Managing the Risks of Multinational Operations Part III Managing the Risks of Multinational Operations Chapter 8 Multinational Treasury Management Chapter 9 Managing Transaction exposure to Currency Risk Chapter 10 Managing Operating Exposure Chapter 11 Managing Translation Exposure and Accounting for Financial Transactions

Multinational Treasury Management Chapter 8 Multinational Treasury Management Learning objectives  Setting financial goals and strategies  Managing operations – Managing international trade – Financing international trade – Managing the firm’s cash flows  Currency risk management – Currency exposures and forward hedges – Implementing a risk management policy

8.1 Determining Financial Goals and Strategies Functions of the modern treasury Treasury serves as a corporate bank Determine the firm’s overall financial goals. Manage risks of domestic & international trade. Arrange financing for domestic & international trade. Consolidate and manage financial flows. Identify, measure & manage financial price risks.

8.1 Determining Financial Goals and Strategies Setting financial goals & strategies Identify the firm’s core competencies and potential growth opportunities. Evaluate the business environment within which the firm operates. Formulate a strategic plan for achieving sustainable competitive advantages. Develop processes for implementing the strategic business plan.

If something can go wrong, it will. 8.2 Managing International Trade “Murphy’s Law” applies to international business If something can go wrong, it will.

8.2 Managing International Trade The problems of international trade Importers must assure timely delivery of goods. Exporters must assure timely payment. Geographic and cultural distances usually are greater than in domestic trade, and disputes can span several legal jurisdictions. Goods or services Importer Payment Exporter

8.2 Managing International Trade Managing the risks of international shipments Trade documentation reduces exposures to operating and financial risks. - Documentation can include an invoice, packing list, certificates of origin, inspection and insurance certificates, import and export licenses, dock and warehouse receipts, etc. Freight forwarders (shippers) coordinate the logistics of trade.

8.3 Payment Methods and Financing for International Trade International payment methods Cash in advance is convenient for the seller: Buyer provides financing for the seller. Open account is convenient for the buyer: Seller delivers goods and then bills the buyer. Receivables can be discounted or factored; long-term receivables can be sold to a forfaiter. Drafts or letters of credit (L/C): Drafts include trade and banker’s acceptances. These are the most common payment methods for international transactions.

8.3 Payment Methods and Financing for International Trade The risks of international payment methods Seller’s Buyer’s Payment mechanism perspective perspective Open account Highest Most risk advantageous Drafts & letters of credit   Cash in advance Lowest Least

8.3 Payment Methods and Financing for International Trade International payment methods Drafts—in a variety of forms Sight drafts are payable on demand. Time drafts are payable on a specified date. Trade acceptances are drawn on and “accepted” by the buyer. Banker’s acceptances have been “accepted” by a commercial bank. Trade and banker’s acceptances can be “discounted” (sold at a discount) in most countries.

8.3 Payment Methods and Financing for International Trade International payment methods The letter of credit A letter of credit issued by the buyer’s bank guarantees payment upon receipt of the specified trade documentation. In some countries, letters of credit can be discounted (sold at a discount) or used as collateral for new borrowings. Other countries do not follow this practice.

8.3 Payment Methods and Financing for International Trade Financing international trade Exporter’s Perspective Importer’s Perspective Open Accounts receivable can Financing is provided account be discounted (sold). by the seller. Trade Trade acceptances can In a time draft, seller acceptance be discounted (sold). extends credit to buyer. Banker’s Banker’s acceptances can The buyer’s bank charges acceptance discounted (sold). a fee for this service. Letter of In some countries, L/Cs L/Cs tie up the buyer’s credit can be discounted (sold) borrowing capacity. (L/C) or used as collateral. Cash in Financing is provided Transaction not secured, advance by buyer. & provides no financing.

