Chapter 11. Transaction Exposure

Transaction Exposure a measure of a firm s profitability, net cash flow, and market value because of a change in exchange rates. The task of the financial manager is to measure foreign exchange exposure and to manage it. 11-2

Exhibit 11.1 Conceptual Comparison of Transaction, Operating, and Translation Foreign Exchange Exposure 11-3

11.1 Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, this type of exposure deals with changes in cash flows resulting from existing contractual obligations. 11-4

Operating exposure also called economic exposure, competitive exposure, or strategic exposure measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates 11-5

The difference between the two transaction exposure is concerned with future cash flows already contracted for. while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness. 11-6

Translation exposure also called accounting exposure, is the potential for accounting-derived changes in owner s equity to occur because of the need to translate foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements. 11-7

Tax Exposure The tax consequence of foreign exchange exposure varies by country. As a general rule, however, only realized foreign exchange losses are deductible for purposes of calculating income taxes. Similarly, only realized gains create taxable income. Realized means that the loss or gain involves cash flows. 11-8

11.2 Why Hedge? MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging. 11-9

Definition of Hedging(P.284) Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position. While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against. 11-10

Why Hedge? Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows. 11-11

Exhibit 11.2 Impact of Hedging on the Expected Cash Flows of the Firm 11-12

Reasons Not to Hedge(P.285) Shareholders are much more capable of diversifying currency risk than the management of the firm Currency risk management does not increase the expected cash flows of the firm Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict) Managers cannot outguess the market 11-13

Reasons to Hedge (P.286) Reduction in risk in 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 (the point of financial distress) Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm Management is in better position to take advantage of disequilibrium conditions in the market 11-14

11.3 Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. 11-15

Exhibit 11.3 The Life Span of a Transaction Exposure 11-16

Measurement of Transaction Exposure Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. The main contractual hedges employ the forward, money, futures, and options markets. Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies. 11-17

Measurement of Transaction Exposure The term natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business. A financial hedge refers to either an offsetting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap. Care should be taken to distinguish operating hedges from financing hedges. 11-18

Trident s Transaction Exposure(P.289) With reference to Trident s Transaction Exposure, the CFO, Maria Gonzalez, has four alternatives: Remain unhedged; hedge in the forward market; hedge in the money market, or hedge in the options market. These choices apply to an account receivable and/or an account payable. 11-19

A Forward Hedge (P.290) A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date. This type of hedge is open or uncovered and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract. The purchase of such funds at a later date is referred to as covering. 11-20

Money Market Hedge In this instance, the contract is a loan agreement. The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. Funds to fulfill the contract to repay the loan may be generated from business operations, in which case the money market hedge is covered. Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge). 11-21

Option Market Hedge (P.294) Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk. The choice of option strike prices is a very important aspect of utilizing options as option premiums, and payoff patterns will differ accordingly. 11-22

Exhibit 11.5 Trident s Hedging Alternatives, Including an ATM Put Option 11-23

11.4 Risk Management in Practice The treasury function of most private firms, is usually considered a cost center. The treasury function is not expected to add profit to the firm s bottom line. Currency risk managers are expected to err on the conservative side when managing the firm s money. 11-24

Risk Management in Practice Firms must decide which exposures to hedge: Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures. 11-25

Risk Management in Practice As might be expected, transaction exposure management programs are generally divided along an option-line ; those that use options and those that do not. Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges. 11-26

Proportional Hedging (P.299) These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. The remaining portion of the exposure is then selectively hedged on the basis of the firm s risk tolerance, view of exchange rate movements, and confidence level. 11-27

Mini-Case Questions: Xian-Janssen Pharmaceutical How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures? 11-28

Mini-Case Questions: Xian-Janssen Pharmaceutical J&J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation in which XJP finds itself? 11-29

Mini-Case Questions: Xian-Janssen Pharmaceutical What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary s financial results by the U.S. parent company? If you were Paul Young, what would you do? 11-30

Exhibit 11.4 Valuation of Cash Flows by Hedging Alternative for Trident 11-31

Exhibit 11.6 Valuation of Hedging Alternatives for an Account Payable 11-32