International Financial Management: INBU 4200 Fall Semester 2004 Lecture 9 Foreign Exchange Exposure (Chapters 12, 13, and 14 )

FOREIGN CURRENCY EXPOSURE Definition: As firms operate on a global basis, they are involved in currencies other than their home currency. Why? –From selling products overseas Exporting to a foreign buyer –From sourcing products and components overseas Importing from a foreign manufacturer –From financing overseas Borrowing funds overseas –From investing overseas Investing in financial assets (e.g., mutual funds) Foreign Direct Investment (FDI); physical investment in plant and equipment overseas.

Exposure is Complex Driven by the composition of a firm’s: –Global sales (how concentrated; how diverse) Issue: Is there a “natural” hedge because the firm operates in many diverse economies? Or is the firm “over-exposed” in limited markets? –Global sourcing (where does the firm source its final sales?) Sourcing components overseas in weak currency markets can offset the impact of selling final product in weak currency markets! –Sourcing in weak currency markets holds down costs. »Offsets lower home currency revenues from sales in weak currency countries. –Also allows firms to remain competitive at home.

Foreign Exchange Risk The foreign currency exposures will subject the firm to foreign exchange risk: –Adverse changes in exchange rates can adversely affect the firm: Cash flows in home currency Profits (and profit margins) in home currency Competitive position (at home and abroad) Home currency value of foreign currency assets and foreign currency liabilities –Financial and real investments overseas –Cost of borrowing overseas

Foreign Exchange Risk Management Refers to the techniques which a firm may use to manage its foreign exchange exposure. –Hopes to reduce (offset) the potential risk associated with these exposures. Two general types of risk management techniques: –Financial hedges –Operational (firm strategic) hedges

Financial Hedges Financial contracts which pass the foreign exchange risk on to someone else. Allows the firm to “cover” (or hedge) its foreign exchange exposure. What are these contracts? –Forward contracts –Future contracts –Option contracts Puts and calls on foreign currency –Insurance contracts

Operational Hedges Strategic response of the firm itself to its exposure. Organizing the activities of the firm to “offset” known exposures. What are some of these activities? –Invoicing receivables and payables (in what currencies?). –Timing of payments. –Avoidance of high risk (currency) markets. –“Neutralizing” asset and liability structures of overseas operations (netting close to zero). –Long term fixed contractual agreements with suppliers or buyers to lock in payment streams. –Organizational diversity (geographic and product). –Operational flexibility (of suppliers)

Types of Foreign Exchange Exposures Global firms face three possible types of foreign currency exposure. Economic Exposure Transaction Exposure Translation (accounting) Exposure

Economic Exposure The extent to which the value of the firm might be affected by “long-term” unanticipated changes in exchange rates. –Long term in nature: Firm’s cannot presently “measure” these future exposures. –Unanticipated in nature: Since unanticipated, firm’s cannot use traditional (financial) hedging strategies to deal with this exposure. This exposure will affect the long term competitive position of a firm, its long term cash home currency flows, and on its long term value! Example: Long term FDI. –General Motors has plants and/ or operations in 65 countries world wide; they sell cars in over 100 countries!

General Motors Locations North AmericaLebanon Asia/Pacific Taiwan Austria Portugal Canada Nigeria Australia Thailand Belgium Spain MexicoOman China E. Europe Denmark Switzerland United StatesQatar Hong Kong Croatia Finland Sweden Africa/Mid East Saudi Arabia India Czech Rep. France Turkey BahrainSouth Africa Indonesia Slovak Rep. Germany U.K. EgyptSyria Japan Hungary Greece Latin America IsraelTunisia Korea Poland Ireland Argentina JordanUnited Arab Malaysia Russia Italy Brazil KenyaEmirates New Zealand Slovenia Netherlands Chile KuwaitYemen Singapore W. Europe Norway Ecuador Paraguay Uruguay Venezuela

Measuring Economic Exposure Economic exposure has two elements: –Asset and Liability Exposure: Changes in the home currency value of overseas assets and liabilities (plant, equipment, accounts payable, loans) –Operating Exposure: Changes in the home currency value of future operating cash flows. –Impact on costs (fixed and variable) and selling prices –This changes the competitive position of the firm in global markets

Operating Exposure Operating Exposure is not as easily quantified as other exposures. However, it is determined by: –The structure of the markets in which the firm sources its inputs (labor and materials). Cost sensitivity! –The structure of the markets in which the firm sells its products and services. Price sensitivity!

Market Structure Questions the firm faces? –Are their opportunities for “exchange rate pass through.” Can the firm pass on higher costs due to exchange rate changes on through higher prices for its products? –Depends upon competitive forces! –Note: If both costs and prices are sensitive to exchange rate changes, a full pass through opportunity may exist, and the firm may face little operating exposure. Operating exposure occurs when there is an imbalance between the two!

Other Considerations In determining the impact of exchange rates on operating exposure, the firm should also consider: –The ability of the firm to offset the effects of exchange rate changes by adjusting its: Markets (where it is physically operating and selling its products) –McDonalds moving out of low revenue areas (South America) Product mix Sourcing –Nike with contract manufacturing in Asian countries –About 99% of all Nike brand apparel is produced outside the US in 35 different countries.

