When a firm is subject to a transaction risk there are four standard ways to deal with it.
To illustrate the consequences of these strategies let us consider a specific case. Suppose a firm is to receive a payment of YF in units of foreign currency T years in the future. Let E0 be the current spot exchange rate (dollars per unit of foreign currency) and let FT,0 be the forward exchange rate as of time 0 for exchange T years in the future. Let iF and i$ be the money market annual interest rates for loans of period T years. The spot exchange rate T years in the future is denoted as ET and what we need to do is express the dollar proceeds of the future payment as function of ET for the four strategies.
The dollar receipt from the foreign currency payment of YF in the absence of any hedging action is simply YFET.
If the foreign currency receipts are sold in the forward market the proceeds will be YFF0,T. Note that this is independent of ET.
For the money market hedge the firm borrows the present value of the future receipt, converts the proceeds of the borrowing into dollars and invests those dollars in the domestic money market. The repayment of the foreign loan is covered by the foreign currency receipts. The result of these actions is, at time T, an amount of dollars equal to
A put option can be purchased in order to guarantee a certain dollar proceeds from the foreign currency receipts. The guaranteed minimum depends upon the exercise rate. Let p be the dollar cost of a put option on one unit of foreign currency for an exercise exchange rate of X. If the exchange at time T, ET is less than X then the proceeds from the sale of the foreign receipts at the exercise price of the put option less the cost of the put is: YFX - YFp. If the exchange rate at or above the exercise price the put option is not exercised and the proceeds are YFET - YFp.
The results are shown below in graphical form with the various variables shown in abbreviated form. of X.