chapter 9 managing accounting exposure. chapter overview i.managing transaction exposure ii.managing...

CHAPTER 9CHAPTER 9

MANAGING MANAGING ACCOUNTING ACCOUNTING

EXPOSUREEXPOSURE

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

II.II. MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

III.III. DESIGNING A HEDGING DESIGNING A HEDGING STRATEGYSTRATEGY

PART I. MANAGING TRANSACTION PART I. MANAGING TRANSACTION EXPOSURE EXPOSURE

I.I. METHODS OF HEDGINGMETHODS OF HEDGINGA.A. Forward market hedgeForward market hedgeB.B. Money market hedgeMoney market hedgeC. Risk shiftingC. Risk shiftingD. Pricing decisionD. Pricing decisionE.E. Exposure nettingExposure nettingF.F. Currency risk sharingCurrency risk sharingG. Currency collarsG. Currency collarsH. Cross-hedgingH. Cross-hedging I. I. Foreign currency options Foreign currency options

MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSURE

Central idea: HedgingCentral idea: Hedging

Hedging a particular currency exposure Hedging a particular currency exposure means establishing an offsetting means establishing an offsetting currency positioncurrency position

whatever is lost or gained on the original whatever is lost or gained on the original currency exposure is exactly offset by a currency exposure is exactly offset by a corresponding foreign exchange gain or corresponding foreign exchange gain or loss on the currency hedgeloss on the currency hedge


Managing transaction exposure:Managing transaction exposure:

A transaction exposure arises whenever a A transaction exposure arises whenever a company is committed to a foreign company is committed to a foreign currency-denominated transaction.currency-denominated transaction.

Protective measures include using: Protective measures include using: forward contracts, price adjustment forward contracts, price adjustment clauses, currency options, and HC clauses, currency options, and HC invoicing.invoicing.


A.A. FORWARD MARKET HEDGEFORWARD MARKET HEDGE

1. consists of offsetting1. consists of offsetting

a. a receivable or payable in a a. a receivable or payable in a foreign currencyforeign currencyb. using a forward contract:b. using a forward contract:- to sell or buy that - to sell or buy that currencycurrency- at a set delivery date- at a set delivery date- which coincides with - which coincides with receipt receipt of the foreign of the foreign currency. currency.


2. True Cost of Hedging:2. True Cost of Hedging:a. The opportunity cost depends upona. The opportunity cost depends upon

future spot rate at settlementfuture spot rate at settlementb. Shown asb. Shown as

ff11 - e - e11

ee00

wherewhere f f11 = forward rate = forward rate

ee00 = spot rate = spot rate ee11 = future spot rate = future spot rate


B.B. MONEY MARKET HEDGEMONEY MARKET HEDGE

1.Definition:1.Definition:

simultaneous borrowing and simultaneous borrowing and lending activities in two lending activities in two

different different currencies to lock in the currencies to lock in the dollar dollar value of a future value of a future foreign currency foreign currency cash flowcash flow


C. RISK SHIFTINGC. RISK SHIFTING

1. home currency invoicing1. home currency invoicing

2. zero sum game2. zero sum game

3. common in global business3. common in global business

4. firm will invoice exports in 4. firm will invoice exports in strong currency, import strong currency, import

in in weak currencyweak currency


C. RISK SHIFTING (con’t)C. RISK SHIFTING (con’t)

5. Drawback:5. Drawback:

it is not possible with it is not possible with informed customers or informed customers or suppliers.suppliers.


D. PRICING DECISIONSD. PRICING DECISIONS

1. general roles: on credit sales 1. general roles: on credit sales connect foreign price to home connect foreign price to home price price using forward rate, but not using forward rate, but not spot rate.spot rate.

2. if the dollar price is high/low 2. if the dollar price is high/low enough the exporter/importer enough the exporter/importer should follow through with the should follow through with the sale.sale.


E.E. EXPOSURE NETTINGEXPOSURE NETTING

1. Protection can be gained by 1. Protection can be gained by selecting currencies that selecting currencies that minimize minimize exposureexposure

2. Netting:2. Netting:

MNC chooses currencies that are MNC chooses currencies that are not perfectly positively not perfectly positively correlated.correlated.

3. Exposure in one currency can be3. Exposure in one currency can be

offset by the exposure in another.offset by the exposure in another.


F. CURRENCY RISK SHARINGF. CURRENCY RISK SHARING

1. 1. Developing a customized Developing a customized hedge hedge contract contract

2. 2. The contract typically takes The contract typically takes the the form of a Price Adjustment form of a Price Adjustment

Clause, whereby a base price Clause, whereby a base price is is adjusted to reflect certain adjusted to reflect certain

exchange rate changes.exchange rate changes.


F. CURRENCY RISK SHARING (con’t)F. CURRENCY RISK SHARING (con’t)

3. 3. Parties would share the Parties would share the currency risk currency risk beyondbeyond a neutral a neutral zone of exchange rate zone of exchange rate

changes.changes.

4. 4. The neutral zone represents The neutral zone represents the the currency range in which risk iscurrency range in which risk is

notnot shared. shared.


G. CURRENCY COLLARSG. CURRENCY COLLARS

1. 1. ContractContract

bought to protect against bought to protect against currencycurrency

moves outside the neutral zone.moves outside the neutral zone.

