13.2. CONTRACTUAL-EXPOSURE HEDGING AND ITS LIMITS 495
rate prevailing at the invoicing date. If, on the other hand, Viticola does not
hedge its contractual exposure, its cash flows will be proportional to the spot
rate prevailing when the invoice matures. In the long run, both series will
have a similar variability, with the hedged version following the swings in the
unhedged one with a three-month lag.
Example 13.1
Suppose that Viticola sets the price of a bottle of wine atusd10. If Viticola
does not hedge its transaction exposure, the revenue ineurfromussales is
random, and depends on theeur/usdspot rate prevailing in three months
time:usd 10 ×S ̃t+3mo. If, on the other hand, Viticola hedges each contract,
theeur cash flows from the sale of each bottle isusd 10 ×Ft,t+3mo. You
should realize, however, that even though the forward rate for three months
from now is known today, future forward rates are as uncertain as future spot
rates. Thus, the revenue from future sales is an uncertain number, equal tousd
10 ×F ̃Ti,Ti+3mo. Every decrease in theeur/usdspot rate means a virtually
identical decrease in the forward exchange rate, which then is reflected in lower
revenue for Viticola three months later.Thus, even perfect hedging of contractual exposure does not reduce the long-
run variability of cash flows; it merely facilitates three-month budget projec-
tions.- Invoicing constantEUR pricesThis means we let the exchange rate de-
termine theusdprice. From a contractual exposure point of view, Viticola
is perfectly hedged since the contract is denominated in its home currency.
Clearly, however, a policy of holding constant the domestic currency price
may create huge swings in theusdprice of the product and, therefore, may
result in huge changes in the volume of Viticola’s sales and profits, as illus-
trated below.
Example 13.2
Suppose that Viticola decides to set the price of each bottle of wine it sells at
eur10. At the current spot rate ofeur/usd1, this implies a price ofusd10,
a price at which Viticola can sell 10,000 bottles in theus, and its total revenue
fromussales iseur100,000. Assume that next month theusddepreciates to
eur/usd0.95. Given that Viticola does not change itseurprice, theusprice,
translated at the new exchange rate, is nowusd10.53. At this new price, in
the competitive wine market, Viticola can sell only 9,000 bottles. Thus, the
export revenue of Viticola now declines to 9, 000 ×10 = 90,000. True, the firm
can now sell an extra 1000 bottles at home, but exports were the preferred
solution (at the old rate, at least) and extra domestic sales probably require
extra discounts too. Clearly, the total revenue of Viticola is exposed to the
exchange rate.
The second policy, with its constanteurprices, guarantees a stable profit per
bottle sold but may cause big swings in volume. So the exposure is there, even if