Measuring and Managing Foreign Exchange Exposure International Financial Management Dr. A. DeMaskey

Learning Objectives What are the three different types of foreign exchange exposures? How is translation and transaction exposure measured? What are the two primary methods of converting foreign currency denominated financial statements into the reporting currency of the U.S. parent company? What are the basic hedging strategies and techniques used by firms to manage their currency transaction and translation risks?

Foreign Exchange Risk Management Exposure refers to the degree to which a company is affected by exchange rate changes. Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.

Foreign Exchange Risk Management Managing accounting exposure centers around the concept of hedging, which means: Entering into an offsetting currency position so whatever is lost/gained on the original currency exposure is exactly offset by a corresponding currency gain/loss on the currency hedge. The coordinated buying or selling of a currency to minimize exchange rate risk.

Types of Exposures Translation Exposure Transaction Exposure Operating Exposure Tax Exposure Economic Exposure

Translation Exposure It arises from the need, for purposes of reporting and consolidation, to convert the results of foreign operations from the local currency to the home currency. Paper exchange gains or losses Retrospective in nature Short-term in nature

Transaction Exposure It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency. Real exchange gains or losses Mixes retrospective and prospective Short-term in nature

Operating Exposure It arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firm’s future revenues and costs. Real exchange gains or losses Prospective in nature Long-term in nature

Economic Exposure It is defined as the extent to which the value of the firm, as measured by the present value of all expected future cash flows, will change when exchange rates change.

Tax Exposure The tax consequence of foreign exposure varies by countries. As a general rule: Only realized foreign exchange losses are tax deductible. Only realized foreign exchange gains create taxable income

Measuring Translation Exposure The difference between exposed assets and exposed liabilities. Exposed assets and liabilities are translated at the current exchange rate. Non-exposed assets and liabilities are translated at the historical exchange rate.

Currency Translation Methods Translation methods differ by country along two dimensions. Subsidiary Characterization Integrated foreign entity Self-sustained entity Functional Currency The currency of the primary economic environment in which the subsidiary operates and in which it generates and expends cash.

Translation Methods Two basic methods for the translation of foreign subsidiary financial statements: The current rate method The temporal method Regardless of which is used, either method must designate The exchange rate at which individual balance sheet and income statement items are remeasured Where any imbalances are to be recorded

Current Rate Method All financial statement items are translated at the “current” exchange rate. Assets & liabilities Income statement items Dividends Equity account Unrealized translation gains or losses are recorded in a separate equity account on the parent’s consolidated balance sheet called the “Cumulative Translation Adjustment (CTA)” account.

Temporal Method Specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation. It assumes that a number of line items such as inventories and net plant and equipment are restated to reflect market value. If these items were not restated and carried at historical costs, then the temporal method becomes the monetary/non-monetary method.

Temporal Method Line items included in this method are Monetary balance sheet items Non-monetary balance sheet items Income statement items Dividends Equity account Unrealized translation gains or losses are recorded within the income statement, not to equity reserves, thereby affecting net income.

US Translation Procedures The US differentiates foreign subsidiaries on the basis of the functional currency, not subsidiary characterization. This, in turn, determines which translation method is used: Local currency Current rate method U.S. dollar Temporal method

Hyperinflation Countries A hyperinflationary country is one which has cumulative inflation of approximately 100% or more over a three year period. Functional currency U.S. dollar Translation method Temporal method

Measuring Translation Exposure: Illustration Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc., had the following balance sheet on January 1: Assets (Ps million) Liabilities (Ps million) Cash, marketable securities 1,000 Current liabilities 47,000 Accounts receivables 50,000 Long-term debt 12,000 Inventory 32,000 Equity 135,000 Fixed assets 111,000 194,000 194,000 ______________________________________________________________ The exchange rate on January 1 was Ps 8,000/$ and on December 31 is Ps 12,000/$

Transaction Exposure It arises from the various types of transactions that require settlement in a foreign currency. Purchasing or selling on credit goods or services denominated in foreign currency. Borrowing and lending funds with repayment made in foreign currency. Acquiring assets denominated in foreign currency.

Net Transaction Exposure Is measured currency by currency. Is the difference between contractually fixed future cash inflows and cash outflows in each currency. It represents real gains and losses.

Designing a Hedging Strategy Management of Foreign Exchange Exposure Organizational Policies for Managing Exposure Degree of centralization Responsibility Statement of Objectives

Hedging Strategy Objectives Minimize translation exposure. Minimize quarter-to-quarter earnings fluctuations arising from exchange rate changes. Minimize transaction exposure. Minimize economic exposure. Minimize foreign exchange risk management costs. Avoid surprises.

Managing Translation Exposure Assets Liabilities ______________________________________________ Hard currencies Increase Decrease Soft currencies Decrease Increase ______________________________________

Balance Sheet Hedge It requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities. This is termed the monetary balance. The cost of this method depends on relative borrowing costs in the varying currencies.

Funds Adjustment Altering either the amounts or the currencies or both of the planned cash flows of the parent and/or subsidiary. Funds Adjustment Methods Direct Indirect

Forward Market Hedge Uncovered or open hedge. Not a hedge but an attempt to gain by forward speculation a sum equal to the book loss in translation. Success depends on precise prediction of future exchange rates. Such a hedge will increase the tax burden.

