Ch 11, 12, and 13 Transaction Exposure Operating Exposure Translation Exposure (will be skipped) 1

Types of Exposure to Foreign Exchange Risk Transaction Exposure Change in the value of a transaction arising from a change in the exchange rate Operating (Economic) Exposure Change in the value of future cash flows from operations arising from a change in the exchange rate Translation (Accounting) Exposure Change in the accounting values such as net income and owner’s equity arising from a change in the exchange rate 2

A Simple Example of Hedging Definition Hedging: A strategy to minimize exposure to unwanted risk, while still allowing to profit from investment Example: Suppose a portfolio manger is currently holding $10 million of GOOG stocks. The current market price of GOOG is $500 per share. The number of shares of current holdings is 20,000 shares (=$10M/$500). The investment horizon is 3-month period. In three month, she expects to dispose the holdings. However, she is afraid that the price may be falling. What can she do to minimize risk using puts? 3

No option strategy If GOOG appreciate by 20% in 3-month, Sell at the market price of $600 Market value of portfolio = $12M Gain = $2M If GOOG depreciate by 20% in 3-month, Sell at the market price of $400 Market value of portfolio = $8M Loss = $2M Volatility = $4M 4

Put option strategy Today, she buys 200 puts with X=$500, P=$10 per share. She pays the option seller $0.2M today. If GOOG appreciates by 20% in 3-month, Don’t exercise. Sell at the market price of $600. Market value of portfolio = $12M (can sell at $600) Gain = $2M – 0.2M = $1.8M If GOOG depreciates by 20% in 3-month, Exercise. Sell at the exercise price of $500. Market value of portfolio = $10M Loss = $0 – 0.2M = −$0.2M (Loss) Volatility = $2M 5

Why Hedge? MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging. 6

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. The fact that these cash flows are expected emphasizes that nothing about the future is certain. Currency risk is defined roughly as 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. 7

Impact of Hedging on the Expected Cash Flows of the Firm 8

TRANSACTION EXPOSURE 9

Types of Foreign Exchange Exposure Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while 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. Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. 10

TRANSACTION EXPOSURE - EXAMPLE An importer has purchased Swiss cuckoo clocks and must pay CHF 600,000 in three months. At the present spot exchange rate of CHF1.4925/USD, the francs would cost USD402,010. If the franc depreciated to CHF1.6000/USD, the importer would only pay USD375,000. If the CHF appreciated to CHF1.4000/USD, the importer would pay USD428,

Four Ways to Hedge Forward Contracts / Currency Futures Contracts Money Market Hedge Currency Options 12

Forward Market Hedge: Imports If you expect to owe foreign currency in the future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract. Forward Contract Counterparty Importer Foreign Supplier Foreign currency Goods or Services Foreign currency Domestic Currency 13

Forward Market Hedge: Exports If you are going to receive foreign currency in the future, agree to sell the foreign currency in the future at a set price by entering into short position in a forward contract. Forward Contract Counterparty Exporter Foreign Customer Goods or Services Foreign Currency Domestic Currency Foreign Currency 14

HOW TO COVER USING FORWARD CONTRACTS MAKING FOREIGN CURRENCY PAYMENT (= SHORT POSITION) BUY FORWARD TO LOCK IN THE RATE ********************************************* RECEIVING FOREIGN CURRENCY PAYMENT (= LONG POSITION) SELL FORWARD TO LOCK IN THE RATE 15

FORWARD MARKET HEDGE An importer has purchased Swiss cuckoo clocks and must pay CHF 600,000 in three months. At today's spot rate of CHF1.4925/USD, the francs would cost USD402,010. The three month forward CHF is trading at CHF1.5149/USD. By BUYING the francs forward, the importer can lock in the cost of the francs in dollar terms at today's forward rate (CHF ). In three months, the importer will pay USD396,066, regardless of the exchange rate which prevails in three months. 16

MONEY MARKET HEDGE An alternative to the forward contract is the money market hedge. The clock importer can create a money market hedge as follows: 1. Borrow USD with repayment in three months. 2. Convert the USD to CHF in the spot fx market. 3. Invest the CHF in the Swiss money market and use the proceeds to pay the CHF 600,000 due. 17

