AJAFIN 6605-07 Foreign Exchange Exposures: Definitions, Measurement and Management.

Definition: Foreign exchange exposure is a measure of the potential for a firm's profitability, net cash flow, and market value to change because of unexpected changes in exchange rates.

Foreign Exchange Risk: Is the chance of loss due to unexpected changes in the relative value of currencies.
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Hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding gain or loss on the currency hedge.

Types of Exposures:
There are three types of exposures, namely:

(a) Transaction Exposure:

This is an uncertain domestic currency value of cash flows which are known and fixed in a foreign currency It deals with changes in cash flows that result from existing business obligations. It is contract specific. The only source of uncertainty is the future exchange rate.

(b) Translation (Accounting) Exposure:

This measures potential accounting-derived changes in owner's equity that result from the need to translate foreign currency financial statements of affiliates into a single reporting currency in order to prepare consolidated financial 3 statements.

(c) Economic Exposure (Real Operating Exposure) This measures changes in the value of the firm that result from changes in future operating cash flows caused by unexpected changes in exchange rates. The changes in value depend on the effects of exchange rate changes on future sales volume, prices and costs. Can have a profound effect on firms competitive position.

Identifying Transaction Exposure: Transaction exposure arises from: (a) Purchasing or selling, on credit, goods or services denominated in foreign currencies. (b) Borrowing or lending denominated in foreign currencies. (c) Taking long or short positions in forward markets or futures markets.

(d) Acquiring asset or incurring liabilities denominated in foreign currencies.

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Examples: (1) Purchasing or selling: A U.S. firm sells a machinery to a British buyer for 1,000,000. Payment is to be made in say 90 days. The current exchange rate is $1.60/. The U.S. seller expects $1,600,000. Transaction exposure arises because the future spot exchange rate in 90 days is unknown. For example it could be $1.70/ or $1.50/. Exposure is the chance of a loss or a gain. An obvious question is: Why not avoid transaction exposure by invoicing the buyer only in dollars? By invoicing in dollars only the sale might not take place. If a British buyer agrees to pay dollars transaction exposure is not eliminated but is transferred to the British buyer. 6

(2) Borrowing and Lending: Britain's Beecham Group borrowed SF100m in 1971 when SF 100m = 10.13m. When the loan became due 5 years later, the cost of repayment of principal was 22.73 million. On the other hand, if XYZ Inc. had borrowed Peso 12,500,000 Peso in 1981 at Peso 12.50/$ it would have raised $1 million. If the loan's principal were to be repaid in 1990, it would amount to a mere $4,630 at Peso 2700/$. (The principal repayment in 1995, at 6500 peso/$, the loan would have been only $1850). (3) Taking a Position in the Forward Market:
Creates transaction exposure because it is an agreement to pay or receive foreign currency in the future. The potential transaction gain (loss) on an account payable for example, is offset by transaction loss (gain) on the fwd contract.
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 Transaction

Exposure to "Net" Cash Flows:

Some Multinational corporations use non-centralized approach for exposure management. Each subsidiary assesses and manages its individual exposure to exchange rate risk. This can cause redundancy in hedging. Centralized exposure management requires the projection of consolidated net amount of currency inflows and outflows for all subsidiaries categorized by currency. Consider two subsidiaries X & Y of a U.S. MNC: Subsidiary X has net inflow of 500,000 Subsidiary Y has net outflows of 600,000 Then, the consolidated "net" outflow for this multinational corporation is 100,000. If the pound decrease it will be unfavorable to X but favorable to Y. If hedging is limited to net exposure, transaction cost savings are 8 realized.

 Other

Factors in Transaction Exposure Measurement

Transaction exposure may also be estimated based on currency variability. The Standard Deviation is a measure of currency variability. Currencies with higher standard deviations imply that the potential for them to deviate from the their projected values is greater than those with smaller standard deviations. However, note that the standard deviations of currencies do not remain constant. They change over time.

