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TOPIC 6: FX Exposure & Management(Shapiro, Chapter 10 & 11)

Foreign exchange exposure is the degree towhich a company is affected by exchangerate changes.

Measures of Foreign Exchange Exposure:TYPES (shapiro page 355-357)

1. Accounting Exposure (or translation

exposure): arises when reporting andconsolidating financial statementsrequire conversion from subsidiary to parent

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2. Economic Exposure: arises becauseexchange rate changes alter the value offuture revenues and costs(operating exposure).

Economic Exposure = Transaction Exposure +Operating Exposure

- Transaction exposure is the sensitivity of thefirms contractual transactions in foreigncurrencies to exchange rate changes.

- Operation exposure measures the degree towhich an exchange rate change, in combinationwith price changes, will alter a companys futureoperating cash flows.

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How Accounting Exposure Arises Accounting exposure is the change in the value of a

firms foreign -currency-denominated accounts dueto a change in exchange rates

Translation Risk

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SubsidiaryFinancials

Subsidiary Financials

SubsidiaryFinancials

Headquarters Consolidated

Financials

A$

A$ A$

US$

Japan United States

Germany

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Accounting vs Economic ExposureMeasurement of exchange rate risk indicatesmajor difference exists:

A. Accounting exposurereflects past decisions of the firm.

B. Economic exposure1. Focuses on future impact ofexchange rate changes.

2. Not all future cash flows appear onthe firms balance sheet.

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Example: Suppose on Jan 1, American Golfssubsidiary in France showed:

Current assets of EUR1 million;Current liabilities of EUR300,000;Total assets = EUR2.5 million;

Total liabilities = EUR900,000Exchange rate on Jan 01 = $0.1270on Dec 31= $0.1180

What is the exposure if the EUR is the functionalcurrency?Functional currency is the currency of the primary

economic environment in which the affiliategenerates and expends cash. 5

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All assets & liabilities translated at currentrate.

At beginning of the year:EUR2500000 - EUR900000 = EUR16000001600000 x $0.1270 = $203200

At the end of the year:1600000 x $0.1180 = $188800

This involves a translation loss of:$188,800 - $203,200 = -$14,400

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Managing Translation & TransactionExposure:

DESIGNING A HEDGING STRATEGY A. Strategies: a management objectiveB. Hedgings basic objective:

to reduce/eliminate volatility of earningsas a result of exchange rate changes.

C. Hedging exchange rate risk

1. Incurs a cost2. Should be evaluated as a purchase of

insurance.

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MANAGING OPERATING EXPOSURE

METHODS OF HEDGING

A. Risk shiftingB. Currency risk sharing

C. Currency collarsD. Cross-hedgingE. Exposure netting

F. Forward market hedge or moneymarket hedge (MMH)

G. Foreign currency options8

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2. Firm would convert its foreigncurrency denominated receivables at

the zone forward rate.

D. CROSS-HEDGING1. Often forward contracts not available

in a certain currency.2. Solution: a cross-hedge

- a forward contract in a related

currency.3. Correlation between 2 currencies iscritical to success of this hedge.

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E. EXPOSURE NETTING1. Protection can be gained by selecting

currencies that minimize exposure2. Netting: MNC chooses currencies that

are not perfectly positively correlated.3. Exposure in one currency can be

offset by the exposure in another.F.Forward market hedge or money market

hedge. An alternative to forward hedge ismoney market hedge which is the use ofsimultaneous borrowing and lendingtransactions in two different currencies to lockin the home currency value of a foreigncurrency transaction.

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Money Market Hedge (MMH)

(a) To hedge export receivable in USD(i) borrow the present value of USD(ii) convert the USD to AUD in spot

market (this allows you to know howmuch AUD you will get for thereceivable, therefore hedged)

(iii) The future value of this AUD isequivalent to the USD receivable, animplied forward rate is obtained.

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(b) To hedge import payable in USD

(i) borrow AUD (pay AUD interest rate)(ii) convert the AUD in spot to USD(iii) invest the USD to earn USD

interest. This will give sufficientUSD later to make payment for thepayable.

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Example: Import payables: EUR1 million due in oneyear. 1-year interest rates for Australian dollar andeuro are 5.5% and 2%, spot exchange rate isEUR0.5854/AUD.

MMH: First, calculate the present value of EUR1million which equals 1m/1.02 = EUR0.980392m.

Second, calculate the equivalent in AUD, ie.,0.980392/0.5854 = AUD1.6747389m. Therefore,to conduct a money market hedge, one wouldborrow AUD1.6747389 and convert it to EUR at0.5854 and then invest the EUR at 2% pa for oneyear. In one year it will accumulate to EUR1 million,sufficient to pay off the debt:

1.6747389(0.5854)(1.02) = EUR1 million 16

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In the MMH above, the one year future valueof AUD1.6747389 million = 1.6747389(1.055)

= AUD1.7668495 million, is equivalent toEUR1 million payable. Therefore, theimplied forward rate is 1/1.7668495 =EUR0.5660/AUD.

If interest rate parity holds, there is nodifference between forward hedge and

money market hedge.

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3. Exposure nettinga. Offsetting exposures in one

currency with exposures in thesame or another currency

b. Gains and losses on the two currencypositions will offset each other.

B.Basic hedging strategy for reducingtranslation exposure:1. Increasing hard-currency (likely to

appreciate) assets.2. Decreasing soft-currency (likely to

depreciate) assets.3. Decreasing hard-currency liabilities.4. Increasing soft-currency liabilities.

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FOREIGN EXCHANGE RISK A. Economic exposure focuses on the

impact of currency fluctuations onfirms value. 1. The most important aspect of foreign

exchange risk management:Incorporate expectations about therisk into all basic decisions of the firm.

2. Definition: Economic exposure =

Transaction exposure + Operatingexposure: arises because currencyfluctuations alter a companys futurerevenues and expenses.

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To measure operating exposure requires alonger-term perspective. i.e., cost and pricecompetitiveness could be affected byexchange rate changes

Operating Exposure begins the moment afirm starts to invest in a market subject toforeign competition or in sourcing goods orinputs abroad.

B. Real Exchange Rates Changes & Risk:Real exchange rate is nominal exchangerate adjusted for price changes.

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C. Implications:1. If nominal rates change with an equal

price change, no alteration to cashflows.

2. If real rates change, it causes relativeprice changes and changes inpurchasing power.

A decline in the real value of a currency makesexports and import-competing goods morecompetitive.

An appreciating currency makes imports andexport-competing goods more competitive.

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During an appreciation of home currencyexporters face two choices: Keep pricesconstant (but lose sales) or adjust prices toforeign currency to maintain market share(lose profits).

SUMMARY:(a) The economic impact of a currency

change depends on the offset by thedifference in inflation rates or the

change in real exchange rates.(b) It is the relative price changes that

ultimately determine a firms long -runexposure.

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ECONOMIC CONSEQUENCES

The impact on operating exposure of a realrate change depends upon pricing flexibilityand

1. Price elasticity of demand2. Degree of product differentiation

3. The ability to shift productionand the substitution of inputs

MANAGING OPERATING EXPOSURE

Operating exposure management requireslong-term operating adjustments and theinvolvement of all departments.

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A. Provide the local manager with forecasts ofinflation and exchange-rate changes.

B. Identify and focus on competitive exposure.C. Design the evaluation criteria so that

operating managers neither rewarded or

penalized for unexpected exchange-ratechanges.

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