Contract and Operating Exposure: Thinking Cash Flows

FIN 700 International Finance Managing Foreign Currency Exposure Professor Robert Hauswald Kogod School of Business, AU Contract and Operating Exposure: Thinking Cash Flows From global markets to corporate finance risks of global operations: FX exposures Three different categories: key concepts contract risk operating or economic risk accounting and translation risk Funding and risk management: soon interaction of capital structure and risks 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 2

FX Risk vs. Exposure Risk: the variability (measured by the standard deviation) of the domestic-currency value of an asset, liability or operating income attributable to (unanticipated) changes in FX rates Exposure: the sensitivity of changes in the (real) domestic-currency value of assets, liabilities or operating income to (surprise) changes in FX rates Relation of risk (change) to exposure (sensitivity): change in value = exposure x change in FX rate Caveat: often used as synonyms: risk used in place of exposure - distinction somewhat artificial 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 3 Example of FX Exposure HP: contract to deliver 20000 Laser Printers to a Israeli computer-store chain for ILS 1,000 each in 3 months. Payment upon Delivery. current spot rate: 0.25 USD/ISL suppose rate would change to 0.20 USD/ISL the potential change is -0.05 USD/ISL Value Change = Exposure x Change in FX Rate -1 Mil USD = 20 Mil ISL x - 0.05 USD/ISL => Exposure = 20 Mil ISL 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 4

FX Exposure FX exposure is a transaction risk: the sensitivity of a currency position s value to FX changes Open net positions: being short or long short = having less than one owes (selling) long = having more than one owes (buying) Four combinations, two outcomes long/appreciation, short/depreciation: gain short/appreciation, long/depreciation: loss Crude measure of risk? 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 5 Economic Exposure Economic exposure: FX s impact on firm s cash flows and market value either through existing or future operations Comes in two different varieties contractual or transaction exposure: FX effects on existing contracts operating exposure: FX effects on future operating cash flows Risk and exposure: what are the analogous definitions for FX risk? 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 6

Nissan s Transaction Exposure Roughly $8 billion/year in overseas receivables Transactions exposure: yen/$ impact on yendenominated revenues from contracted sales e.g., for next year ($8 bln/yr) x (S yen/$) =??? yen: spot the risk! What about future USD-denominated cash flows? 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 7 Nissan s Economic Exposure Roughly $8 billion/year in overseas receivables Economic exposure: yen/$ impact on yendenominated revenues from contracted and future expected sales (for indefinite future) Persistent exchange rate changes affect: future volume of U.S. sales (competitive effect), depending on Nissan s pricing policy in U.S. yen revenues from those U.S. sales (conversion effect) 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 8

From Transaction Year: 1 2 3... $ $8 bln ~ S(1) yen? Transaction Exposure 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 9 to Operating Exposure Operating exposure Year: 1 2 3... $ $8 bln $$$ $$$ $$$ ~ S(1) ~ S(2) ~ S(3) yen???? 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 10

The Crucial Role of Operating Exposure Firm value = expected future cash flows discounted at investors required rate of return Year 0 1 2... ~ ~ yen E[CF(1)] E[CF(2)]... V Operating exposure therefore measures how firm value changes with unexpected changes in exchange rates R 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 11 Measuring Economic Exposure Sensitivity of the future home currency value of the firm s assets and liabilities and the firm s operating cash flow to random changes in exchange rates Regression of the USD value (P) of its British assets on the dollar pound exchange rate, S($/ ): P a b S e a is the regression constant and e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 12

Exposure Coefficient The exposure coefficient, b, is defined as follows: Cov( P, S) b Var( S) Cov(P,S): covariance between the USD value of the asset and the FX rate; Var(S) is the variance of the FX rate 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 13 How to Measure Economic Exposure The exposure coefficient shows that there are two sources of economic exposure: 1. the variance of the exchange rate and 2. the covariance between the dollar value of the asset and exchange rate b = Cov(P,S) Var(S) 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 14

