Transcript IFI_Ch11

Chapter 11
Transaction Exposure
The Goals of Chapter 11
• Introduce three types of foreign exchange exposure:
transaction, operating, and translation exposure
• Discuss the pros and cons of hedging foreign
exchange risk by MNEs
• Analyze the source of transaction exposure, which
corresponds to the risk that the values of foreigncurrency-denominated receipts or payments could be
influenced by the exchange rate changes
• Focus on the introduction of how to manage (or
hedge) the transaction exposure
11-2
Types of Foreign
Exchange Exposure
11-3
Types of Foreign Exchange
Exposure
• Foreign exchange exposure is a measure of the
potential change for a firm’s profitability, net cash
flow, and market value because of a change in
exchange rates
• An important task for the financial manager is to
measure foreign exchange exposure and to manage it
so as to maximize or stabilize the profitability, net
cash flow, and market value of the firm
• The impact on a firm when foreign exchange rates
change can be classified into three kinds of exposure:
transaction, operating, and translation exposure
11-4
Types of Foreign Exchange
Exposure
• Transaction exposure measures changes in the
value of existing foreign-currency-denominated
obligations, which incurred prior to an exchange
rate change but are not due to be settled until after
the exchange rate change
– According to the above definition, the exchange rate
changes cause the transaction exposure for existing
obligations, which start in the past and end in the
future
• In general, this type of exposure can be defined as
changes in cash flows of current existing
contractual obligations due to the movement of
the exchange rates
11-5
Types of Foreign Exchange
Exposure
• Operating exposure, also called economic exposure,
competitive exposure, or strategic exposure,
measures the change in the present value of the
firm resulting from any change in future operating
cash flows of the firm caused by an unexpected
change in exchange rates
• More specifically, the change in firms’ value
depends on the impact of the exchange rate change
on future sales volume, product prices, and costs in
the following years
11-6
Types of Foreign Exchange
Exposure
• Translation exposure, also called accounting exposure,
is the potential for accounting-derived changes in
owner’s equity to occur because of the need to
“translate” foreign currency financial statements of
foreign subsidiaries into a single reporting currency to
prepare worldwide consolidated financial statements
• This risk arises from that the exchange rates for
acquiring assets, liabilities, and equities are different
from that for generating consolidated financial
statements
• So, comparing to time points of acquiring assets,
liabilities, and equities, changes of the exchange rate at
later time points cause the translation exposure
11-7
Exhibit 11.1 Comparison of Occurrence Time of the
Three Foreign Exchange Exposures on the Time Line
Time point when the
exchange rate changes
Translation exposure
Changes in reported owners’ equity
in consolidated financial statements
caused by a change in exchange rates
Operating exposure
Change in expected future cash flows
for following years arising from an
unexpected change in exchange rates
Transaction exposure
Impact of settling existing obligations, which entered into before changes
in exchange rates but to be settled after changes in exchange rates
Time
11-8
Types of Foreign Exchange
Exposure
• Transaction exposure vs. Operating exposure
– Both transaction exposure and operating exposure exist
because of unexpected changes in future cash flows
– The difference between them:
• Transaction exposure is concerned with the uncertainty of
future cash flows which are already contracted
• Operating exposure focuses on expected future cash flows
(not yet contracted) that might change because a change in
exchange rates could altered international competitiveness
11-9
Types of Foreign Exchange
Exposure
• Tax consequence of foreign exchange exposures
– As a general rule, only realized foreign exchange losses are
deductible for calculating income taxes; Similarly, only
realized foreign exchange gains create taxable income
– Losses from transaction exposure usually reduce taxable
income in that year, but losses from operating exposure may
maintain for several years and thus reduce taxable income
over a series of future years
– Note that translation exposure could affect the parent
company’s net worth or net income, but it will not generate
cash losses in practice, i.e., both the parent company and
subsidiaries will not lose any money physically during the
translation of financial statements
– Since losses from translation exposure are only “paper”
losses, involving no cash flows, they are not deductible from
pretax income
11-10
Reasons for Hedging
Foreign Exchange Risk
11-11
Why Hedge?
