Lecture 4 Foreign Exchange Risk Management

MULTINATIONAL FINANCE Foreign Exchange Risk Management (Chapter 10 & 11)

Outline of Lecture 1) Define different types of exchange rate exposures 2) Managing exchange rate exposure 1) 2) 3) 4)

Hedging Managing Translation Exposure Managing Transaction Exposure Managing Operating Exposure

Foreign exchange exposure ‰“A measure of the potential change in a firm’s profitability, net cash flow, and market value because of a change in exchange rates” ‰Focus of lecture: Measure foreign exchange exposure and manage it so as to maximize the profitability, net cash flow, and market value of the firm ‰The effects can be measured in several ways.

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Alternative measures of foreign exchange exposure Translation Exposure

Operating Exposure

Changes in reported owners’ equity in financial statements caused by a changes in exchange rate

Change in expected future cash flows arising from an unexpected change in exchange rates (future sales, future production costs and so on)

Accounting Exposure

Change in exchange rate

Economic Exposure

Time

Transaction Exposure Changes in the value of outstanding (unsettled) foreign currency-denominated contracts (contracts that will give rise to cash flows in the future – after the exchange rate change – but entered into before the exchange rate change) caused by the exchange rate change

Translation exposure ‰ Translation exposure, also called accounting exposure: Accounting-based changes in financial statements caused by a change in exchange rates. It has an influence on the official total shown by the balance sheet ‰ Assets, liabilities, revenues and expenses originally measured in a foreign currency are reported and valuated in the home currency in order to be consolidated in the accounts ‰ Four principal translation methods are used: ¾ ¾ ¾ ¾

the current/non current method the monetary/non monetary method Temporal method The current rate method (US practice)

Translation Exposure Current/Noncurrent Method ‰All foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate ‰Each noncurrent asset or liability is translated at its historical exchange rate, i.e. the exchange rate in effect at the time the asset or liability was incurred

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Translation Exposure Monetary/Nonmonetary method ‰Differentiates between monetary assets and liabilities (cash, accounts payable and receivable and long term debt) and nonmonetary items (inventory, fixed assets and long term investments) ¾ Monetary items are translated at the current exchange rate ¾ Nonmonetary items are translated at historical rates

Translation exposure Temporal method ‰Same as monetary/nonmonetary method but inventory (normally translated at historical rates) can be translated at current rate if the inventory is shown on the balance sheet at market values

Translation Exposure Current rate method ‰All balance sheet and income items are translated at the current exchange rate

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‰The translation gain or loss due to changes in exchange rates depends on the chosen translation method Example:

(Exhibit continues on next slide)

Transaction Exposure ‰ Is often included by firms as part of the translation (accounting) exposure but sometimes included (more logical) as part of the economic exposure (operating exposure + transaction exposure) ‰ Transaction exposure measures changes for operations that are incurred prior to a change in exchange rates but that must be settled after a change in exchange rates. It has an influence on the cash management ‰ This exposure deals with changes in cash flows as the result from existing contractual obligations

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Transaction exposure ‰Arises from possibility of exchange rate gains and losses from the transaction ‰Measured currency by currency and equals the difference between: ¾The contractually-fixed invoice amount in a specific currency ¾The final payment amount denominated in current exchange rate for the specific currency

Transaction exposure t1

t3

t2

Seller quotes a price to buyer

Buyer places order with seller at price offered at time t1

Quotation exposure Time between quoting a price and reaching a contractual sale

t4

Seller ships product and bills buyer

Backlog exposure

Time it takes to fill the order after contract is signed

Buyer settles with cash in amount of currency quoted at time t1

Billing exposure Time it takes to get paid in cash

Operating Exposure ‰Operating exposure, measures change in expected future cash-flows (from future sale and production) due to an unexpected change in exchange rates ‰It affects the firm’s present value. It has a major influence on the stock price for listed companies

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Operating Exposure ‰The exchange rate changes that give rise to operating exposure are real exchange rate changes ‰A dramatic change in the nominal exchange rate accompanied by an equal change in the price level (no real exchange rate change) should have no effects on the relative competitive position of domestic firms and their foreign competitors – i.e. will not alter cash flows

Operating exposure ‰A real exchange rate change alters the relative price of domestic and foreign goods ¾ Affects the relative competitiveness of firms

etr = et ×

(1 + i f ,t ) (1 + ih,t )

where etr = the real exchange rate, et = the nominal exchange rate, i f ,t = foreign inflation (0 - t) ih,t = domestic inflation (0 - t)

Operating exposure ‰Need to consider both nominal exchange rate changes as well as relative inflation rates in order to estimate the operating exposure ‰In general: ¾ a decline in the real value of a currency makes its exports and import-competing firms more competitive ¾ An increase in real value of a currency hurts the exporting firms and those competing with imports

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Operating exposure ‰How a specific firm is affected depends importantly on the firms: 1) Pricing flexibility 2) Production flexibility

Operating exposure 1) Pricing flexibility ‰A changing real exchange rate alters relative prices that lead to questions like: ¾ Can the firm maintain its profit margin home and abroad? ¾ Can the firm maintain its home price on domestic sales in the face of lower-priced foreign goods (appreciating currency)? ¾ Can the firm raise its foreign currency selling price sufficiently to preserve its home country profit margin (appreciating currency)?

