Foreign Exchange

Risk Management
 Lecture Outline

Introduction to foreign exchange exposures

Translation exposure
Transaction exposure
To hedge or not?
Hedging techniques
Operating exposure
Managing Operating exposure

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 Types of Foreign Exchange Exposure
Changes in exchange rates can effect firm value through:

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 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).

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 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.

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 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).

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 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).

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 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
Sell futures or forward
Money market hedge
borrow foreign currency to
be received
convert to domestic
currency
invest for future use
Buy Put Option
Hedging of Payables
Buy futures or forward
Money market hedge
borrow home currency
convert to foreign
currency
invest for future use
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$0.02
interest rates:
US: 6.10% per annum
UK: 9.00% per annum
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 Boeings Forward Hedge
Forward Hedge: By selling GBP forward, Boeing locks
in the US$ receivable at $14.6m (10m * $1.46/)

Unhedged position

$14.6m
Forward Hedge

ST
F = $1.46
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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 Forward Hedge

$14.38m

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
Direct Exposure
Sales abroad Unfavourable Favourable
Source abroad Favourable Unfavourable
Profits abroad Unfavourable Favourable
Indirect Exposure
Competitor sources abroad
Unfavourable Favourable
Supplier sources abroad
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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