Accounting Exposure

Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation.

Example: Consider a U.S. multinational company’s subsidiary in Great Britain whose balance sheet and income statement are translated to the parent’s functional currency—the U.S. dollar. The pound has devalued from $1.50/pound to $1.40/pound since the last translation.

Impact of Translation Methods on U.K. Subsidiary of U.S. Firm Assuming Pound Devalues from $1.50/Pound to $1.40/Pound Current Monetary Temporal All current Non-current non-monetary rate In Millions £ $ £ $ £ $ £ $ Cash 15d 21 15 21 15 21 15 21 Marketable Securities 30 42 30 42 30 42 30 42 Receivables 40 56 40 56 40 56 40 56 Inventory 60 84 60 90 90 90 60 84 Long term assets 250 375 250 375 250 375 250 350 Total Assets 395 578 395 584 395 584 395 553 Payables 100 140 100 140 100 140 100 140 Long term Debt 145 217.5 145 203 145 203 145 203 Equity 150 220.5c 150 241c 150 241c 150 210c

Total Liabilities 395 578 395 584 395 584 395 553 Exposed Assets 145 85 85 395 Exposed liabilities 100 245 245 245 Net Exposure a £45 -£160 -£160 £150 CTAb - $4.5 +$16 +$16 -$15 a Exposed assets minus exposed liabilities b

Cumulative Translation Adjustment = (Net Exposure) ( St –St-1) c Stockholders equity adjusted to the new level after translation. For example, the net worth translated to dollar under the old exchange rate of $1.50/pound produces $225 million. However, the adjusted net worth after translation to dollar of $220.5 million under monetary nonmonetary method shows decline of -$4.5 million that is reflected in the CTA of the same magnitude. However, the stockholders equity under temporal method is $241 million after translation at the new exchange rate, an increase of $16 million as is evidenced by a CTA of the same magnitude.

A U.S. subsidiary in the United Kingdom believes that it will have a net translation exposure of -£160 million for the next translation period. Strategy The subsidiary buys £160 million three-month forward at $1.50/pound. The pound devalues to $1.40/pound for the next translation period. Forward loss: ($1.40/pound - $1.50/pound.) (£160 million) = -$16 million Translation Gains: ($1.40/pound - $1.50/pound.) (-£160 million) = +$16 Results: Paper gains are equal to real losses of $16 million. The above strategy appears to have neutralized the firm’s translation exposure to foreign exchange as the firm substitutes paper gains for real losses and vice versa. The above strategy is speculative in nature and value-maximizing firms will be better off to avoid such strategy.

Illustration 8.1

Hedging in Practice: Nike

Nike markets its products in over 140 countries with foreign sales revenue accounting for 46 percent of its total revenue in fiscal 2001. Given its huge presence in the foreign market, Nike’s annual report states:

“It is the company’s policy to utilize derivative financial instruments to reduce foreign exchange risks where internal netting strategies cannot be effectively employed. Fluctuation in the value of the hedging instruments are

offset by fluctuations in the value of the underlying exposures being hedged”

Nike uses forward contracts for firm commitments to hedge receivables and payables as well as inter-company foreign currency transactions,

Nike uses currency options to hedge certain anticipated but not yet firmly committed export sales and purchase transactions expected in futures denominated in foreign currency.

Cross-currency swaps are employed to hedge foreign currency denominated payments related to inter-company loan agreements.

Transaction Exposure

Transaction exposure is defined as the impact of the unexpected change in exchange rate on the cash flow arising from all the contractual relationships entered prior to the change in exchange rate at time (t1) to be settled after the change in exchange rate at time (t2).

t1 t2 Time

Dupont Acquires AG

In December 1998 DuPont entered into a forward contract in the acquisition of the performance coating business of Hoechst AG for 3.1 billion deutsche marks (DM) at $1.9 billion.

