International Finance
FIN456 ♦ Fall 2012
Michael Dimond
MNCs are exposed to risk from exchange rates
Economic
Exposure
Resulting from
Accounting
Resulting from
Market Forces
Purely
Accounting
Based
Michael Dimond
School of Business Administration
Foreign Exchange Exposure
• Foreign exchange exposure is a measure of the potential
for a firm’s profitability, net cash flow, and market value to
change because of a change in exchange rates
– These three components (profits, cash flow and market value) are
the key financial elements of how we view the relative success or
failure of a firm
– While finance theories tell us that cash flows matter and
accounting does not, we know that currency-related gains and
losses can have destructive impacts on reported earnings – which
are fundamental to the markets opinion of that company
Michael Dimond
School of Business Administration
Types of Foreign Exchange Exposure
• Transaction Exposure – measures changes in the
value of outstanding financial obligations incurred prior to
a change in exchange rates but not due to be settled
until after the exchange rate changes
• Translation Exposure – the potential for accounting
derived changes in owner’s equity to occur because of
the need to “translate” financial statements of foreign
subsidiaries into a single reporting currency for
consolidated financial statements
• Operating Exposure – measures the change in the
present value of the firm resulting from any change in
expected future operating cash flows caused by an
unexpected change in exchange rates
Michael Dimond
School of Business Administration
Why Hedge?
• Hedging protects the owner of an asset (future stream of
cash flows) from loss
• However, it also eliminates any gain from an increase in
the value of the asset hedged against
• Since the value of a firm is the net present value of all
expected future cash flows, it is important to realize that
variances in these future cash flows will affect the value of
the firm and that at least some components of risk
(currency risk) can be hedged against
• Companies must first decide what they are trying to
accomplish through their hedging program.
Michael Dimond
School of Business Administration
Why Hedge - the Pros & Cons
• Proponents of hedging give the following reasons:
– Reduction in risk in future cash flows improves the planning capability of
the firm
– Reduction of risk in future cash flows reduces the likelihood that the
firm’s cash flows will fall below a necessary minimum
– Management has a comparative advantage over the individual investor
in knowing the actual currency risk of the firm
– Markets are usually in disequilibirum because of structural and
institutional imperfections
Michael Dimond
School of Business Administration
Why Hedge - the Pros & Cons
• Opponents of hedging give the following reasons:
– Shareholders are more capable of diversifying risk than the
management of a firm; if stockholders do not wish to accept the
currency risk of any specific firm, they can diversify their portfolios to
manage that risk, investors have already factored the foreign exchange
effect into a firm’s market valuation
– Currency risk management does not increase the expected cash flows
of a firm; currency risk management normally consumes resources thus
reducing cash flow
– The expected NPV of hedging is zero (Managers cannot outguess the
market; markets are in equilibrium with respect to parity conditions)
– Management’s motivation to reduce variability is sometimes driven by
accounting reasons; management may believe that it will be criticized
more severely for incurring foreign exchange losses in its statements
than for incurring similar or even higher cash cost in avoiding the foreign
exchange loss
– Management often conducts hedging activities that benefit management
at the expense of shareholders
Michael Dimond
School of Business Administration
Hedging’s Impact on Expected Cash Flows of the Firm
Michael Dimond
School of Business Administration
Measurement of Transaction Exposure
• Transaction exposure measures gains or losses that arise
from the settlement of existing financial obligations, namely
