page 1 international finance lecture 8. page 2 international finance course topics –foundations of...

International Finance

Lecture 8

International Finance• Course topics

– Foundations of International Financial Management

– World Financial Markets and Institutions

– Foreign Exchange Exposure– Financial Management for a

Multinational Firm

Foreign Exchange Exposure

• Economic Exposure• Translation Exposure• Transaction Exposure

Operating Exposure: Definition• The effect of random changes in exchange

rates on the firm’s __________________ (which is not readily measurable).– A good way to approximate operating

exposure is to study the extent to which the firm’s _______________________ are affected by the exchange rate.

Operating Exposure• Examples

– Alberta skiing resorts. Weaker $US means skiing is not as cheap for US customers as it used to be, with lower demand for services in AB.

– Canadian retailers. Stronger Euro means higher cost of goods sold (COGS) for European shoes and clothing relative to revenues, thus lower profit margins and possibly lower sales in Canada.

Economic Exposure

• Changes in exchange rates can affect not only international but also purely domestic firms.– Canadian bicycle manufacturer who

sources and sells only in Canada.– Since the firm’s product competes against

imported bicycles it is subject to foreign exchange exposure.

• Economic exposure can be defined as the extent to which the value of the firm would be affected by _______________changes in exchange rates.

How to Measure Economic Exposure

• Economic exposure is the sensitivity of the future home currency value of the firm’s _________________ and the firm’s __________________ to random changes in exchange rates.


• If a U.S. MNC were to run a least squares regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form:

• P = a + bS + e

Where

a is the regression constant

e is the random error term with mean zero

The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.


• The exposure coefficient, b, is defined as follows:

Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.

Cov(P,S) Var(S)

b =


• The exposure coefficient shows that there are two sources of economic exposure:

Cov(P,S)

Var(S)b =

1. the variance of the exchange rate and

the covariance between the dollar value of the asset and exchange rate

How to Measure Economic Exposure• How to actually do it:

– If historical data available, use regression. – If only probability estimates available (i.e. from

analysts’ forecasts), use probability theory• Regression

– In Excel: Tools Data Analysis Regression• If Data Analysis is not available, install it

from Add-Ins.

How to Measure Economic ExposureDate Nortel Adj. Close* SPOT CAN $/US$

15-Mar-06 35.1 1.155316-Mar-06 33.9 1.15417-Mar-06 33.6 1.158720-Mar-06 33.1 1.162721-Mar-06 33.5 1.164722-Mar-06 33.3 1.165123-Mar-06 32.7 1.165724-Mar-06 34.2 1.1675

Coefficients Standard Error t Stat P-value Lower 95%Intercept -87.4943 14.55102742 -6.0129301 0.0000000 -116.193X Variable 1 100.7458 12.88846535 7.81674198 0.0000000 75.32631


State Probability Price, FC FX, DC/FC Price, DC

1 0.25 SFr. 980 $0.45 $441.00

2 0.20 SFr. 1,000 $0.52 $520.00

3 0.35 SFr. 1,050 $0.55 $577.50

4 0.20 SFr. 1,140 $0.60 $684.00

1.00 Mean= 0.53 $553.18

• Cov(Price DC, FX)=• Var(FX)=• Exposure coefficient b

=

Economic exposure • Risk decomposition• Variance (Price DC) = b2 Var(FX) + error variance• Hedging = attempt to reduce Variance (Price DC).

– If we manage to reduce Var(FX) to zero, we will get Variance (Price DC) = error variance

– Key points: (i) by how much we can reduce FX exposure, and (ii) how costly hedging is

– Idea: fix the price of b units of foreign currency now by selling b units of foreign currency forward

• Result from Risk Management: optimal hedge ratio is the negative of the estimated coefficient b.

Hedging economic exposure• Your subsidiary in foreign country is an _______,

therefore, to hedge we need to take a _______ position in the foreign currency forwards/futures.– If it were a __________, you would need a

_______ position.• The size of the position is b. • The dollar proceeds a company will receive is

b*(F-S)– F – forward rate you lock in now, S – spot rate

at maturity.• Total value of the hedged position at maturity

will be TVHP=Price DC +b*(F-S)• Assume F = $0.53 and recall that b = 1574

Economic exposure

State Prob.Price, FC

FX,DC/FC

Price, DC

Hedge Payoff TVHP

1 0.25 SFr. 980 $0.45 $441.00 $125.89 $566.89

2 0.20 SFr. 1,000 $0.52 $520.00 $15.74 $535.74

3 0.35 SFr. 1,050 $0.55 $577.50 -$31.47 $546.03

4 0.20 SFr. 1,140 $0.60 $684.00 -$110.15 $573.85

1.00 Mean= 0.53 $553.18 $554.75

• Var(Price DC)=• Var(TVHP)=

Economic Exposure

• The exposure has two components:– The Competitive Effect

• Changes in foreign currency operating cash flows due to competitive pressures on product prices, quantity demanded, costs etc.

