1. International Finance Chapters 12, 13, and 14 Foreign Exchange Exposure

2. FOREIGN CURRENCY EXPOSURE Definition: As firms operate on a global basis, they are involved in currencies other than their home currency. –From selling products overseas Exporting to a physical presence –From sourcing products overseas Importing to a physical presence –From financing and investing overseas

3. Exposure is Complex Driven by the composition of a firm’s –Global sales (how concentrated; how diverse) Issue: Is there a “natural” hedge because the firm operates in many diverse economies? Or is the firm “over-exposed” in limited markets? –Global sourcing (where does the firm source its final sales?) Sourcing components overseas in weak currency markets can offset the impact of selling final product in weak currency markets! –Allows firm to lower prices in final sales countries. –Also allows firms to remain competitive at home.

4. Foreign Exchange Risk The foreign currency exposures will subject the firm to foreign exchange risk: –Adverse changes in exchange rates can adversely affect the firm: Cash flows Profits (and profit margins) Competitive position (at home and abroad) Home currency value of foreign currency liabilities and assets

5. Foreign Exchange Management Refers to the techniques which a firm may use to manage its foreign exchange exposure. –Hopes to reduce (offset) the potential risk associated with these exposures. Two general types of risk management techniques: –Financial hedges –Operational (firm strategic) hedged

6. Financial Hedges Financial contracts which pass the foreign exchange risk on to someone else. Allows the firm to “cover” its exposure. –Forward contracts –Future contracts –Option contracts Puts and calls on foreign currency –Insurance

7. Operational Hedges Strategic response of the firm itself to its exposure. Organizing the activities of the firm to “offset” known exposures. –Invoicing receivables. –Timing of payments. –Avoidance of high risk markets. –“Neutralizing” asset and liability structures. –Long term fixed contractual agreements with suppliers or buyers –Organizational diversity (geographic and product). –Operational flexibility (of suppliers)

8. Types of Exposures Firms face three possible types of foreign currency exposure. Economic Transaction Translation (accounting)

9. Economic Exposure The extent to which the value of the firm might be affected by “long-term” unanticipated changes in exchange rates. –Long term in nature: Firm’s cannot presently “measure” future exposures. –Unanticipated in nature: Since unanticipated, firm’s cannot use traditional (financial) hedging strategies to deal with this exposure. This exposure will affect the long term competitive position of a firm, on its long term cash flows, and on its long term value! Example: Long term FDI.

10. Measuring Economic Exposure Economic exposure has two elements: –Asset Exposure: Changes in the home currency value of overseas assets and liabilities (plant, equipment, accounts payable, loans) –Operating Exposure: Changes in the home currency value of future operating cash flows. –Impact on costs (fixed and variable) and selling prices –This changes the competitive position of the firm in global markets

11. Operating Exposure Operating Exposure is not as easily quantified as other exposures. However, it is determined by: –The structure of the markets in which the firm sources its inputs (labor and materials). Cost sensitivity! –The structure of the markets in which the firm sells its products and services. Price sensitivity!

12. Market Structure Questions the firm faces? –Are their opportunities for “exchange rate pass through.” Can the firm pass on higher costs due to exchange rate changes on through higher prices for its products? –Depends upon competitive forces! –Note: If both costs and prices are sensitive to exchange rate changes, a full pass through opportunity may exist, and the firm will face little operating exposure. Operating exposure occurs when there is an imbalance between the two!

13. Other Considerations In determining the impact of exchange rates on operating exposure, the firm should also consider: –The ability of the firm to offset the effects of exchange rate changes by adjusting its: Markets (where it is operating and selling) Product mix Sourcing

14. Managing Operating Exposure The following strategies are potentially important for managing operating exposure: –Selecting low-cost overseas production sites. “Offshore production.” –Flexibility in sourcing components. Buying components from low cost manufacturers. –Diversification of markets (selling and sourcing) Across countries and product lines. –Product differentiation (allows for exchange rate pass through). Importance of R&D investment –Financial hedging (if possible) May also be appropriate if above strategies prove too costly!

