Risk Management
Strategy
John Oruongo
Time Frame
 Short
Run
 Intermediate Run
 Long Run
Measure of Exposure
 Translation

exposure
Can be ignored
 Transaction


More important in the short run
Hedging possible
 Economic


exposure
exposure
Net worth exposure
Cash flow exposure
Exchange Rate Changes
 Exchange
risk declines with time
 Reinforced by PPP and UIP
 Short run characterized by high risk
 No real exchange risk in the long run
 Time effect on real and nominal exchange
rate changes

Standard deviation ranges from 10-15%
Exchange Rate Changes

Using the standard deviation of 10 percentage
points, the standard deviation of the average
annual exchange rate change for two years is:




[Var(1/2X + 1/2Y)]1/2= [1/4(Var X + Var Y)]1/2
[1/4(2 Var X)]1/2=[1/2 Var X]1/2=[1/2]1/2[Var X]1/2
=[1/2]1/2[σ x] = [.7071][10] = 7.071
Where X is exchange rate change in the first
year and Y is the exchange rate change in the
second year, and X and Y are both drawn from
the same distribution with a standard deviation of
10
Weiner Amalgamated
Weiner Amalgamated is considering an investment in DM-denominated
bonds. For simplicity, the term structure of German interest rates can be
assumed to be flat at 6 percent. The annual standard deviation of
percentage changes in $/DM exchange rate has historically been about
12 percentage points.
•What is the range of dollar-equivalents returns on DM bonds for the 95%
probability level if the investment is held for one year?
•What is the range of dollar-equivalent average annual returns on DM
bonds for the 95% probability level if the investment is held for ten years?
•What is the range of dollar-equivalent average annual returns on DM
bonds for the 95% probability level if the investment is held for twenty
years?
Managing Foreign Exchange Risk
run – transaction exposure
 Intermediate run – economic exposure
 Short



Risk represented by real exchange rate
changes
Hedging is not a viable approach
Operating techniques are used to manage
economic exposure
Summary of Foreign Exchange
Risk
 Short
Run
 Intermediate Run
 Long Run
Short Run
 Focus
on transaction exposure
 Hedging is easy
 Exchange rate volatility is high
 Deviations from PPP and UIP are common
 Exchange risk is predominantly nominal
 Transactions management important
 Marketing and productions plans are fixed
Lufthansa Example
In 1986 the financial press reported that Lufthansa
purchased $500 million of new U.S. aircraft in early 1985
with payment due in early 1986, one year later. The
transaction hit the news because Lufthansa reportedly paid
about DM 1,364 million which was more than the $500
million liability converted at the prevailing rate, $.447/DM or
DM 1,118 million.
This happened because Lufthansa decided to hedge
half of the purchase price using forward contracts at a time
when the dollar subsequently depreciated against the DM.
Forward contract obligated Lufthansa to purchase
dollars at $0.31/DM
The dollar however depreciated from $0.30/DM in
March of 1985 to $0.45/DM in March of 1986
Lufthansa cont’d
Payment in 1986 with 50% hedge
(500*0.5)/0.31 + (500*0.5)/0.45
= DM 1,362 million
Full hedge
500/0.31
=DM 1,613 million
No hedge
500/0.45
=DM 1,111 million
 Was economic exposure associated with transaction
exposure when Lufthansa purchased this aircraft?
 How are Lufthansa’s ongoing cash flows affected by
dollar/DM exchange rate changes
Lufthansa: Economic Exposure
 What
happens to the value of the asset as
exchange rate changes?


Loss on outflow can be offset by gain on value
of assets and vice versa
Market valuation of assets
 Introduced
economic exposure where
none previously existed
Lufthansa: Cash Flow Effect
 Revenue
tied to what currency
 Dollar depreciation
 How the two above may interrelate


Dollar depreciation increasing DM receipts
e.g. stimulate visits to US
Dollar depreciation may result in reduced fuel
costs and vice versa affecting present value of
profits
Intermediate Run
 Focus
on economic exposure
 Hedging is more difficult
 Exchange rate volatility is moderate
 Deviations from PPP and UIP exist
 Exchange risk is predominantly real
 Operations management important
 Marketing and production plans are flexible
Long Run
 Exchange
rate volatility is low and
approaches zero
 PPP and UIP hold
 No exchange risk
 No risk management necessary
 Marketing and production plans are in
long-run equilibrium
Short Run Transactions
Management
 Centralization
vs. Decentralization
 Diversification




Routing of Cash Balances
Payments Netting
Leading and Lagging
Reinvoicing
Waterford Crystal Example
Waterford Crystal, of Kilbarry, Ireland, exports specialty
glassware to the U.S. It faces a potential disastrous situation
in 1985 as the U.S. dollar began to sink against the Irish
pound. A wine decanter that sold in the U.S. for $150
translated into 148 pounds in 1985, but by 1986 it translated
to just 106 pounds
Waterford, however, locked in an exchange rate for a
significant part of its anticipated U.S. receivables by buying
forward contracts on the Irish pound in 1985. The forward
position stretched out for two years or until 1987. In 1986,
Waterford was able to translate $50 million in U.S. sales into
48 million pounds instead of the 37 million it would have
reported at the current exchange rate. Financial hedges
clearly cannot be sustained beyond the short run, however.
Waterford cont’d
 After
1987, Waterford was forced to make
changes to cope with falling dollar
 It diversified into other regions



Bought British china maker Wedgwood Plc
Reduce exposure to fluctuations between
U.S. dollar and Irish pound
Diversified cost structure, since British pound
and Irish pound are not highly correlated visà-vis any of the other currencies in which
revenues are received
Routing of Cash Balances
 Central
cash depository route cash
balances among subsidiaries
 Increases value by taking advantage of
interest rate differences

Balances high borrowing rates and low
lending rates
 Lower
transactions costs due to size
Payments Netting

Reduces number of intracompany payments
 A owes B $1million and B owes A $2million. B
pays only $1million to A – bilateral payments
netting
 A owes B $1million, B owes A $2million, and C
owes B $1million. C pays A $1million, despite
lack of prior transactions – multilateral payments
netting
 May face government restrictions – dealing with
multiple currencies
Leading and Lagging
 Accelerate
payments to affiliates needing
cash, and delay receipts from same
affiliates that are due to other affiliates
 Increases and reduces liquidity to affiliates
 Governments are suspicious – resembles
intracorporate loan
 US tax law – subsidiaries pay/receive no
interest for up to six months
Reinvoicing
 Useful
in import and export transactions
 Central cash facility can buy inputs for an
affiliate, and sell the same to another
 Central cash management takes on
transaction exposure


Affiliates operate exclusively on local currency
Foreign risk management is centralized in one
location
 Government

limits to reinvoicing
Prevent shifting profits to low tax jurisdictions
Summary
 Looked
at time horizons and different
techniques to manage risk
 Examples to illustrate our discussion
 Looked at short run transactions
management techniques