Operating exposure Price-elasticity of demand ‰Less price elastic demand – more price flexibility for the firm ¾Depends on number of competitors in the market and their location – Less competition more price flexibility

¾Depends on product differentiation – The more distinct/differentiated from other products – less price sensitive

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Operating exposure ‰Higher price elasticity – decreased price flexibility for the firm ¾High competition ¾Less differentiated products

‰Less pricing flexibility → Greater exchange rate risk

Operating exposure 2) Production flexibility ‰Move production geographically ¾Home versus foreign production

‰Alter production inputs ¾Change sourcing to different countries, different input substitutes

‰Higher production flexibility → less exchange rate risk

Operating exposure Identification of economic exposure: ‰A real exchange rate change affects a number of aspects of a firms operations ‰Need to identify these aspects: ¾Pose the right questions

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Managing Exchange Rate Exposure Hedging ‰“establishing an offsetting currency position so as to lock in the home currency value for the currency exposure and thereby eliminate the risk posed by currency fluctuations” ‰Whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge

Managing Exchange Exposure Designing a hedging strategy ‰Identify and determine the types of exposure to be monitored ‰Strategies a function of management’s objectives and should be consistent with maximizing shareholder value ‰Hedging’s basic objective: reduce/eliminate volatility of earnings as a result of exchange rate changes

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Basic Hedging Strategies

Managing Exchange Exposure ‰Hedging exchange rate risk ¾Costs money ¾Should be evaluated as any other purchase of insurance

Hedging Costs

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Managing Exchange Exposure ‰Hedging should be used only if it increases the value of the firm – is consistent with the goal of management ‰If market expects a future devaluation/ depreciation or revaluation/appreciation this is likely reflected in forward, futures and currency option prices – hence using these instruments for hedging will probably be a failure ‰Hedging is useful if firm has a deviating (from the market) expectation about future exchange rate changes or against unexpected changes

Managing Translation Exposure ‰ 3 Available Methods 1) Adjusting fund flows

‰ altering either the amounts or the currencies of the planned cash flows of the parent or its subsidiaries to reduce the firm’s local currency accounting exposure.

Managing Translation Exposure 2) Forward contracts

‰ Reducing a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency

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Managing Translation Exposure 3 Exposure netting

‰ Offsetting exposures in one currency with exposures in the same or another currency ¾gains and losses on the two currency positions will offset each other

Managing Translation Exposure ‰Basic hedging strategy for reducing translation exposure (through 1-3 accomplish): ¾increasing hard-currency (likely to appreciate) assets ¾decreasing soft-currency (likely to depreciate) assets ¾decreasing hard-currency liabilities ¾increasing soft-currency liabilities – i.e. reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward.

Managing Transaction Exposure METHODS OF HEDGING A. Forward market hedge B. Money market hedge C. Risk shifting D. Pricing decision E. Exposure netting F. Currency risk sharing G. Currency collars H. Cross-hedging I. Foreign currency options

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Managing Transaction Exposure A. FORWARD MARKET HEDGE ‰consists of offsetting a receivable or payable in a foreign currency using a forward contract: ¾to sell or buy that currency at a set delivery date which coincides with receipt of the foreign currency ¾Will also offset the possibilities of profits from exchange rate changes

Managing Transaction Exposure NOTE: The real cost of Hedging: ‰The opportunity cost depends upon future spot rate at settlement

f1 − e1 eo where f1 = forward rate, e o = current spot rate, e1 = future spot rate

Managing Transaction Exposure B. MONEY MARKET HEDGE ‰Definition: simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow

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Managing Transaction Exposure C. RISK SHIFTING ‰home currency invoicing – shifts risk from one firm to the other ¾firm will invoice exports in strong currency ¾import in weak currency ‰Drawback: it is not possible with informed customers or suppliers – only if they have different exchange rate expectations

Managing Transaction Exposure D. PRICING DECISIONS ‰The general rule on credit sales overseas is to convert between the foreign currency price and the dollar price by using the forward rate, not spot rate ¾if the dollar price is high/low enough the exporter/importer should follow through with the sale

Managing Transaction Exposure E. EXPOSURE NETTING ‰Protection can be gained by selecting currencies that minimize exposure ‰Netting: MNC chooses currencies that are not perfectly positively correlated ‰Exposure in one currency can be offset by the exposure in another

