TYPES OF FOREIGN EXCHANGE EXPOSURE

Types of Foreign Exchange Exposure

v   Changes in exchange rates can effect firm value through:

Example

A Taiwanese company has the following USD exposures:

·         Owns a factory in Texas worth US$5 million.

·         Agreement to buy goods worth US$2 million.

·         Biggest competitor is a US company.

What happens if the NT dollar appreciates?

·         NT$ value of US factory goes down (translation).

·         NT$ cost of buying goods goes down (transaction).

·         Global competitiveness of Taiwanese company decreases (operating).

Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.

Translation exposure is the potential for an increase or decrease in the parent’s 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).

TEMPORAL METHOD

Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s 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.

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 firm’s 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.

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.

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.

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.

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.

Real Life Example

In 1971, Great Britain’s 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!

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).

To Hedge or not?

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.

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. 

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 firm’s 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.

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.

  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.

    Contractual Hedging Techniques

v   Forward/Futures Hedge                                                                  

v   Money Market hedge: Taking a money market position to hedge future receivables/payables                                                    

v   Currency option hedge

§   A way to hedge downside exposure

v   Structuring the Hedge         

§   exporters (sell USD, buy AUD) - receivables

§   importers (Buy USD, sell AUD) - payables                     

 Hedging Techniques

v Hedging Techniques

v     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       

v  Hedging of Payables

                     

• Buy futures or forward                                  
• Money market hedge

–        borrow home currency

–        convert to foreign currency

–        invest for future use

Buy Call Option

•     Example

v   Assume Boeing is expected to receive 10m GBP (£) in one years time.

v   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

•     Boeing’s Forward Hedge

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

                            

•     Boeing’s 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.

                            

•     Boeing’s 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)

                            

•     Alternate Hedging Strategies

Risk Shifting & Risk Sharing

Leading and Lagging                                              

§   leading (accelerate timing of depreciating currency)

§   lagging (delay timing of appreciating currency)   

v   Exposure Netting

v   Cross-Hedging                                                                     

v   Currency Diversification

(Some of these also apply to hedging operating exposure)

v 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.

v Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

v Operating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure.

v Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon.

v Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production.

v 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.

v From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firm’s market value.

v Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

•     Recognising Operating Exposure

v   Where is the company selling? [domestic v. foreign]

v   Who are the key competitors? [domestic v. foreign]

v   How sensitive is demand to price?

v   Where is the company producing? [domestic v. foreign]

v   Where are the company’s inputs coming from? [domestic v. foreign]

•     Recognising Operating Exposure

v   Volvo produces most of its cars in Sweden, but buys most of its inputs from Germany.

v   The U.S. is an important export market for Volvo.

v   Volvo management believed that a depreciating Swedish krona versus the $ and an appreciating Swedish krona versus the DM would be beneficial to Volvo.

v   But researchers found that statistically:

§   A depreciating krona relative to the Deutschemark improved Volvo’s cash flow!

v   These results reflect the fact that Volvo’s major competitors are the German firms BMW, Mercedes and Audi.

•     Recognising Operating Exposure

v  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.

v  So, even a domestic firm with zero transaction exposure to exchange rates can be vulnerable to exchange rate risk.

•     Conduits for Operating Exposure

v  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

•     Estimating Operating Exposure

v   Audits/Scenario Analysis: Qualitative examination of the separate elements of a firm’s operating cash flow and anticipating its sensitivity to real exchange rate changes.

v   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 firm’s public securities measures the effect of exchange rate changes. (measure of aggregate exposure)

Ø   Exchange rate exposure for BHP Billiton (’86 – ’02)

              R_BHP = 0.0119 – 0.8148 $A/$US

            (2.46)           (4.94)

•     Managing Operating Exposure

v  Pass Through – can the company pass the price increase on to the customer?

v  This depends on the product and the level of competition in the market.

v  For low-quality goods, price competition is usually intense, so no one company can change prices.

v  For high-quality goods, there may be room to increase prices and not effect demand.

•     Managing Operating Exposure

v  Use of Marketing Strategies

§   Market Selection

§   Pricing Strategy/Product Strategy

§   Promotional Strategy

v  Use of Production Management

§   Input mix

§   Plant Location & Shifting production among plants

§   Raising Productivity (i.e. lowering costs)

v  Financial Hedging techniques may also be used

•     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.