FOREIGN EXCHANGE (FE) EXPOSURE

Types of exposure:

Impact of Exchange Rate Change

1. Translation or Accounting Exposure in FE rate in owners equity in consolidated financial statements 3. Economic Exposure in FE rate in expected cash flows impacting on firm value or market price

2. Transaction Exposure in FE rate in outstanding contracts (asset or liabilities) giving rise to gains or losses.

Transaction Exposure: Examples

A Taiwanese company has the following USD exposures: 1. Owns a factory in Texas worth US$5 million. 2. Agreement to buy goods worth US$2 million. 3. Biggest competitor is a US company.
What happens if the New Taiwan dollar (NT$) appreciates? 1. NT$ value of US factory goes down (translation). 2. NT$ cost of buying goods goes down (transaction). 3. Global competitiveness of Taiwanese company decreases (economic).

Transaction Exposure
Transaction exposure exists when outstanding transactions (liabilities or assets) incurred in foreign currency are not yet settled and are exposed to exchange rate fluctuations. Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely
When transaction exposure exists, the firm faces three major tasks:
Identify its degree of transaction exposure, Decide whether to hedge its exposure, and Choose among the available hedging techniques if it

decides on hedging.

Transaction Exposure Sources: Example 1

In 1971, Great Britains Beecham Group borrowed SF100 million (equivalent to 10.13 million). When the loan came due five years later, the cost of repayment of principal was 22.73 million more than double the amount borrowed!

Transaction Exposure Sources: Example 2

Purchasing or Selling on Account

Suppose Trident Corporation sells merchandise on open account to a European buyer for 1,800,000 payable in 60 days Further assume that the spot rate is $0.9000/ and Trident expects to exchange the euros for 1,800,000 x $0.9000/ = $1,620,000 when payment is received (assuming no expected change in exchange rate) Transaction exposure arises because of the risk that Trident will receive something other than $1,620,000 expected If the euro weakens to $0.8500/, then Trident will receive $1,530,000 If the euro strengthens to $0.9600/, then Trident will receive $1,728,000

Transaction Exposure Sources: Example 2

Purchasing or Selling on Account

Trident might have avoided transaction exposure by

invoicing the European buyer in US dollars, but this might have caused Trident not being able to book the sale Even if the European buyer agrees to pay in dollars, however, Trident has not eliminated transaction exposure, instead it has transferred it to European buyer whose dollar account payable has an unknown euro value in 60 days

Transaction Exposure Sources: Example 2

Purchasing or Selling on Account
Life Span of a Transaction Exposure

t1
Seller quotes a price to buyer

t2
Buyer places order at offered price

t3
Seller ships product and bills buyer

t4
Buyer settles A/R with cash in amount of currency quoted at t1

Quotation Exposure

Time between quoting a price and order is placed

Work In Progress Exposure Time it takes between order is placed and goods are ready to be shipped

Billing Exposure

Time it takes from the goods are shipped to to get paid in cash after A/R is issued

Transaction Exposure Sources: Example 3

Borrowing and Lending

A second example of transaction exposure arises

when funds are loaned or borrowed Example: PepsiCos largest bottler outside the US is located in Mexico, [Grupo Embotellador de Mexico
(Gemex)]

On 12/94, Gemex had US dollar denominated debt of

$264 million The Mexican peso (Ps) was pegged at Ps3.45/$ On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps4.65/$

Transaction Exposure Sources: Example 3

Borrowing and Lending

Gemexs debt obligation:

Dollar debt mid-December, 1994:
$264,000,000 Ps3.45/$ = Ps910,800,000

Dollar debt in mid-January, 1995:

$264,000,000 Ps5.50/$ = Ps1,452,000,000

Dollar debt increase measured in Ps

Ps541,200,000

Gemexs dollar obligation increased by 59% due to

transaction exposure

Transaction Exposure Sources: Example 4

Forward Contracts

When a firm buys a forward exchange contract, it

deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure

Example: US firm wants to offset transaction

exposure of 100 million to pay for an import from Japan in 90 days Firm can purchase 100 million in forward market to cover payment in 90 days

Identifying Transaction Exposure for MNC

Do it on a currency-by-currency basis
BUT Centralized or Non-Centralized Management?