MONEY MARKET HEDGE - 2 TODAY 1. We need CHF 600,000 in 3 months. Swiss money market investments yield 10% per annum, so today we will need CHF 600,000 / = CHF 585, We buy CHF 585,366 at today's spot rate of CHF1.4925/USD. We need _CHF 585,366 _ CHF /USD =USD 392,205 today. 3.We borrow USD 392,205 at the current USD money market rate of 4% per annum, so in three months we will be repaying USD 392,205 * 1.01 = USD 396,

MONEY MARKET HEDGE - 3 IN THREE MONTHS 1. The maturing Swiss money market investment yields CHF 600,000, which we use to make payment. 2.We repay our bank USD 396,127. The economic effect is exactly that of a forward contract to buy CHF - we pay dollars and we get CHF. 19

MONEY MARKET HEDGE (SYNTHETIC FORWARD CONTRACT) Either use forward market to buy CHF 600,000 Pay $396,066 Or use money market to "buy" CHF 600,000 Pay $396,127 Real Forward Rate CHF600,000 / USD396,066 = CHF1.5149/USD “Money Market" Forward Rate CHF600,000 / USD396,127 = CHF1.5147/USD Better to hedge with a real forward 20

Synthetic Financial Products – The Synthetic Forward A money market hedge is the first example we encounter of a synthetic financial product. Synthetic financial products are products which have the same essential economic characteristics as real products, but which are created by combining a number of other transactions. 21

Synthetic (Money Market) Forward Purchase of Foreign Currency To buy a foreign currency using the money market hedge (synthetic forward purchase) Borrow dollars Convert to foreign currency at the spot rate Invest in the foreign currency money market At the maturity date You receive foreign currency from your investment You pay dollars to pay off your loan 22

Synthetic (Money Market) Forward Sale of Foreign Currency To sell a foreign currency using the money market hedge (synthetic forward sale) Borrow foreign currency Convert to dollars at the spot rate Invest in the dollar money market At the maturity date You receive dollars from your investment You pay foreign currency to pay off your loan 23

HOW TO COVER USING CURRENCY OPTIONS CONTRACTS MAKING FOREIGN CURRENCY PAYMENT (= SHORT POSITION) BUY CALL OPTION TO CREATE A CEILING ON THE RATE ************************************* RECEIVING FOREIGN CURRENCY PAYMENT (= LONG POSITION) BUY PUT OPTION TO CREATE A FLOOR ON THE RATE 24

HEDGING WITH CURRENCY OPTIONS – Making a Foreign Currency Payment If one is making a foreign currency payment at some future point in time, one hedges by buying a call option to limit the loss from currency appreciation. Call options are used to establish a ceiling on the value of foreign exchange. The ceiling is approximately equal to the Strike Price plus Premium 25

HEDGING WITH CURRENCY OPTIONS – Receiving a Foreign Currency Payment If one is receiving a foreign currency payment at some future point in time, one hedges by buying a put option to limit the loss from currency depreciation. Put options are used to establish a floor on the value of foreign exchange. The floor is approximately equal to the Strike Price minus Premium 26

HEDGING USING CURRENCY OPTIONS - EXAMPLE Your firm needs to make a payment of GPL50 million to Nagus Enterprises in three months. GPL=Gold Pressed Latinum, the unit of account of a well- known really alien empire. The current rate of exchange is GPL1 = US$0.40 and the three month forward is at US$0.42. You can buy a call option on the GPL with a strike price of $0.40 at a premium of $0.033 per GPL. For a payment of (GPL50,000,000) * $.033 = $1,650,000 made immediately, you now have the right to buy GPL50,000,000 at $

HEDGING USING CURRENCY OPTIONS - EXAMPLE IMPACT AT MATURITY Spot > $0.40: Your firm exercises the option, buying GPL50,000,000 at $0.40 and pays $20,000,000. Spot < $0.40 Your firm allows the option to expire unexercised and buys GPL50,000,000 at the market spot rate, paying no more than $20,000,

HEDGING USING CURRENCY OPTIONS - EXAMPLE EFFECT OF THE OPTION The option protects against the risk of appreciation of the GPL. Your firm will never pay more than $20,000,000 plus the premium of $1,650,000 for the GPL. CEILING EFFECTIVE RATE ($21,650,000)/GPL50,000,000 = $ $ $ = $

