Understanding Foreign Exchange Exposure

1
Understanding Foreign Exchange Exposure

• In this lecture we will discuss the types of
  foreign exchange exposure facing global firms and
  global investors

2
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 long position Expects to receive foreign
  currency in the future
• Open short position Needs 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.

3
Risk with an Open Foreign Currency Position

• Open long position (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 (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.

4
Global Companies and FX Exposure

• What is the specific risk to a global firm from
  foreign exchange exposure?
• (1) Settlement value of foreign currency
  denominated contracts, in the home currency
  equivalent of the firm, can be adversely
  affected.
• Open long position At settlement (i.e., when
  payment is received), the home currency
  equivalent is less than on origination date.
• Open short position At settlement (i.e., when
  payment is made), the home currency equivalent is
  more than on origination date.

5
Global Companies and FX Exposure -- Continued

• (2) Cash flows from foreign operations, in home
  currency equivalents, can be adversely affected.
• Cash inflows Revenues denominated in foreign
  currencies will be worth less in home currency
  equivalents if the foreign currencies weaken.
• Cash inflows Costs denominated in foreign
  currencies will be more in home currency
  equivalents if the foreign currencies strengthen.
  
• The net impact of the exposure, depends upon the
  net cash flow position of the firm.
• If revenues exceed costs, a strong foreign
  currency with have a net positive effect.
• If costs exceed revenues, a strong foreign
  currency will have a net negative effect.

6
Global Companies and FX Exposure -- Continued

• (3) The global competitive position of the firm
  can be affected by adverse changes in exchange
  rates.
• Exporting firms are adversely affected if the
  currencies of their overseas markets weaken.
• Importing firms are adversely affected if the
  currencies of their overseas markets strengthen.
• Overseas production is adversely affected if the
  currencies of these outsourcing countries
  strengthens.

7
Types of Foreign Exchange Exposure

• 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
• Any MNC engaged in current transactions involving
  foreign currencies (e.g., invoices coming due,
  loans coming due, interest payments coming due,
  etc).
• Economic exposure
• Results for future and unknown transactions in
  foreign currencies resulting from a MNC long term
  involvement in a particular market (because of a
  long term physical presence in that foreign
  market).
• Translation exposure (sometimes called
  accounting exposure).
• Important for MNCs with a physical presence in a
  foreign country and needing to consolidate
  financial statements for reporting purposes.
• We will develop each of these three exposures in
  the slides which follow.

8
Transaction Exposure

• Transaction Exposure Results from a firm taking
  on 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.

9
Transaction Exposure Resulting from Exporting and
Importing Contracts
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
10
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 revenues associated with
  exchange rate changes.
• Explanation U.S. multinational firms with
  significant revenues and costs in foreign
  currencies may have a natural offset (i.e.,
  balance) of revenues and costs.
• Referred to as Operational Hedging.
• These studies also suggest that firms with large
  unbalanced revenue or cost streams are subject to
  substantial foreign exchange exposure.
• See next slide

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13
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.

14
Foreign Exchange Exposure for a Global Investor

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

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Does Foreign Exchange Exposure Matter to Global
Investors in Equities?

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

16
Exchange Rate Impacts on Equity Returns Dec 31,
2009 Nov 3, 2010
Country or Area L.C. Return USD Return Stock Index
United States 7.5 7.5 DJIA
Japan -11.5 1.2 Topix
China -7.6 -5.5 SSEA
Britain 6.2 5.7 FTSE 100
Canada 7.9 12.1 SP TSX
Germany 11.1 8.5 DAX
Switzerland -0.5 5.0 SMI
Australia -1.8 10.0 All Ord.
Mexico 11.6 18.5 IPC
Hong Kong 10.4 10.4 Hang Seng
17
Does Foreign Exchange Exposure Matter to Global
Investors in Bonds?

• The risk elements associated with bonds (fixed
  income securities)
• Default risk (credit risk)
• Decisions of management success or failure of
  (new) products competition
• 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 the annual returns. In
  most years, with the exception of 2005 and the
  first quarter of 2009, currency moves benefited
  the U.S. investor (this is shown by the
  difference between the un-hedged and hedge
  indexes).