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Lecture Financial derivatives - Lecture 15: Managing transaction exposure

This chapter presents the following content: To identify the commonly used techniques for hedging transaction exposure; to show how each technique can be used to hedge future payables and receivables; to compare the pros and cons of the different hedging techniques; and to suggest other methods of reducing exchange rate risk. | Managing Transaction Exposure 15 Lecture Chapter Objectives To identify the commonly used techniques for hedging transaction exposure; To show how each technique can be used to hedge future payables and receivables; To compare the pros and cons of the different hedging techniques; and To suggest other methods of reducing exchange rate risk. Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. When transaction exposure exists, the firm faces three major tasks: Identify its degree of transaction exposure. Decide whether to hedge this exposure. Choose a hedging technique if it decides to hedge part or all of the exposure. Transaction Exposure To identify net transaction exposure, a centralized group consolidates all subsidiary reports to compute the expected net positions in each foreign currency for the entire MNC. Note that sometimes, a firm may be able to reduce its transaction exposure by pricing its exports in the same currency that it will use to pay for its imports. Transaction Exposure Hedging techniques include: Futures hedge, Forward hedge, Money market hedge, and Currency option hedge. MNCs will normally compare the cash flows that would be expected from each hedging technique before determining which technique to apply. Techniques to Eliminate Transaction Exposure A futures hedge uses currency futures, while a forward hedge uses forward contracts, to lock in the future exchange rate. Recall that forward contracts are commonly negotiated for large transactions, while the standardized futures contracts tend to be used for smaller amounts. Futures and Forward Hedges To hedge future payables (receivables), a firm may purchase (sell) currency futures, or negotiate a forward contract to purchase (sell) the currency forward. The hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged, and taking into consideration the firm’s . | Managing Transaction Exposure 15 Lecture Chapter Objectives To identify the commonly used techniques for hedging transaction exposure; To show how each technique can be used to hedge future payables and receivables; To compare the pros and cons of the different hedging techniques; and To suggest other methods of reducing exchange rate risk. Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. When transaction exposure exists, the firm faces three major tasks: Identify its degree of transaction exposure. Decide whether to hedge this exposure. Choose a hedging technique if it decides to hedge part or all of the exposure. Transaction Exposure To identify net transaction exposure, a centralized group consolidates all subsidiary reports to compute the expected net positions in each foreign currency for the entire MNC. Note that sometimes, a firm may be able to reduce its transaction exposure by pricing its exports in the same .