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Measuring and Managing the Risk in International Financial Positions Prices and Policies Second Edition ©2001 Richard M. Levich 16  McGraw Hill / Irwin.

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Presentation on theme: "Measuring and Managing the Risk in International Financial Positions Prices and Policies Second Edition ©2001 Richard M. Levich 16  McGraw Hill / Irwin."— Presentation transcript:

1 Measuring and Managing the Risk in International Financial Positions Prices and Policies Second Edition ©2001 Richard M. Levich 16  McGraw Hill / Irwin International Financial Markets

2 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

3 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

4 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

5 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Policy Issues - Public Policymakers  Disclosure of Financial Exposure  Financial Derivatives and Corporate Hedging Policies

6 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Corporate Treasurer’s 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.

7 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Market Value of the Firm  The market value of a firm at time t (MV t ) is the summation of the firm’s cash flows (CF) over time discounted back to their present value by an appropriate discount factor (i):  Cash flows in each currency are discounted at their own appropriate interest rate and multiplied by a spot exchange rate.

8 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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: €

9 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Channels of Exposure to Foreign Exchange Risk Direct Economic Exposure Home Currency Strengthens Home Currency Weakens Sales AbroadUnfavorable Favorable Revenue worth less in home currency terms Revenue worth more Source AbroadFavorableUnfavorable Inputs cheaper in home currency terms Inputs more expensive Profits AbroadUnfavorable Favorable Profits worth lessProfits worth more

10 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Channels of Exposure to Foreign Exchange Risk Indirect Economic Exposure Home Currency Strengthens Home Currency Weakens Competitor thatUnfavorableFavorable sources abroad Competitor’s margins improve Competitor’s margins decrease Supplier thatFavorableUnfavorable sources abroad Supplier’s margins improve Supplier’s margins decrease Customer thatUnfavorableFavorable sells abroad Customer’s margins decrease Customer’s margins improve Customer thatFavorableUnfavorable sources abroad Customer’s margins improve Customer’s margins decrease

11 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Market Value of the Firm and Channels of Risk  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.

12 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Accounting Measures of 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.

13 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. U.S. Accounting Conventions 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.

14 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. U.S. Accounting Conventions 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.

15 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Economic Measures of 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.

16 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 (MV t )and the spot rate (S t ) using the equation: MV t = a + b S t + e t  The coefficient b measures the sensitivity of the market value of the firm to the exchange rate.

17 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 R 2 of the regression. R 2 measures the percentage of variation in the market value explained by the exchange rate.

18 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Regression Approach  To measure the firm’s exposure to multiple exchange rates, a multiple regression can be estimated: MV t = a + b 1 S $/€,t + b 2 S $/£,t + b 3 S $/¥,t + e t  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: CF t = a + b S t + e t

19 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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.

20 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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.

21 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Scenario Approach A O A* - 15%- 10%- 5%15%10%5% $/A$$0.5435$0.5682$0.5952$0.6250$0.6563$0.6875$ A$/$A$1.84A$1.76A$1.68A$1.60A$1.52A$1.45A$1.39 $ $ Present Value of Cash Flows (Millions) Consider the impact of a permanent 5% appreciation of the US$, holding all other factors constant. The slope measures the exposure of the firm at the initial exchange rate.

22 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Scenario Approach A O A* - 15%- 10%- 5%15%10%5% $/A$$0.5435$0.5682$0.5952$0.6250$0.6563$0.6875$ A$/$A$1.84A$1.76A$1.68A$1.60A$1.52A$1.45A$1.39 $ $ Present Value of Cash Flows (Millions) Suppose the firm can pass along part of the exchange rate change to its Australian customers. B* B The slope of BOB* is flatter than AOA* since the firm has less exposure now.

23 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 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.

24 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Arguments for 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.

25 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Arguments for 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.

26 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Arguments for 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.

27 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Strategies 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.

28 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Strategies Toward Risk Management Characteristics of Currency Exposure Suitable Financial Hedging Instruments Frequency of cash flows Single period Multiple periods Single contract (futures/options) Sets (“strips”) of contracts/swaps or present value hedge Currency dimension Single currency Multiple currencies Contracts on one currency Contracts on an index (ECU, US$) or synthetic hedge

29 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Strategies Toward Risk Management Characteristics of Currency Exposure Suitable Financial Hedging Instruments Certainty about cash flows Certain, contractual cash flows Uncertain, estimated cash flows Naïve hedge to match contract size of financial instrument and exposure Option hedge or dynamic futures hedge to match probability of cash flows

30 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Strategies Toward Risk Management  Note that a hedging strategy may offset certain risks, while leaving open or increasing other risks.

31 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Issues 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.

32 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Issues 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 (-b i ).  Otherwise, an intermediate solution may be chosen, with hedge positions in between 0 and b i.  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.

33 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Issues 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 risk- return decision criteria.

34 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Issues 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.

35 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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.

36 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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.


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