Transaction Exposure
Transaction Exposure
Transaction Exposure
TRANSACTION EXPOSURE
Structure
8.0 Objectives
8.1 Introduction
8.2 Concept and Measurement of Transaction Exposure
8.3 Techniques of Transaction Exposure Management
8.3.1 Forward Market Hedge
8.3.2 Money Market Hedge
8.3.3 Exposure Netting
8.3.4 Currency Risk Sharing
8.3.5 Leading and Lagging
8.3.6 Currency Options
8.3.7 Currency Futures
8.3.8 Currency Swaps
8.4 Let Us Sum Up
8.5 Key Words
8.6 Terminal Questions/Exercises
8.0 OBJECTIVES
8.1 INTRODUCTION
Exposure is a word commonly used in day-to-day life. You may have referred to your
fiiend getting exposed to business ethics in his or her corporate career. Your joining
this course itself is getting you exposed to the world of international finance. However,
the word exposure may also carry a negative connotation especially when some degree
of uncertainty of outcome is involved. Our specific reference is to the outcome of
changes in foreign exchange rates on corporate profitability or the overall position of a
company. Foreign currency exposures arise whenever a business has an income or
expenditure, or an asset or liability in a currency other than the balance sheet currency.
In unit 7 you learnt about the different types of currency risks. In this unit, you will
learn about the concept and measurement of transaction exposure and main techniques
of transaction exposure management.
Firstly, a forward contract cannot be entered into for an unlimited period. The
maximum period was earlier directly related to the maximum credit period permissible,
i.e., six months. Under the new RBI guidelines, the maximum period has now been
extended to one year. A firm may, therefore, enter into a one-year forward contract or
of any shorter duration. Now, you will wonder as to what will happen if the firm's
transaction for which a forward hedge is desired extends beyond a period of one year.
It is typical in case of foreign curre'ncy loans wherein not only the principal amount but
also the series of interest payments is likely to extend beyond a period of one year. In
such a case, there is the facility of roll-over contracts. A roll-over contract is rolled
over for the next desired period every time the maturity date arrives. Let us take the
example of a foreign currency loan which involved hedging through a forward contract
for the principal amount as well as the interest series. Let us say, the table of
repayments [US$]runs as follows:
The firm receives the loan of US$ 500,000 at time-0 and converts it into rupees at the
spot rate. At the same time, it obtains a forward cover for $500,000 to cover the
principal amount and $25,000 to cover the interest instalment. At t-1, it must take
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delivery of $5,25,000 at the contracted forward rate, but since it requires only Measuring rind Managing
$1,25,000, it will sell $400,000 at the spot rate prevailing then and again buy forward Transaelion Exposure
the same amount along with $20,000 of interest payment. On $400,040, we would say
that the f m has done a swap - sold spot and bought forward. For buying $400,000
forward, the swap rate will apply and for buying $20,000 forward, the outright forward
rate will apply. Corporates generally gain in the swap market as the turnover there is
much larger than in the outright forward market. Swaps are common in the interbank
market which explains their huge turnover. The swap rate, for example, may be Rs
32.501$1 as against the outright forward rate of Rs 32.701$1. At t=2, once again, the
firm will take delivery of $420,000 ; sell $300,000 spot and again purchase it forward
along with the needed interest amount of $ 15,000. The series continues until the entire
principal amount along with interest is paid off.
Next is the question of whether a forward contract must necessarily be for a fixed
period. An option in the period of the contract may be desired when there is some
uncertainty as regards the exact date of a receivable or payable. For example, the best
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a fm may know is that shipment will arrive anytime between the third and the sixth
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month of the date of the contract. Accordingly, payment is also due within the third
and the sixth month. The f m , obviously, cannot enter into an outright forward
contract for a fixed period. The firm, in such a case, can enter into a option forward
conh'act. However, it must be remembered that an option forward contract proves to be
quite expensive for the firm, as the authorised dealer will take the maximum benefit of
the premium or discount for itself. Let us take an example to understand it.
