Session7 - Notes - Session 7 > Chapter 11: Managing...

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Notes - Session 7 >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> Chapter 11: Managing Transaction Exposure Chapter 12: Measuring Economic Exposure and Translation Exposure >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> By engaging in international business, MNCs are exposed to the risk that exchange-rate fluctuations may affect them adversely. Let us focus on the three types of currency- related risks that affect the MNC, transaction exposure, economic exposure and translation exposure. TRANSACTION EXPOSURE A firm faces transaction exposure when exchange rate movements can affect the financial results of an international transaction after the firm is legally obligated to complete the transaction. Typical transactions that expose the firm to transaction exposure include purchases and sales of goods, services or assets, extension of credit and borrowing of money. Let me give you an example of transaction exposure arising from sale of goods. Suppose that a U.S. firm named Smith Co. sells merchandise on open account to a Japanese buyer for Yen 12,000,000 with payment to be made in 60 days. If the current exchange rate is Yen120/US$, the U.S. seller expects to exchange the Yen 12,000,000 for $100,000 when payment is received. Transaction exposure arises from the risk that the U.S. seller will receive something other than $100,000. For example, if the yen weakens to Yen130/UDS$, then Smith Co. would receive only $92,308, or $7692 less than expected. Conversely, had the yen strengthened to Yen110/US$, the Smith Co. would receive $109,091, or $9,091 greater than expected. Transaction exposure is the chance of either a loss or a gain. Five alternatives are available to a firm to manage this exposure 1) Remain unhedged (sometimes termed "go naked") 2) Hedge in the futures market. 2) Hedge in the forward market 3) Hedge in the options market 4) Hedge in the money market
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In the example below which shows each of the alternatives for managing exposure, While Smith. Co. appears to do best with the money market hedge; however, this is by no means always the case. Each case is different and must be calculated separately. ALTERNATIVE 1: Remaining unhedged: Hypothetical Proceeds = Unknown By choosing this risky alternative, Smith Co. assumes the foreign exchange risk because it will sell the Yen 12,000,000 at market exchange rates in 60 days. Although Smith Co. will benefit from any appreciation of the yen, the company will also lose if there is any weakening of the yen. ALTERNATIVES 2 and 3: Hedge in the futures or forward market: Hypothetical Proceeds = $98,361 Currency futures contracts are similar to currency forward contracts; however there are some differences, which are summarized in your text on page 110. Essentially, currency furutes constracts are sold on an exchange (“one size fits all”), while each forward contract is negotiated between a commercial bank and a firm. Forward contracts are custom tailored while futures contracts are standardized. Let us consider them both in
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This note was uploaded on 02/14/2011 for the course FINANCE 640 taught by Professor Sen during the Fall '10 term at UMBC.

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Session7 - Notes - Session 7 > Chapter 11: Managing...

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