• MNEs possess a multitude of cash flows that are
sensitive to changes in exchange rates, interest rates,
and commodity prices
– These three financial price risks are the subject of the
growing field of financial risk management
– This chapter focuses only on the sensitivity of the individual
firm’s future cash flows to exchange rates
• Many firms attempt to manage their currency (foreign
exchange) exposures through hedging
– Hedging is the taking of a position, acquiring either a cash
flow, an asset, or a contract (e.g., a forward contract) that
will rise (fall) in value and offset a fall (rise) in the value of
an existing position
– While hedging can protect the owner of an asset from a loss,
it also eliminates any gains from an increase in the value of
11-12
that asset
Why Hedge?
• What is to be gained by the firm from hedging?
– The major motive for firms to hedge is to increase the present
value of firms
– The value of a firm, according to financial theories, is the
present value of all expected future cash flows in the future
– For expected cash flows with higher uncertainty (or risk), a
higher discount rate should be applied to calculating the
present value and thus a lower present value for these cash
flows is generated
– A firm that hedges these foreign exchange exposures reduces
the variance (or risk) in the value of future expected cash
flows (see Exhibit 11.2 on the next slide)
– Thus, a lower discount rate is employed to calculate the
present value of expected future cash flows, which implies
the increase of the present value of the firm
11-13
Exhibit 11.2 Impact of Hedging on the
Expected Cash Flows of the Firm
※ Hedging will not increase the expected value for a cash flow. Actually, if taking the
hedging cost into account, hedge transactions will decrease the expected cash flow
※ Hedging reduces the variability of future cash flows about the expected value of the
distribution. This reduction of distribution variance is a reduction of risk
11-14
Why Hedge?
• However, is a reduction in the variability of future
cash flows to be a sufficient reason for currency risk
management? Opponents of currency hedging
commonly make the following arguments
– Shareholders are much more capable of diversifying
currency risk according to their individual preferences and
risk tolerance than the management of the firm
– Although currency risk management can reduce the variance,
it reduces the expected cash flow due to hedging costs.
• So, the net benefit of hedge depends on the trade-off between
these two effects
– Hedging activities are sometimes conducted to benefit the
management at the expense of the shareholders
• For instance, the true goal of hedging the variance of the
company’s income is to ensure the bonus of the management
11-15
Why Hedge?
– Management may overuse the expensive hedge
• Management may believe that it will be criticized more
severely for incurring foreign exchange losses than for
incurring similar or even higher hedge costs in avoiding the
foreign exchange loss
• Possibly due to the accounting rules: because the foreign
exchange losses appear in the income statements as a highly
visible item or as a footnote, but the hedging costs are buried
in operating or interest expenses
– Efficient market theorists believe that investors can see
through the “accounting veil” and therefore have already
factored the foreign exchange effect into a firm’s market
valuation
• Although the translation exposure are only “paper” losses,
there are still some firms to hedge this risk
• However, the above argument implies that it is not necessary
to hedge the translation (accounting) exposure
11-16
Why Hedge?
• Proponents of hedging cite the following arguments:
– Hedge can reduce the variance of future cash flows and
thus may increase the firm’s present value by reducing
the discount rate
– Firms should focus on the main business they are in and
take activities to minimize risks arising from interest rates,
exchange rates, and other market variables
– Management is in better position than shareholders to
recognize disequilibrium conditions quickly and to
undertake the hedging activities immediately
– Management has a comparative advantage over individual
shareholders in estimating the actual currency risk of the
firm and taking the correct hedging strategy
11-17
Why Hedge?
