Financial Management in IB. Foreign Exchange Exposure
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1 Financial Management in IB Foreign Exchange Exposure 1
2 Exchange Rate Risk Exchange rate risk can be defined as the risk that a company s performance will be negatively affected by exchange rate movements. Exposure to exchange rate fluctuations comes in three forms: Transaction exposure Economic exposure Translation exposure 2
3 Transaction Exposure The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. Two steps are involved in measuring transaction exposure: determine the projected net amount of inflows or outflows in each foreign currency, and determine the overall risk of exposure to those currencies. 3
4 Transaction Exposure If the firm expects net inflows in foreign currency, the firm is in so called long position. If the firm expects net outflows in foreign currency, the firm is in so called short position. 4
5 Transaction Exposure Long position If domestic currency gets stronger the value of the receivables falls and the firm suffers a loss. If domestic currency depreciates the value of the receivables rises and the firm realizes a profit. Short position If domestic currency gets weaker the value of the payables rises and the firm suffers a loss. If domestic currency appreciates the value of payables falls and the firm realizes a profit. 5
6 Transaction Exposure Measurement To determine the overall risk, we have to assess the standard deviations and correlations of the currencies, taking into account the size of the firm s position in each currency in terms of a standard currency. The standard deviation statistic on historical data measures currency variability. The variability may change over time. Correlation coefficients indicate the degree to which two currencies move in relation to each other. They may change over time too. 6
7 Transaction Exposure Measurement A related method, the value-at-risk (VAR) method, incorporates currency volatility and correlations to determine the potential maximum one-day loss. Historical data is used to determine the potential one-day decline in a particular currency. This decline is then applied to the net cash flows in that currency. 7
8 Value at Risk Value at Risk is the method to determine the potential loss on value of net position over certain period of time. It is based on the assumption that the percentage changes in the exchange rate are normally distributed. Maximum expected loss on value of net position at the 95 % confidence level is determined by the 5 % percentile of the distribution which is about 1.65 standard deviations from the expected percentage change in exchange rate. 8
9 Value at Risk VaR has three parameters: The time horizon (period) to be analyzed. Typical periods using VaR are 1 day, 10 days, or 1 year. The confidence level is the probability at which the VaR will not be exceeded by the maximum loss. Commonly used confidence levels are 99% and 95%. Value at risk(var) is given in a unit of the currency. 9
10 Transaction Exposure Management If transaction exposure exists, the corporation should identify the degree of transaction exposure, decide whether to hedge and how much to hedge based on its degree of risk aversion and exchange rate forecasts, and choose among the various hedging techniques available if it decides to hedge. 10
11 Techniques to Eliminate Transaction Exposure Forward hedge A forward hedge involves the use of forward contracts by corporations to hedge transaction exposure. Long position may be closed out by selling foreign currency on the forward market. Short position may be closed out by buying foreign currency on the forward market. Based on the firm s degree of risk aversion, the decision about whether to hedge can be made by comparing the known result of hedging to the possible results of remaining unhedged. 11
12 Techniques to Eliminate Transaction Exposure Future hedge A futures hedge involves the use of currency futures to hedge transaction exposure. Futures contracts represent a standardized number of units for each currency with standardized maturities. Long position in $ may be closed out by selling US Dollar - Euro Future contracts on LIFFE. Short position in $ may be closed out by buying US Dollar - Euro Future contracts on LIFFE. 12
13 Techniques to Eliminate Transaction Exposure Future hedge A futures hedge involves the use of currency futures to hedge transaction exposure. Futures contracts represent a standardized number of units for each currency with standardized maturities. Long position in $ may be closed out by selling US Dollar - Euro Future contracts on LIFFE. Short position in $ may be closed out by buying US Dollar - Euro Future contracts on LIFFE. 13
14 Techniques to Eliminate Transaction Exposure Currency option hedge A currency option hedge involves the use of currency call or put options to hedge transaction exposure. Option owner can choose not to exercise the contract. Hence, the firm will be insulated from adverse exchange rate movements, but may benefit from favorable movements. However, the firm must assess whether the advantages are worth the premium paid for the option. 14
15 Techniques to Eliminate Transaction Exposure Option Strategies Vertical Spread Objective: To reduce the hedging costs. With small speculation. Substance: Corporation buys a call option a simultaneously sells a put option with the same amount of underlying currency, maturity etc. Both options are Out of the money. 15
