Transaction Exposure Risk due to lags in payments Hedging strategies October 27, 20151Transaction Exposure

Transaction Exposure

Risk due to lags in payments

Hedging strategies

April 20, 2023 1Transaction Exposure

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 sources

lending or receivables denominated in foreign currency

borrowing or payables denominated in foreign currency

holding a defaulted forward contract


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)April 20, 2023 Transaction Exposure 4

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)


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


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


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


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


Types of hedges

contractual hedges forwards, futures, option, money market hedges

operating & financial hedges risk-sharing leads & lags swaps


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


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


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


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


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


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


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


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


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


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


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


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


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


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

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Transaction Exposure Risk due to lags in payments Hedging strategies October 27, 20151Transaction Exposure