Identifying Transaction Exposure

Centralized and Non-centralized Management
Some multinational corporations use non-centralized approach for exposure management. Each subsidiary assesses and manages its individual exposure to exchange rate risk. This can cause redundancy in hedging.
Centralized exposure management requires the projection of consolidated net amount of currency inflows and outflows for all subsidiaries categorized by currency. Consider two subsidiaries X & Y of a U.S. MNC: Subsidiary X has net inflow of 500,000 Subsidiary Y has net outflows of 600,000 Then, the consolidated "net" outflow for this multinational corporation is 100,000. If the pound decrease it will be unfavorable to X but favorable to Y. If hedging is limited to net exposure, transaction cost savings are realized.

Identifying Transaction Exposure

Centralized and Non-centralized Management U.S. Based MNC
(millions of $)

Subsidiary London Munich Toronto Consolidated 1)

+ $100 - $110 + $30 + $20

How could the MNC use forward contracts to hedge against its transaction exposure to s?

Should London and Toronto subsidiariessell s forward and Munich subsidiary buy s forward?

OR

2)

Should MNC could sell $20m worth of s forward?

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Identifying Transaction Exposure

Centralized and Non-centralized Management U.S. Based MNC
(millions of $) Subsidiary London Munich Toronto Consolidated + $100 - $110 + $30 + $20 C$ -$60 -$80 +$70 -$70 -$80 +$120 -$10 +$30 - $30 + $80 - $50 + $0

What could the MNC do about its transaction exposure to the ? It may decide it has no transaction exposure to the

Identifying Transaction Exposure

Centralized and Non-centralized Management

Should net exposure be viewed from the subsidiary level or be centralized (from the view of the entire MNC)?

But goal of financial decision maker is to maximize the value of the overall MNC, not the value of individual subsidiaries

Identifying Transaction Exposure

Centralized and Non-centralized Management If exposure of subsidiaries nets out no hedge is necessary Subsidiary London - $30 Munich + $80 Toronto - $50 Consolidated + $0 If all three subsidiaries hedge, MNC experiences unnecessary expenses

If a single subsidiary hedges, then the MNC overall becomes exposed

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Identifying Transaction Exposure

Centralized and Non-centralized Management

But local creditors may look unfavorably toward subsidiarys exposure if it doesnt handle its own exposure

And, subsidiarys management may feel more comfortable handling their own exposure so they will not be hurt by adverse movements in exchange rates which make them look bad on their job record

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Identifying Transaction Exposure

Centralized and Non-centralized Management

Real World
In the past Kodak would bill its subsidiaries in $s for supplies it provided so each subsidiary had to deal with its own transaction exposure

Now Kodak bills its subsidiaries in their local currencies and Kodaks main headquarters handles any transaction exposure

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Identifying Transaction Exposure

Centralized and Non-centralized Management
Fiat (Italian auto maker) has a centralized system for 421 subsidiaries in 55 countries, uses a comprehensive reporting system to keep track of cash flows in each currency, and its main headquarters does any necessary hedging

Techniques for Managing Transaction Exposure

Billing in the foreign currency Pricing in the domestic currency Enter into futures (forward) contracts Money Market Hedge Options Hedge Go Uncovered
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Techniques for Managing Transaction Exposure: CASE

G.E. is awarded a contract to supply turbine blades to Lufthansa (German company). The turbine will be delivered to Lufthansa one year from today and G.E. will receive 25,000,000. Currently the spot rate is $0.55/ and the 1-year futures rate is $0.54/. The size of a futures contract is 125,000. German annual interest rates are 6% on deposits and 8% on borrowed funds and U.S. annual interest rates are 5% on deposits and 7% on borrowed funds.

Also, 1-year call options with a strike price of $0.51/ have a premium of 6 / and put options with a strike price of $0.58/ have a premium of 5 /.
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Techniques for Managing Transaction Exposure: CASE

GE will receive 25,000,000 in the future 0 1 + 25,000,000 If G.E. decides it wants to offset this position, it will set up a situation which will require it to pay 25,000,000 one year from today. Thats HEDGING.

Billing in the foreign currency

If G.E. is buying parts from a European supplier for payment in one year, it could agree to pay for them in s and not $

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Pricing in the domestic currency

When negotiating the contract with Lufthansa, G.E. could insist on being paid in U.S. $s rather than s Could this cause problems for G.E.?

Lufthansa may disagree and award the contract to a firm pricing their blades in s

Futures Contract Hedge

Should G.E. hedge with a futures contract or maintain its current position in s? That depends on what G.E. thinks the future spot rate will be before making the decision. What bad could happen which would cause GE to be interested in futures contract? That one year from today the spot rate will be BELOW $0.54/ (the futures rate today) i.e. that the will depreciate below the current futures rate.

