European options can only be exercised on the

European options can only be exercised on the expiration date while American options can be exercised
at any time up to and including the expiration date.
Chapter 8 –
•
Three main types of currency exposures: Transaction, economic, and
translation.
Transaction Exposure: Defined as the sensitivity of “realized” domestic currency values of the firm’s
contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Also
regarded as Short-term economic exposure. Arises from fixed-price contracting in a world where
exchange rates are changing normally. (PG 198 and ex on PG 199)
Economic exposure: Defined as the extent to which the value of the firm would be affected by
unanticipated changes in exchange rates. Anticipating changes in exchange rates that would have been
already discounted and reflect in the firms value. (PG 198)
Translation exposure: The potential that the firm’s consolidated financial statements can be affected by
changes in exchange rates. Consolidation involves translation of subsidiaries financial statements from
local currencies to the home currency. (PG 198 EX on PG 198)
•
Ways of hedging transaction exposure with financial products: forward
market hedge, money market hedge, option market hedge.
Forward Market Hedge: Used as a way of hedging transaction exposure. The may sell (buy) its
foreign currency receivables (payables) forward to eliminate it exchange risk exposure.

(Example on PG 200)
EX for buyers(import): If you expect to owe foreign currency in the future, you can hedge by agreeing
today to buy the foreign currency in the future at a set price by entering into a long position in a forward
contract.
EX for seller(export): If you are going to receive foreign currency in the future, agree to sell the foreign
currency in the future at a set price by entering into short position in a forward contract.
To figure out the gain or losses from Forward hedging:
Gain = (Forward exchange rate – spot rate on maturity date) x Amount receivable
Money Market Hedge: With this method we can hedge funds by lending and borrowing in the domestic
foreign money markets. Firms may borrow in foreign currency to hedge it foreign currency receivables
(payables), thereby matching it assets and liabilities in the same currency.
(Example on Page 202 -203)
Steps to Hedge using Money Market:
1 Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the
present value? Because the foreign currency loan plus the interest on it should be exactly equal to the
amount of the receivable.
2 Convert the foreign currency into domestic currency at the spot exchange rate.
3 Invest the domestic currency on deposit.
4 Collect the currency receivable and, repay the foreign currency loan.
5 Receive the maturity value of the investment, which would guarantee the proceeds.
Option market hedge: Currency options provide such a flexible “optional” hedge against exchange
exposure. Generally speaking, the firm may buy a foreign currency call (put) option to hedge its foreign
currency payables (receivables). The options hedge allows the firm to