The forward contract effectively locked the company at the forward exchange rate of 1.6316DM/$, insulating DuPont from adverse exchange rate movements that would likely have increased the dollar price of the acquisition.

Payoff and Variance of Hedged and Unhedged Cash Flow Frequency of Distributions Hedged Unhedged Expected Cash Flows

As the graph shows, distribution of hedged cash flows is tighter than its unhedged counterpart.

Structure of Money Market Hedge of Receivables

Pay P&I in £

Borrow £ £

Note: P&I refers to principal and interest

Exporter ships the goods to the

Importer

Importer Issues IOU £3.5 million

for 120 days

Offshore Bank

In the above structure exporter having shipped the goods and received letter of credit in the form of say banker’ acceptance, or time draft to be paid by importer bank in 120 days. Export uses the time draft as collateral in offshore bank and secures pound loan that is equal to the present value of the face value discounted at the borrowing rate of offshore bank. Converts the borrowed pound to the US dollar and investing the dollar at the lending rate of the home country (lending rate). At the end of 120 days exporters pays off the offshore bank with the proceeds of the time draft (IOU). The ratio of the receivables in dollar and pound establishes synthetic forward rate that can be compared to actual 120-day forward rate.

Hedging with Futures Dupont has €12 million payable in 90 days for the supplies it purchased from a Finnish company on August 13. August 13 Spot rate $.97/euro December futures $.9735/euro Buy 96 December futures at $.9735/euro The proceeds per one contract is: 125,000x$.9735/€ = $121687.50 Total proceeds: 96x$121687.50 =$11,682,000 November 13 Spot market: Buy €12,000,000 @ $.9845/euro Close out futures by selling 96 December contracts @$.9858/euro The proceeds per one contract is: 125,000x$.9858/€ =$123,225 Results Spot market: pay $11,814,000 to settle the €12 million payable to Finnish firm Futures market: Gains per contract: $123,225-$121687.50 = $1,537.50 Total Gains: $1,537.50 x 96 = $147,600 Effective cost: $11,814,000 - $147,600 = $11,666,400 Effective rate: $11,666,400/€12,000,000 = $.9722/€

Consider the call option in Euro FX November futures at strike price of 98 cents. The quoted premium is 1.27 cents per euro as of August 23, 02 in the CME.

Each contract is for delivery of 125,000 units of euro. The spot euro is $.9731/pound. The Dupont treasurer in Exhibit 8.9

can buy 96 call options to hedge against the possible appreciation of the euro in the next three months.

The premium for one call option will be equal to $1,587.50, and to hedge the entire exposure requires an upfront premium of $152,400.

The call option is providing protection by imposing a ceiling on the exchange rate that is equal to the strike price plus the premium for the call as follows:

Example

Exhibit 8.11 Hedging Payables with Call Options

11.40

11.60

11.80

12.00

12.20

12.40

12.60

12.80

0.95 0.96 0.97 0.98 0.99 1 1.01 1.02 1.03 1.04 1.05 1.06

Millio

ns

Exchange Rates $/€

Payab

les

unhedged hedged

VALUE AT RISK

Value at risk (VAR) provides a framework for analysis of the maximum potential loss in the fair value of an exposed position over a specific period assuming normal market conditions and a given confidence interval.

MNCs have various exposures due to interest rate changes, foreign exchange rate changes, as well as to the changes in the commodity prices that could adversely affect the value of the firm.

VAR analysis uses simulation models by assuming various scenarios to generate the amount of maximum loss that could be realized in a given period for a given confidence interval.

VAR= amount of exposure*volatility*confidence interval

Example VAR

For example, a bond portfolio with market value of $250 million might have VAR at 95 percent confidence interval of $15.6176 million over the next 10 days assuming standard deviation of the exposed portfolio is equal to 16 percent per annum.

