14.1 Three types of exposure
It is conventional to classify foreign currency exposures into three types:
(1)Transaction exposure. Can be defined as the sensitivity of “realized” domestic currency values of the
firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Is
sometimes regarded as short-term economic exposure. Transaction exposure arises from fixed-price
contracting in a world where exchange rates are changing randomly.
(2)Economic exposure. Can be defined as the extent to which the value of the firm would be affected by
unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been
already discounted and reflected in the firm’s value.
(3)Translation exposure. Refers to the potential that the firm’s consolidated financial statements can be
affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial
statements from local currencies to the home currency. Resultant translation gains and losses represent
the accounting system’s attempt to measure economic exposure ex post. It doesn’t provide a good
measure of ex ante economic exposure.
Unlike economic exposure, transaction exposure is well defined: the magnitude of transaction exposure
is the same as the amount of foreign currency that is receivable or payable. This chapter will focus on
alternative ways of hedging transaction exposure using various financial contracts(forward market
hedge, money market hedge, option market hedge, and swap market hedge) and operational
techniques(choice of the invoice currency, lead/lag strategy, and exposure netting). It is useful to
introduce a particular business situation that gives rise to exposure. Boeing corporation exports a Boeing
737 to British Airways and billed £10 million payable in one year. The money market interest rates and
foreign exchanges rates are as follows: U.S. interest rate(6,10% per annum), U.K. interest rate(9% per
annum), the spot exchange rate($1.50/£), and the forward exchange rate($1,46/£, 1 year maturity).
14.2 Forward market hedge
Generally speaking, the firm may sell (buy) its foreign currency receivables (payables) forward to
eliminate its exchange risk exposure. This will result in bringing £10 million to the bank, this will be
multiplied by the forward exchange rate, 1,46, which will make $14.6 million. Since Boeing is assured of
receiving a given dollar amount from the counter-party of the forward contract, the dollar proceeds from
this British sale will not be affected at all by future changes in the exchange rate. If the spot rate is 1.4$/£
at the time of paying then Boeing gained $0.6 ex post by using forward market hedge. Gain = (F-St) *
amount of money involved. St is the spot rate at maturity date. Whether the firm actually hedges or not
depends on risk aversion. The firm can use a currency futures contract, rather than a forward contract,
to hedge. However, a futures contract isn’t as suitable as a forward contract for hedging purpose for two
reasons: (1)Unlike forward contracts that are tailor-made to the firm’s specific needs, futures contracts
are standardized instruments in terms of contract size, delivery date, and so forth. (2)Due to the
marking-to-market property, there are interim cash flows prior to the maturity date of the futures
contract that may have to be invested at uncertain interest rates. Because of these two reasons hedging
can only be done approximately.
14.3 Money market hedge
Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money
markets.
,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. Boeing can eliminate the exchange
exposure arising from the British sale by first borrowing in pounds, then converting the loan proceeds
into dollars, which then can be invested at the dollar interest rate. On the maturity date of the loan,
Boeing is going to use the pound receivable to pay off the pound loan. If Boeing borrows a particular
pound amount so that the maturity value of this loan becomes exactly equal to the pound receivable
from the British sale, Boeing’s net pound exposure is reduced to zero, and Boeing will receive the future
maturity value of the dollar investment. Read example page 454-455.
14.4 Options market hedge
One possible shortcoming of both forward and money market hedges is that these methods completely
eliminate exchange risk exposure. Consequently, the firm has to forgo the opportunity to benefit from
favorable exchange rate changes. Options market hedge involves a firm that buys a foreign currency call
(put) option to hedge its foreign currency payables (receivables). See example page 456-457.
14.5 Hedging foreign currency payables
In this section we will discuss how to hedge foreign currency “payables.” Suppose Boeing imported a
Rolls-Royce jet engine for £5 million payable in one year. The following market conditions exist: the U.S.
interest rate(6,00% per annum), the U.K. interest rate(6,50% per annum), the spot exchange
rate($1.8/£), and the forward exchange rate($1.75/£, 1 year maturity). Three ways: forward contracts,
money market instruments, and currency options contracts.
Forward contracts
Use £5 million to buy $8.75 million using the forward exchange rate. On the maturity date, Boeing
receives £5 million from the counter-party of the contract in exchange for $8.75 million. Boeing can pay
£5 million to Rolls-Royce then.
