International Financial Management

11th Edition
by Jeff Madura

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 11 Managing Transaction Exposure
Chapter Objectives

 Compare the techniques commonly used to hedge

payables
 Compare the techniques commonly used to hedge
receivables
 Describe limitations of hedging
 Suggest other methods of reducing exchange rate risk
when hedging techniques are not available

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 Policies for Hedging Transaction Exposure

 Hedging Most of the Exposure

Hedging most of the transaction exposure allows MNCs
to more accurately forecast future cash flows (in their
home currency) so that they can make better decisions
regarding the amount of financing they will need.
 Selective Hedging
 MNC must identify its degree of transaction
exposure.
 MNC must consider the various techniques to hedge
the exposure so that it can decide which hedging
technique is optimal and whether to hedge its
transaction exposure.
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 Hedging Exposure to Payables

An MNC may decide to hedge part or all of

its known payables transactions using:
 Futures hedge
 Forward hedge
 Money market hedge
 Currency option hedge

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 Forward or Futures Hedge on Payables

Allows an MNC to lock in a specific exchange rate at

which it can purchase a currency and hedge payables. A
forward contract is negotiated between the firm and a
financial institution. The contract will specify the:
 currency that the firm will pay
 currency that the firm will receive
 amount of currency to be received by the firm
 rate at which the MNC will exchange currencies
(called the forward rate)
 future date at which the exchange of currencies will
occur

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 Money Market Hedge on Payables

 Involves taking a money market position to

cover a future payables position.
 If a firm prefers to hedge payables without
using its cash balances, then it must
 Borrow funds in the home currency and
 Invest in a short-term instrument in the
foreign currency

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 Call Option Hedge on Payables

 A currency call option provides the right to

buy a specified amount of a particular
currency at a specified strike price or
exercise price within a given period of time.
 The currency call option does not obligate its
owner to buy the currency at that price. The
MNC has the flexibility to let the option expire
and obtain the currency at the existing spot
rate when payables are due.

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 Cost of Call Options

 Based on contingency graph (Exhibit 11.1)

 Advantage: provides an effective hedge
 Disadvantage: premium must be paid
 Based on currency forecast (Exhibit 11.2)
 MNC can incorporate forecasts of the spot rate to more
accurately estimate the cost of hedging with call options.
 Consideration of Alternative Call Options
 Several different types of call options may be available,
with different exercise prices and premiums for a given
currency and expiration date.
 Whatever call option is perceived to be most desirable for
hedging a particular payables position would be analyzed,
so that it could then be compared to the other hedging
techniques.
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 Exhibit 11.1 Contingency Graph for Hedging Payables With
Call Options

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 Exhibit 11.2 Use of Currency Call Options for Hedging Euro
Payables (Exercise Price = $1.20, Premium = $.03)

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 Comparison of Techniques to Hedge Payables

 The cost of the forward hedge or money

market hedge can be determined with
certainty
 The currency call option hedge has
different outcomes depending on the
future spot rate at the time payables are
due.

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 Exhibit 11.3 Comparison of Hedging Alternatives for
Coleman Co.

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 Optimal Technique for Hedging Payables

1. Select optimal hedging technique by:

a. Consider whether futures or forwards are preferred.
b. Consider desirability of money market hedge versus
futures/forwards based on cost.
c. Assess the feasibility of a currency call option based on
estimated cash outflows.
2. Choose optimal hedge versus no hedge for
payables
a. Even when an MNC knows what its future payables will
be, it may decide not to hedge in some cases.
3. Evaluate the hedge decision by estimating the
real cost of hedging versus the cost if not hedged.
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 Exhibit 11.4 Graphic Comparison of Techniques to
Hedge Payables

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 Hedging Exposure to Receivables

1. Forward or futures hedge allows the MNC to

lock in the exchange rate at which it can sell a
specific currency.
2. Money market hedge involves borrowing the
currency that will be received and using the
receivables to pay off the loan.
3. Put option hedge on receivables provides the
right to sell a specified amount of a particular
currency at a specified strike price by a
specified expiration date.

