International Finance
Part 2
International
Corporate Finance
Lecture n° 5
Foreign exchange exposure
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DES en Gestion - Année académique 2002-2003
International Corporate Finance
 Part 2 : International Corporate Finance (10 hrs)
Foreign Exchange Exposure (Chap. 6 & 7 - 3 hrs):
Transaction exposure + decision case
Operating exposure
Financing the Global Firm (Chap. 11 & 13 - 3 hrs):
Global cost and availability of capital
Financial structure and international debt
Foreign Investment Decision (Chap. 14 & 15 - 3 hrs):
FDI theory and strategy
Multinational capital budgeting
Adjusting for risk in foreign investment + decision case
Managing Multinational Operations (Chap. 18 & 19 -3 hrs)
Repositioning funds
Working capital management + decision case
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Foreign Exchange Exposure
Type of foreign exchange exposures
The three main types of foreign exchange exposure
are: transaction, operating, and translation exposure.
Transaction exposure
Impact of settling outstanding obligations entered into
before change in exchange rates but to be settled after
change in exchange rates.
Operating exposure
Change in expected future cash flows arising from an
unexpected change in exchange rates.
Translation exposure
Changes in reported owner’s equity in consolidated
financial statements caused by a change in exchange
rates. “Accounting exposure”.
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Foreign Exchange Exposure
Hedge or not hedge?
There is a debate between supporters and opponents
of FX hedging. Some arguments of the two groups are:
NOT hedge, because :
Shareholders are much more capable of diversifying currency
risk than the management of the firm.
Currency risk management does not increase the expected
cash flows of the firm, but rather decreases the variance of the
CF, and decrease them as well by the hedging costs.
Managers cannot outguess the market, if and when markets
are in equilibrium with respect to parity conditions, the
expected net present value of hedging is zero.
In efficient markets, investors and analysts can see across the
“accounting veil” and therefore have already factored the
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foreign exchange effect into a firm's market valuation.
DES en Gestion - Année académique 2002-2003
Foreign Exchange Exposure
Hedge or not hedge?
HEDGE, because :
Reduction of risk in future cash flows reduces the
likelihood that the firm’s cash flow will fall below the
necessary minimum.
Management has comparative advantage over the
individual shareholder in knowing the actual currency risk
of the firm.
Markets are usually in disequilibrium because of
structural and institutional imperfections, as well as
unexpected external shocks. Management is in a better
position than shareholders to take advantage of the onetime opportunities theses imperfections cause, to
enhance the firm value through selective hedging.
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Transaction exposure
Transaction exposure
Transaction exposure arises from :
Purchasing or selling on credit goods or services when
prices are stated in foreign currency.
Borrowing or lending funds when repayments is to be
made in a foreign currency.
Being a party to an unperformed foreign exchange
forward contract.
Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies.
Most common example :
Transaction exposure of a firm has a receivable
denominated in a foreign currency.
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Transaction exposure
Transaction exposure - example
Sale of telecom equipment from Trident (US multinational
corporation) to a British company.
Payment is made in £ : 1 MM due in three months.
If the £ appreciate toward the $, Trident makes a bigger
profit, but if the £ depreciates, Tridents loses part (or all) of its
margin : transaction exposure.
Spot rate = $1.7640/£. The budget rate, the lowest
acceptable dollar per pound exchange rate is established at
$1.70/£ to maintain acceptable margin.
Four alternatives available to Trident to manage the
exposure:
•
•
•
•
Remain unhedged
Hedge in the forward market
Hedge in the money market
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Hedge in DES
the en
options
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Transaction exposure
Transaction exposure - example
Forward market hedge
This involves a forward (or futures) contract and a source of
funds to fulfill that contract.
The forward contract is entered into at the time the
transaction exposure is created.
The sequence is as follows :
• Day 0 : sell £1 MM forward at $1.7540 (fwd rate 3 mths)
• In 3 mths : receive £1 MM (from buyer), deliver £1 MM against
forward sale, receive $1,754 MM (price of the fwd rate).
The forward contract is “covered” or “square”, the funds on
hand or to be received are matched by the funds to be paid.
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Transaction exposure
Transaction exposure - example
Money market hedge
Like a forward market hedge, a money market hedge also
includes a contract and a source of funds. The contract is here
a loan agreement.
The firm seeking the hedge borrows in one currency and
exchange the proceeds for another currency. If funds to fulfill
the contract are generated by business operations, the hedge
is “covered”. If the funds are to buy of the spot market, the
hedge is “uncovered” or “open”.
