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FOREIGN

EXCHANGE
RISK
1. The risk of an investment's value changing
due to changes in currency exchange rates.

2. The risk that an investor will have to close out a
long or short position in a foreign currency at a
loss due to an adverse movement in exchange
rates. Also known as "currency risk" or
"exchange-rate risk"


Transaction exposure measures changes in the
value of financial obligations incurred before a
change in exchange rates but to be settled after
the change.
Operating exposure, or economic exposure,
measures the change in the present value of the
firm resulting from any change in expected
future operating cash flows caused by an
unexpected change in exchange rates.

Translation exposure, or accounting
exposure measures the potential
losses or gains that would appear on
the consolidated financial statements
following a change in exchange rates.
Tax exposure measures the tax
consequences of foreign exchange
exposure
1. Purchasing or selling on credit when
prices are stated in a foreign currency.
2. Borrowing or lending funds when
repayment is to be made in a foreign
currency.
3. Being a party to an unperformed
foreign exchange forward contract.
4. Acquiring assets or incurring liabilities
denominated in a foreign currency.
A U.S. firm sells merchandise on open account to a Belgian
buyer for E1,800,000, payment to be made in 60
days.
Current exchange rate is $1.1200/E.
Seller expects to receive
E1;800;000$1:1200=E = $2;016;000.
Transaction exposure:
If the euro weakens, the seller will receive less than
$2,016,000.
If the euro appreciates, the seller will receive more
than $2,016,000.
PepsiCos largest bottler outside the US is located in
Mexico,Grupo Embotellador de Mexico (Gemex)

December 94: Gemex had US dollar denominated debt
of $264 million. The Mexican peso (Ps$) is pegged
at Ps$3.45/US$
December 22, 94: The peso is allowed to float due to
internal pressures and sinks to Ps$4.65/US$
Peso traded at around Ps$5.50/US$ for most of
January.
Gemexs peso obligations:
Mid-December, 1994:
US$264;000;000Ps$3:45=US$=
Ps$910;800;000:
Mid-January, 1995:
US$264;000;000Ps$5:50=US$ =
Ps$1;452;000;000
Gemexs dollar obligation has increased by
59%. 13
When a firm buys a forward exchange contract, it
deliberately creates transaction exposure; this
risk is incurred to hedge an existing exposure.
A firm offsetting a transaction exposure of U100
million, say, to pay for an import from Japan in
90 days, can purchase U 100 million in the
forward market.
The counterparty to this transaction now faces
foreign exchange exposure.

Contractual Hedge: Forward, money, futures and
options market hedges.
Operating Hedge: Risk-sharing agreements, leads
and lags in payment terms, swaps, and other
strategies.
Natural Hedge: Offsetting operating cash flows.
Financial Hedge: Offsetting debt obligation or
some type of financial derivative such as a swap.
I. FOREIGN EXCHANGE RISK: Step I.

A.Economic exposure defined: focuses on
the future impact of unexpected currency
fluctuations on firms value.
1 .The most important aspect of foreign
exchange risk management: Incorporate
expectations about the risk into all basic
decisions of the firm.




2. Definition:
Economic exposure =Transaction
exposure +Operating exposure:
arises because currency
fluctuations alter a companys
future revenues and
expenses.
B. Real Exchange Rates Changes and
Risk Nominal v. real exchange rates:
real rate has been adjusted for price
changes.

Assume: no two nations have the
same annual rate of inflation.

C. Implications
1. If nominal rates change with
an equal price change, no
alteration to cash flows.

2. If real rates change, it causes
relative price changes and
changes in purchasing power.


Operating Exposure begins: the
moment a firm starts to invest
in a market subject to foreign
competition or in sourcing
goods or inputs abroad
Operating exposure begins with
New product development
A distribution network
Brand name development
Marketing to foreign markets
Foreign supply contracts
Overseas production facilities
To measure operating exposure
requires a longer-term perspective.

i.e. Cost and price
competitiveness could be affected
by unexpected exchange rate
changes
A decline in the real value of a
currency: makes exports and import-
competing goods more competitive
An appreciating currency makes:
imports and export-competing goods
more competitive

During an appreciation of home
currencies: Exporters face two choices:
keep prices constant (but lose
sales)or adjust prices to foreign
currency to maintain market share
(lose profits)
a. the economic impact of a currency
change depends on the offset by the
difference in inflation rates or
the change in real exchange rates.
b. It is the relative price changes that
ultimately determine a firms long-run
exposure.
I. ECONOMIC CONSEQUENCES
The impact on Operating Exposure of a
real rate change depends upon: Pricing
flexibility and
1.Price elasticity of demand
2.Degree of product differentiation
3.The Ability to shift production
and the substitution of inputs

Pricing Flexibility is key
Can the firm maintain its profit margins
both at home and abroad?

