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FOREIGN

EXCHANGERISK

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1. The risk of an investment's value changingdue to changes in currency exchange rates.

2. The risk that an investor will have to close out along or short position in a foreign currency at aloss due to an adverse movement in exchange

rates. Also known as "currency risk" or"exchange-rate risk"

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Translation exposure, or accountingexposure measures the potential

losses or gains that would appear onthe consolidated financial statementsfollowing a change in exchange rates.

Tax exposure measures the taxconsequences of foreign exchange

exposure

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1. Purchasing or selling on credit whenprices are stated in a foreign currency.

2. Borrowing or lending funds whenrepayment is to be made in a foreigncurrency.

3. Being a party to an unperformedforeign exchange forward contract.4. Acquiring assets or incurring liabilities

denominated in a foreign currency.

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A U.S. firm sells merchandise on open account to a Belgianbuyer for E1,800,000, payment to be made in 60

days.

Current exchange rate is $1.1200/E.Seller expects to receiveE1;800;000$1:1200=E = $2;016;000.Transaction exposure:

If the euro weakens, the seller will receive less than$2,016,000.

If the euro appreciates, the seller will receive more

than $2,016,000.

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PepsiCos largest bottler outside the US is located inMexico,Grupo Embotellador de Mexico (Gemex)

December 94: Gemex had US dollar denominated debtof $264 million. The Mexican peso (Ps$) is peggedat Ps$3.45/US$

December 22, 94: The peso is allowed to float due tointernalpressures and sinks to Ps$4.65/US$Peso traded at around Ps$5.50/US$ for most of

January.

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When a firm buys a forward exchange contract, itdeliberately creates transaction exposure; this

risk is incurred to hedge an existing exposure.A firm offsetting a transaction exposure of U100million, say, to pay for an import from Japan in90 days, can purchase U 100 million in theforward market.

The counterparty to this transaction now facesforeign exchange exposure.

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Contractual Hedge: Forward, money, futures andoptions market hedges.

Operating Hedge: Risk-sharing agreements, leadsand lags in payment terms, swaps, and otherstrategies.

Natural Hedge: Offsetting operating cash flows.

Financial Hedge: Offsetting debt obligation orsome type offinancial derivative such as a swap.

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I. FOREIGN EXCHANGE RISK: Step I.

A.Economic exposure defined: focuses on

thefuture impact of unexpected currencyfluctuations on firms value.

1 .The most important aspect of foreign

exchange risk management: Incorporateexpectations about the risk into all basicdecisions of the firm.

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B. Real Exchange Rates Changes andRisk Nominal v. real exchange rates:

real rate has been adjusted for pricechanges.

Assume: no two nations have thesame annual rate of inflation.

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C. Implications

1. If nominal rates change with

an equal price change, noalteration to cash flows.

2. If real rates change, it causesrelative price changes andchanges in purchasing power.

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Operating exposure begins withNew product development

A distribution network

Brand name development

Marketing to foreign marketsForeign supply contracts

Overseas production facilities

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To measure operating exposure

requires a longer-term perspective.

i.e. Cost and price

competitiveness could be affectedby unexpected exchange rate

changes

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A decline in the real value of a

currency: makes exports and import-competing goods more competitiveAn appreciating currency makes:

imports and export-competing goodsmore competitive

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During an appreciation of homecurrencies: Exporters face two choices:

keep prices constant (but losesales)or adjust prices to foreign

currency to maintain market share(lose profits)

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a. the economic impact of a currency

change depends on the offset by the

difference in inflation rates orthe change in real exchange rates.

b. It is the relative price changes that

ultimately determine a firms long-run

exposure.

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I. ECONOMIC CONSEQUENCES

The impact on Operating Exposure of areal rate change depends upon: Pricing

flexibility and

1.Price elasticity of demand

2.Degree of product differentiation3.The Ability to shift production

and the substitution of inputs

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Pricing Flexibility is key

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Can the firm maintain its profit margins

both at home and abroad?

