Three Types of Foreign Exchange Exposure

Three Types of Foreign Exchange Exposure:

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Overview:

• Transaction Exposure

• Risk to Known Foreign Cash-flows
• What we have been hedging

• Economic Exposure

• Two Components
• Asset Exposure—risk to Assets/Liabilities (we know how to hedge)
• Operating Exposure—risk to Uncertain cash-flows (Harder to hedge)

• Translation Exposure

• Risk to Balance Sheets
• Due to a Change in Translated Value of a Foreign Subsidiary
• Impossible to Fully Hedge or Eliminate

Transaction Exposure

1. Risk to contractual cash-flows due to adverse currency movements

1. Known (or contractual) future cash-flows
2. Flow is in a currency other than the home currency

1. Methods of Hedging

1. Forwards, Futures, and Swaps—Fix translated value
2. Options—Eliminate risk of adverse movements, while permitting gains from favorable movements; also used to hedge Contingent Exposures
3. Cross-Hedging—Used when conventional hedging instruments are unavailable
4. Money Market Hedging—Extract the translated PV of the Cash-Flows
5. Exposure Netting—Efficient method of hedging, reducing the need for use of financial hedges

1. Contingent Exposure Hedging

1. Exposures that might manifest, such as from a successful contract bid

1. Options eliminate risk from adverse currency movements without ceding gains from favorable movements

1. Forwards/Futures/Swaps may create a liability if the bid fails

1. Example:  You have placed a bid with PEMEX to buy oil for 215P/barrel, but will not know whether the bid will be accepted for a month.

• Entering into Peso/$ forward, futures, or swap contract, prior to signing the agreement, will create financial exposure if our bid is declined (long the naked forward/futures/swap contracts).

• If we do nothing, the Peso could appreciate during the next month, increasing the price of forward/futures and swap rates.  The oil will be more costly if the bid is accepted.

• Alternatively, we could purchase Peso Call Options maturing on or after the decision date, with a strike equal to the spot, for the Present Value of the commitments.  If the Peso appreciates during that month, the option payoff will offset our losses.

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1. Cross-Hedging

1. Using positions on one currency to hedge another currency with which it is highly correlated
2. Currency derivatives are unavailable for a number of minor currencies.

1. Example: US dollar currency options are unavailable for the Thai Baht; however, the Baht/$ exchange rate is highly correlated to the Yen/$ rate.

• Step 1: Translate the Baht Cash-flows to Yen (using the appropriate spot and forward rates)
• Step 2: Hedge the corresponding Yen values against the dollar
• This reduces risk to the extent that the Baht moves with the Yen, but does not completely eliminate risk

Example:

We owe 10,000,000 Baht per year for the next three years, the current Yen/Baht spot, and 1-year, 2-year, 3-year forwards are: 2.8, 2.79, 2.78, 2.77.[pic 5]

Step 1: Translate to Yen

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Step 2: Hedge the obligation

E.g. buy Yen forward or entering into swap a Yen/dollar swap to receive Yen

Step 3: Hedge the Yen against the Baht (optional)

If Yen/Baht forwards are available, you can further reduce risk by selling Yen forward against the baht.