currency risk: the measurement of corporate exposure prof. ian giddy new york university

Currency Risk:The Measurement of Corporate

Exposure

Prof. Ian Giddy

New York University

Copyright ©2000 Ian H. Giddy Corporate Exposure 2

Measuring and Managing Exposure

Transactions exposureCase study: “G.E.’s Yen Payables” Translation exposure Economic exposureCase study; “U.S. Semiconductor”

Transactions

Exposure

Transactions

Exposure

Translation

Exposure

Translation

ExposureEconomic

Exposure

Economic

Exposure


Transactions Exposure

Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date

Example: If Intel invoices a German company in Deutsche marks for a semiconductor shipment then the firm has German mark exposure and can hedge this by borrowing marks.

This kind of exposure is readily hedgable using forwards, futures or debt


Exchange Rate Risk: Transactions

Transactions exposure arises when a company must pay or receive a foreign currency at an unknown future exchange rate

It is contractual It affects the income statement It can often be hedged directly using

forwards, futures or currency options


Transactions Exposure: Hedging

Reeves International (CT) has a subsidiary in Italy. It makes printing blankets for sale in Europe.

Reeves Italy has to pay a dividend of approximately ITL 24 m. in December. How should Reeves hedge this?Forwards?Futures?Money market hedge?Do nothing?


Hedging Transactions Exposure

Types of exposure One-shot exposure Hedging approaches:

OpenForwardMoney marketFuturesOptions

Ongoing transactions exposure


International Profits

Covered under FASB No. 52 which requires only certain transactional gains or losses to be reflected in the income statement.

Income statement risk is dependent upon exchange rate fluctuations.

In general, if a subsidiary has a positive income flow, the income statement risk will be positive.


Recognition of Exchange Gains & Losses

Exchange Gain/Loss

Transaction Gain/Loss Translation Gain/Loss

Trans-actionDate

FinancialStatement

Date

Settlementdate

FinancialStatement

Date

FinancialSatement

date

Translation

Transaction


Linkages Between Interest Rates

Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Unbiased

forward rate

Uncovered interest

rate parity


Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium

Money Market Hedge(Borrow to matchassets)

Interest ratedifferential

Do nothing Expected rate ofchange ofexchange rate


GE’s Yen Payables

VCRs imported

Yen due in 90 days


GE’s Yen Payables

Yen: Spot 250 Forward 246

(6.5% premium) US$ Debt 15.5%, Yen interest 9.0%

Yen: Spot 250 Forward 246

(6.5% premium) US$ Debt 15.5%, Yen interest 9.0%

VCRs

Yen


What Happens to GE If ¥ Rises?

If US VCR prices are fixed: GE is exposed. Hedging is safer.

If US VCR prices are flexible, and obey PPP, then GE is not exposed, and it would be risky to hedge!

If US VCR prices are fixed: GE is exposed. Hedging is safer.

If US VCR prices are flexible, and obey PPP, then GE is not exposed, and it would be risky to hedge!

VCRs

Yen


The Exposure Triangle

Transactions

Exposure

Transactions

Exposure

Translation

Exposure

Translation

ExposureEconomic

Exposure

Economic

Exposure


Balance Sheet Exposure

Balance sheet exposure (or translation or accounting exposure) results from the way accounting conventions dictate that a company’s foreign assets and liabilities should be booked.

Example: If Intel’s assets in Ireland are regarded as denominated in Irish punts, then the subsidiary’s accounting value is exposed to the punt and the firm may wish to hedge this exposure by financing in punts.


Exchange Rate Risk: Translation

Translation exposure arises when a company has assets and/or liabilities in a foreign currency, which must be translated at an unknown future exchange rate

It affects the balance sheetIt can be hedged using forwards, futures or

currency swapsBut translation exposure can mislead!


Stora in Australia

Assets Cash Accounts receivable Inventory Property, plant and

equipment

Liabilities Accounts payable Bank debt Bonds issued Equity (owned by

parent company in Sweden)

Net translation exposure = Value of foreign currency assets - Value of foreign currency liabilities.