15. Transaction Exposure Variation in the domestic currency values of a firm’s contractual future foreign currency denominated cash flows resulting from changes in exchange rates. –Foreign currency cash flow is known today! Foreign currency denominated account receivable or foreign currency denominated account payable. –Home currency equivalent of foreign currency cash flow is NOT known today

16. Transaction Exposure Arises from “fixed-price” contracting in a world where exchange rates are subject to change. –Firm agreeing to accept a set payment in some foreign currency in the future! –Firm agreeing to make a set payment in some foreign currency in the future! Note: The foreign currency is a known fixed amount; the future home currency equivalent is not known.

17. Measuring Transaction Exposure Of all the exposures, transaction exposure is the probably the easiest to measure. It is represented by the amount of the contractual agreements the firm has entered into. –Accounts payable –Accounts receivable –Loans payable We can attach a foreign currency amount to these agreements!

18. Issue the Firm Faces While we can place an amount on the foreign currency contractual agreement, the issue for the firm is what will be the future home currency equivalent of that agreement? Account receivable in 1 million yen due in 30 days?

19. Hedging Since the foreign currency amount of the contractual agreement is known today, these transaction exposures can be easily hedged if the firm so chooses. –Forward market hedge –Options market hedge –Money market hedge –Swap market hedge

20. Forward Market Hedge Most popular and direct method of hedging transaction exposures. –93% of Fortune 500 firms use them (1995 survey). –Selling foreign currency forward, or –Buying foreign currency forward Forward transaction is arranged to offset contractual agreement –Offset an account payable by buying foreign currency forward. –Offset an account receivable by selling foreign currency forward.

21. Options Hedge Used by about 50% of Fortune 500 firms! Options contracts provides the holder with: –“Insurance” against unfavorable changes in the exchange rate, –The ability to take advantage of a favorable change in the exchange rate.

22. Two Basic Types of Options Call Option: –Allows the holder to call (buy) foreign currency at a price (exchange rate) set today if so desired. Used to offset a foreign currency liability. Provides the holder with an upper limit (“ceiling’) price for the foreign currency. If spot rate proves to be advantageous, the holder will not exercise the call option, but instead buy the needed foreign currency in the spot markets.

23. Two Basic Types of Options Put Option: –Allows the holder to put (sell) foreign currency at a price (exchange rate) set today if so desired. Used to offset a foreign currency receivable. Provides the holder with an lower limit (“floor’) price for the foreign currency. If spot rate proves to be advantageous, the holder will not exercise the put option, but instead sell the foreign currency in the spot markets.

24. Pro and Con of Options Advantage: –Gives firm flexibility to take advantage of a favorable change in exchange rate. Not possible with a forward. Disadvantage: –Firm pays an upfront option premium which it loses if it does not exercise the option.

25. Where does a Firm Negotiate these Contracts? Both forwards and options can be negotiated with major banks. –Bank market is individually tailored to firm’s needs. Amount of currency Timing of the hedge Standard exchange markets do exist for both hedges –Future market. Chicago Mercantile Exchange, Tokyo International Futures Exchange, Singapore International Monetary Exchange –Options markets. Chicago Mercantile Exchange, Philadelphia Stock Exchange, Singapore International Monetary Exchange

26. Web Sites Chicago Mercantile Exchange –http://www.cme.com/http://www.cme.com/ Philadelphia Stock Exchange –http://www.phlx.com/http://www.phlx.com/ Tokyo International Futures Exchange –http://www.tiffe.or.jp/http://www.tiffe.or.jp/

27. Translation Exposure The impact of exchange rate changes on the consolidated financial statements of a global firm. –Consolidation involves the translation of subsidiaries financial statements, which are denominated in local currencies, back to the home currency of the parent. –Changes in exchange rates will affect the home currency value of the subsidiary’s assets and liabilities and revenues.