Foreign Exchange Risk Exposure

Exposure refers to the degree to which a company is affected by exchange rate changes. Exchange rate risk is defined as the variability of a firms value due to uncertain changes in the rate of exchange.

Types of Exposures
Translation Exposure

Economic Exposure
Transaction Exposure
Operating Exposure

Tax Exposure
2

Transaction Exposure
Stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency. They are changes in the value of outstanding contracts
Real exchange gains or losses Mixes retrospective and prospective Short-term in nature
3

Translation Exposure
Arises from the need, for purposes of reporting and consolidation, to convert the results of foreign operations from the local currency to the home currency. Represents change in value of owner equity
Paper exchange gains or losses Retrospective in nature Short-term in nature
4

Operating Exposure
Arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firms future revenues and costs. Represents change in the PV of the firm (real exchange rates)
Real exchange gains or losses Prospective in nature Long-term in nature

Economic Exposure and Tax Exposure

Economic exposure
Is defined as the extent to which the value of the firm, as measured by the present value of all expected future cash flows, will change when exchange rates change.

Tax Exposure
The tax consequence of foreign exposure varies by countries. As a general rule:
Only realized foreign exchange losses are tax deductible. Only realized foreign exchange gains create taxable income

Transaction Exposure Sources

It arises from the various types of transactions that require settlement in a foreign currency. Purchasing or selling on credit goods or services denominated in foreign currency. Borrowing and lending funds with repayment made in foreign currency. Acquiring assets denominated in foreign currency. When does it occur? From the time of agreement to time of payment.

Transaction exposure timing

t0 t1

t2

t3

t0 t1 t2 t3

- order price quoted - order placed - few days later - order shipped - 2 - 3 weeks - order settled - 90 days

Net Transaction Exposure

Is measured currency by currency. Is the difference between contractually fixed future cash inflows and cash outflows in each currency. It represents real gains and losses. To measure transaction exposure:
project the net amount of inflows or

outflows in each foreign currency, and determine the overall risk of exposure to those currencies.

Managing Exposure
Managing exposure centers around the concept of hedging, which means:
Entering into an offsetting currency position so whatever is lost/gained on the original currency exposure is exactly offset by a corresponding currency gain/loss on the currency hedge. The coordinated buying or selling of a currency to minimize exchange rate risk.
10

Why Hedge ?
hedging
reduces volatility of cash flows incurs costs

not hedging
exposure to risk by speculating that exchange rates will not move against you

11

Designing a Hedging Strategy

Hedging exchange rate risk
Costs money Should be evaluated as any other purchase of insurance. Taking advantage of tax asymmetries lowers hedging costs.

Organizational Policies for Managing Exposure

Degree of centralization Responsibility

Maximum benefits accrue from centralizing policy-making, formulation, and implementation

12

Objectives of Hedging
Minimize translation exposure. Minimize quarter-to-quarter earnings fluctuations arising from exchange rate changes. Minimize transaction exposure. Minimize economic exposure. Minimize foreign exchange risk management costs. Avoid surprises.

13

Managing Transaction Exposure

A transaction exposure arises whenever a company is committed to a foreign currency denominated transaction. Protective measures to guard against transaction exposure involve entering into foreign currency transactions whose cash flows exactly offset in whole or in part the cash flows of the transaction exposure.
14

Managing Transaction Exposure

Contractual Hedges
Forward Market Hedge
Money Market Hedge Options Market Hedge Futures Market Hedge

Financial Hedges
Swaps leads & lags

Operating Strategies
Risk Shifting Price adjustment clauses Exposure Netting Risk Sharing
15

Managing Transaction Exposure: Illustration

American Airlines is trying to decide how to go about hedging 70 million in ticket sales receivable in 180 days. The following exchange/ interest rates are available: Spot rate $0.6433-42/ 180-day forward rate Euro 180-day interest rate (per annum) U.S.$ 180-day interest rate (per annum) $0.6578-99/ 4.01%- 3.9%

8.01%-7.98%

16

Alternative Use of Hedging Techniques

Remain unhedged. Hedge in the forward market. Hedge in the money market. Unhedged position American Airlines will wait 180 days and receive an unknown amount of U.S. dollars, depending on the spot rate prevailing in 180 days, for 70 million of the ticket sales
17

