Managing Transaction

Exposure
Transaction exposure exists when there are contractual transactions that cause an
MNC to either need (payables) or receive (receivables) a specified number of foreign
currencies at a specified future time period.

Policies for Hedging Transaction Exposure

An MNC may choose to hedge most of its transaction exposure or to hedge selectively.

Hedging Most of the Exposure

Some MNCs hedge most of their exposure so that their value is not strongly influenced
by exchange rates. Sometimes hedging will lead to worse outcomes than if the
company did not hedge, but that’s a risk they are willing to take to avoid worse
outcomes.
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
Many MNCs use selective hedging where they consider each type of transaction
separately. Certain MNCs that deal with many foreign currencies may not hedge their
exposure since they believe a well-diversified portfolio of foreign currencies limits their
exposure.
Certain large companies state the following in their annual reports regarding selective
hedging:
 ConocoPhillips: “We do not comprehensively hedge the exposure to currency
rate risk, although we may choose to selectively hedge exposure to foreign
exchange risk”
 DuPont Co.: “Decisions regarding whether or not to hedge a given commitment
are made on a case-by-case basis by taking into consideration the amount and
duration of the exposure, market volatility, and economic trends.”
 General Mills Co.: “We selectively hedge the potential effect of the foreign
currency fluctuations related to operating activities.”
When an MNC considers hedging transaction exposure, it must first assess the degree
of its exposure.

FIN4340: International Financial Management 164

Next, it must consider the various techniques to hedge this exposure so it can decide
which hedging technique is optimal and whether to hedge its transaction exposure.

Hedging Exposure to Payables

An MNC may select one of the below techniques to hedge its payables:
1) Forward or future hedge
2) Money market hedge
3) Currency option hedge

Forward or Futures Hedge on Payables

Forward or futures contracts allow an MNC to lock in a specific exchange rate at which
it can pursue a specific currency, thereby hedging payables denominated in that
currency.
A forward contract is negotiated between the firm and a financial institution such as a
commercial bank.
The contract will specify:
 The currency that the firm will pay
 The currency that the firm will receive
 The amount of currency to be received by the firm
 The rate at which the MNC will exchange the currencies (the forward rate)
 The future date at which the exchange of currencies will occur
Futures contracts follow the same procedure, expect that futures contracts are
standardized and can be purchased on an exchange, while forwards are over the
counter instruments.

Example:
Coleman Co. is a U.S.-based MNC needing EUR100,000 in one year. It can obtain a
forward contract to purchase the EUR one year from now. The one-year forward rate
is USD/EUR = 1.20. Thus, if Coleman purchases a forward contract, its USD cost in
one year is:
𝐶𝑜𝑠𝑡 𝑖𝑛 𝑈𝑆𝐷 = 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 × 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
= 𝐸𝑈𝑅100,000 × 1.20
= 𝑈𝑆𝐷120,000

FIN4340: International Financial Management 165

Money Market Hedge on Payables
Money market hedges on payables involves taking a money market position to cover
a future payables position.
If a firm has excess cash, it can create a money market hedge, but many MNCs do
not like to use their cash balance to hedge.
Instead, they will:
1) Borrow funds in the home currency
2) Invest in a short-term investment in the foreign currency

Example:
If Coleman Co. needs EUR100,000 in one year, it can convert USD to EUR and
deposit the EUR in a bank today. Assuming it can earn 5% on this deposit, it would
need to establish a deposit of EUR95,238 today in order to have EUR100,000 in one
year.
𝐸𝑈𝑅100,000
𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 ℎ𝑒𝑑𝑔𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 = = 𝐸𝑈𝑅95,238
(1 + 5%)

Assuming a spot rate today of USD/EUR = 1.18, the dollars needed today would be:
𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝑈𝑆𝐷 = 𝐸𝑈𝑅95,238 × 1.18 = 𝑈𝑆𝐷112,381

