Management and Control

of

Foreign Exchange Risk

Management and Control

of

Foreign Exchange Risk

Laurent L. Jacque

The Fletcher School of Law and Diplomacy, Tufts University (USA)

and

HEC School of Management (France)

Kluwer Academic Publishers Boston, Dordrecht, London

Distributors for North America: Kluwer Academic Publishers 101 Philip Drive Assinippi Park Norwell, Massachusetts 02061 USA

Distributors for all other countries: Kluwer Academic Publishers Group Distribution Centre Post Office Box 322 3300 AH Dordrecht, THE NETHERLANDS

Library of Congress Cataloging-in-Publication Data

Jacque, Laurent L. Management and control of foreign exchange risk / by Laurent L.

Jacque. p. cm.

Includes bibliographical references and index. Rev. ed. of: Management of foreign exchange risk. c1978.

ISBN-13: 978-0-7923-8088-7 DOl: 10.1007/978-94-009-1806-1

e-ISBN-13: 978-94-009-1806-1

1. Foreign exchange futures. 2. Foreign exchange rates. I. Jacque, Laurent L. Management of foreign exchange risk. II. Title. HG3853.J33 1996 332.4'5--dc20

Copyright ID 1996 by Kluwer Academic Publishers

Softcover reprint of the hardcover 1 st edition 1996

95-42605 CIP

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo-copying, recording, or otherwise, without the prior written permission of the publisher, Kluwer Academic Publishers, 101 Philip Drive, Assinippi Park, Norwell, Massachusetts 02061.

Printed on acid-free paper.

Ce livre est dedie a ma mere, Fran90ise Bril Jacque.

TABLE OF CONTENTS

List of Figures xi List of Tables xiii List of Boxes xv Preface xvii Acknowledgments xvii

Introduction xix Defining Foreign Exchange Risk Management and Its Objectives xx The Case for Foreign Exchange Risk Management xxii Risk Management Model and Book Synopsis xxiii Appendix A: Foreign Exchange Risk Management: What Do Firms

Do? xxvii Selected Bibliography xxviii

Chapter 1 Determination of Spot Exchange Rates 1 I. Some First Principles 3 II. Floating Exchange Rates 8 III. Stabilized Exchange Rates 14 IV. Controlled Exchange Rates 26 Summary and Conclusions 30 Annotated Bibliography 32 Problems 34 Case Study 1.1: Hippocrates Inc. 36

Chapter 2 Determination of Forward Exchange Rates 41 I. Forward Exchange Contracts 41 II. Interest Rate Parity Theorem 44 III. Modern Theory 57 Summary and Conclusions 65 Selected Bibliography 66 Problems 67 Case Study 2.1: Bookwell's Financing Choices 70

Chapter 3 Currency Futures, Options, Derivatives, and Swaps 73 I. Currency Futures 73 II. Currency Options 74 III. Derivatives and Zero-Premia Options 86 IV. Currency Swaps 88 Summary and Conclusions 95 Selected Bibliography 96 Problems 96 Case Study 3.1: Daewoo's Unorthodox Funding Strategy 97 Case Study 3.2: Intercomex: Exchange Risk in Coffee Trading 104

viii The Management and Control of Foreign Exchange Risk

Chapter 4 Forecasting Floating Exchange Rates 107 I. Market-Based Forecasts 107 II. Model-Based Forecasts: Technical vs. Econometric Modeling

Approaches 117 Summary and Conclusions 126 Selected Bibliography 127 Problems 128

Chapter 5 Forecasting Pegged Yet Adjustable Exchange Rates 129 I. Step 1: Assessing the Balance of Payments Outlook 131 II. Step 2: Measuring the Magnitude of Required Adjustment 140 III. Step 3: Timing Adjustment Policies 142 IV. Step 4: Anticipating the Nature of Adjustment Policies 143 Summary and Conclusions 145 Appendix 5.A: The Purchasing Power Parity Hypothesis 146 Selected Bibliography 153 Problems 154 Case Study 5.1: Morris De Minas 154

Chapter 6 Accounting Exposure to Foreign Exchange Risk 169 I. Transaction Exposure 170 II. Translation Exposure 179 Summary and Conclusions 193 Selected Bibliography 193 Problems 194

Chapter 7 Economic Exposure to Foreign Exchange Risk 197 I. A Taxonomy of Economic Exposures 198 II. Inflation and Profitability 201 III. Devaluation and Profitability 212 IV. Towards an Operational Measure of Economic Exposure 220 Summary and Conclusions 225 Annotated Bibliography 225 Problems 226 Case Study 7.1: Euclides Engineering, Ltd. 227 Case Study 7.2: British Materials Corporation 230

Chapter 8 Exchange Risks in International Trade 237 I. The Mechanics of Hedging Transaction Exposures 237 II. Eliminating Foreign Exchange Risk in Long-term Contracts 245 III. Exchange Risk in International Bidding 252 IV. The Optimal Hedging Decision 256 Summary and Conclusions 260

Table of Contents ix

Appendix 8.A: An Introduction to the Theory of Expected Utility for Foreign Exchange Risk Management 261

Selected Bibliography 263 Problems 265 Case Study 8.1: Whirlpool Appliances, Inc. 267

