1、ECON 334: INTERNATIONAL BUSINESS AND FINANCE,Lecture 7: Managing foreign exchange exposure,SUMMARY,Last weeks lecture discussed the forward exchange rate and the covered interest parity condition as the basis for foreign exchange risk hedging strategies The relationship between the forward rate and
2、expected exchange rate (risk premium?) was explored in the classes The possibility of real interest parity internationally was mentioned and will arise again in Lectures 9 and 10 This week, we examine the sources of foreign exchange risk exposure to MNEs and techniques for managing them. Start with
3、an example: Ford Motor,FORD: FOREX RISK HEDGING POLICY,“Foreign currency risk is the possibility that our financial results could be better or worse than planned because of changes in foreign currency exchange rates. Accordingly, we use derivative instruments to hedge our economic exposure with resp
4、ect to (forecasted revenues and costs), (assets, liabilities, investments in foreign operations), and (firm commitments denominated in foreign currencies). In our hedging actions, we use primarily instruments commonly used by corporations to reduce foreign exchange risk (e.g., forward contracts and
5、options).” (Annual Report 2006, emphasis and brackets added),Note that there are three basic sources of risk identified in bold type (brackets),SOURCES OF FOREX EXPOSURE,These are the sources of exchange risk exposure normally distinguished: Translation (accounting) exposure (assets, liabilities, in
6、vestments in foreign operations) Transaction exposure (firm commitments denominated in foreign currencies) Operating exposure (forecasted revenues and costs) The last two together represent economic exposure (not distinguished in Ford quote) Briefly discuss translation exposure first:,TRANSLATION EX
7、POSURE,This is separated from sources of economic exposure because it does not generate any actual cash flow implications It is relevant to a MNC as it arises when a subsidiarys accounts are denominated in the local (functional) currency On the parents (consolidated) accounts the assets and liabilit
8、ies of the subsidiary must be translated into the parents home currency,TRANSLATION EXPOSURE,Under the current rate method, a devaluation of the functional currency will affect the MNCs consolidated accounts Most assets and liabilities are translated at the current exchange rate but shareholders fun
9、ds in the subsidiary are treated as historic items and translated at the exchange rate prevailing when last valued This produces accounting losses after devaluation of the functional currency because exposed assetsexposed liabilities. This book loss is deducted from shareholders funds in the parents
10、 consolidated accounts,FORD TRANSLATION EXPOSURE,“The assets and liabilities of foreign subsidiaries using the local currency as their functional currency are translated to U.S. dollars based on current exchange rates and any resulting translation adjustments are included in OCI. The net translation
11、 adjustments for 2006 and 2005 were an increase in net assets and OCI of $2.6 billion and a decrease in net assets and OCI of $3.7 billion (net of $524 million and $299 million of tax), respectively.” (Annual Report, 2006),NB. OCI = Other Comprehensive Income reflects unrealised gains and losses and
12、 is an item in the balance sheet (in the liability shareholders equity). It does not affect reported profits.,CONSEQUENCES OF TRANSLATION EXPOSURE,This might be important if, for example, loan covenants require HQ to maintain a certain debt-equity ratio (since consolidated equity would fall) Subsidi
13、aries expecting local devaluation may hedge by borrowing in local currency, buying HQ currency spot and lending to the parent Generally, though, translation exposure is an accounting and not an economic (cash flow) risk so costs of hedging may be a waste Moreover, if a profit is made from hedging it
14、, this is often taxable, but the translation loss is not deductible. Turn now to economic exposure:,EXCHANGE RISK: ECONOMIC EXPOSURE,Two key sources are: Contractual exposure arising from outstanding assets/liabilities in foreign currency for which payment has not yet been received or made (= balanc
15、e sheet exposure) Operating exposure arising through the firms normal business operations (=income statement exposure ),PROBLEMS OF MEASUREMENT,Contractual exposure may involve multiple amounts of a currency due for payment (or receipt) at different times Operating exposure does not apply to defined
16、 amounts at all the impact of exchange rate changes on revenues can only be estimated,DEFINING CONTRACTUAL EXPOSURE,A UK firm is owed (say) $1000 and the exchange rate changes from 0.5 to 0.48 to the US$ Exposure is defined as unexpected change in domestic currency financial position divided by unex