Assuming that Coleman can borrow USD at a rate of 8%, it would borrow the funds
needed to make the deposit, then at the end of the year, repay this loan.
𝐷𝑜𝑙𝑙𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑈𝑆𝐷112,381 × (1 + 8%) = 𝑈𝑆𝐷121,371

Call Option Hedge on Payables

A currency call option provides the right to buy a specified amount of a particular
currency at a specified price (called the strike price or exercise price) within a given
period of time.
Yet unlike a futures or forward contract, the currency call option does not obligate its
owner to buy the currency at that price. The MNC can choose to either let the option
expire and buy currency at the prevailing market spot rate in the future or buy at the
exercise price.

FIN4340: International Financial Management 166

Applying a Contingency Graph
The cash outflows of an option contract are not known for certainty until the future date
arrives and the spot rate of that date is known.
The USD (or home currency) outflows include the price paid for the currency (exercise
price) plus the option premium.
If the spot rate in the future is less than the exercise price, the MNC would let the
option expire and buy at the market spot rate (since spot rate is cheaper).
If the spot rate in the future is equal or greater than the exercise price, the MNC would
purchase at the exercise price (since spot rate is more expensive).
MNCs develop contingency graphs to determine the USD cash outflows from call
option hedging based on different possible future spot prices.

Example:
Recall that Coleman Co. considers hedging its future payables of EUR100,000 in one
year. It can purchase call options on EUR100,000 to hedge its payables.
Assume that the call options have an exercise price of USD/EUR = 1.20, a premium
of USD0.03, and an expiration date of one year. Coleman can create a contingency
graph for the call option, as shown below.

The horizontal axis shows several possible spot rates of the EUR that could occur in
the future, while the vertical axis shows the USD cash outflows from hedging.

FIN4340: International Financial Management 167

If the spot rate in the future is less than the exercise price of USD/EUR = 1.20,
Coleman would NOT exercise the call option, so the USD cash outflows would be
equal to the spot rate plus the option premium. For example, when the spot rate is
USD/EUR = 1.16, the total cash outflows are USD1.19 (= 1.16 + 0.03).
At any spot rate greater than or equal to the exercise price of USD/EUR = 1.20,
Coleman would exercise the call option; the USD outflows would be fixed at USD/EUR
= 1.20 plus option premium of USD0.03. Thus, cash outflows would be USD1.23.
The above graph shows advantages and disadvantages of call options.
The advantages are that it provides an effective hedge and allows the MNC to let the
option expire if the spot rate is lower than the exercise price.
The main disadvantage, however, is that an option premium has to be paid for it.

Applying Currency Forecasts

An MNC may wish to incorporate its own forecasts of the spot rate in the future so that
it can estimate more accurately the USD cash outflow when using call options.

Example:
We know that Coleman Co. wants to hedge payables of EUR100,000 with a call option
which has exercise price of USD/EUR = 1.20, a premium of USD0.03, and expires in
one year.
Suppose Coleman forecasts the following spot rates for the future:
 USD/EUR = 1.16 (20% probability)
 USD/EUR = 1.22 (70% probability)
 USD/EUR = 1.24 (10% probability)
The effect of these on the USD outflows for Coleman is shown below:

Columns 1 and 2 denote each scenario.

Column 3 shows the premium per unit paid the option which is obviously the same for
each scenario.

FIN4340: International Financial Management 168

Column 4 shows the amount Coleman would pay under each scenario assuming it
owns the call option.
If scenario 1 occurs, Coleman would let the option expire and purchase EUR in the
spot market at USD/EUR = 1.16.
If scenarios 2 or 3 occurs, Coleman will exercise the option (purchasing EUR at
USD/EUR = 1.20).
Column 5 sums up column 3 and 4 and shows the amount paid per unit including the
USD0.03 premium.
Column 6 converts column 5 into a total dollar cost based on the EUR100,000 hedged.

