International Financial Markets
Prices and Policies
Second Edition ©2001
Richard M. Levich
Measuring and Managing the Risk in
 International Financial Positions
16
McGraw Hill / Irwin
16 - 2
Overview
 The Corporate Treasurer’s Financial Risk
Management Problem

The Market Value of the Firm and Channels of Risk
 Accounting Measures of Foreign Exchange
Exposure
Exposure of the Balance Sheet: Translation Exposure
 Exposure of the Income Statement: Transaction
Exposure
 U.S. Accounting Conventions: Reporting Accounting
Gains and Losses

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 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
16 - 3
Overview
 Economic Measures of Foreign Exchange
Exposure
The Regression Approach
 The Scenario Approach

 Empirical Evidence on Firm Profits, Share
Prices, and Exchange Rates
 Arguments for Hedging Risks at the Corporate
Level
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16 - 4
Overview
 Financial Strategies Toward Risk Management

The Currency Profile and Suitable Financial Hedging
Instruments
 Policy Issues - International Financial Managers
Problems in Estimating Economic Exposure
 Picking an Appropriate Hedge Ratio
 The International Investor’s Currency Risk
Management Problem
 The Value at Risk Approach

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16 - 5
Overview
 Policy Issues - Public Policymakers
Disclosure of Financial Exposure
 Financial Derivatives and Corporate Hedging
Policies

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 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
The Corporate Treasurer’s
16 - 6
Financial Risk Management Problem
 Corporate treasurers are directly responsible for
managing the firm’s exposure to financial risk.
 The risks that remain are held by the investor,
who can reduce these risks through a diversified
portfolio of shares, or by applying some of the
same hedging techniques available to the
corporate treasurer.
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16 - 7
The Market Value of the Firm
 The market value of a firm at time t (MVt) is the
summation of the firm’s cash flows (CF) over
time discounted back to their present value by
an appropriate discount factor (i):
T
CFt
MVt  
t
t  0 1  it 
 Cash flows in each currency are discounted at
their own appropriate interest rate and
multiplied by a spot exchange rate.
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16 - 8
The Market Value of the Firm
 The sensitivity of the market value of the firm
to a change in an exchange rate measures
exchange rate exposure.
 For the $/€ exchange rate, the sensitivity
measure can be expressed as:
 MV
 S$ / €
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Channels of Exposure to
16 - 9
Foreign Exchange Risk
Direct Economic
Exposure
Home Currency
Strengthens
Home Currency
Weakens
Unfavorable
Revenue worth less
in home currency
terms
Favorable
Revenue worth
more
Source Abroad
Favorable
Inputs cheaper in
home currency
terms
Unfavorable
Inputs more
expensive
Profits Abroad
Unfavorable
Profits worth less
Favorable
Profits worth more
Sales Abroad
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Channels of Exposure to
16 - 10
Foreign Exchange Risk
Indirect Economic
Exposure
Competitor that
sources abroad
Supplier that
sources abroad
Customer that
sells abroad
Customer that
sources abroad
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Home Currency
Strengthens
Home Currency
Weakens
Unfavorable
Competitor’s
margins improve
Favorable
Supplier’s margins
improve
Unfavorable
Customer’s margins
decrease
Favorable
Customer’s margins
improve
Favorable
Competitor’s
margins decrease
Unfavorable
Supplier’s margins
decrease
Favorable
Customer’s
margins improve
Unfavorable
Customer’s margins
decrease
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
The Market Value of the Firm and
Channels of Risk
16 - 11
 Note that virtually any firm could be exposed to
exchange rate risk through a financial channel.
 In the long run however,
 The
firm can make changes in response to an
unexpected exchange rate change.
 Other economic events that follow the exchange
rate change may lessen the impact on the firm.
 Nevertheless, the short-run exposure is critical
since the firm must survive the shock to get to
the long run.
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Accounting Measures of
16 - 12
Foreign Exchange Exposure

