1. Foreign Exchange Exposure

2. What is Foreign Exchange Exposure? Simply put, foreign exchange exposure is the risk associated with activities that involve a global firm in currencies other than its home currency. Essentially, it is the risk that a foreign currency may move in a direction which is financially detrimental to the global firm. Given our observed potential for adverse exchange rate movements, firms must: – Assess and Manage their foreign exchange exposures.

3. Global Companies and FX Exposure What are the specific risks to a global firm from foreign exchange exposure? – Cash inflows and outflows, as measured in home currency equivalents, associated with foreign operations can be adversely affected. Revenues (profits) and Costs – Settlement value of foreign currency denominated contracts, in home currency equivalents, can be adversely affected. For Example: Loans in foreign currencies. – The global competitive position of the firm can be affected by adverse changes in exchange rates. Influence on required return. – End Result: The value (market price) of the firm can be adversely affected.

4. Types of Foreign Exchange Exposure There are three distinct types of foreign exchange exposures that global firms may face as a result of their international activities. These foreign exchange exposures are: – Transaction exposure Any MNC engaged in current transactions involving foreign currencies. – Economic exposure Results for future and unknown transactions in foreign currencies resulting from a MNC long term involvement in a particular market. – Translation exposure (sometimes called “accounting” exposure). Important for MNCs with a physical presence in a foreign country. We will develop each of these in the slides which follow.

5. Transaction Exposure Transaction Exposure: Results from a firm taking on “fixed” cash flow foreign currency denominated contractual agreements. – Examples of translation exposure: An Account Receivable denominate in a foreign currency. A maturing financial asset (e.g., a bond) denominated in a foreign currency. An Account Payable denominate in a foreign currency. A maturing financial liability (e.g., a loan) denominated in a foreign currency.

6. Economic Exposure Economic Exposure: Results from the “physical” entry (and on-going presence) of a global firm into a foreign market. – This is a long term foreign exchange exposure resulting from a previous FDI location decision. Over time, the firm will acquire foreign currency denominated assets and liabilities in the foreign country. The firm will also have operating income and operating costs in the foreign country. – Economic exposure impacts the firm through contracts and transactions which have yet to occur, but will, in the future, because of the firm’s location. These are really “future” transaction exposures which are unknown today. – Economic exposure can have profound impacts on a global firm’s competitive position and on the market value of that firm.

7. Operating exposure (Revenues and Costs) The Two Channels of Economic Exposure MNC’s Competitive Position and Value Impact on the home currency value of foreign assets and liabilities Impact on home currency amount of future operating cash flows Exchange Rate Fluctuations Foreign currency denominated asset & liability exposure

8. Translation Exposure Translation Exposure: Results from the need of a global firm to consolidated its financial statements to include results from foreign operations. – Consolidation involves “translating” subsidiary financial statements from local currencies (in the foreign markets where the firm is located) to the home currency of the firm (i.e., the parent). – Consolidation can result in either translation gains or translation losses. These are essentially the accounting system’s attempt to measure foreign exchange “ex post” exposure.

9. Assessing Foreign Exchange Exposure All global firms are faced with the need to analyze their foreign exchange exposures. – In some cases, the analysis of foreign exchange exposure is fairly straight forward and known. – For example: Transaction exposure. There is a fixed (and thus known) contractual obligation (in some foreign currency). – While in other cases, the analysis of the foreign exchange exposure is complex and less certain. – For example: Economic exposure There is great uncertainty as to what the firm’s exposures will look like over the long term. – Specifically when they will take place and what the amounts will be.

10. Hedging Strategies It appears that most MNC firms (except for those involved in currency-trading) would prefer to hedge their foreign exchange exposures. But, how can firms hedge? – (1) Financial Contracts Forward contracts (also futures contracts) Options contracts (puts and calls) Borrowing or investing in local markets. – (2) Operational Techniques Geographic diversification (spreading the risk)

11. Mersi