OPERATING EXPOSURE 30

Operating Exposure Defined Change in the value of future cash flows from operations arising from a change in the exchange rate. 1. The dollar value of the foreign currency cash flow changes, even if the local currency cash flow does not. 2. The local currency cash flow may also change. 31

Managing Madison Inc.’s Economic Exposure (in Millions) C$=$.75 C$=$.80 C$=$.85 Sales: (1) U.S.$300.00$304.00$ (2) CanadianC$4= 3.0C$4= 3.20C$4= 3.40 (3) Total$303.00$307.20$ Cost of gods sold: (4) U.S.$ 50.00$ 50.00$ (5) CanadianC$200= C$200= C$200= (6) Total$200.00$210.00$ (7) Gross profit$103.00$ 97.20$ Operating expenses: (8) U.S. - Fixed$ 30.00$ 30.00$ (9) U.S. - Variable (10) Total$ 60.30$ 60.72$ (11) EBIT$ 42.70$ 36.48$ Interest expense: (12) U.S.$ 3.00$ 3.00$ 3.00 (13) CanadianC$10= 7.50C$10= 8.00C$10= 8.50 (14) Total$ 10.50$ 11.00$ (15) EBT$ 32.20$ 25.48$

Managing Madison Inc.’s Economic Exposure The amount of Madison’s earnings before taxes is inversely related to the strength of the Canadian dollar, since the higher expenses more than offset the higher revenue. Madison may reduce its exposure by increasing Canadian sales, reducing orders of Canadian materials, and/or borrowing less from Canadian banks. 33

SHORT RUN OPERATING EXPOSURE – Example 1 A firm will generate a net cash flow of GBP 400,000 per month for the next year in its British subsidiary. We will make the simplifying assumption that the firm will not make any short-term adjustments to its operations to alter this cash flow, regardless of changes in the exchange rate. 34

SHORT RUN OPERATING EXPOSURE – Example 1 At the current exchange rate of USD2.0000/GBP the firm will generate GBP 400,000 * 12 mos. * USD2.0000/GBP = USD 9,600,000 If the exchange rate moves to USD1.9000/GBP the firm will generate GBP 400,000 * 12 mos. * USD1.9000/GBP = USD 9,120,000 35

SHORT RUN OPERATING EXPOSURE Exposure = Exposed Cash Inflows – Exposed Cash Outflows Change in Cash Flow = Exposure * Change in Direct Rate 36

OPERATING EXPOSURE Operating Exposure = Exposed Cash Inflows - Exposed Cash Outflows = 12*GBP400,000 – 0 = GBP 4,800,000 Change in Cash Flow = Exposure * Change in Rate = GBP 4,800,000 * ( ) = - USD 480,

Operating Exposure – Base Case Our subsidiary in Lakland sells 100,000 units of a product per month at a selling price of LAK 2.00/unit. The firm can manufacture the units at a variable cost of LAK 1.00/unit. The firm has a monthly fixed cost of LAK 20,000. The LAK depreciates by 20%, from $0.50/LAK to $0.40/LAK. The inflation rate in the US is 0%. Prices in Lakland will eventually rise to their purchasing power parity level, an increase of 25%. 38

Figuring the Local Price Increase That Offsets an Exchange Rate Change The exact form of purchasing power parity would indicate that (π US – π LA )/(1+ π LA ) = Rate of appreciation ( 0 – π LA ) = -0.20(1+ π LA ) 0.20 = 0.80 π LA π LA = 0.25 = 25% 39

OPERATING EXPOSURE – Scenario A Assumptions Revenues are exposed for 6 months = LAK 1,200,000 Costs are exposed for 6 months = LAK -720,000 Net operating cash flow exposure = LAK 480,000 Change in Cash Flow = LAK 480,000 * -.10 = USD -48,000 40

OPERATING EXPOSURE – Scenario B Assumptions Revenues are exposed for 6 months = LAK 1,200,000 Costs are exposed for 3 months = LAK -360,000 Net operating cash flow exposure = LAK 840,000 Change in Cash Flow = LAK 840,000 * $ = $ -84,000 41