Net
exposed – exposed
=
exposure
assets
liabilities
 Accounting exposure can be subdivided into
translation and transaction exposures.
 Translation exposure focuses on the book value
of assets and liabilities as measured in the
firm’s balance sheet.
 Transaction exposure focuses on the economic
value of transactions denominated in foreign
currency that are planned or forecast to occur in
the next reporting period.
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U.S. Accounting Conventions
16 - 13
Reporting Accounting Gains and Losses
 Under Statement 52 of the Financial
Accounting Standards Board (FASB-52),
translation gains and losses are accumulated in
a translation adjustment account.
 FASB-52 focuses on a parent’s net investment
in a foreign operation to measure the effect of
exchange rate changes.
 Transaction gains and losses represent realized
exchanges and are reported in current income.
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U.S. Accounting Conventions
16 - 14
Reporting Accounting Gains and Losses
 Under FASB-133, derivatives that do not
qualify as hedges of the underlying exposures
must be marked-to-market, with the resulting
gains or losses included in either current or
deferred income.
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Economic Measures of
16 - 15
Foreign Exchange Exposure
 Economic exposure captures the entire range of
effects on the future cash flows of the firm,
including the effects of exchange rate changes
on customers, suppliers, and competitors.
 MV/S reflects economic exposure. Two
approaches for measuring economic exposure
are the regression approach and the scenario
approach.
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16 - 16
The Regression Approach
 The regression approach directly measures the
exposure of a firm to exchange rate changes by
estimating the relationship between the firm’s
market value at time t (MVt)and the spot rate
(St) using the equation:
MVt = a + b St + et
 The coefficient b measures the sensitivity of the
market value of the firm to the exchange rate.
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16 - 17
The Regression Approach
 To interpret the regression analysis, three results
need to be examined:
 The
magnitude of b.
• b > 0  an asset exposure in the foreign currency
• b < 0  a liability exposure
• b = 0  no exposure to the exchange rate
 The t-statistic of b.
• Statistical significance is necessary for confidence
in the results.
 The R2 of the regression.
• R2 measures the percentage of variation in the
market value explained by the exchange rate.
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16 - 18
The Regression Approach
 To measure the firm’s exposure to multiple
exchange rates, a multiple regression can be
estimated:
MVt = a + b1 S$/€,t + b2 S$/£,t + b3 S$/¥,t + et
 If the firm has data on cash flows at the level of
a subsidiary or project, the exposure of these
smaller units can also be measured:
CFt = a + b St + et
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16 - 19
The Regression Approach
 Note that exposure tends to be lower in the long
run due to PPP (which tends to hold better in
the longer run) and the ability of firms to make
adjustments in response to exchange rate
changes.
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16 - 20
The Scenario Approach
 Given a scenario, we can estimate the firm’s
cash flows (and its market value) conditional on
an exchange rate path.
 The scenario approach is well suited to a
spreadsheet analysis where one is encouraged
to ask a variety of “what-if” questions.
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16 - 21
The Scenario Approach
Present Value of Cash Flows
(Millions)
Consider the impact of a permanent 5% appreciation of the US$,
holding all other factors constant.
A*
The slope measures the
exposure of the firm at
the initial exchange rate.
$39.577
$35.222
$/A$
A$/$
O
A
- 15% - 10%
- 5%
5%
10%
15%
$0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188
A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39
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16 - 22
The Scenario Approach
Present Value of Cash Flows
(Millions)
Suppose the firm can pass along part of the exchange rate change
to its Australian customers.
A*
The slope of BOB* is flatter
than AOA* since the firm has
less exposure now.
$39.577
$35.222
$/A$
A$/$
B*
O
B
A
- 15% - 10%
- 5%
5%
10%
15%
$0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188
A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39
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Empirical Evidence on
16 - 23
Firm Profits, Share Prices, & Exchange Rates
 During the Bretton Woods pegged-rate period,
the general stock market index tended to move
up (down) immediately after a devaluation
(revaluation) of the local currency.
 Studies also indicated that exposure coefficients
vary from firm to firm within the same industry
and over time, and that exchange rate changes
can have a substantial impact on the overall
economy.
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Arguments for
16 - 24
Hedging Risks at the Corporate Level
 Shareholders may not favor hedging since they
can select well-diversified portfolios to rid
themselves of firm-specific risks.
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Arguments for
16 - 25
Hedging Risks at the Corporate Level
 However, in view of transaction costs and
taxes, hedging that reduces the volatility of cash
flows may be favored.
If the tax credits of a firm which has incurred losses
over several successive periods cannot be carried
forward to reduce future tax payments, then another
firm with a less volatile pattern of earnings will
enjoy greater after-tax cash flows and a higher
market value.
 A firm with more volatile cash flows is also more
open to the costs of financial distress.

