Ch 12: Foreign Exchange Exposure

1
Ch 12 Foreign Exchange Exposure Management

• Economic Exposure (12)
• Exchange rate risk as applied to the firms
  competitive position.
• Transaction Exposure (13)
• Exchange rate risk as applied to the firms home
  currency cash flows.
• Translation (or Accounting) Exposure (14)
• Exchange rate risk as applied to the firms
  consolidated financial statements.

2
Channels of Economic Exposure
Home currency value of assets and liabilities
Firm value
Exchange rate fluctuations
Future operating cash flows
3
How to Measure Economic Exposure

• Economic exposure is the sensitivity of the
  future home currency value of the firms assets
  and liabilities and the firms operating cash
  flow to random changes in exchange rates.
• There exist statistical measurements of
  sensitivity.

4
How to Measure Economic Exposure

• If a U.S. MNC were to run a regression on the
  dollar value (P) of its British assets on the
  dollar pound exchange rate, S(/), the
  regression would be of the form

Where a is the regression constant and e is the
random error term with mean zero. The regression
coefficient b measures the sensitivity of the
dollar value of the assets (P) to the exchange
rate, S.
5
How to Measure Economic Exposure

• The exposure coefficient, b, is defined as
  follows

Where Cov(P,S) is the covariance between the
dollar value of the asset and the exchange rate,
and Var(S) is the variance of the exchange rate.
6
Operating Exposure Definition

• The effect of random changes in exchange rates on
  the firms competitive position, which is not
  readily measurable.
• Alternatively, a good definition of operating
  exposure is the extent to which the firms
  operating cash flows are affected by the exchange
  rate.

7
An Illustration of Operating Exposure

• In 97-99 (mostly 98), there was an enormous
  shortage in the shipping market from Asia, due to
  the Asian currency crisis.
• This positively affected the shipping companies,
  which enjoyed boom times.
• But also negatively affected retailers, who
  experienced increased costs and delays.

8
An Illustration of Operating Exposure

• Note that the exposure for the retailers has two
  components
• The Competitive Effect
• Difficulties and increased costs of shipping.
• The forex changes affected the retailers
  competitive positions vis-à-vis one another.
• The Conversion Effect
• Lower dollar prices of imports due to foreign
  currency exchange rate depreciation.

9
Determinants of Operating Exposure

• Recall that operating exposure cannot be readily
  determined from the firms accounting statements
  as can transaction exposure.
• The firms operating exposure is determined by
• The market structure of inputs and products how
  competitive or how monopolistic the markets
  facing the firm are.
• The firms ability to adjust its markets, product
  mix, and sourcing in response to exchange rate
  changes.

10
Managing Operating Exposure

• Selecting Low Cost Production Sites
• Flexible Sourcing Policy
• Diversification of the Market
• RD and Product Differentiation
• Financial Hedging

11
Selecting Low Cost Production Sites

• A firm may wish to diversify the location of
  their production sites to mitigate the effect of
  exchange rate movements.
• Example Honda built North American factories in
  response to a strong yen, but later found itself
  importing cars from Japan due to a weak yen.

12
Flexible Sourcing Policy

• Sourcing does not apply only to components, but
  also to guest workers.
• Example Japan Air Lines hired foreign crews to
  remain competitive in international routes in the
  face of a strong yen, but later contemplated a
  reverse strategy in the face of a weak yen and
  rising domestic unemployment.
• H1B visas in the US for foreigners?

13
Diversification of the Market

• Selling in multiple markets to take advantage of
  economies of scale and diversification of
  exchange rate risk.
• Example Casio calculators are made in Indonesia
  (at least mine was) and sold in multiple markets
  (e.g. Hong Kong, US).

14
RD and Product Differentiation

• Successful RD allows for
• cost cutting
• enhanced productivity
• product differentiation.
• Successful product differentiation gives the firm
  less elastic demandwhich may translate into less
  exchange rate risk.
• Remember, if demand is perfectly inelastic,
  consumers will not respond to price changes
  they must have the product!

15
Financial Hedging

• The goal is to stabilize the firms cash flows in
  the near term.
• Financial Hedging is distinct from operational
  hedging.
• Financial Hedging involves use of derivative
  securities such as currency swaps, futures,
  forwards, currency options, among others.