8.3 Payment Methods and Financing for International Trade The all-in cost of trade finance All-in cost is the internal rate of return of the incremental cash flows associated with a financing alternative. Periodic all-in cost = (Forgone cash flow) / (Discounted value) – 1 Discounted value Forgone cash flow

8.3 Payment Methods and Financing for International Trade All-in cost example A ½ percent acceptance fee is charged on a €1 million banker’s acceptance that is due in three months, which is sold at a discount of 1 percent. Solution: The 0.5% fee is deducted at maturity, so the acceptance returns €995,000 at maturity. This acceptance can be sold today for €995,000/(1.01) = €985,149. All-in cost is then (€1,000,000/€985,149) – 1 = 1.51 percent per 3 months, or = (1.0151)4 – 1 = 6.17 percent +€985,149 3 months –€1,000,000

8.3 Payment Methods and Financing for International Trade International payment methods Countertrade is an exchange of goods or services that does not involve cash. Counterpurchase is countertrade in which one contract is conditional upon fulfillment of another. Offsets refer to countertrade that is required as a condition of trade. Delivery and payment terms are negotiated. Goods or services Importer Payment Exporter

8.4 Managing Cash Flows Managing multinational cash flows Cash management Multinational netting Chapter 9 Forecasting the firm’s need for funds Chapter 8 Relationship management between the firm’s operating divisions and external partners Transfer pricing Chapter 15 Credit management Chapter 8 Determination of hurdle rates Chapter 14

8.5 Managing Exposures to Currency Risk Types of exposure to currency risk Economic exposure Change in the value of all future cash flows from unexpected changes in exchange rates. Transaction exposure Change in the value of contractual cash flows from unexpected changes in fx rates. Operating exposure Change in the value of noncontractual cash flows from unexpected changes in fx rates.

8.5 Managing Exposures to Currency Risk Types of exposure to currency risk Economic exposure Change in the value of all future cash flows from unexpected changes in exchange rates Translation (accounting) exposure Change in financial statements from unexpected changes in exchange rates

8.5 Managing Exposures to Currency Risk Economic exposure Monetary assets Monetary liabilities Real assets Common equity Economic exposure = Change in the value of all future cash flows from unexpected changes in exchange rates = Transaction exposure + Operating exposure Exposure of common equity = Net monetary exposure + Operating exposure

8.5 Managing Exposures to Currency Risk The continuum of currency risk exposures Consider the FX risk exposures of a cell phone network in India built by U.S.-based Verizon Communications… Operating exposures Transaction exposures (Nonmonetary or noncontractual cash flows) (Monetary contractual cash flows) - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - > - - - - - - - - - - - - - - - - - - - - - - - - - > Verizon The Indian Revenues flow Sales in India Royalties, invests in a subsidiary into the business, generate dividends, or cell phone opens. Initial depending on receivables management fees system in sales are demand in denominated are repatriated India. made. India. in rupees. to Verizon.

8.5 Managing Exposures to Currency Risk A survey of U.S. corporate treasurers “Managing ______ is important.” Mean score Transaction exposure 1.4 Operating exposure 1.8 Translation exposure 2.4 Key: 1 = strongly agree 3 = neutral 5 = strongly disagree Source: Jesswein, Kwok, and Folks, “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance (1995).

8.5 Managing Exposures to Currency Risk For U.S. corporate treasurers Transaction exposure is viewed by U.S. corporate treasurers as the most important currency risk exposure.

8.5 Managing Exposures to Currency Risk A 5-step currency risk management program Anticipating and responding to changes in foreign exchange rates: Identify the currencies to which the firm is exposed and estimate the distributions of future exchange rates in these currencies. Estimate the sensitivity of revenues and expenses. Determine the desirability of hedging. Evaluate hedging alternatives. Monitor the position and reevaluate.

8.5 Managing Exposures to Currency Risk Exchange rate forecasting Market-based forecasts Forward parity E[Std/f] = Ftd/f Relative purchasing power parity E[Std/f] = S0d/f [(1+id)/(1+if)]t with equal real interest rates E[Std/f] = S0d/f [(1+pd)/(1+pf)]t

8.5 Managing Exposures to Currency Risk Exchange rate forecasting Model-based forecasts Technical analysis uses the recent history of exchange rates to predict exchange rates. Fundamental analysis uses macroeconomic data to predict exchange rates.

