Managing Foreign Exchange Rate Risk Objectives: To discuss the relevance of an MNC’s exposure to exchange rate risk; To explain the types of currency exposure: Identify techniques for hedging transaction exposure;

Is Exchange Rate Risk Relevant? Purchasing Power Parity Argument FX movements matched by price movements. PPP -- not necessarily hold.

Is Exchange Rate Risk Relevant? The Investor Hedge Argument MNC shareholders can hedge on their own. Incomplete information on corporate exposure. May not have skills

Is Exchange Rate Risk Relevant? Currency Diversification Argument An well diversified MNC is not affected --- there are offsetting effects. This is a naive presumption. Why?

Correlations among Movements in Quarterly Exchange Rates

Is Exchange Rate Risk Relevant? Stakeholder Diversification Argument Well-diversified stakeholders insulated against FX losses of an MNC. Many MNCs are similarly affected by FX. Why?

Is Exchange Rate Risk Relevant? For many MNCs – YES!! Because we manufacture and sell products in a number of countries throughout the world, we are exposed to the impact on revenues and expenses of movements in currency exchange rates. —Proctor & Gamble Co. Increased volatility in foreign exchange rates … may have an adverse impact on our business results and financial condition. —PepsiCo

Types of Exposure Foreign Exchange (FX) Exposure is generally divided into three main categories: Transaction exposure Economic exposure Translation exposure

Transaction Exposure Defined: The extent to which an exchange rate change will alter the local currency cash flows from foreign currency denominated business activities

Transaction Exposure Example: Firm sells its products in foreign countries priced in foreign currency terms Local currency cash flows from transactions denominated in a foreign currency are affected by changes in exchange rates Includes: trade receivables/payables, currency denominated debt and investments, dividends, interest, royalties, etc. Most often hedged currency risk Most firms hedge 100% of exposure using forwards

Measuring Transaction Exposure For each currency: estimate the net of cash in and cash out Convert each net flow into USD using an expected exchange rate

Consolidated Net Cash Flow Assessment of ABC Co.

USD 666,667 inflow USD 666,667 outflow USD 540,000 inflow -Sub A of Mega Corp. has a net outflow of AUD 1,000,000 -Sub B has net inflows of AUD 1,600,000. The expected AUD exchange rate is .90 What is the net inflow or outflow in USD? USD 666,667 inflow USD 666,667 outflow USD 540,000 inflow USD 540,000 outflow

Economic Exposure Definition: the degree to which a firm’s future cash flows can be influenced by FX rate fluctuations. Does not necessarily require currency conversion. A purely domestic firm may be affected foreign competition in its local market domestic competition with foreign sourcing Definition: The sensitivity of the firm’s cash flows to exchange rate movements, sometimes referred to as operating exposure. (Exhibits 10.9 & 10.10)

Economic Exposure Example: A manufacturer of autos produces and sells exclusively in the US. Its competitors are Japanese auto makers. If the JPY depreciates significantly against the USD, Japanese auto makers can reduce the USD price of their cars, attracting customers away from the US manufacturer. Long term cumulative cash flow effect of exchange rate movements for all future periods A firm can have no foreign currency cash flows and still have economic exposure to exchange rate movements Economic exposure includes transaction exposure, but is impossible to detect in a firm’s financial statements - it is obscure

Examples That Subject a Firm to Economic Exposure

Translation Exposure Definition: Exposure of an MNC’s consolidated financial statements to exchange rate fluctuations In particular: subsidiary earnings translated into the reporting currency on the consolidated income statement subsidiary balance sheet Difference is in translation component of equity

Translation Exposure Example: Firm has a subsidiary in Switzerland, and is required to translate the Swiss sub’s CHF denominated financial statements into USD on each reporting date (usually quarterly) USD functional CHF functional Translation of foreign subsidiary balance sheets and income statements into home (parent company) currency The translation of revenues and expenses of foreign subsidiaries directly impacts reported earnings to shareholders but is itself obscure In their MD&As, firms often delineate changes in operating income items (sales, cost of goods sold) due to changes in exchange rates

Does Translation Exposure Matter? Cash Flow Perspective Translation for consolidation does not by itself affect an MNC’s cash flows. But: if there is a weak spot FX rate when translated there may be a weak FX rate when subsidiary earnings are remitted.

