FOREIGN EXCHANGE EXPOSURE PRACTICES

Foreign exchange exposure means the risk of loss stemming from exposure to adverse foreign exchange rate movements.

“A measure of the potential change in a firm’s profitability, net cash flow, and market value because of a change in exchange rates”

– These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm

– While finance theories tell us that cash flows matter and accounting does not, we know that currency-related gains and losses can have destructive impacts on reported earnings – which are fundamental to the markets opinion of that company

The foreign exchange rate exposure of a firm is a measure of the sensitivity of its cash flows to changes in exchange rates. Since cash flows are difficult to measure, most researchers have examined exposure by studying how the firm’s market value, the present value of its expected cash flows, responds to changes in exchange rates

Foreign exchange exposure is defined as the degree to which a company is affected by exchange rate changes.

The magnitude of the gain or loss that results from a particular exchange rate change is:

FX Gain (Loss) = [ St+n - St ] [ Exposure ]

Exposure is expressed in units of the underlying host currency, the exchange rate is the price of the host currency in units of home currency (i.e. $/FC), and hence the exchange rate gain/loss is in home currency units.

• An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm.

Transaction exposure

Transaction exposure is a risk to a firm with known future cash flows in a foreign currency that arises from possible changes in the exchange rate.

Transaction exposure is the degree to which cash and transactions denominated in a foreign currency and already entered into for settlement at a future date are affected by exchange rate changes.

Transaction exposure measures net cash and known cash inflows against known cash outflows.

It measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely

– Purchasing or selling on credit goods or services when prices are stated in foreign currencies

– Borrowing or lending funds when repayment is to be made in a foreign currency

– Being a party to an unperformed forward contract and

– Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

1. Transaction Exposure: measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are in a foreign currency. The situations include

Purchasing or selling on credit goods or services when prices are stated in foreign currencies

Borrowing or lending funds when repayment is to be made in a foreign currency

Being a party to an unperformed forward contract Acquiring assets or incurring liabilities denominated in foreign currencies

Example (purchasing or selling): Leo Srivastava is the director of finance for Pixel Manufacturing, a U.S.-based manufacturer of hand-held computer systems for inventory management. Pixel has completed the sale of a bar-code system to a British firm, Grand Metropolitan (UK), for a total payment of £1,000,000. The following exchange rates were available to Pixel on the following dates corresponding to the events of this specific export sale. Assume each month is 30 days.

(a) Assume Leo decides not to hedge the transaction exposure. What is the value of the sale as booked? What is the foreign exchange gain (loss) on the sale?

The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, and the shipment is categorized as an account receivable (A/R).

Value as settled = £1,000,000* $1.7290/£ = $1,729,000

Value as booked = £1,000,000* $1.7689/£ = $1,768,900

Foreign exchange loss = ($1,729,000 - $1,768,900) = -$39,900

(b) Assume Leo decides to hedge the transaction exposure using a forward contract when the product is shipped. What is the value of the sale as booked? What is the foreign exchange gain (loss) on the sale if hedged with a forward contract?

The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met.

Value as forward settlement = £1,000,000* $1.7602/£ = $1,760,200

Value as booked = £1,000,000* $1.7689/£ = $1,768,900

Foreign exchange loss = ($1,760,200 - $1,768,900) = -$8,700

Example (purchasing or selling):

Suppose Trident Corporation sells products to a Belgian buyer for €1,800,000 payable in 60 days. The current spot rate is $1.20/€ and Trident expects to exchange the Euros for €1,800,000*$1.20/€ = $2,160,000 when payment is received.

Transaction exposure arises because of the risk that Trident will receive something other than $2,160,000 expected

If the euro weakens to $1.10/€, then Trident will receive $1,980,000 If the euro strengthens to $1.30/€, then Trident will receive $2,340,000

Example (borrowing and lending)

PepsiCo’s largest bottler outside the U.S. is located in Mexico (Grupo Embotellador de Mexico; Gemex) In mid 12/94, Gemex had US dollar denominated debt of $264 million. The Mexican peso (Ps) was pegged at Ps$3.45/US$. On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$5.50/US$ in mid-January, 1995.

Gemex’s peso obligation:

Dollar debt mid-December, 1994 US$264m*Ps$3.45/US$=Ps$910.8m

Dollar debt in mid-January, 1995 US$264m*Ps$5.50/US$ = Ps$1,452m

Dollar debt increase measured in % (1452-910.8)/910.8 = 59.4%

Gemex’s dollar obligation increases by 59% due to transaction exposure.

Note: US$ appreciates by 59.4%, which is (5.50-3.45)/3.45.

Example (forward contract):

When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure.

A U.S. firm wants to offset transaction exposure of ¥100 million to pay for an import from Japan in 90 days. The firm can purchase ¥100 million in forward market to cover payment in 90 days.

Example (acquiring foreign assets)

Worldwide Travel, a 100% privately owned travel firm based in Honolulu, has signed an agreement to acquire a 50% ownership share of Taipei Travel, a privately owned travel agency based in Taiwan specializing in servicing inbound customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (NT$7,000,000) payable in cash in three months.

