Lecture 12: Managing Foreign Exchange Exposure with Operational Hedges

1
Lecture 12 Managing Foreign Exchange Exposure
with Operational Hedges

• A discussion of the various operational
  arrangements which global firms and global
  investors can use when managing open foreign
  exchange positions

2
Hedging Known Future Cash Flows

• In the previous lecture, the hedging techniques
  we discussed (forwards and options) are most
  appropriate for covering transaction exposure.
• Transaction exposures have known foreign currency
  cash flows and thus they are easy to hedge with
  financial contracts.
• The majority of transaction exposure risk results
  from receivables (payables) from exports
  (imports) contracts and repatriation of
  dividends.
• Usually, the time frame for these committed
  transactions (the time between contracting and
  payment) is relatively short. However, it can in
  some cases reach several years, where deliveries
  are committed a long time in advance (forward
  sales of airplanes or building contracts).

3
Quick Review Identifying Sources of Transaction
Exposure

• Transaction exposure arises from
• (1) Purchasing or selling, on credit, goods or
  services denominated in foreign currencies.
• (2) Borrowing or lending denominated in
  foreign currencies.
• (3) Acquiring financial assets or incurring
  liabilities denominated in foreign currencies.

4
Dealing with Transaction Exposure Through
Operational Hedges

• While global companies can manage their
  transaction exposures with financial hedges, they
  can also utilize operational hedges.
• Operational hedges refers to internal
  organizational strategies that firms use to deal
  with their currency exposures.
• With respect to transaction exposure, potential
  operational techniques include
• Risk Shifting Invoicing overseas purchases and
  sales in home currency.
• Netting Hedged net amounts of transaction
  exposures.
• Leading (speeding up) and Lagging (slowing down)
  payments in response to changes in exchange
  rates.

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Operational Hedging of Transaction Exposures
Risk Shifting, Home Currency Invoicing, 2003-2007
Data
6
Operational Hedging Netting

• Given that large and globally diverse
  multinational firms may need to manage exchange
  rate risk associated with several different
  currencies these generally consider their net
  exposure to currency risk instead of just looking
  at each currency separately.
• Global firms will achieve netting through a
  centralized approach because a non-centralized,
  whereby each subsidiary assesses and manages its
  individual exposure to exchange rate risk will
  result in redundancy and added costs in hedging.

7
Transaction Exposure Using "Net" Cash Flows

• Centralized exposure management requires
  headquarters to consolidate the net amount of
  currency inflows and outflows for all
  subsidiaries categorized by currency.
  
• Consider two subsidiaries X Y of a U.S. MNC
• Subsidiary X has net inflow (long position) of
  500,000
• Subsidiary Y has net outflows (short position)
  of 600,000
• Then, the consolidated "net" outflow for this
  multinational corporation is 100,000 which is
  the amount to be hedged.
• Additionally, if the pound weakens it will be
  unfavorable to X but favorable to Y. If hedging
  is limited to net exposure, transaction cost
  savings are realized.

8
Operational Hedging Leading and Lagging Payments

• Refers to the timing of when a firm with an FX
  exposed position will initiate foreign currency
  payments (or specifically when the firm has an
  open short position).
• Leading (speeding-up) Payments.
• Lead payments when home currency is weakening
  (i.e., foreign currency is strengthening).
• Lagging (slowing down/delaying) Payments
• Lag payments when home currency is strengthening
  (i.e., foreign currency is weakening).

9
Hedging Unknown Cash Flows

• In the previous examples we were dealing with
  known foreign currency cash flows (resulting from
  current transactions).
• However, economic exposures do not provide the
  firm with this known cash flow information.
• Economic exposure refers to the impact of
  exchange rate movements on the home currency
  value of uncertain future cash flows.
• Global firm Uncertain future cash flows relate
  to the firms costs (e.g., raw materials, labor
  costs, etc.) and output prices and sales (e.g.,
  product prices).
• Global investor Uncertain future cash flows
  relate to the future dividends and changes in
  market prices.

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Channels of Economic Exposure for Firms

• (1) Direct effects of FX changes result from a
  companys actual involvement in foreign markets.
• Impact on the home currency equivalents of cost
  and revenue streams in overseas markets.
• (2) Indirect effects refer to FX induced changes
  in foreign company competition in a companys
  domestic market.
• Foreign competitors exporting into companys home
  country (FX induced change in competitive
  position of foreign exporters).
• Foreign companies setting up FDI activities in
  companys home country.
• Both (1) and (2) driven by globalization.

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The Globalization of Business Firms 2010 Data
for SP 500 Firms
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Data for Selected SP 500 Companies, Sorted by
Percentage Point Increase
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The Global Reach of Selected U.S. Companies, 2010
Data

• Wal-Mart. Total revenue 420 billion, 26 from
  overseas nearly 5,000 stores in 14 foreign
  countries, including China, India, the U.K., and
  Latin America.
• Bank of America. Total revenue 134 billion, 20
  from overseas. Europe is biggest market.
• Ford. Total revenue 129 billion, 51 from
  overseas Canada and Europe.
• Boeing. Total revenue 64 billion in revenue,
  41 from overseas Europe, Asia, and the Middle
  East.
• Intel. Total revenue 44 billion, 85 from
  overseas. Taiwan, followed by China.
• Amazon. Total revenue 34 billion, 45 from
  overseas Canada, several European countries,
  Japan, and China.
• McDonald's. Total revenue 24 billion, 66 from
  overseas Europe and Asia.
• Nike. Total revenue 21 billion, 50 from
  overseas North America, Europe and China.

