Types of Foreign Exchange Exposure. Foreign Exchange Exposure

Foreign Exchange Exposure 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. An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm. Types of Foreign Exchange Exposure 1. 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. 1 2 2. Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. The difference is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness. 3 3. Accounting exposure, also called translation exposure, is the potential for accounting -derived changes in owner s equity to occur because of the need to translate foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements. The tax consequence of foreign exchange exposure varies by country. As a general rule, however, only realized foreign exchange losses are deductible for purposes of calculating income taxes. 4

Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure Accounting exposure Changes in reported owners equity in consolidated financial statements caused by a change in exchange rates Time Moment in time when exchange rate changes Transaction exposure Operating exposure Change in expected future cash flows arising from an unexpected change in exchange rates Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates 5 Why Hedge? MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. Many firms attempt to manage their currency exposures through hedging. Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract that will rise (fall) in value and offset a fall (rise) in the value of an existing position. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows. 6 Impact of Hedging on the Expected Cash Flows of the Firm NCF Expected Value, E(V) Hedged Unhedged Net Cash Flow (NCF) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk. 7 Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. 8

Seller quotes a price to buyer (in verbal or written form) The Life Span of a Transaction Exposure t 1 t 2 t 3 t 4 Quotation Exposure Time between quoting a price and reaching a contractual sale Buyer places firm order with seller at price offered at time t 1 Time and Events Backlog Exposure Time it takes to fill the order after contract is signed Seller ships product and bills buyer (becomes A/R) Billing Exposure Time it takes to get paid in cash after A/R is issued Buyer settles A/R with cash in amount of currency quoted at time t 1 9 Management of Transaction Exposure Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. The main contractual hedges employ the forward, money, and options markets. Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies. 10 Dayton Manufacturing s Transaction Exposure To illustrate how contractual hedging techniques may be used to protect against transaction exposure, consider an example in which Dayton, a U.S. manufacturing firm, sells a gas turbine generator to Crown, a British firm, in March for 1,000,000. Payment is due three months later, in June. Dayton s cost of capital is 12%. 11 Dayton Manufacturing s Transaction Exposure With reference to Dayton Manufacturing s Transaction Exposure, the CFO has four alternatives: Remain unhedged Hedge in the forward market Hedge in the money market Hedge in the options market These choices apply to an account receivable and/or an account payable 12

The following quotes are available: Spot exchange rate: $ 1.7640/ Three-month forward rate: $1.7540/ (a 2.2627%per annum discount on the British pound) U.K. three-month borrowing interest rate: 10.0% (or 2.5% / quarter) U.K. three-month investment interest rate: 8.0% (or 2.0% / quarter) U.S. three-month borrowing interest rate: 8.0% (or 2.0% / quarter) U.S. three-month investment interest rate: 6.0% (or 1.5% / quarter) June put option in the over-the-counter (bank) market for 1,000,000; strike price $ 1.75 (nearly at-the-money); 1.5% premium June put option in the over-the-counter (bank) market for 1,000,000; strike price $ 1.71(out-of-the-money); 1.0% premium 1. Forward Contract Purchase a 3-month forward contract to sell pounds at $ 1.7540/ Three-month later, receives sale proceeds of 1,000,000 Convert to U.S. dollars equal to $1,754,000 Dayton s foreign exchange advisory service forecasts that the spot rate in three months will be $ 1.76/. 13 14 2. Money Market Hedge Borrow pounds at rate 10% per annum (2.5%/90Days) 1.025X = 1,000,000 1,000,000 X = 1.025 = 975,610 Convert pounds into U.S.$ at spot $ 1.7640/ Invest $1,720,976 in the U.S. Money Market 3 months later, receives sale proceeds of 1,000,000 Repay Loan; Principal 975,610 and interest 24,390 Compare the forward with the money market hedges 15 Break-Even Rate compare to Forward $1,720,976(1+r) = 1,754,000 1,754,000 r = 1,720,976-1 r = 1.9189% / quarter or r = 7.6756% / annum 16