Managing Transaction Exposure A transaction exposure arises whenever a company is committed to a foreign currency denominated transaction. Protective measures to guard against transaction exposure involve entering into foreign currency transactions whose cash flows exactly offset in whole or in part the cash flows of the transaction exposure.

Managing Transaction Exposure Contractual Hedges Forward Market Hedge Money Market Hedge Options Market Hedge Futures Market Hedge Financial Hedges Swaps Operating Strategies Risk Shifting Price adjustment clauses Exposure Netting Risk Sharing

Managing Transaction Exposure: Illustration American Airlines is trying to decide how to go about hedging €70 million in ticket sales receivable in 180 days. The following exchange/ interest rates are available: Spot rate $0.6433-42/€ 180-day forward rate $0.6578-99/€ Euro 180-day interest rate (p.a.) 4.01%-3.97% U.S.$ 180-day interest rate (p.a.) 8.01%-7.98%

Alternative Use of Hedging Techniques Remain unhedged. Hedge in the forward market. Hedge in the money market.

Unhedged Position American Airlines will wait 180 days and receive an unknown amount of U.S. dollars, depending on the spot rate prevailing in 180 days, for €70 million of the ticket sales.

Future Spot Rate Scenarios Spot rate in 180 days Receivables in dollar terms ____________________________________________ € 1 = $0.64 € 1 = $0.67 € 1 = $0.70 ____________________________________________ SR0 = $0.6433 FR180 = $0.6578

Forward Market Hedge Involves a forward contract and a source of funds to fulfill that contract. The forward contract is entered at the time the transaction exposure is created. Offsetting receivables/payables denominated in a foreign currency with a forward contract to sell/buy that currency. Covered hedge Uncovered or open hedge Cost of forward cover

Forward Market Hedge To hedge in the forward market, American Airlines will enter into a 180-day forward contract to sell €70 million for dollars today (t=0).

Evaluation of Forward Market Hedge Future Spot Rate Value of Receivable (e1) Gain/Loss on Forward (f180) Net Cash Flow ____________________________________________________________ € 1 = $0.64 $46,046,000 € 1 = $0.6578 $0 € 1 = $0.67 $46,046,000 € 1 = $0.70 $49,000,000 _________________________________________________________

Money Market Hedge Involves a contract and a source of funds to fulfill that contract. In this case, the contract is a loan agreement. Reversing foreign currency receivables/payables by creating matching payables/receivables through borrowing in the money markets. Covered hedge Uncovered or open hedge Cost of money market hedge Covered interest arbitrage

Money Market Hedge To hedge in the money market, American Airlines has to borrow today (t=0) sufficient euros for 180 days which, when exchanged today for dollars and invested for 180 days in the U.S., will be paid off with exactly the euro receivable of €70 million. Amount of euros borrowed in Germany for 180 days: Amount of dollars to be invested today in the U.S.: Amount of dollars received from U.S. investment in 180 days:

Comparison of Alternative Hedging Strategies Future Forward Money Spot Rate Unhedged Market Market € 1 = $0.64 $44,800,000 € 1 = $0.6578 € 1 = $0.67 $46,900,000 € 1 = $0.70 ____________________________________

Covered Interest Arbitrage IRP does not hold: Interest rate differential is not equal to forward discount/premium on foreign currency. Effective forward rate:

Futures Market Hedge Similar to hedging with forwards Limitations: Limited number of currencies Limited number of maturity dates Standardized contract size Cross hedge

Options Market Hedge Offsetting a foreign currency denominated receivable/payable with a put option or a call option in that currency. Valuable hedging tool when: Waiting on the outcome of a bid denominated in foreign currency Using of foreign currency price list Shifts in competitor’s currency

General Hedging Rule Future foreign currency cash outflow Certain: Go long futures or forwards Uncertain: Buy a call option Future foreign currency cash inflow Certain: Go short futures or forwards Uncertain: Buy a put option

Currency Risk Shifting Risk shifting: Invoice in U.S. dollar Strategy for risk shifting Denominating exports in a strong currency. Denominating imports in a weak currency. Outcome depends on: Bargaining power or parties involved. Competitiveness of firm’s particular business

Exposure Netting Offsetting exposures in one currency with exposures in the same or another currency. A firm’s currency exposures can be viewed as a portfolio. Exposure netting depends on the correlation between currencies. Exposure netting strategies: Negatively correlated currencies Positively correlated currencies

Currency Risk Sharing Agreement to share currency risk Risk sharing arrangements Price adjustment clause Neutral zone Outside neutral zone

Currency Collars Providing protection if the currency moves outside an agreed-on range. Range forward Cylinder Combined put purchase and call sale Limits upside potential Provides downside risk protection Lowers hedging cost

Choosing Which Exposure to Minimize As a general matter, firms seeking to reduce both types of exposures typically reduce transaction exposure first. They then recalculate translation exposure and then decide if any residual translation exposure can be reduced without creating more transaction exposure.