Multinational Business Finance
Yinghong.chen@liu.se
5/21/2013
11-1
Transaction Exposure
• Foreign exchange exposure is a measure of
how a firm’s profitability, net cash flow, and
market value will change because of a change
in exchange rates.
• An important task of the financial manager is
to measure foreign exchange exposure and to
manage it so as to minimize the potential loss
from exchange rate changes through hedging
activities.
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2
Types of FX Exposure: Transaction and Operating
exposure and translation exposure
• Transaction exposure measures changes in the
value of outstanding financial obligations
• Transaction exposure stems from existing
contractual obligations.
• Therefore, easy to hedge. (offset the exposure
by an opposite transaction). For example:
Foreign currency receivables can be offset by
selling the foreign currency forward.
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11-3
Transaction and Operating Exposure
• Transaction exposure and operating exposure
exist because of unexpected changes in future
cash flows due to an exchange rate change.
• The difference between the two is that
transaction exposure is a contractual
obligation, while operating exposure focuses
on foreign currency cash flows generated from
operation that might change because of a
change of exchange rates.
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11-4
Economic Exposure
• Operating exposure, and transaction exposure
are called economic exposure.
• Operating exposure measures the change in
the expected value of the firm resulting from
an unexpected change in exchange rates.
• Expected changes in exchange rate can be
calculated through Parity conditions. The rest
is unexpected.
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11-5
Types of Foreign
Exchange Exposure
• Translation exposure, also called accounting exposure,
results from translating foreign currency denominated
balance sheet of foreign subsidiaries into the parent´s
reporting currency so the parent can report a
consolidated balance sheet.
• The two basic procedures for translation used today
are the current method and the temporal method.
• The exposure is not real, it is called Balance sheet loss
or gain; but can be important for managers.
• It only becomes material when the subsidiary closes
down and the residual value is repatriated back to
home country.
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Exhibit 11.1 Conceptual Comparison of Transaction, Operating, and
Translation Foreign Exchange Exposure
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11-7
Operating Exposure
• Operating Exposure is the firm’s uncertainty
with respect to its future operating cash flows.
• If PV = present value of a firm, then the firm is
exposed to foreign currency risk if ΔPV/Δe 
0.
• Operating exposure derives from the
operating analysis; hence planning for
operating exposure involves the interaction of
strategies in finance, marketing, purchasing
8
and production.
Real Exchange Rates and Exposure
• Currency changes are accompanied by changes in relative price levels,
which can offset the impact of the currency change.
• Hence, it is impossible to determine exposure to a given currency
change without considering simultaneously the offsetting effects of
these price changes.
• If relative prices remain constant and the law of one price holds, then
the rate of change in the exchange rate equals the difference in inflation
rates between the two countries. That is, the real exchange rate is
constant, and PPP holds.
• The firm’s foreign cash flows will vary with the foreign rate of inflation.
• The exchange rate also depends on the differential rates of inflation;
the movement of the exchange rate will cancel out the effect of the
change in the foreign price level. Real home currency cash flows will be
unaffected.
9
Contracts fixed in foreign currency
• If the firm has contracts fixed in foreign currency terms, it
will be affected by exchange rate risk even if relative prices
are unaffected and PPP holds.
• Examples are debt with fixed interest rates, long-term
leases, labor contracts and rent.
• However, if real exchange rates do not change, what we
see here is really inflation risk and not forex risk. That is,
the same effect can occur domestically, as well.
• If contracts are indexed to relative inflation, that is, if the
real exchange rate remains constant, forex risk is
eliminated.
P.V. Viswanath
10
Effects of Real Exchange Rate Changes
• A decline in the real value of a nation’s currency
makes its exports and import-competing products
more competitive. And vice verse.
• E.g. if Brazil’s inflation rate stays high, but its
exchange rate stays constant, the real exchange rate
will be rising and its products will be at a competitive
disadvantage.
