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Chapter 11

Transaction Exposure

Questions

11-1. Foreign Exchange Exposure. Give a general definition of “foreign exchange exposure” as it relates to the operations of a multinational enterprise.

In its most general sense, foreign exchange exposure is the possibility of either beneficial or

harmful effects on a company caused by a change in foreign exchange rates. The effect on the

company may be on its profits, its cash flows, or its market value.

11-2. Exposure Types. Explain the differences among transaction, operating, and translation exposure.

a. Transaction exposure is the potential for a gain or loss in contracted-for, near-term cash flows

caused by a foreign-exchange-rate-induced change in the value of amounts due to the MNE or

amounts that the MNE owes to other parties. As such, it is a change in the home currency

value of cash flows that are already contracted for.

b. Operating exposure is the potential for a change in the value of an MNE, usually viewed as

the present value of all future cash inflows, caused by unexpected exchange rate changes.

As such, it is a change in expected long-term cash flows; i.e., future cash flows expected in

the course of normal business but not yet contracted for.

c. Translation exposure is the possibility of a change in the equity section (common stock,

retained earnings, and equity reserves) of an MNE’s consolidated balance sheet, caused by a

change (expected or not expected) in foreign exchange rates. As such it is not a cash flow

change, but is rather the result o f consolidating into one parent company’s financial statement

the individual financial statements of related subsidiaries and affiliates.

11-3. Translation versus Transaction Exposure. How do translation exposures and a transaction exposures alter corporate cash flow?

Translation exposure measures accounting (book) gains and losses from a change in exchange

rates, and therefore does not alter corporate cash flows. Transaction exposure measures cash

(realized) gains and losses from a change in exchange rates, and therefore does alter corporate

cash flows.

11-4. Tax Exposure. What is tax exposure and how does it relate to the triumvirate of transaction, operating, and translation exposure?

Tax exposure is separate from the triumvirate of transaction, operating, and accounting exposure because it is basically the tax consequences of a gain or loss caused by this triumvirate. Transaction exposure is a cash loss and so results in a tax savings—in the sense that a lowering of profits

because of a transaction loss lowers income taxes, other things being equal. Any loss from

operating exposure is difficult to measure; a resultant drop in market value of an MNE’s shares

has no tax consequences for the company—although it may have tax consequences for investors holding the shares. To the extent that operating exposure causes a lowering of corporate profits in future years, taxes in those years are reduced. Translation exposure is a measurement loss, rather than a cash loss, and so has no tax consequences.

Chapter 11 Transaction Exposure 47

11-5. Hedging. What is a hedge?

A “hedge” is the acquisition of a contract or a physical asset that will offset a change in value of

some other contract or physical asset. Hedges are entered into to reduce or eliminate risk.

11-6. Cash Flow Variability. Exhibit 11.2 in the text shows two normal distributions about a mean called expected value.

a. What is the implication of the areas toward the center of the distributions where the hedged

line is higher than the unhedged line?

The areas toward the center of the dist ributions, where the “hedged” line is higher than the

“unhedged” line, implies that a greater proportion of expected values will be near the expected

mean value when the cash flows are hedged. Variability of expected results is reduced.

b. What is the implication of the areas toward the outlying edges of the distributions where the

unhedged line is higher than the hedged line?

The areas toward the outlying edges of the distributions, where the “unhedged” line is higher

than the “hedged” line, imply that a greater likelihood exists for significantly higher cash

flows as well as significantly lower cash flows than exist when the cash flows are hedged.

c. Can an argument be made that the mean of the hedged distribution should be to the left or

right of, but not the same as, the mean of the unhedged distribution? Discuss.

Hedging is not cost free; something is paid to obtain the hedge. Hence the expected value for

hedged cash flows should be that of the unhedged cash flow less the cost of the hedge. Thus

one might argue that the mean expected value of the hedged cash flow should be to the left of

that for the unhedged cash flow. (No reason exists for the mean cash flow of the hedged flows

to be to the right of that for the unhedged cash flows.)

11-7. Investor Expectations. Proponents of the efficient market hypothesis argue that an MNE should not hedge because investors can hedge themselves if they do not like the foreign exchange risks

carried by the firm. Assess this argument.

Proponents of the efficient marke t hypothesis believe that the current market price of an MNE’s

shares of stock fully and appropriately discounts all the risks of the firm, including foreign

exchange risk, and that the firm should not pay the cash cost of hedging because investors can

individually hedge or not as they see fit, and that the present share price already reflects this risk.