– Reduction in risk in future cash flows improves the
planning capability of the firm. Therefore, the firm can
undertake more investment projects that it might not
consider before
– Since a firm must generate sufficient cash flows to
make debt-service payments, reduction of risk in
future cash flows reduces the likelihood that the firm’s
cash flows will fall below a necessary minimum (This
minimum level of cash flows is also terms as the point of
financial distress)
11-18
Sources of Transaction
Exposure
11-19
Sources of Transaction Exposure
• Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations whose terms are stated in a foreign
currency
• The sources of transaction exposure include
– Purchasing or selling goods and services in foreign
currencies through credit accounts (to form the A/P or
A/R on the balance sheet)
– Borrowing or lending funds in foreign currencies
– Entering into foreign exchange or foreign currency
derivative contracts
11-20
Purchasing or Selling through
Credit Account
• The most common example of transaction exposure
arises when a firm has a receivable or payable
denominated in foreign currencies
• For each trade of goods and services, the total
transaction exposure consists of quotation, backlog,
and billing exposures (see Exhibit 11.3)
• Suppose that a U.S. firm sells merchandise on credit
account to a Belgian buyer for €1,000,000 to be made
in 60 days. The current exchange rate is $1.12/€, so the
seller expects to receive $1,120,000
– For the exchange rate to become $1.08/€ ($1.15/€), the seller
will receive $1,080,000 ($1,150,000)
– Thus exposure (or risk) means not only the probability of
some losses but also the probability of some gains
11-21
Exhibit 11.3 The Life Span of the Transaction
Exposure for Trades of Goods and Services
Time and Events
t1
t2
Seller quotes a price
in foreign currency to
buyer (in verbal or
written form)
t3
Buyer places
firm order with
seller at price
offered at time t1
t4
Seller ships
products and
bills buyer
(becomes A/R)
Buyer settles A/R
with cash in
foreign currency
quoted at time t1
Time between quoting
a price and reaching a
contractual sale
Time it takes to
fill the order after
contract is signed
Time it takes to
get paid in cash after
A/R is issued
Quotation
Exposure
Backlog
Exposure
Billing
Exposure
※After the price is quoted at t1, if the exchange rate changes against the seller at t2, the
seller may earn less or even suffer losses. So the transaction exposure starts from t1
※At t3, the seller books foreign-currency-denominated receivables at the exchange rate
of that time point, but changes in exchange rate between t3 and t4 will affect the
received cash flow in domestic dollars at t4, that is the billing exposure
※The transaction exposure on credit account is actually the billing exposure
11-22
Borrowing or Lending Foreign
Currencies
• A true case for the transaction exposure over foreign
debt is about the Grupo Embotellador de Mexico
(Gemex)
• Gemex, the largest bottler of PepsiCo outside the U.S.,
had U.S. dollar debt of $264 million in 1994
• The Mexico’s new peso was pegged at Ps3.45/$ since
Jan. 1, 1993, but the peso was forced to float in Dec.
1994 because of economic and political events and the
exchange rate stabilized near Ps5.5/$
• So, the debt in pesos is from Ps910 million to Ps1452
million, which increases by 59%
11-23
Entering into Foreign Exchange or
Foreign Currency Derivative Contracts
• Suppose a U.S. firm purchases ￥100 million through
a foreign exchange forward contract at the forward
exchange rate ￥100/$ after 90 days
– When a firm enters into a foreign exchange derivatives
contract, it deliberately creates a transaction exposure
– The motive to create transaction exposure could be the need
for hedge the account payable of ￥100 million after 90
days