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.
The trade-off is that the MNC must either pay a higher premium for a call option with
a lower strike price or accept a higher exercise price for a call option with a lower
premium.
The call option perceived to be most desirable for hedging a particular payables
position will be analysed so that it can be compared with other hedging techniques.

Comparison of Techniques for Hedging Payables

The methods of hedging payables can be summarized as below using our example of
Coleman Co.:
Forward Hedge
Purchase EUR one year forward:
𝑈𝑆𝐷 𝑛𝑒𝑒𝑑𝑒𝑑 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 = 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑖𝑛 𝐸𝑈𝑅 × 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝐸𝑈𝑅
= 𝐸𝑈𝑅100,000 × 1.20
= 𝑈𝑆𝐷120,000

Money Market Hedge

Borrow USD, convert to EUR, invest EUR, repay USD loan in one year.
𝐸𝑈𝑅100,000
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐸𝑈𝑅 𝑡𝑜 𝑏𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 =
(1 + 5%)
= 𝐸𝑈𝑅95,238
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝑈𝑆𝐷 𝑛𝑒𝑒𝑑𝑒𝑑 𝑡𝑜 𝑐𝑜𝑛𝑣𝑒𝑟𝑡 𝑖𝑛𝑡𝑜 𝐸𝑈𝑅 𝑓𝑜𝑟 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 = 𝐸𝑈𝑅95,238 × 1.18
= 𝑈𝑆𝐷112,381

FIN4340: International Financial Management 169

 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑖𝑛 𝑈𝑆𝐷 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 = 𝑈𝑆𝐷112,381 × (1 + 8%)
= 𝑈𝑆𝐷121,371

Call Option
Purchase call option (strike price USD/EUR = 1.20; premium = USD0.03)

Note that the USD outflows in the forward and money market hedge can be determined
with certainty, but when it comes to options, the USD outflow depends on the prevailing
spot price in the future.

Optimal Technique for Hedging Payables

An MNC can select the optimal technique for hedging payables by following these
steps:
1) Since the futures and forwards are essentially the same thing, the MNC can
choose any of the two it prefers.

2) When comparing forwards and money market hedges, the MNC can easily
determine which hedge is more desirable as the USD outflows from each
method can be determined with certainty.

3) Determine the USD outflows from using call options and assess the likelihood
that the USD outflows of the option will be lower that the alternative hedging
technique.

Example:
Continuing with Coleman Co., we can determine the company’s USD outflows under
each technique and show these graphically as so:

FIN4340: International Financial Management 170

For Coleman, the forward hedge is preferrable over the money market hedge as it
results in lower USD outflows when hedging payables.
The USD outflows from the call option are computed as:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑈𝑆𝐷 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
= (𝑈𝑆𝐷119,000 × 20%) + (𝑈𝑆𝐷123,000 × 70%)
+ (𝑈𝑆𝐷123,000 × 10%)

FIN4340: International Financial Management 171

 = 𝑈𝑆𝐷122,200
The USD outflows expected from using call options exceeds the cash outflows from
forward contracts. There is only a 20% chance that the currency call option will be
cheaper than the forward hedge; there is an 80% (= 70% + 10%) chance it will be
more expensive. Given this, the forward contract is more optimal.

Optimal Hedge versus No Hedge on Payables

Even when an MNC knows what its future payables will be, it may decide not to hedge
in some cases. In that event, it should determine the probability distribution of its USD
cash outflows when not hedging.

Example:
Coleman Co. in the previous example decided that forward contracts were the best
hedging technique if it decide to hedge. Now, it wants to see if not hedging is better
than the forward contract.
Based on its expectations for the future EUR spot rate (as shown before), it has the
following outflows when not hedging:

The probability distribution of not hedging is shown as the last graph in the previous
example.
The expected USD outflows are then:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑜𝑙𝑙𝑎𝑟 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
= (𝑈𝑆𝐷116,000 × 20%) + (𝑈𝑆𝐷122,000 × 70%)
+ (𝑈𝑆𝐷124,000 × 10%)
= 𝑈𝑆𝐷121,000
The expected USD outflows are higher than when using the forward contract by
USD1,000, and there is an 80% chance USD outflows will be higher than when using
forward contracts.
Thus, forward contracts still remain the best choice.

