Application Weyerhaeuser Quotes a Euro Price for Its Lumber 
Weyerhaeuser is asked to quote a price in euros for lumber sales to a French company. The lumber will be shipped and paid for in four equal quarterly installments. Weyerhaeuser requires a minimum price of $1 million to accept this contract. If PF is the euro price contracted for, then Weyerhaeuser will receive 0.25PF every three months, beginning 90 days from now. Suppose the spot and forward rates for the euro are as follows:
Spot
90-Day
180-Day
270-Day
360-Day
$1.4772
$1.4767
$1.4761
$1.4758
$1.4751
On the basis of these forward rates, the certainty-equivalent dollar value of this euro revenue is 0.25PF(1.4767 + 1.4761 + 1.4758 + 1.4751), or 0.25PF(5.9037) = $1.4759PF. In order for Weyerhaeuser to realize $1 million from this sale, the minimum euro price must be the solution to
or
At any lower euro price, Weyerhaeuser cannot be assured of receiving the $1 million it demands for this sale. Note that the spot rate did not enter into any of these calculations.
Exposure Netting
As defined in Section 10.4, exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, when exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. Although simple conceptually, implementation of exposure netting can be more involved. It is easy to see, for example, that a €1 million receivable and €1 million payable cancel each other out, with no net (before-tax) exposure. Dow Chemical explained this basic form of exposure netting in its 2007 Form 10-K (p. 81) when it stated that “Assets and liabilities denominated in the same foreign currency are netted, and only the net exposure is hedged.” It may be less obvious that such exposure netting can also be accomplished by using positions in different currencies. However, multinationals commonly engage in multicurrency exposure netting. In practice, exposure netting involves one of three possibilities:
1. A firm can offset a long position in a currency with a short position in that same currency.
2. If the exchange rate movements of two currencies are positively correlated (e.g., the Swiss franc and euro), then the firm can offset a long position in one currency with a short position in the other.
3. If the currency movements are negatively correlated, then short (or long) positions can be used to offset each other.
Application Using Exposure Netting to Manage Transaction Exposure
Suppose that Apex Computers has the following transaction exposures:
Apex T-Account (Millions)
Marketable securities
€2.4
Accounts payable
Mex$15.4
Accounts receivable
SFr 6.2
Bank loan
SFr 14.8
Tax liability
€1.1
On a net basis, before taking currency correlations into account, Apex’s transaction exposures—now converted into dollar terms—are
Apex T-Account (Millions)
Euro (1.3)
$1.9
Swiss franc (8.6)
$8.5
Mexican peso (15.4)
$2.2
Given the historical positive correlation between the euro and Swiss franc, Apex decides to net out its euro long position from its franc short position, leaving it with a net short position in the Swiss franc of $6.6 million ($1.9 million − $8.5 million). Finally, Apex takes into account the historical negative correlation between the Mexican peso and the Swiss franc and offsets these two short positions. The result is a net short position in Swiss francs of $4.4 million ($6.6 million − $2.2 million). By hedging only this residual transaction exposure, Apex can dramatically reduce the volume of its hedging transactions. The latter exposure netting—offsetting euro, Swiss franc, and Mexican peso exposures with one another—depends on the strength of the correlations among these currencies. Specifically, Apex’s offsetting its exposures on a dollar-for-dollar basis will be fully effective and appropriate only if the correlations are + 1 for the €/SFr currency pair and − 1 for the SFr/Mex$ currency pair.