Lecture 12: Managing Foreign

Exchange Exposure with

Operational Hedges
A discussion of the various
operational arrangements
which global firms and
global investors can use
when managing open
foreign exchange positions
Hedging Known Future Cash Flows
 In the previous lecture, the hedging techniques we
discussed (forwards and options) are most
appropriate for covering transaction exposure.
 Transaction exposures have known foreign currency cash
flows and thus they are easy to hedge with financial contracts.
 The majority of transaction exposure risk results
from receivables (payables) from exports (imports)
contracts and repatriation of dividends.
 Usually, the time frame for these committed transactions (the
time between contracting and payment) is relatively short.
However, it can in some cases reach several years, where
deliveries are committed a long time in advance (forward sales
of airplanes or building contracts).
Quick Review: Identifying Sources
of Transaction Exposure
 Transaction exposure arises from:
 (1) Purchasing or selling, on credit, goods or
services denominated in foreign
currencies.
 (2) Borrowing or lending denominated in
foreign currencies.
 (3) Acquiring financial assets or incurring
liabilities denominated in foreign currencies.
 Dealing with Transaction Exposure
Through Operational Hedges
 While global companies can manage their
transaction exposures with financial hedges,
they can also utilize operational hedges.
 Operational hedges refers to “internal”
organizational strategies that firms use to deal with
their currency exposures.
 With respect to transaction exposure, potential
operational techniques include:
 Risk Shifting: Invoicing overseas purchases and sales in
home currency.
 Netting: Hedged net amounts of transaction exposures.
 Leading (speeding up) and Lagging (slowing down)
payments in response to changes in exchange rates.
Operational Hedging of Transaction
Exposures: Risk Shifting, Home
Currency Invoicing, 2003-2007 Data
Operational Hedging: Netting
 Given that large and globally diverse
multinational firms may need to manage
exchange rate risk associated with several
different currencies these generally consider
their net exposure to currency risk instead of just
looking at each currency separately.
 Global firms will achieve netting through a
centralized approach because a non-centralized,
whereby each subsidiary assesses and
manages its individual exposure to exchange
rate risk will result in redundancy and added
costs in hedging.
Transaction Exposure Using
"Net" Cash Flows
 Centralized exposure management requires
headquarters to consolidate the 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 (long position) of £500,000
 Subsidiary Y has net outflows (short position) of
£600,000
 Then, the consolidated "net" outflow for this multinational
corporation is £100,000 which is the amount to be
hedged.
 Additionally, if the pound weakens it will be unfavorable
to X but favorable to Y. If hedging is limited to net
exposure, transaction cost savings are realized.
Operational Hedging: Leading and
Lagging Payments
 Refers to the timing of when a firm with an FX
exposed position will initiate foreign currency
payments (or specifically when the firm has an
open short position).
 Leading (“speeding-up) Payments.
 Lead payments when home currency is weakening
(i.e., foreign currency is strengthening).
 Lagging (“slowing down/delaying”) Payments
 Lag payments when home currency is
strengthening (i.e., foreign currency is weakening).
Hedging Unknown Cash Flows
 In the previous examples we were dealing with
known foreign currency cash flows (resulting
from current “transactions”).
 However, economic exposures do not provide
the firm with this “known” cash flow information.
 Economic exposure refers to the impact of
exchange rate movements on the home
currency value of uncertain future cash flows.
 Global firm: Uncertain future cash flows relate to the
firm’s costs (e.g., raw materials, labor costs, etc.) and
output prices and sales (e.g., product prices).
 Global investor: Uncertain future cash flows relate to
the future dividends and changes in market prices.
Channels of Economic Exposure
for Firms
 (1) Direct effects of FX changes result from a
company’s actual involvement in foreign markets.
 Impact on the home currency equivalents of cost and revenue
streams in overseas markets.
 (2) Indirect effects refer to FX induced changes in
foreign company competition in a company’s
domestic market.
 Foreign competitors exporting into company’s home country
(FX induced change in competitive position of foreign
exporters).
 Foreign companies setting up FDI activities in company’s
home country.
 Both (1) and (2) driven by globalization.
The Globalization of Business Firms:
2010 Data for S&P 500 Firms
Data for Selected S&P 500 Companies,
Sorted by Percentage Point Increase
The Global Reach of Selected U.S.
Companies, 2010 Data
 Wal-Mart. Total revenue: $420 billion, 26% from overseas; nearly 5,000
stores in 14 foreign countries, including China, India, the U.K., and Latin
America.
 Bank of America. Total revenue: $134 billion, 20% from overseas.
Europe is biggest market.
 Ford. Total revenue: $129 billion, 51% from overseas; Canada and
Europe.
 Boeing. Total revenue: $64 billion in revenue, 41% from overseas;
Europe, Asia, and the Middle East.
 Intel. Total revenue: $44 billion, 85% from overseas. Taiwan, followed by
China.
 Amazon. Total revenue: $34 billion, 45% from overseas; Canada,
several European countries, Japan, and China.
 McDonald's. Total revenue: $24 billion, 66% from overseas; Europe and
Asia.
 Nike. Total revenue: $21 billion, 50% from overseas; North America,
Europe and China.
McDonald’s, 2010 Annual Report
Impact of FX Changes on Sales

Note: Excluding F/X estimates sales based on the previous

year’s exchange rate
Dealing with Economic Exposure
 Recall that economic exposure is long term
and involves unknown future cash flows.
 What can the firm do to manage this
economic exposure?
 Firm can employ an “operational hedge.”
 One such strategy involves global diversification
of production and/or sales markets to produce
natural hedges for the firm’s unknown foreign
exchange exposures.
 As long as currencies associated with these
different markets do not move in the same
direction, the firm can “stabilize” its overall home
currency equivalent cash flow.
Global Diversification of Sales
 Subway:
 35,561 restaurants in 98 countries
 Visit:
http://www.subway.com/subwayroot/exploreourwo
rld.aspx
 McDonald’s (2010):
 32,737 restaurants in
117 countries.

