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FINM 7406
Lecture 6:
Exchange Rate Exposure I:
Transaction and Translation Exposure
Instructor: Dr Kelvin Tan
Reading: Eun Resnick Chapters 8 & 10
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• Risks firms face include:
• Interest Rate risk
• Relative Price Risk
• Political Risk
• Exchange rate risk – “is the variance of domestic-currency value of an asset, liability, or
operating income that is attributable to unanticipated changes in exchange rates.” (Adler
and Dumas, 1983)
Introduction
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Outline
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• Transaction (Contractual) Exposure
• How is it measured?
• Methods of Hedging Transaction Exposure
• Financial instruments
• Operational Hedges
• Translation (Accounting) Exposure
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Type of Foreign Exchange Exposure
Unexpected changes in exchange rates may affect a firm’s cash flows and
market value
1. either through its effect on existing contracts ⇒ Transaction
Exposure (see next slide)
2. or through its impact on the future operating cash flows of the firm
⇒ Operating Exposure (aka Economic Exposure)
Exchange rate changes may have an impact
on accounting values
3. This is called Accounting or Translation Exposure
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Transaction Exposure
Transaction exposure measures gains or losses that arise from
the settlement of existing financial obligations (e.g., account
receivables, account payables) whose terms are stated in a
foreign currency.
A classic example of transaction exposure is a firm that has
signed a contract to ship goods overseas at a fixed foreign
currency price.
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Transaction Exposure Example
Suppose an Australian firm (Trident) sells merchandise on open account to
Belgian buyer for:
 €1,800,000, payment to be made in 60 days.
 S0 = $0.9000/€
 The Australian seller expects to exchange the €1,800,000 for
$1,620,000 when payment is received
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Transaction Exposure Example
Transaction exposure arises because of the risk that the Australian seller will
receive something other than $1,620,000.
 If the euro weakens to $0.8500/€, then Trident will receive $1,530,000
(€1.8mil * $0.85/€)
 If the euro strengthens to $0.9600/€, then Trident will receive
$1,728,000 (€1.8mil * $0.96/€)
Thus, exposure is the chance of either a loss or a gain.
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Transaction Exposure Example
Transaction exposure arises from:
 Purchasing or selling on credit goods or services whose 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 foreign exchange forward contract;
 Otherwise acquiring assets or incurring liabilities denominated in foreign
currencies.
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Transaction Exposure: Inflows & Outflows
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Inflows of FC
• Accounts receivable
denominated in a foreign
currency (FC)
• Long-term sales contracts
denominated in a FC
• Deposits, bonds, or notes
denominated in a FC
• Forward purchase of a FC
Outflows of FC
• Accounts payable
denominated in a FC
• Long-term purchase con-
tracts denominated in a FC
• Loans, bonds, or notes
due denominated in a FC
• Forward sales of a FC
Net Exposure by currency and date =
Total Inflows – Total Outflows
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Measuring Transaction Exposure (1)
It is the consolidated net amount in currency inflows and outflows
Example:
Currency Total inflow Total Outflow Net Inflow or outflow
GBP 17,000,000 7,000,000 +10,000,000
CAD 12,000,000 2,000,000 +10,000,000
HKD 20,000,000 120,000,000 -100,000,000
MEX 90,000,000 10,000,000 +80,000,000
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Measuring Exposure (2): Value-at-Risk
Aim – To estimate the potential maximum loss (over a certain period) on the
value of positions that are exposed to exchange rate movements
Blue Bossa Records has €10m position (receivable). The current spot rate is
$1.20/ €. What is its VaR?
 Need to specify reference probability and horizon
 Need an estimate of the distribution of dollars exchange rate,
e.g. Normal distribution with μ = 0 and σ = 6% per month
With the normal distribution, the 5% tail probability of adverse move starts at
1.65 standard deviation below the mean
x = μ – 1.65 * σ
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Value-at-Risk (cont.)
With the normal distribution, the 5% tail probability of adverse move starts at
1.65 standard deviation below the mean.
x = μ – 1.65 * σ
So, x= 0 – 1.65 * 0.06 = - 0.099
For the $12m position, VaR is -0.099 * $12m is –$1,188,000
[i.e. there is 5% chance of losing $1,188,000] over the next month.
Problems with VaR?
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Why Hedge?
Hedging is the taking of a position, either acquiring a cash flow or an asset or a
contract (including a forward contract) that will rise (fall) in value and
- offset a drop (rise) in value of an existing position.
Hedging, therefore, protects the owner of the existing asset from loss (but it also
eliminates any gain resulting from changes in exchange rates on the value of
the exposure).
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Why Hedge?
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Expected Value, E(V) Net Cash Flow (NCF)NCF
Unhedged
Hedged
Hedging reduces the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk.
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The Impact of Hedging on Expected Cash Flows
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Unhedged
Hedged
$250,000
15%
10%
$0 $1,000,000
25%
50%
Net Cash FlowExpected Value
Probability
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Why Hedge?
