International Finance
Lecture 8
Page 1
International Finance
• Course topics
– Foundations of International Financial
Management
– World Financial Markets and Institutions
– Foreign Exchange Exposure
– Financial Management for a Multinational
Firm
Page 2
Foreign Exchange Exposure
• Economic Exposure
• Translation Exposure
• Transaction Exposure
Page 3
Operating Exposure: Definition
• The effect of random changes in exchange rates
on the firm’s __________________ (which is
not readily measurable).
– A good way to approximate operating
exposure is to study the extent to which the
firm’s _______________________ are
affected by the exchange rate.
Page 4
Operating Exposure
• Examples
– Alberta skiing resorts. Weaker $US means skiing is
not as cheap for US customers as it used to be, with
lower demand for services in AB.
– Canadian retailers. Stronger Euro means higher cost
of goods sold (COGS) for European shoes and
clothing relative to revenues, thus lower profit
margins and possibly lower sales in Canada.
Page 5
Economic Exposure
• Changes in exchange rates can affect not only
international but also purely domestic firms.
– Canadian bicycle manufacturer who sources
and sells only in Canada.
– Since the firm’s product competes against
imported bicycles it is subject to foreign
exchange exposure.
• Economic exposure can be defined as the extent
to which the value of the firm would be affected
by _______________changes in exchange rates.
Page 6
How to Measure Economic Exposure
• Economic exposure is the sensitivity of the
future home currency value of the firm’s
_________________ and the firm’s
__________________ to random changes in
exchange rates.
Page 7
How to Measure Economic Exposure
• If a U.S. MNC were to run a least squares
regression on the dollar value (P) of its British
assets on the dollar pound exchange rate,
S($/£), the regression would be of the form:
• P = a + bS + e
Where
a is the regression constant
e is the random error term with mean zero
The regression coefficient b measures the sensitivity of the
dollar value of the assets (P) to the exchange rate, S.
Page 8
How to Measure Economic Exposure
• The exposure coefficient, b, is defined
as follows:
b=
Cov(P,S)
Var(S)
Where Cov(P,S) is the covariance between the dollar value
of the asset and the exchange rate, and Var(S) is the
variance of the exchange rate.
Page 9
How to Measure Economic Exposure
• The exposure coefficient shows that there
are two sources of economic exposure:
1. the variance of the exchange rate and
the covariance between the dollar value
of the asset and exchange rate
b=
Page 10
Cov(P,S)
Var(S)
How to Measure Economic Exposure
• How to actually do it:
– If historical data available, use regression.
– If only probability estimates available (i.e. from
analysts’ forecasts), use probability theory
• Regression
– In Excel: Tools  Data Analysis  Regression
• If Data Analysis is not available, install it from
Add-Ins.
Page 11
How to Measure Economic Exposure
Date
Nortel Adj. Close*
15-Mar-06
16-Mar-06
17-Mar-06
20-Mar-06
21-Mar-06
22-Mar-06
23-Mar-06
24-Mar-06
Intercept
X Variable 1
Page 12
SPOT CAN $/US$
35.1
33.9
33.6
33.1
33.5
33.3
32.7
34.2
Coefficients Standard Error
t Stat
-87.4943
14.55102742 -6.0129301
100.7458
12.88846535 7.81674198
1.1553
1.154
1.1587
1.1627
1.1647
1.1651
1.1657
1.1675
P-value Lower 95%
0.0000000 -116.193
0.0000000 75.32631
How to Measure Economic Exposure
State
Probability
Price, FC
FX, DC/FC
Price, DC
1
0.25
SFr. 980
$0.45
$441.00
2
0.20
SFr. 1,000
$0.52
$520.00
3
0.35
SFr. 1,050
$0.55
$577.50
4
0.20
SFr. 1,140
$0.60
$684.00
1.00
Mean=
0.53
$553.18
• Cov(Price DC, FX)=
• Var(FX)=
• Exposure coefficient b =
Page 13
Economic exposure
• Risk decomposition
• Variance (Price DC) = b2 Var(FX) + error variance
• Hedging = attempt to reduce Variance (Price DC).