In measuring the transaction exposure it is also necessary to assess currency correlations. Correlation coefficient indicates the degree of linear relationship (or co-movement) between two currencies. Let r = correlation coefficient. Then -1 r 1.
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For two highly correlated currencies transaction exposure to inflows of one currency and outflows of the other have offsetting effects. For a multinational corporation exposed to inflows (outflows) of a combination (a portfolio) of currencies, the lower the correlation among the component currencies, the lower the overall variability of the portfolio of cash flows. And a portfolio of currencies with very low or negative correlation can even reduce overall risk.
Note that currency correlations are not constant over time.
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 Managing

Transaction Exposure:

Transaction exposure can be managed by contractual techniques, operating strategies, arranging swap agreements, and risk-sharing agreements.

The main contractual techniques are forward, futures, options, money markets, Operating strategies include leads and lags, re-invoicing centers ... Others include back-to-back loans, parallel loans, currency swaps, credit swaps ...
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 Forward

Market Hedging: An illustration.

Suppose General Electric was awarded a contract to supply Brazil with turbine blades on Jan 1, 2009. Payment is due Dec 31, 2009. Amount due is 25 m Brazilian Real (R). Suppose the current spot rate is $/R = .5247 1 year forward rate is $/R = .5015 Then, a forward sale of R 25 million for delivery in 1 year will yield $12,537,500 at maturity. Examine the consequences of a forward sale under several possible future spot rate scenarios. Spot rate $/R = .5247 Spot rate $/R = .5015 Spot rate $/R = .4825
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 The

Opportunity Cost of Forward Contract:

Let Ft = Forward rate et = Future spot rate (unknown) eo = Current Spot rate

Then the annualized percentage cost (the opportunity cost) of a forward contract is given by:
(Ft - et ) / eo * 360/n Where n = maturity in days (n = 30, 60, 80 180, 360)

In an efficient market the expected cost of a forward contract must be zero, otherwise, there will be an arbitrage opportunity. The essence of a forward hedge is to limit your loss or gain to the difference between future spot and currently quoted forward rate. 13

 Money

Market Hedge: An illustration.

The basic idea of a money market hedge is to transform foreign currency assets (liabilities) to domestic currency assets (liabilities). Let ius = 10% (U.S. interest rate) ib = 15% (Brazilian interest rate) For receivables: Let B = required borrowing, R = amount of receivable. For payables: Let D = required deposit, P = the amount of payable.
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In the GE example the company will borrow against its receivable so that: B(1+ib) = R B= R = 25 1+ ib 1.15 = R 21.74 million Then the company will convert the R 21.74 million into $8.7 million in the spot market, and invest the $8.7 million for 1 year at 10%, so that the real denominated receivable is converted to a dollar denominated investment: $8.7 million (1.10) = $9.57 million.
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In practice, what GE does with the loan proceed depends on other considerations, especially if borrowing and investing rates are not the same and if GE's cost of capital is higher than the US investing rate.
Typically, kx > iB > iI where kx is GE's required rate of return, iB = Borrowing rate, iI = Investing rate.
Hence, GE might use the proceeds to substitute for an equal dollar loan it would otherwise have undertaken at say, iB = 12% Or, GE might invest the loan proceeds in its general operations at the GE's required rate of return (kx), say 14%.

The money market hedge would be superior especially if GE used loan proceeds, to replace higher rate dollar loans, or in its general business operations. 16

In the case of foreign currency-denominated payables: With Excess Cash: Let D = Deposit, and P = Payable Then, D( 1 + ) = P
ib D = P (1+ i b )

The firm needs to provide D*.5247 dollars, convert into R and invest for 1 year such that the proceeds pay off the payables in DM.
Without Excess Cash: Amount needed to Deposit D = P/(1+ ib), (in Real) hence Borrow $ {P/(1+ib) *.5247} at ius . Deposits or purchase R securities whose proceeds will equal the amount payable = {P/(1+ ib)}(1+ ib). Repay U.S. loan at end of period + interest = {P/(1+ ib)* .5247}(1+ius).
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Note: If interest rate parity holds and transaction costs are assumed to be zero then a money market hedge will yield the same result as a forward hedge.