– The Conversion Effect• Changes in domestic currency values of

foreign COGS and/or revenues in response to unexpected changes in FX rates.

Operating exposure• Measuring the operating exposure of a firm

requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposure of all the firm’s competitors and potential competitors– Example: Eastman Kodak has economic exposures from

present and future sales abroad– The sum of these future exposures will have an effect on

Kodak’s cash flows as exchange rates change– Kodak’s value and competitiveness depends on (1) the

structure of the market in which it sources it inputs such as labor and materials and sells its products and (2) whether or not it can manage them better than their competition

• This long term view is the objective of operating exposure analysis

Operating exposure• A profit margin of a firm depends on

– the effect of exchange rate on the cost of inputs

– How much of that cost change is passed through to product prices

– Elasticity of product demand

Exchange Rate Pass-Through

Demand elasticity• Recall from microeconomics, ε = %ΔQ / %ΔP

– ε - price elasticity of demand– %ΔQ – percentage change in quantity demanded, =

change in quantity (Q1-Q0) ÷ midpoint quantity (Q1+Q0)/2

– %ΔP – percentage change in price, = change in price (P1-P0) ÷ midpoint price (P1+P0)/2

•

• For example, if you are DaimlerChrysler and your company was selling 50 Mercedes Benz cars per week in Canada at $70,000 and 70 cars per week at $60,000, then the demand elasticity for your cars is

ε=[(70-50)/(70+50)/2]÷[(60,000-70,000)/(60,000+70,000)/2] = _______

Definition of Cash flows for Capital Budgeting

• Operating Cash Flow (OCF) in period t:• OCFt = (PtQt-FCt-cQt-Deprt)(1-) +Deprt =

– P is the price per unit of output– Q is the demanded quantity– c is production cost per unit, FC is fixed

cost is the tax rate on corporate profit in

Germany– Depr is the depreciation expense per

year• The last term is known as depreciation tax

shield.

Working Capital Dynamics

• Our working assumption is as follows:

• ∆WC is the change in Working Capital• Working Capital is completely

recovered at the end of the project life.

• Total Cash Flow, CF:

0 T

∆WC>0 ∆WC<0

1

Algebra of Exposures

• S0 – current exchange rate

• X – exposed variable (e.g., CF denominated in FX)

• Change of dollar equivalent CF in response to an unexpected change in S is then:

• ∆(SX) = (S0 + ∆S)(X0 + ∆X) – S0X0 =

Algebra of Exposures

• ∆(SX) = ∆SX0 + (S0 + ∆S) ∆X

• ∆(SX) = ∆SX0 + Snew ∆X

Example: Operating Exposure

• Carlton derives much of its reported profits from its German subsidiary, and there has been an unexpected depreciation of the euro thus affecting Carlton Germany significantly.

• Carlton’s German subsidiary is operating in a euro-denominated competitive environment– The subsidiary’s profitability and performance

will be impacted by any changes in performance and pricing from its suppliers and customers as a result of changes in the US$/euro exchange rate

Carlton Germany Data

• Carlton Europe manufactures in Germany from European material and labor.

• Half of production is sold within Europe, the other half is exported to non-European countries.

• All sales are invoiced in euros and accounts receivable (AR) are 25% of sales.

• Inventories are 25% of sales.• Cost of capital is 20%.• Corporate tax rate in Germany is 34%.

Base Case• Carlton Germany: S0 = $/€ 1.2• P = €12.80; Q = 1 mil units• c = € 9.60• FC = € 0.89 mil, Depr = € 0.6 mil = 34%• Base case: _______________ to

exchange rates. Relevant horizon for assessing the impact of exchange rate fluctuations is 5 years.

Base Case Cash Flows

• Base case CF (€ mil).• t=1:

– OCF = [(€12.80-9.6)*1 - € 0.89]*0.66 + 0.34*0.6 = € 1.7286

• t=2-4:

• t=5:

Possible Scenarios• There are various possible scenarios

in terms of management actions in response to an unexpected € _____________ from $/€1.2 to $/€ 1.0 :– Can afford to raise domestic sales prices

without hurting demand; this is because competing imports are more expensive to locals

– Same thing can be done with export prices

– Alternatively, they could fix the price and let the volume change; what they will do will depend on the price elasticity of demand.

