MANAGING TRANSACTION EXPOSURE

● There are many techniques by which the firms can manage their transaction exposure.
● These techniques can be broadly divided into hedging techniques and operational
techniques.
● Hedging refers to taking an offsetting position in order to lock in the home currency
value for the currency exposure, eliminating the risk arising from changes in the
exchange rate.
● The important hedging techniques are forwards/futures, money market hedges, options,
and swaps.
● Operational techniques include exposure netting, leading and lagging, and currency of
invoicing.

HEDGING TECHNIQUES

Hedging with forwards and futures

● A forward contract is a legally enforceable agreement to buy or sell a certain amount of

foreign currency on a specified date at an exchange rate fixed at the time of entering the
contract.
● Firms may hedge their transaction exposure by entering into forward contracts. That is, a
firm may buy or sell the foreign currency forward and thereby avoid fluctuations in the
home currency value of the foreign currency–denominated fixed future cash flows.
● For example, assume an Indian trader has three-month receivables of USD 1 million. In
order to eliminate the currency risk, the trader signed a forward contract with a bank,
which agrees to buy that amount in three months at a forward rate of USD/INR 40. The
 current spot rate is USD/INR 39.75. By entering the forward contract, the Indian trader
has fixed the INR value of his three-month receivables. Regardless of what happens to
the exchange rate in the future, the trader would get INR 40 million on the realisation of
his receivables.
● gains and losses may also arise on entering into forwards, depending on the future spot
rate and the forward rate.
● A firm's decision on hedging (or not hedging) depends on three considerations: (i) the
real cost of hedging; (ii) the anticipated absolute gains and losses that are most likely to
arise from hedging; and (iii) the expected transaction costs.
● Furthermore, the risk perception and risk aversion of the firm may also influence the
decision of whether or not to hedge a particular transaction exposure. A firm that is more
risk averse may hedge every transaction exposure
● As forwards and futures have many common characteristics, hedging the foreign
exchange exposure with currency futures is similar to hedging exposure with forward
contracts.

EXAMPLE: A U.S.-based MNC has sold its product to a firm in the United Kingdom. The
invoice amount is USD 10 million. The payment is due three months from today. The current
spot rate is USD/GBP 0.5252. It is expected that the U.S. dollar will depreciate by 5 per cent
over the three months period. The three-month forward rate as quoted is USD/GBP 0.54. What is
the expected loss to the British firm, and how it can be hedged?

Solution Expected future spot rate = USD/GBP 0.5515 (i.e. USD/GBP 0.5252 + 5%)
The expected loss without hedging can be calculated as:
Invoice amount = USD 10 million, which is equivalent to GBP 5.252 million at the current spot
rate.
After three months, the British firm has to pay USD 10 million × GBP 0.5515 = GBP 5.515
million.
Expected loss = GBP 0.263 million.
The loss under forward cover will be:
Payment after three months with a three-month forward contract is GBP 5.40 million
Loss = GBP 5.40 million − GBP 5.252 million = GBP 0.148 million

So, by entering into a forward contract, the British firm could reduce its loss by GBP 0.263
million − GBP 0.148 million = GBP 0.115 million.
Money market hedging

● The firm seeking the money market hedge borrows in one currency and exchanges the
proceeds for another currency.
● Money market hedging involves simultaneous borrowing and lending or investing in the
money market, with an aim to avoid or reduce foreign exchange exposure with regard to
receivables or payables thus creating a homemade forward contract
● A firm that wants to hedge foreign exchange exposure on receivables (payables) may
borrow (lend) foreign currency in the money market, so that its assets and liabilities in the
same currency will match.
● Only firms that have access to the international money market can use this type of
hedging effectively.
● money market hedging is particularly used for cash flows in currencies for which there
are no forward markets.

For example, consider an Indian importer who has USD 50 million 90-day payables. The interest
rate in the United States is 8 per cent per annum or 2 per cent per 90-day period. This means an
amount of USD 49.02 million invested or borrowed today will become USD 50 million at the
end of a 90-day period at an interest rate of 8 per cent per annum. So the importer borrows an
amount of INR 2,108 million at an interest rate of 10 per cent per annum or 2.5 per cent per
90-day period, and converts this into USD 49.02 million at the current spot rate of USD/INR 43.
Then that amount (USD 49.02 million) is invested at 8 per cent per annum for 90 days, which
will become USD 50 million at the end of the 90-day period. On the day when the importer has
to pay off the import bills, he or she will have an amount of USD 50 million sufficient for
clearing the dues. Further, the importer has to pay back the loan of INR 2,160.7 million
(principal plus interest).

Hedging with currency options

● A currency option is a contract that gives the buyer the right, but not the obligation, to
buy or sell a specified currency at a specified exchange rate in the future. Options are
basically of two types: put options and call options.
● A put option gives the option holder the right to sell a specified quantity of foreign
currency to the option seller at a fixed rate of exchange on or before the expiration date.
● A call option gives the option holder the right to buy a specified quantity of foreign
currency from the option seller at a predetermined exchange rate on or before the
expiration date.