Translation of Individual Accounts

For US companies, governed by FASB No. 52 which specifies the current rate method

First, each entity's balance sheet and income statement are measured in terms of their Functional Currency, which is the currency of the economic environment in which the entity primarily operates and maintains records

Next, the functional-currency-denominated financial statements are translated into the parent's currency using the All-Current-Rate Method, which reports balance sheet items at the closing rate and income statement items at their average rates.


Key Features of FAS 52

Objective of translation: Local subsidiary perspective (preserve foreign currency financial results and relationships in consolidated statements)

Functional currency: Primary currency of economic environment in which foreign entity operates

Translation method: If functional currency is US$: Temporal method If functional currency is foreign currency: Current rate method

Transaction gains & losses: Recognized in current income except those on intercompany transactions of long-term nature

Translation gains & losses: Recognized in separate owners' equity account.


Sweden Down Under

Stora, the Swedish pulp & paper company, has a plant in Melbourne, and sells in Australian dollars

But newsprint is a world-wide, dollar-traded commodity

So the revenues are effectively in dollars, not Ozzies.


Stora in Australia: What’s Exposed?

Assets A$ Cash Accounts receivable Inventory Property, plant and

equipment

Liabilities A$ Accounts payable A$ Bank debt A$ Bonds issued Equity (owned by

parent company in Sweden)

Net translation exposure = Value of foreign currency assets - Value of foreign currency liabilities.


Criteria Favoring Local Currency As Functional Currency

Cash flows Mainly in local currency and do notimpact parent's cash flows

Sales price Irresponsive to exchange ratechanges and governed by localcompetition

Sales market Largely in host country anddenominated in local currency

Expenses Incurred primarily in localenvironment

Financing Primarily local currency financing

Intercompanytransactions

Neither frequent nor extensive


S t=1-St = I-I*

St 1+I*

JAPAN 1995

MEXICO 1994

EXCHANGE-RATE

CHANGE

RELATIVE

INFLATION

Purchasing Power Parity:Theory and Evidence


Case Study: Arauco’s 1993 Forex Loss

ARAUCO

Net income($m)

Price-levelrestatement

19921st Q

37.6 9.2

19931st Q

(4.1) (54.4)


Case Study: Arauco’s 1993 Forex Loss

ARAUCO

Net income($m)

Price-levelrestatement UF US$

19921st Q

37.6 9.2 2.2% -6.5%

19931st Q

(4.1) (54.4) 1.0% +4.9%


Foreign Currency Translation

AllCurrent

AssetsCashA/RInventoryFixed assets

CCCC

LiabilitiesShort-term DebtLong-term Debt

CC

Equity Residual



AllCurrent

Current/Non-

currentAssetsCashA/RInventoryFixed assets

CCCC

CCCH


CC

CH

Equity Residual Residual



AllCurrent

Current/Non-

current

Monetary/Non-

monetaryAssetsCashA/RInventoryFixed assets

CCCC

CCCH

CCHH


CC

CH

CC

Equity Residual Residual Residual


Balance SheetItem Prices

ExchangeRates

NetEffect

1. Fixed Assets

2. Inventories

3. Monetary Items

Exposed or Not Exposed?


Currency Risk: Economic Exposure

Change in the economic value of the firm resulting from unanticipated exchange rate changes.

Booked vs. anticipated transactions Expected vs. unexpected changes; the "cost

of hedging" Exposure and the parity assumptions: "We

are not exposed in the long run" Currency of denomination vs currency of

determination; compet., elasticities, etc.


Economic Exposure

Economic exposure is how the firm’s revenues and costs will respond to exchange rate changes. Example: Even though Intel invoices German customers

in marks, its future revenues may be unaffected by fluctuations in the mark if the currency of determination of prices in the semiconductor business is the dollar or even the yen.