Is the reduction of variability of cash flows then sufficient reason for
currency risk management?
• This question is actually a continuing debate in multinational financial
management and corporate finance.
• There are several schools of thought.
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Opponents of Hedging
Opponents of currency hedging commonly make the following arguments:
• Stockholders are much more capable of diversifying currency risk than
the management of the firm.
• Currency risk management does not add value to the firm, and it incurs
costs.
• Hedging might benefit corporate management more than shareholders.
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Opponents of Hedging (cont.)
Managers cannot outguess the market.
• If and when markets are in equilibrium with respect to parity conditions,
the expected NPV of the hedging is zero.
Management’s motivation to reduce variability is sometimes driven by
accounting reasons.
• However, 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.
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Proponents of Hedging
Reduction of risk in future cash flows improves the planning capability of the
firm.
• If the firm can more accurately predict future cash flows, it may be able
to undertake specific investments or activities that it might otherwise not
consider.
 Example of MERCK & Co. [Lewent and Kearney, 1990]
• External concerns were not important
• Internal concerns such as a “large proportion of overseas earnings and
cash flows” and the impact of cash flow volatility on MERCK’s strategic
plan (R&D) drove it to hedge against exchange risk
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Proponents of Hedging
Risk Profile of Investments (Agency Costs):
• Debtholders vs. Shareholders vs. Managers
• Shareholders hold an option on the value of the firm and would prefer riskier projects.
• Since, riskier projects reduce the value of bondholders’ claims, bondholders are likely
to require compensation in the form of a higher returns.
• If shareholders can credibly commit not to unduly increase risks, a lower cost of debt
financing could result.
• Additional sources of agency costs come from managers’ preference for less risky
projects (job security).
Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall
below a necessary minimum (and put the firm in financial distress).
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Hedging and Financial Distress
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Net Cash FlowExpected Value
Unhedged
HedgedPoint of
Financial
Distress
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Proponents of Hedging
Individuals and corporations do not have same access to hedging instruments
or same cost.
Management has a comparative advantage over the individual stockholder in
knowing the actual currency risk of the firm.
Hedging reduces expected cash flows if taxes are convex rather than linear
functions of income.
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More on Convex Tax
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Suppose that if income is ≤ $10m, your tax rate is 20%
> $10m, your tax rate is 40%
When you:
• Don’t Hedge, your taxes are expected to be:
Tax = 50%[($10m×20%)+($5m×40%)]
Tax = 50%($5m×20%)
• Hedge, your earnings will be $10m (50%*$15m+50%*5m) for certain.
In this case your taxes will be: E[Tax] = 100%($10m×20%)=$2m
Therefore, if we hedge so that earnings = $10 with probability 1, we reduce our expected tax
payment.
E(Tax) =$2.5mil
50%
50%
$15m
$5m
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“A Survey of Derivatives Usage by U.S.
Non-Financial Firms,” The Wharton School
and CIBC; July 1998.
Derivatives usage:
• 399 (20.7%) of 1,928 large U.S. non-
financial corporations responded.
• 50% admitted some use of derivatives.
• 83% of large firms
(’96 sales>$1.2bn)
• 12% of small firms
(’96 sales <$150m)
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Reasons for FX derivatives usage (frequently
+ sometimes):
• 89% hedge on Balance Sheet
commitments.
• 85% hedge anticipated transactions
within one year.
• 39% hedge longer term economic
exposure.
Extent of exposures hedged:
• 49% of on-BS commitments.
• 42% of anticipated transactions within
one year.
• 7% of economic exposure.
How Prevalent is Hedging
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The 2011 FTA Corporate Treasury Survey – Australia and NZ
by Stephen Gray and Kelvin Tan
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http://www.finance-treasury.com/newsletter/docs/FTA_2011_Corporate_Treasury_Survey.pdf
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The 2011 FTA Corporate Treasury Survey – Australia and NZ
by Stephen Gray and Kelvin Tan
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Chart 5: Foreign exchange instruments used
http://www.finance-treasury.com/newsletter/docs/FTA_2011_Corporate_Treasury_Survey.pdf
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Transaction exposure can be managed by contractual, operating, and
financial hedges:
Contractual Hedges employ the
• Forward, Options, and Money Markets
Operating and Financial Hedges employ the use of
• Risk-Sharing Agreements, Leads and Lags in Payment Terms,
Swaps and Other Strategies
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Hedging Transaction Exposure
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Contractual Hedging Techniques
Forward/Futures Hedge
Currency option hedge
• A way to hedge contingent exposure
Money Market hedge: Taking a money market position to hedge future
receivables/payables
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Hedging Techniques (cont.)
