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566-8 - CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE...

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CHAPTER 8 - MANAGEMENT OF TRANSACTION EXPOSURE Transaction exposure - Currency risk when a firm faces contractual CFs fixed (invoiced) in another currency - receive or pay a fixed amount of foreign currency in the future, i.e. any receivable (AR), or payable (AP) in a foreign currency. Source of currency risk from transaction exposure for MNC could be either: a) export/import activities, or b) borrowing/lending activities - anytime future CFs (to be paid or received) are fixed in a foreign currency. Example: U.S. firm sells its product to a German client for €1m, payable in 3 months, now faces transaction exposure since the CFs are fixed in Euros, and the future value of the Euro is uncertain, meaning that the dollars received are uncertain. Worried about?? ______________ Example: U.S. firm borrows in U.K. pounds, owes £1m in one year, faces transaction exposure since the CFs are fixed in a foreign currency. Worried about?? _______________ Unlike many forms of currency risk (economic exposure), currency risk in the form of transaction exposure is always easily identifiable and quantifiable, because the exact amount of the CFs, payable or receivable, are known and certain, and the timing of the CFs is known. An example of economic exposure is the effect of future currency fluctuations on sales revenue for Merck or GM, which is more uncertain and harder to quantify. Transaction exposure always involves known and certain CFs, so the risk exposure is well defined. Financial contracts (derivatives) and operational techniques (see p. 193) can be used to deal with transaction exposure. An important part of Intl. Finance is the management of transaction exposure. To illustrate transaction exposure, consider case of Boeing Corporation, p. 194. Boeing Corporation (NYSE:BA, DJIA stock), a U.S. MNC, exports a 747 to British Airways, invoice is for £10m, payable in one year. Int. rates and FX rates are: U.S. interest rate (one year) = 6.10% U.K. interest rate (one year) = 9.00% S = $1.50/£ F 1 = $1.46/£ (one-year forward rate) Check for IRP (full formula): 1.061 = 1.09 x ($1.46/£/ $1.50/£) IRP is Holding Without a hedge, Boeing is exposed to currency risk, see Exhibit 8.1 on p. 195, specifically if ______________. Hedging Options for Boeing: 1. Forward Hedge. Most direct and popular way to hedge currency risk is a currency forward contract , sell the £10m forward at $1.46/£ for a guaranteed receipt of $14.6m (£10m x $1.46/£), regardless of what happens to the spot rate. See Exhibits 8.1 and 8.2 on p. 195: If £ (BP) depreciates to $1.40 (what Boeing is worried about), they only receive $14m for the order (selling £10m at the spot rate), but the profit on the forward contract is $0.60m to make up the difference and Boeing nets $14.6m. If £ (BP) appreciates to $1.50, Boeing will receive $15m for the order, but will lose $0.4m on the forward contract, for a net of $14.6m. No matter what happens to S, Boeing will net $14.6m with a currency forward hedge, and will lock in ex-rate of $1.46/£.
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