8.5 Managing Exposures to Currency Risk Risk management should complement the overall business plan Risk management policy Passive management Active management Static approach Dynamic approach Technical forecasts Fundamental forecasts

The Rationale for Hedging Currency Risk Appendix 8-A The Rationale for Hedging Currency Risk Firm value V = ∑t E[CFt] / (1+it)t If hedging is to increase firm value, then it must either increase expected future cash flows or decrease the discount rate in a way that cannot be replicated by investors. Hedging matters when there are Costs of financial distress Agency conflicts Other asymmetries

Appendix 8-A Costs of Financial Distress Equity as a call option Promised payment to bondholders is $1,000. Firm value will be either $750 or $1,750 with equal probability.

Appendix 8-A Costs of Financial Distress Payoffs with no costs of financial distress Unhedged firm value is either $750 or $1,750 E[VBONDS ] = (½)($750) + (½)($1,000) = $875 + E[VSTOCK ] = (½) ($0) + (½) ($750) = $375 E[VFIRM ] = (½)($750) + (½)($1,750) = $1,250 Hedged firm value is $1,250 for certain E[VBONDS ] = $1,000 + E[VSTOCK ] = $250 E[VFIRM ] = $1,250

Appendix 8-A Costs of Financial Distress Without costs of financial distress: A zero-sum game In the absence of a market imperfection such as the costs of financial distress, hedging does not create value for the firm. Risk shifting When there is debt outstanding, hedging transfers wealth from shareholders to bondholders. The benefits of a hedging policy Instituting a hedging plan prior to borrowing can benefit shareholders by reducing borrowing costs.

Appendix 8-A Costs of Financial Distress Equity call option with direct bankruptcy costs Suppose the firm must pay $500 in bankruptcy

Appendix 8-A Costs of Financial Distress Payoffs with direct bankruptcy costs Unhedged firm value is either $750 or $1,750 E[VBONDS ] = (½)($250) + (½)($1,000) = $625 + E[VSTOCK ] = (½) ($0) + (½) ($750) = $375 E[VFIRM ] = (½)($250) + (½)($1,750) = $1,000 Hedged firm value is $1,250 for certain E[VBONDS ] = $1,000 + E[VSTOCK ] = $250 E[VFIRM ] = $1,250

Appendix 8-A Costs of Financial Distress Hedging with direct bankruptcy costs Hedging can preserve firm value when there are direct bankruptcy costs. Equity wins if the gain from hedging is larger than the wealth shift to debt.

Appendix 8-A Costs of Financial Distress Direct and indirect costs $500 direct costs if bankruptcy occurs Changes debt’s payout if bankruptcy occurs $250 indirect costs incurred prior to bankruptcy Changes firm value prior to bankruptcy $750 $1,750 Firm value before indirect costs of financial distress $500 $1,500 Firm value after indirect costs of financial distress

Appendix 8-A Costs of Financial Distress The equity call option with direct and indirect costs of financial distress

Appendix 8-A Costs of Financial Distress Payoffs with direct and indirect costs of financial distress Unhedged firm value is either $500 or $1,500 E[VBONDS ] = (½)($0) + (½)($1,000) = $500 + E[VSTOCK ] = (½)($0) + (½) ($500) = $250 E[VFIRM ] = (½)($0) + (½)($1,500) = $750 Hedged firm value is $1,250 for certain E[VBONDS ] = $1,000 + E[VSTOCK ] = $250 E[VFIRM ] = $1,250

Appendix 8-A Costs of Financial Distress and the consequences of hedging Hedging can increase expected cash flows by reducing the costs of financial distress. Hedging can reduce debt’s required return and hence the firm’s overall cost of capital. Equity may or may not benefit, depending on whether the increase in firm value is more or less than the value transfer to debt from the reduction in risk.

Appendix 8-A Agency Costs Agency costs & the consequences of hedging Agency costs are the costs of ensuring that managers act in the interests of other stakeholders. Hedging can increase the value of the firm to shareholders by aligning managements’ incentives with shareholders’ objectives and thereby reducing agency costs.