FIN4340: International Financial Management 172

Evaluating Past Decisions on Hedging Payables
After the payables transactions occur in the future, MNCs can assess the outcome of
its decision to hedge by estimating the real cost of hedging payables (RCHp) as
follows:
𝑅𝐶𝐻𝑝 = 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 𝑤ℎ𝑒𝑛 ℎ𝑒𝑑𝑔𝑖𝑛𝑔 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 − 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑤ℎ𝑒𝑛 𝑢𝑛ℎ𝑒𝑑𝑔𝑒𝑑

Example:
Recall that Coleman Co.’s decision to hedge will result in a cash outflow of
USD120,000. Suppose when the future date to settle payables arrives, the spot rate
is USD/EUR = 1.18.
If Coleman had not hedged, the USD outflow would have been USD118,000 (=
EUR100,000 × 1.18). Thus, real cost of hedging is:
𝑅𝐶𝐻𝑝 = 𝑈𝑆𝐷120,000 − 𝑈𝑆𝐷118,000
𝑅𝐶𝐻𝑝 = 𝑈𝑆𝐷2,000

Hedging Exposure to Receivables

An MNC may decide to hedge part of or all of its receivable’s transactions denominated
in foreign currencies to protect itself from those currencies depreciating. The same
techniques are used for payables can be used here.

Forward or Futures Hedge on Receivables

Forward or futures contracts allow an MNC to lock in a specific exchange rate at which
it can sell a particular currency, thereby enabling it to hedge foreign receivables.

Example:
Viner Co. is a U.S.-based MNC that is to receive CHF200,000 in six months’ time. It
can obtain a forward contract to sell CHF at a rate of USD/CHF = 0.71 in six months.
Then, USD received in six months would be:
𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 𝑖𝑛 𝑈𝑆𝐷 = 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 × 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
= 𝐶𝐻𝐹200,000 × 0.71
= 𝑈𝑆𝐷142,000

FIN4340: International Financial Management 173

Money Market Hedge on Receivables
A money market hedge on receivables involves borrowing the currency that will be
received, and then using the receivables to pay off the loan.

Example:
Recall that Viner Co. will receive CHF200,000 in six months. Assume it can borrow
CHF today at a rate of 3% for six months. The amount it should borrow today is:
𝐶𝐻𝐹200,000
𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑜𝑟𝑟𝑜𝑤 =
(1 + 3%)
= 𝐶𝐻𝐹194,175
Then, in six months’ time, at 3%, it will owe the bank CHF200,000, which it can pay
using the receivables. The original CHF borrowed will be put into business operations.
If Viner Co. does not need any funds to put into the business, it will invest these
borrowed CHF in the money market. Assume today the spot rate is USD/CHF = 0.70.
CHF will convert its borrowings to USD thus:
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑈𝑆𝐷 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑙𝑜𝑎𝑛 = 𝐶𝐻𝐹194,175 × 0.70 = 𝑈𝑆𝐷135,922
Assuming the U.S. money market six-month rate is 2%, the funds in the future will be
worth:
𝑈𝑆𝐷135,922 × (1 + 2%) = 𝑈𝑆𝐷138,640

Put Option Hedge on Receivables

A put option allows an MNC to sell a specific amount of currency at a specified exercise
price by a specified expiration date.
Just like a call option, a put option is not an obligation; it is a right meaning that if the
future spot rate is higher than the exercise price the MNC will let the option expire and
instead sell the currency on the spot market. Conversely, if the future spot rate is lower
than the exercise price the MNC will exercise the put option and sell at the exercise
price. The MNC has to consider the option premium here too.