Chapter 9 Optimal Currency Denomination in Long-Term Debt Financing 273 I. Expected Cost of Foreign Currency Financing 274 II. Risk-adjusted Cost of Foreign Debt Financing 280 Summary and Conclusions 289 Selected Bibliography 290 Problems 291 Case Study 9.1: BC Hydro 293

Chapter 10 Hedging Translation Exposure 299 I. The Mechanics of Contractual Hedging 300 II. The Mechanics of Financial Hedging 308 III. Hedging in a Multicurrency World: A Risk-Preference

Framework 313 Summary and Conclusions 320 Selected Bibliography 320 Problems 321 Case Study 10.1: Gillette International Finance 323

Chapter 11 Exchange Rates and the International Control Conundrum 333 I. The International Control Conundrum 334 II. Mapping the Currency Space 338 III. Value-Based Contingent Budgeting with Imperfect Currency

Pass Through 342 IV. Estimating Exchange Rate Pass Through 347 Summary and Conclusions 351 Selected Bibliography 352 Case Study 11.1: Multiquimica Do Brasil 353

Index of Authors 361 Index of Subjects 363 Solutions to Selected Problems 367 About the Author 369

List of Figures Figure I.i Omega's pattern of quarterly earnings ............. xxi Figure l.ii Omega's pattern of quarterly earnings with and without

hedging ............................ xxii Figure Liii Foreign Exchange Risk Management model (FERM) .. xxv Figure 1.1 Map of currency relationships . . . . . . . . . . . . . . . . . . . 2 Figure 1.2 Equilibrium exchange rate ..................... 4 Figure 1.3 Shifts in supply and demand curves ................ 9 Figure 1.4 Oscillating exchange rate ...................... 9 Figure 1.5 Modus operandi of central bank intervention . . . . . . . .. 12 Figure 1.6 Taxonomy of central bank intervention strategies . . . . .. 13 Figure 1.7 The gold exchange standard under the Bretton Woods

system .............................. 16 Figure 1.8 Exchange rate remains within tunnel of permissible

fluctuations . . . . . . . . . . . . . . . . . . . . . . . . . .. 17 Figure 1.9 Central bank intervenes at the ceiling exchange rate .... 17 Figure 1.10 Central bank intervenes at the floor exchange rate. . . .. 18 Figure 1.11 ACU pegging vs. free $/DM float. . . . . . . . . . . . . .. 25 Figure 1.12 Sri Lanka's controlled exchange rate . . . . . . . . . . . .. 27 Figure 1.13 Brazil's minidevaluations (1980-1983) ............ 31 Figure 2.1 Covered vs. uncovered foreign investment .......... 47 Figure 2.2 The Interest Rate Parity theory ................. 50 Figure 2.3 Interest rate arbitrage with bid-asked spreads ........ 56 Figure 2.4 Arbitragers' schedule ....................... 59 Figure 2.5 Speculators' schedule ....................... 62 Figure 2.6 Equilibrium forward exchange rate . . . . . . . . . . . . . .. 65 Figure 3.1 Call option .............................. 78 Figure 3.2 Put option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 79 Figure 3.3 Writing a covered call option. . . . . . . . . . . . . . . . . .. 80 Figure 3.4 Buying a straddle .......................... 81 Figure 3.5 International put-call parity. . . . . . . . . . . . . . . . . . .. 83 Figure 3.6 Value of a sterling call option prior to maturity . . . . . .. 85 Figure 3.7 Forward range agreement . . . . . . . . . . . . . . . . . . . .. 87 Figure 3.8 Payoff profile of a forward participation agreement .... 89 Figure 3.9 Initial exchange of principal at inception of swap . . . . .. 93 Figure 3.10 Stream of annual interest payments by each party over the

life of the swap ........................ 94 Figure 3.11 Reexchange of principal at maturity of swap ........ 94 Figure 4.1 Forward rates as unbiased predictors . . . . . . . . . . . .. 115 Figure 4.2 French Franc spot and 90-day lagged forward exchange

rates .............................. 116 Figure 4.3 Technical Forecasting ...................... 119 Figure 4.4 Head and shoulder reversal pattern . . . . . . . . . . . . .. 120 Figure 4.5 Chartism .............................. 121 Figure 5.1 Mapping "pegged yet adjustable exchange rates" ..... 130 Figure 5.2 DM/US$ nominal and PPP exchange rates, 1960-1995 . 152 Figure 6.1 Translating inventory accounts. . . . . . . . . . . . . . . .. 191 Figure 7.1 Classification of Omega's output markets. . . . . . . . .. 199

xii The Management and Control of Foreign Exchange Risk

Figure 7.2 Classification of Omega's input markets. . . . . . . . . .. 200 Figure 7.3 Comparative economic exposure analysis . . . . . . . . .. 202 Figure 8.1 Risk proflle of covered vs. uncovered exports . . . . . .. 241 Figure 8.2 Hedging proflles as a function of the exercise price

continuum. . . . . . . . . . . . . . . . . . . . . . . . . .. 243 Figure 8.3 Hedging with currency options vs. a forward

participation contract . . . . . . . . . . . . . . . . . . .. 245 Figure 8.4 Split currency invoicing . . . . . . . . . . . . . . . . . . . .. 251 Figure 8.5 "Time is of the essence" in international bidding . . . .. 253 Figure 8.6 Risk proflle curve. . . . . . . . . . . . . . . . . . . . . . . .. 259 Figure 9.1 (A) Break-even risk-aversion level with higher variance

of exchange rates. (B) Break-even risk-aversion level with higher covariance between domestic revenues and exchange rates. . . . . . . . . . . . . . . . . . . . .. 284