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Arguments for
16 - 26
Hedging Risks at the Corporate Level
 For the same reasons, banks and bondholders
will prefer firms with less volatile cash flows
(holding average cash flows equal) and reward
them with greater borrowing capacities and
higher credit ratings.
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Financial Strategies
16 - 27
Toward Risk Management
 An important step in the process of determining
the appropriate financial hedging instruments
for a firm is to analyze the nature of the firm’s
currency cash flows.
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Financial Strategies
16 - 28
Toward Risk Management
Characteristics of
Currency Exposure
Frequency
of cash flows
Currency
dimension
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Suitable Financial
Hedging Instruments
Single period
Single contract (futures/options)
Multiple
periods
Sets (“strips”) of contracts/swaps
or present value hedge
Single
currency
Contracts on one currency
Multiple
currencies
Contracts on an index (ECU,
US$) or synthetic hedge
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Financial Strategies
16 - 29
Toward Risk Management
Characteristics of
Currency Exposure
Certainty
about cash
flows
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Suitable Financial
Hedging Instruments
Certain,
contractual
cash flows
Naïve hedge to match contract
size of financial instrument and
exposure
Uncertain,
estimated cash
flows
Option hedge or dynamic futures
hedge to match probability of
cash flows
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Strategies
16 - 30
Toward Risk Management
 Note that a hedging strategy may offset certain
risks, while leaving open or increasing other
risks.
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Policy Issues
16 - 31
International Financial Managers
Problems in Estimating Economic Exposure
Using market data presumes that financial markets
are efficient, and that share prices respond quickly
and appropriately to exchange rate changes.
 The approach is unsuitable for newly organized or
reorganized firms for which there is not a large
sample of consistent observations.
 For the exposure coefficient to be useful, the
relationship between exchange rate changes and
market value must remain stable in the future.

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Policy Issues
16 - 32
International Financial Managers
Picking an Appropriate Hedge Ratio
If the exchange rate is expected to change
favorably, hedging may not be desirable.
 Complete hedging may be achieved by taking
offsetting positions (-bi).
 Otherwise, an intermediate solution may be chosen,
with hedge positions in between 0 and bi.
 Note that the more direct approach is to restructure
the firm’s long-term financing, so as to permanently
alter the firm’s financial exposure.

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Policy Issues
16 - 33
International Financial Managers
The International Investor’s Currency Risk
Management Problem
A portfolio’s exposure to foreign exchange risk can
be measured using the regression approach in much
the same way as the treasurer measures the firm’s
exposure.
 The investor can hedge foreign exchange risk using
forward contracts, or retain the risk using a riskreturn decision criteria.

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Policy Issues
16 - 34
International Financial Managers
The Value at Risk (VAR) Approach
The VAR approach is a relatively new approach for
measuring the exposure of financial assets.
 It can be applied to any portfolio of assets (and
liabilities) whose market values are available on a
periodic basis and whose price volatilities () can
be estimated.
 Assuming normal price distributions, calculate the
loss in value of the portfolio if an unlikely (say, 5%
chance) adverse price movement occurs. The result
of this calculation is the value at risk.

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16 - 35
Policy Issues - Public Policymakers
Disclosure of Financial Exposure
The possibility that individual firms may face
substantial exposure to exchange rate changes, as
well as the increased trading in financial derivatives
in recent years, create a genuine concern among
investors and regulators regarding corporate
exposure to financial risks.
 Note that a firm without a financial position may
still face substantial currency and interest rate risk
due to its ongoing operations.

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16 - 36
Policy Issues - Public Policymakers
Financial Derivatives and Corporate Hedging
Policies
The findings of various studies were consistent with
the notion that firms used derivatives to lower the
variability of their cash flows or earnings.
 It was also found that the likelihood of using
derivatives was positively related to foreign pretax
income, foreign sales, and foreign-denominated
debt.

McGraw Hill / Irwin
 2001 by The McGraw-Hill Companies, Inc. All rights reserved.