Currency Risk: The Measurement of Corporate Exposure Prof. Ian Giddy New York University

Copyright ©2000 Ian H. Giddy Corporate Exposure 2 Measuring and Managing Exposure l Transactions exposure Case study: “G.E.’s Yen Payables” l Translation exposure l Economic exposure Case study; “U.S. Semiconductor” Transactions Exposure Transactions Exposure Translation Exposure Translation Exposure Economic Exposure Economic Exposure

Copyright ©2000 Ian H. Giddy Corporate Exposure 3 Transactions Exposure l Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date l Example: If Intel invoices a German company in Deutsche marks for a semiconductor shipment then the firm has German mark exposure and can hedge this by borrowing marks. l This kind of exposure is readily hedgable using forwards, futures or debt

Copyright ©2000 Ian H. Giddy Corporate Exposure 4 Exchange Rate Risk: Transactions u Transactions exposure arises when a company must pay or receive a foreign currency at an unknown future exchange rate u It is contractual u It affects the income statement u It can often be hedged directly using forwards, futures or currency options

Copyright ©2000 Ian H. Giddy Corporate Exposure 5 Transactions Exposure: Hedging l Reeves International (CT) has a subsidiary in Italy. It makes printing blankets for sale in Europe. l Reeves Italy has to pay a dividend of approximately ITL 24 m. in December. How should Reeves hedge this?  Forwards?  Futures?  Money market hedge?  Do nothing?

Copyright ©2000 Ian H. Giddy Corporate Exposure 6 Hedging Transactions Exposure Types of exposure l One-shot exposure l Hedging approaches:  Open  Forward  Money market  Futures  Options l Ongoing transactions exposure

Copyright ©2000 Ian H. Giddy Corporate Exposure 7 International Profits l Covered under FASB No. 52 which requires only certain transactional gains or losses to be reflected in the income statement. l Income statement risk is dependent upon exchange rate fluctuations. l In general, if a subsidiary has a positive income flow, the income statement risk will be positive.

Copyright ©2000 Ian H. Giddy Corporate Exposure 8 Recognition of Exchange Gains & Losses

Copyright ©2000 Ian H. Giddy Corporate Exposure 9 Linkages Between Interest Rates Interest rate differential Interest rate differential Forward premium Forward premium Expected % change in exchange rate Expected % change in exchange rate Covered interest rate parity Unbiased forward rate Uncovered interest rate parity

Copyright ©2000 Ian H. Giddy Corporate Exposure 10 Cost of Hedging

Copyright ©2000 Ian H. Giddy Corporate Exposure 11 GE’s Yen Payables VCRs imported Yen due in 90 days

Copyright ©2000 Ian H. Giddy Corporate Exposure 12 GE’s Yen Payables l Yen:  Spot250  Forward246 (6.5% premium) l US$ Debt 15.5%, Yen interest 9.0% l Yen:  Spot250  Forward246 (6.5% premium) l US$ Debt 15.5%, Yen interest 9.0% VCRs Yen

Copyright ©2000 Ian H. Giddy Corporate Exposure 13 What Happens to GE If ¥ Rises? l If US VCR prices are fixed: GE is exposed. Hedging is safer. l If US VCR prices are flexible, and obey PPP, then GE is not exposed, and it would be risky to hedge! l If US VCR prices are fixed: GE is exposed. Hedging is safer. l If US VCR prices are flexible, and obey PPP, then GE is not exposed, and it would be risky to hedge! VCRs Yen

Copyright ©2000 Ian H. Giddy Corporate Exposure 14 The Exposure Triangle Transactions Exposure Transactions Exposure Translation Exposure Translation Exposure Economic Exposure Economic Exposure

Copyright ©2000 Ian H. Giddy Corporate Exposure 15 Balance Sheet Exposure l Balance sheet exposure (or translation or accounting exposure) results from the way accounting conventions dictate that a company’s foreign assets and liabilities should be booked. l Example: If Intel’s assets in Ireland are regarded as denominated in Irish punts, then the subsidiary’s accounting value is exposed to the punt and the firm may wish to hedge this exposure by financing in punts.

Copyright ©2000 Ian H. Giddy Corporate Exposure 16 Exchange Rate Risk: Translation l Translation exposure arises when a company has assets and/or liabilities in a foreign currency, which must be translated at an unknown future exchange rate l It affects the balance sheet  It can be hedged using forwards, futures or currency swaps  But translation exposure can mislead!