 Revenues by segment
Balancing Costs and Revenues:
Restructuring to Reduce Economic
Exposure
 Restructuring involves shifting the sources of costs
or revenues to other locations in order to match
cash inflows and outflows in foreign currencies.
 Restructuring Decisions:
 Should the firm attempt to increase or decrease sales in
specific countries (i.e., revenues)?
 Should the firm attempt to increase or decrease
dependency on foreign suppliers (i.e., cost)?
 Should the firm establish or eliminate production facilities in
foreign markets (i.e., costs)?
 Should the firm increase or decrease its level of foreign
currency denominated debt (i.e., costs)?
Nike’s Global Diversification of
Manufacturing for Footwear,
By Country, 2005
Country Percent
China 36
Vietnam 26
Indonesia 22
Thailand 15
Big Four 99
Others: Argentina, Brazil, India, Mexico, and South
Africa
Source: Nike, 2005 Annual report
Nike’s Global Diversification of
Sales by International Region
(U.S. Dollars in Millions), 2005
Market Revenue Percent
United States $5,129.3 37.3%
EMEA 4,281.6 31.2%
Asia Pacific 1,897.3 13.8%
Americas 695.8 5.1%
Other 1,735.7 12.6%
Total $13,739.7

Note: EMEA is Europe, Middle East and Africa

Is Nike a Balanced Firm?
 Foreign Currency Costs concentrated in:
 Yuan, Dong, Rupiah, Baht
 Foreign Currency Revenues concentrated in:
 Euros, Pounds, Yen
 What if the cost currencies strengthen (against
the USD) and the revenue currencies weaken
(against the USD)?
 Negative impact on USD profits
 Possible solution: Adjust prices in revenue countries.
 What if the cost currencies weaken and the
revenue currencies strengthen?
 Positive impact on USD profits
 How could Nike balance its overseas activities?
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure
 Step 1: Determining Specific Foreign Exchange
Exposures
 What type of exposure are you dealing with?
 By currency and net amounts (i.e., long minus short positions)
 Are the net amounts worth hedging? If they are go to Step 2; if
not, no need to hedge.
 Step 2: Forecasting Exchange Rates
 Determining the potential for and possible range of currency
movements.
 Important to select the appropriate forecasting model.
 A “range” of forecasts is probably appropriate here (i.e., forecasts
under various assumptions)
 How comfortable are you with your forecast? If comfortable, go to
Step 3. If not, hedge.
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure
 Step 3: Assessing the Impact of Forecasted Exchange
Rates on Company’s Home Currency Equivalents (What
is the Measured Risk?).
 Impact on earnings, cash flow, liabilities (positive or
negative?)
 Go to Step 4
 Step 4: Deciding Whether to Hedge or Not
 Determine whether the anticipated impact of the forecasted
exchange rate change merits the need to hedge.
 Perhaps the estimated negative impact on home currency
equivalent is so small as not to be of a concern.
 But, if impact is unacceptable, go to Step 5
 Or, perhaps the firm feels it can benefit from its exposure.
 If this is the case, go to Step 6
A Comprehensive Approach or Assessing and
Managing Foreign Exchange Exposure
 Step 5: Selecting the Appropriate Hedging Instruments if
Risk is Unacceptable.
 Consider:
 Which hedge is appropriate for the type of exposure?
 Financial and/or operational
 Firm’s familiarity and comfort level with types of hedging
strategies.
 Review the cost involved with different financial
contracts.
 Step 6: Selecting the Appropriate Strategy to Position
the Firm to Take Advantage of a Favorable Exchange
Rate Change.
 Consider:
 Partial “open” position versus complete “open” position.
 Which financial contract will achieve your objective?
Appendix 1

The following slides illustrate how

companies deal with and report
translation exposures
Translation Exposure
 Translation exposure is commonly referred to as
“accounting exposure” because it refers to the
impact of exchange rate changes on the
consolidated financial reports of a global firm.
 These include impacts on assets and liabilities and
profits which have been acquired or occurred in the past.
 Why do global firms need to consolidate statements?
 To report financial results to their shareholders.
 To report income to taxing authorities.
 The accounting approach for consolidating financial
statements depends upon the accounting requirements of the
firm’s headquartered country.
 The U.S. is governed by FASB 52.
 Balance sheet and income statement gains or losses associated with
the consolidation process show up in the shareholders’ equity account
Nike’s 2005 Financial Statement
Summary
 Consolidated Balance Sheet, Fiscal 2005 (millions
of U.S. dollars)

 Assets $8,793.6
 Liabilities $3,149.4
 Shareholders’ Equity $5,644.2
 Of which foreign currency
translation adjustments were: 70.1*
*This is a cumulative amount (e.g., in 2004 it was $27.5