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McDonalds, 2010 Annual Report
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Impact of FX Changes on SalesNote Excluding
F/X estimates sales based on the previous years
exchange rate
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Dealing with Economic Exposure

• Recall that economic exposure is long term and
  involves unknown future cash flows.
• What can the firm do to manage this economic
  exposure?
• Firm can employ an operational hedge.
• One such strategy involves global diversification
  of production and/or sales markets to produce
  natural hedges for the firms unknown foreign
  exchange exposures.
• As long as currencies associated with these
  different markets do not move in the same
  direction, the firm can stabilize its overall
  home currency equivalent cash flow.

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Global Diversification of Sales

• Subway
• 35,561 restaurants in 98 countries
• Visit http//www.subway.com/subwayroot/exploreour
  world.aspx
• McDonalds (2010)
• 32,737 restaurants in
• 117 countries.
• Revenues by segment

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Balancing Costs and Revenues Restructuring to
Reduce Economic Exposure

• Restructuring involves shifting the sources of
  costs or revenues to other locations in order to
  match cash inflows and outflows in foreign
  currencies.
• Restructuring Decisions
• Should the firm attempt to increase or decrease
  sales in specific countries (i.e., revenues)?
• Should the firm attempt to increase or decrease
  dependency on foreign suppliers (i.e., cost)?
• Should the firm establish or eliminate production
  facilities in foreign markets (i.e., costs)?
• Should the firm increase or decrease its level of
  foreign currency denominated debt (i.e., costs)?

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Nikes Global Diversification of Manufacturing
for Footwear, By Country, 2005

• Country Percent
• China 36
• Vietnam 26
• Indonesia 22
• Thailand 15
• Big Four 99
• Others Argentina, Brazil, India, Mexico, and
  South Africa
• Source Nike, 2005 Annual report

20
Nikes Global Diversification of Sales by
International Region (U.S. Dollars in Millions),
2005

• Market Revenue Percent
• United States 5,129.3 37.3
• EMEA 4,281.6 31.2
• Asia Pacific 1,897.3 13.8
• Americas 695.8 5.1
• Other 1,735.7 12.6
• Total 13,739.7
• Note EMEA is Europe, Middle East and Africa

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Is Nike a Balanced Firm?

• Foreign Currency Costs concentrated in
• Yuan, Dong, Rupiah, Baht
• Foreign Currency Revenues concentrated in
• Euros, Pounds, Yen
• What if the cost currencies strengthen (against
  the USD) and the revenue currencies weaken
  (against the USD)?
• Negative impact on USD profits
• Possible solution Adjust prices in revenue
  countries.
• What if the cost currencies weaken and the
  revenue currencies strengthen?
• Positive impact on USD profits
• How could Nike balance its overseas activities?

22
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure

• Step 1 Determining Specific Foreign Exchange
  Exposures
• What type of exposure are you dealing with?
• By currency and net amounts (i.e., long minus
  short positions)
• Are the net amounts worth hedging? If they are
  go to Step 2 if not, no need to hedge.
• Step 2 Forecasting Exchange Rates
• Determining the potential for and possible range
  of currency movements.
• Important to select the appropriate forecasting
  model.
• A range of forecasts is probably appropriate
  here (i.e., forecasts under various assumptions)
• How comfortable are you with your forecast? If
  comfortable, go to Step 3. If not, hedge.

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A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure

• Step 3 Assessing the Impact of Forecasted
  Exchange Rates on Companys Home Currency
  Equivalents (What is the Measured Risk?).
• Impact on earnings, cash flow, liabilities
  (positive or negative?)
• Go to Step 4
• Step 4 Deciding Whether to Hedge or Not
• Determine whether the anticipated impact of the
  forecasted exchange rate change merits the need
  to hedge.
• Perhaps the estimated negative impact on home
  currency equivalent is so small as not to be of a
  concern.
• But, if impact is unacceptable, go to Step 5
• Or, perhaps the firm feels it can benefit from
  its exposure.
• If this is the case, go to Step 6

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A Comprehensive Approach or Assessing and
Managing Foreign Exchange Exposure

• Step 5 Selecting the Appropriate Hedging
  Instruments if Risk is Unacceptable.
• Consider
• Which hedge is appropriate for the type of
  exposure?
• Financial and/or operational
• Firms familiarity and comfort level with types
  of hedging strategies.
• Review the cost involved with different financial
  contracts.
• Step 6 Selecting the Appropriate Strategy to
  Position the Firm to Take Advantage of a
  Favorable Exchange Rate Change.
• Consider
• Partial open position versus complete open
  position.
• Which financial contract will achieve your
  objective?

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Appendix 1

• The following slides illustrate how companies
  deal with and report translation exposures

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Translation Exposure

• Translation exposure is commonly referred to as
  accounting exposure because it refers to the
  impact of exchange rate changes on the
  consolidated financial reports of a global firm.
• These include impacts on assets and liabilities
  and profits which have been acquired or occurred
  in the past.
• Why do global firms need to consolidate
  statements?
• To report financial results to their
  shareholders.
• To report income to taxing authorities.
• The accounting approach for consolidating
  financial statements depends upon the accounting
  requirements of the firms headquartered country.
• The U.S. is governed by FASB 52.
• Balance sheet and income statement gains or
  losses associated with the consolidation process
  show up in the shareholders equity account

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Nikes 2005 Financial Statement Summary

• Consolidated Balance Sheet, Fiscal 2005 (millions
  of U.S. dollars)
• Assets 8,793.6
• Liabilities 3,149.4
• Shareholders Equity 5,644.2
• Of which foreign currency
• translation adjustments were
  70.1
• This is a cumulative amount (e.g., in 2004 it
  was 27.5