1. Debt and Foreign Exchange Exposure Dr. Himanshu Joshi

2. Debt and Foreign Exchange Exposure We will discuss how and why managers use financial hedging to go beyond operational hedging of FX exposure. We also show how managers need to consider the ultimate impact of FX changes on the firm’s stock value and net cash flow- that is from the viewpoint of the shareholders.

3. Debt and Foreign Exchange Exposure First we will discuss use of debt denominated in foreign currency in financial hedging. Operational hedging and foreign currency debt are considered to be the form of natural hedging. (hedging without use of derivatives)

4. Debt and Foreign Exchange Exposure Measured in the firm’s base currency, interest payments on foreign currency debt fluctuate in the same direction as the operating cash flows, reducing the FX exposure of net cash flows. If Infosys debt is denominated in US dollars, it will reduce the adverse effect of UD dollar appreciation on its Rupee Revenue.

5. Debt and Foreign Exchange Exposure But any debt, whatever the currency, also creates financial leverage, in which fixed interest cost causes an increase in the volatility of the net cash flow. For a leveraged firm, revenues are uncertain, but payment of interest is fixed, which create risk and uncertainty on net cash flows. So, we have to keep in mind the financial leverage effect when analyzing the use of foreign currency denominated debt in hedging FX exposure.

6. Debt and Foreign Exchange Exposure By discounting future cash flows, we can think in terms of the intrinsic value of a firm and of its debt and equity. When a firm has a positive FX operating exposure, fluctuations in the value of a foreign currency debt tend to reduce the FX exposure of the firm’s intrinsic stock value. However, again consider the impact of financial leverage.. Extension of the same concept is one of the important reason for Cross Listing. Infosys…

7. Should Firm Manage FX Exposure? Some firms choose not to hedge FX exposure because in an efficient financial market, FX hedging does not affect the current stock value, even though hedging does affect the volatility of the future stock values. But many firm realize that real world markets are not perfect. They believe that stock market wants stability in dividends and reported earnings growth rates, and thus stabilizing the cash flow stream has a desirable impact on the current stock price.

8. Should Firm Manage FX Exposure? Another reason for not hedging FX exposure is that managers think some shareholders want the FX exposure and do not want the managers to hedge. And, any other shareholders who don’t want the FX exposure are free to manage it using their own financial hedging. In reality though, shareholder’s often cannot hedge FX exposure on their own even if they want to, because the FX exposure is too complex for them to understand. And providing shareholders with information on FX exposures would be expensive and might reveal strategic information.

9. Should Firm Manage FX Exposure? Another argument for not hedging is that firms assumes the impact of FX changes will get even out over the long run. In reality FX swings could cause sudden shortfalls of cash from operations that might undermine a company’s ability to follow through on capital investment plans. Many firms practice strategic hedging to avoid the consequences of FX changes on their competitive position.

10. Operational Hedging vs. Financial hedging.. For many firms, there are limits to which operational hedging can be used. For example, Merck concluded that operational hedging by producing overseas was not viable, given the company’s need to centralize R&D efforts in US. For mining companies, there may be no way to do operational hedging. So firms manage FX operating exposure by using financial hedging in addition to or instead of operational hedging.

11. Should Firm Manage FX Exposure? As the basic purpose of financial hedging of FX exposure is to eliminate uncertainty in net cash flows and stock value. After a hedge has been put on, it theoretically should not matter to the hedger what the future spot FX rate actually turns out to be. If you hedge a positive FX operating exposure and currency depreciates, you enjoy making the right call. But if the currency appreciates, you regret the decision to hedge.

12. Debt Denominated in Foreign Currencies: Euro Bonds A euro bond is a bond issued outside the country of the bond’s currency denomination, not a bond denominated in euros. The first euro bond was denominated in US dollars and issued in 1962 by the Italian highway authority, Autostrada. Investors in England, Belgium, Germany, and Netherlands purchased it. Following its issue, bonds were listed on LSE. If Autostrada had issued bonds in US, the bond would have been classified as foreign bonds * and not the euro bonds. *(SEC requirements)

13. Debt and FX Net Cash Flow Exposure.. We first look at the impact of debt, including foreign currency debt on net cash flows. We define net cash flows as operating cash flows – interest on debt. N $ = O $ - I $ Where I $ is the interest expense expressed in base currency, assumed here as dollar.