If price elasticity of demand is low, the
more price flexibility a firm has. i.e.
Availability of good substitutes
The Ford Corp in Indonesia, 1997
Product Differentiation
price elasticity depends on degree of
differentiation
The greater the differentiation, the
more the firm can control its prices.

e.g. Daimler Chrysler Corp.
The Ability to Shift Production and to
source inputs from other countries

e.g. Japanese car makers
(Toyota) in the late 1980s
Operating exposure
management requires
long-term operating
adjustments and the
involvement of ALL
departments.
II. Marketing Strategy
A. Market Selection:
use competitive advantage
to carve out market share
when currency values
change

B. Pricing strategy: Expectations critical 1.If
HC depreciates, exporter gains
competitive advantage by increasing
unit profitability or market share.
2. The higher price elasticity of
demand, the more currency risk the
firm faces by other product
substitution.
C. Product Strategy exchange rate changes may
alter
1. The timing of new product
introductions,
2. Product deletion
3. Product innovations
III. Product Management Adjustments
A. Input mix shop the world
B. Shift production among plants
C. Plant relocation (new)
D. Raising productivity


IV. Planning For Exchange-Rate Changes
A. Develop contingency plans
with plausible scenarios
before the impact of a
currency change makes itself
felt.
e.g. flexible mfg systems
Risk Management is the name given
to a logical and systematic method
of identifying, analysing, treating
and monitoring the risks involved
in any activity or process.

Economic exposure
any impact of exchange rate
fluctuations on future cash flows
an MNC should examine how all
cash flow is affected by exchange
rate movement

Restructuring an MNCs exposure
The approach depends upon form of exposure
MNC with revenue (inflow) exposure
decrease revenue in foreign currency
increase costs in foreign currency to balance flows
MNC with expense (outflow) exposure
increase revenues in foreign currency
decrease costs in foreign currency to balance
flows

Assessing economic exposure
examine sensitivity of revenues and
costs to exchange rate fluctuation
an imbalance between costs and
revenues creates higher exposure level
determine sensitivity of earnings to
exposure

Managing Economic Exposure
balances sensitivity of revenues and expenses to
exchange rate fluctuations

choose one international company and analyze its
financing strategies and overall risk management
strategies as you are the CFO in a multinational
company.
The US firm with subsidiary in Japan
most revenue (receivables) in the US
dollars
most costs occur in Japanese yen
most borrowing occurs in Japan
a currency imbalance exists between costs
and revenues
Income statement becomes sensitive to
currency fluctuations

Income statement becomes sensitive to
currency fluctuations
effect of currency imbalance among costs and
revenues
Measuring exposure for US MNC Y
Costs
Revenues
Net earnings
Impact if yen were to strengthen
increases MNC Ys production costs
increases MNC Ys interest expenses
decreases net earnings
Measuring exposure for US MNC Y
Costs
Net earnings
Response to a strong yen over time
MNC Y may change emphasis of the two sites
increase Japanese revenue
shift costs to US
attempt to reduce effect of currency
imbalance
Measuring exposure for US MNC Y
It also helps to know that in general you should borrow the
currency that is expected to be softer in value / depreciate
against home currency. Meaning you pay less in home currency
later.
Sell the future gains if you expect the foreign currency to
depreciate more than the forward rate indicates (otherwise you
lose in terms of home currency). But if you believe in the parity
condition, you dont gain by trading in the foreign exchange
market.
In reality, the equivalence models do not hold in the short run
due to market imperfections, that provides one of the solid
ground for hedging transaction exposure.