Applying a Contingency Graph

The USD cash inflows when using put options to hedge receivables are not known
with certainty as it depends on the future spot rate and whether the option is exercised
or not.
An MNC can develop a contingency graph to determine the cash received from
hedging depending on potential future spot rates.

FIN4340: International Financial Management 174

Example:
Recall that Viner Co. considers hedging receivables of CHF200,000 in six months. It
can do this by purchasing put options on CHF200,000.
Assume that the put options have an exercise price of USD/CHF = 0.70, a premium of
USD0.02, and expires in six months.
Viner can create a contingency graph for the put option hedge as shown below:

The horizontal axis shows several possible values of the Swiss franc spot rate
prevailing when Viner’s receivables arrive, while the vertical axis shows the cash to be
received from the put option hedge based on each of the possible spot rates.
At any spot rate less than or equal to the exercise price of USD/CHF = 0.70, Viner Co.
would exercise the put option, selling the CHF at the exercise price. After subtracting
the USD0.02 premium, Viner would receive USD0.68 (= 0.70 – 0.02) per CHF.
At any spot rate higher than the exercise price, Viner would let the option expire
worthless, and sell CHF at the prevailing spot rate. For instance, if the future spot rate
was USD/CHF = 0.75, Viner would sell CHF at this rate; after the premium, it will
receive USD0.73 (0.75 – 0.02) per CHF.
The graph shows the advantages and disadvantages of a put option for hedging
receivables.
The advantage is that the put option provides an effective hedge while allowing the
MNC the flexibility to choose not to exercise the option.
However, the disadvantage is that a premium must be paid for it.

FIN4340: International Financial Management 175

Applying Currency Forecasts
An MNC can apply its own forecasts of the spot rate when estimating the USD inflow
when hedging with put options.

Example:
Viner Co. considers purchasing a put option contract on CHF; the option has an
exercise price of USD/CHF = 0.72 and a premium of USD0.02. The company has
developed the following probability distribution for the future spot rate of the CHF:
 USD/CHF = 0.71 (30% probability)
 USD/CHF = 0.74 (40% probability)
 USD/CHF = 0.76 (30% probability)
The expected USD inflows from purchasing the put option is shown below:

Column 2 lists the possible spot rates in six months.

Column 3 gives the option premium which is unchanged no matter the spot rate.
Column 4 shows the amount to be received per unit as a result of the put option. If the
future spot rate is USD/CHF = 0.71 (1st row), then the put option is exercised at the
exercise price of USD/CHF = 0.72. If the spot rate is higher than the exercise price
(2nd and 3rd rows) Viner will not exercise the put option; instead, it will sell CHF at the
market spot rate.
Column 5 shows the cash received per CHF after adjusting for the option premium.
Column 6 shows the USD to be received considering the CHF200,000.

Comparison of Techniques for Hedging Receivables

The techniques for hedging receivables are summarized below using our example fo
Viner Co.:
Forward Hedge
Sell CHF six months forward.

FIN4340: International Financial Management 176

 𝑈𝑆𝐷 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑖𝑛 𝑠𝑖𝑥 𝑚𝑜𝑛𝑡ℎ𝑠 = 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑖𝑛 𝐶𝐻𝐹 × 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝐶𝐻𝐹
= 𝐶𝐻𝐹200,000 × 0.71
= 𝑈𝑆𝐷142,000

Money Market Hedge

Borrow CHF, convert to USD, invest USD, use receivables to pay off the loan in six
months.
𝐶𝐻𝐹200,000
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐶𝐻𝐹 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 =
(1 + 3%)
= 𝐶𝐻𝐹194,175
𝑈𝑆𝐷 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑐𝑜𝑛𝑣𝑒𝑟𝑡𝑖𝑛𝑔 𝐶𝐻𝐹 = 𝐶𝐻𝐹194,175 × 0.70
= 𝑈𝑆𝐷135,922
𝑈𝑆𝐷 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑎𝑓𝑡𝑒𝑟 𝑠𝑖𝑥 𝑚𝑜𝑛𝑡ℎ𝑠 = 𝑈𝑆𝐷135,922 × (1 + 2%)
= 𝑈𝑆𝐷138,640

Put Option Hedge

Purchase put option (Assume the options will be exercised in six months, or not at all;
exercise price USD/CHF = 0.72, premium = USD0.02)

The MNC can now compare each technique by assessing the USD inflows of each.
Since the option’s cash flows depends on the spot rate, cash flows from this technique
can be shown as a probability distribution.