Let us say that a firm's payables are denominated in DM. As you are aware, there are
no direct quorCs available of DM vs. rupee or for that matter for any non-dollar
currency against the rupee. The rate vis-a-vis the rupee in such cases is calculated via
two Steps: step 1 is obtaining the DM/$ rate and step 2 involves obtaining the $/Rs.
rate. A simple multiplication of the two rates (recall cross rate)will give the DMlrupee
rate. For the purpose of illustrating an option forward contract, let us say that the
authorised'dealer deals only with the rate vis-a-vis the US dollar. Let us further say
that on a particular day, the following rates are ruling in the market:
Clearly, the DM is at a premium for both the 3 month and the 6 month maturity. If
the customer wanted to buy DM (sell $), the bank will charge the largest possible
premium for the purchase of dollars over the option period. The 3 month forward rate
is DM 1.59501%and the 6 month forward rate is DM 1.57001$. As is obvious, the six
month forward rate of DM 1.5700/$ is more favourable for the bank as it has to give
fewer DM for every dollar it purchases from the customer firm. That is, the bank
charges the six month premium when it sells DM (buys $). But, if the firm wanted to
sell DM (buy $), the bank will charge the 3 month premium for the sale of dollars.
The two rates applicable are DM 1.59701%and DM 1.57301%- the bank will choose
DM 1.59701$ as it gets more DM for every dollar it sells.
This was the case when DM was at a premium to the dollar. Now, let us take the case
of the DM being quoted at a discount. Let us say the rates are as follows:
For the sale of DM (purchase of $) to the customer in this case, the bank will quote
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the rate 1.64401%as it has to give fewer DM fbr every dollar it purchases that is, it
gives the least possible discount to the customer. For the purchase of DM from the
customer (sale of $), it will quote the rate 1.67101$ as it gets maximum DM for every
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dollar sold that is, it takes the maximum possible discount from the customer.
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Foreign Exchange Risk One must remember that in all cases, the amount of the forward cover cannot exceed
Management the value of the underlying commercial transaction. That is because no speculation is
permissible under Indian laws. Another aspect relating to forward contracts is that
although it does not offer any flexibility to the customer in terms of the rate (the
contract with the authorised dealer must be honoured at the fixed rate), it offers the
facility of cancellation and rebooking of forward contracts. Forward contracts can be
cancelled at or before maturity depending on the view taken by the corporate on the
fbture prevailing rates or due to some genuine Feason, for example, delayed shipment of
goods. For a forward sale by the customer to the bank, cancellation on due date is
deemed as purchase by the bank at the contracted forward rate and a simultaneous sale
at the then ruling spot rate. If the currency has appreciated beyond the forward rate,
the difference is recovered from the customer; conversely, the gain, if any, is paid to
the customer. The bank charges a flat fee every time the contract is cancelled. Let us
now take up other method of hedging.
In this market condition, anybody would like to borrow US dollars, convert into rupees
and avail of the higher interest rate on rupees. The clear profit-making opportunity will
surely increase demand for US dollars as more players enter the market for making a
profit. As a result, the dollar will begin to be quoted at a premium to the rupee while
interest rate on dollars will move up and on rupees will fall. Ultimately, equilibrium
will settle at a premium which will be exactly equal to the interest rate differential
between the dollar and the rupee. What this means is that it should not matter to an
investor in which currency he invests as higher interest rate yielding currencies are
bound to be quoted at a discount in a free market. Thus, in efficient markets, covered
investment in any currency would give the same returns. There are no riskless arbitrage
profits to be had. This is the famous covered interest parity theorem. However,
departures from this theorem exist because of transaction costs, political risks,
withholding taxes on interest, government restrictions, etc. Because of such restrictions,
significant difference may occur between the forward premia / discounts and Euro
market interest differentials between two currencies. Such an imperfection will present
opportunities for cost savings.
So, what really happens in a money mvket hedge? A firm with planned receivables in
a currency can hedge by borrowing in that currency .a that the outflows on accowit of
interest and repayments can be set off against the receivables. Conversely, the firm
could obtain a forward cover and if the covered interest theorem prevailed, the forward
discount/premium would be exactly equal to the interest differential between the two
currencies. But, due to the departures from the covered interest theorem, there may be a
cost saving using the money market hedge. Let us take an example:
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Measuring and Managing
1. Borrow DG in the Euro DG market for 90 days. Transactior~Exposure
2. Convert DG spot into DM.
3. Use DM in its operations, e.g., to pay off a short-term bank loan or finance
A comparison between the spot and the forward rate clearly shows that the DG is at a
discount to @e DM. But the covered interest parity does not hold.
Let us now compare forward cover against the money market cover.
