Exam 10: Transaction Exposure

There are as many different approaches to foreign exchange transaction exposure management as there are firms and no real consensus exists regarding the best approach. List and discuss three different exposures you can hedge and three different types of hedges (for example option hedges versus non-option hedges).

A firm's risk tolerance is a combination of management's philosophy toward transaction exposure and the specific goals of treasury activities.

The various hedging alternatives explored (the forward, money market, and purchase option hedges) only work to protect the value of the exposed asset at the time of maturity.

When there is a full forward cover with the spot rate equal to the forward rate all of the following are true EXCEPT:

In efficient markets, interest rate parity should assure that the costs of a forward hedge and money market hedge should be approximately the same.

A forward hedge involves a put or call option contract and a source of funds to fulfill that contract.

Many MNEs have established rigid transaction exposure risk management policies which mandate proportional hedging (a percentage of existing transaction exposures). Explain the pros and cons of proportional hedging.

Managers CAN outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be POSITIVE.

TRANSACTION exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.

________ exposure measures the change in the present value of the firm resulting from unexpected changes in exchange rates.

Hedging is accomplished by combining the exposed asset with a hedge asset to create a two-asset portfolio in which the two assets react in relatively equal directions to an exchange rate change.

There are as many different approaches to exposure management as there are firms and no real consensus exists regarding the best approach. Discuss the following theoretical dimensions to currency hedging: optimal hedge ratio, hedge symmetry, hedge effectiveness and hedge timing.

Remaining unhedged is NOT an option when dealing with foreign exchange transaction exposure.

The effectiveness of a hedge is determined to what degree the change in spot asset's value is correlated with the equal change in the hedge asset's value to a change in the underlying spot exchange rate.

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. If CVT chooses NOT to hedge their euro payable, the amount they pay in six months will be:

The objective of currency hedging is to eliminate the change in the value of the exposed asset or cash flow from a change in exchange rates.

According to a survey by Bank of America, the type of foreign exchange risk most often hedged by firms is:

The stages in the life of a transaction exposure can be broken into three distinct time periods. The first time period is the time between quoting a price and reaching an actual sale agreement or contract. The next time period is the time lag between taking an order and actually filling or delivering it. Finally, the time it takes to get paid after delivering the product. In order, these stages of transaction exposure may be identified as:

Each of the following is another name for operating exposure EXCEPT:

A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£, the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. If the exchange rate changes to $1.52/£ the U.S. firm will realize a ________ of ________.