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Transaction Exposure

Transaction Exposure. Risk due to lags in payments Hedging strategies. Exposure. Transaction exposure changes in the value of outstanding contracts Operating exposure (economic exposure) change in the PV of the firm (real exchange rates) Translation exposure (accounting exposure)

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Transaction Exposure

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  1. Transaction Exposure Risk due to lags in payments Hedging strategies Transaction Exposure

  2. Exposure • Transaction exposure • changes in the value of outstanding contracts • Operating exposure (economic exposure) • change in the PV of the firm (real exchange rates) • Translation exposure (accounting exposure) • change in value of owner equity • Tax exposure Transaction Exposure

  3. Transaction exposure sources • lending or receivables denominated in foreign currency • borrowing or payables denominated in foreign currency • holding a defaulted forward contract Transaction Exposure

  4. Lags and transaction exposure • t0 - order placed • Forward contract agreed to • t1 - order shipped (10 days) • t2 - order delivered (24 days) • t3 - order settled (90 days) Transaction Exposure

  5. Balance sheet perspective • Contract: price, quantity, due date (today) • Forward contract purchased (today) • Input inventories purchased (today) • Inventories increase • (Payables increase) • May also be funded by LT debt • Output inventories created (8days) • Input inventories decrease • Output inventories increase • (Accruals increase) • May also be funded by LT debt • Goods shipped (no change) (10 days) Transaction Exposure

  6. Balance sheet perspective (cont) • Goods received (24 days) • Inventories decrease • Receivables increase • Contract paid (90 days) • Receivables decrease • Take delivery on forward contract • Cash increases • During this process • Payables paid • Accruals paid Transaction Exposure

  7. To Hedge • Reduce the volatility of future cash flows • Eliminate one source of risk • Exchange rate volatility • Cost of the hedge • Does not change default risk • Management either hedges or speculates ?? • Does not have expertise in exchange rate risk Transaction Exposure

  8. To not Hedge • Shareholders better able to diversify risk than firm • If parity holds NPV of hedging negative • Costs of hedging • Efficient markets have already impounded the risk into share price • Agency problem • Management is risk averse relative to their jobs not to stockholder value Transaction Exposure

  9. Accounting practices non-hedged position • Balance sheet • Input inventories at cost • Output inventories at COGS • Receivable denominated in cd • Spot in effect at time of delivery • Income statement • At payment • Gain or loss realized • Counted on income statement Transaction Exposure

  10. Types of hedges • contractual hedges • forwards, futures, option, • money market hedges • operating & financial hedges • risk-sharing • leads & lags • swaps Transaction Exposure

  11. Forward hedge - 90 day • short goods (delivered) • selling goods for 154,000 usd • long bill of exchange (bankers accept) • payment 154,000 usd promised forward • long a forward contract • forward contract set for delivery of 229,460 cd • delivery of 154,000 usd • delivery of 229,460 cd • discounted value 225,796.28 Transaction Exposure

  12. Forward hedge - Sources of risk • delivery on bill • bank backing the bill could default • delivery on forward contract • bank delivering cd forward could defaulat • risk of default is low • the hedge reduces transaction exposure Transaction Exposure

  13. Accounting practicesHedged position • Contract values • 231,000 receivable @ spot = 1.50 • 229,460 payable @ forward = 1.49 • Balance sheet • Input inventories at cost • Output inventories at COGS • Receivable denominated • Denominated at spot in effect at time of delivery • Forward contract as payable • Denominated at forward rate Transaction Exposure

  14. Money market hedge - 90 day • short goods (delivered) • 154,000 usd • long bill for 154,000 usd • short loan 154,000/(1.0765) .25 = 151,188 • exchange for 225,270 cd • delivery of 154,000 usd • pay off loan of 154,000 Transaction Exposure

  15. Money market hedge - Sources of risk • delivery on bill • bank backing the bill could default • no forward contract • risk of default is lower • the hedge reduces transaction exposure Transaction Exposure

  16. One can also discount the bill - 90 day • short goods • 154,000 usd • long bill of exchange • sell bill at discount to bank @ 8.65% • 150,839 usd • exchange for 224,750 cd Transaction Exposure

  17. Discounting bill of exchange - Sources of risk • no risk delivery on bill • bill sold at discount to another party • no forward contract • risk of default is eliminated • the hedge eliminates transaction exposure Transaction Exposure

  18. OTC option contract - 90 day • short goods • 154,000 usd • long bill of exchange • long call option to buy 229,508 cd • @0.0025 usd/cd cost = 573.77 usd • exercise price = 6710 • delivery of 154,000 • if e > x, exercise option • get 229,508 cd net of cost of hedge Transaction Exposure

  19. Option contract - Sources of risk • risk of bank default on delivery on bill • risk of default by bank on option contract • the hedge reduces transaction exposure Transaction Exposure

  20. Present value of the hedges • forward hedge = 225,796 cd • money market hedge = 225,270 • discounting = 224,750 • option contract = 229,508 cd / (1.0667).25 - (573.77 usd * 1.49cd/usd) = 224,989 cd Transaction Exposure

  21. Accounting for unhedged positions • Payables and receivables are booked at current spot • income statements • balance sheets • at settlement - changes to book value must be counted • losses • gains Transaction Exposure

  22. Accounting hedged positions • Payables and receivables are booked at current spot • Use your forward rate as best estimator of future expected spot • foreign exchange gain/loss = forward - spot • forward contract loss = 0 • Gains/losses will be the difference between • contract evaluated at forward and • contract evaluated at spot Transaction Exposure

  23. Risk management • Hedging costs money • Hedging exposure • As contracts are anticipated • Contracts may not be signed • If contracts signed unanticipated exchange rate changes • As contracts are signed • Risk that contract may be refused • Risk that goods may not clear customs • As contracts are delivered • Default by the importer • Out goods • Must deliver on forward contract Transaction Exposure

  24. Other hedge practices • Proportional hedges • Forward contracts hedge percentage of exposure • Percentage cover directly related to term to maturity • Forward points (using Interest Rate Parity) • The usd sells forward at discount • May not hedge this transaction because they may get a better exchange rate in the future Transaction Exposure

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