Copyright ©2000 Ian H. Giddy Corporate Exposure 17 Stora in Australia Assets l Cash l Accounts receivable l Inventory l Property, plant and equipment Liabilities l Accounts payable l Bank debt l Bonds issued l Equity (owned by parent company in Sweden) Net translation exposure = Value of foreign currency assets - Value of foreign currency liabilities.

Copyright ©2000 Ian H. Giddy Corporate Exposure 18 Translation of Individual Accounts l For US companies, governed by FASB No. 52 which specifies the current rate method l First, each entity's balance sheet and income statement are measured in terms of their Functional Currency, which is the currency of the economic environment in which the entity primarily operates and maintains records l Next, the functional-currency-denominated financial statements are translated into the parent's currency using the All-Current-Rate Method, which reports balance sheet items at the closing rate and income statement items at their average rates.

Copyright ©2000 Ian H. Giddy Corporate Exposure 19 Key Features of FAS 52 l Objective of translation: Local subsidiary perspective (preserve foreign currency financial results and relationships in consolidated statements) l Functional currency: Primary currency of economic environment in which foreign entity operates l Translation method:  If functional currency is US$: Temporal method  If functional currency is foreign currency: Current rate method l Transaction gains & losses: Recognized in current income except those on intercompany transactions of long-term nature l Translation gains & losses: Recognized in separate owners' equity account.

Copyright ©2000 Ian H. Giddy Corporate Exposure 20 Sweden Down Under l Stora, the Swedish pulp & paper company, has a plant in Melbourne, and sells in Australian dollars l But newsprint is a world-wide, dollar- traded commodity l So the revenues are effectively in dollars, not Ozzies.

Copyright ©2000 Ian H. Giddy Corporate Exposure 21 Stora in Australia: What’s Exposed? Assets l A$ Cash l Accounts receivable l Inventory l Property, plant and equipment Liabilities l A$ Accounts payable l A$ Bank debt l A$ Bonds issued l Equity (owned by parent company in Sweden) Net translation exposure = Value of foreign currency assets - Value of foreign currency liabilities.

Copyright ©2000 Ian H. Giddy Corporate Exposure 22 Criteria Favoring Local Currency As Functional Currency

Copyright ©2000 Ian H. Giddy Corporate Exposure 23 S t=1 -S t = I - I * S t 1+ I * n JAPAN 1995 n MEXICO 1994 EXCHANGE- RATE CHANGE RELATIVE INFLATION Purchasing Power Parity: Theory and Evidence

Copyright ©2000 Ian H. Giddy Corporate Exposure 24 Case Study: Arauco’s 1993 Forex Loss ARAUCO

Copyright ©2000 Ian H. Giddy Corporate Exposure 25 Case Study: Arauco’s 1993 Forex Loss ARAUCO

Copyright ©2000 Ian H. Giddy Corporate Exposure 26 Foreign Currency Translation

Copyright ©2000 Ian H. Giddy Corporate Exposure 27 Foreign Currency Translation

Copyright ©2000 Ian H. Giddy Corporate Exposure 28 Foreign Currency Translation

Copyright ©2000 Ian H. Giddy Corporate Exposure 29 Exposed or Not Exposed?

Copyright ©2000 Ian H. Giddy Corporate Exposure 30 Exposed or Not Exposed?

Copyright ©2000 Ian H. Giddy Corporate Exposure 31 Currency Risk: Economic Exposure Change in the economic value of the firm resulting from unanticipated exchange rate changes. l Booked vs. anticipated transactions l Expected vs. unexpected changes; the "cost of hedging" l Exposure and the parity assumptions: "We are not exposed in the long run" l Currency of denomination vs currency of determination; compet., elasticities, etc.

Copyright ©2000 Ian H. Giddy Corporate Exposure 32 Economic Exposure l Economic exposure is how the firm’s revenues and costs will respond to exchange rate changes.  Example: Even though Intel invoices German customers in marks, its future revenues may be unaffected by fluctuations in the mark if the currency of determination of prices in the semiconductor business is the dollar or even the yen. l The currency of determination is the currency in which most of the competition prices similar products.  Example: General Electric’s Yen Payables

Copyright ©2000 Ian H. Giddy Corporate Exposure 33 Operational Aspects of Exchange Risk 1.VOLUME EFFECTS (compensate for changes in profit margins) 2.PRICING FLEXIBILITY (change in margins to offset effect of exchange rate change) 3.DIVERSIFICATION of markets for inputs and outputs 4.FLEXIBILITY (ability to shift markets and sources quickly)

