INTERNATIONAL FINANCE Lecture 26 INTERNATIONAL FINANCE

Review If the real cost of hedging is negative, then hedging is more favorable than not hedging. Money Market Hedge For payables: Borrow in the home currency For receivables: Borrow in the foreign currency Currency Option Hedge MNCs Policies to Hedge Currency swap Parallel loan Source: Adopted from South-Western/ Thomson Learning 2006

Managing Economic Exposure And Translation Exposure Lecture 26 Managing Economic Exposure And Translation Exposure

Objectives To explain how an MNC’s economic exposure can be hedged; To explain how an MNC’s translation exposure can be hedged.

Alternative Hedging Techniques Sometimes, a perfect hedge is not available (or is too expensive) to eliminate transaction exposure. To reduce exposure under such conditions, the firm can consider: leading and lagging, cross-hedging, or currency diversification.

Leading and Lagging Leading and lagging strategies involve adjusting the timing of a payment request or disbursement to reflect expectations about future currency movements. Expediting a payment is referred to as leading, while deferring a payment is termed lagging.

Cross-Hedging When a currency cannot be hedged! Another currency that can be hedged and is highly correlated may be hedged instead. The stronger the positive correlation between the two currencies, the more effective the cross-hedging strategy will be.

Currency Diversification An MNC may reduce its exposure to exchange rate movements when it diversifies its business among numerous countries. Currency diversification is more effective when the currencies are not highly positively correlated.

Economic Exposure Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. Some of these affected cash flows do not require currency conversion. Even a purely domestic firm may be affected by economic exposure if it faces foreign competition in its local markets.

Economic Exposure In general, firms with more foreign costs than revenues tend to be unfavorably affected by stronger foreign currencies. Transaction exposure is a subset of economic exposure. But economic exposure also includes other ways in which a firm’s cash flows can be affected by exchange rate movements.

Economic Exposure Economic exposure can be measured by assessing the sensitivity of the firm’s earnings to exchange rates. This involves reviewing how the earnings forecast in the firm’s income statement changes in response to alternative exchange rate scenarios.

Economic Exposure From a U.S. firm’s perspective, transaction exposure represents only the exchange rate risk when converting net foreign cash inflows to U.S. dollars or when purchasing foreign currencies to send payments. Economic exposure represents any impact of exchange rate fluctuations on a firm’s future cash flows. Corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions.

Economic Exposure Thus, firms cannot focus just on hedging their foreign currency payables or receivables but must also attempt to determine how all their cash flows will be affected by possible exchange rate movements.

Example Nike’s economic exposure comes in various forms. First, it is subject to transaction exposure because of its numerous purchase and sale transactions in foreign currencies, and this transaction exposure is a subset of economic exposure. Second, any remitted earnings from foreign subsidiaries to the U.S. parent also reflect transaction exposure and therefore reflect economic exposure.

Example Third, a change in exchange rates that affects the demand for shoes at other athletic shoe companies (such as Adidas) can indirectly affect the demand for Nike’s athletic shoes. Nike attempts to hedge some of its transaction exposure, but it cannot eliminate transaction exposure because it cannot predict all future transactions.

Example Moreover, even if it could eliminate its transaction exposure, it cannot perfectly hedge its remaining economic exposure; It is difficult to determine exactly how a specific exchange rate movement will affect the demand for a competitor’s athletic shoes and, therefore, how it will indirectly affect the demand for Nike’s shoes.

Economic Exposure PCFt = a0 + a1et + t Economic exposure can also be measured by assessing the sensitivity of the firm’s cash flows to exchange rates through regression analysis. For a single foreign currency: PCFt = a0 + a1et + t PCFt = %  in inflation-adjusted cash flows measured in the firm’s home currency over period t et = %  in the exchange rate over period t

Review Cross Hedging Currency Diversification Economic Exposure Empirical Analysis Source: Adopted from South-Western/ Thomson Learning 2006