14. Debt and FX Net Cash Flow Exposure.. In terms of US dollar, FX net cash flow exposure is defined with the usual elasticity notion, the percentage change in the net cash flow in US dollars, n $ = %∆ N $, divided by the percentage change in the FX value of foreign currency. Ę $ N£ = n $ /x $/£ When a firm’s FX operating exposure is positive (>0), it will have more FX NCF exposure for higher levels of base currency debt. This is financial leverage effect of the debt. The firm will also have less FX NCF exposure if some debt is denominated in the exposure currency than it would be with the same amount of the base currency debt, because the foreign currency debt is a financial hedge of the firm’s FX operating exposure.

15. Debt and FX Net Cash Flow Exposure.. ITX Corporation a US firm initially has an expected operating cash flow stream of $1000 per year. Assume that the firm’s FX operating exposure to the pound is Ę $ 0£ = 1. if pounds drops by 20% (relative to USD), the ITX’s operating cash flows will also drop by 20% to $800. And if pounds appreciates by 20%, ITX’s cash flows will appreciates by 20% to $1200.

16. Debt and FX Net Cash Flow Exposure.. Suppose in the first case that ITX has issued $7500 in US dollar denominated debt with a coupon interest of 5%. The interest =.05($7500)=$375 per year. And N $ = $1000 - $375= $625. If pound depreciates by 20%. N $ = $800-$375= $425. Or $1200 - $375 =$825.

17. Debt and FX Net Cash Flow Exposure.. You can see that volatility in the net cash flows is greater than the volatility in the operating cash flows..

18. If ITX was using Pound Debt..?? ITX has £5000 in pound denominated debt instead of $7500 of US Dollar debt. If X 0 $/£ = 1.5$/£.. Assumption: interest is 5%...

19. Foreign Currency Debt Thus you see here that the FX hedging effect of the pound debt results in a lower FX NCF exposure: (1) than if an equivalent amount of US dollar debt is used (1.6). Note that foreign currency debt does not eliminate the FX NCF exposure, or even reduce it below the firm’s FX operating Exposure. The reason is that pound debt has a financial leverage effect in addition to its FX hedging effect.

20. Foreign Currency Debt Higher the FX operating exposure, the more pronounced is the financial leverage effect of foreign currency debt relating to the FX hedging effect. If a firm’s FX operating exposure is greater than 1, the financial leverage effect of foreign currency denominated debt will be stronger than the FX hedging effect. The result will be even higher FX NCF exposure greater than FX operating exposure..

21. Do it Yourself.. ITX’s FX operating exposure is 1.5 instead of 1. what would be the company’s FX NCF exposure in case I (US dollar debt) and Case II (pound debt)? You can also check it for FX operating exposure of 0.5.

22. Summary of ITX Corporation’s ITX FX Operating Exposure$-Debt£-Debt Ę O£ $ = 1Ę N£ $ = 1.60Ę N£ $ =1 Ę O£ $ = 1.5Ę N£ $ =2.40Ę N£ $ =1.80 Ę O£ $ = 0.5Ę N£ $ =.80Ę N£ $ = 0.20

23. FX Equity Exposure Three elements determine a firm’s FX Equity Exposure: 1.The firm’s FX value (FX Operating) Exposure. 2.The financial leverage. 3.The relative amount of debt denominated in the FX Operating Exposure Currency.

24. Example of Equity Exposure US Firm XYZ company has an FX operating exposure of 1.2 to the euro. Intrinsic value of the firm is V $ = $2000, and its overall debt value is D $ = $600. thus Intrinsic value of the firm’s equity would be S $ = $2000-$600= $1400. Assume 5% drop in spot FX value of the euro. We compare two cases. In the first case, XYZ has no debt denominated in euros; all debt is denominated in USD. in the second case, half of XYZ’s $600 of debt is Euro-Denominated debt.

25. FX Equity Exposure Ę $ S€ = [Ę $ o€ - D $ € /V $ ] / [1-D $ /V $ ]

26. Hedging FX value exposure with foreign currency debt