GF581 Unit 3 Transaction Exposure Register Analysis Example

Three Invoices, Three Currencies: A Unit 3 Transaction Exposure Analysis for a Membrane Maker

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Purdue University Global

GF581: Financial Strategies for a Global Environment

Unit 3 Transaction Exposure Analysis

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[Date]

The membrane maker, its customers and suppliers, and every amount and volatility are composite and illustrative; the article and textbooks cited are real.

What Counts as Transaction Exposure

Transaction exposure arises when a firm has a contracted amount to pay or receive in a currency other than the functional currency of the entity that records it. A change in the exchange rate between today and settlement changes the cash the entity will actually receive or pay (Eiteman et al., 2016). Each item below is measured in the functional currency of the entity that holds it: dollars for the Milwaukee parent and baht for the Thai subsidiary.

The Register

Item 1, parent: yen receivable. A Japanese desalination contractor owes 420 million yen for membrane elements, due in 90 days. At today's spot rate of 148.00 yen per dollar it is worth about $2,837,838. The parent is long yen.

Item 2, parent: Swiss franc payable. The parent owes a Swiss equipment maker 1.9 million francs for a casting line, due in 180 days. At 0.8800 francs per dollar it costs about $2,159,091. The parent is short francs.

Item 3, Thai subsidiary: dollar resin bill against dollar sales. The subsidiary, whose functional currency is the baht, owes $3.2 million to a resin supplier in 60 days and expects $2.1 million from regional distributors who pay in dollars in 45 days. Netting the two leaves the subsidiary short about $1.1 million, or about 37.4 million baht at 34.00.

Measuring the Risk

Each exposure is sized by the loss that would be exceeded only 5 percent of the time over its horizon, using annual volatilities from the past two years and scaling by the square root of time.

Yen receivable. Annual yen volatility against the dollar of about 10 percent gives about 5 percent over 90 days. A 1.645-standard-deviation move against the parent, the yen weakening, would cut the receivable's dollar value by about $233,400.

Franc payable. Annual franc volatility of about 8 percent gives about 5.7 percent over 180 days. A franc strengthening of that size would raise the dollar cost by about $200,900.

Subsidiary's net dollar position. Annual baht volatility against the dollar of about 7 percent gives about 2.9 percent over 60 days. A baht weakening of that size would raise the subsidiary's baht cost by about 1.76 million baht, about $52,000 at today's rate.

The two largest exposures sit with the parent and point in opposite directions, long yen and short francs, but they cannot be netted against each other because the yen and the franc do not move together reliably against the dollar and the amounts fall due three months apart.

Why Each Item Is Measured Separately

It is tempting to treat the company's currency risk as one number. That would be misleading here for three reasons. The items belong to different entities with different functional currencies, so a baht move affects the subsidiary's results while leaving the parent's yen receivable untouched. The settlement dates differ, so even offsetting amounts would leave a timing gap. And the currencies are imperfectly correlated: in the past two years the yen and the franc moved in the same direction against the dollar only about half the time. Research on corporate currency exposure finds that firms' measured exposures are often far smaller than their gross positions suggest, because price pass-through, operating offsets and financial hedges each absorb part of the effect, which is why item-by-item measurement is the safer starting point (Bartram et al., 2010).

What Is Not in the Register

Economic exposure, the way a lasting currency shift could change next year's orders and the firm's competitive position, is excluded. A sustained stronger dollar might make the company's membranes dearer for Japanese buyers next year, but that risk does not arise from a contracted invoice and is treated in a later unit. Translation of the subsidiary's balance sheet into dollars is also excluded; it affects reported equity, not cash.

Netting Within Each Entity

Within the parent, the yen receivable and the franc payable cannot be netted, as explained above. Within the Thai subsidiary, however, netting is natural: its dollar receipts from distributors arrive 15 days before its dollar resin payment, so it can hold the dollars and pay the supplier, leaving only the $1.1 million shortfall exposed. The register records exposures after this kind of within-entity netting, because hedging the gross amounts would cost more and protect nothing extra.

Ranking

1. Yen receivable: largest potential loss, about $233,400, and the nearest date.

2. Franc payable: about $200,900, but six months away, leaving time to act.

3. Subsidiary's dollar shortfall: about $52,000, small and partly offset by future dollar sales.

Next Step

The hedging memo in Unit 4 will price forward, money market and option hedges for the yen receivable and consider whether the franc payable and the subsidiary's position justify cover (Bekaert & Hodrick, 2018).

References

Bartram, S. M., Brown, G. W., & Minton, B. A. (2010). Resolving the exposure puzzle: The many facets of exchange rate exposure. Journal of Financial Economics, 95(2), 148-173. https://doi.org/10.1016/j.jfineco.2009.09.002

Bekaert, G., & Hodrick, R. J. (2018). International financial management (3rd ed.). Cambridge University Press.

Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2016). Multinational business finance (14th ed.). Pearson.