Does Translation Exposure Matter? Stock Price Perspective Since translation exposure affects consolidated earnings, and many investors use earnings to value firms, the MNC’s valuation may be affected.

Translation Exposure Degree of translation exposure is dependent on: proportion of business in foreign subs locations of subs accounting methods used

Exposure Comparison Economic Translation Cash Flow focus Accounting Value Focus Future Oriented Past Oriented Considers all Cash Flows Only Balance Sheet & Income Statement Data Only Firms With Foreign Subsidiaries Affected Can Affect all Firms Depends on Economic Facts Depends on Accounting Rules

Managing Transaction Exposure Reminder: Transaction exposure exists when the cash flows from foreign currency denominated transactions are affected by exchange rate fluctuations.

Transaction Exposure When transaction exposure exists, the firm faces three major tasks: Identify its degree of transaction exposure Decide whether to hedge Choose a hedging technique

Transaction Exposure To identify net transaction exposure, Centralized group consolidates all subsidiary reports Consolidated net positions are computed

Transaction Exposure Estimated Cash Flows in 90 Days Unit CCY 1 CCY2 200 -300 -100 B 100 -40 -10 C -180 120 -140 -150

Hedging Policies of MNCs In general, an MNC’s hedging policy varies with the management’s degree of risk aversion. Choices: Accept risk without hedging Take it as a typical business risk Full hedging Establish opposite positions to all exposures Selective hedging Offset only major positions of concern Offset only when the currency is expected to move in a certain direction. Offset only a percentage of the exposure Avoidance Engage in no such contracts/activities

Techniques to Manage Transaction Exposure Non-financial (natural) hedging involves creating offsetting flows within the business: Selling in CAD? Make purchases in CAD Buying in CAD? Invoice sales in CAD

Techniques to Manage Transaction Exposure Financial Hedging techniques include: Forward contract hedge, Money market hedge, and Currency option hedge.

Forward Contract Hedges To hedge future payables, a firm may negotiate a forward contract to purchase the currency forward. To hedge future receivables, a firm may negotiate a forward contract to sell the currency forward.

Forward Contract Hedges Allows an MNC to lock in a specific exchange rate A forward contract is negotiated between the firm and a financial institution. The contract will specify the: currency that the firm will pay currency that the firm will receive amount of foreign currency to be received or paid by the firm rate at which the MNC will exchange currencies (called the forward rate) future date at which the exchange of currencies will occur

Money Market Hedge A money market hedge involves taking a money market position to cover a future payables or receivables position. For payables: Borrow in the home currency (or use surplus funds) Spot exchange – Sell home currency/buy foreign currency Invest in the foreign currency Use foreign currency p+i to make payment

A firm needs to pay NZ$1,000,000 in 30 days. Money Market Hedge A firm needs to pay NZ$1,000,000 in 30 days. 1. Borrows $646,766 Borrows at 8.40% for 30 days 3. Pays $651,293 3. Receives NZ$1,000,000 2. Holds NZ$995,025 Exchange at $0.6500/NZ$ Effective exchange rate $0.6513/NZ$ Invests at 6.00% for 30 days

Money Market Hedge Borrow in the foreign currency For receivables: Borrow in the foreign currency Spot exchange – Sell foreign currency/buy home currency Invest in the home currency (or repay debt) Use foreign currency inflow to repay borrowing

A firm expects to receive S$400,000 in 90 days. Money Market Hedge A firm expects to receive S$400,000 in 90 days. 1. Borrows SGD392,157 Borrows at 8.00% for 90 days 3. Pays SGD400,000 3. Receives USD219,568 2. Holds USD215,686 Exchange at $0.5500/S$ Effective exchange rate $0.5489/S$ Invests at 7.20% for 90 days

Currency Option Hedge A currency option hedge uses currency call or put options to hedge transaction exposure. Since options need not be exercised, they can insulate a firm from adverse exchange rate movements, and yet allow the firm to benefit from favorable movements. Currency options are also useful for hedging contingent exposure.

