TRANSACTION EXPOSURE Chapter 10 Multinational Business Finance (2nd Edition) Chapter 10 David Eiteman | Kevin Daly Subhrendu Rath | Arthur Stonehill | Michael Moffett TRANSACTION EXPOSURE

Foreign Exchange Exposure Foreign Exchange Exposure Foreign exchange exposure 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. Financial managers are responsible to measure foreign exchange exposure and to manage it so as to maximise the profitability, net cash flow, and market value of the firm.

Foreign Exchange Exposure Foreign Exchange Exposure The effect on a firm when foreign exchange rates change can be measured in several ways. Transaction exposure Operating exposure Translation exposure Tax exposure

Foreign Exchange Exposure Foreign Exchange Exposure (Page 293)

Types of Foreign Exchange Exposure Types of Foreign Exchange Exposure Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. deals with changes in cash flows the result from existing contractual obligations.

Types of Foreign Exchange Exposure Types of Foreign Exchange Exposure Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates.

Types of Foreign Exchange Exposure Types of Foreign Exchange Exposure Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. Transaction exposure is concerned with future cash flows already contracted for and Operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.

Types of Foreign Exchange Exposure Types of Foreign Exchange Exposure Accounting exposure, also called translation exposure is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements

Types of Foreign Exchange Exposure Types of Foreign Exchange Exposure The tax exposure consequence of foreign exchange exposure varies by country. As a general rule only realised foreign exchange losses are deductible for purposes of calculating income taxes realised gains create taxable income. “Realised” means that the loss or gain involves cash flows.

Why Hedge? Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position. While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.

Why Hedge? MNEs need financial risk management since their cash flows are sensitive to changes in exchange rates, interest rates, and commodity prices. MNCs use hedging to manage their currency exposures.

Why Hedge? The value of a firm Currency risk is Why Hedge? The value of a firm is the net present value of all expected future cash flows. Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.

Why Hedge? (Page 296)

Why Hedge? Reasons not to hedge: Why Hedge? Reasons not to hedge: Shareholders are much more capable of diversifying currency risk than the management of the firm Currency risk management does not increase the expected cash flows of the firm Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict) Managers cannot outguess the market Management’s motivation to reduce variability is sometime driven by accounting reasons Efficient market

Why Hedge? Reasons not to hedge : Why Hedge? Reasons not to hedge : Improves the planning capability of the firm Reduces the likelihood that the firm’s cash flows will fall below a necessary minimum A comparative advantage over the individual shareholder in knowing the actual currency risk of the firm To take advantage of disequilibrium conditions in the market

Measurement of Transaction Exposure Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. arises when a firm has a receivable or payable denominated in a foreign currency.

Measurement of Transaction Exposure Measurement of Transaction Exposure (Page 298)

Measurement of Transaction Exposure Measurement of Transaction Exposure Foreign exchange transaction exposure can be managed by using Contractual hedges forward, money, futures, and options markets Operating and financial hedges use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies

Measurement of Transaction Exposure Measurement of Transaction Exposure Natural hedge an off-setting operating cash flow, a payable arising from the conduct of business Financial hedge either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap.

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Refer to the Belmont Mining’s Transaction Exposure in page 297 Susan Martin has four alternatives: Remain unhedged; hedge in the forward market; hedge in the money market, or hedge in the options market. These choices apply to an account receivable and/or an account payable.

Case: Belmont Mining’s Transaction Exposure (page 297) Case: Belmont Mining’s Transaction Exposure (page 297) Susan Martin has four alternatives: Remain unhedged; hedge in the forward market; hedge in the money market, or hedge in the options market. These choices apply to an account receivable and/or an account payable.

Case: Belmont Mining’s Transaction Exposure (page 297) Case: Belmont Mining’s Transaction Exposure (page 297) Susan Martin has four alternatives: Remain unhedged; hedge in the forward market; hedge in the money market, or hedge in the options market. These choices apply to an account receivable and/or an account payable.

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Remain unhedged Today Three months later Do nothing Receive EUR1,000,000. Sell EUR1,000,000 spot and receive AUD at that day’s spot rate

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. ‘Open’ or ‘uncovered’ hedge Funds to fulfill the forward exchange contract may not be already available or due to be received later, but must be purchased in the spot market at some future date. involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract.