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 Cost of Put Options

1. Based on Contingency Graph (Exhibit

11.5)
a. Advantage: provides an effective hedge
b. Disadvantage: premium must be paid
2. Based on Currency Forecasts (Exhibit
11.6)
a. MNC can use currency forecasts to more
accurately estimate the dollar cash inflows to
be received when hedging with put options.

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 Exhibit 11.5 Contingency Graph for Hedging Receivables with
Put Options

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 Exhibit 11.6 Use of Currency Put Options for Hedging Swiss
Franc Receivables (Exercise Price = $.72; Premium = $.02)

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 Comparison of Techniques for Hedging Receivables

1. Optimal Technique for Hedging Receivables:

a. Consider whether futures or forwards are preferred.
b. Consider desirability of money market hedge versus
futures/forwards based on cost.
c. Assess the feasibility of a currency put option based
on estimated cash outflows.
2. Choose optimal hedge versus no hedge for
receivables
3. Evaluate the hedge decision by estimating the
real cost of hedging receivables versus the cost
of receivables if not hedged.

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 Exhibit 11.7 Comparison of Hedging Alternatives for Viner Co.

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 Exhibit 11.8 Graph Comparison of Techniques to Hedge
Receivables

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 Exhibit 11.9 Review of Techniques for Hedging Transaction
Exposure

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 Limitations of Hedging

 Limitation of Hedging an Uncertain Payment

Some international transactions involve an
uncertain amount of foreign currency, leading to
overhedging.
 Limitation of Repeated Short-Term Hedging
The continual short-term hedging of repeated
transactions may have limited effectiveness.
 Long-term Hedging as a Solution
Some banks offer forward contracts for up to 5
years or 10 years on some commonly traded
currencies.
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 Exhibit 11.10 Illustration of Repeated Hedging of Foreign
Payables When the Foreign Currency Is Appreciating

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 Exhibit 11.11 Long-Term Hedging of Payables When the
Foreign Currency Is Appreciating

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 Alternative Hedging Techniques

 Leading and Lagging: adjusting the timing of a

payment or disbursement to reflect expectations
about future currency movements.
 Cross-Hedging: hedging by using a currency
that serves as a proxy for the currency in which
the MNC is exposed.
 Currency Diversification: reduce exposure by
diversifying business among numerous
countries.

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 SUMMARY

 An MNC may choose to hedge most of its transaction

exposure or to selectively hedge. Some MNCs hedge
most of their transaction exposure so that they can more
accurately predict their future cash inflows or outflows
and make better decisions regarding the amount of
financing they will need. Many MNCs use selective
hedging, in which they consider each type of transaction
separately.
 To hedge payables, a futures or forward contract on the
foreign currency can be purchased. Alternatively, a
money market hedge strategy can be used; in this case,
the MNC borrows its home currency and converts the
proceeds into the foreign currency that will be needed in
the future. Finally, call options on the foreign currency
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can bein apurchased.
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 SUMMARY (Cont.)

 To hedge receivables, a futures or forward contract on

the foreign currency can be sold. Alternatively, a money
market hedge strategy can be used. In this case, the
MNC borrows the foreign currency to be received and
converts the funds into its home currency; the loan is to
be repaid by the receivables. Finally, put options on the
foreign currency can be purchased.
 When hedging techniques are not available, there are
still some methods of reducing transaction exposure,
such as leading and lagging, cross-hedging, and
currency diversification.

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 SUMMARY (Cont.)

 The currency options hedge has an advantage over the

other hedging techniques in that the options do not have
to be exercised if the MNC would be better off
unhedged. A premium must be paid to purchase the
currency options, however, so there is a cost for the
flexibility they provide. One limitation of hedging is that if
the actual payment on a transaction is less than the
expected payment, the MNC overhedged and is partially
exposed to exchange rate movements.

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 SUMMARY (Cont.)

Alternatively, if an MNC hedges only the minimum

possible payment in the transaction, it will be partially
exposed to exchange rate movements if the transaction
involves a payment that exceeds the minimum. Another
limitation of hedging is that a short-term hedge is only
effective for the period in which it was applied. One
potential solution to this limitation is for an MNC to use
long-term hedging rather than repeated short-term
hedging. This choice is more effective if the MNC can be
sure that its transaction exposure will persist into the
distant future.

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