Transaction Exposure

by Obaidullah Jan, ACA, CFA

Transaction exposure is a type of foreign exchange risk that results from the difference in the final settlement value of foreign-currency denominated assets and liabilities due to changes in exchange rate between the date those assets or liabilities arose and their settlement date.

Transaction exposure associated assets such as cash, accounts receivable, notes receivables, investments, etc. results in a gain when the currency in which the assets are denominated appreciates and vice versa. Similarly, transaction exposure associated with liabilities such as accounts payable, loan payable, etc. affects the income statement and cash flows negatively if the currency in which the liabilities are denominated appreciated and vice versa.

You work for a company based in US. Following are some recent transactions that your company participated in:

  • Sold equipment to a European company for EUR 10 million on 30-day credit and recorded accounts receivable of USD 12 million. EUR/USD exchange rate depreciated to €0.85/$ by the time cash was received.
  • Raised a loan of GBP 100 million on 1 January 2015 due to be repaid on 30 June 2015. GBP/USD exchange rates on the above dates were £0.72/$ and £0.70/$ respectively.
  • Purchased inventories worth CAD 15 million on credit. Current amount due is USD 12.5 million. Payment due in 45 days when the exchange rate would be CAD1.25/USD.

Due to changes in foreign exchange rates between EUR and USD, GBP and USD and CAD and USD, the USD denominated value of the associated cash inflows and cash outflows will change between the date these assets or liabilities were recognized. The following table compares the USD-denominated value of the assets and liabilities at the transaction date (i.e. the date the assets or liabilities were created) and the settlement date (i.e. the date when payments were made).

Transaction Foreign Currency Transaction Date Settlement Date Gain/(Loss)
Revenue in EUR EUR 10 million USD 12 million USD 11.76 million (0.24 million)
Loan in GBP GBP 100 million USD 138.89 million USD 142.86 million (3.97 million)
Payable in CAD CAD 15 million USD 12.5 million USD 12 million 0.5 million

Due to deterioration of EUR against USD, the receipt from accounts receivable of EUR 10 million is worth less when the actual payment was received resulting in a loss of USD 0.24 million. Similarly, appreciation of GBP against USD has increased in the domestic-currency (i.e. USD) value of the loan by USD 3.97 million highlighting a loss. However, appreciation of USD (the domestic currency) against the CAD (the foreign currency) has resulted in a gain of USD 0.5 million. It is because your company will be required to pay less USD now.

Management of transaction exposure

While appreciation (appreciation) of foreign currency increases the value of cash inflows (outflows), it is hard to predict the actual movement of foreign currencies. Only a small movement in foreign currency can turn a company’s profitability upside down. It is why businesses frequently attempt to eliminate the foreign exchange risk using forward contracts, future contracts, currency options and money market hedge.

Let’s illustrate how each of the tools can be used to hedge the foreign exchange transaction exposure in the above transactions.

Money market hedge

The foreign exchange risk resulting from EUR/USD exchange rate can be hedged using money market hedge. You expect to receive EUR 10 million. If the interest rates applicable to EUR is 5% per annum, the money market hedge strategy would require you to borrow an amount M such that the loan principal amount plus associated accrued interest in 30 days equal the EUR 10 million you will receive.

Following is the formula used to determine the required borrowing:

$$ Borrowing=\frac{10\ million}{(1+5\%\times\frac{30}{360})}=EUR\ 9,958,506 $$

You can convert the loan proceeds to USD at the spot exchange rate of €0.85/$ (=€12 million/$10 million). Your USD receipt will be 11,715,889 which you can use right away or place in an interest-paying account.

Currency futures contracts

The GBP exposure resulting from principal balance of loan can be hedged using future contracts. At the time of inception of loan agreement, you can purchase GBP 100 million forward by entering into a 6-month futures contract to sell GBP. In the futures contract, the rate is locked based on the prevailing 180-day forward GBP/USD exchange rate, but the actual settlement occurs when your company is required to pay GBP 100 million.

Currency options

The CAD exposure can be hedged by buying call options on CAD. The call option entitles you to purchase CAD at an exchange rate locked at time 0. If the CAD appreciates against USD, it won’t affect you because the option entitles you to purchase CAD at a rate determined before the appreciation. However, if CAD depreciated, you can let the option expire. Options are better than futures contracts and money market hedge in that it is not an obligation but an ‘option’.