– If the spot exchange rate becomes ￥110/$ (￥90/$) after 90
days, the U.S. firm will have a transaction loss (gain)
through this foreign exchange forward contract
– On the other hand, if the spot exchange rate is ￥110/$
(￥90/$) after 90 days, the account payable of ￥100
million after 90 days have a transaction gain (loss)
11-24
Sources of Transaction Exposure
※ Note that cash balances in foreign currency (外幣
現金部位) DO NOT create transaction exposure,
even though their domestic currency value changes
immediately with a change in exchange rates
– Since the firm does not have the obligation to transfer cash
in foreign currency into cash in domestic currency, there is
no transaction exposure for the cash in foreign currency
– This kind of risk is reflected in the consolidated statement
and thus classified as the translation exposure
11-25
Management of
Transaction Exposure
11-26
Management of Transaction
Exposure
• Transaction exposure can be managed by operating,
financial, and contractual hedges
• The term operating hedge refers to an off-setting
operating cash flow arising form the conduct of
business
– For example, the payments in a foreign currency could be
offset by the foreign currency cash inflow generated from
operating activities, e.g., from sales. This kind of hedge for
the transaction exposure is also termed natural hedge
– Operating hedge could also employ the use of risk-sharing
agreements, leads and lags in payment terms, and other
strategies (discussed in detail in Ch 12)
11-27
Management of Transaction
Exposure
• A financial hedge refers to either an off-setting debt
obligation (such as a loan) or some type of financial
derivative such as an interest rate swap
– To eliminate the transaction exposure, firms can borrow
foreign currencies today to prepare for the settlement of
A/Rs in foreign currencies in the future
– Due to the borrowing activities, this kind of hedge is
classified as financial hedge
• Contractual hedges employ the forward, futures, and
options contracts to hedge transaction exposures
• The Trident case as follows illustrates how contractual
and financial hedging techniques may be used to
protect against transaction exposure
11-28
Trident’s Transaction Exposure
• Trident company just concludes negotiations for the
sale of telecommunication equipments to Regency, a
British firm, for ￡1,000,000
– The sale is made in March with payment due three months
later in June
– The financial and market information is as follows
‧Spot exchange rate: $1.7640/￡
‧Three-month forward rate: $1.7540/￡
‧Cost of capital for Trident company: 12%
‧U.K. three-month deposit (borrowing) interest rate: 8% (10%)
‧U.S. three-month deposit (borrowing) interest rate: 6% (8%)
‧Put option expired in June for ￡1,000,000 with the strike price
$1.75/￡ ($1.71/￡) is quoted as 1.5% (1.0%) premium
‧Trident’s foreign exchange advisory service forecasts that the
spot rate after three months will be $1.76/￡
11-29
Trident’s Transaction Exposure
• Trident’s minimum acceptable margin is at a sales
price of $1,700,000, which implies the budget rate,
the lowest acceptable dollar per pound exchange
rate, is at $1.70/￡
• Trident company has four alternatives to deal with
the transaction exposure:
–
–
–
–
Remain unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the options market
• These choices can be applied to both an account
receivable (in this case) and an account payable
11-30
Trident’s Transaction Exposure
• Unhedged position
• Forward Market Hedge
– A forward hedge involves a forward (or futures) contract
and a source of funds to fulfill the contract in the future
– If funds to fulfill the forward contract are on hand or are
due because of a business operation, the hedge is considered
“covered,” since no residual foreign exchange risk exists
11-31