– Purchasing or selling on credit goods or services when prices are
stated in foreign currencies
– Borrowing or lending funds when repayment is to be made in a foreign
currency
– Being a party to an unperformed forward contract and
– Otherwise acquiring assets or incurring liabilities denominated in
foreign currencies
Michael Dimond
School of Business Administration
Purchasing or Selling on Open Account
• Suppose Caterpillar sells merchandise on open account to a
Belgian buyer for €1,800,000 payable in 60 days
• Further assume that the spot rate is $1.2000/€ and Trident
expects to exchange the euros for €1,800,000 x $1.2000/€ =
$2,160,000 when payment is received
– Transaction exposure arises because of the risk that Caterpillar will
something other than $2,160,000 expected
– If the euro weakens to $1.1000/€, then Caterpillar will receive
$1,980,000
– If the euro strengthens to $1.3000/€, then Caterpillar will receive
$2,340,000
Michael Dimond
School of Business Administration
Purchasing or Selling on Open Account
• Caterpillar might have avoided transaction exposure by
invoicing the Belgian buyer in US dollars (risk shifting),
but this might have lead to Caterpillar not being able to
book the sale
• If the Belgian buyer agrees to pay in dollars, Caterpillar
has transferred the transaction exposure to the Belgian
buyer whose dollar account payable has an unknown
euro value in 60 days
Michael Dimond
School of Business Administration
The Life Span of a Transaction Exposure
Michael Dimond
School of Business Administration
Borrowing and Lending
• A second example of transaction exposure arises when funds
are loaned or borrowed
• Example: PepsiCo’s largest bottler outside the US is located
in Mexico, Grupo Embotellador de Mexico (Gemex)
– On 12/94, Gemex had US dollar denominated debt of $264 million
– The Mexican peso (Ps) was pegged at Ps$3.45/US$
– On 12/22/94, the government allowed the peso to float due to internal
pressures and it sank to Ps$4.65/US$. In January it reached Ps$5.50
Michael Dimond
School of Business Administration
Borrowing and Lending
• Gemex’s peso obligation now looked like this
– Dollar debt mid-December, 1994:
• US$264,000,000  Ps$3.45/US$ = Ps$910,800,000
– Dollar debt in mid-January, 1995:
• US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000
– Dollar debt increase measured in Ps
• Ps$541,200,000
• Gemex’s dollar obligation increased by 59% due to
transaction exposure
Michael Dimond
School of Business Administration
Other Causes of Transaction Exposure
• When a firm buys a forward exchange contract, it deliberately
creates transaction exposure; this risk is incurred to hedge
an existing exposure
– Example: US firm wants to offset transaction exposure of ¥100 million
to pay for an import from Japan in 90 days
– Firm can purchase ¥100 million in forward market to cover payment in
90 days
Michael Dimond
School of Business Administration
Contractual Hedges
• Transaction exposure can be managed by contractual, operating, or
financial hedges
• The main contractual hedges employ forward, money, futures and
options markets
• Operating and financial hedges use risk-sharing agreements, leads
and lags in payment terms, swaps, and other strategies
• A natural hedge refers to an offsetting operating cash flow, a payable
arising from the conduct of business
• A financial hedge refers to either an offsetting debt obligation or
some type of financial derivative such as a swap
Michael Dimond
School of Business Administration
Risk Management in Practice
• Which Goals?
– The treasury function of most firms is usual considered a cost center;
it is not expected to add to the bottom line
– However, in practice some firms’ treasuries have become aggressive
in currency management and act as though they were profit centers
• Which Exposures?
– Transaction exposures exist before they are actually booked yet some
firms do not hedge this backlog exposure
– However, some firms are selectively hedging these backlog
exposures and anticipated exposures
Michael Dimond
School of Business Administration
Risk Management in Practice
• Which Contractual Hedges?