The currency of determination is the currency in which most of the competition prices similar products. Example: General Electric’s Yen Payables


Operational Aspects of Exchange Risk

1.VOLUME EFFECTS (compensate for changes in profit margins)

2.PRICING FLEXIBILITY (change in margins to offset effect of exchange rate change)

3.DIVERSIFICATION of markets for inputs and outputs

4.FLEXIBILITY (ability to shift markets and sources quickly)


Translation vs Economic Exposure

Accounting exposure Exposure = "Exposed" assets - "exposed"

liabilities

Economic exposure Exposure = How will an unanticipated exchange

rate change affect the cash flows of the firm? Domestic sales Exports Domestic costs Import costs


A Realistic Approach

Banks versus corporations: To the extent that the firm is like a bank, do bank-style hedging. Match financial assets with liabilities of the same kind.

Seek to identify economic exposure using product cost-and-market analysis, industry competitive analysis, or statistical analysis on the sensitivity of the company’s value to exchange rate changes.

Hedge economic exposure using debt/swaps for long term exposure, short term instruments for uncertain exposure, and options for disaster insurance


Case Study: US Semiconductor

CHIPS

US DOLLARS


Case Study: US Semiconductor

The transactions: a cost comparison Translation of assets and liabilities The economic risks


US Semiconductor: The Transaction

USD interest rate: 8% GBP interest rate: 12% Spot dollar/pound: 2.40 5-yr forward $/pound: 1.97

Diff, % per annum: -3.87%

Borrow GBP & hedge: 12%-3.6%=8.13%


US Semiconductor:Translation Exposure

CURR/NONCURR

MON/NONMON (FAS 8)

TEMPORAL(FAS 52)

A/R

CHIPS $

YELLOWTRUCKS

$ $

WAREHOUSE $ $


US Semiconductor: Economic Exposure

LAND WAREHOUSE TRUCKS

CHIPS

SOLD IN UK

INVOICED IN GBP GBP?




CHIPS

SOLD IN UK

INVOICED IN GBP

SOLD IN

WORLDWIDE MARKET

GBP?

USD?




CHIPS

SOLD IN UK

INVOICED IN GBP

SOLD IN

WORLDWIDE MARKET

DETERMINED BY

COMPETITION

GBP?

USD?

JPY?


Summary: Types of Exposure

Transactions

Exposure

Transactions

Exposure

Translation

Exposure

Translation

ExposureEconomic

Exposure

Economic

Exposure


Which Instrument?

Identifiableexposure

Debt, swaps,forward contracts

Uncertain exposure Instruments withflexibility, such asforwards and futures

Exposure thatthreatens financialdistress

Deep-out-of-the-money options


UNDERSTANDING THE EXCHANGE

RISK MANAGEMENT PROBLEM Value of hedging Goals Nature of the business

UNDERSTANDING THE EXCHANGE

RISK MANAGEMENT PROBLEM Value of hedging Goals Nature of the business

MEASUREMENT OF EXPOSUREMEASUREMENT OF EXPOSURE

ACCOUNTINGACCOUNTING TRANSACTIONTRANSACTION ECONOMICECONOMIC

NATURE OF THE CASH FLOW EXPOSURE: One-shot? Linear? Contingent on exchange rates? Contingent on other events?

NATURE OF THE CASH FLOW EXPOSURE: One-shot? Linear? Contingent on exchange rates? Contingent on other events?

HEDGING METHODSHEDGING METHODS

OPERATIONALOPERATIONAL FINANCIALFINANCIAL

Linear Forwards Futures Debt Currency swaps

Linear Forwards Futures Debt Currency swaps

Exchange-rate

contingent Options Debt with option

features

Exchange-rate

contingent Options Debt with option

features

Contingent on

other events Event options Probability-based

hedging

Contingent on

other events Event options Probability-based

hedging

Examples: Sourcing flexibility Pricing strategy Market

diversification

Examples: Sourcing flexibility Pricing strategy Market

diversification

A Corporate Foreign Exchange Roadmap


Local Exposure

currency risk: the measurement of corporate exposure prof. ian giddy new york university

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