Futures Contract Hedge

Develop a probability distribution for what the spot rate will be one year from today Possible Future
Spot Rates $0.53/ $0.54/ $0.55/
Calculate the expected spot rate E[spot] = (15%)($0.53) + (40%)($0.54) + (45%)($0.55) =$0.542/ Since E[spot] > Future Rate, do not hedge Probability 15% 40% 45%

Futures Contract Hedge

If GE doesnt hedge, what is the probability it made the correct choice?
40% + 45% = 85% What is GEs expected revenue without hedging? (25,000,000)($0.542) = $13,550,000 Compare this to GEs revenue if it hedges (25,000,000)($0.54) = $13,500,000 GE will have to decide if the extra expected revenue of $50,000 is worth the risk of going unhedged.

Futures Contract Hedge

Should G.E. buy or sell a futures contract? Since it will receive s in the future and wants to convert them to $s, it should sell Futures Contracts

Today
G.E. sells 25,000,000 125,000 = 200 contracts at $0.54/

Futures Contract Hedge

One Year from Today G.E. receives 25,000,000 from Lufthansa G.E. delivers s on Futures Contract

G.E. receives (25,000,000)(0.54) = $13,500,000

Money Market Hedge Receivables

Take a money market position to offset a future foreign currency payables or receivables position

Case #1
Suppose GE needs to borrow $15,000,000 to build a new plant in the U.S. GE can borrow s today instead of $s with the idea of using the 25,000,000 it receives from Lufthansa to repay this loan
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Money Market Hedge Receivables

Should GE borrow 25,000,000? It should borrow less than 25,000,000 Borrowed(1 + iGer) = 25,000,000 Borrowed =

25,000,000 = 23,148,148 1 + 8%

Money Market Hedge Receivables

Today
1. GE borrows 23,148,148 from German bank at 8% for 1 year 2. Convert s to $s at current spot rate (23,148,148)($0.55) = $12,731,481

3. Use the $s to help build the new plant in the U.S.

Money Market Hedge Receivables

One Year from Today
1. GE receives 25,000,000 from Lufthansa 2. Use the 25,000,000 to repay loan from the German bank (23,148,148)(1 + 8%) = 25,000,000

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Money Market Hedge Receivables Case # 2

GE does not need to borrow $s to help finance construction of a new plant.

Today
1. GE borrows 23,148,148 from German bank at 8% for 1 year 2. Convert s to $s at spot rate 23,148,148($0.55) = $12,731,481 3. Deposit $s in U.S. bank for 1 year at 5%

Money Market Hedge Receivables

One Year from Today
1. GE receives 25,000,000 from Lufthansa

2. Use these s to repay loan from German bank

(23,148,148)(1 + 8%) = 25,000,000 3. GE receives $s from U.S. bank (12,731,481)(1 + 5%) = $13,368,055
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Money Market Hedge Receivables

GE gets $13,500,000 with the Futures hedge compared to $13,368,055 with this Money Market hedge
Which is better for GE, the Money Market hedge or the Futures hedge? It depends on the spot rate at the maturity of the future contract.
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Money Market Hedge Payables

Now, suppose GE must pay 25 million to a German company three months from today. The 90-day interest rate on borrowed funds in the U.S. is 1.75% and on deposits in Germany is 1.5%. Use a Money market hedge.
How many s should GE deposit in a German bank? 25,000,000 1.015 = 24,630,541.87

Case # 1
GE has excess $s it does not need during the next 90 days

Today

Money Market Hedge Payables

1. GE converts appropriate amount of $s to s

24,630,541.87 (0.55) = $ 13,546,798.03

2. GE deposits 24,630,541.87 in a German bank at 1.5% for 90 days
Three Months from Today

1. GE receives s from German bank 24,630,541.87 (1.015) = 25,000,000

2. GE uses these s to pay German company.

Money Market Hedge Payables Case # 2

GE does not have excess cash (or has excess but doesnt want to use it for this purpose)

Today
1. GE borrows the right amount of $s for 90 days at 1.75% from U.S. bank
24,630,541.87 (0.55) = $ 13,546,798.03 2. Convert $ 13,546,798.03 to 24,630,541.87 3. GE deposits 24,630,541.87 in German bank for 90 days at 1.5%

Money Market Hedge Payables

Three Months from Today

1. GE receives s from German bank 24,630,541.87 (1.015) = 25,000,000

2. GE uses these s to pay German company 3. GE repays loan $ 13,546,798.030(1.0175) = $ 14,562,807.88

Whats the implicit exchange rate?