– Transaction exposure management programs are generally divided
along an “option-line;” those which use options and those that do not
– Also, these programs vary in the amount of risk covered; these
proportional hedges are policies that state which proportion and type
of exposure is to be hedged by the treasury
Michael Dimond
School of Business Administration
Translation Exposure
• Translation exposure arises because the financial statements of
foreign subsidiaries must be restated in the parent’s reporting
currency for the firm to prepare its consolidated financial
statements
• Translation exposure is the potential for an increase or decrease
in the parent’s net worth and reported income caused by a change
in exchange rates since the last transaction
• Translation methods differ by country along two dimensions
– One is a difference in the way a foreign subsidiary is
characterized depending on its independence
– The other is the definition of which currency is most important
for the subsidiary
Michael Dimond
School of Business Administration
Subsidiary Characterization
• Most countries specify the translation method to be used by a
foreign subsidiary based upon its operations
• A foreign subsidiary can be classified as
– Integrated Foreign Entity – one which operates as an extension of
the parent company, with cash flows and line items that are highly
integrated with the parent
– Self-sustaining Foreign Entity – one which operates in the local
economy independent of its parent
• The foreign subsidiary should be valued in terms of the
currency that is the basis of its economic viability
Michael Dimond
School of Business Administration
Functional Currency
• A foreign affiliate’s functional currency is the currency of
the primary economic environment in which the subsidiary
operates
• The geographic location of a subsidiary and its functional
currency can be different
– Example: US subsidiary located in Singapore may find that its
functional currency could be
• US dollars (integrated subsidiary)
• Singapore dollars (self-sustaining subsidiary)
• British pounds (self-sustaining subsidiary)
Michael Dimond
School of Business Administration
Translation Methods
• There are four principal translation methods available:
the current/noncurrent method, the
monetary/nonmonetary method, the temporal method,
and the current-rate method.
• The two most used the translation of foreign subsidiary
financial statements are
– The current rate method
– The temporal method
• Regardless of which is used, either method must
designate
– The exchange rate at which individual balance sheet and income
statement items are remeasured
– Where any imbalances are to be recorded
• This can affect either the balance sheet or the income statement
Michael Dimond
School of Business Administration
Current Rate Method
• Under this method all financial statement items are translated at the
“current” exchange rate
• Assets & liabilities – are translated at the rate of exchange in effect on
the balance sheet date
• Income statement items – all items are translated at either the actual
exchange rate on the dates the various revenues, expenses, gains and
losses were incurred or at a weighted average exchange rate for the
period
• Distributions – dividends paid are translated at the rate in effect on the
date of payment
• Equity items – common stock and paid-in capital are translated at
historical rates; year end retained earnings consist of year-beginning
plus or minus any income or loss on the year
Michael Dimond
School of Business Administration
Current Rate Method
• Any gain or loss from re-measurement is closed to an
equity reserve account entitled the cumulative translation
adjustment, rather than through the company’s
consolidated income statement
• These cumulative gains and losses from remeasurement
are only recognized in current income under the current
rate method when the foreign subsidiary giving rise to that
gain or loss is liquidated
Michael Dimond
School of Business Administration
Temporal Method
• Under this method, specific assets and liabilities are
translated at exchange rates consistent with the timing of the
item’s creation
• The temporal method assumes that a number of line items
such as inventories and net plant and equipment are restated
to reflect market value
• If these items were not restated and carried at historical
costs, then the temporal method becomes the monetary/nonmonetary method
Michael Dimond
School of Business Administration
Temporal Method
• Line items included in this method are
– Monetary assets (primarily cash, accounts receivable, and long-term
receivables) and all monetary liabilities are translated at current
exchange rates
– Non-monetary assets (primarily inventory and plant and equipment)
are translated at historical exchange rates
– Income statement items – are translated at the average exchange rate
for the period except for depreciation and cost of goods sold which are
associated with non-monetary items, these items are translated at
their historical rate
Michael Dimond
School of Business Administration
Temporal Method
• Line items included in this method are
– Distributions – dividends paid are translated at the exchange rate in
effect the date of payment
– Equity items – common stock and paid-in capital are translated at
historical rates; year end retained earnings consist of year-beginning
plus or minus any income or loss on the year plus or minus any
imbalance from translation
• Under the temporal method, any gains or losses from
remeasurement are carried directly to current consolidated
income and not to equity reserves
Michael Dimond
School of Business Administration
US Translation Procedures
• The US differentiates foreign subsidiaries on the basis of functional
currency, not subsidiary characterization. Translation methods are
mandated in FASB-8 and FASB-52.
