Chapter 14 Transaction Exposure to Currency Risk


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Chapter 14 Transaction Exposure to Currency Risk

  • 14.1 An Example of Transaction Exposure to Currency Risk
  • 14.2 Managing Transaction Exposure Internally
    • Multinational netting
    • Leading and lagging
  • 14.3 Managing Transaction Exposure in the Financial Markets
    • Currency forwards
    • Currency futures
    • Money market hedges
    • Currency options
    • Currency swaps
  • 14.4 Summary

Economic exposure to currency risk

  • Economic exposure  change in firm value due to unexpected changes in exchange rates
  • Transaction exposure
        • change in the value of contractual cash flows
        • change in the value of monetary assets and liabilities
  • Operating exposure
        • change in the value of noncontractual cash flows
        • change in the value of real assets
  • Real
  • assets
  • Monetary
  • assets
  • Common
  • equity
  • Monetary
  • liabilities

A survey of corporate treasurers

  • Do you agree or disagree with the following statements?
  • Mean score
  • “Managing transaction exposure is important.” 1.4
  • “Managing economic exposure is important.” 1.8
  • “Managing translation exposure is important.” 2.4
  • Key: 1= strongly agree, ... 3=neutral, ... 5= strongly disagree
  • Source: Kurt Jesswein, Chuck C.Y. Kwok, William R. Folks, Jr., “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance, Fall 1995.
  • Transaction exposure is viewed as the most important currency risk exposure

Currency risk versus currency risk exposure

  • sd/f
  • Rd/f
  • sd/f
  • Currency risk
  • Currency risk exposure

Exposure to foreign exchange risk (contract price FF40,000)

  • Expected receipt in francs
  • at E[S1$/FF] = $0.25/FF
  • Actual exchange
  • S1$/FF = $0.20/FF
  • Net loss from
  • original position
  • Risk (or payoff) profile
  • of underlying exposure
  • V$/FF
  • S$/FF
  • -$0.05/FF
  • -$0.05/FF
  • FF40,000  +$10,000 at $0.25/FF
  • FF40,000  +$8,000 at $0.20/FF
  • $2,000

Currency hedging with forwards (contract price FF40,000)

  • Buy $10,000 forward $10,000
  • at F$/FF = $0.25/FF
  • Sell FF40,000 forward FF40,000
  • Market exchange of FF +$8,000
  • for $ at S$/FF = $0.20/FF
  • FF40,000
  • Net gain on forward +$2,000
  • Risk (or payoff) profile
  • of forward contract
  • V$/FF
  • S$/FF
  • -$0.05/FF
  • $0.05/FF

Net currency exposure

  • Underlying position
  • (long francs)
  • Sell francs forward
  • (short francs and long dollars)
  • Net position
  • Net exposure
  • V$/FF
  • long francs
  • S$/FF
  • short francs
  • FF40,000
  • $10,000
  • FF40,000
  • $10,000

Managing transaction exposure

  • Managing transaction exposure internally
    • leading and lagging
    • currency diversification and multinational netting
  • Managing transaction exposure in financial markets
    • currency forwards
    • money market hedges
    • futures
    • options
    • swaps

Multinational netting

Cash flows before multinational netting

Cash flows after multinational netting

Leading and lagging

  • Timing of cash flows within the corporation to offset underlying currency exposures.
    • Leading - If a U.S. parent is short euros, the parent can accelerate euro repatriations from its European affiliates.
    • Lagging - If a U.S. parent is long euros, the parent can accelerate euro payments to its European affiliates.
  • Like multinational netting, leading and lagging works best when the currency needs of the individual units within the corporation offset one another.

Financial market instruments used to hedge currency risk

  • Currency forward contracts
  • Advantages
        • Currency forwards can provide a perfect hedge of transactions of known size and timing
  • Disadvantages
        • Bid-ask spreads can be large on long-dated contracts or infrequently traded currencies
        • A pure credit instrument, so currency forward contracts have credit risk

Financial market instruments used to hedge currency risk

  • Currency futures contracts
  • Advantages
        • Low cost if the currency and maturity match the underlying exposure
        • Low credit risk because of daily marking-to-market
  • Disadvantages
        • Exchange-traded futures come in limited currencies and maturities
        • Daily marking-to-market can cause a cash flow mismatch

Financial market instruments used to hedge currency risk

  • Money market hedges
  • Advantages
        • Forward positions can be built in currencies for which there are no forward currency markets
  • Disadvantages
        • Relatively expensive hedge
        • Might not be feasible if there are contraints on borrowing or lending

Financial market instruments used to hedge currency risk

  • Currency option contracts
  • Advantages
        • Disaster hedge insures against unfavorable currency movements
  • Disadvantages

Financial market instruments used to hedge currency risk

  • Currency swap contracts
  • Advantages
        • Quickly transforms liabilities into other currencies or payout structures (e.g., fixed vs. floating)
        • Low cost for plain vanilla swaps in actively traded currencies
        • Able to hedge long-term exposures
  • Disadvantages
        • Not the best choice for near-term exposures
        • Innovative or exotic swaps can be expensive

Corporate use of currency risk management products

  • Used Used Used once Never
  • Type of product often sometimes or twice heard of
  • Forward contracts 72.3% 17.9% 2.9% 0.0%
  • Foreign currency swaps 16.4 17.0 19.3 1.2
  • OTC currency options 18.8 19.4 10.6 6.5
  • Currency futures contracts 4.1 10.7 5.3 1.2
  • Exchange-traded
  • currency (spot) options 3.6 6.5 7.1 3.6
  • Exchange-traded
  • futures options 1.8 3.0 4.2 4.2
  • Foreign currency warrants 1.8 1.2 1.2 22.3
  • Cylinder options 7.0 9.9 11.7 8.8
  • Synthetic forwards 3.0 8.9 10.1 12.5
  • Source: Jesswein, Kwok, and Folks, “What New Currency Risk Products Are Companies Using and Why?” Journal of Applied Corporate Finance 8, Fall 1995, pages 115-124.


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