4 types of exposure exposure (to fx risk): firm is affected by a change in the exchange rate...
TRANSCRIPT
4 types of exposure
• Exposure (to FX risk): firm is affected by a change in the exchange rate
• Transactions Exposure: firm’s cash flow
• Operating Exposure: firm’s cash flow
• Accounting Exposure: firm’s financial statements
• Translation Exposure: firm’s financial statements
Transactions Exposure
• Contractual: contract exists that specifies a certain amount of FX will be received/paid e.g. export/import, debt denominated in FX.
• Change in the FX rate results in gain/loss.• FX receipt worry: FX depreciation• FX payment worry: FX appreciation • Transactions exposure is reflected in the firm’s
financial statements, i.e. firm with transactions also has accounting exposure.
Hedging a future FX receipt
• Worry: FX depreciation• Sell the FX forward: sign contract now with bank
committing to sell the FX at the future date at a rate set now
• Will receive Y10 million at year end• Hedge by selling Y10 million one-year forward at
one-year forward rate• The C$-value of the Y10 million is now set, i.e.
now know the C$-value
Hedging a future FX payment
• Worry: FX appreciation• Buy the FX forward: sign contract now with bank
committing to buy the FX at the future date at a rate set now
• E.g. will pay Y10 million at year end• Hedge by buying Y10 million one-year forward at
one-year forward rate.• The C$-value of the Y10 million is now set, i.e.
now know the C$-value of the FX payment
Operating Exposure
• Non-contractual: no contract exists, yet firm is exposed
• Change in the exchange rate results in gain or loss of competitive advantage
• Explored in 3 vignettes document• Effects of operating exposure do not appear on
the firm’s financial statements• Explored in Canuck Ltd.’s accounting exposure
3 operating exposure vignettes
• 1. Aspen Skiing (US firm): Revenues exhibited positive operating exposure to French franc, C$, Italian lira, etc.
• 2. Laker Airways (UK firm): Ditto, but negative operating exposure to U$.
• 3. Canuck Ltd. (Canadian firm): Positive operating exposure to UK pound sterling.
Aspen Skiing
• Colorado resort: all balance sheet items and cash flows in greenbacks.
• Yet exposed to C$, FFr, etc.
• In 1983, U$ appreciated, I.e. C$, FFr depreciated.
• Domestic and foreign clientele shifted holidays to Banff, Chamonix, Chicopee.
Aspen Skiing
Y-axis: Cash flows in U$; X-axis: S(U$/C$)
Aspen Skiing: Lesson Gleaned
Although you operate exclusively domestically, if your clientele has the option of purchasing in a foreign market, you exhibit positive exposure to that foreign market’s currency. A U.S. firm with Aspen Skiing as client likewise possesses the same type of exposure.
Aspen Skiing: Two Hedges
• Hedge positive operating exposure of cash flows to C$, FFr, etc.
• Denominate some debt in C$, FFr, etc. Result: negative transactions exposure of debt offsets positive operating exposure of revenues.
• Buy resorts in Canada, France, etc. Result: some revenue streams rise, other fall with rise in C$, FFr, etc.
Laker Airways
• Early exploiter of air transport deregulation in late 70’s. Target market: Price conscious Brit tourists vacationing in Florida.
• Cost structure: jet fuel U$-denominated.• Financed jets with cheap U$-debt provided
by US Ex-Im Bank.• Steep U$ appreciated in early 80’s spelled
doom for Laker Airways.
Laker Airways’ Exposures
• Jet fuel: both transactions and operating exposure to U$.
• Debt: transactions exposure to U$.
• Revenues: negative operating exposure to U$. When U$ appreciated target clientele shifted holidays from Florida to Palma de Mallorca, Islas Canarias, Marbella, etc.
Laker Airways: Lessons Gleaned
• If your business involves assisting a domestic clientele purchase goods/services in a foreign country, you have negative operating exposure to that foreign country’s currency.
• Dollar denomination of debt aggravated the firm’s negative exposure to the greenback.
Sir Freddie’s Egregious Error
• Error: Denominated debt in U$’s.
• Appreciation of U$ resulted in: Sterling value of costs and debt service increasing; Sterling value of revenues decreasing.
• Sir Freddie got squeezed!
• Hedges: debt denominated in Sterling; cater to Yank clientele vacationing in UK.
Canuck Ltd.
• Canadian firm operating exclusively in Canada with no FX denominated assets/contracts.
• Major competitor in Canada sources product in the UK.
• Canuck Ltd. has positive exposure to the Pound Sterling, PS. If PS appreciates, Canuck gains competitive advantage.
• Hedge with PS denominated debt.
Accounting Exposure
• Effects of FX rate changes that are reflected in the firm’s financial statements.
• Transactions exposure is reflected.
• Translation exposure is reflected.
• Operating exposure is not reflected.
• Accounting Exp. comprised of Transactions Exp. & Translation Exp
Translation Exposure
• Parent company has a foreign subsidiary• Foreign subsidiary’s financial statements must
be consolidated (combined) with those of parent• E.g. Canadian parent (C$) vs. Chinese
subsidiary (RMB) currency• Subsidiary’s statements are FX denominated• If FX (RMB) rate changes, consolidated
statements are impacted: translation exposure!
Subsidiary’s Functional Currency
• Primary currency of the subsidiary’s activities, i.e. in which cash flows are generated
• 2 possibilities: parent’s currency (C$) versus subsidiary’s currency (RMB)
• Distinction: subsidiary’s currency versus subsidiary’s functional currency
Subsidiary is self-sustaining
• Most foreign subsidiary’s sales in the foreign country. It is a freestanding entity with self-contained operations
• Functional currency is foreign (RMB)
• Translation via current rate method
• All assets / liabilities translated at the rate prevailing on the balance sheet date
Subsidiary is integrated with parent
• Most foreign subsidiary’s sales in the parent country; a mere extension of parent, i.e. not freestanding
• Subsidiary’s functional currency is parent’s currency (C$)
• Translation via temporal method• Only monetary assets / liabilities translated at
the rate that prevails on the balance sheet date.
Subsidiary’s Monetary
• Assets: cash, marketable securities, accounts receivable
• Liabilities: current liabilities, all debt (short term and long term)
• Monetary means promises a fixed amount of currency
• Nonmonetary: inventory, fixed assets, equity
Hedging Translation Exposure
• Net Translation Exposure (NTE) in FX
• Sell the amount of NTE forward: write contract now with bank committing to sell the amount of NTE at year-end
• E.g. NTE=Y10 million; Hedge by selling Y10 million one-year forward
• If NTE=-Y4 million, buy Y4 million forward; selling a negative quantity means buying