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Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates• These three components are the key financial elements
of how we view a firm’s success, thus a financial manager must know how to limit the firm’s exposure to changes in exchange rates
Types of foreign exchange 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 rate changes
• Operating Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates
• Translation Exposure – also called accounting exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements
• Tax Exposure – the tax consequence of foreign exchange exposure varies by country, however as a general rule only realized foreign losses are deductible for purposes of calculating income taxes
Accounting exposureChanges in reported owners’ equityin consolidated financial statementscaused by a change in exchange rates
Operating exposureChange in expected future cash flows arising from an unexpected change inexchange rates
Transaction exposureImpact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates
Why Hedge - the Pros & Cons Opponents of hedging give the following reasons:
• Shareholders are more capable of diversifying risk than the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk
• Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow
• Management often conducts hedging activities that benefit management at the expense of shareholders
Why Hedge - the Pros & Cons Opponents of hedging give the following reasons (continued):
• Managers cannot outguess the market; if and when markets are in equilibrium with respect to parity conditions, the expected NPV of hedging is zero
• Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss
• Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation
Hedging reduces the variability of expected cash flows about the mean of the distribution.This reduction of distribution variance is a reduction of risk.
Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely• Purchasing or selling on credit goods or services when
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 forward contract and
• Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
Suppose Trident Corporation sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days
Further assume that the spot rate is $0.9000/€ and Trident expects to exchange the euros for €1,800,000 x $0.9000/€ = $1,620,000 when payment is received• Transaction exposure arises because of the risk that Trident will
something other than $1,620,000 expected
• 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
Trident might have avoided transaction exposure by invoicing the Belgian buyer in US dollars, but this might have lead to Trident not being able to book the sale
Even if the Belgian buyer agrees to pay in dollars, however, Trident has not eliminated transaction exposure, instead it has transferred it to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days
A second example of transaction exposure arises when funds are loaned or borrowed
Example: PepsiCo’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex)• On 12/94, Gemex had US dollar denominated debt of
$264 million
• The Mexican peso (Ps) was pegged at Ps$3.45/US$
• On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$4.65/US$
When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure• Example: US firm wants to offset transaction exposure
of ¥100 million to pay for an import from Japan in 90 days
• Firm can purchase ¥100 million in forward market to cover payment in 90 days
In order to compare the forward hedge with the money market hedge, Maria must analyze the use of the loan proceeds• Remember that the loan proceeds may be used today,
but the funds for the forward contract may not
• Because the funds are relatively certain, comparison is possible in order to make a decision
• Three logical choices exist for an assumed investment rate for the next 3 months
Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if Maria used the proceeds to replace a dollar loan (8%) or conduct general business operations (12%)
The forward hedge would be preferable if Maria were to just invest the loan proceeds (6%)
We will assume she uses the cost of capital as the reinvestment rate
In other words, if Maria can invest the loan proceeds at a rate equal to or greater than 7.68% p.a. then the money market hedge will be superior to the forward hedge
The following chart shows the value of Trident’s A/R over a range of possible spot rates both uncovered and covered using the previously mentioned alternatives
Trident’s Transaction Exposure Because we are using future value to compare the various
hedging alternatives, it is necessary to project the cost of the option in 3 months forward
Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium cost of the option as of June would be
– $26,460 1.03 = $27,254
Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1.75/£ and would purchase pounds on the spot market
If for example, the spot rate of $1.76/£ materializes, Trident would exchange pounds on the spot market to receive £1,000,000 $1.76/£ = $1,760,000 less the premium of the option ($27,254) netting $1,732,746
Unlike the unhedged alternative, Maria has limited downside with the option
Should the pound depreciate below $1.75/£, Maria would exercise her option and exchange her £1,000,000 at $1.75/£ receiving $1,750,000• Less the premium of the option, Maria nets $1,722,746
• Although this downside is less than that of the forward or money market hedge, the upside potential is not limited
After all the strategies have been explained, Trident now needs to compare the alternatives and their outcomes in order to choose a strategy
There were four alternatives available to manage this account receivable and Maria has a budget rate at which she cannot fall below on this transaction
Just as Maria’s alternatives for managing the receivable, the choices are the same for managing a payable• Assume that the £1,000,000 was an account payable in
90 days
Remain unhedged – Trident could wait the 90 days and at that time exchange dollars for pounds to pay the obligation• If the spot rate is $1.76/£ then Trident would pay
Use a forward market hedge – Trident could purchase a forward contract locking in the $1.754/£ rate ensuring that their obligation will not be more than $1,754,000
Use a money market hedge – this hedge is distinctly different for a payable than a receivable• Here Trident would exchange US dollars spot and
invest them for 90 days in pounds
• The pound obligation for Trident is now offset by a pound asset for Trident with matching maturity
Using an option hedge –• If the spot rate is less than $1.75/£ then the option
would be allowed to expire and the £1,000,000 would be purchased on the spot market
• If the spot rate rises above $1.75/£ then the option would be exercised and Trident would exchange the £1,000,000 at $1.75/£ less the option premium for the payable
Which Contractual Hedges?• Transaction exposure management programs are
generally divided along an “option-line;” those which use options and those that do not
• Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury
Summary of Learning Objectives MNEs encounter three types of currency exposure: (1)
transaction; (2) operating; and (3) translation exposure Transaction exposure measures gains or losses that arise from
the settlement of financial obligations whose terms are stated in a foreign currency
Operating exposure measures the change in the present value of the firm resulting from any change in future operating cash flows caused by an unexpected change in exchange rates
Translation exposure is the potential for accounting-oriented changes in owner’s equity when a firm translates foreign subsidiaries’ financial statements to consolidated financial statements
Transaction exposure arises from (1) purchasing or selling on credit and prices are stated in foreign currencies; (2) borrowing or lending funds when repayment is to be made in a foreign currency; (3) being party to an unperformed forward contract; and (4) otherwise acquiring assets or liabilities denominated in foreign currencies
Considerable theoretical debate exists as to whether or not firms should hedge currency risk
• Transaction exposure can be managed by contractual techniques and certain operating strategies. Contractual techniques include forward contracts, money market and option hedges
• The choice of which hedge to use depends on the individual firm’s currency risk tolerance and its expectations of the probable movement of exchange rates over the transaction exposure period
In general, if an exchange rate is expected to move in a firm’s favor, the preferred contractual hedges are those which allow the firm to participate in some of the upside potential, but protect it against adverse exchange rate movements
In general, if an exchange rate is expected to move against the firm, the preferred contractual hedge is one which locks-in an exchange rate
Risk management in practice requires a firm’s treasury department to identify its goals. Is the treasury a cost or a profit center?
Treasury must also choose which contractual hedges it wishes to use and what proportion of the currency risk should be hedged. Additionally, treasury must determine whether the firm should buy and/or sell currency options, a strategy that has historically been risky for some firms and banks