Lecture 10: Understanding Foreign Exchange Exposure

The Types of Foreign Exchange Exposure Facing Global Firms

and Global Investors

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What is Foreign Exchange Exposure and Exposure Risk? Foreign exchange exposure comes about when a firm or

investor has an open position in a foreign currency. Open position: Unhedged; subject to exchange rate risk Open long position: Expect to receive foreign currency in the

future Open short position: Need to pay foreign currency in the future

Foreign exchange exposure risk refers to the possibility that a foreign currency may move in a direction which is financially detrimental to the global firm or global investor.

Important: Global firms and investors cannot have foreign exchange exposure in their home currencies. Suggests a strategy for managing exposure.

Risk with an Open Foreign Currency Position Open long position (when you expect to receive

foreign currency in the future). Specific risk is that the foreign currency may weaken

against your home currency, thus reducing the home currency equivalent of the long position.

Open short position (when you expect to pay foreign currency in the future). Specific risk is that the foreign currency may

strengthen against your home currency (thus requiring more home currency to acquire the foreign currency). This increases the home currency equivalent of the short position.

The Risks Associated with FX Exposure There are three specific risks to global firms

and/or global investors from their foreign exchange exposures: (1) Settlement Value Risk: Occurs because

foreign currency denominated contracts and investments, in the home currency equivalent of the firm or investor, can be adversely affected by FX changes. Fixed income investments (e.g., bonds). Accounts receivable held multinationals. Loans payable to banks.

Risks Associated with FX Exposure (2) Future Cash Flows Risk: Occurs because

the home currency equivalents of anticipated foreign currency cash flows can be adversely affected. Foreign currency cash inflows and outflows:

Interest payments on fixed income securities. Future revenues from ongoing multinational operations. Future costs associated with ongoing multinational operations.

Note: the net impact of this cash flow exposure depends upon the net cash flow position of the firm. For example, if foreign currency revenues exceed foreign

currency costs, a strong foreign currency with have a net positive effect on the net home currency equivalent.

And if foreign currency costs exceed foreign currency revenues, a strong foreign currency will have a net negative effect on the net home currency equivalent.

Risks Associated with FX Exposure (3) Global Competitive Risk: Occurs because the

competitive position of a firm can be affected by adverse changes in exchange rates. Exporting firms are adversely affected if the currencies

of their overseas markets weaken. More difficult to compete with domestic firms.

Importing firms are adversely affected if the currencies of their overseas markets strengthen. May need to increase their home market selling prices.

Overseas production is adversely affected if the currencies of these “outsourcing” countries strengthens. Home currency equivalent of producing offshore will increase.

Types of Foreign Exchange Exposure Facing Global Firms There are three types of foreign exchange exposures that

global firms may face as a result of their international activities.

These foreign exchange exposures are: Transaction exposure

Results from a global firm engaged in current transactions involving contractual arrangements in foreign currencies (e.g., invoices coming due, loans coming due, interest payments coming due, etc).

Economic exposure Results from future and unknown transactions in foreign currencies

resulting from a global firm’s long term involvement in a particular market (i.e., because of a long term physical presence in that foreign market).

Translation exposure (sometimes called “accounting” exposure). Important for global firms with a physical presence in a foreign country

needing to consolidate their individual country financial statements for reporting purposes.

Transaction Exposure Transaction Exposure: Results when a firm

agrees to “fixed” cash flow foreign currency denominated contractual agreements. Examples of transaction exposure:

An Account Receivable denominate in a foreign currency.

A maturing financial asset (e.g., a bond) denominated in a foreign currency.

An Account Payable denominate in a foreign currency.

A maturing financial liability (e.g., a loan) denominated in a foreign currency.

