Translation Exposure

1
CHAPTER 10

• Translation Exposure

2
CHAPTER OVERVIEW

• EXPOSURE DEFINED
• TRANSACTION EXPOSURE
• III. DESIGNING A HEDGING STRATEGY
• IV. MANAGING TRANSACTION EXPOSURE

3
EXPOSURE DEFINED

• 1. Accounting Exposure Impact of exchange rate
  changes on accounting values.
• 2. Economic Exposure Impact of exchange rate
  changes on firms cash flows and market value.

4
Accounting Exposure

• Exposed assets and liabilities are those
  translated at the spot rate.
• Unexposed assets and liabilities are those
  translated at historical rates.
• Accounting/translation exposure is the difference
  between the two.
• Why translate?

5
Economic Exposure

• The change in firm value, as measured by the
  present value of future cash flows, due to a
  change in exchange rates.
• Transaction exposure gains or losses on
  existing contracts.
• Operating exposure gains or losses on future
  contracts.

6
Transaction Exposure

• EX
• Say Boise Cascade bought 10 giant bulldozers
  last week from Komatsu for 1,000 million each
  with payment due in six months. e0 .008950
• f1 .009083
• HC cost?

7
Transaction Exposure

• Forward hedge.
• Cost of hedge
• Suppose, e1 .0095.
• e1 .0085.
• Cost of hedge?

8
Transaction Exposure

• 2. Money Market Hedge.
• Suppose, rUS 5.
• rJP 2.
• Steps
• Borrow or lend yen?
• Convert.
• Borrow or lend .

9
Transaction Exposure

• 3. Shift the currency risk to Komatsu.
• Minimum price acceptable to Komatsu is found by
  recognizing they could sell forward.
• Boise Cascade would pay no more than ?

10
Transaction Exposure

• General rule for pricing credit sales in foreign
  currencies
• Always use the forward rate.
• EX If Komatsu had quoted a price of
• 10,000m x .00895/ 89.5 m
• they would have lost
• 9,083 m - 8,950m 133m
• immediately

11
Transaction Exposure

• Exposure Netting take the opposite position in
  same or similar currency.
• EX Suppose Boise Cascade sold W8,950m in lumber
  to a Korean builder. Would the account
  receivable cancel out the account payable to
  Komatsu?

12
Transaction Exposure

• Negotiate a risk-sharing agreement.
• Currency collar either with bank or through use
  of options.
• EX Suppose Boise Cascade agreed to
• Buy at .0995 if e1 gt .0995
• Buy at e1 if .0995 gt e1 gt .00795
• Buy at .00795 if e1 lt .00795

13
Transaction Exposure

• Suppose U.S. Steel bid to provide steel for a
  high rise project in Toronto for Can 8 million.
  A Chinese, a Japanese, and a Canadian firm have
  also submitted bids.
• The winning bid will be announced in six months
  with payment in one year.
• e0 .73
• Does U.S. Steel face transaction exposure?

14
Transaction Exposure

• Current contract value?
• Expected profit on sale?
• Future contract value?
• e1 .70 or .76 with prob .5
• Choices?
• Forward Contract.
• Futures contract.
• Options contracts (X.73, C.03).

15
Transaction Exposure

• In general,
• 1. Foreign currency outflows
• - if amount known, buy forward/futures
• - if amount unknown, buy currency call
• 2. Foreign currency inflows
• - if amount known, sell forward/futures
• - if amount unknown, put currency put