Figure 10.1 Net hedging gain (loss) function under the contractual approach ........................... 303

Figure 10.2 Translation hedging with currency options ........ 305 Figure 10.3 Black & Decker's translation exposure paranoia. . . .. 308 Figure 10.4 Hedging percentage p as a function of level of risk

aversion (r) . . . . . . . . . . . . . . . . . . . . . . . . .. 318 Figure 10.5 Risk-adjusted cost of hedging as a function of level of

risk aversion . . . . . . . . . . . . . . . . . . . . . . . " 319 Figure 11.1 Mapping the currency space ................. 340 Figure 11.2 Taxonomy of economic exposure for foreign subsidiary i 343

List of Tables Table 1.1 French Franc and Deutsche Mark Intervention Points . . .. 20 Table 1.2 What Is an ECU and How Much Is It Worth in Dollars? .. 21 Table 1.3 Multiple Exchange Rates Classification ........... " 29 Table 1.4 Pakistani Advanced Deposit Rate System . . . . . . . . . . .. 35 Table 3.1 Futures vs. Forward Contracts .................. 75 Table 3.2 NSP and KLM's Respective Cost of Debt Before and (After)

the Currency Swap (Percent per Annum) ... . . . .. 92 Table 3.3 NSP/KLM Currency Swap. . . . . . . . . . . . . . . . . . . .. 92 Table 4.1 Forecast Summary (LIT/LCU) .... . . . . . . . . . . . .. 128 Table 5.1 The Hamburger Standard . . . . . . . . . . . . . . . . . . . .. 135 Table 5.2 Index of Export Concentration for Less-Developed

Countries, 1991 ....................... 139 Table 5.3 Consumer Prices and Exchange Rates in the United States

and the Philippines, 1990-1994 ............. 150 Table 6.1 Recapitulation of Transaction Exchange Gain or Loss . .. 172 Table 6.2 Matrix of Transaction exposures ................ 173 Table 6.3 Matrix of Maturity-t Specific Asset and Liability Exposures 174 Table 6.4 Matrix of Aftertax Net Transaction Exposures ....... 177 Table 6.5 "Exposed" versus "Unexposed" Segmentation of Foreign

Subsidiaries' Balance Sheet Items . . . . . . . . . . .. 185 Table 6.6 Net Exposures Under Alternative Translation Methods .. 188 Table 6.7 Balance Sheet of Archimedes SA, December 31, 1994 (in

Thousands of Pesos) .................... 195 Table 7.1 Taxonomy of Economic Exposures .............. 201 Table 7.2 Textron's Cash Flow Adjustments to the Inflation/Deflation

Cycle .............................. 221 Table 7.3 Measurements of Exposures to Interest Rate, Foreign

Exchange Rates, and Oil Prices ............. 224 Table 8.1 Forward Participation Contracts ................ 244 Table 8.2 Hedging with Currency Options and Forward

Participation Agreements ................. 244 Table 8.3 Currency Swaps as a Long-Term Hedge . . . . . . . . . .. 246 Table 8.4 Put and Call Option Premia ... . . . . . . . . . . . . . . .. 268 Table 10.1 Balance Sheet of French Subsidiary of Pax Americana in

FF (December 31, 1995) ................. 311 Table 10.2 Pro-Forma Balance Sheet of Iberica Ltd. As of December

31, 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . .. 321 Table 10.3 Pro-Forma Balance Sheet of Archimedes SA As of

December 31, 1994 . . . . . . . . . . . . . . . . . . . .. 322 Table 11.1 Asymmetry in Currency Pass-Through for

Differentiated Consumer Durables ........... 350

List of Boxes Box I.i A Management Guru's View of Foreign Exchange Risk

Management . . . . . . . . . . . . . . . . . . . . . . . . .. xx Box 1.1 The Foreign Exchange Market .................... 6 Box 1.2 The Bretton Woods System (1944-1971) . . . . . . . . . . . .. 15 Box 1.3 The European Currency Unit and European Monetary Union 19 Box 2.1 Forward Foreign Exchange Markets in Less Developed

Countries (LDCs) . . . . . . . . . . . . . . . . . . . . . .. 51 Box 2.2 Central Bank Intervention by Proxy ................ 64 Box 3.1 Enterprise Oil's $26 Million for a Dollar Call Option . . . .. 76 Box 3.2 Allied Lyons' Deadly Game ..................... 82 Box 3.3 Lexicon for Non-standard Hedge Instruments .......... 90 Box 4.1 On Currency Overshooting .................... , 111 Box 4.2 How Forecasting Prowess Helps Ingersoll-Rand Control a

$2 Billion Portfolio of Currency Exposures . . . . .. 122 Box 5.1 Big MacCurrencies ......................... 134 Box 6.1 Transaction Exposure in the Trading Room: Citibank Forex

Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . .. 172 Box 6.2 Medtronic Centralizes Exposure to Make Banks Take Notice 176 Box 7.1 Rolls-Royce's Global Economic Exposure ........... 203 Box 8.2 Lufthansa's Unfriendly Foreign Exchange Skies ....... 242 Box 8.3 Walt Disney's Yen-Phobia . . . . . . . . . . . . . . . . . . . .. 249 Box 8.4 The SCOUT (Shared Currency Option Under Tender) ... 254 Box 9.1 International Capital Market Segmentation: Arbitraging the

Onshore/ Offshore Eurobond Market. . . . . . . . .. 274 Box 9.2 The IBM-World Bank Currency Swap ............. 279 Box 9.3 Laker Airways Crashes into Bankruptcy ............ 281 Box 10.1 Black & Decker's Translation Exposure Paranoia ..... 306 Box 10.2 Gillette Purchases "Umbrella" Protection with Average

Spot Rate Options and Basket Options . . . . . . . .. 314 Box 11.1 Levi's Performance Evaluation ................. 336

PREFACE

Since I first published Management of Foreign Exchange Risk (Lexington Books, 1978), financial innovation-spurred, in part, by exploding volatility in currency prices-has revolutionized the theory and praxis of foreign exchange risk management. Old-fashioned forward contracts have surrendered market share to currency swaps and options as well as to their perpetually multiplying derivatives. Interestingly, forex derivatives now provide a low cost and highly efficient method of transferring risk from the firms that are exposed to risk but which would rather not be (i.e., risk-hedgers) to those which are not exposed but which-in exchange for a fee-would assume some exposure to risk (i.e., risk­bearers). Perhaps more importantly, foreign exchange risk management, which was once a fairly mechanical task confmed to the international treasury function, is now permeating global strategic management. Indeed, since the demise of the Bretton Woods system of pegged exchange rates, the cost of forex hedging instruments has fallen so dramatically that firms can readily avail themselves of hedging products which can reduce unwanted risk, thereby potentially gaining a competitive advantage over rivals that do not. Management and Control of Foreign Exchange Risk has grown out of a fundamental revision of my earlier work published almost 20 years ago. In the process, my thinking about risk and its mathematics has greatly benefitted from my association with John Cozzolino and Charles Tapiero. This volume hopefully captures the excitement, complexity and sophistication of risk management as it pertains to foreign exchange while differentiating itself from its many competitors.

Acknowledgments Over the years, consulting projects and discussions with many savvy

executives have helped me challenge received wisdom in the area of foreign exchange risk management: for their insight this book is a better one. Most notably, I wish to thank several individuals: Y. D. Ahn (Daewoo), P. Alexander (Bunge y Born), G. Byker (Offshore Energy), A. Chintakananda (Stock Exchange of Thailand), C. Jotishkatira (Siam Commercial Bank), G. Ehrensperger (Garantia), J. Francis (Wharton Econometrics Forecasting Associates), V. Mareuse (Andre et Cie), D. Narayana (Norwest Bank), L. Polsky (Bankers Trust), J. D'Oliveira (Braesilinterpart), and J. Sroka (British Petroleum).

I am grateful to several authors for allowing me to reprint one of their case studies in this volume: Y.D. Ahn (Daewoo), E. Barrett (Thunderbird), W. Davidson (University of Southern California), I. Giddy (New York University), M. Moffet (Thunderbird), and A. Shapiro (University of Southern California).

Challenging questions and insightful comments from students and executives at the Wharton School (University of Pennsylvania), Carlson School (University of Minnesota), HEC School of Management (France), Chulalongkorn University (Thailand). and, since 1993, the Fletcher School of Law and Diplomacy (and sometimes Commerce) led me to make numerous revisions. I am also indebted to several students who selflessly read and edited numerous versions of the manuscript and wish to express my appreciation to Ph. Aquilino, Erin Conaton, Maria Lopez, C. Schmidt, and P. Vaaler Esq. Last but not least, the author is

xviii The Management and Control of Foreign Exchange Risk

indebted to J. Ari Day who never defaulted on a forward contract (whose floating-at times sinking-maturity raised interesting valuation questions) and who masterminded the entire production of this volume.

Yet, with so much help from so many, I am still searching for the ultimate hedge which would shield me from any remaining errors: but this is not escape, they are entirely mine!

L.LJ. Winchester, Massachusetts March 1996

INTRODUCTION

It is part of wise men to preserve themselves today for tomorrow, and risk all in one day.