The volatility is usually quoted in year, however, for the purpose of estimating the VAR of an asset, the volatility of the asset is quoted on a daily basis as volatility per day as follows:

σd = σy / (252) 1/2

One-day VAR = .010079 x1.65x $250 = $4.1575 million. 10-day VAR = One-day VAR. 10-day VAR = $4.1575 = $13.1471 million This portfolio is likely to suffer at least a loss of $4.1575 million in 5 out of

100 days (one –day VAR with 95 percent confidence interval).

Value at Risk on Various Exposures for Dupont

2000 2001 (Dollars in millions)* Interest rates (7) (30) Foreign exchange (29) (20) Agricultural commodities (20) (20) Energy feedstock commodities - (14)

* Source: Dupont 2001 Annual Report.

Value at Risk

Notional amount Sensitivity Analysis, Duration ignores non-

linearity in the price yield relationship Scenario Analysis, allows investor to

investigate nonlinear extreme effect on price, but fails to associate risk with a probability.

Both sensitivity and scenario analysis do not allow for the aggregation of risk across different markets.

Value at risk achieves all of the above.

Value at Risk (VAR)

VAR provides a framework for the analysis of potential unexpected loss over a specific horizon and a given confidence interval.

VAR estimate recognizes various sources of risk and expresses loss in terms of probability.

VAR= amount of exposure*volatility*confidence interval

VAR (dP) = D.P x VAR(dy)

VAR

Consider a hedge fund is contemplating on Japanese yen devaluation against US dollar. The hedge funds sells $5 billion worth of Japanese yen at the CME. Using 10 years of data from 1985-1994, we estimated VAR at 95 percent confidence Interval.

2512 observations of daily returns are used to generate estimate of VAR.

VAR=$47,401,685

Distribution of Losses Left Tail

0

10

20

30

40

50-1

70

-16

0

-15

0

-14

0

-13

0

-12

0

-11

0

-10

0

-90

-80

-70

-60

-50

Loss in millions

Fre

qu

en

cy

Distribution of Losses and Gains

Distribution

0

50

100

150

200

250

300

350

400

450

500

Loss and gain in 100 millions

Fre

qu

en

cy

VAR=$47,401,685

Margin Setting

CME or CBOT has set as of March 12, 2007, the initial margin in JPY/USD futures at $1350. The size of contract is ¥ 12,500,000. The spot exchange on march 12 was ¥116/$. The volatility of the exchange rate is estimated to be 8.4%.

What is the 1-day VAR at 99% confidence interval?

VAR=2.33(8.4%/ 252 )x 12,500000/116= $1300

•In the OTC market the level of margin is related to the amount of volatility

and exchange rate.

VAR: Caveats

Shortcomings: VAR does not define the worst loss VAR does not describe the losses on the left

tail, it does not say anything about the distribution of the losses.

VAR is measured with some error VAR(T days)=VAR(1-day)*T^1/2

Lufthansa purchased 20 aircraft from Boeing at the cost of $500 million payable in one year in January 1986. The spot and one-year forward exchange rates at the time the contract entered into was $.3125/deutsche marks.

Lufthansa by agreeing to pay dollars for the aircrafts accepted all the exchange rate risk and reward for the above contract.

To manage exposure to dollar appreciation the company decided to leave half of the liability exposed to foreign exchange risk and purchased the other half, $250 million, in the forward market at the forward rate of $.3125/deutsche mark or 3.2 DM/$. By hedging half of the exposure the company effectively locked at the forward rate of $.3125/deutsche mark, to pay DM800 million for buying $250 million forward.

Lufthansa Buys Aircraft from Boeing

Hedging Alternatives

Hedging Alternatives: 1. Remain unhedged 2. Fully cover the exposure: buy dollars forward 3. Manage some of the exposure, leaving some exposed 4. Use call options in dollar/deutsche mark or its equivalent the

put options in deutsche mark/dollar 5. Buy caps in dollars or floors in deutsche marks (in the over

the counter market from a bank or insurance company) 6. Money market hedge of payables.