2. 2. Firm would convert its foreignFirm would convert its foreign

currency denominated receivablecurrency denominated receivable

at the zone forward rate.at the zone forward rate.


H.H. CROSS-HEDGINGCROSS-HEDGING

1. Often forward contracts not available1. Often forward contracts not available

in a certain currency.in a certain currency.

2. Solution: a cross-hedge2. Solution: a cross-hedge

- a forward contract in a related - a forward contract in a related currency. currency.

3. Correlation between 2 currencies is3. Correlation between 2 currencies is

critical to success of this hedge.critical to success of this hedge.

MANAGING TRANSACTION MANAGING TRANSACTION EXPOSUREEXPOSUREI. Foreign Currency OptionsI. Foreign Currency Options

When transaction is uncertain, currency When transaction is uncertain, currency options are a good hedging tool in options are a good hedging tool in situations in which the quantity of situations in which the quantity of foreign exchange to be received or paid foreign exchange to be received or paid out is uncertain.out is uncertain.


I. Foreign currency optionsI. Foreign currency options

1. A 1. A call optioncall option

is valuable when a firm has offered is valuable when a firm has offered

to to buy a foreign asset at a fixed buy a foreign asset at a fixed

foreign foreign currency price but is currency price but is

uncertain whether uncertain whether its bid will be its bid will be

accepted.accepted.


2. The firm can lock in a maximum 2. The firm can lock in a maximum

dollar dollar price for its tender offer, while price for its tender offer, while

limiting its downside risk limiting its downside risk

to the call to the call premium in the event premium in the event

its bid is rejected.its bid is rejected.


3. A 3. A put optionput option

allows the company to insure its allows the company to insure its

profit margin against adverse profit margin against adverse

movements in the foreign currency movements in the foreign currency

while guaranteeing fixed prices to while guaranteeing fixed prices to

foreign customer.foreign customer.

PART II. MANAGING PART II. MANAGING TRANSLATION EXPOSURETRANSLATION EXPOSURE

I.I. MANAGING TRANSLATION EXPOSUREMANAGING TRANSLATION EXPOSURE

A.A. 3 options3 options

1.1. Adjusting fund flowsAdjusting fund flows

altering either the amounts altering either the amounts or or the currencies of the the currencies of the planned planned cash flows of the cash flows of the parent or its parent or its subsidiaries to subsidiaries to reduce the reduce the irm’s local irm’s local currency currency accounting exposure.accounting exposure.

MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE

2.2. Forward contractsForward contracts

reducing a firm’s translation reducing a firm’s translation exposure by creating an exposure by creating an

offsetting asset or offsetting asset or liability in the liability in the foreign foreign currency.currency.

MANAGING TRANSLATION MANAGING TRANSLATION EXPOSUREEXPOSURE3.3.Exposure nettingExposure netting

a. offsetting exposures in one a. offsetting exposures in one currency with exposures in currency with exposures in

the the same or another currency same or another currency

b. gains and losses on the two b. gains and losses on the two currency positions will currency positions will

offset offset each other. each other.


B.B. Basic hedging strategy for reducing Basic hedging strategy for reducing translation exposure:translation exposure:

1.1. increasing hard-currency(likely increasing hard-currency(likely to appreciate) assetsto appreciate) assets

2.2. decreasing soft-currency(likely decreasing soft-currency(likely to depreciate) assetsto depreciate) assets

3.3. decreasing hard-currency decreasing hard-currency liabilitiesliabilities


4.4. increasing soft-currency increasing soft-currency liabilitiesliabilities

i.e. reduce the level of cash, tighten credit i.e. reduce the level of cash, tighten credit terms to decrease accounts terms to decrease accounts receivable, receivable, increase LC borrowing, increase LC borrowing, delay accounts delay accounts payable, and sell the payable, and sell the weak currency weak currency forward.forward.

PART III. DESIGNING PART III. DESIGNING A HEDGING STRATEGYA HEDGING STRATEGY

III. DESIGNING A HEDGING STRATEGYIII. DESIGNING A HEDGING STRATEGY

A.A. StrategiesStrategies

a function of management’sa function of management’s

objectiveobjective

B.B. Hedging’s basic objective:Hedging’s basic objective:reduce/eliminate volatility ofreduce/eliminate volatility ofearnings as a result of earnings as a result of

exchangeexchangerate changes.rate changes.

DESIGNING A HEDGING DESIGNING A HEDGING STRATEGYSTRATEGY

C.C. Hedging exchange rate riskHedging exchange rate risk

1.1. Costs moneyCosts money

2.2. Should be evaluated as any otherShould be evaluated as any other

purchase of insurance.purchase of insurance.

3.3. Taking advantage of taxTaking advantage of tax

asymmetries lowers hedging asymmetries lowers hedging costs.costs.

DESIGNING A HEDGING DESIGNING A HEDGING STRATEGYSTRATEGY

D.D. Centralization v. DecentralizationCentralization v. Decentralization

1.1. Important aspects:Important aspects:a.a. Degree of centralizationDegree of centralizationb.b. Responsibility for Responsibility for

developingdevelopingc.c. Implementing the hedgingImplementing the hedging

strategy.strategy.

2.2. Maximum benefits accrue fromMaximum benefits accrue fromcentralizing policy-making, centralizing policy-making, formulation, and implementation.formulation, and implementation.

chapter 9 managing accounting exposure. chapter overview i.managing transaction exposure ii.managing...

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