Hedging with Currency Options Hedging Payables with Currency Call Options Hedging Receivables with Currency Put Options Strike price = $1.60 Premium = $ .04 Strike price = $0.50 Premium = $ .03 Nominal Cost for each £ $1.58 $1.62 $1.66 Future Spot Rate Nominal Income for each NZ$ $.44 $.48 $.52 Future Spot Rate Without Hedging Without Hedging With Hedging With Hedging

Comparison of Hedging Techniques Hedging techniques are compared to identify the one that minimizes outflows/expenses or maximizes inflows/receipts.

Alternative Exposure Management 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, (aka proxy hedging)

Leading and Lagging Leading and lagging strategies involve adjusting the timing of a payment to reflect expectations about future currency movements. Expediting a payment is referred to as leading When the foreign currency is expected to appreciate Deferring a payment is termed lagging. When the foreign currency is expected to depreciate

Cross-Hedging / Proxy Hedging When an exposed currency cannot be hedged, use another currency that can be hedged and is highly correlated The stronger the positive correlation between the two currencies, the more effective the cross-hedging strategy will be.

Cross-Hedging : Example Nortel in Canada is bidding for a contract in China. If awarded, the contract terms will require Nortel to make an initial investment of 450 million Chinese Yuan (CNY). The current exchange rate is .17 CAD/CNY. Nortel expects a substantial appreciation of CNY by the time the contract bid is determined and wants to hedge the potential CNY cash outflow. CNY and USD are highly correlated in their relationship to the CAD Even though there is no option contract available for CNY, Nortel can use a USD option contract to hedge against the exposure.

SUMMARY Transaction exposure is the exposure of an MNC’s contractual transactions to exchange rate movements. MNCs can measure their transaction exposure by determining their future payables and receivables positions in various currencies, along with the volatility levels and correlations of these currencies. From this information, they can assess how their revenue and costs may change in response to various exchange rate scenarios.

SUMMARY (Cont.) Economic exposure is any exposure of an MNC’s cash flows (direct or indirect) to exchange rate movements. MNCs can attempt to measure their economic exposure by determining the extent to which their cash flows will be affected by their exposure to each foreign currency. Translation exposure is the exposure of an MNC’s consolidated financial statements to exchange rate movements. To measure translation exposure, MNCs can forecast their earnings in each foreign currency and then determine how their earnings could be affected by the potential exchange rate movements of each currency. Thus, MNCs recognize the relevance of exchange rate risk, and may benefit from hedging their exposure.

SUMMARY (Cont.) An MNC may choose to hedge most of its transaction exposure or to selectively hedge. Some MNCs hedge most of their transaction exposure so that they can more accurately predict their future cash inflows or outflows and make better decisions regarding the amount of financing they will need. Many MNCs use selective hedging, in which they consider each type of transaction separately.

SUMMARY (Cont.) To hedge payables, a forward contract on the foreign currency can be purchased. Alternatively, a money market hedge strategy can be used; in this case, the MNC borrows its home currency and converts the proceeds into the foreign currency that will be needed in the future. Finally, call options on the foreign currency can be purchased

SUMMARY (Cont.) To hedge receivables, a forward contract on the foreign currency can be sold. Alternatively, a money market hedge strategy can be used. In this case, the MNC borrows the foreign currency to be received and converts the funds into its home currency; the loan is to be repaid by the receivables. Finally, put options on the foreign currency can be purchased. When hedging techniques are not available, there are still some methods of reducing transaction exposure, such as leading and lagging, cross-hedging