Hedging

(1) What constitutes a hedge?

Acquiring a cash flow, asset, or contract that will rise in value to offset a decrease in value of an underlying (existing) position

2. Why hedge?

Hedging protects the owner of an asset (future stream of cash flows) from loss. However, it also eliminates any gain from an increase in the value of the asset

hedged against. Since the value of a firm is the net present value of all expected future cash

flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against.

Example: Suppose there is a company drilling oil and it plans on selling 2 million barrels of oil in 60 days. How can the firm hedge the exposure to changes in oil prices?

- sell a futures contract on oil deliverable in 60 days

Example 1 (managing account receivable; A/R): Maria Gonzalez, CFO of Trident, has just concluded a sale to Regency, a British firm, for £1,000,000. The sale is made in March with payment due in June (3 months). Assumptions for Maria’s currency exposure problem are:

- Spot rate is $1.7640/£

- 3-month forward rate is $1.7540/£

- Trident’s cost of capital is 12.0%

- UK 3 month borrowing rate is 10.0% p.a. (per annum)

- UK 3 month investing rate is 8.0% p.a.

- US 3 month borrowing rate is 8.0% p.a.

- US 3 month investing rate is 6.0% p.a.

- June put option in the OTC market (bank) for £1,000,000; strike price $1.75; 1.5% for option premium

- Trident’s foreign exchange advisory service forecasts future spot rate in 3 months to be $1.76/£

Trident operates on narrow margins and Maria wants to secure the most amount of US dollars; her budget rate (lowest acceptable amount) is $1.70/£, below which Trident actually lose money on the transaction. Maria faces four possibilities:

– Remain un-hedged– Hedge in the forward market– Hedge in the money market– Hedge in the options market

(1) Un-hedged position

Maria may decide to accept the transaction risk. If she believes that the future spot rate will be $1.76/£, then Trident will receive

£1,000,000*$1.76/£ = $1,760,000 in 3 months.

However, if the future spot rate is $1.65/£, Trident will receive only $1,650,000 well below the budget rate.

(2) Forward market hedge

- A forward hedge involves a currency forward or futures contract and a source of funds to fulfill the contract

- The forward contract is entered at the time when the A/R (account receivable) is created, in this case in March.

- When this sale is booked, it is recorded at the spot rate.

- In this case the A/R is recorded at a spot rate of $1.7640/£, thus $1,764,000 is recorded as a sale for Trident.

- If Trident does not have an offsetting A/P (account payable) in the same amount, then the firm is considered uncovered.

- If Maria wants to cover this exposure with a forward contract, then she will sell £1,000,000 forward today at the 3-month forward rate of $1.7540/£

- She is now “covered” and Trident no longer has any transaction exposure

- In 3 months, Trident will receive £1,000,000 and exchange those pounds at $1.7540/£ receiving $1,754,000.

- This would be recorded in Trident’s books as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled)

(3) Money market hedge

- A money market hedge also includes a contract and a source of funds, similar to a forward contract

- In this case, the contract is a loan agreement

- The firm borrows in one currency and exchanges the proceeds for another currency

- Hedges can be left “open” (i.e., no investment) or “closed” (i.e., investment).

- To hedge in the money market, Maria will borrow pounds in London, convert the pounds to dollars and repay the pound loan with the proceeds from the sale

- To calculate how much to borrow, Maria needs to discount the PV of the £1,000,000 to today £1,000,000/(1+10%*1/4) = £975,610

- Maria should borrow £975,610 today and in 3 months repay this amount plus £24,390 in interest from the proceeds of the sale (£1,000,000).

- Trident would exchange the £975,610 at the spot rate of $1.7640/£ and receive $1,720,976 immediately.

- This hedge creates a pound denominated liability (bank loan) that is offset with a pound denominated asset (the sale of goods; A/R) thus creating a balance sheet hedge

In order to compare the forward hedge with the money market hedge, Maria must analyze the use of the loan proceeds

- Remember that the loan proceeds may be used today, but the funds for the forward contract may not

- Three logical choices exist for an assumed investment rate for the next 3 months

- First, if Trident is cash rich, the loan proceeds might be invested at the US rate of 6.0% p.a.

- Second, Maria could use the loan proceeds to substitute an equal dollar loan that Trident would have otherwise taken for working capital needs at a rate of 8.0% p.a.

- Third, Maria might invest the loan proceeds in the firm itself in which case the cost of capital is 12.0% p.a.

- Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if Maria used the proceeds to replace a dollar loan (8%) or conduct general business operations (12%)

- The forward hedge would be preferable if Maria were to just invest the loan proceeds (6%)

- We assume that she uses the cost of capital as the reinvestment rate

- A breakeven investment rate can be calculated and help Maria in her decision

- Conclusion: If Maria can invest the loan proceeds at a rate equal to or greater than 7.68% p.a., then the money market hedge will be superior to the forward hedge.

(4) Options market hedge:

- Maria could also cover the £1,000,000 exposure by purchasing a put option (insurance). This allows her to speculate on the upside potential for appreciation of the pound while limiting her downside risk.