16 Techniques to Eliminate Transaction Exposure Zero-Cost Vertical Spread Objective: Removal of hedging costs With a little bit higher risk Substance: Corporation buys a call option a simultaneously sells a put option with the same amount of underlying currency, maturity etc. Both options are Out of the money and have the same price. 16
17 Techniques to Eliminate Transaction Exposure Money market hedge A money market hedge involves taking one or more money market position to cover a future payables or receivables position. Often, two positions are required: For payables, (1) borrow the home currency representing future payables, and (2) invest in the foreign currency. For receivables, (1) borrow the foreign currency representing future receivables, and (2) invest in the home currency. 17
18 Techniques to Eliminate Transaction Exposure Example: receivables of $100,000 with maturity 90 days 1. Credit $98,522 Borrowing at 6%, p.a. for 90 Days 4. Repayment $100,000 Exchange Rate: $1,2000/ 2. 82,102 Lending at 4% p.a. for 90 Days Effective Exchange Rate $1,2059/ 3. Revenues 82,923 18
19 Techniques to Eliminate Transaction Exposure Money market hedge If interest rate parity (IRP) exists, and transaction costs do not exist, the money market hedge will yield the same results as the forward hedge. This is so because the forward premium on the forward rate reflects the interest rate differential between the two currencies. 19
20 Alternative Techniques Sometimes, a firm may not be able to eliminate its transaction exposure completely because it cannot accurately predict its cash flows, or because the costs of hedging are too high. To reduce exposure under such conditions, the firm can consider leading and lagging, cross-hedging, currency diversification or netting. 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. 20
21 Alternative Techniques When a currency cannot be hedged, cross-hedging may be practiced. With cross-hedging, a currency that is highly correlated with the currency of concern is hedged instead. The stronger the positive correlation, the more effective the strategy will be. With currency diversification, the firm diversifies its business among numerous countries whose currencies are not highly correlated. 21
22 WechselExchange Raterisiko: Absicherung Netting (bilateral, multilateral) reduces transaction costs and risk Without Netting Subsidiary company USA USD 500,000 EUR 300,000 Parent corporation Germany With Netting: Fix Exchange Rate (for bilateral Netting): EUR/ USD 1,20 Subsidiary company USD 140,000 Parent corporation USA Germany 22
23 Economic Exposure Economic exposure refers to the degree to which a firm s present value of future cash flows can be influenced by exchange rate fluctuations. Cash flows that do not require conversion of currencies do not reflect transaction exposure. Yet, these cash flows may also be influenced significantly by exchange rate movements. 23
24 Economic Exposure Transactions that Influence the Firm s Local Currency Inflows Impact of Local Currency Appreciation Impact of Local Currency Depreciation Local sales (relative to foreign competition in local markets) Decrease Increase Firm s exports denominated in local currency Decrease Increase Firm s exports denominated in foreign currency Decrease Increase Interest received from foreign investments Decrease Increase 24
25 Economic Exposure Transactions that Influence the Firm s Local Currency Outflows Impact of Local Currency Appreciation Impact of Local Currency Depreciation Firm s imported supplies denominated in local currency No Change No Change Firm s imported supplies denominated in foreign currency Decrease Increase Interest owed on foreign funds borrowed Decrease Increase 25
26 Economic Exposure Management The management of economic exposure tends to result in a longterm solution. A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios. The firm can then reduce its exposure by restructuring its operations. 26
27 Economic Exposure Management For example, a firm may attempt to balance its exchange-rate sensitive revenues and expenses by: Increasing or reducing sales in new or existing foreign markets. Increasing or reducing its dependency on foreign suppliers. Establishing or eliminating production facilities in foreign markets. Increasing or reducing its level of debt denominated in foreign currencies. 27
28 Translation Exposure The exposure of the MNC s consolidated financial statements to exchange rate fluctuations is known as translation exposure. Translation exposure may not be relevant because translating financial statements for consolidated reporting purposes does not affect an MNC s cash flows. In reality however, translation exposure may affect the stock price of a firm through its impact on consolidated earnings. 28
29 Translation Exposure Note that the current translation of earnings may be a useful base to derive the expected future cash flows when earnings are remitted by the foreign subsidiaries to the parent. Translation exposure is dependent on: the degree of foreign involvement by foreign subsidiaries, the locations of foreign subsidiaries, and the accounting methods used. 29
30 Translation Exposure Management To hedge translation exposure, forward contracts can be used. Hedging translation exposure is limited by: inaccurate earnings forecasts, inadequate forward contracts for some currencies, accounting distortions, and Increased transaction exposure. 30
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