Cervantes

The ever-increasing integration of the international economy coupled with the heightened volatility of foreign exchange rates has elevated managing currency risk from a tactical, functional assignment to a cross-functional and truly strategic management responsibility. Indeed, since the demise of the Bretton Woods system of quasi-fixed exchange rates in 1973, the international monetary system has experienced exploding exchange rate volatility coupled with periods of prolonged over or undershooting of currency values, which tends to wreak havoc with strategic plans laid on shifting sands. As one author notes allegorically,

in this era of floating exchange rates, no business in the industrial world may consider itself insulated from currency risk. For if business is a war without bullets, then that war is increasingly fought on a floating battlefield. Imagine an army that struggles mightily to take a hill only to find that the hill, overnight, has turned into a valley, and the plain, out of which the enemy had been beaten, is now the high ground. Currency is such a battleground. Every company may be such an army. I

Indeed, managers who continue to ignore foreign exchange risk are a rapidly disappearing species! Simply put, foreign exchange risk management refers to the pro-active management of currency exposures deemed to affect the finn's cash flows and stock price. Thus, its purpose is to increase shareholder value by stabilizing the firm's earnings stream. This book is about foreign exchange risk management, its theory and praxis as understood from a financial, managerial, and strategic perspective. Accordingly, this book develops a risk-management framework and offers a rigorous set of operational guidelines within which forex risk can be (1) consistently hedged both across different risk situations and over time, (2) tightly integrated with other types of financial risk such as interest rate and commodity price risk, and (3) managed consistently with the firm's overall strategic plans so that the financial engineering dimensions of risk hedging are fully integrated with strategic management. (See box I.i for how a management scholar sees foreign exchange risk management-not necessarily this author's

I Millman, Gregory J. The Floating Battlefield: Corporate Strategies in the Currency Wars (New York: AMACOM, 1990), pp. 3-4.

xx The Management and Control of Foreign Exchange Risk

Box I.i A Management Guru's View of Foreign Exchange Risk: Management 1. Exchange rates are inherently WlStable and will remain so. Fixed

exchange rates are not from Genesis. It must be accepted tbat governments mess with exchange rates.

2. Predicting currency rates is a foolish game. Talk and emotions often move exchange rates in unpredictable directions. Imponderables such as these make it dangerous to engage in rale-dependent financial maneuvers. In other words, you had better hedge.

3. Not to bedge is to speculate. Exchange rates are a cost of production that financial executives must manage. A multinational corporation (MNC) with 60 percent foreign sales had better sell forward this year's expected earnings.

4. MNCs must take advantage of global markets. Most MNCs still fmance largely in one country. This is an increasingly dubious lUXUry. Managers should protect earnings by financing capital in the same currency.

S. F.inance managers cannot bl.ame corporate losses on market volatility. The company's business is not finance but making widgets. In the next violent currency fluctuation-and it will occur during the bu iness life of everyone working today-many managers will find that corporate profits are down, say, 40 percent owing to foreign exchange. This will not be accepted and the company will say, "You are paid to protect us from thaI. "

Excerpted from: Keynote Address, Peter Drucker, Chief Financial Officers Conference, sponsored. by Business International, San Francisco. 1990. Reprinted with permission.

view.) Thus, the new imperative for the international treasurer is to involve himself proactively with the strategic planning process so as to recognize early the impact of currency fluctuations on the firm's market share, profit margins, and ultimately valuation-a far cry from hedging yen-denominated account receivables, computing options' premia, or marking-to-market currency swaps. But first, we must define foreign exchange risk and make a case for managing it.

DEFINING FOREIGN EXCHANGE RISK MANAGEMENT AND ITS OBJECTIVES

Risk is at the core of economic activity. Indeed, a firm becomes exposed to various kinds of risk in its quest to create a competitive advantage and ultimately value for its shareholders. However, business risk should be clearly distinguished from fInancial risk (of which foreign exchange risk is a major component), which can be carefully hedged through appropriate market-traded instruments/techniques.

As a first approximation, foreign exchange risk can generally be defmed as the additional variability experienced by a multinational corporation in its worldwide consolidated earnings due to unexpected currency fluctuations. By

Introduction xxi

way of illustration, consider the 1995 earnings performance reported by a large U. S. multinational corporation-call it Omega-under the following three mutually exclusive scenarios (illustrated in figure I.i).

$ Earnings per Share

.52

.51

.50

.49

.48

.47

.46

.45

.44

/ \ / \ /

/ L-______________________ -1 ________________ ~

1 st quarter

2nd quarter

3rd quarter

4th quarter

Situation I: fixed exchange rates

Time

Situation II: floating exchange rates without Exchange Risk Management

Situation III: floating exchange rates with Exchange Risk Management

Figure I.i Omega's pattern of quarterly earnings

Under situation I, characterized by stable exchange rates throughout the 1995 accounting period, Omega reports small but steady increases in earnings per share. Situation II relaxes the assumption of fixed exchange rates-that is, fluctuating exchange rates prevail over the accounting horizon. Omega now exhibits an erratic pattern in quarterly earnings, with attendant exchange gains and losses. Finally, in situation III, Omega is assumed to be conservatively managing its foreign exchange risk exposure, thus reporting a somewhat lower but definitely more stable pattern of quarterly earnings. The considerable earnings variability has been virtually eliminated at a substantial cost, namely the cost of managing foreign exchange risk.

xxii The Management and Control of Foreign Exchange Risk

However, this focus on accounting values is increasingly challenged by a sounder emphasis on economic value derived fromJree cashflows. Exchange risk should then be redefmed as the variance component in the firm's overall cash­flow due to exchange rate volatility. Foreign exchange risk management aims at reducing the volatility of a firm's pretax cash flow and, therefore, its riskiness (illustrated in figure I.ii by the lower variance of the probability distribution of the firm's value). Presumably by stabilizing its cash flows, hedging reduces the firm's cost of capital and enhances its ability to implement strategic plans now predicated on more dependable future cash flows.