• Regardless of the translation method selected, measuring
accounting exposure is conceptually the same. It involves
determining which foreign currency-denominated assets and
liabilities will be translated at the current (postchange) exchange
rate and which will be translated at the historical (prechange)
exchange rate. The former items are considered to be exposed,
while the latter items are regarded as not exposed. Translation
exposure is just the difference between exposed assets and
exposed liabilities.
• By far the most important feature of the accounting definition of
exposure is the exclusive focus on the balance sheet effects of
currency changes. This focus is misplaced since it has led firms to
ignore the more important effect that these changes may have on
future cash flows.
Michael Dimond
School of Business Administration
Managing Translation Exposure
• Balance Sheet Hedge – this requires an equal amount of
exposed foreign currency assets and liabilities on a firm’s
consolidated balance sheet
– A change in exchange rates will change the value of exposed assets
but offset that with an opposite change in liabilities
– This is termed monetary balance
– The cost of this method depends on relative borrowing costs in the
varying currencies
Michael Dimond
School of Business Administration
Managing Translation Exposure
• When is a balance sheet hedge justified?
– The foreign subsidiary is about to be liquidated so that the value of its
CTA would be realized
– The firm has debt covenants or bank agreements that state the firm’s
debt/equity ratios will be maintained within specific limits
– Management is evaluated on the basis of certain income statement
and balance sheet measures that are affected by translation losses or
gains
– The foreign subsidiary is operating in a hyperinflationary environment
Michael Dimond
School of Business Administration
Choosing Which Exposure to Minimize
• As a general matter, firms seeking to reduce both types of
exposures typically reduce transaction exposure first
• They then recalculate translation exposure and then decide if
any residual translation exposure can be reduced without
creating more transaction exposure
Michael Dimond
School of Business Administration
Operating Exposure
• The change in company value resulting from changes in future
operating cash flows caused by an unexpected change in exchange
rates.
• Because the value of a firm is equal to the present value of future cash
flows, accounting measures of exposure that are based on changes in
the book values of foreign currency assets and liabilities need bear no
relationship to reality.
• Because currency changes are usually preceded by or accompanied
by changes in relative price levels between two countries, it is
impossible to determine exposure to a given currency change without
considering simultaneously the offsetting effects of these price
changes.
Michael Dimond
School of Business Administration
Operating Exposure
•
•
The primary exposure management objective of financial executives should
be to arrange their firm's finances in such a way as to minimize the real
effects of exchange rate changes.
The major burden of coping with exchange risk must be borne by the
marketing and production people
– They deal in imperfect product and factor markets where their specialized
knowledge provides a real advantage.
– Their role is to design marketing and production strategies to deal with exchange
risks.
– The appropriate marketing and production strategies are similar to those that
would be suitable for any firm confronted with shifting relative output or input
prices caused by any economic, political, or social factors.
•
•
Measuring the operating of a firm requires forecasting and analyzing all the
firm’s future individual transaction exposures together with the future
exposure of all the firm’s competitors and potential competitors
This long term view is the objective of operating exposure analysis
Michael Dimond
School of Business Administration
Operating Exposure
• Exchange rate changes do not always increase the riskiness of
multinational corporations.
– Purchasing Power Parity tells us devaluations (or revaluations) are usually
preceded by higher (or lower) rates of inflation, therefore we should not evaluate
only the devaluation phase of an inflation-devaluation cycle.
– Nominal currency changes smooth out the profit peaks and valleys caused by
differing rates of inflation. Devaluations or revaluations should actually reduce
earnings variability for MNCs. Only if currency changes involve real exchange
rate changes does risk increase.
• Domestic firms are also subject to exchange rate risk, not just MNCs
– Domestic facilities that supply foreign markets normally entail much greater
exchange risk than foreign facilities supplying local markets (because material
and labor used in a domestic plant are paid for in the home currency while the
products are sold in a foreign currency).