CASH FLOW EXPOSURES MATTER
P =
FCF
k
n
n
( ) 1+


Given the above model, future cash flow is the key to
corporate valuation.
Logically, transaction and economic exposures
matter. But pure translation might not.
However, at higher levels of gearing, failure to
manage pure translation exposure may result in
breach of a borrowing covenant, see example at A.
Buckley, p 175.
Base case subsequent move to
exchange rate $ to 1,8 1,4
Assets ( M)
in UK 100 100
in US ($ 180M) 100 128,6
200 228,6
Financed by ( M)
shareholders' funds 100 100
US$ debt ($ 180M) 100 128,6
200 228,6
Debt to equity ratio 1 to 1 1,28 to 1
The example. Chapter 10, Page 175. Debt equity ratio can be a reason for
firms to hedge. (note: this example is in the excel file for chapter 8
online.)
Covering exposures is designed to reduce the
volatility of a firms profits and/or cash generation.
Reducing foreign exchange risks so that FIRMS CAN
take on more operating risks, and
reducing probability of financial distress bankruptcy
risk, enabling firms to borrow more, and add value of
the tax shields. (can you find a real world example of a
MNC?)
( )
( )

=
+

=
n
t
t
t t t
r
e CO CI
PV
0
1

OR, IS THE VALUE OF THE FIRM EQUAL TO ......
V
F
= [EV
i
] P(o)
V
F
= Value of firm.
V
i
= Present value of division i.
P(o) = Penalty factor (or risk premium?) based on the impact on
after tax cash flows of the total risk of the firm.
V
i
is the net present value of each of the firms division and P() is a
penalty factor that reflects the impact on after tax cash flows of the
total risk of the firm.
The penalty factor (risk premium) is a function
of total risk. This equation supports the reduced
volatility of return argument, (see diagram before)
which reduces bankruptcy probability. It suggests
that hedging is a good thing for shareholders
because, in lowering the risk premium, corporate
value is enhanced, at least this is true for
undiversified shareholders. Because diversification
would render the hedging activities unnecessary for
shareholders.
) (o P

= ) (o P V V
i F

Macroeconomic exposure is concerned with how a firms
cash flows, profit and/or value, change as a result of
changes in the economic environment as a whole. This
includes changes in:
Exchange rates.
Interest rates.
Inflation rates.
Wage levels.
Commodity price level.
Etc.



A Profit
or
ACF = o + |
1
AE + |
2
Ai + |
3
Ap + |
4
AW + |
5
AP +|
6
ARP
or
AV
Profit is before interest and tax p = Price level.
CF = Real cash flow W = Wage levels.
V = Value of firm P = Commodity price level.
E = Exchange rate RP = Relative prices.
i = Interest rates
and..........clearly one can try to manage exposure due to the
magnitude of the impact on the firms cash flow.
Value at risk estimates potential pre-tax loss resulting from an
adverse movement in interest rates, exchange rate, and/or market
prices over a certain holding period.
Finding out the interest rate, exchange rate sensitivity of the
exposure:

1. variance (covariance) method, 2. historical method, 3. Monte Carlo
simulation.

Daily Earnings At Risk=Dollar market value of the position*price volatility

where Price volatility= Price sensitivity of the position*potential adverse
move in yield

For N days: VaR=DEAR*square root of N

the maximum loss that can occur 5% (1%) of the time. (worst daily
loss in history evaluated at 5% (1%) significance level). This enables
you to decide how to hedge and how much.

Netting.
Matching.
Leading and lagging.
Pricing policies.
Asset/liability management.
Netting requires a two-way cash flow in
the same foreign currency.
It involves associated companies with
debts, possibly as a result of trade with
each other. Associate companies simply
cancel out amounts owed with amounts
due and settle for the difference

Matching is a term applied to not just
subsidiaries and within groups, but also third
parties
See example

= netting arrangement
UK
subsidiary
Swiss subsidiary
French subsidiary
Ex: If UK subsidiary owes the French subsidiary $6m, and the French sub.
owes the UK $4m, the netted amount would be $2m
treasur
y
Leading and lagging are techniques
related to expected devaluations or
revaluations.
It involves making an advance payment or
delaying payment on amounts due that is
denominated in foreign currency
Need to consider relative interest rate changes,
and after tax effect.
The expected devaluation should make the
company to refinance their debts in local
currency
Due: means deadline to make the payment.
Price variation: transfer pricing
Pricing of goods and services that change hands within a
group to counter the adverse effect of exchange rate
movement
This is to minimize the tax paid to the host country. It is
illegal nevertheless and involves a fine.
Currency of invoice
The sellers ideal currency is a stable currency or its own
currency. So that it will not lose value when receiving.
The buyers ideal currency is its own currency or a stable
currency.
Use currency of your income so as to reduce the exposure.
Forwards.
Short-term borrowing or depositing.
Discounting receivables.
Factoring receivables.
Currency overdrafts and currency hold
accounts.
Government exchange risk guarantees.
Currency swaps.
Financial futures.
Currency options.
Do some home
work and ready for
further discussion
on this topic