Table 3-5. Example of Transaction Exchange Rate Risk

		AMOUNT OF TRANSACTION
DATE	EXCHANGE RATE	U.S. Dollars	British Pounds
Purchase date	$1.69/pound	$3,380,000	£2,000,000
Payment date	$1.74/pound	$3,480,000	£2,000,000

For example, in September 1992, in a period of extreme volatility of European currencies, Dow Chemical announced that it would use the German mark as the common currency for all of its European business transactions. This action shifts currency risks from Dow to its customers who do business in other currencies. When a firm is considering this alternative, it needs to determine whether this strategy is competitively possible, or whether parties on the other side of the transaction may resist or perhaps insist on a lower price if they are forced to bear all of the transaction risk. In Dow's case, analysts and competitors doubted that customers would be willing to bear all of the exchange rate risk and fell that Dow would ultimately abandon this strategy.

Two hedging techniques that are possible for a U.S. company to protect itself against transaction exposure are:

• Execute a contract, in the Forward exchange market or in the foreign exchange futures market.

• Execute a money market hedge.

Consider a situation in which Westinghouse purchases materials from a British supplier, Commonwealth Resources, Ltd. Because the amount of the transaction (£2 million) is stated in pounds, Westinghouse bears the exchange risk. This example of transaction exposure is illustrated in Table 3-5. Assume that Commonwealth Resources extends 90-day trade credit to Westinghouse and that the value of the pound unexpectedly increases from $1.69/pound on the purchase date to $1.74/pound on the payment date. If Westinghouse takes the trade credit extended to it, the cost of, the purchase effectively increases from $3.38 million to $3.48 million (that is, £2,000,000 x $1.74/pound).

First, Westinghouse could execute a contract in the forward exchange market to buy £2 million at the known 90-day forward rate, rather than at the uncertain spot rate prevailing on the payment date. This is referred to as a forward market hedge. Assume, for example, that the 90-day forward rate is $1.7()/pound. Based on this rate, Westinghouse effectively would be able to exchange $3.4 million (that is, £2,000,000 x $1.70/pouiid) 90 days later on the payment date when it is required to pay for the materials. Thus, Westinghouse would be able to take advantage of the trade credit and, at the same time, hedge against foreign exchange risk.

A second hedging technique, called a money market hedge, involves Westinghouse borrowing funds from its bank, exchanging them for pounds at the spot rate, and investing them in interest-bearing British securities to yield £2 million in 90 days. By investing in securities that mature on the same date the payment is due to Commonwealth Resources (that is, 90 days after the purchase date), Westinghouse will have the necessary amount of pounds available to pay for the materials. The net cost of this money market hedge to Westinghouse will depend on the interest rate on the funds it borrows from its bank relative to the interest rate on the funds it invests in securities. If the conditions of interest rate parity are satisfied, these two hedging techniques are equivalent.

Other transaction risk reduction strategies include the use of options on foreign currencies (discussed in Chapter 19) and negotiating a risk-sharing contract between the two parties to a transaction in which the both parties agree in advance to share in some way the financial consequences of changes in value between the affected currencies.

For large multinational companies, there will be many international transac­tions involving many different currencies. Attempting to hedge separately the transaction exposure for each international transaction would be time consum­ing and inefficient. For example, consider Sara Lee Corporation which has operations both in Italy and France. The Italian subsidiary makes purchases in France that require French francs. At the same time the French subsidiary makes purchases in Italy that require Italian lira. To the extent that these transactions offset, no hedge is necessary. Multinational firms often make thousands of overlapping transactions using different currencies. Thus it is a complex matter to keep track of net currency exposures and avoid hedging against risks that do not really exist when one takes the consolidated corporate view, rather than the narrow subsidiary view of exchange risk.