Money Market Hedge Payables

Now, compare the amount repaid to the U.S. bank to the cost of getting the needed s with a futures contract to determine which is best.
25,000,000 125,000

1. G.E. buys

= 200 contracts at $0.54/

2. G.E. pays (25,000,000)(0.54) = $13,500,000 Which alternative is the best?

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Currency Option Hedge

Consider the 25 million GE will receive from Lufthansa. What bad could happen which would cause GE to be interested in buying a Futures Contract?

That one year from today the spot rate will be BELOW $0.54/ (the Futures rate today) i.e. that the will depreciate below the current futures rate

Should GE use a Put or a Call? Put Option Should GE buy or sell a Put? BUY

Currency Option Hedge

Today
GE buys 200 Put Options to sell 25,000,000 with a strike price of $0.58/ and a premium of 5/ Cost: (25,000,000)(5 /) = $1,250,000

GE is now guaranteed that the minimum they will receive for the turbine blades is (25,000,000)($0.58 - 5) = $13,250,000

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Currency Option Hedge

One Year from Today GE receives 25,000,000 from Lufthansa How does GE decide if it should exercise the Put? GE should compare the spot rate to the strike price

If spot < $0.58 GE should exercise the Put GE receives 25,000,000($0.58) = $14,500,000 GE clears $14,500,000 - $1,250,000 = $13,250,000
If spot > $0.58 GE should not exercise the Put GE sells the s in the spot market GE receives 25,000,000(spot rate) clears 25,000,000(spot rate) - $1,250,000

Currency Option Hedge

Which would have been better for GE?
Sell Futures Contract $0.54/ Buy Put Option strike $0.58/ @ 5 cent/ premium

Depends on what the spot rate is expected to be one year from today

Futures Contract is better if spot < $0.59/ = $0.54/ + 5 / Futures rate

Put Option is better if spot > $0.59

Put premium

Alternative Hedging Techniques

Leading & Lagging

Adjust timing of payables and receivables depending on expectation of exchange rate movement
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EXAMPLE
French firm ships supplies to its subsidiary in Switzerland and will be paid in SFs What should the French firm do if it thinks the SF will depreciate against the ? Speed up the payment

Leading

What should the French firm do if it thinks the SF will appreciate against the ? Slow down the payment

Lagging
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Cross-Hedging
Suppose a firm has transaction exposure against a currency where a hedge does not exist Identify another foreign currency which is highly positively correlated with the currency needed (relative to movements against the home currency) and for which a hedge does exist

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Cross-Hedging
Suppose a firm has transaction exposure against a currency where a hedge does not exist Identify another foreign currency which is highly positively correlated with the currency needed (relative to movements against the home currency) and for which a hedge does exist

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To Hedge or not?
Is the reduction of variability in cash flows then sufficient reason for currency risk management?
This question is actually a continuing debate in multinational financial management and corporate finance. There are several schools of thought.

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To Hedge or not?

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Opponents of Hedging
Opponents of currency hedging commonly make the following arguments:
Stockholders are much more capable of diversifying currency risk than the management of the firm. Currency risk management does not add value to the firm and it incurs costs. Hedging might benefit corporate management more than shareholders.

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Proponents of Hedging
Proponents of hedging cite:
Reduction in risk in future cash flows improves the planning capability of the firm. Reduction of risk in future cash flows reduces the likelihood that the firms cash flows will fall below a necessary minimum (the point of financial distress). Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Individuals and corporations do not have same access to hedging instruments or same cost.
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To Hedge or not?
Should the firms hedging strategy be to use forward contracts for all of its future foreign exchange transactions?

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To Hedge or not?
Should the firm hedge a future foreign exchange transaction if it feels the exchange rate will move in an unfavorable direction?

If it is fairly good at forecasting exchange rate movements

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To Hedge or not?
The MNCs level of risk aversion, and its ability (and desire) to forecast exchange rates determine:

If it will hedge How much it will hedge How it will hedge

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2005 Financial Report, McDonalds Corporation, p 18

http://www.mcdonalds.com/corp/invest/pub/2005_Financial_Report.RowPar.0002.ContentPar.0001.ColumnPar.0003.DownloadFiles.000 1.File.tmp/Financial_Report_2005.pdf