The structure is similar to the forward hedge. Here, the price
is determined by the interest rate differential between the two
currencies, whereas in the fwd hedge, the price is the forward
premium. In efficient fwd markets, interest rate parity states
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that these prices
the
same.
Transaction exposure
Transaction exposure - example
Money market hedge
The sequence is as follows :
• Day 0 : borrow enough to repay £1 MM in 3mths; that is : £1MM
/ 1+0.25 = £ 975,610.
• Day 0 : exchange £ 975,610 against $ at spot rate (1.7640), that
is $1,720,976
• In 3 mths : receive £1 MM (from buyer), deliver £1 MM to repay
the loan, that is £ 975,610 principal + £ 24,390 interests.
Depending on the relative prices of forward markets and
interest rates differences, the money market hedge or the
forward hedge will be preferable.
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Transaction exposure
Transaction exposure - example
Option market hedge
The transaction exposure could also be covered by a £ 1 MM
put option. This technique allows speculation on the upside
appreciation of the pound while limiting the downside risk to a
know amount (the premium of the option).
The sequence is as follows :
• Day 0 : buy put option to sell pounds at $1.75/£, pay $26,460
for the option.
• Option cost = (size of option)x(premium)x(spot rate) =
£1,000,000 x 0.015 x $1.7640 = $ 26,460
• In 3 mths : receive £1 MM. Either deliver £1 MM against put,
receiving $1,750,000 or sell £1 MM spot if current spot rate >
$1.75/£
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Transaction exposure
Transaction exposure - example
Comparison of alternatives
In order to evaluate the full cost of the option hedge, one has to
include the opportunity cost of the premium paid.
If one considers 12% of cost of capital ,it makes 3% a quarter. The
full premium cost of the option is thus: $26,460x1.03 = $27,254. In
contrast, the downside risk is limited to the premium cost incurred,
in case of an option hedge. But the upside gain is unlimited.
We can calculate the trading range for the £ that defines the breakeven for the option compared to others alternatives.
The upper bound of the range is determined compared to the
forward rate. The £ must appreciate enough above the forward rate
to cover the 0.0273$/£ to cover the cost of the option : $1.7540 +
$0.0273 = $1.7813/£.
The lower bound is is determined compared to the unhedged
strategy. If the spot rate falls below $1.75/£, the option is exercised.
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Transaction exposure
Transaction exposure - example
Comparison of alternatives
One can thus compare the various gains or losses brought by the
hedge at strike price £1.75/$, depending on the realized FX rate :
• Option cost (future value) : $27.254
• Proceeds if exercises : $1,750,000
• Minimum net proceeds : $1,722,746 (proceeds at strike - cost)
• Maximum net proceeds : unlimited
• Break-even spot rate (upside) : $1.7813/£
• Break-even spot rate (downside) : $1.75/£
Strategy choice and Outcome
Two selection criteria : risk tolerance & expectations of the
direction and distance the exchange rate will move the period
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Transaction exposure
Value in US dollars of
Trident’s £1,000,000 A/R
Uncovered
Forward rate
is $1.7540/£
1.84
ATM put option
1.82
1.80
Money market
1.78
1.76
Forward contract
1.74
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
1.82
Ending
spot exchange
rate (US$/£)
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1.84
1.86
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Transaction exposure
Risk Management in practice
No real consensus seems to emerge, according to
international surveys.
In most firms, treasury functions are responsible for
transaction exposure management and usually considered a
cost function. Expected to act as conservative.
Transaction exposure generally allowed to be hedged once
actually booked as receivables and payables (transaction
certain).
Transaction management programs divided among those
using options, and those who do not. The latter rely almost
exclusively on fwd contracts and money market hedges.
Many firms establish risk mgt policy requiring proportional
hedging on a % of the total exposure. The remainder is
selectively hedged on the basis of expectations and views.
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Transaction exposure
Risk Management in practice - Decision Case
See : Lufthansa’s purchase of Boeing 737
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Operating exposure
Definition
Operating exposure (OE) measures any change in the
present value of a firm resulting from changes in future
operating ash flows caused by any unexpected change in
exchange rates.
Operating exposure analysis examines the consequences of
changing FX rates on a firm’s own operations over the
coming months and years and on its competitive position
relative to other firms.
Operating exposure and transaction exposure are both
related to future cash-flows. They differ in terms of which
CF are considered and why they change when FX rates
change.
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Operating exposure
Attributes of Operating exposure
Measuring the OE of a firm requires forecasting and analyzing all
the firm’s future exposures of all the firm’s competitors and
potential competitors worldwide. OE is far more important for the
long-run health of a business than transaction exposure or
translation exposure.