17、pected change in exchange rate. That is: 500 - 480/0.5 - 0.48 $1000 Exposure is therefore an amount of foreign currency,THE COSTS OF EXPOSURE,The firm is owed $ so this change in value represents a loss. The cost of exposure is: 500 - 480 = $10000.5 - 0.48 Generally, therefore, Cost of exposure = NP
18、F (S0 S1) Thus, if the foreign currency depreciates the cost of a net long position is positive,HEDGING CONTRACTUAL EXPOSURE (I),For a single outstanding amount, a forward or futures hedge would be sufficient. If we must pay $1000 in 12 months, we could buy the currency forward as discussed last wee
19、k But what about several amounts at different maturities? Covering each transaction with a sequence of forward hedges is comparatively expensive. What can be done?:,HEDGING CONTRACTUAL EXPOSURE (II),If interest rates are static, a net present value hedge is possible. Say we must pay three separate a
20、mounts of in each of the next three years: NPV = 1/(1+r) + 2/(1+r)2 + 3/(1+r)3 We could take out a loan equivalent to this amount to make immediately a deposit. This would yield the necessary payments and our loan would be in - currency exposure would have been removed,HEDGING CONTRACTUAL EXPOSURE (
21、III),But, we also face interest rate uncertainty. A fall in interest rates would leave us short of when our payments needed to be made Forward (interest) rate agreements can help in this situation Consider an example:,FORWARD INTEREST RATES,The problem of multiple exposure as at Year 0In Year 0, we
22、could commit to a forward sale of 200 + the NPV of 150 as at end Year 1 the NPV of the 100 debt as at end Year 1 We would leave enough on deposit to pay the Year2 amount and the Year 3 receipt would pay off remaining borrowings But what interest rate applies to Years 1-2 and Years 2-3?,FORWARD RATE
23、AGREEMENT,Given a term structure of interest rates in Year t, we can compute the forward interest rate for future time periods: (1+rtfwd,T1,T2) (1+rt,T1) = (1+rt,T2)2 where rt,T1 is the (quoted) interest rate for the period t,T1 and rt,T2 is the (quoted) annual interest rate for the longer period t,
24、T2. That is:,FORWARD RATE AGREEMENTS,These permit the interest rate for a deposit or loan made at some time in the future to be fixed today FRAs are cash-settled at the time the deposit or loan is made In Year 0 we could commit to a FRA, fixing our borrowing cost over 2 years (from end Year 1: the N
25、PV of 150) and another FRA to fix interest on a 12-month deposit to pay the 100 in Year 2,OPERATING EXPOSURE (I),Firms are exposed in their current and future operations when exchange rates fluctuate (export markets, import supplies and competition) The definition of operating exposure is analogous
26、to that of contractual exposure: = Total unexpected change in operational cash flows in home currency/unexpected exchange rate change,OPERATING EXPOSURE (II),A firm might try natural hedges (for example, producing in the customer country) Alternatively, a regression approach might be tried, perhaps
27、using past data or future rate scenarios : VT(i) = aT + bTST(i) + eT(i) Note that b must be an amount of foreign currency with S defined as domestic currency per unit of foreign currency,OPERATING EXPOSURE (III),Operating exposure (b) can be positive or negative reflecting that we are long or short
28、in foreign currency by our operations Each year we could carry out an offsetting forward hedge (selling $ forward if we are long and vice versa if we are short),OPERATING EXPOSURE: FORDS VIEW,“The U.S. dollar has depreciated against most major currencies since 2002. This created downward margin pres
29、sure on auto manufacturers that have U.S. dollar revenue with foreign currency cost. Because we produce vehicles in Europe (e.g., Jaguar, Land Rover, Aston Martin and Volvo models) for sale in the United States and produce components in Europe (e.g., engines) for use in some of our North American ve
30、hicles, we experienced margin pressure. - We, like many other automotive manufacturers with sales in the United States, are not always able to price for depreciation of the U.S. dollar due to the extremely competitive pricing environment in the United States.” (Annual Report, 2006, emphasis added),F
31、ORD: NET HEDGE POSITIONS,The net fair value of financial instruments with exposure to cash flow foreign currency risk was an asset of $705 million as of December 31, 2006 compared to a net fair value liability of $421 million as of December 31, 2005. The increase in fair value primarily reflects mar
32、k-to-market adjustments resulting from the weakening of the U.S. dollar against the euro, the British pound and the Swedish krona.,The potential decrease in fair value for such financial instruments, assuming a 10% adverse change in quoted foreign currency exchange rates, would be $2.1 billion and $1.6 billion at December 31, 2006 and 2005, respectively.,So, this suggests that firms undertake major hedging positions, despite the argument that shareholders may prefer them not to. As we have seen in this session, one reason will be that exposure is difficult to gauge even for management,
