Accounting Exposure Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation. Example: Consider a U.S. multinational company’s subsidiary in Great Britain whose balance sheet and income statement are translated to the parent’s functional currency—the U.S. dollar. The pound has devalued from $1.50/pound to $1.40/pound since the last translation.

Hedging in Practice: Nike Nike markets its products in over 140 countries with foreign sales revenue accounting for 46 percent of its total revenue in fiscal Given its huge presence in the foreign market, Nike’s annual report states: “ It is the company’s policy to utilize derivative financial instruments to reduce foreign exchange risks where internal netting strategies cannot be effectively employed. Fluctuation in the value of the hedging instruments are offset by fluctuations in the value of the underlying exposures being hedged ”

Nike uses forward contracts for firm commitments to hedge receivables and payables as well as inter-company foreign currency transactions, Nike uses currency options to hedge certain anticipated but not yet firmly committed export sales and purchase transactions expected in futures denominated in foreign currency. Cross-currency swaps are employed to hedge foreign currency denominated payments related to inter-company loan agreements.

Transaction Exposure Transaction exposure is defined as the impact of the unexpected change in exchange rate on the cash flow arising from all the contractual relationships entered prior to the change in exchange rate at time (t 1 ) to be settled after the change in exchange rate at time (t 2 ).

Dupont Acquires AG In December 1998 DuPont entered into a forward contract in the acquisition of the performance coating business of Hoechst AG for 3.1 billion deutsche marks (DM) at $1.9 billion. The forward contract effectively locked the company at the forward exchange rate of DM/$, insulating DuPont from adverse exchange rate movements that would likely have increased the dollar price of the acquisition.

Consider the call option in Euro FX November futures at strike price of 98 cents. The quoted premium is 1.27 cents per euro as of August 23, 02 in the CME. Each contract is for delivery of 125,000 units of euro. The spot euro is $.9731/pound. The Dupont treasurer in Exhibit 8.9 can buy 96 call options to hedge against the possible appreciation of the euro in the next three months. The premium for one call option will be equal to $1,587.50, and to hedge the entire exposure requires an upfront premium of $152,400. The call option is providing protection by imposing a ceiling on the exchange rate that is equal to the strike price plus the premium for the call as follows: Example

VALUE AT RISK Value at risk (VAR) provides a framework for analysis of the maximum potential loss in the fair value of an exposed position over a specific period assuming normal market conditions and a given confidence interval. MNCs have various exposures due to interest rate changes, foreign exchange rate changes, as well as to the changes in the commodity prices that could adversely affect the value of the firm. VAR analysis uses simulation models by assuming various scenarios to generate the amount of maximum loss that could be realized in a given period for a given confidence interval. VAR= amount of exposure*volatility*confidence interval

Example VAR For example, a bond portfolio with market value of $250 million might have VAR at 95 percent confidence interval of $ million over the next 10 days assuming standard deviation of the exposed portfolio is equal to 16 percent per annum. The volatility is usually quoted in year, however, for the purpose of estimating the VAR of an asset, the volatility of the asset is quoted on a daily basis as volatility per day as follows: σ d = σ y / (252) 1/2 One-day VAR = x1.96x $250 Million = $ million. 10-day VAR = One-day VAR.(10)^1/2 10-day VAR = $4.9387*(10)^1/2 = $ million

Lufthansa purchased 20 aircraft from Boeing at the cost of $500 million payable in one year in January The spot and one-year forward exchange rates at the time the contract entered into was $.3125/deutsche marks. Lufthansa by agreeing to pay dollars for the aircrafts accepted all the exchange rate risk and reward for the above contract. To manage exposure to dollar appreciation the company decided to leave half of the liability exposed to foreign exchange risk and purchased the other half, $250 million, in the forward market at the forward rate of $.3125/deutsche mark or 3.2 DM/$. By hedging half of the exposure the company effectively locked at the forward rate of $.3125/deutsche mark, to pay DM800 million for buying $250 million forward. Lufthansa Buys Aircraft from Boeing

Hedging Alternatives Hedging Alternatives: 1. Remain unhedged 2. Fully cover the exposure: buy dollars forward 3. Manage some of the exposure, leaving some exposed 4. Use call options in dollar/deutsche mark or its equivalent the put options in deutsche mark/dollar 5. Buy caps in dollars or floors in deutsche marks (in the over the counter market from a bank or insurance company) 6. Money market hedge of payables. By January 1986, the deutsche mark appreciated and the dollar weakened to $.45/deutsche mark and the forward hedging turned out to be very costly ex-post.

Managing Operating Exposure The operating exposure arises due to the impact of unexpected change in the exchange rate on the firm’s input price, that is, raw materials, labor costs, and out put prices such as prices of the goods and services produced. Operating exposure is long term in nature and therefore can only be managed through operating hedges.. Operating hedges can be achieved as follows: 1) Increasing Flexibility of Operating Net Works: Provide MNCs the flexibility to arbitrage institutional restrictions, such as regulatory impediments, various requirements by regulatory agencies as well as to arbitrage taxes and factors of productions across international boundaries.]] 2) Diversifying Operations: This type of diversification naturally hedges cash flow derived from various operations overseas; however, it is expensive in terms of cost and lengthy in implementation. 3) Diversifying Financing with Matching Cash Flows: This approach is similar to the money market hedging discussed earlier in the chapter. The exporter selling goods and services overseas in this scenario has accepted the foreign currency for the receivables and therefore is exposed to foreign exchange risk.