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Forward hedge Today Three months later Sell EUR1,000,000 forward at AUD1.67/EUR Receive EUR1,000,000. Deliver €1000,000 against forward And receive AUD1,670, 000

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure A money market hedge involves a contract and a source of funds to fulfill that contract. A loan agreement The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. Funds to fulfill the contract [to repay the loan] may be generated from business operations, in which case the money market hedge is covered. Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge).

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure A money market hedge Borrow Euros in Frankfurt [Germany] at 2.0% per quarter Repay the loan €980,392.15 with interest €19,608 from the sale proceed Exchange €980,392.15 loan proceed for Australian dollar EUR980,392.15×AUD1.68 = AUD1,647,059.00 Invest AUD in

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure A money market hedge Today Three months later Borrow EUR980,392 Exchange EUR980,392 at AUD1.68 Receive AUD1,647,059 Receive EUR1,000,000. Repay EUR980,392 plus interest EUR19,608 For total of EUR1000,000 .

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk The choice of option strike prices is a very important aspect of utilising options as option premiums, and payoff patterns will differ accordingly.

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Hedging with options Today Three months later Buy a put option to sell euros at AUD1.68/􀀨. Pay AUD42 000 for put option Receive EUR 1,000,000. Either deliver EUR1000,000 against put, receiving AUD1,680, 000 or sell EUR1 ,000,000 spot if current spot rate is greater than AUD1.68/ EUR .

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Transaction exposure (payables)

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Remain un-hedge -Payables Today Three months later Do nothing Pay EUR 1,000,000. buy EUR1000,000 spot and pay AUD at that day spot rate

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Money market forward -Payables Today Three months later Buy EUR1,000,000 at AUD1.67/EUR Pay EUR 1,000,000. buy EUR1000,000 using forward And pay AUD1,670, 000

Belmont Mining’s Transaction Exposure Money market hedge –Payables Invest in a 90-day euro-denominated interest bearing account Buy euro for the investment at spot EUD985,221.67×AUD1.68/EUR = AUD1,655,172.41 Total carried forward cost AUD1,655,172.41× [1+(0.10×90/360] = AUD1,696,551.72

Belmont Mining’s Transaction Exposure Money market hedge (payable) Today Three months later Borrow AUD1,655,172.41 Exchange at AUD 1.68/EUR Receive EUD985,221.67 Pay EUR 1,000,000 using the EUR deposit AUD cost in three months AUD1,696,551.72

Belmont Mining’s Transaction Exposure Belmont Mining’s Transaction Exposure Hedging with options -Payables Today Three months later Buy a call option to buy euros at AUD1.68/􀀨. Pay AUD43,050 for call option Pay EUR 1,000,000. Either deliver AUD1,680, 000 against call receiving EUR1000,000 or buy EUR1,000,000 spot if current spot rate is lower than AUD1.68/ EUR .

Risk Management in Practice Risk Management in Practice Which Goal? The treasury function [a cost center] of most private firms responsible for transaction exposure management. The treasury function is not expected to add profit to the firm’s bottom line. Currency risk managers are expected to err on the conservative side when managing the firm’s money.

Risk Management in Practice Risk Management in Practice Which exposures? Transaction exposure exist before they are actually booked as foreign denominated receivable and payables. Quotation exposure or backlog exposure is not allowed to hedge as a matter of policy Conservative hedging policies dictate that contractual hedges be placed only on existing exposure An increasing number of firms are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures. Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties

Risk Management in Practice Risk Management in Practice Which contractual Hedges? Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level.

Mini-Case Questions: Xian-Janssen Pharma (cont’d) Mini-Case Questions: Xian-Janssen Pharma (cont’d) How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures? J&J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralised organisational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation in which XJP finds itself?

Mini-Case Questions: Xian-Janssen Pharma (cont’d) Mini-Case Questions: Xian-Janssen Pharma (cont’d) What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary’s financial results by the U.S. parent company? If you were Paul Young, what would you do?

Additional Exhibits (Page 307)

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