16
Ch 13 Transaction Exposure

• Example Charoen Pokphand is a diversified Thai
  conglomerate. One of their listed subsidiaries
  is Ek Chor China Motorcycle Co., Ltd (EKC).
  EKC designs and manufactures motorcycles in China
  for sale in multiple locations. EKC has 80 share
  of Chinese market key export markets are Europe,
  US and India.
• What is EKCs transaction exposure?
• How does this affect Charoen Pokphand overall?
• http//www.cpthailand.com/

17
Forward Market Hedge

• If you are going to owe foreign currency in the
  future, agree to buy the foreign currency now by
  entering into long position in a forward
  contract.
• If you are going to receive foreign currency in
  the future, agree to sell the foreign currency
  now by entering into short position in a forward
  contract.

18
Forward Market Hedge an Example

• Intel sold computers to British Telecom and is to
  be paid 100M in one year.
• Question How can Intel hedge the cash
  receivable in dollars?
• Answer One method is for Intel to sell a forward
  contract on the pound. This will ensure delivery
  of a certain US amount in one year.

19
Forward Market Hedge Proceeds
Proceeds ()
Unhedged position
120mn
Forward hedge
Note For any given spot rate at time of
maturity, we can calculate the exact gains/losses
from the hedge.
St
F1.20/
20
Forward Market Hedge Gains/losses
Gains/Losses ()
120mn
Gains
F
0
St
Losses
21
Money Market Hedge

• This is the same idea as covered interest
  arbitrage.
• Remember, CIA is when IRP doesnt hold.
• So if IRP holds, there are no possible
  profit-taking opportunities.

22
Money Market Hedge Example

• British Telecom (BT) can hedge their 100 million
  payable with a money market hedge
• Borrow dollars in the U.S.
• Convert the dollars into pounds at the spot rate
  today.
• Invest the pounds in the UK for one year.
• In one year BTs investment will yield exactly
  enough pounds to pay their bill.

23
Money Market Hedge

• BT owes Intel 100 million in one year. So we
  know BT needs to have an investment with a future
  value of 100 million. Since i 11.56 BT needs
  to invest 89.64 million at the start of the year.

How many dollars will it take to acquire 89.64
million at the start of the year if the spot rate
S(/) 1.25/?
24
Money Market Hedge General Rule

• Suppose you want to hedge a payable in the amount
  of y with a maturity of T
• i. Borrow x at t 0 on a loan at a rate of
  i per year.
• (Note that x y/(1 i)T at the spot
  rate.)
• ii. Exchange x for y/(1 i)T at the
  prevailing spot rate, invest y/(1 i)T at i
  for the maturity of the payable to achieve y.
• At maturity, you will owe x(1 i).
• Your British investments will have grown enough
  to service your payable and you will have no
  exposure to the pound.

25
Options Market Hedge

• Options provide a flexible hedge against the
  downside, while preserving the upside potential.
• To hedge a foreign currency payable buy calls on
  the currency.
• If the currency appreciates, your call option
  lets you buy the currency at the exercise price
  of the call.
• To hedge a foreign currency receivable buy puts
  on the currency.
• If the currency depreciates, your put option lets
  you sell the currency for the exercise price.

26
When To Use These Tools

• Forward market hedge
• Protect against downside risk. No upside
  potential.
• Money market hedge
• Assuming IRP holds, then no gain/loss. Use if
  expect IRP might not hold.
• Options market hedge
• Caps possible downside risk while leaving open
  possibility of upside gains.

27
Cross-Hedging Minor Currency Exposure

• The major currencies are the U.S. dollar,
  Canadian dollar, British pound, Swiss franc,
  Mexican peso, Japanese yen, and the euro.
• Everything else is a minor currency, like the
  Polish zloty.
• It is difficult, expensive, or impossible to use
  financial contracts to hedge exposure to minor
  currencies.

28
Cross-Hedging Minor Currency Exposure

• Cross-Hedging involves hedging a position in one
  asset by taking a position in another asset.
• The effectiveness of cross-hedging depends upon
  how well the assets are correlated.
• An example would be a U.S. importer with
  liabilities in Czech koruna hedging with long or
  short forward contracts on the euro. If the
  koruna is expensive when the euro is expensive,
  or even if the koruna is cheap when the euro is
  expensive it can be a good hedge. But they need
  to co-vary in a predictable way.

29
Hedging Contingent Exposure

• If only certain contingencies give rise to
  exposure, then options can be effective
  insurance.
• For example, if Bechtel (a US engineering firm)
  bid on the contract for the Hong Kong Disneyland,
  they would need to hedge the HKD-USD exchange
  rate only if they won the contract.
• Bechtel could hedge this contingent risk with
  options.

