Foreign Exchange Risk Management

Readings: Chapters 8, 9 and 10 (p335-352)

Lecture Outline
Introduction to foreign exchange exposures Translation exposure Transaction exposure To hedge or not? Hedging techniques Operating exposure Managing Operating exposure

Types of Foreign Exchange Exposure

Changes in exchange rates can effect firm value through:

Example
A Taiwanese company has the following USD exposures: 1. Owns a factory in Texas worth US$5 million. 2. Agreement to buy goods worth US$2 million. 3. Biggest competitor is a US company.
What happens if the NT dollar appreciates? 1. NT$ value of US factory goes down (translation). 2. NT$ cost of buying goods goes down (transaction). 3. Global competitiveness of Taiwanese company decreases (operating).

Translation Exposure
Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries which are stated in foreign currency must be restated in the parents reporting currency for the firm to prepare consolidated financial statements. Translation exposure is the potential for an increase or decrease in the parents net worth and reported net income caused by a change in exchange rates since the last translation.
The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.

Translation Methods
Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: The current rate method The temporal method
Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).

Current Rate Method

The current rate method is the most prevalent in the world today.
Assets and liabilities are translated at the current rate of exchange. Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period. The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).
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Temporal Method
Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the items creation.
This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).

Monetary / Non-monetary Method

If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/non-monetary method of translation.
Monetary assets and liabilities are translated at current exchange rates. Non-monetary assets and liabilities are translated at historical rates. Income statement items are translated at the average exchange rate for the period. Dividends (distributions) are translated at the exchange rate on the date of payment. Equity items are translated at historical rates.
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Managing Translation Exposure

The main technique to minimize translation exposure is called a balance sheet hedge.
A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firms consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.

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Transaction Exposure
Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.

Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations.

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Sources of Transaction Exposure

Transaction exposure arises from:
Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.

Borrowing or lending funds when repayment is to be made in a foreign currency.

Being a party to an unperformed foreign exchange forward contract. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.
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Transaction Exposure Example

Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for: 1,800,000 payment to be made in 60 days. S0 = $0.9000/

The U.S. seller expects to exchange the 1,800,000 for $1,620,000 when payment is received.

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Transaction Exposure Example

Transaction exposure arises because of the risk that the U.S. seller will receive something other than $1,620,000. If the euro weakens to $0.8500/, then Trident will receive $1,530,000 If the euro strengthens to $0.9600/, then Trident will receive $1,728,000

Thus, exposure is the chance of either a loss or a gain.

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Real Life Example

In 1971, Great Britains Beecham Group borrowed SF100 million (equivalent to 10.13 million).

When the loan came due five years later, the cost of repayment of principal was 22.73 million more than double the amount borrowed!

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To Hedge or not?
Hedging is the taking of a position, either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (fall) in value to offset a fall (rise) in value of an existing position.

Hedging, therefore, protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure).

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To Hedge or not?

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To Hedge or not?
Is the reduction of variability in cash flows then sufficient reason for currency risk management?
This question is actually a continuing debate in multinational financial management and corporate finance. There are several schools of thought.

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Opponents of Hedging
Opponents of currency hedging commonly make the following arguments:
Stockholders are much more capable of diversifying currency risk than the management of the firm. Currency risk management does not add value to the firm and it incurs costs. Hedging might benefit corporate management more than shareholders.

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Proponents of Hedging
Proponents of hedging cite:
Reduction in risk in future cash flows improves the planning capability of the firm. Reduction of risk in future cash flows reduces the likelihood that the firms cash flows will fall below a necessary minimum (the point of financial distress). Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Individuals and corporations do not have same access to hedging instruments or same cost.
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How Prevalent is Hedging?

A Survey of Derivatives Usage by U.S. Non-Financial Firms, The Wharton School and CIBC; July 1998. Derivatives usage: 399 (20.7%) of 1,928 large U.S. non-financial corporations responded. 50% admitted some use of derivatives. 83% of large firms (96 sales>$1.2bn) 12% of small firms (96 sales <$150m)

Reasons for FX derivatives usage (frequently + sometimes): 89% hedge on Balance Sheet commitments. 85% hedge anticipated transactions within one year. 39% hedge longer term economic exposure. Extent of exposures hedged: 49% of on-BS commitments. 42% of anticipated transactions within one year. 7% of economic exposure.
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Hedging Transaction Exposure

Transaction exposure can be managed by contractual, operating and financial hedges: Contractual Hedges include
Forward, Options and Money Market hedges.

Operating and Financial Hedges include

Risk-Sharing Agreements, Leads and Lags in Payment Terms, Swaps and Other Strategies.

