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Transaction Exposure
Transaction exposure arises when a firm faces contractual cash

flows that are fixed in a foreign currency - Receive or pay a fixed amount of foreign currency in the future
i.e. any receivable (AR), or payable (AP) in a foreign currency.

Receive or pay a fixed amount of foreign currency in the future, Source of currency risk from transaction exposure for MNC

could be either: a) export/import activities, or b) borrowing/lending activities - anytime future CFs (to be paid or received) are fixed in a foreign currency.

Internal & external Techniques of Exposure Management

Currency Invoicing
The firm can shift, share, or diversify exchange risk by

appropriately choosing the currency of invoice.

Example Assume that Boeing has a contract to build five 747s for British Airways, and deliver one each year for the next 5 years, and receive 10m per plane. a) If Boeing can invoice in USD, then it has eliminated currency risk for itself and shifted it to British Airways. Now if S = $1.50/, British Airways has a $15m AP and Boeing has a $15m AR

Currency Invoicing
b) Boeing could share the currency risk with British

Airways by invoicing 50% in USD and 50% in BP: $7.5m + 5m for each plane, and each company shares half the risk. " c) Invoice in a basket of currencies to diversify and reduce currency risk with a portfolio of currencies: e.g. SDRs ($, , , ; weights are 44%, 34%, 11%, 11%) or in the past, ECUs (11 currencies). Companies can issue bonds denominated in SDRs or ECU (prior to euro) to diversify risk, Egyptian govt. charges fees in SDRs for passage through the Suez Canal. Invoicing in currency baskets can be a useful hedging tool when no forward or currency contracts are available

Exposure Netting
A multinational firm should not consider deals in

isolation, but should focus on hedging the firm as a portfolio of currency positions.

As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won Even if its not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.

Exposure Netting
Many multinational firms use a reinvoice center.

Which is a financial subsidiary that nets out the intrafirm transactions.

Once the residual exposure is determined, then the

firm implements hedging.

Exposure Netting: An example Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$20 $30 $40 $10 $35 $25 $20 $30 $60

$10

$30 $40

Exposure Netting

$10 $20 $25 $15

$10

$10

 Leading and lagging FX transactions -Leading

Changing

the timing of a cash flow so that it takes place prior to the originally agreed date
If

foreign currency appreciates, lead/lag the payable/receivable

the timing of an existing FX cash flow

-Lagging
Delaying

If

foreign currency depreciates, lag/lead the payable/receivable

-Need to assess costs/impact of strategies, e.g. unpredictable payment behavior

Used in intra firm payables and receivables, such as material

costs, rents, royalties, interests, and dividends, among subsidiaries of the same multinational corporation
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Currency Risk Sharing

Developing a customized hedge contract The contract typically takes the form of a Price

Adjustment Clause, whereby a base price is adjusted to reflect certain exchange rate changes
Parties would share the currency risk beyond a neutral

zone of exchange rate changes

The neutral zone represents the currency range in

which risk is not shared

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The Zone
Take no actions

$1.50/

$1.60/

Take no action

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1. 2. 3.

Forward Market Hedge Currency Futures Hedge Money Market Hedge

4. Options Market Hedge

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Forward Market Hedge

An over-the-counter contract between parties to exchange currency at an agreed exchange rate, to be paid or received on an obligation at a specified future date.

If you are going to owe foreign currency in the future, agree to

buy the foreign currency now by entering into long position in a forward contract.
If you are going to receive foreign currency in the future, agree to

sell the foreign currency now by entering into short position in a forward contract.
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Currency Futures Hedge

A currency futures contract is a transferable futures

contract that specifies the price at which a currency can be bought or sold at a future date
Currency future contracts allow investors to hedge

against foreign exchange risk

Unlike forward contracts that are tailor made to the

firms specific needs, futures contracts are standardized instruments in terms of contract size, delivery date, and so forth.
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Money Market Hedge

The use of borrowing and lending transactions in foreign

currencies to lock in the home currency value of a foreign currency transaction

The firm may borrow (lend) in foreign currency to hedge

its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.

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Options Market Hedge

A contract that grants the holder the right, but not the

obligation, to buy or sell currency at a specified exchange rate during a specified period of time
For this right, a premium is paid which will vary

depending on the number of contracts purchased

Currency options are one of the best ways for

corporations or individuals to hedge against adverse movements in exchange rates.

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Translation Exposure
It arises from the need, for purposes of reporting

and consolidation, to convert the results of foreign operations from the local currency to the home currency.
Paper exchange gains or losses Retrospective in nature Short-term in nature

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Measuring Translation Exposure

The difference between exposed assets and exposed

liabilities.
Exposed assets and liabilities are translated at the

current exchange rate.

Non-exposed assets and liabilities are translated at the

historical exchange rate.

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Translation Methods
Current/Noncurrent Method
Monetary/Nonmonetary Method Temporal Method Current Rate Method

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Current/Noncurrent Method
The underlying principal is that assets and liabilities

should be translated based on their maturity.

Current assets translated at the spot rate.
Noncurrent assets translated at the historical rate in

effect when the item was first recorded on the books.