Trident’s Transaction Exposure
– It would be recorded on Trident’s income statement as a
foreign exchange loss of $10,000 ($1,764,000 as booked,
$1,754,000 as settled)
– Different from the above case, if funds to fulfill the forward
exchange contract are not already available or due to be
received later, funds to fulfill the forward contract must be
purchased in the spot market at some future time points
– This type of hedge is “open” or “uncovered” and involves
considerable risk because of the uncertain future spot rate to
obtain funds to fulfill the forward contract
– In this chapter, only the covered hedge is considered
11-32
Trident’s Transaction Exposure
• Money Market Hedge
– A money market hedge also involves a contract and a source
of funds to fulfill that contract
– In this instance, the contract is a loan agreement, so the
money market hedge is a kind of financial hedge
– The firm seeking the money market hedge borrows in one
currency and exchanges the proceeds for another currency
– Funds to fulfill the contract–to repay the loan–may be
generated from business operations, in which case the money
market hedge is covered
※ ￡975,610 =￡1,000,000 / (1+10%×90/360)
11-33
Trident’s Transaction Exposure
– The money-market hedge actually creates a pounddenominated liability (the pound loan) to offset the pounddenominated asset (the account receivable)
– So, the money-market hedge is also a kind of balance sheet
hedge
– Money market hedge vs. forward market hedge
Received today Invested in
Rate (annual) FV after 3 months
$1,720,976
Deposit
6%
$1,746,791
$1,720,976
Dollar loans
8%
$1,755,396
$1,720,976
Operations of the firm
12%
$1,772,605
※ A break-even investment rate can be calculated that would make Trident
indifferent between the forward market hedge and the money market hedge
$1, 720,976 (1  r )  $1, 754, 000  r  1.92% (7.68% annually)
※ If Trident can invest the loan proceeds at a rate higher than 7.68% per annum,
it would prefer the money market hedge
11-34
Trident’s Transaction Exposure
• Option Market Hedge
– Trident could also cover ￡1,000,000 exposure by
purchasing a put option to acquire the right to sell British
pounds forward at the strike price
– Hedging with purchasing options allows for participation
in any upside potential associated with the position while
limiting downside risk
– The choice of option strike prices is an important aspect
of utilizing options for hedging because option premiums
and payoff patterns will differ accordingly
– Trident consider (1) a nearly ATM put with the strike
price of $1.75/￡ and the premium of 1.5%, or (2) an
OTM put with the strike price of $1.71/￡ and the
premium of 1%
11-35
Trident’s Transaction Exposure
– For the ATM put, the cost of put is ￡1,000,000 × 1.5% =
￡15,000 = $26,460 (= ￡15,000 × $1.7640/￡)
– The minimal dollar receipts in June is $1,750,000 –
$26,460×(1 + 12%×90/360) = $1,750,000 – $27,254 =
$1,722,746 when the spot exchange rate is below $1.75/￡
(The opportunity cost of $26,460 is the cost of capital of
Trident, i.e., 12%)
– The maximal dollar receipts in June is unlimited and
increasing with the appreciation of the pounds
11-36
Trident’s Transaction Exposure
– Compare the ATM put and the OTM put
Put option with strike price
Option cost (FV in June)
ATM put at $1.75/￡
OTM put at $1.71/￡
$27,254
$18,169
Proceeds if exercised
$1,750,000
$1,710,000
Minimum net proceeds
$1,722,746
$1,691,831
Maximum net proceeds
Unlimited
Unlimited
※ The option premium for the OTM put is ￡1,000,000 × 1% = ￡10,000 =
$17,640 (= ￡10,000 × $1.7640/￡)
※ The minimal dollar receipts in June is $1,710,000 – $17,640×(1 +
12%×90/360) = $1,710,000 – $18,169 = $1,691,831 when the spot exchange
rate is below $1.71/￡
※ The OTM put is much cheaper today, but the minimum net proceeds of the
