FINANCIAL TECHNIQUE FOR MANAGING TRANSACTION EXPOSURE

A thorough knowledge of international risk exposure techniques can serve as an effective way to supplement legal strategies for clients involved in international business transactions. While creative and thorough legal drafting can go a long way to reduce some international transactions risks, many business risks can be obviated in whole or in part by the financial markets. One such area of particular risk is known as transaction risk and is associated with foreign exchange rate. Mostly this type of risk correlated with imports or exports. If a company imports or exports goods on credit the amount it will pay out or receive in home currency terms is subject to uncertainty. For example, suppose that Mitsubishi of Japan enters into a loan contract with the Swiss bank UBS that calls for payment of SF100 million for principal and interest in one year. To the extent that the yen/Swiss franc exchange rate is uncertain, Mitsubishi does not know how much yen will be required to buy SF100 million spot in one year’s time. If the yen appreciates (depreciates) against the Swiss franc, a smaller (larger) yen amount will be needed to retire the SF-denominated loan.

This example suggests that whenever a firm has foreign-currency-denominated receivables or payables, it is prone to transaction exposure, and the firm’s cash flow position is subject to be potentially affected by eventual settlements. Because of modern firms are often involved in commercial and financial contracts denominated in foreign currencies, management of transaction exposure has become an important function of international financial management. There are some alternative methods of hedging transaction exposure using various financial techniques, and the techniques are:

1.      Forward Contracts

When there is an agreement for a firm to pay (receive) a fixed amount of foreign currency at  some date in the future, in most currencies it can retrieve a contract today that specifies a price at which it can buy (sell) the foreign currency at the specified date in the future. This substantially converts the uncertain future home currency value of this liability (asset) into a certain home currency value to be earned on the specified date, independent of the change in the exchange rate over the remaining life of the contract. 

2.      Futures Contracts

These are identical to forward contracts in function, although they vary in several important features. Futures contracts are exchange traded and therefore have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. Given that futures contracts are available in only certain sizes, maturities and currencies, it is generally not possible to get an exactly offsetting position to totally eliminate the exposure. The futures contracts, unlike forward contracts, are traded on an exchange and have a liquid secondary market that make them easier to loosen or close out in case the contract timing does not match the exposure timing. In addition, the exchange requires position taker to post s bond (margins) based upon the value of their positions. This virtually eliminates the credit risk involved in trading in futures.

3.      Money Market Hedge

This method employs the fact from covered interest parity, that the forward price must be exactly equal to the current spot exchange rate times the ratio of the two currencies' riskless returns. It can also be thought of as a form of financing for the foreign currency transaction. A firm that has an agreement to pay foreign currency at a specified date in the future can determine the present value of the foreign currency obligation at the foreign currency lending rate and convert the appropriate amount of home currency given the current spot exchange rate. This converts the obligation into a home currency payable and eliminates all exchange risk.

4.      Options

Foreign currency options are contracts that have an upfront fee, and give the owner the right, but not the obligation to trade domestic currency for foreign currency (or vice versa) in a specified quantity at a specified price over a specified time period. The key difference between an option and the three hedging techniques above is that an option has a nonlinear payoff profile. They allow the removal of downside risk without cutting off the benefit form upside risk.