- Given the quote earlier, Maria could purchase 3-month put option at an ATM (at-the-money) strike price of $1.75/£ and a premium of 1.5%

The cost of this option = (size of option)*(premium)*(spot rate)

= £1,000,000*0.015*$1.7640/£ = $26,460

- Because we are using future value to compare the various hedging alternatives, it is necessary to project the cost of the option in 3 months. Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium of the option as of June $26,460*1.03 = $27,254

- Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1.75/£ and would sell pounds on the spot market

www.unm.edu/~chenh/474_11_Transaction%20Exposure.doc

Economic exposure

Economic exposure is an exposure to fluctuating exchange rates, which affects a company's earnings, cash flow and foreign investments. The extent to which a company is affected by economic exposure depends on the specific characteristics of the company and its industry.

The risks faced by a country that does business or holds investments abroad. Economic exposure can include changes in foreign exchange rates or the chance of foreign countries defaulting on their debt. Companies often hedge against this type of risk through the foreign exchange market.

www.investopedia.com/terms/e/ economicexposure .asp

Why real exchange rate changes?

Relative price changes ultimately determine a firm’s long-run exposure to currency change.

Currency changes - particularly those of high-inflation currencies - are usually preceded by or accompanied by changes in relative price levels between two countries.

Hence, it is impossible to determine exposure to a given currency without considering simultaneously the offsetting effects of these price changes.

Alternatively, exchange rates often affect firms most severely when the nominal exchange rate does not move at all - when relative price changes are not being offset by exchange rate adjustments.

Measuring economic exposure

A statistical measure of economic exposure can be obtained by applying linear regression analysis to cash flows or real net asset values.

For cash flow exposure, a regression of the following type can be estimated:

CFt = a + b st + ut,

where CFt denotes cash flows in home currency units in period t and st is the spot exchange rate in terms of home currency units per foreign currency unit.

The estimated coefficient b, will be:

b = Cov(CFt st) / Var(st)

b = Cov(CFt st) / Var(st)

Hence, b will measure the sensitivity of cash flows to the level of the exchange rate - which is precisely exposure denominated in the foreign currency units.

Example.

The R2 statistic from the regression will measure the fraction of cash flow variability that can be explained by changes in the exchange rate.

The regression should be run in real terms.

- The cash flows should be deflated by the home currency inflation (i.e. converted into constant 1980 dollars).

- The exchange rate should be the real exchange rate

What happens if the regression is run in nominal terms?

As an example, consider the case where the Pound-Dollar real exchange rate is constant.

If inflation is 10% in the U.S. per year and zero in the U.K., the dollar must be depreciating by 10% per year to maintain the constant real exchange rate.

If a nominal regression is run, however, dollar cash flows will be increasing at 10% per year and the spot exchange rate will be rising at 10% per year reflecting the nominal depreciation of the dollar.

b will pick up the fact that each side of the regression is increasing at 10% per year - which will be misattributed to exposure.

Run in real terms, the regression correctly delivers b = 0.

This measurement technique can be applied in many different ways:

- Regressing net asset value on exchange rate to determine net worth exposure.

- Regressing total market value, recovered from the stock price, onto exchange rate changes.

- including lagged values of the exchange rate in the regression if an adjustment lag in cash flows might exist.

Accounting Exposure

1. A backward-looking concept: it reflects past decisions as reflected in the subsidiary's assets and liabilities.

2. A change in an accounting value due to translation is not a "realized" gain or loss; no change in the cash situation is involved —except possibly through taxation effects.

3. Changes the firm's accounting value, but not necessarily its market value.

4. Depends on the accounting rules chosen. This is because the subsidiary's own internal rules affect its accounting values (e.g., type of depreciation, or inventory valuation methods) and also because the translation process itself can be done in different ways (see below).

5. Accounting exposure only exists in the case of foreign direct investment, since pure exporting or import-substituting firms have no foreign subsidiaries.

Translation exposure is relevant to the preparation of the parent company’s financial statements, where a firm’s foreign currency-denominated accounts on the balance sheet are affected by exchange rate changes.

A firm which has subsidiaries and assets in another country is subject to translation exposure. Translation exposure results as a consequence of the fact that a parent company must consolidate all of the operations of its subsidiaries into its own

financial statements. Since a foreign subsidiary’s assets are carried on its books in a foreign currency, it is necessary to convert the foreign values into domestic currency for combining with the parent’s assets. Fluctuating exchange rates results in gains and losses occurring during the translation process. Since this type of exposure is related to balance sheet assets and liabilities, it is often referred to as accounting exposure. 

The primary issue related to the translation of foreign asset values has to do with whether the proper exchange rate to use is the current rate of exchange or the historic rate of exchange that existed at the time that an asset was acquired

When converting financial statement items (transactions) denominated in currencies other than the parent currency, two choices of exchange rate are possible:

The historical rate, the exchange rate prevailing at the time of the transaction

The current rate, the exchange rate prevailing at the balance sheet date or during the income statement period