OTM put is smaller than those of the ATM put, i.e., the OTM put provides a
lower level of protection
※ In the Trident’s case, the OTM put cannot meet its budgeted exchange rate
of $1.70/￡ after taking the premium expenses into consideration
11-37
Trident’s Transaction Exposure
• Comparison of alternative hedging strategies for Trident
Unhedged position
Wait three months then sell the received
￡1,000,000 for dollars in the spot market
Result
Receipt in US$ in June
1. An unlimited maximum
2. An expected $1,760,000
3. A zero minimum
Forward market hedge
Sell ￡1,000,000 forward for dollars
Result
Certain receipts of $1,754,000 in June
Money market hedge
1. Borrow ￡975,610 at the interest rate of
10%
2. Exchange for $1,720,976 at the spot
exchange rate
3. Invest $1,720,976 in US markets for
three months
Result
1. The received ￡1,000,000 is for the repayment
of the interest and principal of the borrowed
amount of ￡975,610
2. The FV of $1,720,976 in June depends on the
US$ investment rate (The break-even rate of
7.68% generates the same payment as the
forward contract, i.e., $1,754,000)
Options market hedge
Purchase a three-month put option of
￡1,000,000 with the strike price of
$1.75/￡ and premium cost of $27,254 (FV
after 3 months)
Result
Receipt in US$ in June
1. An unlimited maximum less $27,254
2. An expected $1,760,000 less $27,254
3. A minimum of $1,750,000 less $27,254
11-38
Exhibit 11.5 Valuation of Cash Flows
Under Hedging Alternatives for Trident
Value of Trident’s £1,000,000 A/R
(in million US dollars)
Uncovered
Put option strike
price of $1.75/£
1.84
OTM put
option hedge
Put option strike
price of $1.71/£
1.82
ATM put
option hedge
1.80
1.78
Money market hedge
1.76
1.74
Forward contract hedge
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
1.82
1.84
1.86
Ending spot exchange rate (US$/£)
11-39
Trident’s Transaction Exposure
• The final choice among hedges depends on the firm’s
risk tolerance, its view of the future exchange rate,
and its confidence in its view
– Thus, transaction exposure management with contractual or
financial hedges requires managerial judgment
• For an account payable, where the firm would be
required to make a foreign currency payment at a
future date, it is possible to apply similar techniques
to hedging this transaction exposure
• Suppose that Trident had a ￡1,000,000 account
payable which will be settled in 90 days, the possible
hedge alternative are summarized in the table on the
next slide
11-40
Trident’s Transaction Exposure
Unhedged position
Wait 90 days, exchange dollars for
￡1,000,000 at that time, and make its
payment
Result
Total payment for ￡1,000,000 in June
1. Unlimited US$
2. Expected amount of $1,760,000
3. Minimal zero US$ payment
Forward market hedge
Buy ￡1,000,000 forward for dollars
Result
Certain payments of $1,754,000 in June
Money market hedge
1. Borrow $1,729,411.77 at the interest rate
of 8%
2. Exchange for ￡980,392.16 at the spot
exchange rate of $1.764/￡
3. Deposit ￡980,392.16 in the British
pound money market at the interest rate
of 8% for 90 days
Result
1. The interest and principal of ￡980,392.16 is
￡1,000,000, which is just enough for the
payment after 90 days
2. The repayment amount of $1,729,411.77 in
90 days is $1,764,000 (This cost is higher
than the forward hedge and therefore
unattractive)
Options market hedge
Purchase a three-month call option of
￡1,000,000 with a nearly at-the-money
strike price of $1.75/￡ and premium is
assumed to be 1.5%, which implies a cost of
$27,254 (FV after 3 months)
Result
Total payment for ￡1,000,000 in June
1. A limited maximum of $1,750,000 +
$27,254 = $1,777,254
2. A minimum of $0 plus $27,254
11-41
Exhibit 11.6 Valuation of Hedging
Alternatives for an Account Payable
Value of Trident’s £1,000,000 A/P
in million US dollars
-1.68
1.68
1.70
Ending spot exchange rate (US$/£)