With forward cover, each DG sold will give 90 days later an inflow of:
DM(111.1065) = DM 0.9038
0.90381(1+(0.047514)) = DM 0.893 1
To cover using the money market, for each DG of receivable, the fm will borrow DG
equivalent to : 11(1+(0.05514)) = DG 0.9864. Next, the fm sells these DG spot to
get DM equivalent to (0.986411.1035) = DM 0.8939. The fm will then pay off the
M3 loan when the receivable matures.
Thus, with the money market cover, there is a net gain of DM 0.0008 [DM 0.8939 -
DM 0.89311 per DG of receivable or DM 8,000 for the 10 million guilder receivable.
1. A fm can offset a long position in a currency with a short position in the same
currency.
2. If the exchange rate movements of two currencies are positively correlated, then
Foreign Exchange Risk 3. If the currency movements are negatively correlated, then short (or long)
Management positions can be used to offset each other.
Just like we saw in the case of the money market hedge, if the covered interest parity
holds, a firm woyld be indifferent between a forward market hedge and using the
40 leadingllagging technique. Let us take an example:
A French firm has a 180 day payable of SFr 3,50,000 to a SWISS supplier. The spot Measuring and Managing
Transactio~tExposure
rate is FFr .3.2500/SFr. The 180 dollar forward is 3.3312 , i.e., the SFr is at a
forward premium by 2.5%. The Swiss supplier is prepared to give a discount of 2.5%
for cash payment. The French firm can borrow at 10% p.a. The net cost of leading
the payment would, thus, be 2.5% [ 5% for 180days minus 2.5% cash discount] which
is equal to the 180 day premium on the SFr. The interest differential, as you can see,
is exactly captured in the forward premium and, hence, leading and forward hedge are
equivalent. If some imperfections drive a significant wedge between Euro interest rates
and domestic interest rates, then leading or lagging an exposure may turn out to be
cheaper than a forward hedge.
Let us say, the Australian authorities have imposed a restriction on Australian firms
which prevents them from borrowing in the Euro A$ market. Similarly, non-residents
cannot make money market investments in Australia. As a consequence, the domestic
180 day interest rate in Australia is 9.5% p.a. The American firm may consider the
following four alternative hedging strategies:
d) Borrow A$ in the Euro market, settle the payable, buy A$ 180 day forward to
pay off the loan (Lead with a forward).
Leads and lags in combination with netting form an important cash management strategy
for multinationals with extensive intra-company payments.
When are options useful for currency hedging? Options are particularly useful for
hedging uncertain cash flows, i.e., cash flows that are contingent on other events.
Typical situations are:
1. International Tenders: Foreign exchange inflows will materialise only if the bid
is successful. If execution of the contract also involves purchase of materials,
equipment, etc. from third countries, there are contingent foreign currency
outflows too.
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Foreign Exchange Risk 2. Foreign currency receivables with substantial default risk o r political risk,
Management
e.g., the host government of a foreign subsidiary might suddenly impose
restrictions on dividend repatriation.
3. Risky Portfolio Investment: A funds manager, say in UK, might hold a
portfolio of foreign stockslbonds currently worth say DM 50 million which he is
planning to liquidate in six months' time. If he sells-DM 50 million forward,
and the portfolio declines in value because of a falling German stock market and
rising interest rates, he will find himself to be overinsured and short in DM.
The Swiss firm can purchase put options - why? Because it is expecting depreciation of
the dollar vis-a-vis the DM. Further, if the firm purchases out of the money put option
- strike price less favourable than the market price - the firm may make a neat profit.
After the depreciation of the dollar, the out of the money put option contract is likely
to become in the money put option contract - strike price more favourable than the
market price. The Swiss firm can then profitably sell these options at a profit enabling
it to partly compensate for its lost competitiveness.
In fixed to fixed currency swap, one party raises a fixed rate liability in say US dollars
and the other party raises fixed rate funding iri another currency, say DM. The
principal amounts are equivalent at the current market rate of exchange. At the
initiation of the swap contract, the principal amounts are exchanged, the first party
"getting DM and the second party getting US dollars. Subsequently, the first party
makes periodic DM payments to the second, computed as interest at a fixed rate on the
DM principal while it receives from the second party payments in dollars again
computed as interest on the dollar principal. On the maturity date, the principal
amounts are once again exchanged. It may be noted, however, that the exchange of
principals, both at the beginning and at the end is notional - not real. What is real is
the cash flows resulting from interest payments. Whether or not the parties to the swap
contract benefit from the swaps will depend on how the underlying currencies and
interest rates move during the contract period, which is normally for three to five years.