Future Spot Rate Scenarios

Spot rate in 180 days Receivable in $

1 = $0.64 1 = $0.67 1 = $0.70

44,800,000 46,900,000 49,000,000

Let us assume that SR0 = $0.6433 (Spot Rate day 0) FR180 = $0.6578 (Forward rate day 180)
18

Forward Market Hedge

Involves a forward contract and a source of funds to fulfill that contract. The forward contract is entered at the time the transaction exposure is created. Offsetting receivables/payables denominated in a foreign currency with a forward contract to sell/buy that currency.
Covered hedge Uncovered or open hedge Cost of forward cover

To hedge in the forward market, American Airlines will enter into a 180-day forward contract to sell 70 million for dollars today (t=0).

19

Accounting hedged positions

Payables and receivables are booked at current spot Use your forward rate as best estimator of future expected spot
foreign exchange gain/loss = forward - spot forward contract loss = 0

Gains/losses will be the difference between

contract evaluated at forward and contract evaluated at spot
20

Evaluation of Forward Market Hedge

Future Spot Rate Value of Receivable (e1) Gain/Los s on Forward (f180) $ Net Cash Flow

1 = $0.64

$44,800,000 1,246,000 $46,046,000

1= $0.6578

$46,046,000

$46,046,000

1 = $0.67

$46,900,000 -854,000

$46,046,000

1 = $0.70

$49,000,000 2,954,000 $46,046,000

21

Money Market Hedge

Involves a contract and a source of funds to fulfill that contract. In this case, the contract is a loan agreement. Reversing foreign currency receivables/payables by creating matching payables/receivables through borrowing in the money markets. Often, two positions are required.
Payables: Borrow in the home currency, and invest in the foreign currency. Receivables: borrow in the foreign currency, and invest in the home currency.

Types of money market hedges

Covered hedge Uncovered or open hedge Cost of money market hedge Covered interest arbitrage
22

Money Market Hedge

To hedge in the money market, American Airlines has to borrow today (t=0) sufficient euros for 180 days which, when exchanged today for dollars and invested for 180 days in the U.S., will be paid off with exactly the euro receivable of 70 million. Amount of euros borrowed in Germany for 180 days: Amount of dollars to be invested today in the U.S.:

Amount of dollars received from U.S. investment in 180 days:

23

Futures Market Hedge

Similar to hedging with forwards Limitations:
Limited number of currencies Limited number of maturity dates Standardized contract size

Cross hedge

24

CROSS-HEDGING
1. Often forward contracts not available in a certain currency. 2. Solution: a cross-hedge
a forward contract in a related currency.

3. Correlation between 2 currencies is critical to success of this hedge.

25

Options Market Hedge

Offsetting a foreign currency denominated receivable/payable with a put option or a call option in that currency. Valuable hedging tool when:
Waiting on the outcome of a bid denominated in foreign currency Using of foreign currency price list Shifts in competitors currency

26

General Hedging Rule

Future foreign currency cash outflow
Certain: Go long futures or forwards Uncertain: Buy a call option

Future foreign currency cash inflow

Certain: Go short futures or forwards Uncertain: Buy a put option

27

Currency Risk Shifting

Risk shifting: Invoice in U.S. dollar Strategy for risk shifting
Denominating exports in a strong currency. Denominating imports in a weak currency.

Outcome depends on:

Bargaining power or parties involved. Competitiveness of firms particular business

Drawback:
it is not possible with informed customers or suppliers

28

Exposure Netting
Offsetting exposures in one currency with exposures in the same or another currency. A firms currency exposures can be viewed as a portfolio. Exposure netting depends on the correlation between currencies. Exposure netting strategies: Negatively correlated currencies Positively correlated currencies
29

Currency Risk Sharing

Agreement to share currency risk Developing a customized hedge Risk sharing arrangements
Price adjustment clause - The contract typically takes the form of a Price Adjustment Clause, whereby a base price is adjusted to reflect certain exchange rate changes. Neutral zone - Parties would share the currency risk beyond a neutral zone of exchange rate changes. The neutral zone represents the currency range in which risk is not shared.
30

Currency Collars
Contract bought to protect against currency moves outside the neutral zone. Firm would convert its foreign currency denominated receivable at the zone forward rate. Providing protection if the currency moves outside an agreed-on range.
Range forward Cylinder
Combined put purchase and call sale Limits upside potential Provides downside risk protection Lowers hedging cost

31

Foreign Currency Options

Foreign Currency options are a good hedging tool in situations in which the quantity of foreign exchange to be received or paid out is uncertain.
A call option
is valuable when a firm has offered to buy a foreign asset at a fixed foreign currency price but is uncertain whether its bid will be accepted. The firm can lock in a maximum dollar price for its tender offer, while limiting its own side risk to the call premium in the event its bid is rejected

A put option
allows the company to insure its profit margin against

adverse movements in the foreign currency while

guaranteeing fixed prices to foreign customer.

