CHAPTER 10
TRANSACTION EXPOSURE
1. Foreign Exchange Exposure. Define the three types of foreign exchange exposure.
The three main types of foreign exchange exposure are transaction, translation, and
operating:
▪ Transaction exposure measures changes in the value of outstanding financial
obligations incurred prior to a change in exchange rates but not due to be settled
until after the exchange rates change. Thus, it deals with changes in cash flows
that result from existing contractual ob-ligations.
▪ Translation exposure is the potential for accounting-derived changes in owner’s
equity to occur because of the need to “translate” foreign currency financial
statements of foreign subsidiaries into a single reporting currency to prepare
2. Currency Exposure and Contracting. Which of the three currency exposures relate
to cash flows already contracted for, and which of the exposures do not?
3. Currency Risk. Define currency risk.
4. Hedging. What is a hedge? How does that differ from speculation?
A hedge is the acquisition of a contract or a physical asset that will offset a change in
5. Value of the Firm. What – according to financial theory – is the value of a firm?
According to financial theory, the value of a firm is the net present value of all
expected future cash flows.
6. Cash Flow Variability. How does currency hedging theoretically change the
expected cash flows of the firm?
7. Arguments for Currency Hedging. Describe four arguments in favor of a firm
pursuing an active currency risk management program?
1. Reduction in risk of future cash flows improves the planning capability of the
firm. If the firm can more accurately predict future cash flows, it may be able to
undertake specific investments or activities that it might otherwise not consider.
3. Management has a comparative advantage over the individual shareholder in
knowing the actual currency risk of the firm. Regardless of the level of disclosure
provided by the firm to the public, management always possesses an advantage in
the depth and breadth of knowledge concerning the real risks.
8. Arguments Against Currency Hedging. Describe six arguments against a firm
pursuing an active currency risk management program?
1. Shareholders are more capable of diversifying currency risk than the management
of the firm. If stockholders do not wish to accept the currency risk of any specific
3. Management often conducts hedging activities that benefit management at the
expense of the shareholders. The field of finance called agency theory frequently
argues that management is generally more risk-averse than shareholders.
5. Management’s motivation to reduce variability is sometimes driven by accounting
reasons. Management may believe that it will be criticized more severely for
incurring foreign exchange losses than for incurring similar or even higher cash
costs in avoiding the foreign exchange loss. Foreign exchange losses appear in the
income statement as a highly visible separate line item or as a footnote, but the
higher costs of protection are buried in operating or interest expenses.
9. Hedging versus Speculating. What is the difference between hedging and
speculating?
Hedging involves taking an offsetting position that attempts to eliminate the changes
in value of an existing position. Speculating, on the other hand, is to profit from
10. Hedging with Forward Contracts. Explain how a Singaporean corporation could
hedge a receivable in British pounds using a forward contract. What is the cost of
such a forward market hedge?
The Asian corporation could sell British pounds using a forward contract. This is
11. Unperformed Contracts. Which contract is more likely not to be performed, a
payment due from a customer in foreign currency (a currency exposure), or a forward
contract with a bank to exchange the foreign currency for the firm’s domestic
currency at a contracted rate (the currency hedge)?
The forward contract agreement with a financial service provider – a bank – is much
more ‘certain’ than is the receipt of cash in payment on an outstanding receivable.
12. Cash Balances. Why do foreign currency cash balances not cause transaction
exposure?
13. Contractual Currency Hedges. What are the four main contractual instruments used
to hedge transaction exposure?
14. Money Market Hedges. How does a money market hedge differ for an account
receivable versus that of an account payable? Is it really a meaningful difference?
A money market hedge for an account receivable is the use of the A/R as collateral
against a foreign currency loan (the A/R is not being sold, only posted as collateral
for a loan). This creates a short-term loan or debt obligation on the hedger’s balance
sheet which ‘matches’ the foreign currency receivable.
15. Balance Sheet Hedging. What is the difference between a balance sheet hedge, a
financing hedge, and a money market hedge.
▪ A balance sheet hedge is any foreign currency denominated asset or liability
created to offset a similar foreign currency denominated liability or asset.
16. Forward Versus Money Market Hedging. Theoretically, shouldn’t forward contract
hedges and money market hedges have the same identical outcome? Don’t they both
use the same three specific inputs – the initial spot rate, the domestic cost of funds,
and the foreign cost of funds?
17. Foreign Currency Option Premia. Why do many firms object to paying for foreign
currency option hedges? Do firms pay for forward contract hedges? How do forwards
and options differ if at all?
Consider the traditional alternative to the option – the forward contract. A firm does
not exchange any cash flow up-front for a forward. It does, however, have its
available line of credit with the financial institution reduced by the amount of the
forward, but that is not an out-of-pocket cash obligation.
18. Decision Criteria. Ultimately, a treasurer must choose among alternative strategies to
manage transaction exposure. Explain the two main decision criteria that must be
used.
19. Risk Management Hedging Practices. According to surveys of corporate practices,
which currency exposures do most firms regularly hedge?
Transaction exposures, once booked (recorded on the financial statements as an
20. Hedging Booked Exposures. Why do many firms only allow hedging of booked
exposures, and not quotation or backlog exposures?
Until the transaction exists on the accounting books of the firm, the probability of the