– A purely domestic company selling locally but facing import competition may be
seriously hurt (helped) by the devaluation (revaluation) of a competitor's home
currency.
Michael Dimond
School of Business Administration
Managing Exchange Risk
•
•
•
•
•
Since currency risk affects all facets of a firm's operations, it should not be the
concern of financial managers alone.
Operating managers should develop marketing & production initiatives that help to
ensure profitability over the long run. They should also devise anticipatory strategic
alternatives in order to gain competitive leverage internationally.
The key to effective exposure management is to integrate currency considerations
into the general management process.
Managers trying to cope with actual or anticipated exchange rate changes must first
determine whether the exchange rate change is real or nominal. Nominal changes
can be ignored. Real changes must be responded to.
If real, the manager must first assess the permanence of the change. In general, real
exchange rate movements that narrow the gap between the current rate and the
equilibrium rate are likely to be longer lasting than are those that widen the gap.
Neither, however, will be permanent. Rather, there will be a sequence of equilibrium
rates, each of which has its own implications for the firm's marketing and production
strategies.
Michael Dimond
School of Business Administration
Integrated Exchange Risk Program
• The role of the financial executive in an integrated exchange
risk program is fourfold
• to provide local operating management with forecasts of inflation and
exchange rates
• to identify and highlight the risks of competitive exposure
• to structure evaluation criteria such that operating managers are not
rewarded or penalized for the effects of unanticipated real currency
changes
• to estimate and hedge whatever real operating exposure remains after
the appropriate marketing and production strategies have been put in
place.
Michael Dimond
School of Business Administration
Expected Versus Unexpected Changes in Cash Flows
• Operating exposure is far more important for the long-run
health of a business than changes caused by transaction or
translation exposure
– Planning for operating exposure is total management responsibility
since it depends on the interaction of strategies in finance, marketing,
purchasing, and production
– An expected change in exchange rates is not included in the definition
of operating exposure because management and investors should
have factored this into their analysis of anticipated operating results
and market value
Michael Dimond
School of Business Administration
Measuring Operating Exposure
• Short Run - The first-level impact is on expected cash flows in the 1-year
operating budget. The gain or loss depends on the currency of
denomination of expected cash flows. These are both existing transaction
exposures and anticipated exposures. The currency of denomination
cannot be changed for existing obligations
• Medium Run Equilibrium - The second-level impact is on expected
medium-run cash flows, such as those expressed in 2- to 5-year budgets
• Medium Run: Disequilibrium. The third-level impact is on expected
medium-run cash flows assuming disequilibrium conditions. In this case,
the firm may not be able to adjust prices and costs to reflect the new
competitive realities caused by a change in exchange rates
• Long Run. The fourth-level impact is on expected long-run cash flows,
meaning those beyond five years. At this strategic level, a firm’s cash
flows will be influenced by the reactions of both existing and potential
competitors, possible new entrants, to exchange rate changes under
disequilibrium conditions
Michael Dimond
School of Business Administration
Strategic Management of Operating Exposure
• The objective of both operating and transaction exposure
management is to anticipate and influence the effect of
unexpected changes in exchange rates on a firm’s future
cash flows
• To meet this objective, management can diversify the
firm’s operating and financing base
• Management can also change the firm’s operating and
financing policies
Michael Dimond
School of Business Administration
Diversifying Operations
• Diversifying operations means diversifying the firm’s
sales, location of production facilities, and raw material
sources
• If a firm is diversified, management is prepositioned to
both recognize disequilibrium when it occurs and react
competitively
• Recognizing a temporary change in worldwide
competitive conditions permits management to make