Money market instruments
Boeing should first compute the present value of its foreign currency payable, that is £5 billion/1.065 =
£4,694,836. It should immediately invest the same amount at the British interest rate of 6.5%. Then it is
assured of having £5 million in one year, and Boeing can pay off its pound payable. Under this money
market hedging, Boeing has to outlay a certain dollar amount today in order to buy spot the pound
amount that needs to be invested. £4,694,836 * $1.8/£ = $8,450,705. The future value of this dollar cost
of buying the necessary pound amount is computed by $8,450,705 * 1.06 = $8,957,747. Which exceeds
the dollar cost of securing £5 million under forward hedging. Since Boeing will have to try to minimize
the dollar cost of securing the pound amount, forward hedge would be preferable.
Currency options contract
Read example page 459.
14.6 Cross-hedging minor currency exposure
If a firm has receivables or payables in major currencies, it can easily use the techniques explained
above, but if the firm has positions in less liquid currencies, it may be either very costly or impossible to
use financial contracts in these currencies.
,This is because financial markets of developing countries are relatively underdeveloped and often highly
regulated. Cross-hedging techniques may be used to manage its minor currency exposure. It involves
hedging a position in one asset by taking a position in another asset. Suppose a U.S. firm has an account
receivable in Korean won and it would like to hedge its won position. This can be very costly. However,
since the won/dollar exchange rate is highly correlated with the yen/dollar exchange rate, the U.S. firm
may sell a yen amount, which is equivalent to the won receivable, forward against the dollar thereby
cross-hedging its won exposure. The effectiveness depend on the stability and strength of the won/yen
correlation.
Benet(1990) suggest that commodity futures contracts may be used effectively to cross-hedge some
minor currency exposure. Suppose the dollar price of the Mexican Peso is positively correlated to the
world oil price. Then, a firm may use oil futures contracts to manage its peso exposure. The firm can sell
(buy) oil futures if it has peso receivables (payables). The effectiveness depends on the strength and
stability of the relationship between the exchange rate and the commodity futures prices.
14.7 Hedging contingent exposure
Options contract can also provide an effective hedge against what might be called contingent exposure.
This term refers to a situation in which the firm may or may not be subject to exchange exposure.
Suppose GE motors is bidding on a project on Canada. If the bid is accepted, which will be known in three
months, GE is going to receive C$100 million to initiate the project. Forward hedging isn’t effective,
because if the bid is rejected, GE motors has an unhedged short position in Canadian dollars. A “do-
nothing” technique doesn’t guarantee a satisfactory outcome. An alternative approach is to buy a three-
month put option on C$100 million. In this case there are four possible outcomes:
(1)The bid is accepted and the spot exchange rate turns out to be less than the exercise rate. The firm
will simply exercise the put option and convert C$100 million at the exercise rate.
(2)The bid is accepted and the spot exchange rate turns out to be greater than the exercise rate. The firm
will let the put option expire and convert C$100 million at the spot rate.
(3)The bid is rejected and the spot exchange rate turns out to be less than the exercise rate. The firm will
exercise the put option and make a profit.
(4)The bid is rejected and the spot turns out to be greater than the exercise rate. The firm will simply let
the put option expire.
14.8 Hedging recurrent exposure with swap contracts
Recurrent cash flows in foreign currency can best be hedged using a currency swap contract, which is an
agreement to exchange one currency for another at a predetermined exchange rate, that is, the swap
rate, on a sequence of future dates. As such, a swap contract is like a portfolio of forward contracts with
different maturities. Suppose Boeing should deliver an aircraft to British Airways every December 1 of
each year for five years, starting 1996. Boeing faces a sequence of exchange risk exposures. Boeing can
hedge this type of exposure using a swap agreement by which Boeing delivers £10 million to the
counterparty of the contract on December 1 of each year for five years and takes delivery of a
predetermined dollar amount each year. If the swap exchange rate is $1.5/£ then Boeing receives $15
million each year, regardless of future spot and forward rates. The sequence of five forward years will
not be uniform priced, but will be different for different maturities. Longer-term forward contracts are
not readily available.
,14.9 Hedging through invoice currency
The firm can shift, share, or diversify exchange risk by appropriately choosing the currency of invoice. For
instance, if Boeing invoices $15 million instead of £10 million, it doesn’t face exchange exposure
anymore. It had shifted to British Airways. Another option is half of the money in $ and half of the money
in £. As a practical manner, the firm may not be able to use risk shifting or sharing as much as it wishes
for fear of losing sales to competitors. If the currencies of both the exporter and the importer are not
suitable for settling international trade, neither party can resort to risk shifting/sharing to deal with
exchange exposure. The firm can diversify exchange exposure to some extent by using currency basket
units such as the SDR as the invoice currency. The SDR comprises four individual currencies, the U.S.
dollar, the euro, the Japanese yen, and the British pound. It should be more stable than the value of the
individual currencies, because it is a portfolio of the four currencies together. It can be a useful
technique especially for long-term exposure for which no forward or options contracts are readily
available.