1.72
1.74
1.76
1.78
1.80
1.82
1.84
1.86
-1.70
Forward contract hedge locks
in a payment of $1,754,000
-1.72
-1.74
-1.76
-1.78
-1.80
Call option hedge
Money market hedge locks
in a payment of $1,764,000
-1.82
-1.84
Call option strike
price of $1.75/£
Uncovered payment
whatever the ending
spot rate is in 90 days
11-42
Risk Management in
Practice
11-43
Risk Management in Practice
• The following paragraphs summarized the results of
many surveys of corporate risk management practices
in recent years
1. Treasury function:
– The treasury function of most private firms, which is the
group typically responsible for transaction exposure
management, is usually considered a cost center
– It is not suited to treat the treasury as a profit center. Since
assets with higher risk will provide higher expected returns,
if the treasury operates as a profit center, it might tolerate
more risks that should be hedged
11-44
Risk Management in Practice
2. Currency risk managers are expected to err on the
conservative side when managing the firm’s money
– Although transaction exposures exist before they are actually
booked as foreign-currency-denominated receivables or
payables, many firms do not allow the hedging of quotation
exposure or backlog exposure as a matter of policy
• Many firms feel that until the transaction exists on the
accounting books of the firm, the probability of the exposure
actually occurring is considered to be less than 100%
– These conservative policies dictate that contractual or
financial hedges should be placed only on existing exposures
– An increasing number of firms, however, are actively
hedging not only backlog exposures, but also selectively
hedging quotation and anticipated exposures
• Anticipated exposures are transactions for which there are–at
present–no contracts or agreements between parties, but that are
anticipated on the basis of historical trends and continuing
business relationships
11-45
Risk Management in Practice
3. Which contracts are used for hedge?
– In practice, transaction exposure management programs are
generally divided along an “option-line”; those that use
options and those that do not
– Those firms that do use currency options are generally more
aggressive in their tolerance of currency risk
– Firms that do not use currency options rely almost
exclusively on forward contracts and money market hedge
– For extremely conservative and risk-intolerant firms, they
hedge all existing exposures with forwards and hedge a
variety of backlog and anticipated exposures with options
11-46
Risk Management in Practice
4. Proportional hedges
– Many MNEs have established rather rigid transaction
exposure risk management policies that mandate
proportional hedging
– These policies generally require the use of forward
contract hedges on a percentage (e.g., 50%, 60%, or 70%)
of existing transaction exposures
– The remaining portion of the exposure is then selectively
hedged on the basis of the firm’s risk tolerance, the view
of exchange rate movements, and the confidence level
about the view
11-47
Risk Management in Practice
5. Full hedge only at favorable forward exchange rates
– Many firms require that when there is a favorable forward
exchange rate, full forward-cover is put in place; Otherwise,
they may adopt the proportional hedges
– More specifically, for the account receivables (payables) of
Trident case, the full forward-cover strategy is adopted
when the forward exchange rate is at premium (discount),
i.e., the forward exchange rate is higher (lower) than the
spot exchange rate, $1.7640/￡
– The reason is that if firms use forward contracts to hedge
when the forward rate is unfavorable, a certain foreign
exchange loss will be shown in the income statement (see
the example on Slides 11-31 and 11-32)
• For the management, it is difficult to explain why there is still
a foreign exchange loss after conducting a hedging
transaction
11-48
Risk Management in Practice
6. Other derivatives
– Recently, many other complex options are employed to
hedge the exchange rate risk, like range forwards,
participating forwards, average rate options, etc.
– Consider that Trident possess a ￡1,000,000 account
receivable to be settled in 90 days and the following
information
Spot rate
$1.479/￡
90-day forward rate
$1.470/￡
90-day dollar interest rate
3.25%
90-day pound interest rate
5.72%
90-day $/￡ volatility
11%
11-49
Risk Management in Practice
– Range forward
• Buy a put option with a strike rate below the forward rate, and sell
a call option with a strike rate above the forward rate
• The benefits of the combined position
– With a near-zero net premium (the premium from selling the call is
used to finance the purchase of the put)
– The foreign exchange risk is bounded in a range
11-50
Risk Management in Practice
– Participating forward
• Buy a put option with a strike rate below the forward rate, and sell
a call option with a strike rate the same as the put option but only
for a portion of the total currency exposure
• The benefits of the combined position
– With a zero net premium by a proper participation rate (53.18% here)
– For all favorable exchange rate movements (those above $1.45/￡),
the hedger would enjoy 46.82% (=1 – 53.18%) of the differential
between the uncovered position and the short position of the call 11-51
Risk Management in Practice
– Average rate option
• It is a more recent currency derivative contract
• It is normally classified as a “path-dependent” currency option,
because its payoff depends on averages of spot rates over some
pre-specified period of time
• There are two basic categories, the average rate option and the
average strike option
– The average rate call is with the payoff max(S  K,0), where S is
the average spot rate over the period
– The average strike call is with the payoff max(ST  S,0)
• For firms that generate foreign-currency-denominated receivable
or payable at a regular frequency, e.g., daily, since there are too
many transactions, it is difficult and expensive for firms to hedge
each transaction separately
• The average rate option is a better alternative for these firms to
hedge their transaction exposure with lower hedge costs
11-52