• Hence there could be exchange risk even without
changes in nominal rates.
11
To be or not to be: Why Hedge?
• MNEs possess a multitude of cash flows that
are sensitive to changes in exchange rates,
interest rates, and commodity prices.
• These three financial price risks are the subject
of the growing field of financial risk
management.
• Many firms attempt to manage their currency
exposures through hedging.
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11-12
To be or not to be: Why Hedge?
• Hedging is the taking of a position, i.e. a cash
flow, an asset, or a contract (including a
forward contract) that will rise (fall) in value
and offset a fall (rise) in the value of an
existing position.
• While hedging can protect the owner of an
asset from a loss, it also eliminates any gain
from an increase in the value of the asset.
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11-13
To be or not to be: Why Hedge?
• The value of a firm, according to financial
theory, is the net present value of all
expected future cash flows. Nothing is certain
yet.
• Currency risk is defined roughly as the changes in
expected cash flows arising from unexpected
exchange rate changes.
• A firm that hedges these exposures reduces some
of the variations in the value of its future expected
cash flows.
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11-14
Exhibit 11.2 Impact of Hedging on the Expected Cash
Flows of the Firm
E(V)´
E(V)
E(V)´<E(V)
5/21/2013
The cost of hedging needs to be taken into
account!
11-15
Argument Against Hedge
• Opponents of hedging argue:
– It is costly to hedge. Currency risk management does not
increase the expected cash flows of the firm. It decreases
volatility only.
– Shareholders are capable of diversifying currency risk
through holding a diversified portfolio. Less costly
alternatives.
– Management often conducts hedging activities that
benefit management at the expense of the shareholders
(agency theory perspective)
– Market is efficient. Managers cannot outguess the market.
– If all parity conditions holds, there is no need for hedging.
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11-16
Argument For Hedge
• Proponents of hedging argue:
– Reduction in risk in future cash flows improves the
planning capability of the firm
– Reduction of risk in future cash flows reduces the
bankruptcy probability (financial distress)
– Lower volatility increases firm´s borrowing capacity
– Management has a comparative advantage over the
individual shareholder in knowing the actual currency risk
of the firm
– Management is in better position to take advantage of
disequilibrium conditions in the market
–.
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11-17
Measurement
of Transaction Exposure
• Transaction exposure measures gains or losses
that arise from the settlement of existing
financial obligations whose terms are stated in
a foreign currency.
• The most common example of transaction
exposure arises when a firm has an account
receivable or payable denominated in a
foreign currency.
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11-18
Exhibit 11.3 The Life Span of a
Transaction Exposure
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11-19
Measurement
of Transaction Exposure
• Foreign exchange transaction exposure can be
managed by contractual, operating, and financial
hedges.
• The main contractual hedges are the forward,
futures, money market hedge, and options market
hedge.
• Operating and financial hedges are the use of risksharing agreements, leads and lags in payment
terms, swaps, and other strategies.
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11-20
Measurement
of Transaction Exposure
• The term natural hedge refers to an off-setting
operating cash flow, for example, a payable
arising from the conduct of business to offset a
receivable.
• A financial hedge refers to either an off-setting
debt obligation (such as a loan) or some type of
financial derivative such as an interest rate swap.
• Care should be taken to distinguish operating
hedges from financial hedges.
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11-21
Transaction Exposure
• With reference to Trident’s Transaction
Exposure, the CFO, Maria Gonzalez, has four
alternatives:
– Remain unhedged;
– hedge in the forward market;
– hedge in the money market, or
– hedge in the options market.
• These choices apply to an account receivable
(AR) and an account payable (AP).
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11-22
Transaction Exposure
• A forward hedge involves a forward (or futures) contract and
a source of funds to fulfill the contract.
• In some situations, funds to fulfill the forward exchange
contract are not already available or due to be received later,
but must be purchased in the spot market at some future
date. This type of hedge is “open” or “uncovered” and
involves considerable risk because the hedge must take a
chance on the uncertain future spot rate to fulfill the forward
contract.