– If we manage to reduce Var(FX) to zero, we will get
Variance (Price DC) = error variance
– Key points: (i) by how much we can reduce FX
exposure, and (ii) how costly hedging is
– Idea: fix the price of b units of foreign currency now
by selling b units of foreign currency forward
• Result from Risk Management: optimal hedge ratio is
the negative of the estimated coefficient b.
Page 14
Hedging economic exposure
• Your subsidiary in foreign country is an _______,
•
•
•
•
therefore, to hedge we need to take a _______ position
in the foreign currency forwards/futures.
– If it were a __________, you would need a _______
position.
The size of the position is b.
The dollar proceeds a company will receive is b*(F-S)
– F – forward rate you lock in now, S – spot rate at
maturity.
Total value of the hedged position at maturity will be
TVHP=Price DC +b*(F-S)
Assume F = $0.53 and recall that b = 1574
Page 15
Economic exposure
State
Price,
FC
Prob.
FX,
DC/FC
Price,
DC
Hedge
Payoff
TVHP
1
0.25
SFr. 980
$0.45
$441.00
$125.89 $566.89
2
0.20
SFr. 1,000
$0.52
$520.00
$15.74 $535.74
3
0.35
SFr. 1,050
$0.55
$577.50
-$31.47 $546.03
4
0.20
SFr. 1,140
$0.60
$684.00
-$110.15 $573.85
1.00
Mean=
0.53
$553.18
$554.75
• Var(Price DC)=
• Var(TVHP)=
Page 16
Economic Exposure
• The exposure has two components:
– The Competitive Effect
• Changes in foreign currency operating cash
flows due to competitive pressures on product
prices, quantity demanded, costs etc.
– The Conversion Effect
• Changes in domestic currency values of foreign
COGS and/or revenues in response to
unexpected changes in FX rates.
Page 17
Operating exposure
• Measuring the operating exposure 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
– Example: Eastman Kodak has economic exposures from present
and future sales abroad
– The sum of these future exposures will have an effect on
Kodak’s cash flows as exchange rates change
– Kodak’s value and competitiveness depends on (1) the structure
of the market in which it sources it inputs such as labor and
materials and sells its products and (2) whether or not it can
manage them better than their competition
• This long term view is the objective of operating
exposure analysis
Page 18
Operating exposure
• A profit margin of a firm depends on
– the effect of exchange rate on the cost of
inputs
– How much of that cost change is passed
through to product prices
– Elasticity of product demand
Page 19
Exchange Rate Pass-Through
Page 20
Demand elasticity
• Recall from microeconomics, ε = %ΔQ / %ΔP
– ε - price elasticity of demand
– %ΔQ – percentage change in quantity demanded, = change in
quantity (Q1-Q0) ÷ midpoint quantity (Q1+Q0)/2
– %ΔP – percentage change in price, = change in price
(P1-P0) ÷ midpoint price (P1+P0)/2
•
• For example, if you are DaimlerChrysler and your company
was selling 50 Mercedes Benz cars per week in Canada at
$70,000 and 70 cars per week at $60,000, then the demand
elasticity for your cars is
ε=[(70-50)/(70+50)/2]÷[(60,000-70,000)/(60,000+70,000)/2] = _______
Page 21
Definition of Cash flows for
Capital Budgeting
• Operating Cash Flow (OCF) in period t:
• OCFt = (PtQt-FCt-cQt-Deprt)(1-) +Deprt =
– P is the price per unit of output
– Q is the demanded quantity
– c is production cost per unit, FC is fixed cost
–  is the tax rate on corporate profit in Germany
– Depr is the depreciation expense per year
• The last term is known as depreciation tax shield.
