international finance fin556 michael dimond. michael dimond school of business administration...

International FinanceFIN556

Michael Dimond

Michael DimondSchool of Business Administration

Foreign Exchange Exposure• Foreign exchange exposure is a measure of the potential

for a firm’s profitability, net cash flow, and market value to change 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


MNCs are exposed to risk from exchange rates

Resulting from Market ForcesEconomic

Exposure

Purely Accounting Based

Resulting from Accounting


Why Hedge?• Hedging protects the owner of an asset (future stream of cash flows) from loss, but 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

• Companies must first decide what they are trying to accomplish through their hedging program.

Arguments in favor:•Reduction in risk in future cash flows improves the planning capability of the firm•Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum•Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm•Markets are usually in disequilibirum because of structural and institutional imperfections

Arguments against:•Currency risk mgmt. does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow•The NPV of hedging is zero (Managers cannot outguess the market)•Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss•Management often conducts hedging activities that benefit management at the expense of shareholders


Measurement of Transaction Exposure• 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


Purchasing or Selling on Open Account• Suppose Caterpillar sells merchandise on open account to a

Belgian buyer for €1,800,000 payable in 60 days• Further assume that the spot rate is $1.2000/€ and

Caterpillar expects to exchange the euros for €1,800,000 x $1.2000/€ = $2,160,000 when payment is received– Transaction exposure arises because of the risk that Caterpillar will

something other than $2,160,000 expected– If the euro weakens to $1.1000/€, then Caterpillar will receive

$1,980,000– If the euro strengthens to $1.3000/€, then Caterpillar will receive

$2,340,000


Purchasing or Selling on Open Account

• Caterpillar might have avoided transaction exposure by invoicing the Belgian buyer in US dollars (risk shifting), but this might have lead to Caterpillar not being able to book the sale

• If the Belgian buyer agrees to pay in dollars, Caterpillar has transferred the transaction exposure to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days


Ch 10, P2Rolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts from U.S. companies. Suppose it has accounts receivable of $1.5 billion and accounts payable of $740 million. It also borrowed $600 million. The current spot rate is $1.5128/£.

a. What is Rolls-Royce's dollar transaction exposure in dollar terms? In pound terms?ANSWER. Rolls-Royce has $160 million in dollar transaction exposure ($1.5 billion - $740 million - $600 million). In pound terms, its transaction exposure equals £105.76 million (160,000,000/1.5128).

b. Suppose the pound appreciates to $1.7642/£. What is Rolls-Royce's gain or loss, in pound terms, on its dollar transaction exposure?ANSWER. Translated at the new exchange rate, the value of its transaction exposure is now £90.69 million. Compared to the former value of its transaction exposure, the result is a loss of £15.07 million (£90.69 million - £105.76 million).


Borrowing and Lending• A second example of transaction exposure arises when funds

are loaned or borrowed• Example: PepsiCo’s largest bottler outside the US is located

in Mexico, Grupo Embotellador de Mexico (Gemex)– On 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$4.65/US$. In January it reached Ps$5.50


Borrowing and Lending• Gemex’s peso obligation now looked like this

– Dollar debt mid-December, 1994:• US$264,000,000 Ps$3.45/US$ = Ps$910,800,000

– Dollar debt in mid-January, 1995:• US$264,000,000 Ps$5.50/US$ = Ps$1,452,000,000

– Dollar debt increase measured in Ps • Ps$541,200,000

• Gemex’s dollar obligation increased by 59% due to transaction exposure


Translation Exposure

• Translation exposure arises because the financial statements of foreign subsidiaries must be restated in the parent’s reporting currency for the firm to prepare its consolidated financial statements

• Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction

• Translation methods differ by country along two dimensions– One is a difference in the way a foreign subsidiary is

characterized depending on its independence – The other is the definition of which currency is most important

for the subsidiary


Summary of Translation Methods

• Current Rate Method – Everything uses the current rate

• Current/ NonCurrent Method – CA & CL at current rate – All others at Historic Rate

• Monetary/ NonMonetary Method – Monetary assets at current rate – NonMonetary assets at historic rate

• Temporal Method – Like Mon/NonMon, but Inventory is

translated at Current rate (only if inventory is at Market Cost)

A few pointers:• Cash & A/R: Current rate for all methods • Inventory (@ mkt): Current rate for all except Mon/NonMon • Fixed Assets: Historic rate for all except current rate method • Curr Liabilities: Current rate for all methods • LT Debt: Current rate for all except Curr/NonCurr• Equity: plug • Translation Gain (Loss): Difference in Equity (Historic vs Method)


Operating Exposure• The change in company value resulting

from changes in future operating cash flows caused by an unexpected change in exchange rates.

• Because the value of a firm is equal to the present value of future cash flows, accounting measures of exposure that are based on changes in the book values of foreign currency assets and liabilities need bear no relationship to reality.

• The primary exposure management objective of financial executives should be to arrange their firm's finances in such a way as to minimize the real effects of exchange rate changes.

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

The major burden of coping with exchange risk must be borne by the marketing and production people•They deal in imperfect product and factor markets where their specialized knowledge provides a real advantage. •Their role is to design marketing and production strategies to deal with exchange risks. •The appropriate marketing and production strategies are similar to those that would be suitable for any firm confronted with shifting relative output or input prices caused by any economic, political, or social factors.


Ch 11, P1Hilton International is considering investing in a new Swiss hotel. The required initial investment is $1.5 million (or SFr 2.38 million at the current exchange rate of $0.63 = SFr 1). Profits for the first ten years will be reinvested, at which time Hilton will sell out to its partner. Based on projected earnings, Hilton's share of this hotel will be worth SFr 3.88 million in ten years.

a.What factors are relevant in evaluating this investment?Answer. Hilton should focus on the real dollar value of future cash flows: 3,880,000e10/[(1+k)(1+ius)]^10where e10 is the nominal dollar value of the Swiss franc in ten years, ius is the average annual rate of U.S. inflation over the next ten years, and k is Hilton's real required return for this project. That is, the SFr 3.88 million expected to be received in ten years should first be converted to nominal dollars, then into real dollars, and finally discounted at the real required return. This present value figure should then be compared to $1.5 million, the current cost of the investment (2,380,000 x .63).



b. How will fluctuations in the value of the Swiss franc affect this investment?Answer. Only fluctuations in the real value of the Swiss franc matter; fluctuations in the nominal value of the Swiss franc that are fully offset by higher U.S. inflation should not affect the investment. If the real value of the Swiss franc rises, the real dollar price of the hotel services being sold by Hilton will also rise. If demand for these services is elastic, which it seems to be given the Swiss hotel industry's heavy dependence on tourists, real dollar revenues will decline. Inelastic demand will cause an increase in real dollar revenues. The hotel's real dollar cost of Swiss labor and services will rise. Thus, if PPP holds, nominal currency changes shouldn't affect Hilton's Swiss investment; if PPP does not hold, an increase in the real exchange rate is likely to reduce the real value of Hilton's investment.



c. How would you forecast the $:SFr exchange rate ten years ahead?Answer. There are several ways to forecast the nominal Swiss exchange rate ten years out: (1) Rely on the international Fisher effect, using nominal interest differentials between U.S. and Swiss bonds with maturities of ten years; (2) project relative price levels changes in Switzerland and the U.S. over the next ten years and then use PPP to forecast the rate change; and (3) use the forward rate if a ten‑year swap can be found. But what really matters is what happens to the real exchange rate. The best forecast of the real rate ten years out is the current spot rate. Over the long run, PPP tends to hold, leading to a relatively constant real exchange rate.

international finance fin556 michael dimond. michael dimond school of business administration...

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