International Finance
In Class Exercise
Managing Foreign Exchange Risk
The Nature of Hedging
In the last 3 weeks, we have:
1. Developed a number of measures of exposure
2. Constructed measures of the risks associated with
these exposures
3. Determined how to identify the appropriate
exposure to hedge among a portfolio of exposures.
4. Reviewed the advantages and disadvantages of a
number of financial instruments that can aid us in
hedging these exposures.
The Nature of Hedging
We have also discussed the following:
1. Why hedge?
2. What kinds of risks should we focus on to
hedge?
3. At what horizon should the hedging take place?
4. What can be done from the operational side to
manage foreign exchange risks?
5. Appropriate overall approaches to managing
foreign exchange risk at a multinational.
Group Project
A. Under what
circumstances would
the one-year forward
rate be equal to the
current spot rate?
Fred Thompson
4
Group Project
B. If Jaguar can sell all
100K cars at $50K,
what is the pound
revenue at the spot
rate? The gain or loss
on the forward
contract? The net
gain to Jaguar?
Fred Thompson
5
Group Project
C. What if Jaguar has
to cut its price to
$45K, what is the
pound revenue at the
spot rate? The gain
or loss on the
forward contract?
The net gain to
Jaguar?
Fred Thompson
6
What Risks Should be Hedged?
Economic exposure is ultimately what the firm should be
concerned with
Indeed, even transaction exposures should be evaluated in
terms of whether they are associated with an underlying
economic exposure.
When considering hedging a known outflow or cost, the
firm must evaluate the revenue side operations; when
considering a known inflow or revenue, the firm needs to
evaluate the cost side.
Whenever the currency movement affects revenues and
costs equally, only the profit margin is truly exposed.
What Risks Should be Hedged?
For treating economic exposure, financial hedges
have two main shortcomings:
1. Horizon. Outside of swaps, most financial hedges
become quite expensive over longer horizons. While
swaps can provide an inexpensive way to construct a
series of long-dated forward contracts, they require
accurate assessment of future cash flows.
For hedging uncertain future cash flows, long-term
futures contracts are unavailable, and the costs of
long-term options will be prohibitively large.
What Risks Should be Hedged?
2. Real vs. Nominal. Financial hedges can only
hedge nominal amounts. If there are real changes
in home currency costs and revenues, nominal
hedges may be quite ineffective.
As we have seen, real and nominal exchange rates
coincide reasonably well in developed countries,
but the correspondence is usually weak for
emerging economies.
Economic Exposure in the Long
Run
Recall that economic exposure is only concerned with
changes in the market value of the firm that result from
real exchange rate changes.
Hence, if RPPP holds in the long run, changes in the real
exchange rate should balance out in the long run.
This is what we saw with most of the developing countries
that saw large short-term swings in the real exchange rate.
Thus, long-term hedging activity may not be needed or
productive.
Where then is the value in hedging economic exposure?
Economic Exposure in the Long
Run
Recall that most of the arguments for hedging activities
focus on the short-run:
1. Ensuring that the firm (or manager) gets to the long run.
2. Minimizing systematic shareholder risks.
3. Achieving short-run tax, monitoring, and investment
efficiencies.
Hence, a shorter-horizon perspective that focuses on the
economic exposure of highly-known nominal cash flows
may be reasonable after all. In other words, only
exposures which pose a material threat to the value of the
firm’s periodic cash flows should be hedged.
Marketing Management
Pricing. If firms have some flexibility to adjust prices
and ‘pass-through’ the exchange rate effects, they
will want to do so in responding to exchange rate
changes.
Specifically, firms selling in overvalued currencies
will want to lower the local currency price to capture
larger market share, while those operating in
undervalued currencies will raise prices to maintain
profit margins.
Firms in more competitive industries face less
flexibility in terms of their pricing schedules.
Foreign Exchange Risk
Management
1. Focus attention on risks which have a material impact
on the expected value and systematic risk of the firm
to shareholders.
2. Measure exposures and risks accurately:
-
recognize any potentially offsetting effects in costs,
revenues, quantities, or pass-through.
-
take into account offsetting movements in
exposures to other currencies.
-
apply appropriate measures of risk: RPPP for
exposures not linked to interest rates and UIP for
those that are interest sensitive (i.e. cash deposits).
Foreign Exchange Risk
Management
3. Use risk management to control risks in the shortrun, while relying on firm, manager, and exchange
rate fundamentals to dominate in the long-run.
4. Don’t ignore opportunities to manage exchange
rate risks from the operational side.
Foreign Exchange Risk
Management
5. Recognize that risk management often creates
more risk than it eliminates - no firm (or
municipality) ever went bankrupt solely due to
insufficient risk management, plenty have gone
bankrupt as a result of too much.
6. Keep in mind that investment banks make
more money when you worry about FX risk than
when you don’t.