Unhedged Position: An illustration GE may decide to accept the transaction risk. In this case it receives R 25 million * S360 . This amount is however at risk. GM receives a sum ranging in value as follows:
An expected value of R 25m*S360 An unlimited maximum (best case) A zero minimum (worst case)

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Other Transaction Exposure Management Techniques

Exposure Netting
Risk Shifting -- Dollar invoicing

Pricing Decisions -- Use forward rate to convert dollar prices to foreign currencies
Currency Risk Sharing: In addition (to or instead of) traditional hedges GE and Brazil can agree to share the currency risk associated with the turbine blade contract. This leads to creation of neutral zone, the currency range in which risk is not shared, and beyond which risk is shared.
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Exposure Netting:

It is not worthwhile to hedge every exposure individually. Therefore: Offset a long position with a short position in the same currency

If two currencies are highly positively correlated, offset long position with a short position. If two currencies are highly negatively correlated, offset long position with a long position.
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Options Hedge:

The forward contract is ideal when the exposure has a straight risk-reward profile. Forward contract gains (losses) are exactly offset by losses (gains) on the underlying transaction. If however, the transaction exposure is uncertain because of unknown volume and or foreign currency prices a forward contract will not match. Enter the options market. The options market provides an appropriate hedging tool in this situation where the quantity of foreign exchange is uncertain. 21

Futures Contract Hedge:

The concept is similar to the forward contracts except that forward contracts are common for large transactions while futures contracts may be more appropriate for firms hedging in smaller amounts. To hedge on future payables the firm may purchase currency futures contracts representing the needed currency. By holding this contract it locks in the amount of its home currency needed to make the payment.
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Leads and Lags:

Require that the time preference of one firm be imposed on the other firm.
For example:

Speed up payment to avoid appreciation of a foreign currency.

Delay payment, if foreign currency is expected to depreciate.

For account payables of foreign customers, i.e., local company's receivables, an inducement may be necessary before they would willingly lead their payables.
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Re-invoicing Centers:
A

re-invoicing center is a separate corporate subsidiary that manages all transactions exposure from intracompany trade from one location. Manufacturing affiliates sell goods to distribution affiliates of the same firm by selling to a re-invoicing center which in turn resells to the distribution affiliate. Title passes to the re-invoicing center but physical movement of goods is direct from manufacturing plant to distribution affiliate. Re-invoicing center handles paperwork but does not handle any inventory. All manufacturing units and all distribution affiliates deal only in their local currency. All transaction exposure is borne by the re-invoicing center. 24

Advantages of Re-invoicing Centers Are:

Centralization of transaction exposure management

Specialized Only

expertise and economies of scale

residual exposures are hedged.

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Cross Hedging: When hedging techniques are not available in one particular currency X, a multinational corporation looks for a proxy for that currency - typically a currency Y that is highly correlated with X. A Cross hedge is then effected.
To

cross hedge a receivable in X, multinational corporation sets up a forward contract for the sale of Y. If Y decreases so will X and vice-versa. Also receivables in X can be matched with payables in Y.
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Other Exposure Management Measures:

Transfer

pricing. Swap contracts (interest rate and currency swaps) Currency diversification (currency cocktail) Use of foreign currency exchange risk insurance Parallel loans and back-to-back loans.

Currency Collars: A currency collar is a contract that provides protection against currency movements outside an agreed upon range. A currency collar is also called a range forward.
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Parallel Loans: Occur when each of two different national firms make a loan to each other's subsidiary in its respective currency. Each of the subsidiary is located in the others country - e.g., MNCUS making $ loans to a subsidiary of MNCUK located in the U.S., while MNCUK lends s to a subsidiary of MNCUS located in the U.K. Principal and periodic interest payments on these loans are scheduled to coincide. Exposure to exchange risk is minimized by this arrangement.
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Back-to-back Loans: In a back-to-back loan, the parent

company in country A (MNCA) deposits funds in the local branch of a multinational bank from country B (Sub B), and the parent bank in country B (MNBB) loans funds to the MNCAs subsidiary in country B. A($) B()
MNCA MNBB

