Question

You are a U.S. exporter concerned about your transaction exposure on a recent sale to an

importer in Germany. The invoice, just sent, is for 500,000 euros payable in 60 days, which will

be about mid-February. The current exchange rate is $1.00 per euro, and you fear that the dollar

will appreciate against the euro due to the rebound in the domestic economy and the improvement

in the economy with potentially increasing interest rates. The 60-day forward rate is $.99.

a. What is the value of the invoice in dollars at the current spot rate?

b. If a forward contract is sold, what will be the value of the invoice in dollars at the forward

rate?

c. What are the advantages and disadvantages of hedging the transaction with a forward

contract?

d- What is the difference between transaction exposure and translation exposure?

e- Define the following: default risk, liquidity risk, reinvestment-rate risk, price risk, event risk.

Answer 1

a) Invoice value at current spot rate: (Euro 500,000*$1.00)= $ 500,000

b) Invoice value at forward contract rate: Invoice will be issued at $ 500,000 at spot rate. Further, the following entries will be done by exporter in his books to book the sale and forward contract.

- At the time of sale

Importer A/c----Dr. $500,000

To Sales A/c $500,000

- when forward contract rate is taken

Forward contract receivable A/c.... Dr. $ 4,95,000 (Euro 500,000*$.99)

To Forward contract payable A/c $ 4,95,000

- At the time of payment comes due after 60 days

Foreign exchange loss A/c.... Dr. $ 5,000 (Euro 5,00,000*($100-.$99))

To Importer A/c $ 5,000

Cash/bank A/c .... Dr. $ 4,95,000

To Importer A/c $ 4,95,000

Forward contract payable A/c.... Dr. $ 4,95,000

To Forward contract receivable A/c $ 4,95,000

C) Advantages and disadvantages of forward contract

A forward contract is when two parties agree to buy or sell a product at a specific price, but the actual transaction will take place at a certain date in the future. A spot contract is when a product is bought or sold immediately. One characteristic of forward contracts is that the price on the day of making the agreement is the price at which the product is transacted at the later date. This is done regardless of whether the price increases or decreases.

Advantages:

- Buy now, pay later

- Lock in the current exchange rate for a future purchase/receipt

- Hedge your exposure and reduce your risk

- Very simple to set up

- Inexpensive to maintain

- You can draw down to get currency early

- You can rollover f you don’t need funds until after the original settlement

Disadvantages:

- If the currency moves in your favour you have missed the gains

- Small deposit required still ties up capital

d) Difference between transaction exposure and translation exposure

Transaction exposure:

-  Transaction exposure impacts the cash flow movement and arises while conducting purchase and sale transactions in different currencies.

- For a transaction exposure to arise, the parent company doesn’t necessarily need to have a foreign affiliate or a subsidiary

- Transaction exposure results in realized gain or losses

- Transaction exposure arises the moment a company enters into a transaction involving foreign currency and commits to make or receive payment in currency other than its domestic currency

- Because a transaction exposure has an actual cash flow impact, it impacts the value of a company

- Transaction exposure measures gain or loss to the cash flow on account of forex movements. In case of loss, the cash flows reduce and hence you get tax benefit on the loss and vice versa

Translation exposure:

- Translation exposure is not a cash flow change and arises as a result of consolidating results of a foreign subsidiary. Translation exposure is usually driven by legal requirement asking the parent company to consolidate financials

- Translation exposure can arise only when a parent company is consolidating financials of a foreign affiliate or subsidiary

- Translation exposure results in notional / book gain or losses

- Translation exposure arises on the balance sheet consolidation date and is at the end of a given financial period (quarter or year)

- Since the translation exposure doesn’t create any cash flow impact, the value of a company doesn’t change due to this type of exposure

- Translation exposure is a measurement concept rather than dealing with actual cash flow impact on account of forex. Hence, there is no tax exemption or benefit available on losses due to translation exposure

e) Default risk:  Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk. A higher level of risk leads to a higher required return.

Liquidity risk: Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process.

For example, consider a $1,000,000 home with no buyers. The home obviously has value, but due to market conditions at the time, there may be no interested buyers. In better economic times when market conditions improve and demand increases, the house may sell for well above that price. However, due to the home owner’s need of cash to meet near term financial demands, the owner may be unable to wait and have no other choice but to sell the house in an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset.

Reinvestment-rate risk: Reinvestment risk is the chance that an investor will not be able to reinvest cash flows from an investment at a rate equal to the investment's current rate of return.

For example, consider a Company XYZ bond with a 10% yield to maturity (YTM). In order for an investor to actually receive the expected yield to maturity, she must reinvest the coupon payments she receives at a 10% rate. This is not always possible. If the investor could only reinvest at 4% (say, because market returns fell after the bonds were issued), the investor's actual return on the bond investment would be lower than expected.

Price risk: Price risk is simply the risk that the price of a security will fall.

Earnings volatility, unexpected financial performance, pricing changes, and bad management are common factors in price risk. For example, assume that Company XYZ is trading at $4 per share. The company is stable and doing well, but there is some uncertainty in the market about Company XYZ's new model of widget that it coming out next year, and the economy looks like it's headed for a recession. There is no certainty that the price of Company XYZ will stay at $4 per share or rise above $4, and thus investors in Company XYZ bear price risk when they hold the stock.

Event risk: Event risk is the risk of a negative impact on a company's financial position as a result of an unexpected event like a natural disaster, industrial accident or hostile takeover. Occasionally companies face events that unexpectedly impact their ability to operate or their ability to make debt payments. A company's vulnerability to unexpected events is its event risk.