30
Hedging Recurrent Exposure with Swaps

• Recall that swap contracts can be viewed as a
  portfolio of forward contracts.
• Firms that have recurrent exposure can very
  likely hedge their exchange risk at a lower cost
  with swaps than with a program of hedging each
  exposure as it comes along.
• It is also the case that swaps are available in
  longer-terms than futures and forwards.

31
Hedging through Invoice Currency

• The firm can shift, share, or diversify
• shift exchange rate risk
• by invoicing foreign sales in home currency
• share exchange rate risk
• by pro-rating the currency of the invoice between
  foreign and home currencies
• diversify exchange rate risk
• by using a market basket index
• Caveat both parties must agree to these
  arrangements. Not always possible.

32
Hedging via Lead and Lag

• If a currency is appreciating, pay those bills
  denominated in that currency early let customers
  in that country pay late as long as they are
  paying in that currency.
• If a currency is depreciating, give incentives to
  customers who owe you in that currency to pay
  early pay your obligations denominated in that
  currency as late as your contracts will allow.

33
Exposure Netting

• A multinational firm should not consider deals in
  isolation, but should focus on hedging the firm
  as a portfolio of currency positions.
• As an example, consider a U.S.-based
  multinational with Korean won receivables and
  Japanese yen payables. Since the won and the yen
  tend to move in similar directions against the
  U.S. dollar, the firm can just wait until these
  accounts come due and just buy yen with won.
• Even if its not a perfect hedge, it may be too
  expensive or impractical to hedge each currency
  separately.

34
Exposure Netting

• Many multinational firms use a reinvoice center.
  That is a financial subsidiary that nets out the
  intrafirm transactions.
• Once the residual exposure is determined, then
  the firm implements hedging.

35
Exposure Netting an Example

• Consider a U.S. MNE with three subsidiaries and
  the following foreign exchange transactions

20
30
40
10
35
10
40
30
25
60
20
30
36
Exposure Netting an Example

• Bilateral Netting would reduce the number of
  foreign exchange transactions by half

10
20
15
25
10
10
37
Exposure Netting an Example

• Consider simplifying the bilateral netting with
  multilateral netting . Clearly, multilateral
  netting can simplify things greatly.

15
40
38
Should the Firm Hedge?

• Not necessarily
• Hedging by the firm may not add to shareholder
  wealth if the shareholders can manage exposure
  themselves.
• Hedging may not reduce the non-diversifiable risk
  of the firm. Therefore shareholders who hold a
  diversified portfolio are not helped when
  management hedges.

39
Reasons Why a Firm Should Hedge

• In the presence of market imperfections, the
  firm should hedge.
• Information Asymmetry
• The managers may have better information than the
  shareholders.
• Differential Transactions Costs
• The firm may be able to hedge at better prices
  than the shareholders.
• Default Costs
• Hedging may reduce the firms cost of capital if
  it reduces the probability of default.
• Taxes
• Progressive tax rates greatly increase the lure
  of managing earnings to ensure a steady tax bill.

40
Ch 14 Translation Exposure

• Also called Accounting Exposure.
• Definition Impact of unanticipated changes in
  exchange rates on the consolidated financial
  reports of a multinational.

41
Current/Noncurrent Method

• The underlying principle is that assets and
  liabilities should be translated based on their
  maturity.
• Current assets translated at the spot rate.
• Noncurrent assets translated at the historical
  rate in effect when the item was first recorded
  on the books.
• Net result most income statements are translated
  at the average exchange rate for the accounting
  period.
• This method of foreign currency translation was
  generally accepted in the United States from the
  1930s until 1975, at which time FASB 8 became
  effective.

42
Current/Noncurrent Method

• Current assets translated at the spot rate. e.g.
  DM21
• Noncurrent assets translated at the historical
  rate in effect when the item was first recorded
  on the books. e.g. DM31

43
Monetary/Nonmonetary Method

• The underlying principle is that monetary
  accounts have a similarity because their value
  represents a sum of money whose value changes as
  the exchange rate changes.
• All monetary balance sheet accounts (cash,
  marketable securities, accounts receivable, etc.)
  of a foreign subsidiary are translated at the
  current exchange rate.
• All other (nonmonetary) balance sheet accounts
  (owners equity, land) are translated at the
  historical exchange rate in effect when the
  account was first recorded.