Sub.B

Sub.A

In the Euro Disney case, the parent company Disney limited its own exposure by having its subsidiary raise funds from local French banks, with the debt to be serviced by franc revenues in France. In addition the debt was guaranteed by the French government. 29

Measuring Translation Exposure

Financial

statements of MNC's overseas subsidiaries must be translated from local currencies to the parent currency for consolidation with the parent company's financial statements. Changing currency values results in translation gains or losses.
Basic Methods:

1. Current Rate Method (FASB 52): This is the simplest approach for translating financial statements. All balance sheet items are translated are the current rate. Income statement is translated at either the current rate or the average exchange rate of the reporting periods. 30

 Translation

gains or losses are not included in the calculation of net income.

are reported in a special equity account called the "Cumulative Translation Adjustment" (CTA).

They

This

avoids exchange rate induced variations in reported earnings. investment in the foreign affiliate is sold or liquidated, CTA account is closed and gains or losses are reported for the time (period) of liquidation.
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When

2. Current / Non-current Method: All foreign subsidiary's current assets and liabilities are translated at the current rate. Each non-current asset and liability translated at its historical rate.
Income

statement is translated at the average exchange rate for the period. However those revenues and expenses associated with non-current asset or liability are translated at the same rates as the corresponding balance sheet item, e.g., depreciation
.

The

criterion underlying this method is maturity.

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3. Monetary and Non-monetary Method: This method differentiates between monetary assets and liabilities and non-monetary or physical assets and liabilities. Short-term assets & liability change with exchange rates. Long-term assets & liability face uncertain changes, hence assumed unexposed. Monetary assets are: Cash, accounts payables, accounts receivables, and long-term debt. Non-monetary assets are: Inventory, fixed assets, longterm investments. Monetary items are translated at current rates. Non-monetary items are translated at historical rates. Income statements items are translated at the average 33 exchange rate during the period.

 Revenue

and expenses items related to non-monetary assets or liabilities, primarily depreciation and cost of goods sold, are translated at same rate as their corresponding balance sheet items. assets behave differently from monetary assets.

Real

Adjust

only the monetary (not real) assets & liabilities for changes in exchange rates - because of PPP real value of goods & equipment (real assets) will not be affected.

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4. Temporal Method
This

is a modified version of the monetary/nonmonetary method.

Monetary assets (cash, marketable securities, account receivables, long-term receivables) and Monetary liabilities (current liabilities [APs] and long-term debt) are translated at current market value and current exchange rate. Non-monetary (physical) assets and liabilities [fixed assets (plant and equipment)] and equity plus inventories are valued and translated at historical cost and historical exchange rate i.e., the rate in effect at time the assets were acquired. 35

The underlying principle is that assets and liabilities should be translated based on how they are carried on the firms books. Balance sheet accounts 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

Income statements items are translated at an average rate for the period. Inventory, normally translated at historical rates can be translated at current rate if inventory is shown on the balance sheet at market values (FIFO).

(This approach has the drawback of using too many rates - historical, current, and average and therefore makes it difficult to interpret the 36 final numbers obtained)

FASB 8 (1976-1981)

FASB 8 required temporal method of translation under which: exchange-rate

- Monetary assets/liabilities are translated at current

- Fixed assets translated at historical exchange rate - Translation gains & losses reported in income

statement, creating volatility in reported earnings.

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FASB-52: Since 1981 (replaced FASB-8)

Stipulates the use of current-rate method for assets and liabilities.

Revenue and expenses on income statement are translated at either the rate in effect when each item is recognized or appropriately weighted average exchange rate for the period Translation gains/losses bypass income statement and are accumulated in a separate equity account (CTA) on the parent's balance sheet.

FASB-52 also differentiates between functional and reporting currency for an affiliate. The functional currency is currency of primary 38 economic environment of an affiliate.

