International Financial Management

13th Edition
by Jeff Madura

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 11 Managing Transaction Exposure
Chapter Objectives

• Describe common policies for hedging transaction exposure.

• 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 (1 of 11)

An MNC may decide to hedge part or all of its known

payables transactions using:
• Forward or futures hedge
• Money market hedge
• Currency option hedge

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 Hedging Exposure to Payables (2 of 11)

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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 Hedging Exposure to Payables (3 of 11)

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 the foreign currency.
• Money market hedge versus forward hedge
• Since the results of both hedges are known beforehand,
the firm can implement the one that is more feasible.

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 Hedging Exposure to Payables (4 of 11)

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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 Hedging Exposure to Payables (5 of 11)

Call Option Hedge on Payables (cont.)

• Cost of call options based on contingency graph (Exhibit 11.1)
• Advantage: provides an effective hedge
• Disadvantage: premium must be paid
• Cost of call options based on currency forecasts (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 Using Currency Call Options to Hedge Euro
Payables (exercise price = $1.20, premium = $.03)

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 Hedging Exposure to Payables (6 of 11)

Comparison of Techniques to Hedge Payables

(Exhibit 11.3)
• 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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12 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Hedging Exposure to Payables (7 of 11)

Comparison of Techniques to Hedge Payables

• Optimal Technique for Hedging Payables (Exhibit 11.4)
• Select optimal hedging technique by:
• Considering whether futures or forwards are preferred.
• Considering desirability of money market hedge versus
futures/forwards based on cost.
• Assessing the feasibility of a currency call option based on
estimated cash outflows.
• Choose optimal hedge versus no hedge for payables.
• Even when an MNC knows what its future payables will be, it
may decide not to hedge in some cases.
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

Cengage Learning
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14 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Hedging Exposure to Receivables (8 of 11)

Forward or futures hedge on receivables allows the

MNC to lock in the exchange rate at which it can sell a
specific currency.
Money market hedge on receivables involves
borrowing the currency that will be received and using
the receivables to pay off the loan.

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 Hedging Exposure to Receivables (9 of 11)

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.
• Cost of Put Options Based on Contingency Graph (Exhibit 11.5)
• Advantage: provides an effective hedge
• Disadvantage: premium must be paid
• Cost of Put Options Based on Currency Forecasts (Exhibit 11.6)
• MNC can use currency forecasts to more accurately estimate
the dollar cash inflows to be received when hedging with put
options.
• Consideration of Alternative Put Options
• Several different types of put options may be available that
feature different exercise prices and premiums for a given
currency and expiration date.
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16 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 11.5 Contingency Graph for Hedging Receivables with
Put Options

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17 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 11.6 Use of Currency Put Options for Hedging Swiss
Franc Receivables (exercise price = $.72; premium = $.02)

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18 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Hedging Exposure to Receivables (10 of 11)

Comparison of Techniques for Hedging Receivables

(Exhibit 11.7)
• Optimal Technique for Hedging Receivables: (Exhibit 11.8)
• Consider whether futures or forwards are preferred.
• Consider desirability of money market hedge versus
futures/forwards based on cost.
• Assess the feasibility of a currency put option based on
estimated cash outflows.
• Optimal hedge versus no hedge on receivables
• An MNC may know what its future receivables will be yet still
decide not to hedge. In that case, the MNC needs to
determine the probability distribution of its revenue from
receivables when not hedging

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 Exhibit 11.7 Comparison of Hedging Alternatives for Viner Co.

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20 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 11.8 Graph Comparison of Techniques to Hedge
Receivables

Cengage Learning
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21 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Hedging Exposure to Receivables (11 of 11)

Evaluating the hedge decision by estimating the

real cost of hedging receivables versus the cost of
receivables if not hedged.
Summary of Hedging Techniques (Exhibit 11.9)

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 Exhibit 11.9 Review of Techniques for Hedging Transaction
Exposure

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23 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 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. (Exhibits
11.10 and 11.11)
• 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 Repeated Hedging of Foreign Payables When
the Foreign Currency Is Appreciating

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25 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 11.11 Long-Term Hedging of Payables When the
Foreign Currency Is Appreciating

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26 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 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: Reducing exposure by
diversifying business among numerous countries.

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27 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (1 of 4)

• 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 can be purchased.

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 SUMMARY (2 of 4)

• 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 like forward and
currency option contracts are not available, there are still
some methods of reducing transaction exposure, such as
leading and lagging, cross-hedging, and currency
diversification. The currency option hedge has an advantage
over the other hedging techniques in that the options do not
have to be exercised. However, a premium must be paid to
purchase the currency option, so there is a cost for the
flexibility they provide.
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 SUMMARY (3 of 4)

• 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. 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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30 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SUMMARY (4 of 4)

• When hedging techniques like forward and currency

option contracts 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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31 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.