Case 1

• There is ______________________ change from 1.2$/€ to 1.0 $/€. There are no real changes (no changes in functional currency, i.e., € cash flows).

Case 1 Cash Flows• ∆(S*CF) = ∆S*CFbase + Snew ∆CF =

= ∆S*CFbase

• Total cash flow (including changes in WC) at t=1:

– CFbase = OCF - ∆WC = € 1.7286 – € 5.6 = ______________

• Incremental $ cash flow:• ∆(S*CF) = ∆S*CFbase = -0.2*(- € 3.8714

mil) = ________________

Case 1 Cash Flows

• What about the Incremental Cash Flow for the years 2 through 4?

• In each of the years 2-4 Operating Cash Flow in € is still:

• OCF = € 1.7286 mil• ∆WC = 0 (because sales do not

change)

• ∆(S*CF) = ∆S*CF = -0.2* € 1.7286

mil = ______________

Case 1 Cash Flows• Incremental Cash Flow for year 5?

• Operating Cash Flow is still:• OCF = € 1.7286 mil• ∆WC = - € 5.6 mil

• CF = OCF - ∆WC = € 7.3286 mil

• ∆(S*CF) = ∆S*CF = -0.2* € 7.3286

mil = ________________

Case 2• _____________________________, both in

Europe and export, in response to exchange rate change from 1.2$/€ to 1.0 $/€.

• Carlton Germany:• P = €12.80; ∆Q = 1 mil units• c = € 9.60• FC = € 0.89 mil, Depr = € 0.6 mil = 34%• _____________________________________

Case 2

• Two effects now:• ∆(S*CF) = ∆S*CFbase + Snew ∆CF

• Need CFbase (already know) and ∆CF= ∆OCF - ∆WC to compute the effect.

Case 2

• Incremental OCF in €:• ∆OCF=(P-c)*∆Q*(1-) (why?)• ∆OCF = = (€12.80-9.6)*1 *0.66= €

2.112 mil• Incremental WC adjustment in €

:• Change in WC adjustment = € 11.2-

€ 5.6 = € 5.6 mil in year 1• Change in WC adjustment = -€

11.2+€ 5.6 = -€ 5.6 mil in year 5

Case 2

• Incremental Euro denominated Cash Flow :

• ∆CF1= ∆OCF1 - ∆WC = 2.112 - 5.6 =

• ∆CF2= ∆OCF2 - ∆WC = 2.112 =

• ∆CF1= ∆OCF1 - ∆WC = 2.112 + 5.6 =

Case 2• Incremental Dollar denominated

Cash Flows:• year 1:

– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(- € 3.8714 mil) +1.00(- € 3.488 mil) = _______________

• years 2-4:– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(- €

1.7286 mil) +1.00(€ 2.112 mil) = __________________

• year 5:– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(€7.3286

mil) +1.00(€ 7.712 mil) = ____________________

Example: PV of incremental Cash Flows

• Present Value of the incremental year-end cash flows:

• Case 1:

• Case 2:

76.447,591$2.1

720,465,1720,345

2.1

280,7745

4%20 AFPV

47.420,132,5$2.1

280,246,6720,457,2

2.1

720,713,25

4%20

AFPV

Strategic Management of OE

• The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows

• To meet this objective, management can diversify the firm’s _____________ and _____________________.

Strategic Management of OE

• Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources

• Diversifying the financing base means raising funds in more than one capital market and in more than one currency

Proactive Management of OE

• Operating and transaction exposures can be _____________________ by adopting operating or financing policies that offset anticipated currency exposures

• Four of the most commonly employed proactive policies are– Matching currency cash flows– Risk-sharing agreements– Back-to-back or parallel loans (already

considered)– Currency swaps (already considered)

Cash Flow Matching

Principal and interestpayments on debt

in Canadian dollars

CanadianBank

(loans funds)

US Corp borrowsCanadian dollar debtfrom Canadian Bank

Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars

U.S.Corporation

CanadianCorporation(buyer of goods) Exports

goods toCanada

Payment for goodsin Canadian dollars

Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars

Risk-Sharing• Risk-sharing is a contractual arrangement

in which the buyer and seller agree to “share” or split currency movement impacts on payments– Example: Ford purchases from Mazda in

Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$.

– If the spot rate falls outside of this range, Ford and Mazda will share the difference equally

– If on the date of invoice, the spot rate is ¥110/$, then Mazda would agree to accept a total payment which would result from the difference of ¥115/$- ¥110/$ (i.e. ¥5)

Risk-Sharing• Ford’s payment to Mazda would

therefore be

• Note that this movement is in Ford’s favor, however if the yen depreciated to ¥130/$ Mazda would be the beneficiary of the risk-sharing agreement

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