Exchange rate exposure
Foreign exchange exposure is a measure of the potential change in profitability, net cash flow, and market value because of a change in exchange rates
Two types
Transaction exposure: Effects of change in exchange rate on contractual future cash flows
paying in foreign currency
Operating exposure: Effects of change in exchange rate on non-contractual future cash flows
Are you subject to transaction exposure if the payment is immediate?
No, there should be no uncertainty
Forward contract - seller of euro or contract
short position
forward price
A firm is exposed to exchange risk mainly through the effect of exchange rate changes on its competitive position.
Thus, operating exposure is also called as competitive exposure.
Revenue and operating costs
A company with foreign production and domestic sales
Sales in US --> $ revenues stay the same
Costs in foreign currencies à $ costs change with changes in exchange rate
What if $ weakens?
Operating exposure
Revenues: none
Costs: increased
Net effects: decrease in cash flows
What is the goal of hedging?
Hedging is to eliminate risk
Hedging a particular currency exposure means establishing an offsetting currency position on your transaction
Internal (operational) hedging
1. Invoice all transactions in domestic currency
2. Matching
3. Lead and lag payment
External (financial) hedging
1. Forward market hedge
2. Money-market hedge
3. Options market hedge
Account receivable + Option
Insured for the minimum amount you will collect
Account payable + Option
Insured for the maximum amount you will pay
You will receive £1 million in 3 months
Purchase 3 month pound put option (right to sell)
Strike price: $1.76/£
Premium: $0.03/£ (cost of having your protection or insurance)
Cost of option (right to buy)
Option premium: $0.03/£
Option Premium:
Premium = £1,000,000 x $0.03/£ = $30,000
Become seller of pound forward contract
Borrow pounds today, at certain maturity pay that pound in the future
X(1+0.10/4) = £1,000,000 X = £1,000,000/(1+0.10/4) = £975,610
Borrow £ today
How much? PV of £1,000,000
X = £1,000,000/(1+0.10/4) = £975,610
Invest $ today
How much?
Covert £ received from the loan into $ at today’s spot rate
£975,610 * $1.77/£ = $1,726,830
Receive $ at the maturity
$1,726,830 * (1+0.08/4) = $1,760,000
Use receivable to pay off loan in 3 months
The interest rates and forward and spot rates are selected so that interest rate parity would hold
The net cash flows from the forward market and money market hedges are equal
Using money market hedge, you can create a “homemade” forward contract
Money market hedge: The spot rate is locked in
Forward market hedge: The forward rate is locked in
You will receive £1 million in 3 months
Purchase 3 month pound put option
Strike price: $1.76/£
Premium: $0.03/£
Cost of option
Option premium: $0.03/£
Buyer, buyer will have the right to sell
Call option
Buy - right to buy
Put options
Buyer - right to sell