Measuring Contractual Exposure Effect of FX rate changes on foreign currency cash flows contractually fixed in the past Parameters: currency, date Net exposure by currency and date matrix of contractual exposure allows to calculate risk: analogous to securities portfolios For a particular date and currency Category Inflows Outflows Trade Credit Accounts receivables Accounts payables Contracts Long-term sales contracts Long-term purchase contracts Securities Loans, bonds, notes due Deposits, bonds, notes FX FFX purchase FFX sale Net exposure Total inflows - total outflows 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 15 Forward Market Hedge If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 16

Forward Market Hedge: Imports If you expect to owe foreign currency in the future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract. Importer Forward Contract Counterparty Foreign Supplier 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 17 Forward Market Hedge: Exports If you are going to receive foreign currency in the future, agree to sell the foreign currency in the future at a set price by entering into short position in a forward contract. Exporter Forward Contract Counterparty Foreign Customer 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 18

Importer s Forward Market Hedge A U.S.-based importer of Italian shoes has just ordered next year s inventory. Payment of 100M is due in one year. If the importer buys 100M at the forward exchange rate of $1.50/, the cash flows at maturity look like this: U.S. Importer Forward Contract Counterparty Italian Supplier 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 19 Forward Market Hedge: an Example You are a U.S. importer of British woolens and have just ordered next year s inventory. Payment of 100M is due in one year. Question: How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers 100M in one year a long forward contract on the pound. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 20

Suppose the forward exchange rate is $1.50/. If he does not hedge the 100m payable, in one $0 year his gain (loss) on the $30m unhedged position is shown in green. Forward Market Hedge $30m The importer will be better off if the pound depreciates: he still buys 100m but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/ Value of 1 in $ $1.20/ $1.50/ $1.80/ in one year But he will be worse off if the pound appreciates. Unhedged payable 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 21 If he agrees to buy 100m in one year at $1.50/ his gain (loss) on the forward are shown in blue. Forward Market Hedge $30m $0 $30m If you agree to buy 100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80. $1.20/ $1.50/ Long forward Value of 1 in $ $1.80/ in one year If you agree to buy 100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 22

The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. Forward Market Hedge $30 m $0 $30 m $1.20/ $1.50/ Long forward Hedged payable Value of 1 in $ $1.80/ in one year Unhedged payable 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 23 Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy foreign currency today and sit on it. Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 24

The Hedging Need A U.S. based importer of Italian bicycles In one year owes 100,000 to an Italian supplier. The spot exchange rate is $1.25 = 1.00 The one-year interest rate in Italy is i = 4% 100,000 Can hedge this payable by buying 96,153.85 = 1.04 today and investing 96,153.85 at 4% in Italy for one year. At maturity, he will have 100,000 = 96,153.85 (1.04) $1.25 Dollar cost today = $120,192.31 = 96,153.85 1.00 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 25 Market Parameters With this money market hedge, we have redenominated a one-year 100,000 payable into a $120,192.31 payable due today. If the U.S. interest rate is i $ = 3% we could borrow the $120,192.31 today and owe in one year $123,798.08 = $120,192.31 (1.03) $123,798.08 = 100,000 S($/ ) (1+ i ) T (1+ i $ ) T 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 26

Money Market Hedge: Step One Suppose you want to hedge a payable in the amount of y with a maturity of T: i. Borrow $x at t = 0 on a loan at a rate of i $ per year. $x = S($/ ) y (1+ i ) T Repay the loan in T years $x $x(1 + i $ ) T 0 T 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 27 Money Market Hedge: Step Two y ii. Exchange the borrowed $x for (1+ i ) T at the prevailing spot rate. y Invest at i for the maturity of the payable. (1+ i ) T At maturity, you will owe a $x(1 + i $ ) T. Your British investments will have grown to y. This amount will service your payable and you will have no exposure to the pound. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 28