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Contractual Hedging Techniques

Forward/Futures Hedge

Money Market hedge: Taking a money market position to hedge future receivables/payables
Currency option hedge A way to hedge downside exposure Structuring the Hedge exporters (sell USD, buy AUD) - receivables importers (Buy USD, sell AUD) - payables
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Hedging Techniques
Hedging of Receivables

Hedging of Payables

Sell futures or forward

Money market hedge
borrow foreign currency to be received convert to domestic currency invest for future use

Buy futures or forward

Money market hedge
borrow home currency convert to foreign currency invest for future use

Buy Put Option

Buy Call Option

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Example
Assume Boeing is expected to receive 10m GBP () in one years time. Available information: one-year forward rate: US$1.46/ spot rate: US$1.50/ put option on pounds expires in one year with strike of US$1.46 and premium of US$0.02 interest rates:
US: UK: 6.10% per annum 9.00% per annum
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Boeings Forward Hedge

Forward Hedge: By selling GBP forward, Boeing locks in the US$ receivable at $14.6m (10m * $1.46/)
Unhedged position

$14.6m Forward Hedge

F = $1.46

ST
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Boeings Options Hedge

Options Hedge: Has the right to sell @ $1.46/GBP will receive $14.6m if exercised.
Note: A premium of $200,000 (10m * $0.02) was paid up-front. We need to take into account time-value of money. Therefore, the upfront cost is $212,000 ($200,000 * 1.061) after one year.
Option Hedge

$14.6m $14.38m

Forward Hedge

X = $1.46 ST* = $1.48

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Boeings Money Market Hedge

Money Market Hedge: Borrow (or lend) in the foreign currency to hedge foreign currency receivables (payables) this matches FC assets & liabilities in the same currency.
Borrow the PV of 10m ( 9,174,312) Convert into $ at $1.50/ ($13,761,468) Invest $ in the US at 6.1% for one year ($14,600,918) Collect 10m in one-year and repay the loan (the receivable offsets the loan)

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Alternate Hedging Strategies

Risk Shifting & Risk Sharing Leading and Lagging
leading (accelerate timing of depreciating currency) lagging (delay timing of appreciating currency)

Exposure Netting Cross-Hedging Currency Diversification

(Some of these also apply to hedging operating exposure)
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Operating Exposure
Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.
Measuring the operating exposure of a firm requires forecasting and analyzing all the firms future individual transaction exposures together with the future exposures of all the firms competitors and potential competitors worldwide.
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Operating Exposure
Operating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure.
Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon. Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production.
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Operating Exposure
An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value.
From an investors perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firms market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.
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Recognising Operating Exposure

Where is the company selling? [domestic v. foreign] Who are the key competitors? [domestic v. foreign] How sensitive is demand to price? Where is the company producing? [domestic v. foreign] Where are the companys inputs coming from? [domestic v. foreign]

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Recognising Operating Exposure

Volvo produces most of its cars in Sweden, but buys most of its inputs from Germany. The U.S. is an important export market for Volvo. Volvo management believed that a depreciating Swedish krona versus the $ and an appreciating Swedish krona versus the DM would be beneficial to Volvo. But researchers found that statistically: A depreciating krona relative to the Deutschemark improved Volvos cash flow! These results reflect the fact that Volvos major competitors are the German firms BMW, Mercedes and Audi.
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Recognising Operating Exposure

Aspen Skiing Company owns and operates ski resorts in Colorado Uses only American labor and materials Nonetheless, hurt by a strong dollar that made American skiers opt for the French Alps or the Canadian Rockies, and foreign skiers stay at home. So, even a domestic firm with zero transaction exposure to exchange rates can be vulnerable to exchange rate risk.
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Conduits for Operating Exposure

Impact of Exposure can be DIRECT or INDIRECT
HC strengthens HC weakens
Favourable Unfavourable Favourable

Direct Exposure
Sales abroad Source abroad Profits abroad Unfavourable Favourable Unfavourable

Indirect Exposure
Competitor sources abroad Unfavourable Supplier sources abroad Favourable Favourable Unfavourable
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Estimating Operating Exposure

Audits/Scenario Analysis: Qualitative examination of the separate elements of a firms operating cash flow and anticipating its sensitivity to real exchange rate changes. Statistical Approach: Regress changes in firm value on changes in exchange rates to obtain a quantitative assessment of sensitivity.
Presumption is that changes in the value of a firms public securities measures the effect of exchange rate changes. (measure of aggregate exposure)

Exchange rate exposure for BHP Billiton (86 02) RBHP = 0.0119 0.8148 $A/$US
(2.46) (4.94)
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Managing Operating Exposure

Pass Through can the company pass the price increase on to the customer? This depends on the product and the level of competition in the market. For low-quality goods, price competition is usually intense, so no one company can change prices. For high-quality goods, there may be room to increase prices and not effect demand.

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Managing Operating Exposure

Use of Marketing Strategies
Market Selection Pricing Strategy/Product Strategy Promotional Strategy

Use of Production Management

Input mix Plant Location & Shifting production among plants Raising Productivity (i.e. lowering costs)

Financial Hedging techniques may also be used

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Example
Matsushita exports TVs to the US. Suppose the yen is expected to move from 130/$ to 110/$ over the next few years. What can Matsushita do about its currency risk? As yen appreciates, Matsushita becomes less competitive. Can it increase prices in the US? Probably not as TV market is competitive. It can keep US$ prices constant to retain market share but this will hurt profits. Can it cut costs and become more efficient? Matsushita could move production to US or low-cost US$ zone. Move to high-end TVs or other products with less price competition. Hedge using currency derivatives. Stop selling in US markets.
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