• The purchase of such funds at a later date is referred to as
covering.
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11-23
Transaction Exposure
• A money market hedge also involves a contract and a source
of funds to fulfill that contract.
• In this instance, the contract is a loan agreement.
• The firm seeking the money market hedge borrows in one
currency and exchanges the proceeds for another currency.
• Funds to fulfill the contract – to repay the loan – may be
generated from business operations, this type of money
market hedge is covered.
• Alternatively, funds to repay the loan may be purchased in
the foreign exchange spot market when the loan matures
(uncovered or open money market hedge).
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11-24
Transaction Exposure
• Hedging with options allows for
participation in any upside potential
associated with the position while limiting
downside risk.
• The choice of option strike prices is a very
important aspect of utilizing options.
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11-25
Exhibit 11.5 Trident’s Hedging Alternatives, Including an ATM
Put Option
Net exposure
of the firm
with put
option
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Risk Management in Practice
• The treasury function of most private firms,
typically responsible for transaction exposure
management, is usually considered a cost
center.
• The treasury function is not expected to add
profit to the firm’s bottom line.
• Currency risk managers are expected to be
conservative.
5/21/2014
11-27
Risk Management in Practice
• Transaction exposure management programs
are generally divided along an “option-line”;
those that use options and those that do not.
• Firms that do not use currency options rely
almost exclusively on forward contracts and
money market hedges.
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11-28
Risk Management in Practice
• Many MNEs have established rather rigid transaction
exposure risk management policies that mandate
proportional hedging.
• These contracts generally require the use of forward
contract hedges on a percentage of existing
transaction exposures.
• The remaining portion of the exposure is then
selectively hedged on the basis of the firm’s risk
tolerance, its view of exchange rate movements, and
confidence level.
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11-29
Trident´s transaction exposure
U.S. Dollar market
Trident´s weighted average cost of capital =12% (3% for 30 days)
US 3 month borrowing rate=8% (2% for 90 days)
US 3 month investment rate 6% (1,5% for 90 days)
Sales=$1764000 90 days Account receivable 100000£.
Spot rate =$1,7640/£ F90 =$1,7540
S90 =1,7600 (forcasted by the advisor)
British pound market
UK 3 month borrowing rate=10% (2,5% for 90 days)
UK 3 month investment rate 8% (2% for 90 days)
June (3 month) put option for £1000000 with a strike price of $1,75/£, premium
is 1,5%.
What is the dollar amount of the 1M£ sales in 3 month time?
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11-30
Trident´s transaction exposure: 1000000£
receivable
• Remain unhedged: possible to get 1760000$ as forcasted by the
advisor. But considerable risk!
• Hedge with a forward sell of 1000000£ to get 1754000$ in 90days
at the forward rate of $1,7540/£.
• Money market hedge: borrow british punds
1000000/(1+0,025)=975610£ now and convert it to dollars.
975610*1,7640=1720976$. Invest it or save it to get the interest.
1720976*1,03=1772605$>1754000$ better than the forward!
• Purchase put option costs 1000000£*0,015*1,7640=26460$, in 90
days, 26460$*1,03=27254$. If the future spot rate is $1,76/£, the
payment =1760000-27254=1732746$. Note, the put option hedge
has unlimited upside potential. But the upside still not better than
unhedged due to the cost of the option. (note the strike price=1,75$/£,
the lowest amount is 1722746$ with no upper limit.)
5/21/2014
11-31
Exhibit 11.4 Valuation of Cash Flows by Hedging
Alternative for Trident
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11-32
Valuation of Hedging Alternatives for an
Account Payable (ex 2 )
Call option used to
hedge the payable.
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11-33
OPERATING EXPOSURE
MANAGEMENT
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11-34
What is Operating Exposure?