32

Leads and lags

The act of leading and lagging refers to an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements. Expediting a payment is referred to as leading, while deferring a payment is termed lagging.

33

Translation Exposure
Translation exposure results when an MNC translates each subsidiarys financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings Translation exposure arises when
financial statements are denominated in another currency lines on income statement
accrued at different times accrued at different exchange rates

balance sheet assets & liabilities

historical rates current rates
34

Measuring Translation Exposure

The difference between exposed assets and exposed liabilities.
Exposed assets and liabilities are translated at the current exchange rate. Non-exposed assets and liabilities are translated at the historical exchange rate.

35

Currency Translation Methods

Translation methods differ by country along two dimensions. Subsidiary Characterization
Integrated foreign entity Self-sustained entity

Functional Currency
The currency of the primary economic environment in which the subsidiary operates and in which it generates and expends cash.
36

Translation Methods
Methods for the translation of foreign subsidiary financial statements:
Current / non current Monetary / non monetary The temporal method The current rate method

Regardless of which is used, either method must designate

The exchange rate at which individual balance sheet and income statement items are remeasured Where any imbalances are to be recorded
37

Current / non-current
Current accounts use current exchange rate for conversion. Non-Current accounts use the historical exchange rates (at the time the asset or liability showed up on balance sheet). Income statement accounts use average exchange rate for the period. This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.
balance sheet items - stock statement current assets & liabilities - current rate non-current assets & liabilities historical rate income statement items - flow statement most items - average rate except cashflows associated with non-current assets or liabilities translated - historical rate depreciation
38

Current / non-current
Example Current Spot S$/dm=.50 Historic Spot S$/dm = .333
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Currency Noncurrent 2,100 DM $1,050 1,500 DM $750 3,000 DM $1,000 6,600 DM $2,800 1,200 DM $600 1,800 DM $600 2,700 DM $900 900 DM $700 --------------6,600 DM $2,800

39

Monetary / nonmonetary
The underlying principal is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts (owners equity, land) are translated at the historical exchange rate in effect when the account was first recorded. balance sheet items - stock statement monetary assets (claims) - current rate non-monetary (physical) assets historical rate income statement items - flow statement most items - average rate except cashflows associated with noncurrent assets or liabilities translated historical rate depreciation, cost of goods sold
40

Monetary / nonmonetary
Example Current Spot S$/dm=.50 Historic Spot S$/dm = .333

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity

Local Monetary/ Currency Nonmonetary 2,100 DM $1,050 1,500 DM $500 3,000 DM $1,000 6,600 DM $2,550 1,200 DM $600 1,800 DM $900 2,700 DM $900 900 DM $150 --------------6,600 DM $2,550

41

Temporal method
The underlying principal is that assets and liabilities should be translated based on how they are carried on the firms books. Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books. balance sheet items - stock statement
monetary assets (claims) - current rate inventories current rate / historical rate non-monetary (physical) assets - historical rate

income statement items - flow statement

most items average rate except cashflows associated with non-current assets or liabilities translated - historical rate
depreciation, cost of goods sold, amortization

42

Temporal method (contd.)

Line items included in this method are Monetary balance sheet items Non-monetary balance sheet items Income statement items Dividends Equity account Unrealized translation gains or losses are recorded within the income statement, not to equity reserves, thereby affecting net income.
Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency 2,100 DM 1,500 DM 3,000 DM 6,600 DM 1,200 DM 1,800 DM 2,700 DM 900 DM -------6,600 DM Temporal $1,050 $900 $1,000 $2,950 $600 $900 $900 $550 -------$2,950

43

Current method
All financial statement items are translated at the current exchange rate.
Assets & liabilities Income statement items Dividends Equity account

Unrealized translation gains or losses are recorded in a separate equity account on the parents consolidated balance sheet called the Cumulative Translation Adjustment (CTA) account balance sheet items at current rate income statement items
exchange rate in effect on dates incurred average exchange rate over the period

distributions - rate on date of payment equity

equity & pd in capital historical rates retained earnings at historical

cum translation adjustment - on consolidated BS

44

Current method (contd.)