Incident of Exporting and Importing Transaction Exposure By Global Firm’s Home CountryCountry Exports in Home

Currency (% of invoices)

Imports in Home Currency (% of invoices)

United States 96.0% 85.0%

Germany 81.5% 52.6%

France 58.5% 48.9%

United Kingdom 57.0% 40.0%

Italy 38.0% 27.0%

Japan 34.3% 13.3%

Note: 1988 Data

Economic Exposure Economic Exposure: Results from the “physical”

entry of a global firm into a foreign country. This is a long term foreign exchange exposure

resulting from a previous FDI location decision. Economic exposure impacts the firm through

contracts and transactions which have yet to occur, but will, in the future. These are really “future” transaction exposures which are unknown today.

Economic exposure also impacts the firm through its operating income (revenue) and costs which are denominated in the currency of the foreign country.

Economic Exposure of U.S. Firms Empirical studies of large U.S. multinational

firms (with significant foreign operations) have generally found low or negligible foreign exchange exposure, i.e., little variation in home currency equivalent profits associated with exchange rate changes. Explanation #1: U.S. multinationals might be very

successful in hedging their exposures. Explanation #2: U.S. multinational firms with a

relatively balanced revenue and cost in foreign currencies may have a natural offset. Whereas unbalanced firms (without hedging) could be subject to more foreign exchange exposure. Explanation 2 referred to as “Operational Hedging.”

Translation Exposure

Translation Exposure: Results from the need of a global firm to consolidated its financial statements to include results from foreign operations. Consolidation involves “translating” subsidiary

financial statements in local currencies (i.e., in the foreign markets where the firm is located) to the home currency of the firm (i.e., the parent).

Consolidation can result in either translation gains or translation losses. These are essentially the accounting system’s attempt

to measure foreign exchange “ex post” exposure.

Foreign Exchange Exposure for a Global Investor Foreign exchange exposure for a global

investor results from the acquisition of financial assets denominated in a currency other than the home currency of the investor.

FX exposure can affect: (1) The home currency equivalent market

price of those assets and (2) The home currency equivalent cash

flows (dividends and interest) associated with particular financial assets.

Risk Elements for Global Investors in Equities The specific risk components associated with

common stock (equities): Company risk (micro risk):

Decisions of management; changes in management; success or failure of (new) products.

Environment risk (macro risk): Risk produced by the industry (competition), governments

(regulation), country (business cycles) and global environment in which the company operates.

Market risk (systematic risk): Associated with movements in the overall equity market of a

country. Under CAPM, measured by the stock’s beta. Exchange rate risk:

Associated with investing in equities who’s market price and dividends are denominated in other than the home country of the investor.

Exchange Rate Impacts on Equity Returns: Dec 31, 2010 – Oct 15, 2011Country or Area L.C. Return USD Return Stock Index

United States -0.5% -0.5% DJIA

Egypt -42.8% -44.4% CASE

Japan -16.2% -12.1% Topix

China -13.8% -10.6% SSEA

Britain -7.8% -7.1% FTSE 100

Canada -10.5% -12.5% TSX

Germany -13.3% -10.8% DAX

Switzerland -10.2% -6.4% SMI

Australia -12.0% -14.3% All Ord.

Pakistan +0.8% -1.0% KSE

South Africa -3.1% -17.7% JSE

Hong Kong -20.4% -20.5% Hang Seng

Saudi Arabia -7.8% -7.8% Tadawul

Risk Elements for Global Investors in Bonds The specific risk components associated with

bonds (i.e., fixed income securities): Default risk (credit risk): Risk that issuer will not be

able to repay debt as contracted. Corporates: Cash flow issues. Sovereigns: Governmental debt servicing issues.

Market risk (price risk): Associated with changes in the market’s overall assessment

of risk and willingness to take risk (or avert risk). Contagion risk:

Associated with spillover effects from other countries. Exchange rate risk:

Associated with investing in bonds who’s market price and interest payments are denominated in other than the home country of the investor.

Exchange Rates and Bond Yields The gap between the U.S. dollar un-hedged and hedged Global Treasuries shows the

effect currency has played in these annual returns. In most years (with the exception of 2005 and the first quarter of 2009), currency moves (represented by unhedged returns) benefited the U.S. investor (this is shown by the difference between the un-hedged and hedge indexes).