Example:
When hedging the CHF200,000, Viner Co. can compare the cash to be received as a
result of applying different hedging techniques.
The below image shows a summary based on Viner’s cash flows. In this example,
forward hedge is much better than the money market hedge as it generates more
cash.

FIN4340: International Financial Management 177

The graph for the put option hedge shows how expected cash flows depend on the
future spot rate. The expected cash flows can be found as:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑
= (𝑈𝑆𝐷140,000 × 30%) + (𝑈𝑆𝐷144,000 × 40%)
+ (𝑈𝑆𝐷148,000 × 30%)

= 𝑈𝑆𝐷144,000
The expected value of cash received from hedging is much greater than from the
forward contract. Hence the option is better is this case.

FIN4340: International Financial Management 178

Based on the graph, there is a 30% chance that cash from the put option is less than
from the forward hedge; there is also a 70% chance the option will give higher cash
flows than the forward hedge.
Thus, for Viner, the put option is the optimal hedge.

Optimal Hedge versus No Hedge on Receivables

An MNC may know what its future receivables will be and still decide not to hedge.
In that case the MNC needs to know the probability distribution of its revenue from
receivables when not hedging.
We will see this through an example:

Example:
Viner Co. previously determined that the put option hedge was optimal. Now it wants
to compare it with no hedging.
Given its expectations of the CHF rate in six months, the cash expected if not hedged
is as follows:

The expected cash flows from not hedging are:

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
= (𝑈𝑆𝐷142,000 × 30%) + (𝑈𝑆𝐷148,000 × 40%)
+ (𝑈𝑆𝐷152,000 × 30%)
= 𝑈𝑆𝐷147,400
Now, we see that cash inflows from not hedging are higher than from the option hedge
(USD144,000). Thus, the company will now decide to remain unhedged.

Evaluating Past Decision on Hedging Receivables

Once the receivables transaction occurs, only then can the MNC evaluate whether it
was a good idea to hedge or not.

FIN4340: International Financial Management 179

Example:
Recall that Viner Co. decided not to hedge receivables. Suppose the six-month spot
rate is actually USD/CHF = 0.75. Because Viner did not hedge, its cash inflows are:
𝐶𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 = 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝐶𝐻𝐹 × 𝐶𝐻𝐹200,000 𝑓𝑟𝑜𝑚 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
= 0.75 × 𝐶𝐻𝐹200,000
= 𝑈𝑆𝐷150,000
Now, what if Viner had hedged using the put option? Given the spot rate in six months
of USD/CHF = 0.75, the company would not have exercised the option. They would
have exchanged CHF at the market spot rate and had to pay the USD0.02 option
premium. Its cash inflow would then be:
𝐶𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 = (0.75 − 0.02) × 𝐶𝐻𝐹200,000
= 𝑈𝑆𝐷146,000
Thus, Viner would be getting USD4,000 more when it doesn’t hedge.

Summary of Hedging Techniques

These can be summarized as below:

Limitations of Hedging
Limitations of Hedging an Uncertain Payment
Some international transactions involve an uncertain number of products to be ordered
and therefore involve an uncertain transaction payment in a foreign currency.
In such cases the MNC may create a hedge for a larger number of units than it will
actually need which results in the opposite form of exposure.

