Lecture 10: Understanding Foreign Exchange Exposure

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Lecture 10 Understanding Foreign Exchange
Exposure

• The Types of Foreign Exchange Exposure Facing
  Global Firms and Global Investors

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Where is this Financial Center?
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4,000 year old Pyramids of Giza
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At the Top -- 455 Ft
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View From the Top
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What is Foreign Exchange Exposure and Exposure
Risk?

• Foreign exchange exposure comes about when a firm
  or investor has an open position in a foreign
  currency.
• Open position Unhedged subject to exchange
  rate risk
• Open long position Expect to receive foreign
  currency in the future
• Open short position Need to pay foreign
  currency in the future
• Foreign exchange exposure risk refers to the
  possibility that a foreign currency may move in a
  direction which is financially detrimental to the
  global firm or global investor.
• Important Global firms and investors cannot
  have foreign exchange exposure in their home
  currencies.
• Suggests a strategy for managing exposure.

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Risk with an Open Foreign Currency Position

• Open long position (when you expect to receive
  foreign currency in the future).
• Specific risk is that the foreign currency may
  weaken against your home currency, thus reducing
  the home currency equivalent of the long
  position.
• Open short position (when you expect to pay
  foreign currency in the future).
• Specific risk is that the foreign currency may
  strengthen against your home currency (thus
  requiring more home currency to acquire the
  foreign currency). This increases the home
  currency equivalent of the short position.

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The Risks Associated with FX Exposure

• There are three specific risks to global firms
  and/or global investors from their foreign
  exchange exposures
• (1) Settlement Value Risk Occurs because
  foreign currency denominated contracts and
  investments, in the home currency equivalent of
  the firm or investor, can be adversely affected
  by FX changes.
• Fixed income investments (e.g., bonds).
• Accounts receivable held multinationals.
• Loans payable to banks.

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Risks Associated with FX Exposure

• (2) Future Cash Flows Risk Occurs because the
  home currency equivalents of anticipated foreign
  currency cash flows can be adversely affected.
• Foreign currency cash inflows and outflows
• Interest payments on fixed income securities.
• Future revenues from ongoing multinational
  operations.
• Future costs associated with ongoing
  multinational operations.
• Note the net impact of this cash flow exposure
  depends upon the net cash flow position of the
  firm.
• For example, if foreign currency revenues exceed
  foreign currency costs, a strong foreign currency
  with have a net positive effect on the net home
  currency equivalent.
• And if foreign currency costs exceed foreign
  currency revenues, a strong foreign currency will
  have a net negative effect on the net home
  currency equivalent.

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Risks Associated with FX Exposure

• (3) Global Competitive Risk Occurs because the
  competitive position of a firm can be affected by
  adverse changes in exchange rates.
• Exporting firms are adversely affected if the
  currencies of their overseas markets weaken.
• More difficult to compete with domestic firms.
• Importing firms are adversely affected if the
  currencies of their overseas markets strengthen.
• May need to increase their home market selling
  prices.
• Overseas production is adversely affected if the
  currencies of these outsourcing countries
  strengthens.
• Home currency equivalent of producing offshore
  will increase.

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Types of Foreign Exchange Exposure Facing Global
Firms

• There are three types of foreign exchange
  exposures that global firms may face as a result
  of their international activities.
• These foreign exchange exposures are
• Transaction exposure
• Results from a global firm engaged in current
  transactions involving contractual arrangements
  in foreign currencies (e.g., invoices coming due,
  loans coming due, interest payments coming due,
  etc).
• Economic exposure
• Results from future and unknown transactions in
  foreign currencies resulting from a global firms
  long term involvement in a particular market
  (i.e., because of a long term physical presence
  in that foreign market).
• Translation exposure (sometimes called
  accounting exposure).
• Important for global firms with a physical
  presence in a foreign country needing to
  consolidate their individual country financial
  statements for reporting purposes.

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Transaction Exposure

• Transaction Exposure Results when a firm agrees
  to fixed cash flow foreign currency denominated
  contractual agreements.
• Examples of transaction exposure
• An Account Receivable denominate in a foreign
  currency.
• A maturing financial asset (e.g., a bond)
  denominated in a foreign currency.
• An Account Payable denominate in a foreign
  currency.
• A maturing financial liability (e.g., a loan)
  denominated in a foreign currency.