Nike Contract Manufacturing By Country, 2003 CountryPercent Peoples Republic of China38 Indonesia27 Vietnam18 Thailand16 Italy< 1 Taiwan< 1 South Korea< 1

Nike Revenue by International Region (Dollars in Millions), 2003 Revenue: Percent: USA: 4, % EMEA: 3, % Asia Pacific: 1, % Americas: % Other: % Total:10,687.0 Note: EMEA (Europe, Middle east and Africa)

Managing Operating Exposure The following strategies are potentially important for managing operating exposure: –Selecting low-cost overseas production sites. “Offshore production.” –Flexibility in sourcing components. Buying components from low cost manufacturers. –Diversification of markets (selling and sourcing) Across countries and product lines. Nike: Produce in Asia; sell in North America and Europe –Product differentiation (allows for exchange rate pass through). Importance of R&D investment –Financial hedging (if possible) May also be appropriate if above strategies prove too costly!

Transaction Exposure: Defined Variation in the home (domestic) currency values of a firm’s contractual future foreign currency denominated cash flows resulting from changes in exchange rates. –Foreign currency cash flow is known today! Foreign currency denominated account receivable or foreign currency denominated account payable. Both the amount and the timing are known today. –Home currency equivalent of foreign currency cash flow is NOT known today

Transaction Exposure: Issues Arises from “fixed-price” contracting in a world where exchange rates are subject to change. –Firm agreeing to accept a set payment in some foreign currency at a date in the future! –Firm agreeing to make a set payment in some foreign currency at a date in the future! Note: The foreign currency is a known fixed amount, the date in the future is known; the future home currency equivalent is not known.

Measuring Transaction Exposure Of all the exposures, transaction exposure is the probably the easiest to measure. It is represented by the amount of the contractual agreements the firm has entered into. –Accounts payable –Accounts receivable –Loans (bank) payable, bonds payable We can attach a foreign currency amount to these agreements!

Exposure Issue the Firm Faces While we can place an amount on the foreign currency contractual agreement, the issue for the firm is what will be the future home currency equivalent of that agreement? Example for U.S. exporter: –Account receivable in 1 million yen due in 30 days? –What will the yen be worth in U.S. dollar terms in 30 days. Spot rate in 30 days? Problem: Forecasting future spot rates is very difficult.

Hedging Transaction Exposures Since the foreign currency amount of the contractual agreement is known today, these transaction exposures can be easily hedged if the firm so chooses. –Forward market hedge –Options market hedge –Money market hedge –Swap market hedge All of the above done for a specific amount of foreign currency and at a specified future time.

Forward Market Hedge Most popular and direct (easiest) method of hedging transaction exposures. –93% of Fortune 500 firms use them (1995 survey). –Selling foreign currency forward, or –Buying foreign currency forward Forward transaction is arranged to offset contractual agreement –Offset an account payable by buying foreign currency forward. –Offset an account receivable by selling foreign currency forward.

Options Hedge Used by about 50% of Fortune 500 firms! Options contracts provides the holder with: –“Insurance” against unfavorable changes in the exchange rate, and provides the firm with –The ability to take advantage of a favorable change in the exchange rate.

Two Basic Types of Options Call Option: –Allows the holder to call (buy) foreign currency at a price (exchange rate is the strike price) set today if so desired. Used to offset a foreign currency liability. Provides the holder with an upper limit (“ceiling’) price for the foreign currency. If spot rate proves to be advantageous, the holder will not exercise the call option, but instead buy the needed foreign currency in the spot markets. –Will not exercise if the spot rate is “cheaper” to the firm.

Two Basic Types of Options Put Option: –Allows the holder to put (sell) foreign currency at a price (exchange rate is the strike price) set today if so desired. Used to offset a foreign currency receivable. Provides the holder with an lower limit (“floor’) price for the foreign currency. If spot rate proves to be advantageous, the holder will not exercise the put option, but instead sell the foreign currency in the spot markets. –Will not be exercised if the spot rate has appreciated (i.e., foreign currency is worth more).

Pro and Con of Options Advantage: –Gives firm flexibility to take advantage of a favorable change in exchange rate. Not possible with a forward. Disadvantage: –Costly: Firm pays an upfront option premium which it loses if it does not exercise the option.

Where does a Firm Negotiate these Contracts? Both forwards and options can be negotiated with major banks (over the counter market). –Bank market is individually tailored to firm’s needs. Amount of currency Timing of the hedge Standard exchange markets do exist for both hedges –Future market. Chicago Mercantile Exchange, Tokyo International Futures Exchange, Singapore International Monetary Exchange –Options markets. Chicago Mercantile Exchange, Philadelphia Stock Exchange, Singapore International Monetary Exchange

Web Sites Chicago Mercantile Exchange – Philadelphia Stock Exchange – Tokyo International Futures Exchange –

Translation Exposure The impact of exchange rate changes on the consolidated financial statements of a global firm. –Consolidation involves the translation of subsidiaries financial statements, which are denominated in local currencies, back to the home currency of the parent. –Changes in exchange rates will affect the home currency value of the subsidiary’s assets and liabilities and revenues.