Probability

I Bankruptcy-+----~ I

Distribution of net worth without hedging

.... ----- Expected value of the firm

Value of Omega

Distribution of net worth with hedging

Figure I.ii Omega's pattern of quarterly earnings with and without hedging

THE CASE FOR FOREIGN EXCHANGE RISK MANAGEMENT

Hedging foreign exchange risk may, however, be suboptimal from the point of view of a shareholder who, by holding a scientifically diversified portfolio of securities, may be able to layoff this risk more cheaply. After all, shareholders could very well reduce the earnings volatility experienced by Omega (because of foreign exchange gains or losses) by holding part of their portfolio in the stocks of other multinational corporations that do business only in certain foreign countries or by simply investing in foreign stocks. Presumably, these countries should be selected on the basis of the imperfect or negative correlation in their currency movements with the currencies of the countries in which multinational

Introduction xxiii

Omega is operating.2 Srinivasulu and Dufey (1983) argue, however, that because individual investors face exchange controls, high transaction and information costs, the dead-weight cost of financial distress, and agency relationships, multinational corporations can better reduce the burden of such market imperfections and segmentation, since they are superiorly equipped to carry out currency diversification and to assume the responsibility of exchange risk management on behalf of their shareholders. For privately-held firms, whose owners (presumably risk-averse) may hold the bulk of their wealth in their corporate ventures, the case for foreign exchange risk management is even more compelling. Similarly, firms which are highly leveraged will pursue conservative hedging to avoid "surprises" which may push them into bankruptcy.

The benefits of hedging are confirmed by the widespread practice of multinational corporations that selectively manage foreign exchange risk because they presume its benefits outweigh its costs. (See appendix A.) That such costs are justified further presumes that corporate treasurers should be concerned-up to a point-with the smooth period-to-period earnings pattern so cherished by security analysts. A volatile earnings stream can affect a firm's stock price and, in turn, by depressing its price-earnings ratio, reduce its ability to raise funds at a reasonable cost, fend off hostile takeovers, or implement effectively a merger/acquisition strategy through a stock swap. Indeed, the readily established link between the variability of corporate earnings and the value of the firm justifies the allocation of (scarce) cash resources to hedging exchange risk.

RISK MANAGEMENT MODEL AND BOOK SYNOPSIS

Part I of this book lays the foundation of foreign exchange risk management by offering an in-depth discussion of the valuation of spot and forward foreign exchange rates, currency futures and options, swaps, and other forex derivative products. That the need for a comprehensive understanding of the macroeconomic theater within which foreign exchange risk management is played out should be readily apparent to the reader. First, foreign exchange risk

2 Modern capital market theory, which defines foreign exchange risk as the systematic or diversijiable risk associated with a foreign currency denominated revenue (or cost) stream, argues that under certain assumptions of market efficiency, foreign exchange risk management is totally superfluous. In this somewhat hypothetical world, multinational corporation treasurers abdicate the initiative of foreign exchange risk management whose responsibility is fully transferred to the shareholders, who, in turn, will manage the unsystematic portion of exchange risk through efficient portfolio diversification. How to diversify exchange risk effectively at the investor level remains an unanswered question because existing international asset pricing models require satisfaction of a strict set of conditions that are far removed from the multicurrency institutional environment facing international investors (Adler and Dumas, 1984).

xxiv The Management and Control of Foreign Exchange Risk

originates from the volatile spot exchange rate relationship linking different currencies. Chapter I provides an analytical overview of systems of exchange rate determination. Depending on the nature and the degree of central banks' intervention in their foreign exchange market, exchange rates are classified as either floating, stabilized, or controlled. Second, forward contracts are a major instrument of protection against foreign exchange risk. Chapter 2 discusses the determination of forward exchange rates as resulting from the interplay of market participants, namely, interest rate arbitragers, traders, hedgers, and speculators. Chapter 3 introduces in some details the gamut of forex products that have appeared in the last 25 years, namely, currency futures, options, swaps, and derivatives.

Our discussion of foreign exchange risk management then proceeds in the context of the risk management model outlined in figure !.iii. Steps I and 2, the preliminary steps of defining the firm's attitudes toward risk and establishing objectives which are congruent with the firm's risk aversion, are indeed treacherous as they require systematic introspection on the part of the firm's senior managers as well as consistency in dealing with different types of risk whether it is exchange risk, interest rate risk, commodity price risk, or general liability risk.

Part II provides a framework for generating foreign exchange rate forecasts. Chapter 4 explores the perplexing issue of forecasting floating exchange rates: market-based forecasts are contrasted with model-based forecasts as an attempt is made to answer the ever-elusive question: "Can we beat the forex market?" The somewhat different problem of forecasting pegged yet adjustable exchange rates is tackled in chapter 5, where a four-step forecasting framework, based upon the estimation of macroeconomic indicators, is introduced. Our pessimistic conclusion with respect to forecasters' ability to generate reliable forecasts is the very foundation for foreign exchange risk management: to the extent that we cannot forecast exchange rates with great accuracy, it becomes imperative to manage exposure to foreign exchange risk, which requires the firm to take inventory of its exposure to currency risk (step 4).