14.10 Hedging via lead and lag
To lead means to pay or collect early, whereas to lag means to pay or collect late. The firm would like to
lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of
the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm
will attempt to lead the hard currency payables and lag soft currency payables. Suppose Boeing would
like British Airways to prepay £10 million, because of likely depreciation of sterling. This may encounter
difficulties: (1)British Airways would like to lag this payment, which is denominated in the soft
currency(the pound), and thus has no incentive to prepay unless Boeing offers a substantial discount to
compensate for the prepayment. (2)Pressing British Airways for prepayment can hamper future sales
efforts by Boeing. (3)To the extent that the original invoice price incorporates the expected depreciation
of the pound, Boeing is already partially protected against the depreciation of the pound. The lead/lag
strategy can be employed more effectively to deal with intrafirm payables and receivables among
subsidiaries of the same corporation.
14.11 Exposure netting
A firm which has both receivables and payables in a given foreign currency should consider hedging only
in its net exposure. If the firm has a portfolio of currency positions, it makes sense to hedge residual
exposure rather than hedge each currency position separately. If exposure netting is applied
aggressively, it helps to centralize the firm’s exchange exposure management function in one location.
Many multinational corporations are using a reinvoice center, a financial subsidiary, as a mechanism for
centralizing exposure management functions. All the invoices arising from intrafirm transactions are sent
to the reinvoice center, where exposure is netted. Once the residual exposure is determined, the foreign
exchange experts at the center determine optimal hedging methods and implement them.
14.12 Should the firm hedge?
There exists hardly a consensus about this. Some would argue that exchange exposure management at
the corporate level is redundant when stockholders can manage the exposure themselves. Others argue
that what matters in the firm valuation is only systematic risk; corporate risk management may only
reduce the total risk. These arguments suggest that corporate exposure management would not
necessarily add to the value of the firm.
, While the above arguments against corporate risk management may be valid in a “perfect” capital
market, one can make a case for it based on various market imperfections:
(1)Information asymmetry: Management knows about the firm’s exposure position much better than
stockholders. Thus management should manage exchange exposure.
(2)Differential transaction costs. The firm is in a position to acquire low-cost hedges; transaction costs for
individual stockholders can be substantial. Also, the firm has hedging tools like the reinvoice center that
are not available to stockholders.
(3)Default costs. If this is significant, corporate hedging would be justifiable because it will reduce the
probability of default. Perception of a reduced default risk can lead to a better credit rating and lower
financing costs.
(4)Progressive corporate taxes. Then, stable before-tax earnings lead to lower corporate taxes than
volatile earnings with the same average value. This happens because under progressive tax rates, the
firm pays more taxes in high-earning periods than it saves in low-earnings periods. See example page 464
14.13 What risk management products do firms use?
On the basis of a survey of Fortune 500 firms, they found that the traditional forward contract is the
most popular product. About 93% used this. The next commonly used instruments are foreign currency
swaps(52.6%), and over-the-counter currency options(48,8%). Recent innovations as compound
options(3.8%), and look-back options(5.1%) are among the least extensively used instruments.
The Jesswein, Kwok, and Folks survey also shows that, among the various industries, the
finance/insurance/real estate industry stands out as the most frequent user of exchange risk
management products. This industry has more finance experts who are skillful at using derivative
securities. Also, this industry handles mainly financial assets, which tend to be exposed to exchange risk.
The survey further shows that the corporate use of foreign exchange risk management products is
positively related to the firm’s degree of international involvement. Not surprising, because as the firm
becomes more internationalized through cross-border trade and investments, it is likely to handle an
increasing amount of foreign currencies, giving rise to a greater demand for exchange risk hedging.
Marshall(2000) documented that U.K. and U.S. firms show relatively similar patterns of using various
currency derivative contracts to manage exposure. But Asian firms show somewhat different patterns.
Most multinational firms use currency forward contracts, regardless of their domiciles. But the use of
currency futures and options contracts is substantially more popular among Asian multinationals,
especially Japanese and Singaporean, than among U.K. and U.S. multinationals. The survey further shows
that regardless of the domiciles, multinationals extensively use such operational techniques as netting,
matching, and leading and lagging to manage transaction exposure. The survey also suggests that many
multinational firms use a combination of operational techniques and financial contracts to deal with
transaction exposure.
15.1 Introduction
U.S. dollar depreciation against the Japanese yen can have significant economic consequences for both
U.S. and Japanese firms. It can seriously affect the competitive position of firms. Changes in exchange
rates also affect purely domestic firms. For example when these firms have to compete against firms
who import from the U.S.