44
Monetary/Nonmonetary Method

• All monetary balance sheet accounts are
  translated at the current exchange rate. e.g.
  DM21
• All other balance sheet accounts are translated
  at the historical exchange rate in effect when
  the account was first recorded. e.g.DM31

45
Temporal Method

• The underlying principle is that assets and
  liabilities should be translated based on how
  they are carried on the firms books.
• Balance sheet accounts are translated at the
  current spot exchange rate if they are carried on
  the books at their current value.
• Items that are carried on the books at historical
  costs are translated at the historical exchange
  rates in effect at the time the firm placed the
  item on the books.

46
Temporal Method

• Items carried on the books at their current value
  are translated at the spot exchange rate.
  e.g. DM21
• Items that are carried on the books at historical
  costs are translated at the historical exchange
  rates. e.g. DM31

47
Current Rate Method

• All balance sheet items (except for stockholders
  equity) are translated at the current exchange
  rate.
• Very simple method in application.
• A plug equity account named cumulative
  translation adjustment is used to make the
  balance sheet balance.

48
Current Rate Method

• All balance sheet items (except for stockholders
  equity) are translated at the current exchange
  rate.
• A plug equity account named cumulative
  translation adjustment is used to make the
  balance sheet balance

49
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
Spot exchange rate
50
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
Book value of inventory historic rate
earnings
Book value of inventory at spot exchange rate
Current value of inventory at spot exchange rate.
51
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
historic rate
spot exchange rate.
52
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
spot rate
53
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
spot rate
54
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
historical rate
55
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
From income statement
56
How Various Translation Methods Deal with a
Change from DM3 to DM2 1
earnings
Under the current rate method, a plug equity
account named cumulative translation adjustment
makes the balance sheet balance.
57
FASB Statement 8

• Essentially the temporal method, with some
  subtleties.
• Example translating inventory at historical
  rates.
• Requires taking foreign exchange gains and losses
  through the income statement.
• This leads to variability in reported earnings.
• This year-to-year variation isnt viewed
  favorably by corporate executives and/or the
  market.

58
FASB Statement 52

• Functional Currency
• The currency that the business is conducted in.
• Reporting Currency
• The currency in which the MNE prepares its
  consolidated financial statements.
• Usually this is the currency of the country where
  the parent firm is located and conducts most of
  its business.

59
FASB 52 Two-Stage Process

• Determine in which currency the foreign entity
  keeps its books.
• If the local currency in which the foreign entity
  keeps its books is not the functional currency,
  remeasurement into the functional currency is
  required.
• Uses temporal method.
• produce the same results as if the books were
  maintained in the functional currency.
• When the foreign entitys functional currency is
  not the same as the parents currency, the
  foreign entitys books are translated using the
  current rate method.

60
The Mechanics of FASB Statement 52
Parents currency
Foreign entitys books kept in?
Nonparent Currency
Functional Currency?
Third currency
Temporal Remeasurement
Local currency
Current Rate Translation
Parents Currency
Parents Currency
61
Highly Inflationary Economies

• Foreign entities are required to remeasure
  financial statements using the temporal method
  as if the functional currency were the reporting
  currency.

62
Translation Exposure vs. Transaction Exposure

• Translation Exposure
• The effect that unanticipated changes in exchange
  rates has on the firms consolidated financial
  statements.
• An accounting issue.
• Transaction Exposure
• The effect that unanticipated changes in exchange
  rates has on the firms cash flows.
• A finance issue.
• It is generally not possible to eliminate both
  translation exposure and transaction exposure.
• So what should a company do?

63
Hedging Translation Exposure

• If the managers of the firm wish to manage their
  accounting numbers as well as their business,
  they have two methods for dealing with
  translation exposure.
• Balance Sheet Hedge
• Derivatives Hedge

64
Balance Sheet Hedge

• Eliminates the mismatch between net assets and
  net liabilities denominated in the same currency.
• May create transaction exposure, however.

65
Derivatives Hedge

• An example would be the use of forward contracts
  with a maturity of the reporting period to
  attempt to manage the accounting numbers.
• Using a derivatives hedge to control translation
  exposure really involves speculation about
  foreign exchange rate changes, however.
• Assumes deviation from IRP.

66
Translation Exposure versus Operating Exposure

• The effect that unanticipated changes in exchange
  rates has on the firms ongoing operations.
• Operating exposure is a substantive issue with
  which the management of the firm should concern
  itself with.
• Why is this a strategic issue for the firm?