If price elasticity of demand is low, the

more price flexibility a firm has. i.e.

Availability of good substitutesThe Ford Corp in Indonesia, 1997

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Product Differentiationprice elasticity depends on degree of

differentiationThe greater the differentiation, themore the firm can control its prices.

e.g. Daimler Chrysler Corp.

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The Ability to Shift Production and to

source inputs from other countries

e.g. Japanese car makers

(Toyota) in the late 1980s

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Operating exposuremanagement requires

long-term operatingadjustments and the

involvement of ALLdepartments.

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II. Marketing StrategyA. Market Selection:

use competitive advantageto carve out market share

when currency valueschange

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B. Pricing strategy: Expectations critical 1.IfHC depreciates, exporter gains

competitive advantage by increasingunit profitability or market share.2. The higher price elasticity of

demand, the more currency risk thefirm faces by other productsubstitution.

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C. Product Strategy exchange rate changes mayalter

1. The timing of new productintroductions,

2. Product deletion

3. Product innovations

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III. Product Management Adjustments

A. Input mix shop the world

B. Shift production among plantsC. Plant relocation (new)D. Raising productivity

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IV. Planning For Exchange-Rate ChangesA. Develop contingency plans

with plausible scenariosbefore the impact of a

currency change makes itselffelt.

e.g. flexible mfg systems

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Risk Management is the name given

to a logical and systematic method

of identifying, analysing, treating

and monitoring the risks involved

in any activity or process.

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Economic exposure

any impact of exchange rate

fluctuations on future cash flows

an MNC should examine how all

cash flow is affected by exchangerate movement

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Restructuring an MNCs exposureThe approach depends upon form of exposure

MNC with revenue (inflow) exposure

decrease revenue in foreign currency

increase costs in foreign currency to balance flows

MNC with expense (outflow) exposure

increase revenues in foreign currency

decrease costs in foreign currency to balanceflows

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Managing Economic Exposure

balances sensitivity of revenues and expenses to

exchange rate fluctuations

choose one international company and analyze its

financing strategies and overall risk management

strategies as you are the CFO in a multinationalcompany.

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The US firm with subsidiary in Japanmost revenue (receivables) in the US

dollars

most costs occur in Japanese yen

most borrowing occurs in Japan

a currency imbalance exists between costsand revenues

Income statement becomes sensitive to

currency fluctuations

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Income statement becomes sensitive to

currency fluctuations effect of currency imbalance among costs and

revenues

Measuring exposure for US MNC Y

Costs Revenues

Net earnings

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Impact if yen were to strengthen

increases MNC Ys production costs increases MNC Ys interest expenses

decreases net earnings

Measuring exposure for US MNC Y

Costs Net earnings

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Response to a strong yen over time

MNC Y may change emphasis of the two sites increase Japanese revenue

shift costs to US

attempt to reduce effect of currency

imbalance

Measuring exposure for US MNC Y

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It also helps to know that in general you should borrow thecurrency that is expected to be softer in value / depreciateagainst home currency. Meaning you pay less in home currencylater.

Sell the future gains if you expect the foreign currency to

depreciate more than the forward rate indicates (otherwise youlose in terms of home currency). But if you believe in the paritycondition, you dont gain by trading in the foreign exchangemarket.

In reality, the equivalence models do not hold in the short run

due to market imperfections, that provides one of the solidground for hedging transaction exposure.

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CASH FLOW EXPOSURES MATTER

P FCFk

n

n( )1

Given the above model, future cash flow is the key to

corporate valuation.

Logically, transaction and economic exposuresmatter. But pure translation might not.

However, at higher levels of gearing, failure tomanage pure translation exposure may result inbreach of a borrowing covenant, see example at A.Buckley, p 175.