OPERATING EXPOSURE – Scenario C Assumptions Revenues are exposed for 3 months = LAK 600,000 Costs are exposed for 6 months = LAK -720,000 Net operating cash flow exposure = LAK -120,000 Change in Cash Flow = LAK -120,000 * $ = $12,000 42

OPERATING EXPOSURE – Scenario D Assumptions Revenues are exposed for 6 months = LAK 1,200,000 Local costs are exposed for 3 months = LAK -210,000 Net operating cash flow exposure = LAK 990,000 Change in Cash Flow = LAK 990,000 * -.10 = -99,000 43

OPERATING EXPOSURE – Scenario E - Disequilibrium Assumptions: At the end of six months Prices increase by 18% Costs increase by 31% Unit sales increase by 12% Local Currency Cash Flow is LAK 91,400 Dollar Cash Flow is $36,560 The change in dollar cash flow is ($3,440) This fall in dollar cash flow is a “permanent” effect of this exchange rate change. 44

Managing Operating Exposure Matching Currency Cash Flows Risk-sharing Agreements Currency Swaps 45

Matching Currency Cash Flows Matching borrowing to operating cash flows: Company has a positive cash flow in a particular currency, for example, the Euro. Company borrows Euros and uses its Euro cash flow to pay off the debt. Present Value of Euro cash flow = EUR 10,000,000 Present Value of Euro borrowing = EUR 10,000,000 If Euro depreciates by $0.10/EUR, the cash flow is worth $1,000,000 less If Euro depreciates by $0.10/EUR, the present value of the Euro borrowing is worth $1,000,000 less. 46

Matching Currency Cash Flows Matching Operating Cash Flows Company has a positive cash flow in a particular currency, for example, the Euro. Company changes its suppliers to companies that are located in Europe and whose costs are determined in Euros. 47

Risk-sharing Agreements Used when companies have a long-term relationship with a supplier or customer. Technique involves having a clause in the long-term contract that allows the price to change if the exchange rate changes substantially. 48

Risk-sharing Agreements - EXAMPLE At a time when the dollar/Euro exchange rate is $1.25/EUR, Deep South Lumber Company agrees to a contract to supply 10,000 thousand board feet of 15/32-inch 3- ply exterior sheathing plywood per year for five years to a company in Europe. The negotiated price of EUR400 per thousand board feet. At this price the order is worth EUR 4,000,000 per year, or $5,000,000 per year at the present exchange rate. 49

Risk-sharing Agreements - EXAMPLE Because Deep South Lumber quotes in Euros, it is exposed to exchange risk. To reduce that risk, it also negotiates an agreement with the following terms: If the Euro appreciates by more than 5% against the dollar, the price of the lumber in Euro will be reduced by half the percentage appreciation of the Euro against the dollar. If the Euro appreciates by 3%, there will be no price change. If the Euro appreciates by 10%, the price in Euros will be reduced by 5%. If the Euro depreciates by more than 5% against the dollar, the price of the lumber in Euro will be increased by half the percentage depreciation of the Euro against the dollar. If the Euro depreciates by 3%, there will be no price change. If the Euro depreciates by 10%, the price in Euros will be increased by 5%. 50

Currency Swaps Depending on the anticipated direction of future exchange rate changes, Enter currency swap to swap Domestic currency with foreign currency, or Foreign currency with domestic currency 51

TRANSLATION EXPOSURE (WILL BE SKIPPED) 52

Overview of Translation Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements. The accounting process of translation, involves converting these foreign subsidiaries financial statements into US dollar-denominated statements. 53

Overview of Translation Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. While the main purpose of translation is to prepare consolidated statements, management uses translated statements to assess performance (facilitation of comparisons across many geographically distributed subsidiaries). 54

TRANSLATION AND CONSOLIDATION Most firms present their accounting results on a consolidated basis and present their reports in one currency, the reporting currency. U.S. firms must present results based on principles contained in Statement of Financial Accounting Standards No. 52 (SFAS 52 or FASB 52, for short). 55

Current assets translated at the spot rate. e.g. €2 = $1 Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books. e.g. €3 = $1 Current/Noncurrent Method 56

Items carried on the books at their current value are translated at the spot exchange rate. e.g. €2 = $1 Items that are carried on the books at historical costs are translated at the historical exchange rates. e.g. €3 = $1 Temporal Method 57