These proponents also argue that the propensity to carry risk is different for management than for shareholders, and that risk hedging is often undertaken by management to protect its own interests, which differ from the interests of shareholders. Lastly they argue that management is more likely to hedge accounting risks, which are more precisely measured, than operating risks, which are

conceptual and deal with future expectations.

The argument that management might appropriately hedge its foreign currency risks is based on

the logic that management has firsthand knowledge of foreign currency risks, that the nature and magnitude of these risks change from day to day (or at least month to month), and that the specifics of such risks cannot be known (and so discounted) by the impersonal forces of an “efficient”

market. Other arguments in favor of hedging include improved cash flow management for the

firm and the need to preserve liquidity for debt service and/or unexpected variations in near-term cash flows.

48 Eiteman/Stonehill/Moffett ?Multinational Business Finance, Twelfth Edition

11-8. Creating Transaction Exposure. Identify and create a hypothetical example for each of the four causes of transaction exposure.

Assume a hypothetical U.S. company named Smith Company.

a. Purchasing or selling on open account. Smith Company sells goods to a buyer in Great

Britain with the sale denominated in British pounds sterling and payment due in 60 days.

When Smith Company receives the pounds sterling 60 days after the sale, the U.S. dollar

value of those pounds may be less, or more, than was expected at the time of sale.

b. Borrowing and lending. Smith Company finds that it can borrow Swiss francs at 4% per annum

interest, and exchange them for the needed U.S. dollars, whereas borrowing dollars in the U.S.

will cost 7% per annum. Hence it borrows Swiss francs for one year in order to “save” on the

interest cost. One year hence the Swiss franc has strengthened against the dollar by more than

the 3% interest differential, and the Swiss franc borrowing ends up costing more than 7% in

U.S. dollar terms.

c. Owning an unperformed foreign exchange forward contract. Believing that the Japanese yen

will weaken within three months, Smith Company decides to speculate by selling yen forward.

It hopes to profit by buying the yen to deliver against this forward sale at a cheaper exchange

rate in three months. In fact the yen strengthens and Smith Company must buy yen to cover its

forward yen obligation at a price higher than will be received via the forward sale.

d. Acquiring assets or incurring liabilities denominated in foreign currencies. Having excess

cash and faced with euro interest rates of 8% and U.S. rates of 5%, Smith Company invests

the cash in euro money market obligations. At maturity the euro has weakened by more than

three percentage points and Smith Company ends up earning in dollars less than the 5% it

could have earned by investing in a U.S. dollar asset.

11-9. Cash Balances. Why does the holding of foreign currency cash balances not lead to transaction exposure?

Transaction exposure arises from the payment of one currency to a party wanting, in the end, a

different currency. Thus a movement of currency value from one currency to another is required.

Foreign currency cash balances held for operating purposes by a foreign subsidiary are not

inherently intended for exchange for another currency, nor is such an exchange required. Hence

they do not create transaction exposure. (They do, however, create translation exposure.)

11-10. Natural versus Contractual Hedges. Explain the difference between a natural hedge and a contractual hedge. Give a hypothetical example of each.

A natural hedge is one that results from matching foreign currency cash flows that come about

from the normal operations of a MNE. An example would be for a MNE that had euro operating inflows from sales to borrow an equivalent amount of euros to finance working capital. Should the dollar/euro exchange rate change, any gain or loss from the euro operating inflows would be offset by a loss or gain on the euro borrowing. In effect, the euro operating inflows would be used to pay the euro debt. Any foreign exchange transaction is avoided.

A contractual hedge is a contract specifically entered into as a financial rather than operating

hedge. Examples are forward and future foreign exchange agreements, money market hedges,

and the purchase of options.

Chapter 11 Transaction Exposure 49

11-11. Risk Tolerance. What is risk tolerance? Can it be measured?

Risk tolerance is the psychological or philosophical willingness of a firm, or of its managers, to

bear risk. As such, it cannot be measured or quantified, although observations and comparisons

of management decisions over time can provide a rough inkling of such managements’ risk

tolerance. Variations in risk tolerance reflect the fact that different individuals have different

opinions about whether or not a risk is worth bearing, or conversely, whether or not a risk should be left open ended or hedged.