4 types of exposure Exposure (to FX risk): firm is affected by a change in the exchange rate Transactions Exposure: firm’s cash flow Operating Exposure: firm’s cash flow Accounting Exposure: firm’s financial statements Translation Exposure: firm’s financial statements

Transactions Exposure Contractual: contract exists that specifies a certain amount of FX will be received/paid e.g. export/import, debt denominated in FX. Change in the FX rate results in gain/loss. FX receipt worry: FX depreciation FX payment worry: FX appreciation Transactions exposure is reflected in the firm’s financial statements, i.e. firm with transactions also has accounting exposure.

Hedging a future FX receipt Worry: FX depreciation Sell the FX forward: sign contract now with bank committing to sell the FX at the future date at a rate set now Will receive Y10 million at year end Hedge by selling Y10 million one-year forward at one-year forward rate The C$-value of the Y10 million is now set, i.e. now know the C$-value

Hedging a future FX payment Worry: FX appreciation Buy the FX forward: sign contract now with bank committing to buy the FX at the future date at a rate set now E.g. will pay Y10 million at year end Hedge by buying Y10 million one-year forward at one-year forward rate. The C$-value of the Y10 million is now set, i.e. now know the C$-value of the FX payment

Operating Exposure Non-contractual: no contract exists, yet firm is exposed Change in the exchange rate results in gain or loss of competitive advantage Explored in 3 vignettes document Effects of operating exposure do not appear on the firm’s financial statements Explored in Canuck Ltd.’s accounting exposure

3 operating exposure vignettes 1. Aspen Skiing (US firm): Revenues exhibited positive operating exposure to French franc, C$, Italian lira, etc. 2. Laker Airways (UK firm): Ditto, but negative operating exposure to U$. 3. Canuck Ltd. (Canadian firm): Positive operating exposure to UK pound sterling.

Aspen Skiing Colorado resort: all balance sheet items and cash flows in greenbacks. Yet exposed to C$, FFr, etc. In 1983, U$ appreciated, I.e. C$, FFr depreciated. Domestic and foreign clientele shifted holidays to Banff, Chamonix, Chicopee.

Aspen Skiing Y-axis: Cash flows in U$; X-axis: S(U$/C$)

Aspen Skiing: Lesson Gleaned Although you operate exclusively domestically, if your clientele has the option of purchasing in a foreign market, you exhibit positive exposure to that foreign market’s currency. A U.S. firm with Aspen Skiing as client likewise possesses the same type of exposure.

Aspen Skiing: Two Hedges Hedge positive operating exposure of cash flows to C$, FFr, etc. Denominate some debt in C$, FFr, etc. Result: negative transactions exposure of debt offsets positive operating exposure of revenues. Buy resorts in Canada, France, etc. Result: some revenue streams rise, other fall with rise in C$, FFr, etc.

Laker Airways Early exploiter of air transport deregulation in late 70’s. Target market: Price conscious Brit tourists vacationing in Florida. Cost structure: jet fuel U$-denominated. Financed jets with cheap U$-debt provided by US Ex-Im Bank. Steep U$ appreciated in early 80’s spelled doom for Laker Airways.

Laker Airways’ Exposures Jet fuel: both transactions and operating exposure to U$. Debt: transactions exposure to U$. Revenues: negative operating exposure to U$. When U$ appreciated target clientele shifted holidays from Florida to Palma de Mallorca, Islas Canarias, Marbella, etc.

Laker Airways: Lessons Gleaned If your business involves assisting a domestic clientele purchase goods/services in a foreign country, you have negative operating exposure to that foreign country’s currency. Dollar denomination of debt aggravated the firm’s negative exposure to the greenback.

Sir Freddie’s Egregious Error Error: Denominated debt in U$’s. Appreciation of U$ resulted in: Sterling value of costs and debt service increasing; Sterling value of revenues decreasing. Sir Freddie got squeezed! Hedges: debt denominated in Sterling; cater to Yank clientele vacationing in UK.

Canuck Ltd. Canadian firm operating exclusively in Canada with no FX denominated assets/contracts. Major competitor in Canada sources product in the UK. Canuck Ltd. has positive exposure to the Pound Sterling, PS. If PS appreciates, Canuck gains competitive advantage. Hedge with PS denominated debt.

Accounting Exposure Effects of FX rate changes that are reflected in the firm’s financial statements. Transactions exposure is reflected. Translation exposure is reflected. Operating exposure is not reflected. Accounting Exp. comprised of Transactions Exp. & Translation Exp

Translation Exposure Parent company has a foreign subsidiary Foreign subsidiary’s financial statements must be consolidated (combined) with those of parent E.g. Canadian parent (C$) vs. Chinese subsidiary (RMB) currency Subsidiary’s statements are FX denominated If FX (RMB) rate changes, consolidated statements are impacted: translation exposure!

Subsidiary’s Functional Currency Primary currency of the subsidiary’s activities, i.e. in which cash flows are generated 2 possibilities: parent’s currency (C$) versus subsidiary’s currency (RMB) Distinction: subsidiary’s currency versus subsidiary’s functional currency

Subsidiary is self-sustaining Most foreign subsidiary’s sales in the foreign country. It is a freestanding entity with self-contained operations Functional currency is foreign (RMB) Translation via current rate method All assets / liabilities translated at the rate prevailing on the balance sheet date

Subsidiary is integrated with parent Most foreign subsidiary’s sales in the parent country; a mere extension of parent, i.e. not freestanding Subsidiary’s functional currency is parent’s currency (C$) Translation via temporal method Only monetary assets / liabilities translated at the rate that prevails on the balance sheet date.

Subsidiary’s Monetary Assets: cash, marketable securities, accounts receivable Liabilities: current liabilities, all debt (short term and long term) Monetary means promises a fixed amount of currency Nonmonetary: inventory, fixed assets, equity

Hedging Translation Exposure Net Translation Exposure (NTE) in FX Sell the amount of NTE forward: write contract now with bank committing to sell the amount of NTE at year-end E.g. NTE=Y10 million; Hedge by selling Y10 million one-year forward If NTE=-Y4 million, buy Y4 million forward; selling a negative quantity means buying