Copyright ©2000 Ian H. Giddy Corporate Exposure 34 Translation vs Economic Exposure Accounting exposure l Exposure = "Exposed" assets - "exposed" liabilities Economic exposure l Exposure = How will an unanticipated exchange rate change affect the cash flows of the firm?  Domestic sales  Exports  Domestic costs  Import costs

Copyright ©2000 Ian H. Giddy Corporate Exposure 35 A Realistic Approach l Banks versus corporations: To the extent that the firm is like a bank, do bank-style hedging. Match financial assets with liabilities of the same kind. l Seek to identify economic exposure using product cost-and-market analysis, industry competitive analysis, or statistical analysis on the sensitivity of the company’s value to exchange rate changes. l Hedge economic exposure using debt/swaps for long term exposure, short term instruments for uncertain exposure, and options for disaster insurance

Copyright ©2000 Ian H. Giddy Corporate Exposure 36 Case Study: US Semiconductor CHIPS US DOLLARS

Copyright ©2000 Ian H. Giddy Corporate Exposure 37 Case Study: US Semiconductor l The transactions: a cost comparison l Translation of assets and liabilities l The economic risks

Copyright ©2000 Ian H. Giddy Corporate Exposure 38 US Semiconductor: The Transaction l USD interest rate:8% l GBP interest rate:12% l Spot dollar/pound:2.40 l 5-yr forward $/pound:1.97 Diff, % per annum:-3.87% l Borrow GBP & hedge:12%-3.6%=8.13%

Copyright ©2000 Ian H. Giddy Corporate Exposure 39 US Semiconductor: Translation Exposure

Copyright ©2000 Ian H. Giddy Corporate Exposure 40 US Semiconductor: Economic Exposure n LAND n WAREHOUSE n TRUCKS CHIPS SOLD IN UK INVOICED IN GBP GBP?

Copyright ©2000 Ian H. Giddy Corporate Exposure 41 US Semiconductor: Economic Exposure n LAND n WAREHOUSE n TRUCKS CHIPS SOLD IN UK INVOICED IN GBP SOLD IN WORLDWIDE MARKET GBP? USD?

Copyright ©2000 Ian H. Giddy Corporate Exposure 42 US Semiconductor: Economic Exposure n LAND n WAREHOUSE n TRUCKS CHIPS SOLD IN UK INVOICED IN GBP SOLD IN WORLDWIDE MARKET DETERMINED BY COMPETITION GBP? USD? JPY?

Copyright ©2000 Ian H. Giddy Corporate Exposure 43 Summary: Types of Exposure Transactions Exposure Transactions Exposure Translation Exposure Translation Exposure Economic Exposure Economic Exposure

Copyright ©2000 Ian H. Giddy Corporate Exposure 44 Which Instrument?

Copyright ©2000 Ian H. Giddy Corporate Exposure 45 UNDERSTANDING THE EXCHANGE RISK MANAGEMENT PROBLEM n Value of hedging n Goals n Nature of the business UNDERSTANDING THE EXCHANGE RISK MANAGEMENT PROBLEM n Value of hedging n Goals n Nature of the business MEASUREMENT OF EXPOSURE ACCOUNTING TRANSACTION ECONOMIC NATURE OF THE CASH FLOW EXPOSURE: n One-shot? n Linear? n Contingent on exchange rates? n Contingent on other events? NATURE OF THE CASH FLOW EXPOSURE: n One-shot? n Linear? n Contingent on exchange rates? n Contingent on other events? HEDGING METHODS OPERATIONAL FINANCIAL Linear n Forwards n Futures n Debt n Currency swaps Linear n Forwards n Futures n Debt n Currency swaps Exchange-rate contingent n Options n Debt with option features Exchange-rate contingent n Options n Debt with option features Contingent on other events n Event options n Probability-based hedging Contingent on other events n Event options n Probability-based hedging Examples: n Sourcing flexibility n Pricing strategy n Market diversification Examples: n Sourcing flexibility n Pricing strategy n Market diversification A Corporate Foreign Exchange Roadmap

Copyright ©2000 Ian H. Giddy Corporate Exposure 46 Local Exposure

Copyright ©2000 Ian H. Giddy Corporate Exposure 47

Copyright ©2000 Ian H. Giddy Corporate Exposure 48 Ian Giddy NYU Stern School of Business Tel ; Fax