Managing Transaction Exposure Exposure = Risk Managing Risk = “Hedging”
Transaction Risk Example Foreign RECEIVABLES: Boeing (USA) sells 747 Jet to British Airways (UK) for £10m payable in 1 year.
Forwards vs. Futures For hedging transaction risk, forward contracts are better than futures contracts because…
Money Market Hedge Borrow in the foreign country to offset the future foreign receipt of money. *Note: For comparison, all money flows must be expressed at a single point in time; i.e. one year from now.
UK£ Put Option Payouts (Proceeds) * Note future cost of call = ($0.02x$10m)x1.061 = $212,200. The one-year future value is calculated to match it in time with all other cash flows.
Option Hedge (put + receivable)Payout Function FV of call cost = $212,200
Transaction Risk Example Foreign PAYABLES: Boeing (USA) buys a Rolls Royce (UK) engine for £5m payable in 1 year.
Should Firms Hedge? NO – Because….
Should Firms Hedge? YES – Because….