The CF can be divided in operating cash-flows and financial cashflows.
Operating cash flows arise from intercompany and
intracompany receivables and payables, rent and lease payments
of facilities, royalties and license fees, etc.
Financial cash flows are payments for the use of intercompany
and intracompany loans and stockholders equity.
Each of these CF can occur in different time intervals, amounts,
currencies and denomination, and each has a different
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predictability of DES
occurrence.
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Operating exposure
Attributes of Operating exposure
Financial and Operating Cash Flows between a Parent and
Affiliate
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Operating exposure
Attributes of Operating exposure
An expected change in FX rates is not included in the definition of
OE, because it has already been included in the firm’s valuation
parameters. Only unexpected changes in FX rate, or inefficient
foreign exchange market should cause market value to change.
OE is not just the sensitivity of a firm’s future CF to unexpected
change in FX rates, but also its sensitivity to other key
macroeconomic variables.
Illustrating of Operating Exposure : Trident
Suppose an MNE US Corp. Deriving much of its profits from its
German subsidiary. If the euro unexpectedly falls in value :
How will Trident Europe’s revenue change (prices in euro
terms and volumes) ?
How will its costs change (input costs in euro) ?
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How will its competitors react ?
DES en Gestion - Année académique 2002-2003
Operating exposure
Illustrating of Operating Exposure : Trident
Imagine that input are bought in Europe, labeled in Euro.
Half of the production is sold in Europe, half is exported
to non-European countries. All sales are invoiced in
Euros, and the average collection of period account
receivables is 90 days.
Following a Euro depreciation, Trident might choose to :
maintain its domestic price constant in euro terms
try to raise domestic prices because competing
imports are now priced higher in Europe
keep exports prices constant in terms of foreign
currencies, in terms of euro, or some where in
between (partial pass-through)
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Operating exposure
Illustrating of Operating Exposure : Trident
The strategy undertaken depends largely on
management's opinion about the price elasticity of
demand.
On the cost side, Trident Europe might raise price
because of more expensive imported raw material or
components.
Trident’s domestic sales and costs might also be partly
determined by the effect of the euro devaluation on
demand.
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Operating exposure
Strategic Management of Operating Exposure
The objective of both transaction and operating exposure
management is to anticipate and to influence the effect of the
changes in FX rates on a firm’s future cash-flows.
To this end, management can :
Diversify operations : sales, location of production
facilities, and raw material sources. Flexibility can allow
firms to change its operating structure according to
international changes (ex. Goodyear and the Mexican Peso
devaluation)
Diversify financing : raise funds in more than one capital
market and in more than one currency.
A diversification strategy permits the firm to react either
actively or passively, depending on management’s risk
preferences, and to opportunities presented by disequilibirum
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conditions in theDES
FX,
capital,
or
products
markets.
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Operating exposure
Proactive Management of Operating Exposure
Operating and transaction exposures can be partially
managed by adopting policies that partially offset the
effect of FX changes. The four most common used
techniques are the following :
1. Matching currency cash-flow : Ex : exporting US firm
in Canada : match the in flows of CAD from its sales by
the outflows of part of its debt labeled in CAD.
2. Risk sharing agreements : contractual arrangements in
which the buyer and the seller agree to split currency
movements impacts on payments between them.
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Operating exposure
Proactive Management of Operating Exposure
3. Back-to-back or parallel loans, or credit swaps : two business
firms in separate countries agree to borrow each other’s
currency from a limited period of time. At an agreed terminal
date, they return to their borrowed currencies. The transaction
takes place outside of the FX markets, although the spot
quotation can be used as a reference point.
4. Currency swaps : similar to a back-to-back loan but off
balance sheet. Agreement between two parties to exchange a
given amount of one currency for another and, after a period of
time, to give back the original amounts swapped. Currency
swaps can be negotiated for a wide range of maturities and
currencies. The swap dealer or swap bank acts as a middleman
in setting up the swap agreement.
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Operating exposure
Proactive Management of Operating Exposure
4. Currency swaps :
Japanese
Corporation
Assets
United States
Corporation
Liabilities & Equity
Inflow
Assets
Liabilities & Equity
Inflow
Sales to US
Sales to Japan
Debt in yen
of US$
Debt in US$
of yen
Receive
yen
Pay
dollars
Pay
yen
Receive
dollars
Swap Dealer
Wishes to enter into a swap to
“pay dollars” and “receive yen”
Wishes to enter into a swap to
“pay yen” and “receive dollars” 26
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