The reporting currency is the currency in which parent prepares its own financial statements. FASB-52 includes special provision for hyper-inflation countries. Generally defined as countries with inflation of 100% or more over a 3-5 year period. In such hyper inflationary environment, the dollar becomes then functional currency and financial statements from such a country must be translated using temporal method. This helps to correct the distortion that occurs when depreciation at historical cost is matched against revenue at current prices. 39

FASB 52: Stipulates the use of current or temporal rate translation method depending on nature of foreign affiliate:

$-based accounting: no translation problem.

FC-based accounting: FC functional currency: Use current rate method (self-sustaining foreign entity) FC-based accounting: $ functional currency:
Use temporal method (integrated foreign entity = extension of parent)

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 Accounting

exposure, as a measure of a firm's exposure to exchange rate change has several limitations:
data focus on financial and investment decisions that have been made in the past - but ignore decisions that have implications for future cash flows. exposure is an incomplete measure of the risks that a firm faces since it ignores operating exposures. exposure is limited by the fact that assets are valued at historical costs.

Accounting

Accounting

Accounting

Regardless

of the translation method used, the asset or liability value translated is the historical value which may not reflect current reality.
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Managing Translation Exposure.

Translation exposure exists when functional currency assets exceed liabilities

.

The main technique to minimize translation exposure is called balance sheet hedge Requires an equal amount of exposed foreign currency assets and liabilities on a companys consolidated balance sheet. If this can be accomplished for each foreign currency, net translation exposure will be zero.
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Managing Translation Exposure

Methods:
Funds Adjustment, contractual hedges, and exposure netting.

Funds Adjustments: Altering amounts or currencies of planned cash flows of parent or its subsidiaries to reduce firms local currency accounting exposure Funds Adjustments (In anticipation of local currency devaluations):

Direct: Purchasing hard currency imports, investing in hard currency securities, repaying hard currency borrowing.

Indirect: Transfer pricing between affiliates; speeding

up payment of dividends, fees, and royalties; leads and lags (inter-subsidiary transactions).
(Reverse these techniques for expected local currency revaluations) 43

Contractual Hedges:

Use of forward, money or options markets. Forward contracts can reduce translation exposure by creating an offsetting asset or liability in the foreign currency.
Example: IBM, UK, has translation exposure of 100 million. It can eliminate this exposure by selling 100 million forward. Any loss (or gain) on its translation exposure will be offset by a gain (or loss) in its forward contracts

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Basic Hedging Technique

If a devaluation appears likely for a local currency: Reduce level of cash, Tighten credit terms to reduce the accounts receivables, Increase LC borrowing Delay accounts payable in LC. Sell the weak currency (LC) forward
Other Hedging Techniques:

Exposure Netting: For multinationals with positions in more than one currency. Swap Contracts Invoicing Practices 45

Measuring Economic Exposure

Economic exposure or real operating exposure is much more important for the L-R health of a business entity than changes caused by translation or transaction exposures. Economic exposure is derived from economic analysis. Managing economic exposure is a management responsibility because it involves the interaction of strategies in Finance, Marketing, Purchasing, and Production. Economic exposure is based on the extent to which the value of the firm, measured by the present value of its expected future benefits, will change with unexpected changes in exchange rates.
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Economic exposure does not include the effects of expected changes in foreign exchange rates. If the foreign exchange market is efficient information about expected changes in exchange rates should be widely known and be reflected in a firm's market value. Only the unexpected changes in exchange rates or an inefficient foreign exchange market should cause market value to change. Exchange risk is the variability in the firms value resulting from uncertain exchange rate changes, or the possibility that currency fluctuations may alter the expected amounts or variability of firms future cash flows
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Importance of real exchange rates. The economic impact of changes in exchange rates depends on whether changes in exchange rates are fully offset by differences in domestic and foreign inflation or whether because of price controls, monetary policies, or other distortions the real exchange rate, and hence relative prices, change. Relative price changes and exchange risk
.

Relative price changes ultimately determine firm's long-run exposure.

The key is firms ability to adjust its markets, product mix and sourcing in response to exchange 48 rate dynamics.