Assessment of a multinational corporation's exposure to foreign exchange risk is discussed in part III. Chapter 6 offers an accounting answer that distinguishes between transaction and translation exposures. Transaction exposure results from foreign currency-denominated contracts, with a well-defmed maturity, that generally materialize imports, exports, or international financing transactions. By contrast, translation exposures stems from a multinational corporation's practice of consolidating foreign subsidiaries' fmancial statements with those of their parents. Although widely used, this accounting concept of exposure to foreign exchange risk is, by defmition, misleading, since it fails to incorporate the longer-term impact of exchange rate changes on the economic valuation of the multinational corporation. In chapter 7, we sketch the link between the fIrm'S value and exchange rates by tracing the impact of the inflatiOn/devaluation cycle upon the profitability of the subsidiary of an oligopolistic multinational corporation. It is shown that such a subsidiary's

Introduction

Identify firm's attitude toward risk: is management "risk-paranoid" or simply "risk-averse"?

Establish objectives for Foreign Exchange Risk Management (FERM): "Risk-locking vs. Risk­smoothing vs. Risk-taking" and define appropriate performance indices.

Measure exposure to Foreign Exchange Risk (on a rolling basis): ex post transaction and translation vs. ex ante economic/operating exposure. How does the firm compare with its key rivals?

Identify currencies which are grossly over/undervalued. Generate forecast for each currency in probabilistic terms. Forecasts should be continuously updated.

Simulate pro-forma budgets under multiple scenarios to gauge in probabilistic terms "cash flow at risk." Measure also the impact of worst exchange rate scenarios on key performance indices.

Set optimal percentage of exposure to be hedged (as a function of firm's attitude to foreign exchange risk).

Compare costs and benefits of applying different forex instruments and techniques. Set internal guidelines governing the use of forex derivatives for hedging purposes.

Incorporate hedging policies in the performance evaluation system in setting budget and tracking performance.

Implement FERM policies.

Compare results ofFERM policies with FERM objectives. Variance analysis leads to recalibration of FERM objectives.

Figure I.iii Foreign Exchange Risk Management (PERM) model

xxv

xxvi The Management and Control of Foreign Exchange Risk

economic exposure to foreign exchange risk primarily depends on (1) the destination of its output, that is, export market vs. domestic market, as well as the origin of its inputs, that is, imported vs. domestically sourced inputs, and (2) the relative response to the inflation/devaluation cycle by its key competitors (steps 3 and 5).

How to eliminate or, as a second-best option, mitigate cash-flow losses that may result from transaction exposure to foreign exchange risk is discussed in part IV. Specifically, chapter 8 provides operational guidelines designed for coping with exchange risk entailed by commercial transactions inclusive of international bids/tenders. The cases of short- vs. medium- or long-term contracts denominated in both convertible and inconvertible currencies are examined separately. The use of currency options and swaps is systematically introduced. An analytical framework for quantifying the cost of eliminating foreign exchange risk stemming from international fmancing is introduced next in chapter 9. Specifically, long-term international fmancing incorporates exchange gains or losses in the effective cost of long-term debt fmancing. The use of such artificial currency units such as Special Drawing Rights or European Currency Units in denominating long-term debt is explored as a technique for dampening exchange losses that corporate borrowers may experience in sourcing funds from foreign capital markets. Throughout part IV, decision rules are formulated algebraically to enable the decision maker to simulate, under alternative future spot exchange rates (break-even analysis), the relative cost of covering vs. not covering against exchange risk (steps 5, 6, and 7).

Exchange rate devaluation may severely disrupt the steadiness of multinational corporations' foreign income streams. Even though no cash-flow losses are involved, consolidated accounting income may exhibit erratic trends that will in turn affect the corporation's overall risk profile as perceived by its shareholders and the investment community at large. Chapter 10 shows how the accounting income of multinational corporations' foreign operations can be smoothed by combining a strategy of selective hedging through the forward market with adequate manipulation of translation exposures through local borrowing or leading/lagging intracorporate payments (steps 7 and 9). The last chapter explores how currency risk can distort the performance-evaluation process of foreign subsidiaries by their parents. It constructs a value-based contingent budgeting model that builds on the economic exposure model introduced in chapter 7 and aligns shareholder value creation with exchange-rate-dependent operating decisions (steps 8 and 10).

Throughout the text more technical sections which can be omitted without loss of continuity are indicated by opening 0 and closing. symbols. Each chapter is followed by case studies based on real-life situations and is supplemented by a set of problems; answers to selected problems appear at the end of the book. Detailed solutions to both case studies and problem sets are provided in a separate instructor's manual, which also includes a master set of transparencies for each chapter. It is available upon request from the publisher.

Introduction

APPENDIX A: FOREIGN EXCHANGE RISK MANAGEMENT: WHAT DO FIRMS DO?3

xxvii

• Accounting considerations remain the single most important factor influencing the practice for foreign exchange exposure management today.

• Current accounting rules discourage corporations from implementing some of the hedging strategies including hedging forecasted transactions two to three years in the future with derivatives with hedge accounting treatment.