Money Market Hedge: Steps 1. Calculate the present value of y at i y (1+ i ) T 2. Borrow the U.S. dollar value of receivable at the spot rate. y 3. Exchange $x = S($/ ) for (1+ i ) T y 4. Invest at i for T years. (1+ i ) T y (1+ i ) T 5. At maturity your pound sterling investment pays your receivable. 6. Repay your dollar-denominated loan with $x(1 + i $ ) T. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 29 Importer s Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy the present value of that foreign currency payable today and put it in the bank at interest. Buy the present value of the foreign currency payable today at the spot exchange rate. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 30

Importer s Money Market Hedge A U.S. based importer of Italian bicycles owes 100,000 to an Italian supplier in one year. The spot exchange rate is $1.50 = 1.00. The one-year interest rate in Italy is i = 4%. The importer can hedge this payable by buying 100,000 96,153.85 = 1.04 and investing 96,153.85 at 4% in Italy for one year. At maturity, he will have 100,000 = 96,153.85 (1.04). Dollar cost today = $144,230.77 = 96,153.85 $1.50 1.00 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 31 Importer s Money Market Hedge With this money market hedge, we have redenominated a one-year 100,000 payable into a $144,230.77 payable due today. If the U.S. interest rate is i $ = 3%, we could borrow the $144,230.77 today and owe $148,557.69 in one year. $148,557.69 = $144,230.77 (1.03) $148,557.69 = 100,000 S($/ ) (1+ i ) T (1+ i $ ) T 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 32

Importer s Money Market Hedge: Cash Flows Now and at Maturity Spot Foreign Exchange 96,153.85 Market $144,230.77 Importer $144,230.77 $148,557.69 U.S Bank deposit i = 4% 96,153.85 100,000 T= 1 cash flows Italia Bank Supplier 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 33 Exporter s Money Market Hedge Spot Foreign Exchange 95,238.10 Market $119,047.62 An American exporter has just sold 100,000 worth of shoes to a French customer. Payment is due in one year. Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone. The spot exchange rate is $1.25/ 1.00. Use a money market hedge to eliminate the exporter s exchange rate risk. deposit i $ = 7.10% Exporter $119,047.62 $127,500.00 U.S Bank 95,238.10 Borrow i = 5% 100,000 T= 1 cash flows Crédit Agricole Customer 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 34

Example: GBPdenominated accounts receivable (transaction exposure) The Effect of Hedging Hedging can reduce the volatility of cash flows, and reduce exchange rate exposure 100% hedged 50% hedged unhedged 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 35 F $ value Managing Contractual Exposure FX Hedging with the usual instruments take position offsetting net exposure per currency calculate current risk from exposure and derive residual hedge from statistical hedge ratios Money market hedge: DIY FFX synthetic FFX: borrow + invest in needed currency Default risk: hard to hedge credit risk : nascent market of credit risk derivatives reverse FX risk: if initial exposure was hedged, one still has the obligation to deliver on derivatives 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 36

Hedging Recurrent Exposure with Swaps Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 37 Hedging through Invoice Currency The firm can shift, share, or diversify: shift exchange rate risk by invoicing foreign sales in home currency share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk by using a market basket index 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 38

Hedging via Lead and Lag If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 39 Operating Exposure: Definition The effect of random changes in exchange rates on the firm s competitive position, which is not readily measurable. A good definition of operating exposure is the extent to which the firm s operating cash flows are affected by the exchange rate. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 40

Operating Exposure Operating exposure: the impact of future exchange rates on non-contractual future cash flows per unit change of net expected cash flows to unexpected changes in spot FX Key characteristics: concerns the survival of the company in the long-term unexpected change future operational cash flows sources of operating exposure Measuring operating exposure quantification of qualitative statements about future 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 41 Channels of Operating Exposure Asset exposure Home currency value of assets and liabilities Exchange rate fluctuations Firm Value Operating exposure Future operating cash flows 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 42