Operating exposure (also called competitive
exposure, and strategic exposure) measures the
change in the firm´s present value resulting
from the expected changes in future operating
cash flows denominated in foreign currency
(caused by an unexpected change in exchange
rates!).
Note: All the expected exchange rate changes
should be already incorporated in the financial
plan, thus should not influence the firm value.
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How to measure Operating Exposure?
Two difficulties
• Measuring the operating exposure of a firm
requires forecasting and analyzing all the
firm’s future individual transaction exposures
together with the future exposures of all the
firm’s competitors and potential competitors
worldwide.
• To analyze the longer term exchange rate
changes that are unexpected and its impact
on the firm– is the goal of operating exposure
analysis. ∆FV/ ∆E*
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Operating cash flows and financing
cash flows
Differentiating cash flows of MNEs:
•Operating cash flows arise from business activities: that
is, from intercompany (between unrelated companies) and
intracompany (between units of the same company)
receivables and payables, rent and lease payments, royalty
and license fees and management fees.
•Financing cash flows are from financing activities, that is
payments for loans (principal and interest), equity
injections and dividends.
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11-37
Exhibit 12.1 Financial and Operating Cash Flows Between
Parent and Subsidiary
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11-38
Attributes of Operating Exposure
• Operating exposure is important for the long-run health
of a business.
• However, operating exposure is inevitably subjective
because it depends on estimates of future cash flow
changes over an arbitrary time horizon.
• Planning for operating exposure is a management
responsibility because it relates to the interaction of
strategies in finance, marketing, purchasing and
production.
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11-39
Attributes of Operating Exposure
 An expected change in foreign exchange rates
is not of concern.
 From an investor’s perspective, if the foreign
exchange market is efficient, information
about expected changes in exchange rates
should be reflected in a firm’s market value.
 Only unexpected changes in exchange rates,
or an inefficient foreign exchange market,
should cause market value to change.
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Example:
• We discuss the dilemma facing Trident as a
result of an unexpected change in the value
of the euro, €, the currency of denomination
for Trident´s German subsidiary.
• There is concern over how the subsidiary´s
revenues (price and volumes in euro terms),
costs (input costs in euro terms), and
competitive landscape will change with a fall
in the value of the euro.
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11-41
Exhibit 12.2 Trident Corporation and Its European Subsidiary: Operating
Exposure of
the Parent and Its Subsidiary
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Measuring the Impact of Operating
Exposure
• Trident Europe:
– Case 1: Euro Devaluation €, no change in any
variable.
– Case 2: Increase in sales volume; other variables
remain constant.
– Case 3: Increase in sales price; other variables
remain constant.
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The objective of the Operating
Exposure management
 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.
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Benefits of diversification
 Management team is prepositioned both to
recognize disequilibrium when it occurs and to
react competitively if the firm´s operations are
diversified internationally .
 Recognizing a temporary change in worldwide
competitive conditions permits management to
make changes in operating strategies.
 Domestic firms do not have the option to react in
the same manner as an MNE.
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Benefits of diversification
• If a firm’s financing sources are diversified, it
will be prepositioned to take advantage of
temporary deviations from the international
Fisher effect. i$ –i€ =PUS -PEU
• However, to switch financing sources from one
capital market to another, a firm must have
the ability to operate in the international
investment community.
• Again, this would not be an option for a
domestic firm.
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6 Proactive policies of Management of
Operating Exposure
• Operating and transaction exposures can be partially
managed by adopting operating or financing policies that
offset anticipated foreign exchange exposures.
• The six most commonly employed proactive policies are:
–
–
–
–
–
–
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Matching currency cash flows
Risk-sharing agreements
Back-to-back ( parallel loans), or credit swaps.
Currency swaps
Leads and lags
Reinvoicing center
11-47
Proactive Management of Operating
Exposure
Example: a US firm has a continuing export sales to Canada.
 In order to compete effectively in Canadian markets, the firm
invoices all export sales in Canadian dollars.