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Monetary/Nonmonetary Method
The underlying principal is that monetary accounts

have a similarity because their value represents a sum of money whose value changes as the exchange rate changes
All monetary balance sheet accounts (cash, marketable

securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate.
All other (nonmonetary) balance sheet accounts

(owners equity, land) are translated at the historical exchange rate in effect when the account was first recorded.
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Operating Exposure - Introduction

Also known as Economic Exposure, Competitive

Exposure & Strategic Exposure

Measures a change in the present value of a firm

resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates
Arises when a firm invests in new product

development, establishes foreign supply contracts, manufactures products abroad, etc

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 Measuring and managing operating exposure is a

long-run philosophy
Suppose:

PV = present value of the firm; PV = change in present value of the firm; S = change in exchange rate
If PV/S 0, then the firm is exposed to currency

risk
Firms exporting or competing with imports are at a

disadvantage when the home currency appreciates, and vice versa

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Operating Exposure - Example

US and 1 in France

Suppose /$ exchange rate is 1.0. Hence an Apple costs $1 in

Euro depreciation to 1.20 increases the cost to 1.20 if the

exporter does not adjust the $

Demand for the Apple in France will go down due to 20%

hike in price
If price in France is kept at 1, then the exporter receives

1/1.20 = $0.83 for the Apple

In practice, we are somewhere in between these two

extremes
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Managing Operating Exposure

The following techniques are used:
1.

Marketing Managment

2. Production Managment 3. Financial Hedging

4. Proactive Managment
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The marketing manager analyzes the effect of a change in

the exchange rate and evaluates the strategy required to manage the exposure. The four strategies available:
Market selection,

Pricing strategy,
Promotional strategy, and

Product strategy.
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 Market Selection
Involves selection of the markets in which the firm

wishes to market its products and providing relevant

services to provide the firm an edge in these markets
This strategy is useful when the actual or anticipated

change in the real exchange rate is likely to persist for a medium/long time
The decision also depends on the fixed cost associated

with establishing or increasing market share

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Pricing Strategy
Frequency of price adjustments:
Exchange rates move even on a minute-to-minute basis. A

firms sales may get affected by frequent price changes

On the other hand, a firm may lose on account of unfavorable

exchange rate movements if it delays the change in the price

of its product
Finally, a balance between the two needs to be arrived at: level of uncertainty the firms customers are ready to face duration for which the exchange rate movement is likely to

persist
loss expected to be incurred by not changing the prices
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Promotional Strategy
Essential issue in any marketing program - promotional

budget
Change in the exchange rate would change the domestic-

currency cost of overseas promotion

Effect of exchange rate movements on promotional costs is

also in the form of the expected revenues that can be

generated per unit of expenditure on promotion

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Product Strategy
Timing of introduction of new products Introduce a new product when there is a price

advantage(e.g. in case of an exporting firm, when the domestic currency has depreciated) Hold back the products from the market when the conditions are not favorable
Product Innovation

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Production Strategies
Exchange rate movements are too large and long

lasting
Marketing strategies are not effective Long-term decisions to protect the firm from harmful

effects of an unfavorable exchange rate movement Strategies

Product sourcing
Plant location
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Product Sourcing
Distribute production among different production

centers(in different countries)

Firm can reallocate production to increase the

quantity produced in the country whose currency has

depreciated, and reducing production in countries

whose currency has appreciated
Due to this flexibility, an MNC faces less economic

exposure than a company having production facilities in only one country

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Plant Location
Companies, which do not have multiple production

facilities, may be forced to set up such facilities abroad as a response to exchange rate movements (which change the relative cost advantages of countries)
Firms may even decide to set up production facilities

in third-world countries for labor-intensive products due to the low labor cost there, without there being any specific advantage due to exchange rate movements
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Financial Hedging
It involves the use of currency swaps, currency futures,

currency forwards, and currency options

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Proactive Managment
Its generally a long term hedging tool Some of the commonly used Proactive policies are: 1.
2.
3. 4.

Matching currency cash flows

Risk-sharing agreements
Back-to-Back Loans Currency Swaps

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Matching Currency Cash Flows

One way to offset an anticipated continuous exposure

to a particular currency is to acquire debt denominated in that currency

This policy results in a continuous receipt of payment

and a continuous outflow in the same currency

This can sometimes occur through the conduct of

regular operations and is referred to as a natural hedge

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Risk Sharing Agreements

Risk-sharing is a contractual arrangement in which the

buyer and seller agree to share or split currency movement impacts on payments

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Back-to-Back Loans
Also referred to as a parallel loan or credit swap, occurs

when two firms in different countries arrange to borrow each others currency for a specific period of time
The operation is conducted outside the FOREX

markets, although spot rates may be used to decide the equivalent amount
This swap creates a covered hedge against exchange

loss, since each company, on its own books, borrows the same currency it repays
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Currency Swaps
Also called a cross-currency swap Currency swaps resemble back-to-back loans except that it

does not appear on a firms balance sheet

In a currency swap, a dealer and a firm agree to exchange an

equivalent amount of two different currencies for a specified period of time

Currency swaps can be negotiated for a wide range of

maturities

A typical currency swap requires two firms to borrow funds

in the markets and currencies in which they are best known or get the best rates
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ANY QUERIES?

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