Transaction, Operating Accounting Exposures

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Transaction, Operating, & Accounting (Translation) Exposures

Foreign Exchange Exposure – measures the potential for a firm’s profitability, net cash flow, and market value to alter because of a change in exchange rates.

Q: What are the three main foreign exchange exposures?

A: 1) Transaction Exposure
2) Operating Exposure
3) Accounting Exposure

Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.

Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) – measures a change in the present value of a firm resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates.

Accounting Exposure (Translation Exposure) – measures accounting-derived changes in owner’s equity as a result of translating foreign currency financial statements into a single reporting currency.

Exhibit 8.1

Note: In the fourth quarter of 2001 reported a net income of $5 million, due in part to a one-time foreign currency gain of $16 million.

Hedging – To take a position that will rise (or fall) in value to offset a change in value of an existing position.

|Benefits of Hedging |Costs of Hedging | |Improved the planning capability of the firm. |Risk-averse strategy that benefits management more than | |Reduced the likelihood of financial distress. (i.e. the risk that cash|shareholders. (i.e. shareholders can diversify currency risk on an| |flows will fall below what is required for debt payments and continued|“as needed” basis) | |operations) |Consumes the firm’s resources and expected cash flows to the firm | |Management has a comparative advantage over shareholders. (i.e. |are not increased. (i.e. agency theory, NPV of hedging is zero, | |understanding the currency risk of the firm and take advantage of a |and FX losses appear on the I/S while hedging are buried in | |disequilibrium through selective hedging) |operating and interest expenses) |

Transaction Exposure

Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.

Transaction exposure can arise from the following activities: ▪ Purchasing or selling foreign goods and services on credit. ▪ Borrowing or lending in another currency.
▪ Foreign exchange contracts.

Exhibit 8.3 The Life Span of Transaction Exposure


Expect to collect ₤1,000,000 in three months on a sale, minimum acceptable value $1,700,000.

Q: What type of transaction exposure has occurred?

A: Billing Exposure

S0 = $1.7640/£
ES90= $1.76/£
F90= $1.7540/£
iU.K.= 10% per year (2.5% per quarter)
kU.K.= 8% per year (2% per quarter)
iU.S.= 8% per year (2% per quarter)
kU.S.= 6% per year (1.5% per quarter)
P90ATM = $1.75 (1.5% premium)
P90OTM = $1.71 (1% premium)

Note: ES90 is the estimated spot rate in three months, “i” is the borrowing interest rate, and “k” is the investment interest rate, P90ATM is an at-the-money three-month put option, and P90OTM is an out-of-the-money three month put option.

Q: Is the pound expected to appreciate or depreciate?

A: Depreciate

Q: What is the forward premium/discount on the pound?


Q: What are the four alternatives to hedge a transaction exposure?

A:1) Remain unhedged
2) Hedge in the forward market
3) Hedge in the money market
4) Hedge in the options market

1) Remain unhedged, collect ₤1,000,000 in...
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