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Base case subsequent move to

exchange rate $ to 1,8 1,4

Assets ( M)

in UK 100 100

in US ($ 180M) 100 128,6

200 228,6

Financed by ( M)

shareholders' funds 100 100

US$ debt ($ 180M) 100 128,6

200 228,6

Debt to equity ratio 1 to 1 1,28 to 1

The example. Chapter 10, Page 175. Debt equity ratio can be a reason forfirms to hedge. (note: this example is in the excel file for chapter 8

online.)

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Covering exposures is designed to reduce thevolatility of a firms profits and/or cash generation.Reducing foreign exchange risks so that FIRMS CANtake on more operating risks, and

reducing probability of financial distress bankruptcyrisk, enabling firms to borrow more, and add value ofthe tax shields. (can you find a real world example of aMNC?)

n

t

t

ttt

r

eCOCIPV

0 1

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OR, IS THE VALUE OF THE FIRM EQUAL TO ......

VF [Vi] P()

VF Value of firm.

Vi Present value of division i.

P() Penalty factor (or risk premium?) based on the impact on

after tax cash flows of the total risk of the firm.

Vi is the net present value of each of the firms division and P() is a

penalty factor that reflects the impact on after tax cash flows of the

total risk of the firm.

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The penalty factor (risk premium) is a functionof total risk. This equation supports the reducedvolatility of return argument, (see diagram before)which reduces bankruptcy probability. It suggests

that hedging is a good thing for shareholdersbecause, in lowering the risk premium, corporatevalue is enhanced, at least this is true forundiversified shareholders. Because diversification

would render the hedging activities unnecessary forshareholders.

)(P

)(PVV iF

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Macroeconomic exposure is concerned with how a firmscash flows, profit and/or value, change as a result ofchanges in the economic environment as a whole. Thisincludes changes in:

Exchange rates.

Interest rates.

Inflation rates.

Wage levels.

Commodity price level.

Etc.

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ProfitorCF 1E 2i 3p 4W 5P 6RPorVProfit is before interest and tax p Price level.CF Real cash flow W Wage levels.V Value of firm P Commodity price level.E Exchange rate RP Relative prices.i Interest ratesand..........clearly one can try to manage exposure due to themagnitude of the impact on the firms cash flow.

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Value at risk estimates potential pre-tax loss resulting from anadverse movement in interest rates, exchange rate, and/or marketprices over a certain holding period.

Finding out the interest rate, exchange rate sensitivity of theexposure:

1. variance (covariance) method, 2. historical method, 3. Monte Carlosimulation.

Daily Earnings At Risk=Dollar market value of the position*price volatility

where Price volatility= Price sensitivity of the position*potential adversemove in yield

For N days: VaR=DEAR*square root of N the maximum loss that can occur 5% (1%) of the time. (worst daily

loss in history evaluated at 5% (1%) significance level). This enablesyou to decide how to hedge and how much.

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Netting. Matching. Leading and lagging. Pricing policies. Asset/liability management.

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Netting requires a two-way cash flow inthe same foreign currency. It involves associated companies with

debts, possibly as a result of trade witheach other. Associate companies simplycancel out amounts owed with amountsdue and settle for the difference

Matching is a term applied to not just

subsidiaries and within groups, but also thirdparties See example

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= netting arrangement

UKsubsidiary

Swiss subsidiary French subsidiary

Ex: If UK subsidiary owes the French subsidiary $6m, and the French sub.owes the UK $4m, the netted amount would be $2m

treasury

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Price variation: transfer pricing Pricing of goods and services that change hands within a

group to counter the adverse effect of exchange ratemovement

This is to minimize the tax paid to the host country. It isillegal nevertheless and involves a fine.

Currency of invoice

The sellers ideal currency is a stable currency or its own

currency. So that it will not lose value when receiving. The buyers ideal currency is its own currency or a stable

currency.

Use currency of your income so as to reduce the exposure.

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Forwards. Short-term borrowing or depositing. Discounting receivables. Factoring receivables. Currency overdrafts and currency hold

accounts.

Government exchange risk guarantees. Currency swaps. Financial futures. Currency options.

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Do some home

work and ready for

further discussionon this topic

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