Determinants of Operating Exposure Operating exposure cannot be readily determined from the firm s accounting statements in contrast to transaction exposure. The firm s operating exposure is determined by: the market structure of inputs and products, i.e., how competitive or how monopolistic the markets facing the firm are. its ability to adjust its markets, product mix, and sourcing in response to exchange rate changes. 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 43 Measuring and Estimation of Operating Exposure Fundamental problem: qualitative statements about future events need to be quantified Problems with estimating operating exposure unrealistic assumptions for data generation hypothesized exposure relationships structural shifts carry over to hedging, business decisions Arts and science: dynamic process simulations scenario analyses statistical solutions 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 44

Hedging Operating Exposure Derive hedge coefficients from the underlying exposure measurement Alternatives: self-insurance with reality check: identify and target sources of operating exposure break-even analysis of economic environment business strategy hedge The best never rest : operating exposure management requires a good understanding of competitive forces and economic environment 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 45 Implications for Treasury Management Treasure management can partly be used to off-set operating exposure what does this imply for the risk management function in the corporate structure and decision making process? Forward transactions can hedge not only contractual exposure but also operating exposure: witness Disney Problems: symmetry in payoffs: options ruin risk: temporary liquidity problems could sink the company (Metallgesellschaft) estimation risk: only approximate hedging never reduces operating losses - only offsets them 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 46

Driving in the Dark: Accounting The source of the problem: multi-dimensional reporting in terms of currency, rules and time several sets of books need to be reconciled tax accounting interferes with economic accounting Implications of FX markets on MNC s view of itself Problem: bad economic decisions induced by good accounting based strategies For definitional purposes: replace financial position with net worth (accounting value) 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 47 Nature of Translation Exposure Translation exposure is the effect of exchange rate changes on the translated value of a foreign subsidiary s financial statements requires assets abroad affects consolidated balance sheets and income statements Legal basis: FAS 52 - Foreign Currency Translations, Financial Accounting Standards Board, 1981. Much copied in other countries: even if MNC not domiciled in US, FAS still applicable from a conceptual point of view 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 48

Financial Statements Translation Foreign subsidiary s statements maintained in local currency Translation requirement: tax purposes: foreign income including capital gains/losses needs to be translated into home currency reporting purposes: consolidation of parents and subsidiaries financial statements (A&L, P&L) corporate decision making: capital allocation, budgeting, investments performance measurements valuation: economic valuation preceded by accounting valuation and balance sheet analysis Fundamental problems: translation at historic vs current FX rates whether and when should FX gains/losses be recognized as income? Principle: consistent set of accounting rules 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 49 Economic vs. Translation Exposure Analogy: market vs. book value economic exposure matters for firm s value translation exposure affects value only through taxes Accounting exposure: hedge accounting exposure arising from FX spot and derivatives transactions and their accounting treatment Economic Exposure Translation Exposure Focus Cash flows, economic (market) value Accounting values, tax effects Perspective Forward looking: future cash flows Backward looking: past cash flows Scope All cash flows, sources of value Only balance sheet or income statement items Firms All companies - potential exposure Foreign subsidiaries (assets) required Source Economic facts Accounting rules 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 50

Limitations of Translation Exposure Accounting data is not forward looking decision making is: accounting rules are not conducive to active risk management per se One can only hedge one exposure: choose! managing (artificial) translation exposure creates (very real) contractual exposure Translation exposure can not and should not be used as a proxy for economic exposure the historic costing curse: local historic cost based accounting rules falsify economic reality of A&L even under current rate methods 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 51 Summary Exposure = unexpected change in financial position at T in domestic currency unexpected change in S T Exposure vs. risk: sensitivity vs. variability Transaction exposure: analogous to open positions arising from contracts financial hedges Lewent and Kearney (1990): FX Risk Operating exposure: arising from the economics of the company: competitiveness natural hedges: business strategy Translation exposure is an artificial risk pro-active management: corporate (mis)organization 10/9/2018 Three FX Exposures - Robert B.H. Hauswald 52