By January 1986, the deutsche mark appreciated and the dollar weakened to $.45/deutsche mark and the forward hedging turned out to be very costly ex-post.

Lufthansa’s Payables with Various Hedging Alternatives

1696

1150

1250

1350

1450

1550

1650

1750

1850

1950

22.12.22.32.42.52.62.72.82.933.13.23.33.43.53.63.73.83.9

DM/$

Du

tch

Mar

ks p

ayab

le

unhedged forward 50/50 ATM option OTM option

exchange unhedged forward 50/50 ATM optionOTM option2 1000 1600 1300 1096 1048

2.2 1100 1600 1350 1196 11482.4 1200 1600 1400 1296 12482.3 1150 1600 1375 1246 11982.6 1300 1600 1450 1396 13482.8 1400 1600 1500 1496 1448

3 1500 1600 1550 1596 15483.09 1545 1600 1572.5 1641 15933.2 1600 1600 1600 1696 1593

3.392 1696 1600 1648 1696 15933.4 1700 1600 1650 1696 15933.6 1800 1600 1700 1696 15933.9 1950 1600 1775 1696 1593

Summary of the Lufthansa’s Payable Under Various Alternatives Ex-Post Uncovered 2.3 DM/$ x $500 M = 1.15 billion DM Forward hedging 100 percent of the exposure 3.2 DM/$ x $500 M = 1.6 billion DM Partial hedging 50 percent of the exposure 3.2 x $250 +2.3x$250 M = 1.375 billion DM Options hedging 1.15 billion DM + 96 million DM =1.246 billion DM Partial hedging 50 percent of the exposure through rollover 1.275 billion DM

Managing Operating Exposure

The operating exposure arises due to the impact of unexpected change in the exchange rate on the firm’s input price, that is, raw materials, labor costs, and out put prices such as prices of the goods and services produced. Operating exposure is long term in nature and therefore can only be managed through operating hedges..

Operating hedges can be achieved as follows: 1) Increasing Flexibility of Operating Net Works: Provide MNCs the flexibility to

arbitrage institutional restrictions, such as regulatory impediments, various requirements by regulatory agencies as well as to arbitrage taxes and factors of productions across international boundaries.]

2) Diversifying Operations: This type of diversification naturally hedges cash flow derived from various operations overseas; however, it is expensive in terms of cost and lengthy in implementation.

3) Diversifying Financing with Matching Cash Flows: This approach is similar to the money market hedging discussed earlier in the chapter. The exporter selling goods and services overseas in this scenario has accepted the foreign currency for the receivables and therefore is exposed to foreign exchange risk.

Matching Cash Flow

Receive kron

Pay kron

Export Goods

Norwegian kron

U.S.A Exporter Ships goods to Oslo

Importer Norway

Off-Shore Bank

In the above structure exporter manages foreign exchange risk (foreign denominated receivables) by hedging the foreign denominated cash flows with foreign denominated debt secured in offshore bank using the receivables as collateral.

Parallel Loans

$152 million £100 million

Direct loan Periodic Interest Return of the Principal

MMM U.S.A Parent

Allied Lyon Subsidiary in

New York

MMM Subsidiary in

London

Allied Lyon U.K

Parent Indirect Financing

Indirect Financing

Parallel loans as portfolio of two forward foreign denominated debts, creates synthetic interest rate swaps. Minnesota Mining and Manufacturing borrows dollar in the US capital market and funnels the fund to the subsidiary of Allied Lyon in New York. Allied Lyon does the same thing using its high credit rating by borrowing the pound in UK capital market and passing the fund to MMM subsidiary in London.

Back to Back Loans

$ 6.5% $ £ £

Principal

U.S.A Capital Market

UK Capital Market

MMM U.S.A

Allied Lyons U.K

$

£ £

LIBOR+1 £

$ 6.5%

Principal Borrowed Periodic interest Return of the Principal