Foreign Exchange Risk Management

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Foreign ExchangeRisk Management
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Foreign Exchange Risks

• Transaction Risk
• Translation Risk
• Economic Risk

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Transaction Risk

• The risk of changes in the expected value of a
  contract between its signing and its execution as
  a result of unexpected changes in foreign
  exchange rates.
• Whoever makes a contract denominated in a foreign
  currency bears transaction risk.
• Ocean Drilling has transaction risk if it borrows
  money in French francs or Japanese yen, and
  Hintz-Kessels-Kohl has transaction risk if it
  agrees to accept future payments for its vehicles
  in U.S. dollars.

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Translation Risk

• Gains or losses from exchange rate changes that
  occur as a result of converting financial
  statements from one currency to another in order
  to consolidate them.
• Every company having at least one subsidiary
  using a different functional currency bears
  translation risk.
• MSDI has translation risk from having a
  subsidiary, MSDI Alcala de Henares, whose
  financial statements are kept in Spanish pesetas
  and not in U.S. dollars.

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Economic Risk

• Changes in competitive position as a result of
  permanent changes in exchange rates.
• Every company buying or selling abroad or even
  just competing with foreign companies has
  economic risk.
• Maybach has economic risk from manufacturing its
  automobiles in Germany for export to the United
  States, where it competes with Rolls Royces
  manufactured in England.

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Transaction Risk
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Passive Transaction Risk Management

• Denominate all contracts in domestic currency.
  This is a possible strategy for companies with
  market power.
• Do nothing about transaction risk. This is a
  possible strategy for companies with a large
  number of small contracts in a large number of
  currencies.

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Natural Transaction Risk Hedging

• Centralize cash management to net all offsetting
  transactions, transactions which are long and
  short the same currency.
• Time, lead and lag, offsetting business
  transactions in the same currency.
• Create offsetting business transactions in the
  same currency.

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Market Transaction Risk Hedging

• Forward Markets
• Futures Markets
• Money Markets
• Swaps Markets
• Options Markets

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Hedging

• Insuring against transaction risk to reduce or
  eliminate the effects of unexpected changes in
  exchange rates.
• You can hedge only at market rates. The effects
  of expected changes in exchange rates are
  incorporated in these market rates.
• Hedging is insurance. The purpose of hedging is
  to reduce or eliminate risks, not to make profits.

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Reasons Not To Hedge

• Since no one can out-guess the market, the
  expected value of hedging, not including the
  direct costs, is zero. With the direct costs,
  hedging is expected to lose money. But are there
  offsetting benefits?
• Hedging affects the appearance of a company but
  not the economic reality. Investors can see
  through the accounting statements to the
  underlying economics. But do investors really
  have enough information to do this?
• Hedging stabilizes financial performance, which
  benefits the managers of a company but not the
  owners. The owners can diversify away the risk
  in their investment portfolios. But is such
  diversification always possible?

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Reasons To Hedge

• Hedging reduces the risk of the extraordinary
  costs of extreme financial distress.
• Hedging facilitates the execution of complex
  operational and financial plans.
• Hedging prevents changing economic conditions
  from destroying the effectiveness of performance
  evaluation systems.

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Translation Risk
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Example of Translation Risk

• Narodno Pivo intends to set up a marketing
  subsidiary in the United States.
• It loans this subsidiary 125,000,000 SIT when the
  exchange rate is 250 SIT/USD.
• The 500,000 USD (125,000,000/250) is deposited in
  an account at a U.S. bank.
• Narodno Pivo credits cash and debits a new asset,
  loan to subsidiary, for 125,000,000 SIT.
• The subsidiary debits cash and credits a new
  liability, loan from parent, for 500,000 USD.

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Financial Statement Consolidation

• No other transactions have occurred, and the cash
  remains in the account at the U.S. bank.
• The tolar has strengthened, and the exchange rate
  is now 200 SIT/USD.
• The financial statements of Narodno Pivo and its
  subsidiary must be consolidated for financial
  reporting at the end of the fiscal year.

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Convert at Current Rate

• The cash is worth 100,000,000 SIT (500,000 x
  200).
• On the subsidiary statements, the loan from
  parent is also worth 100,000,000 SIT (500,000 x
  200).
• The subsidiary balance sheet balances.
• But on the Narodno Pivo statements, the loan to
  subsidiary is still 125,000,000 SIT.
• The loan to subsidiary and the loan from parent
  no longer offset each other.

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Convert at Historical Rates

• The cash is worth 100,000,000 SIT (500,000 x
  200).
• On the subsidiary statements, the loan from
  parent is still worth 125,000,000 SIT (500,000 x
  250).
• On the Narodno Pivo statements, the loan to
  subsidiary is still 125,000,000 SIT.
• The loan to subsidiary and the loan from parent
  still offset each other.
• But the subsidiary balance sheet does not balance
  in SIT. The asset is 100,000,000 SIT and the
  liability is 125,000,000 SIT.

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Solutions

• If current rates were used for consolidation, the
  value of the loan to subsidiary on Narodno Pivos
  balance sheet must be written down by 25,000,000
  SIT (125,000,000 - 100,000,000).
• If historical rates were used for consolidation,
  a 25,000,000 SIT loss (125,000,000 - 100,000,000)
  must be recognized in order to make the Narodno
  Pivo consolidated balance sheet balance.

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Is the Loss Real?

• Yes. Narodno Pivo has lost 25,000,000 SIT in
  tolar value as a result of transaction risk that
  is, making a loan denominated in a foreign
  currency. Had they kept that money in Slovenia,
  they could be doing more with it now.
• No. Narodno Pivo has lost nothing in dollar
  value. The ability of the subsidiary to perform
  its economic function has not changed as a result
  of the exchange rate change. Had the subsidiary
  belonged to a U.S. company, the exchange rate
  change would have been completely irrelevant.
  Narodno intended the subsidiary to be successful
  and did not intend to get the cash back. It
  cannot lose what it never intended to have.

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Hedging Translation Risk

• Translation risk is hedged in the same ways as
  transaction risk.
• Does it make sense to create a real risk (a
  natural or market hedge) to offset a translation
  risk that may or may not be real?
• It appears as if investors are indifferent to
  foreign currency translation gains and losses.

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Market Transaction Risk Hedging

• Forward Markets
• Futures Markets
• Money Markets

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Forward and Futures Markets

• Selected currencies, standard contracts, standard
  maturities
• Liquid
• Government-regulated exchange-based market
• Contract with exchange
• Requires margin account
• Marked to market daily
• Settled by offsetting trade
• Hedge by making a transaction whose gains or
  losses offset those of the underlying position

• Any currency, any amount, any maturity
• Illiquid
• Self-regulated OTC market
• Contract with dealer
• Requires credit-worthiness
• Cash flow only at maturity
• Settled by executing contract
• Hedge by buying forward the short currency or
  selling forward the long currency

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Forward and Money Markets

• Money markets can always be used to synthesize
  forward markets.
• Money market rates are used to set forward market
  rates.
• Money market transactions are likely to be more
  costly than forward market transactions, since
  three transactions having their own bid-ask
  spreads are required to duplicate one forward
  market transaction with one bid-ask spread.
• Money market transactions appear on the balance
  sheet forward market transactions do not.

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