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Incident of Exporting and Importing Transaction
Exposure By Global Firms Home Country
Country Exports in Home Currency ( of invoices) Imports in Home Currency ( of invoices)
United States 96.0 85.0
Germany 81.5 52.6
France 58.5 48.9
United Kingdom 57.0 40.0
Italy 38.0 27.0
Japan 34.3 13.3
Note 1988 Data
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Economic Exposure

• Economic Exposure Results from the physical
  entry of a global firm into a foreign country.
• This is a long term foreign exchange exposure
  resulting from a previous FDI location decision.
• Economic exposure impacts the firm through
  contracts and transactions which have yet to
  occur, but will, in the future. These are really
  future transaction exposures which are unknown
  today.
• Economic exposure also impacts the firm through
  its operating income (revenue) and costs which
  are denominated in the currency of the foreign
  country.

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Economic Exposure of U.S. Firms

• Empirical studies of large U.S. multinational
  firms (with significant foreign operations) have
  generally found low or negligible foreign
  exchange exposure, i.e., little variation in home
  currency equivalent profits associated with
  exchange rate changes.
• Explanation 1 U.S. multinationals might be
  very successful in hedging their exposures.
• Explanation 2 U.S. multinational firms with a
  relatively balanced revenue and cost in foreign
  currencies may have a natural offset. Whereas
  unbalanced firms (without hedging) could be
  subject to more foreign exchange exposure.
• Explanation 2 referred to as Operational
  Hedging.

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Translation Exposure

• Translation Exposure Results from the need of a
  global firm to consolidated its financial
  statements to include results from foreign
  operations.
• Consolidation involves translating subsidiary
  financial statements in local currencies (i.e.,
  in the foreign markets where the firm is located)
  to the home currency of the firm (i.e., the
  parent).
• Consolidation can result in either translation
  gains or translation losses.
• These are essentially the accounting systems
  attempt to measure foreign exchange ex post
  exposure.

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Foreign Exchange Exposure for a Global Investor

• Foreign exchange exposure for a global investor
  results from the acquisition of financial assets
  denominated in a currency other than the home
  currency of the investor.
• FX exposure can affect
• (1) The home currency equivalent market price of
  those assets and
• (2) The home currency equivalent cash flows
  (dividends and interest) associated with
  particular financial assets.

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Risk Elements for Global Investors in Equities

• The specific risk components associated with
  common stock (equities)
• Company risk (micro risk)
• Decisions of management changes in management
  success or failure of (new) products.
• Environment risk (macro risk)
• Risk produced by the industry (competition),
  governments (regulation), country (business
  cycles) and global environment in which the
  company operates.
• Market risk (systematic risk)
• Associated with movements in the overall equity
  market of a country. Under CAPM, measured by the
  stocks beta.
• Exchange rate risk
• Associated with investing in equities whos
  market price and dividends are denominated in
  other than the home country of the investor.

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Exchange Rate Impacts on Equity Returns Dec 31,
2010 Oct 15, 2011
Country or Area L.C. Return USD Return Stock Index
United States -0.5 -0.5 DJIA
Egypt -42.8 -44.4 CASE
Japan -16.2 -12.1 Topix
China -13.8 -10.6 SSEA
Britain -7.8 -7.1 FTSE 100
Canada -10.5 -12.5 TSX
Germany -13.3 -10.8 DAX
Switzerland -10.2 -6.4 SMI
Australia -12.0 -14.3 All Ord.
Pakistan 0.8 -1.0 KSE
South Africa -3.1 -17.7 JSE
Hong Kong -20.4 -20.5 Hang Seng
Saudi Arabia -7.8 -7.8 Tadawul
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Risk Elements for Global Investors in Bonds

• The specific risk components associated with
  bonds (i.e., fixed income securities)
• Default risk (credit risk) Risk that issuer will
  not be able to repay debt as contracted.
• Corporates Cash flow issues.
• Sovereigns Governmental debt servicing issues.
• Market risk (price risk)
• Associated with changes in the markets overall
  assessment of risk and willingness to take risk
  (or avert risk).
• Contagion risk
• Associated with spillover effects from other
  countries.
• Exchange rate risk
• Associated with investing in bonds whos market
  price and interest payments are denominated in
  other than the home country of the investor.

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Exchange Rates and Bond Yields

• The gap between the U.S. dollar un-hedged and
  hedged Global Treasuries shows the effect
  currency has played in these annual returns. In
  most years (with the exception of 2005 and the
  first quarter of 2009), currency moves
  (represented by unhedged returns) benefited the
  U.S. investor (this is shown by the difference
  between the un-hedged and hedge indexes).