Very simple method in application.

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity

Local Currency DM2,100 DM1,500 DM3,000 DM6,600 DM1,200 DM1,800 DM2,700 DM900 -------DM6,600

Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

45

US Translation Procedures
The US differentiates foreign subsidiaries on the basis of the functional currency, not subsidiary characterization. This, in turn, determines which translation method is used:
Local currency

Current rate method

U.S. dollar

Temporal method

46

Hyperinflation Countries
A hyperinflationary country is one which has cumulative inflation of approximately 100% or more over a three year period.
Functional currency
U.S. dollar

Translation method
Temporal method

47

A Procedural flow chart for US Translation Process

48

Managing Translation Exposure

An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets. To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds. If the pound depreciates during the fiscal year, the gain generated from the forward contract position will help to offset the translation loss.
49

MANAGING TRANSLATION EXPOSURE

3 Available Methods
Adjusting fund flows altering either the amounts or the currencies of the planned cash flows of the parent or its subsidiaries to reduce the firms local currency accounting exposure. Forward contracts reducing a firms translation exposure by creating an offsetting asset or liability in the foreign currency. Exposure netting

offsetting exposures in one currency with exposures in the same or another currency
gains and losses on the two currency positions will offset each other.
50

Hedging strategy for reducing translation exposure

Basic hedging strategy for reducing translation exposure: 1. increasing hard-currency (likely to appreciate) assets 2. decreasing soft-currency (likely to depreciate) assets decreasing hard-currency liabilities increasing soft-currency liabilities

3. 4.

i.e. reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward.

51

Hedging translation exposure

Since translation exposure doesnt involve anything real, it is very hard to see why a firm would want to hedge. As we have seen from Enron, there is much to be said for not trying to confuse financial markets. Nevertheless, a firm could Hedge by rearranging balance sheet items. For example using foreign denominated assets to offset liabilities. Use derivatives to hedge. Note the quotes, in fact what a firm would really be doing is speculating in foreign exchange markets to try and cover a translation exposure. Heres an example. Suppose a U.S. firms european subsidiary has assets of 1500 million and liabilities of 1000 million (i.e., a net worth of $500 million). If the current spot rate is S$/=.90, this would translate to $450 million. Suppose management believes that the euro is going to fall to S$/=.80 and thus the subsidiaries net worth will translate to $400 million, a loss of $50 million. Suppose further that the forward rate was F$/=.85. If the firm were to sell 1000 million forward and if the future spot rate really did fall to S$/=.80, they would make a profit of $50 million [(.85-.80)1000] and so would cover the translation loss. But all theyre really doing is making a betand in fact, theyre betting that forward parity wont hold.
52

Hedging translation exposure

Hedging translation exposure is limited by: inaccurate earnings forecasts, inadequate forward contracts for some currencies, accounting distortions (the choice of the translation exchange rate, taxes, etc.), and increased transaction exposure (due to hedging activities). In particular, if the foreign currency depreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. Note that the translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss. Perhaps, the best way for MNCs to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements

53

Different types of Hedges

Balance Sheet Hedge It requires an equal amount of exposed foreign currency assets and liabilities on a firms consolidated balance sheet A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities. This is termed the monetary balance. The cost of this method depends on relative borrowing costs in the varying currencies. Funds adjustment Altering either the amounts or the currencies or both of the planned cash flows of the parent and/or subsidiary. Funds Adjustment Methods Direct Indirect

Forward Hedge Uncovered or open hedge. Not a hedge but an attempt to gain by forward speculation a sum equal to the book loss in translation. Success depends on precise prediction of future exchange rates. Such a hedge will increase the tax burden.
54

Choosing Which Exposure to Minimize

As a general matter, firms seeking to reduce both types of exposures typically reduce transaction exposure first. They then recalculate translation exposure and then decide if any residual translation exposure can be reduced without creating more transaction exposure.

55