International Finance - Transaction Exposure

There are various techniques available for managing transactional exposure. The objective here is to shun the transactions from exchange rate risks. In this chapter, we will discuss the four major techniques that can be used to hedge transactional exposure. In addition, we will also discuss some operational techniques to manage transactional exposure.

Financial Techniques to Manage Transaction Exposure

The main feature of a transaction exposure is the ease of identifying its size. Additionally, it has a well-defined time interval associated with it that makes it extremely suitable for hedging with financial instruments.

The most common methods for hedging transaction exposures are −

  • Forward Contracts − If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value.

  • Futures Contracts − These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure.

  • Money Market Hedge − Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies' riskless returns. It is also a form of financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks.

  • Options − A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period.

Note − The major difference between an option and the hedging techniques mentioned above is that an option usually has a nonlinear payoff profile. They permit the removal of downside risk without having to cut off the profit from upside risk.

The decision of choosing one among these different financial techniques should be based on the costs and the penultimate domestic currency cash flows (which is appropriately adjusted for the time value) based upon the prices available to the firm.

Transaction Hedging Under Uncertainty

Uncertainty about either the timing or the existence of an exposure does not provide a valid argument against hedging.

Uncertainty about transaction date

Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-currency cash flow. The key reason is that, even if they are sure that a foreign currency transaction will occur, they are not quite sure what the exact date of the transaction will be. There may be a possible mismatch of maturities of transaction and hedge. Using the mechanism of rolling or early unwinding, financial contracts create the probability of adjusting the maturity on a future date, when appropriate information becomes available.

Uncertainty about existence of exposure

Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids with prices fixed in foreign currency for future contracts. The firm will pay or receive foreign currency when a bid is accepted, which will have denominated cash flows. It is a kind of contingent transaction exposure. In these cases, an option is ideally suited.

Under this kind of uncertainty, there are four possible outcomes. The following table provides a summary of the effective proceeds to the firm per unit of option contract which is equal to the net cash flows of the assignment.

State Bid Accepted Bid Rejected
Spot price better than exercise price : let option expire Spot Price 0
Spot price worse than exercise price: exercise option Exercise Price Exercise Price - Spot Price

Operational Techniques for Managing Transaction Exposure

Operational strategies having the virtue of offsetting existing foreign currency exposure can also mitigate transaction exposure. These strategies include −

  • Risk Shifting − The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, it is not possible in all cases.

  • Currency risk sharing − The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero sum game, one party loses and the other party gains%

  • Leading and Lagging − It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging.

  • Reinvoicing Centers − A reinvoicing center is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the transaction exposure.

Reinvoicing centers have three main advantages −

  • The centralized management gains of transaction exposures remain within company sales.

  • Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting processes and improve intra affiliate cash flows, as intra-company accounts use domestic currency.

  • Reinvoicing centers (offshore, third country) qualify for local non-resident status and gain from the offered tax and currency market benefits.

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