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Managing Transaction Exposure F. CURRENCY RISK SHARING ‰Developing a customized hedge contract ‰The contract typically takes the form of a Price Adjustment Clause, whereby a base price is adjusted to reflect certain exchange rate changes ‰The buyer and seller agree on splitting the exchange rate risk

Managing Transaction Exposure F. CURRENCY RISK SHARING (con’t) ‰Parties would share the currency risk beyond a neutral zone of exchange rate changes ‰The neutral zone represents the currency range in which risk is not shared ¾For example: $0.98-1.02/€ ¾If exchange rate moves out of the range the parties share the gain/loss

Managing Transaction Exposure G. CURRENCY COLLARS ‰Also called a range forward ‰Contract bought (from bank) to protect against currency moves outside an agreed-upon range ‰Example: “Euro receivable” ¾ If future spot rate is in the range $0.95-$1.05/€ it will be converted at the future spot rate ¾ If future spot rate is above $1.05/€ it will be converted at $1.05/€ (bank profits) ¾ If future spot rate is below $0.95/€ it will be converted at $0.95/€ (bank losses)

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Managing Transaction Exposure H. CROSS-HEDGING ‰Often futures contracts not available in a certain currency ‰Solution: a cross-hedge ¾ a futures contract in a related currency ¾ Use regression to obtain correlation between the currencies

‰Correlation between 2 currencies is critical to success of this hedge

Managing Transaction Exposure I. Foreign Currency Options ‰

When transaction is uncertain, currency options are a good hedging tool in situations in which the quantity of foreign exchange to be received or paid out is uncertain.

January

Bid

April

Decision of the bidding process

December

Time

Payment (receive € 10 million)

Managing Transaction Exposure I. Foreign currency options

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A call option is valuable when a firm has offered to buy a foreign asset at a fixed foreign currency price but is uncertain whether its bid will be accepted or not

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The firm can lock in a maximum dollar price for its tender offer, while limiting its downside risk to the call premium in the event its bid is rejected

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Managing Transaction Exposure ‰A put option allows the company to insure its profit margin against adverse movements in the foreign currency while limiting the downside risk to the premium if they lose the bidding process

Managing Operating Exposure ‰Because currency risk affects all facets of a company’s operations it should not be the concern of financial managers alone ‰Operating exposure (competitive exposure) management requires in addition to financial hedging techniques long-term operating adjustments ‰Relative price changes (changes in the real exchange rate) leads to marketing and/or production revisions

Managing Operating Exposure Proactive Marketing Initiatives 1) Market selection ¾use competitive advantage due to favorable exchange rate to carve out market shares ¾Market segmentation – pull out of unprofitable markets devote more attention to profitable markets (caused by different exchange rate levels)

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Managing Operating Exposure Proactive Marketing Initiatives 2) Product strategy ¾Exchange rate changes may alter: – The timing of new product introductions (competitive advantage – after devaluation) – Product deletion (not competitive) – Product innovation (high-quality products - strong home currency)

Managing Operating Exposure Proactive Marketing Initiatives 3) Pricing strategy ‰Key issue to be addressed: Emphasize market share or profit margin ¾Following a home currency depreciation (competitive advantage for home exporter) – Raising its home currency price and boosting profit margins or keeping its home currency price expanding its market shares?

Managing Operating Exposure Proactive Marketing Initiatives ‰Decision (profit margin vs market shares) depends on: ¾ Temporal advantage? ¾ Economics of scale in production (emphasize market share) ¾ Cost structure for expanding production ¾ Consumer price sensitivity (high price elasticity – keep price low) ¾ Attracting competition (through high unit profits)

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Managing Operating Exposure Proactive Marketing Initiatives 4) Promotional strategy ‰Devote resources to promote products that have a strong competitive position (due to favorable exchange rate) to gain market shares

Managing Operating Exposure Proactive Production Initiatives 1) Product sourcing ¾input mix (increased use of foreign inputs – if strong home currency) ¾Shifting production among a firms plants – Increasing production in nations whose currency has devalued – Decreasing production in nations whose currency has revalued

Managing Operating Exposure Proactive Production Initiatives 2) Plant location ¾ Strong home currency may warrant new plants to be located abroad (in a weaker currency country)

3) Raising productivity ¾ Raising competitiveness by improving productivity – Closing inefficient plants – Automating heavily (decrease labor usage) – Negotiating wage and benefit cutbacks

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Managing Operating Exposure Planning For Exchange-Rate Changes ‰With better planning and more competitive options, firms can change strategies substantially before the impact of a currency change makes itself felt ‰With better planning ahead (prepare for different scenarios) the firm may act quicker and can be more flexible

Financial Management of Exchange Rate Risk: ‰Financial manager’s role in marketing and production: ¾ Provide local manager with forecasts of inflation and exchange rate changes ¾ Identify and focus on competitive exposure ¾ Design the evaluation criteria so that operating managers neither are rewarded or penalized for unexpected exchange-rate changes ¾ Estimate and hedge the operating exposures after adjustments made (marketing, production)

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