Use $1,720,976 to repay existing $ loan (interest 8% per annum) achieve value worth of = $1,720,976(1+0.02) = $1,755,396 at the end of quarter 3. Options Market Hedge Purchase a 3-month put options at strike $1.75/ (A premium cost of 1.50%) Options Premium = (Contract Size)(Premium)(Spot Rate) = 1,000,000X 0.015X $1.7640 / = $ 26,460 If the cost of capital is 12% per annum (3%per quarter) 17 Options Cost = $26,460(1.03) = $27,254 18 The Break-Even Points 1. Upper Bound 1; Compare with forward rate UB 1 = $1.7540 + $0.0273 = $1.7813 If pound appreciates above $1.7813, then options better than forward. 3. Lower Bound; Compare with unhedged strategy LB = $1.7500 - $0.0273 = $1.7227 If pound falls below $1.7227, then options better than unhedged. 2. Upper Bound 2; Compare with money market UB 2 = $1.7554 + $0.0273 = $1.7827 If pound appreciates above $1.7827, then options better than money market. 19 20

Put Values at Expiration Valuation of Cash Flows Under Hedging Alternatives for Dayton P T Puts expire in the money P T = K - S T when S T < K Puts expire out of the money and are worthless; P T = 0 when S T > K Value in US dollars of Dayton s 1,000,000 A/R 1.84 1.82 1.80 Put option strike price of $1.71/ Put option strike price of $1.75/ Uncovered OTM put option hedge ATM put option hedge 1.78 1.76 Money market hedge 0 45 * 1.7227 1.7813 K = $ 1.75/ S T 1.74 1.72 1.70 Forward contract hedge Exercise put option if spot falls below $1.75/ 21 1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86 Ending spot exchange rate (US$/ ) 22 Management of an Account Payable Dayton had a 1,000,000 A/P in 90 days A. Remain Unhedged Wait 90 days and pay B. Forward Market Hedge Buy 1,000,000 forward at $1.7540/ cost $1,754,000 C. Money Market Hedge Convert U.S. $ for and invest them for 90 days in pound money market rate 8% (2% per 90 days) Pounds Needed; (1.02) X = 1,000,000 1,000,000 X = = 980,392.16 1.02 This Equal = 980,392.16 X $1.7640 = $ 1,729,411.77 If the cost of capital is 12% (3% per 90 days) Hedging Cost = $1,729,411.77 (1.03) = $1,781,294.12 > Forward Hedge 23 24

D. Options Hedge Purchase call options at strike $1.75 /, premium 1.5% Pounds Premium = 1,000,000 X 0.015 X $1.764/ = $26,460 If the cost capital is 12% (3% for 90 days) Options Cost = (1.03) X 26,460 = $27,254 If 90-days later, spot > 1.75/ Exercise Call Total Cost of Options Hedge = $1,750,000 + $27,254 = $1,777,254 25 The Break-Even Points 1. Upper Bound; Compare with unhedged strategy UB = $1.7500 + $0.0273 = $1.7773 If pound appreciates above $1.7773, then option better than unhedged. 2. Lower Bound; Compare with forward strategy LB = $1.7540 - $0.0273 = $1.7267 If pound falls below $1.7267, then option better than forward. 26 C T Call Values at Expiration Call expire out of the money and are worthless: C T = 0 when S T < K Calls expire in the money and are worth their intrinsic value; C T = S T -K when S T > K Cost in US dollars of Dayton s 1,000,000 A/P 1.84 1.82 1.80 1.78 Call option strike price of $1.75/ Forward rate is $1.7540/ Uncovered costs whatever the ending spot rate is in 90 days Money market hedge Locks in a cost of $1,781,294 1.76 1.74 Call option hedge Forward contract hedge locks in a cost of $1,754,000 0 1.7267 45 o 1.7773 K = $ 1.75/ Exercise call option if spot rises above $1.75/ S T 27 1.72 1.70 1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86 Ending spot exchange rate (US$/ ) 28

Alternative Cost Degree of Risk 1. Unhedged $1,760,000 Uncertain 2. Forward $1,754,000 Certain 3. MM Hedge $1,781,294 Certain 4. Call Options $1,777,254 Maximum Cost The final decision depends on firm s exchange rate expectations 29 Risk Management in Practice Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. The remaining portion of the exposure is then selectively hedged on the basis of the firm s risk tolerance, view of exchange rate movements, and confidence level. 30