.A floating to floating currency swap will have both payments at floating rate but in
different currencies. In most cases, an intermediary -a swap bank structures the deal
and routes the payment from one party to another.
There is a growing market for swaps for which many explanations have been advanced.
Most of these hypotheses rely either on a capital market imperfection or factors like
differences in investor attitudes, informational asymmetries, differing financial norms,
peculiarities of national regulatory and tax structures, etc. You will agree that
borrowers and investors differ in their preferences and market access. For instance, a
manufacturing firm or a utility might prefer fixed rate funding to 'finance long gestation
physical investment projects but finds that fixed rate investors do not view it very
kindly while it is able to borrow relatively easily in the floating market. On the other
side, is a large international financial institution such as a money centre bank which can
borrow on excellent terms in the fixed market but prefers floating rate funding because
it has a large portfolio of floating rate loans.
Swaps help borrowers and investors overcome the difficulties posed by market access
andlot provide opportunities for arbitraging some market imperfection. Swaps, thus,
bec.ome a good way of managing transaction exposures in any particular currency.
Forward Market Hedge: A forward market hedge involves a company that is long in
a foreign currency selling the foreign currency forward and a company that is short in a
foreign currency buying the foreign currency forward.
Roll-Over Contracts: Roll-over forward contract is one that can be rolled over at the
initial forward rate agreed upon subject to a roll-over charge. This is particularly useful
for large importers in countries with constantly depreciating currencies.
Option Forward Contract: Option forwards are contracts in which the rate of
exchange between two currencies is fixed at the time the contract is entered into as in
a standard forward (outright forward contract) but the delivery date is not a fixed date.
One of the parties (usually a corporate customer) can, at its option, take or make
delivery on any day between two fixed dates. The interval between these two dates is
the option period.
Money Market Hedge: A money market hedge involves simultaneous borrowing and
lending activities in two different currencies to lock in the local currency value of a
future foreign currency cash flow.
Covered Interest Arbitrage: According to the covered interest arbitrage theory, the
currency of the country with a lower interest rate should be at a forward premium in
terms of the currency of the country with the higher interest rate. More specifically, in
an efficient market with no transaction costs, the interest differential should be equal to
the forward differential. When this condition is met, the forward rate is said to be at
interest parity, and equilibrium prevails in the money markets.
Exposure Netting: Exposure netting is a method used mainly by MNCs to reduce the
number of foreign exchange transactions needed to settle inter-unit transactions. The
basic idea is to chart out all the payments that units have to make to one another and
work out a solution that minimises the number of transactions needed.
Currency Risk Sharing: Currency risk sharing is different from a traditional hedge in
the sense that the parties agree to share the risks associated with currency rate
fluctuations. Typically, a hedge contract, in the form of a price adjustment clause, is
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imbedded in the underlying trade transaction. Exchange rate changes are reflected in Measuring snd Managing
Transaction Exposure
adjustments to base price. The base price representsethe currency range in which risk is
not shared.
Leading and Lagging: Leading and lagging shift the timing of transaction exposures.
The general rule followed is lead, i.e., advance payables and lag, i.e., postpone
receivables in strong currencies and, conversely, lead receivables and lag payables in
weak currencies.
Out of the money option: An option contract wherein the strike price is less
favourable than the market price.
In the money option: An option contract wherein the strike price is more favourable
than the market price.
Tick Value: Tick value is a measure commonly used by traders in currency futures.
In futures parlance, the tick value is 0.01 cents per unit of foreign currency.
Swaps : Swaps involve exchange of a series of periodic payments between two parties,
usually through an intermediary which is a large financial institution. The two payment
streams are estimated to have identical present values at the outset when discounted at
the respective cost of funds in the relevant primary financial markets. The two major
types are interest rate swaps and currency swaps. The two are combined to give a
cross-currency interest rate swap. A number of variations are possible within each type:
Swaps also refer to the simultaneous purchase (sale) of a currency in the spot or the
forward market coupled with forward sale (purchase) of that currency. In case both
transactions are in the forward market, the forward periods differ with respect to their
maturities.