 This policy results in a continuing receipt of Canadian dollars
month after month.
 This series of transaction exposures could be continually
hedged with forwards, futures or options, etc.
 Or using operating exposure management methods
described as follows:
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Matching currency cash flows
 One way to offset an anticipated continuous long
exposure to a particular company is to acquire
debt denominated in that currency (matching).
 Alternatively, the US firm could seek out potential
suppliers of raw materials or components in
Canada as a substitute for US and other foreign
firms.
 In addition, the company could engage in currency
switching, in which the company would pay
foreign suppliers with Canadian dollars.
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11-49
Exhibit 12.4 Matching:
Debt Financing as a Financial Hedge
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Proactive Management of Operating
Exposure: Risk Sharing
• Currency Risk-Sharing:
– a method to manage a long-term cash flow
exposure.
– This is a contractual arrangement in which the
buyer and seller agree to “share” or split currency
movement impacts on payments between them.
– This agreement is intended to smooth the impact
on both parties of volatile and unpredictable
exchange rate movements.
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11-51
Risk Sharing: Ford and Mazda
 Risk Sharing Agreement between Mazda and
Ford.
Ford agrees to pay all purchases in Japanese
Yen to Mazda as long as the spot exchange rate
on the day of invoice is between 115 yen/$ to
125 yen/$. If however the exchange rate falls
out of this range, Mazda and Ford will share the
difference equally.
What happens if the rate falls to 110 yen/$?
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Proactive Management
of Operating Exposure
 Back-to-Back Loans:
 A back-to-back loan, also referred to as a parallel loan
or credit swap, occurs when two business firms in
separate countries arrange to borrow foreign currency
for a specific period of time, but totally circumvent the
foreign exchange market . See the following slides.
 At an agreed terminal date they return the borrowed
currencies.
 Such a swap creates a covered hedge against
exchange loss, since each company, on its own books,
borrows the same currency it repays.
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11-53
Exhibit 12.5 Using a Back-to-Back Loan
for Currency Hedging
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Proactive Management
of Operating Exposure
• There are risks involved in the widespread use
of the back-to-back loan:
1. It is difficult for a firm to find a partner, termed a
counterparty for the currency amount and timing
desired.
2. A risk exists that one of the parties will fail to
return the borrowed funds at the designated
maturity – although each party has 100%
collateral (denominated in a different currency).
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Proactive Management
of Operating Exposure
• Currency Swaps:
– A currency swap resembles a back-to-back loan
except that it does not appear on a firm’s balance
sheet.
– In a currency swap, a firm and a swap dealer or
swap bank agree to exchange an equivalent
amount of two different currencies for a specified
amount of time.
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11-56
Exhibit 12.6 Using a Cross-Currency
Swap to Hedge Currency Exposure
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11-57
Proactive Management
of Operating Exposure
• Leads and Lags: Re-timing the transfer of funds
– Firms can reduce both operating and transaction exposure
by accelerating or decelerating the timing of payments
that must be made or received in foreign currencies.
– Intracompany leads and lags is more feasible as related
companies presumably embrace a common set of goals for
the consolidated group.
– Intercompany leads and lags requires the time preference
of one independent firm to be imposed on another.
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11-58
Proactive Management
of Operating Exposure
• Reinvoicing Centers: There are three basic
benefits arising from the creation of a
reinvoicing center:
– Managing foreign exchange exposure
– Guaranteeing the exchange rate for future orders
– Managing intrasubsidiary cash flows
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11-59
Exhibit 12.7 Use of a Reinvoicing
Center
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11-60
Proactive Management
of Operating Exposure
• Some MNEs now attempt to hedge their operating exposure
with contractual hedges.
• Merck and Eastman Kodak have undertaken long-term
currency option positions hedges designed to offset lost
earnings from adverse exchange rate changes.
• The ability to hedge the “unhedgeable” is dependent upon:
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor’s responses to
exchange rate changes
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