374 Planning and Forecasting
Hedging Costs There is little discussion in company reports about the cost of
hedging. In some cases cost issues surely underlie decisions of firms not to
hedge currency risk, but the consideration of cost is not reported. Also, the act
of using internal operations to reduce currency exposure can be seen as de-
signed to reduce the exposure that may then be hedged with currency deriva-
tives—thus reducing hedging costs. Clear efforts to reduce hedging costs are
represented by the activities of Baxter International and Compaq Computer.
Each sells (is a writer of the option) currency option contracts from which it
receives an option premium. They then use these amounts to reduce the cost of
currency options used for hedging and where, as the holder of the option, they
are paying an option premium.
Many firms report that they expect to be able to reduce hedging activity
and hedging costs as a result of the introduction of the Euro. This will result
from the replacement of 11 European currencies with the Euro. Transactions
can take place by one Euro country with up to 10 others without incurring any
currency exposure.
Terms of Currency Derivatives The terms of derivative contracts are kept
relatively short, usually less than one year. This partly ref lects the fact that the
maturity of the underlying item being hedged, an account payable or account
receivable, for example, is also quite short. Moreover, the typical maturity
of exchange traded derivatives are short. Also, the cost to acquire currency
through either a for ward or option contract also increases with the maturity.
For example, the for ward rate (rate at which the foreign currency can be pur-
chased for future delivery) for the British pound sterling was the following at
the end of 2000:
Contract Term Forward Rate
One month $1.4574
Three months $1.4588
Six months $1.4606The prices of currencies in both futures and option contracts display the
same increasing cost as maturity lengthens.
The discussion to this point has focused on currency risk and actions that
management can take to reduce the effect of f luctuations in currency values on
the volatility of earnings and cash f low. The examples have centered on what
are normally termed transaction exposures. Examples of transaction exposure
include accounts payable, accounts receivable and bonds payable that are de-
nominated in foreign currencies. If left unhedged, increases and decreases in
exchange rates cause these balances to expand and contract. This expansion
and contraction produces transactional gains and losses.
Transaction gains and losses are also produced by the combination of
(1) positions in currency derivatives and (2) increases and decreases in ex-
change rates. Offsetting losses and gains result when the derivatives are used