changes in operating strategies
Michael Dimond
School of Business Administration
Diversifying Financing
• Diversifying the financing base means raising funds in more
than one capital market and in more than one currency
• If a firm is diversified, management is prepositioned to take
advantage of temporary deviations from the International
Fisher effect
Michael Dimond
School of Business Administration
Proactive Management of Operating Exposure
• Operating and transaction exposures can be partially
managed by adopting operating or financing policies that
offset anticipated currency exposures
• Six of the most commonly employed proactive policies are
–
–
–
–
–
–
Matching currency cash flows
Risk-sharing agreements
Back-to-back or parallel loans
Currency swaps
Leads and lags
Reinvoicing centers
Michael Dimond
School of Business Administration
Matching Currency Cash Flows
• One way to offset an anticipated continuous long exposure to
a particular currency is to acquire debt denominated in that
currency
• This policy results in a continuous receipt of payment and a
continuous outflow in the same currency
• This can sometimes occur through the conduct of regular
operations and is referred to as a natural hedge
Michael Dimond
School of Business Administration
Debt Financing as a Financial Hedge
Michael Dimond
School of Business Administration
Currency Clauses: Risk-sharing
• Risk-sharing is a contractual arrangement in which the buyer
and seller agree to “share” or split currency movement
impacts on payments
– Example: Ford purchases from Mazda in Japanese yen at the current
spot rate as long as the spot rate is between ¥115/$ and ¥125/$.
– If the spot rate falls outside of this range, Ford and Mazda will share
the difference equally
– If on the date of invoice, the spot rate is ¥110/$, then Mazda would
agree to accept a total payment which would result from the difference
of ¥115/$- ¥110/$
(i.e. ¥5)
Michael Dimond
School of Business Administration
Currency Clauses: Risk-sharing
• Ford’s payment to Mazda would therefore be



 ¥25,000,00
¥25,000,00
0
0

 $222,222.22


¥5.00/$
¥112.50/$
 ¥115.00/$
2


• Note that this movement is in Ford’s favor, however if the yen
depreciated to ¥130/$ Mazda would be the beneficiary of the
risk-sharing agreement
Michael Dimond
School of Business Administration
Back-to-Back Loans
• A back-to-back loan, also referred to as a parallel loan or
credit swap, occurs when two firms in different countries
arrange to borrow each other’s currency for a specific period
of time
– The operation is conducted outside the FOREX markets, although
spot quotes may be used
– This swap creates a covered hedge against exchange loss, since
each company, on its own books, borrows the same currency it repays
Michael Dimond
School of Business Administration
Cross-Currency Swaps
• Cross-Currency swaps resemble back-to-back loans except
that it does not appear on a firm’s balance sheet
• In a currency swap, a dealer and a firm agree to exchange an
equivalent amount of two different currencies for a specified
period of time
– Currency swaps can be negotiated for a wide range of maturities
• A typical currency swap requires two firms to borrow funds in
the markets and currencies in which they are best known or
get the best rates
Michael Dimond
School of Business Administration
Cross-Currency Swaps
• For example, a Japanese firm exporting to the US wanted to
construct a matching cash flow swap, it would need US dollar
denominated debt
• But if the costs were too great, then it could seek out a US firm
who exports to Japan and wanted to construct the same swap
• The US firm would borrow in dollars and the Japanese firm would
borrow in yen
• The swap-dealer would then construct the swap so that the US
firm would end up “paying yen” and “receiving dollars” be
“paying dollars” and “receiving yen”
• This is also called a cross-currency swap
Michael Dimond
School of Business Administration
Using Cross Currency Swaps
Michael Dimond
School of Business Administration
Contractual Approaches
• Some MNEs now attempt to hedge their operating exposure with
contractual strategies
• These firms have undertaken long-term currency option positions
hedges designed to offset lost earnings from adverse changes in
exchange rates
• The ability to hedge the “unhedgeable” is dependent upon
predictability
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor responses to exchange rate
changes
• Few in practice feel capable of accurately predicting competitor
response, yet some firms employ this strategy
Michael Dimond
School of Business Administration