Page 22
Working Capital Dynamics
• Our working assumption is as follows:
∆WC>0
∆WC<0
0 1
T
• ∆WC is the change in Working Capital
• Working Capital is completely recovered
at the end of the project life.
• Total Cash Flow, CF:
Page 23
Algebra of Exposures
• S0 – current exchange rate
• X – exposed variable (e.g., CF
denominated in FX)
• Change of dollar equivalent CF in
response to an unexpected change
in S is then:
• ∆(SX) = (S0 + ∆S)(X0 + ∆X) – S0X0 =
Page 24
Algebra of Exposures
• ∆(SX) = ∆SX0 + (S0 + ∆S) ∆X
• ∆(SX) = ∆SX0 + Snew ∆X
Page 25
Example: Operating Exposure
• Carlton derives much of its reported profits from
its German subsidiary, and there has been an
unexpected depreciation of the euro thus
affecting Carlton Germany significantly.
• Carlton’s German subsidiary is operating in a
euro-denominated competitive environment
– The subsidiary’s profitability and performance will be
impacted by any changes in performance and pricing
from its suppliers and customers as a result of changes
in the US$/euro exchange rate
Page 26
Carlton Germany Data
• Carlton Europe manufactures in Germany from
•
•
•
•
•
European material and labor.
Half of production is sold within Europe, the other
half is exported to non-European countries.
All sales are invoiced in euros and accounts
receivable (AR) are 25% of sales.
Inventories are 25% of sales.
Cost of capital is 20%.
Corporate tax rate in Germany is 34%.
Page 27
Base Case
•
•
•
•
•
•
Carlton Germany: S0 = $/€ 1.2
P = €12.80; Q = 1 mil units
c = € 9.60
FC = € 0.89 mil, Depr = € 0.6 mil
 = 34%
Base case: _______________ to
exchange rates. Relevant horizon for
assessing the impact of exchange rate
fluctuations is 5 years.
Page 28
Base Case Cash Flows
• Base case CF (€ mil).
• t=1:
– OCF = [(€12.80-9.6)*1 - € 0.89]*0.66 +
0.34*0.6 = € 1.7286
• t=2-4:
• t=5:
Page 29
Possible Scenarios
• There are various possible scenarios in
terms of management actions in response
to an unexpected € _____________ from
$/€1.2 to $/€ 1.0 :
– Can afford to raise domestic sales prices
without hurting demand; this is because
competing imports are more expensive to
locals
– Same thing can be done with export prices
– Alternatively, they could fix the price and let
the volume change; what they will do will
depend on the price elasticity of demand.
Page 30
Case 1
• There is ______________________
change from 1.2$/€ to 1.0 $/€. There are
no real changes (no changes in functional
currency, i.e., € cash flows).
Page 31
Case 1 Cash Flows
• ∆(S*CF) = ∆S*CFbase + Snew ∆CF =
= ∆S*CFbase
• Total cash flow (including changes in WC)
at t=1:
– CFbase = OCF - ∆WC = € 1.7286 – € 5.6 =
______________
• Incremental $ cash flow:
• ∆(S*CF) = ∆S*CFbase = -0.2*(- € 3.8714 mil) =
________________
Page 32
Case 1 Cash Flows
• What about the Incremental Cash Flow
for the years 2 through 4?
• In each of the years 2-4 Operating
Cash Flow in € is still:
• OCF = € 1.7286 mil
• ∆WC = 0 (because sales do not change)
∆S*CF = -0.2* € 1.7286 mil
= ______________
• ∆(S*CF) =
Page 33
Case 1 Cash Flows
• Incremental Cash Flow for year 5?
• Operating Cash Flow is still:
• OCF = € 1.7286 mil
• ∆WC = - € 5.6 mil
• CF = OCF - ∆WC = € 7.3286 mil
∆S*CF = -0.2* € 7.3286 mil
= ________________
• ∆(S*CF) =
Page 34
Case 2
• _____________________________, both in
•
•
•
•
•
•
Europe and export, in response to exchange rate
change from 1.2$/€ to 1.0 $/€.