Hedging of Receivables
• Sell futures or forward
• Buy Put Option
• Money market hedge
1. borrow foreign currency to be
received
2. convert to domestic currency
3. invest for future use
(domestic currency)
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Hedging of Payables
• Buy futures or forward
• Buy Call Option
• Money market hedge
3. borrow domesticcurrency
2. convert to foreign currency
1. invest for future use
(foreign currency)
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An Example
Assume Boeing is expected to receive 10m GBP (£) in one years time
Available Information:
• one-year forward rate: US$1.46/£
• spot rate: US$1.50/£
• put option on pounds with strike of US$1.46 has a premium of US$0.02
• interest rates:
US: 6.10% per annum UK: 9.00% per annum
F = USD1.50/£∗ 1+0.061
1+0.09 =USD1.46/£
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B
ABA
t
BA
tt i
iSFIRP
+
+
=+ 1
1*: // 1,
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Boeing’s Forward Hedge
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Forward Hedge: By selling GBP forward, Boeing locks in the US$ receivable at $14.6m (£10m
* $1.46/£)
• Note: Gain/Loss from forward hedging: (F – ST) * FC hedged
Forward Hedge=Unhedged + Short Forward Payoff
Unhedged position
ST
F = $1.46
$14.6m
Value
Short Forward Payoff
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Boeing’s Options Hedge
Options Hedge: Long Put  Has the right to sell £ @ $1.46/GBP – will receive $14.6m if
exercised
Note: A premium of $200,000 (£10m * $0.02) was paid up-front.
We need to take into account time-value of money. Therefore, the upfront cost is actually
$212,200 ($200,000 * 1.061) in one years time.
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$14.6m
$14.38m
Forward Hedge
Option Hedge
= Long Put +Unhedged
X =
$1.46
ST* =
$1.48
Value
$212,200 Premium
Long Put - Premium
ST
Unhedged position
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Boeing’s Money Market Hedge
Money Market Hedge: Borrow (or lend) in the foreign currency to hedge its
foreign currency receivables (payables) – match FC assets & liabilities in the
same currency
• Borrow the PV of £10m at 9% (£ 9,174,312)
• Convert £ into $ at $1.50/£ ($13,761,468)
• Invest $ in the US at 6.1% for one year ($14,600,918)
• Collect £10m in one-year and repay the loan (the £ receivable offsets
the loan)
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Boeing’s Money Market Hedge
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$13,761,468
Pound money market
£9,174,000 £10,000,000× 1.09Start End
£ = 9.00 % per annum
US money market $14,600,918× 1.061
i us = 6.10 % per annum
£,,*
* Rounding error.
× = $./£ ÷ F ==USD1.46/£÷ F=USD1.50/£∗ 1+0.061
1+0.09
 Borrow the PV of £10m (£ 9,174,312)
 Convert £ into $ at $1.50/£ ($13,761,468)
 Invest $ in the US at 6.1% for one year
($14,600,918)
 Collect £10m in one-year and repay the
loan (the £ receivable offsets the loan)
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Alternate Hedging Strategies
• Risk Shifting
• Leading and lagging
• leading (accelerate timing of depreciating currency receivables)
• lagging (delay timing of appreciating currency receivables)
• Currency Risk Sharing
• Cross-hedging
• Currency diversification
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1.36
$1.33/£
1.30
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Hedging Positions with “Reverse Risk”
In the above examples, we used options to hedge a risk-free cash flow denominated in foreign
currency.
One can also use options to hedge foreign currency cash flows that are not certain – that is,
foreign currency cash flows that are conditional on other events.
Examples where inflows or outflows may be uncertain include the following:
• International tender offer bids
• Foreign exchange accounts receivable with substantial default risk
• Risky portfolio investment (e.g. corporate bond that defaults)
In each case, options are more flexible hedging devices than forwards and futures in the sense
that the forward contract must be exercised.
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Translation (Accounting) Exposure
Multinational corporations have foreign subsidiaries with assets and liabilities denominated in
many different currencies.
Financial statements need to be converted into the home currency when consolidated.
Exchange rate changes will alter the home-currency value of foreign subsidiaries assets and
liabilities and cash flows.
• Example: If the Chilean subsidiary of an Aust. firm deposits 10 million pesos in a Chilean
bank, then this would be reflected in the company’s consolidated accounts as $1m (if the
spot exchange rate is 10pesos/dollar).
If the peso depreciates (or dollar appreciates) to 12 pesos/dollar then this is a dollar asset of
$833,333.
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Translation Exposure (cont.)
Accounting Rules dictate how the translation takes place.
Translation rates:
• Current (exchange) rate
• Historical (exchange) rate
• Average (exchange) rate
The most common way to hedge is a balance sheet hedge in which the
company has equal amounts of assets and liabilities in each currency that offset
each other and leave the company without any translation exposure.
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Accounting Rules for Translation
Current/Non-current Method
Monetary/Non-monetary method
Temporal method
• Assets & liabilities: Translated at the historical exchange rate if they are recorded at
historical cost
• Revenue & expense items: Translated at the historical exchange rate or at the
average rate if there are multiple transactions of a similar nature
Current rate method
• Assets & liabilities: Translated at the current exchange rate
• Revenue & expense items: Translated at their historical rates (or at an average rate if
there are multiple transactions)