494 CHAPTER 13. MEASURING EXPOSURE TO EXCHANGE RATES
Note that in the case of translation exposure we are talking about accounting
values, that is, numbers written into books rather than cash flows that enter or
leave bank accounts. To stress the difference, contractual and operating exposure
are often referred to aseconomicexposures, as opposed to translation exposure.
We provide a more in-depth discussion of each of these in the rest of this chapter.
We start with a discussion of contractual exposure.
13.2 Contractual-Exposure Hedging and its Limits
In Chapter 5 we saw already how one can close a contractual exposure, primarily
by manipulating the financial items in the above list. We also saw how one can pool
exposures for “similar” dates and hedge the aggregate net exposure, but too much
grouping may create an interest-rate exposure problem. What we want to add now
is a discussion of the limits and limitations of contractual-exposure hedging. First
we consider the limitations: we show that hedging contractual exposure can achieve
less than the uninitiated may have hoped. We then discuss the limits: how firm and
certain should a cash flow be for it to be “contractual”; and what happens if we are
less strict about this and include near-certain or even just “expected” cash flows?
13.2.1 What does Management of Contractual Exposure Achieve?
You may remember the example of Slite, the shipping line that keeled over when
the devaluation of thefimhad made its new ship unaffordable. This could have
been avoided by buying forwarddem. But this example is rather specific in that it
involved a one-shot, and huge, exposure. The situation for a committed exporter
or importer is different: there is a steady stream of in- or outflows, each of which
is relatively small. The message to take home from this subsection is that even
if such a firm continuously hedges all its contractual exposures, the impact of the
exchange rate will be far from completely eliminated. There will still be exposure to
the exchange rate from two sources: (i) exposure to variations in the forward rate,
and (ii) “operating” exposure through the effect of the exchange rate on the volume
of sales. We explain these issues below.
Consider an Italian firm, Viticola, which exports its fine wines to theus. Viticola
can choose between at least two invoicing policies: (a) invoice inusdat (in the short
run) constantusprices, and hedge each invoice in the forward market; or (b) invoice
ineurat (in the short run) constant home currency prices. In either case, Viticola
has zero contractual exposure. Still, the exchange rate affects its profits:
- Invoicing constantUSDprices and hedging forwardAssume that the
Italian firm extends three months credit to itsuscustomers. If the firm hedges
its contractual exposure systematically every time a new invoice is sent, its
eurcash flows ninety days later will be proportional to the ninety-day forward