Transaction Hedging Under Uncertainty

Uncertainty about either the timing or the existence of an exposure does not provide a valid argument against hedging.

Uncertainty about transaction date

Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-currency cash flow. The key reason is that, even if they are sure that a foreign currency transaction will occur, they are not quite sure what the exact date of the transaction will be. There may be a possible mismatch of maturities of transaction and hedge. Using the mechanism of rolling or early unwinding, financial contracts create the probability of adjusting the maturity on a future date, when appropriate information becomes available.

Uncertainty about existence of exposure

Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids with prices fixed in foreign currency for future contracts. The firm will pay or receive foreign currency when a bid is accepted, which will have denominated cash flows. It is a kind of contingent transaction exposure. In these cases, an option is ideally suited.

Under this kind of uncertainty, there are four possible outcomes. The following table provides a summary of the effective proceeds to the firm per unit of option contract which is equal to the net cash flows of the assignment.

StateBid AcceptedBid Rejected
Spot price better than exercise price : let option expireSpot Price0
Spot price worse than exercise price: exercise optionExercise PriceExercise Price – Spot Price

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