/$
• On 12/22/94, the government allowed the peso to float
due to internal pressures and it sank to Ps4.65/$

Slide 11
 Borrowing and Lending
 Gemex’s peso obligation now looked like this
• Dollar debt mid-December, 1994:
– $264,000,000  Ps3.45/$ = Ps910,800,000
• Dollar debt in mid-January, 1995:
– $264,000,000  Ps5.50/$ = Ps1,452,000,000
• Dollar debt increase measured in Ps
– Ps541,200,000
 Gemex’s dollar obligation increased by 59% due to
transaction exposure

Slide 12
 Other Causes of Transaction
Exposure
 When a firm buys a forward exchange contract, it
deliberately creates transaction exposure; this risk is
incurred to hedge an existing exposure
• Example: US firm wants to offset transaction exposure
of ¥100 million to pay for an import from Japan in 90
days
• Firm can purchase ¥100 million in forward market to
cover payment in 90 days

Slide 13
 Hedging Alternatives
 Transaction exposure can be managed by
contractual, operating, or financial hedges
 Contractual hedges: forward, money market, futures,
and options
 Operating and financial hedges use risk-sharing
agreements, leads and lags in payment terms, swaps,
and other strategies
 A natural hedge refers to an offsetting operating cash
flow
 A financial hedge refers to either an offsetting debt
obligation or some type of financial derivative such
as a swap
Slide 14
 Foreign Currency Derivatives
 Derivatives drive their values from the underlying asset
 They might be used for two distinct management objectives:
• Speculation – the financial manager takes a position in the
expectation of profit
• Hedging – the financial manager uses the instruments to reduce
the risks of the corporation’s cash flow
 In the wrong hands, derivatives can cause a corporation to
collapse (Barings, Allied Irish Bank), but used wisely they
allow a financial manager the ability to plan cash flows
 The derivatives we will consider are:
• Foreign Currency Futures
• Foreign Currency Options

Slide 15
 Foreign Currency Futures
 A foreign currency futures contract is an alternative
to a forward contract
• It calls for future delivery of a standard amount of
currency at a fixed time and price
• These contracts are traded on exchanges with the
largest being the Chicago Mercantile Exchange (CME)
 Contract Specifications:
• Size of contract – called the notional principal, trading
in each currency must be done in an even multiple
• Method of stating exchange rates – “American terms”
are used; quotes are in US dollar cost per unit of
foreign currency, also known as direct quotes
Slide 16
 Foreign Currency Futures
 Contract Specifications
• Maturity date – contracts mature on the 3rd Wednesday
of January, March, April, June, July, September,
October or December
• Last trading day – contracts may be traded through the
second business day prior to maturity date
• Collateral & maintenance margins – the purchaser or
trader must deposit an initial margin or collateral
– At the end of each trading day, the account is marked to
market and the balance in the account is either credited
if value of contracts is greater or debited if value of
contracts is less than account balance
Slide 17
 Foreign Currency Futures
 Contract Specifications
• Settlement – only 5% of futures contracts are settled by
physical delivery, most often buyers and sellers offset
their position prior to delivery date by taking offsetting
positions
– The complete buy/sell or sell/buy is termed a round turn
• Commissions – customers pay a single commission to
their broker to execute a round turn
• Use of a clearing house as a counterparty – All
contracts are agreements between the client and the
exchange clearing house. Therefore, there is no
counter-party risk
Slide 18
 Using Foreign Currency Futures
 If an investor wishes to speculate on the movement of
a currency can pursue one of the following strategies
• Short position – selling a futures contract based on
view that currency will fall in value
• Long position – purchase a futures contract based on
view that currency will rise in value

Slide 19
 Using Foreign Currency Futures
 Example (cont.): Amy believes that the value of the
peso will fall, so she sells a March futures contract
 By taking a short position on the Mexican peso, Amy
locks-in the right to sell 500,000 Mexican pesos at
maturity at a set price above their current spot price
 Amy sells one March contract for 500,000 pesos at
the settle price: $0.10958/Ps

Value at maturity (Short position) = – Notional principal  (Spot – Futures)

Slide 20
 Using Foreign Currency Futures
 To calculate the value of Amy’s position we use the following
formula
Value at maturity (Short position) = – Notional principal  (Spot – Futures)
 Using the settle price from the table and assuming a spot rate of
$0.09450/Ps at maturity, Amy’s profit is
Value = – Ps500,000  ($0.09450/Ps – $0.10958/Ps) = $7,540
 If Amy believed that the Mexican peso would rise in value, she
would take a long position on the peso

Value at maturity (Long position) = Notional principal  (Spot – Futures)

 Using the settle price from the table and assuming a spot rate of
$0.11500/Ps at maturity, Amy’s profit is
Value = Ps500,000  ($0.11500/Ps – $0.10958/Ps) = $2,710 Slide 21
Foreign Currency Futures Versus Forward
Contracts
Forward Markets Futures Markets
Contract size Customized. Standardized.
Delivery date Customized. Standardized.
Participants Banks, brokers, MNCs. Public Banks, brokers, MNC. Qualified
speculation not encouraged public speculators.
Security deposit Compensating bank balances or Small security deposit required
credit lines needed
Clearing Handled by individual banks and Handled by exchange clearinghouse.
operation brokers Daily settlements.
Marketplace Worldwide Central exchange
Regulation Self-regulating. Commodity Futures Trading
Commission (CFTC) and National
Futures Association
Liquidation Mostly settled by actual delivery Mostly settled by offsetting
transactions
Transaction Bank’s bid/ask spread Negotiated brokerage fees
Costs

Slide 22
 Foreign Currency Options
 A foreign currency option is a contract giving the
purchaser of the option the right to buy or sell a given
amount of currency at a fixed price per unit for a
specified time period
• The most important part of clause is the “right, but not
the obligation” to take an action
• Two basic types of options, calls and puts
– Call – buyer has right to purchase currency
– Put – buyer has right to sell currency
• The buyer of the option is the holder and the seller of
the option is termed the writer

Slide 23
 Foreign Currency Options
 Every option has three different price elements
• The strike or exercise price is the exchange rate at
which the foreign currency can be purchased or sold
• The premium, the cost, price or value of the option
itself paid at time option is purchased
• Spot exchange rate in the market
 There are two types of option maturities
• American options may be exercised at any time during
the life of the option
• European options may not be exercised until the
specified maturity date

Slide 24
 Foreign Currency Options
 Options may also be classified as per their payouts
• At-the-money (ATM) options have an exercise price
equal to the spot rate of the underlying currency
• In-the-money (ITM) options may be profitable,
excluding premium costs, if exercised immediately
• Out-of-the-money (OTM) options would not be
profitable, excluding the premium costs, if exercised

Slide 25
Foreign Currency Options Markets
 Over-the-Counter (OTC) Market – OTC options are most
frequently written by banks for US dollars against British
pounds, Swiss francs, Japanese yen, Canadian dollars and the
euro
• Main advantage is that they are tailored to purchaser
• Counterparty risk exists
• Mostly used by individuals and banks
 Organized Exchanges – similar to the futures market,
currency options are traded on an organized exchange floor
• The Chicago Mercantile and the Philadelphia Stock Exchange
serve options markets
• Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC)

Slide 26