Carlton Germany:
P = €12.80; ∆Q = 1 mil units
c = € 9.60
FC = € 0.89 mil, Depr = € 0.6 mil
 = 34%
_____________________________________
Page 35
Case 2
• Two effects now:
• ∆(S*CF) = ∆S*CFbase + Snew ∆CF
• Need CFbase (already know) and ∆CF=
∆OCF - ∆WC to compute the effect.
Page 36
Case 2
• Incremental OCF in €:
• ∆OCF=(P-c)*∆Q*(1-) (why?)
• ∆OCF = = (€12.80-9.6)*1 *0.66= €
2.112 mil
• Incremental WC adjustment in € :
• Change in WC adjustment = € 11.2-€ 5.6
= € 5.6 mil in year 1
• Change in WC adjustment = -€ 11.2+€
5.6 = -€ 5.6 mil in year 5
Page 37
Case 2
• Incremental Euro denominated
Cash Flow :
• ∆CF1= ∆OCF1 - ∆WC = 2.112 - 5.6 =
• ∆CF2= ∆OCF2 - ∆WC = 2.112 =
• ∆CF1= ∆OCF1 - ∆WC = 2.112 + 5.6 =
Page 38
Case 2
• Incremental Dollar denominated
Cash Flows:
• year 1:
– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(- € 3.8714
mil) +1.00(- € 3.488 mil) = _______________
• years 2-4:
– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(- € 1.7286
mil) +1.00(€ 2.112 mil) = __________________
• year 5:
– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(€7.3286 mil)
+1.00(€ 7.712 mil) = ____________________
Page 39
Example: PV of incremental
Cash Flows
• Present Value of the incremental year-
end cash flows:
• Case 1:
774,280
1,465,720
4
PV 
 345,720 AF20% 
 $591,447.76
5
1.2
1.2
• Case 2:
 2,713,720
6,246,280
4
PV 
 2,457,720 AF20% 
 $5,132,420.47
5
1.2
1.2
Page 40
Strategic Management of OE
• The objective of both operating and
transaction exposure management is to
anticipate and influence the effect of
unexpected changes in exchange rates
on a firm’s future cash flows
• To meet this objective, management can
diversify the firm’s _____________ and
_____________________.
Page 41
Strategic Management of OE
• Diversifying operations means
diversifying the firm’s sales, location of
production facilities, and raw material
sources
• Diversifying the financing base means
raising funds in more than one capital
market and in more than one currency
Page 42
Proactive Management of OE
• Operating and transaction exposures can
be _____________________ by adopting
operating or financing policies that offset
anticipated currency exposures
• Four of the most commonly employed
proactive policies are
– Matching currency cash flows
– Risk-sharing agreements
– Back-to-back or parallel loans (already
considered)
– Currency swaps (already considered)
Page 43
Cash Flow Matching
Canadian
Corporation
(buyer of goods)
Payment for goods
in Canadian dollars
Canadian
Bank
Exports
goods to
Canada
(loans funds)
US Corp borrows
Canadian dollar debt
from Canadian Bank
U.S.
Corporation
Principal and interest
payments on debt
in Canadian dollars
Exposure: The sale of goods to Canada creates a foreign
currency exposure from the inflow of Canadian dollars
Hedge:
Page 44
The Canadian dollar debt payments act as a financial
hedge by requiring debt service, an outflow of Canadian dollars
Risk-Sharing
• Risk-sharing is a contractual arrangement in
which the buyer and seller agree to “share” or
split currency movement impacts on payments
– Example: Ford purchases from Mazda in Japanese
yen at the current spot rate as long as the spot rate
is between ¥115/$ 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)
Page 45
Risk-Sharing
• Ford’s payment to Mazda would therefore
be
• 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
Page 46