An increase in the real value of a domestic currency acts as a "tax" on exports and a subsidy on imports. Hence an appreciating domestic currency hurts firms that export or compete with imports. However, such firms benefit from home currency depreciation which makes exports and importcompeting goods more competitive.

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A change in real exchange rate affects many aspects of a firms operations. In the case of a U.S. (domestic) firm, the major issue is its degree of price flexibility both at home and abroad.

The less price elastic the demand for the firms products, the more price flexibility the firm will have to respond to exchange rate changes.
Price elasticity depends on the degree of competition and the location of the firms key competitors. The more differentiated a companys products are, the less competition it will face and therefore the greater its ability to maintain its domestic currency prices both at home and abroad. (e.g. Lexus, BMW, Mercedes)
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The less differentiated a firms products are and the more internationally diversified its competitors are, the greater the price elasticity of demand for its products and the less price flexibility it enjoys. Such a firm faces greater exchange risk. Key questions help identify exchange risk: Where is the company selling?; Who are key competitors?; Where is the company producing?; How sensitive is demand to price?; Where are inputs coming from?; How are companys inputs or outputs priced (world market or domestic market) ? If costs and prices are similarly affected by exchange rates, a natural hedge may result. 51

Economic Exposure as a Regression Slope:

Sensitivity of revenues and costs to changes in exchange rates can be examined in a regression analysis. Firms can develop forecasts of costs, prices, sales volume (and hence cash flows) and exchange rates for several periods ahead under various scenarios. Firms can apply regression analyses to historical data on cash flows and exchange rates, for example:

CF t = a0 + a1 Ext + t CF t = a0 + a1 Exit + t
i=1 n

CF t = a0 + a1 Ext + a 2 Ext -1 + t
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Or the stock price may be used as a proxy for a firm's value, so that:

Pt = a0 + a1 Ext + t
V A = 10m$ + 50mBP
d(BP) dV A = 0 + 50m det det

OR

If et = $/, a change in et can be +ve, -ve, or zero. In general, the economic sector in which the firm operates is an important factor. i.e., whether the firm operates in exports sector, import-competing sector, or purely in domestic market which may be potentially import-competing. Sources of the firm's inputs (imports, domestic traded or non-traded sectors and real exchange rate changes are very important in determining economic exposure, than any accounting definition.
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Managing Economic Exposure:

Involves proactive marketing and production strategies including:

Market selection Product sourcing Product strategy Input mix Pricing strategy Plant location Promotional effort Productivity improvement Financial management Restructuring operations Market segmentation: pull out of unprofitable markets in favor of profitable markets. Proactive marketing initiatives: profit margin vs 54 market shares

Most MNCs use operational hedging techniques known as strategic (operational) methods such as diversification in production, marketing, and financing. The objective of economic exposure management is to anticipate and counter the effect of unexpected changes in exchange rates on a firms future cash flows.

Diversification is a major strategy, for example: Diversifying operations: sales, location of production facilities, raw material sources, etc. Diversifying financing: multiple capital markets for funds, multiple currencies, etc.
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Economic Exposure Vs Accounting Exposure

Economic Exposure
1. Concerned with flows, not just accounting figures, and the resulting impact on the market value of the firm Economic Exposure is forward-looking. It focuses on future cash flows.

Accounting Exposure
Focus only on accounting values - a change in accounting value due to translation, in itself, may not affect the firm's cash flows - except through its effect on taxes. Is backward-looking. Relates to past decisions as reflected in the subsidiary's financial statements. It ignores cash flows from future operations. Looks only at items on the balance sheet or income statement. Arises only when a firm has foreign subsidiaries.

2.

3.

Considers all cash flows whether or not they are recorded in financial statements. Also applies to firms without foreign subsidiaries including exporting firms, importcompeting firms, or potential import competing firms. Depends on economic realities. Exchange rate induced changes in prices, costs, and sales volume as their effect of firm value- depending on the economic environment in which the firm operates.

4.

5.

Depends on the accounting rules chosen. The subsidiary's accounting rules (inventory valuation method/ depreciation method) affect its accounting value, and translating accounting values can be done in many different ways.

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