• Because of current Financial Accounting Standards Board (FASB) hedge accounting rules and requirements to mark to market hedging instruments that do not qualify for hedge treatment, most companies appear to use the accounting model as the basis for measuring their exposure to exchange gains and losses. Accordingly, they focus mainly on the elements of translation, transaction, and commitment exposure that fall within the accounting model or generally accepted accounting principles (GAAP).

• While operating within the accounting model in daily exposure management, most companies understand that the accounting model does not capture the economic and competitive impacts that exchange gains and losses have on their companies.

• Most companies have created policies for foreign exchange exposure management, but they do not always take into account the development of derivatives.

• Senior management is becoming aware of the complexity of exposures and the need to understand how they are managed, due to recent incidents involving the use of derivatives. In leading companies, treasury departments are working with management to define business and financial risks, to decide which of those risks the company is in the business of taking and which it wants to hedge, to decide where on the risk spectrum the company wants to be, to design hedging programs to fit the company's risk tolerance, and to defme benchmarks to measure and control the hedging program.

• Treasury departments are acting in a more consultive capacity, supporting business units that assume profit and loss responsibility for foreign exchange exposure and hedging decisions. In the past, treasury departments have operated independently and sometimes had more of a profit center orientation.

• In some larger companies, business units enter into hedging transactions with an internal treasury unit. In turn, treasury hedges externally for the company as a whole. In those companies, it is common for business units to use a budget or benchmark rate to hedge the U.S. dollar equivalent of their foreign currency earnings for performance measurement purposes and to use relatively

3 Abridged from Davis, Henry A., and Militello, Frederick C., Jr. "Foreign Exchange Risk Management: A Survey of Corporate Practices," Financial Executives Research Report 2, No.1 (January 1995), pp. 1-3.

xxviii The Management and Control of Foreign Exchange Risk

conservative hedging strategies designed to make or slightly beat the benchmark rate.

• The two most widely used fmancial hedging tools are forward exchange contracts and over-the-counter options. Forward exchange contracts are used for hedging booked transaction exposures, while options are used extensively for committed off balance sheet transactions. Few companies are active in the futures market.

• In the past ten years, the corporate practice of foreign exchange exposure management has become more systematic and less driven by day-to-day currency movements. The development of relatively inexpensive computer power has spurred the development of increasingly complex derivative fmancial instruments, technical currency rate trend analysis, and systems that help corporations identify exposures, simulate alternative exposure scenarios and hedging strategies, execute hedging transactions, and manage portfolios of hedging instruments.

• Foreign exchange, interest rate, and commodity risk management are becoming integrated because the hedging instruments are similar and the same personnel in the company have expertise in using them.

SELECTED BIBLIOGRAPHY

Adler, Michael, and Dumas, Bernard. "International Portfolio Choice and Corporate Finance: a Synthesis," Journal of Finance 38 (1983), pp. 925-984.

Davis, Henry A., and Militello, Frederick C., Jr. Foreign Exchange Risk Management: A Survey of Corporate Practices (Morristown, NJ: Financial Executive Research Foundation, 1995).

DeRosa, David F. Managing Foreign Exchange Risk (Chicago: Probus, 1991). Froot, Kenneth A., Scharfstein, David S., and Stein, Jeremy. "Risk

Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance 48, no. 5 (December 1993), pp. 1629-1658.

Giddy, Ian H. "Exchange Risk: Whose View?" Financial Management 6, no. 2 (Summer 1977), pp. 23-33. How foreign exchange risk is perceived by multinationals' shareholders, corporate treasurers and affiliates' financial officers.

Jacque, Laurent L. "Management of Foreign Exchange Risk: a Review Article," Journal of International Business Studies 12, no. 1 (Spring/Summer 1981), pp.81-101.

Jesswein, Kurt, Kwok Chuck C.Y., and Folks, William R., Jr. "What New Currency Risk Products Are Companies Using and Why?" Journal of Applied Corporate Finance 8, no. 3 (Fall 1995), pp. 103-114.

Jorion, Philippe, and Khoury, Sarkis J. Financial Risk Management (Cambridge: Blackwell, 1996).

Introduction xxix

Kenyon, Alfred. Cu"ency Risk and Business Management (Oxford: Blackwell, 1990).

Lessard, Donald R. "Global Competition and Corporate Finance in the 1990s," Journal of Applied Corporate Finance 3, no. 1 (Spring 1990), pp. 59-72.

Levi, Maurice D., and Sercu, Piet. "Erroneous and Valid Reasons for Hedging Foreign Exchange Rate Exposure," Journal of Multinational Financial Management 1, no. 2 (1990), pp. 25-37.

Remmers, H.L. FORAD: International Financial Management Simulation (INSEAD: Fountainbleau, France, 1990).

Rodriguez, Rita M. "Corporate Exchange Risk Management: Theme and Aberrations," Journal of Finance 36, no. 2 (May 1981), pp. 427-439.

Smith, Clifford W., and Stulz, Rene M. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis 20, no. 4 (December 1985), pp. 391-405.

Smithson, Charles W., Smith, Clifford W., Jr., and Wilford, D. Sykes. Managing Financial Risk (Chicago: Irwin, 1995).

Srinivasulu, S.L. and Dufey, Gunter. "The Case for Corporate Management of Foreign Exchange Risk," Financial Management 11, no. 4 (Winter 1983), pp.54-61.