FIN4340: International Financial Management 180

Example:
Recall our example on hedging receivables. We assumed Viner Co. will receive
CHF200,000 in six months. Now assume the receivables is actually much lower than
this. If Viner uses the money market hedge, and the actual receivables are only
CHF120,000, then it will have to repay the CHF200,000 loan payable by purchasing
additional CHF80,000. If the CHF appreciates in six months this means they need
more USD to buy this CHF80,000.
This example shows a case of over-hedging where MNCs hedge a larger payment in
a currency than is actually needed.
To overcome over-hedging, the MNC can:
1) Hedge only the minimum payment expected

2) Use money market hedge for the minimum expected payment and use an
option contract for the remaining amount

Limitations of Repeated Short-Term Hedging

Repeated hedging of short-term transactions has limited effectiveness in the long run.

Example:
Winthrope Co. is a U.S. firm that specialises in importing TVs from Japan and
distributing them in the U.S. Assume that today’s spot rate of the JPY is USD/JPY =
0.005 and that the TVs are worth JPY60,000 or USD300 each.
The forward rate of the JPY generally exhibits a premium of 2% over the spot rate.
This is shown below:

FIN4340: International Financial Management 181

As the spot rate changes, the forward rate will often change by a similar amount.
Thus, if the spot rate increases by 10%, then the forward rate will also increase by
around that amount.
In that case, the importer will pay 10% more for next year’s shipment of TVs. The use
of a forward contract when the yen is strong would then be better than no hedge. But
this hedge does not eliminate the eventual price increase paid by the importer.
Therefore, the use of short-term hedging does not completely protect the MNC from
exchange rate exposure, even if the hedges are used repeatedly over time.

Long-Term Hedging as a Solution

Some MNCs use long-term hedging to overcome the limitations of short-term hedging.
In our example, Winthrope today can create a hedge for shipments that will arrive in
the next several years. The forward rate would be based on today’s spot rate as shown
below:

If the JPY is appreciating, then such a strategy would save a substantial amount of
money.

FIN4340: International Financial Management 182

Alternative Methods to Reduce Exchange Rate Risk
When a perfect hedge is not available to eliminate transaction exposure, the firm
should consider methods that can at least reduce exposure. Such methods include:
1) Leading and lagging
2) Cross-hedging
3) Currency diversification

Lending and Lagging

Leading and lagging strategies involve adjusting the timing of payment request or
disbursement to reflect expectations about future currency movements.

Example:
Corvalis Co. based in the U.S., has subsidiaries across the world. The subsidiary in
the U.K. purchases some supplies from a subsidiary in Hungary. These supplies are
paid for in the Hungarian forint (HUF). If Covalis expects that the GBP will depreciate
against the HUF, it may try to settle its payment to Hungary before the GBP
depreciates. This is called leading.
Also, now suppose the British subsidiary expects the GBP to appreciate against the
HUF. In this case Covalis will try to delay payments until the GBP appreciates. This is
known as lagging.

Cross-Hedging (Proxy Hedge)

Cross-hedging is a common method of reducing exposure when hedging is not
possible.

Example:
Greeley Co. in the U.S. has payables denominated in the Polish zloty (PLN). It is
worried that the PLN may appreciate against the USD and wants to hedge this
position. Assuming forward contracts or other hedging techniques are unavailable for
the PLN, they will resort to cross hedging.
The first step is to identify a currency that can be hedged and that is highly correlated
with the PLN. Greely observes that the EUR has been moving together with the PLN
and decides to set up a forward contract on the EUR.
The next step is to purchase EUR at the forward rate in the future, which enables the
company to exchange higher EUR for the higher PLN (assuming both appreciated in
tandem) when the payment is due.

FIN4340: International Financial Management 183

Currency Diversification
Currency diversification can reduce the potential effect of any single currency’s
movements on the value of an MNC.
For this to occur, the currencies that inflow to the company must not be highly
correlated so that the depreciation of one currency would not result in the others
depreciating as well.

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 can be purchased.

 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. 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.

 One limitation of hedging is that if the actual payment on a transaction is less

than the expected payment, the MNC over-hedged 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.

 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.

FIN4340: International Financial Management 184