Lecture 12: Managing Foreign Exchange Exposure with Operational Hedges A discussion of the various operational arrangements which global firms and global investors can use when managing open foreign exchange positions

Where is this and Why is it in the News this Week?

November 1, 2011 Greek Prime Minister George Papandreou’s unexpected announcement that he was calling for a referendum to approve the Greek bailout.  A few days after the markets’ thought this issue had been settled. What do you think this did to the global financial market’s aversion for risk? How do you think specific financial market’s reacted?  Stock Markets?  Foreign Exchange Markets?  Spreads in Bond Markets?  Credit Default Swap Markets?

Stock Markets: Tuesday, November 1, 2011 DJIA: (-2.48%) FTSE 100: (-2.21%) CAC 40: (-5.38%) DAX: (-5.00%) Athens Index: (-6.92%) Nikkei 225: (-2.21%)*  *Wednesday, November 2

Greek Credit Default Swaps

Hedging Known Future Cash Flows In the previous lecture, the hedging techniques we discussed (forwards, options, money market hedges) are most appropriate for covering transaction exposure.  Transaction exposures have known foreign currency cash flows and thus they are easy to hedge with financial contracts. The majority of transaction exposure risk results from receivables (payables) from exports (imports) contracts and repatriation of dividends.  Usually, the time frame for these committed transactions (the time between contracting and payment) is relatively short. However, it can in some cases reach several years, where deliveries are committed a long time in advance (forward sales of airplanes or building contracts).

Dealing with Transaction Exposure Through Operational Hedges While global companies can manage their transaction exposures with financial hedges, they can also utilize operational hedges.  Operational hedges refers to organizational strategies that firms use to deal with currency exposure. With respect to transaction exposure, potential operational techniques which are available include: Risk Shifting: Invoicing overseas purchases and sales in home currency. Netting: Hedged net amounts of transaction exposures. Leading (speeding up) and Lagging (slowing down) payments in response to changes in exchange rates.

Operational Hedging of Transaction Exposures: Risk Shifting, Home Currency Invoicing, Data

Operational Hedging: Netting Large multinational firms may need to manage the exchange rate risk associated with several different currencies. The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately. Additionally, hedging individual currencies could time consuming and expensive.

Operational Hedging: Leading and Lagging Payments Refers to the timing of when a firm with an FX exposed position will initiate foreign currency payments (or specifically when the firm has an open short position). Leading (“speeding-up) Payments.  Lead payments when home currency is weakening (i.e., foreign currency is strengthening). Lagging (“slowing down/delaying”) Payments  Lag payments when home currency is strengthening (i.e., foreign currency is weakening).

Hedging Unknown Cash Flows In the previous examples we were dealing with known foreign currency cash flows. However, economic exposures do not provide the firm with this “known” cash flow information.  Economic exposure refers to the impact of exchange rate movements on the home currency value of uncertain future cash flows. Global firm: Uncertain future cash flows relate to the firm’s costs (e.g., raw materials, labor costs, etc.) and output prices and sales (e.g., product prices). Global investor: Uncertain future cash flows relate to the future dividends and changes in market prices.

Channels of Economic Exposure for Firms (1) Direct effects of FX changes result from a company’s actual involvement in foreign markets. Impact on the home currency equivalents of cost and revenue streams in overseas markets. (2) Indirect effects refer to FX induced changes in foreign company competition in a company’s domestic market. Foreign competitors exporting into company’s home country (FX induced change in competitive position of foreign exporters). Foreign companies setting up FDI activities in company’s home country. Both (1) and (2) driven by globalization.

The Globalization of Business Firms: 2010 Data for S&P 500 Firms

Data for Selected S&P 500 Companies, Sorted by Percentage Point Increase

The Global Reach of Selected U.S. Companies, 2010 Data Wal-Mart. Total revenue: $420 billion, 26% from overseas; nearly 5,000 stores in 14 foreign countries, including China, India, the U.K., and Latin America. Bank of America. Total revenue: $134 billion, 20% from overseas. Europe is biggest market. Ford. Total revenue: $129 billion, 51% from overseas; Canada and Europe. Boeing. Total revenue: $64 billion in revenue, 41% from overseas; Europe, Asia, and the Middle East. Intel. Total revenue: $44 billion, 85% from overseas. Taiwan, followed by China. Amazon. Total revenue: $34 billion, 45% from overseas; Canada, several European countries, Japan, and China. McDonald's. Total revenue: $24 billion, 66% from overseas; Europe and Asia. Nike. Total revenue: $21 billion, 50% from overseas; North America, Europe and China.

McDonald’s, 2010 Annual Report

Excluding FX Reports Revenues using Average of Previous Year’s Exchange Rate: Note: Excluding F/X reports sales based on the previous year’s exchange rate

Dealing with Economic Exposure Recall that economic exposure is long term and involves u nknown future cash flows. What can the firm do to manage this economic exposure?  Firm can employ an “operational hedge.”  One such strategy involves global diversification of production and/or sales markets to produce natural hedges for the firm’s unknown foreign exchange exposures.  As long as currencies associated with these different markets do not move in the same direction, the firm can “stabilize” its overall home currency equivalent cash flow.

Global Diversification of Sales Subway:  35,561 restaurants in 98 countries  Visit: rld.aspx rld.aspx McDonald’s (2010):  32,737 restaurants in 117 countries.  Revenues by segment

Balancing Costs and Revenues: Restructuring to Reduce Economic Exposure Restructuring involves shifting the sources of costs or revenues to other locations in order to match cash inflows and outflows in foreign currencies. Restructuring Decisions:  Should the firm attempt to increase or decrease sales in specific countries (i.e., revenues)?  Should the firm attempt to increase or decrease dependency on foreign suppliers (i.e., cost)?  Should the firm establish or eliminate production facilities in foreign markets (i.e., costs)?  Should the firm increase or decrease its level of foreign currency denominated debt (i.e., costs)?

Nike’s Global Diversification of Manufacturing for Footwear, By Country, 2005 Country Percent China36 Vietnam26 Indonesia22 Thailand15 Big Four99 Others: Argentina, Brazil, India, Mexico, and South Africa Source: Nike, 2005 Annual report

Nike’s Global Diversification of Sales by International Region (U.S. Dollars in Millions), 2005 MarketRevenue Percent United States $5, % EMEA 4, % Asia Pacific 1, % Americas % Other 1, % Total $13,739.7 Note: EMEA is Europe, Middle East and Africa

Is Nike a Balanced Firm? Foreign Currency Costs concentrated in:  Yuan, Dong, Rupiah, Baht Foreign Currency Revenues concentrated in:  Euros, Pounds, Yen What if the cost currencies strengthen (against the USD) and the revenue currencies weaken (against the USD)?  Negative impact on USD profits  Possible solution: Adjust prices in revenue countries. What if the cost currencies weaken and the revenue currencies strengthen?  Positive impact on USD profits How could Nike balance its overseas activities?

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure Step 1: Determining Specific Foreign Exchange Exposures  What type of exposure are you dealing with?  By currency and net amounts (i.e., long minus short positions)  Are the net amounts worth hedging? If they are go to Step 2; if not, no need to hedge. Step 2: Forecasting Exchange Rates  Determining the potential for and possible range of currency movements. Important to select the appropriate forecasting model. A “range” of forecasts is probably appropriate here (i.e., forecasts under various assumptions) How comfortable are you with your forecast? If comfortable, go to Step 3. If not, hedge.

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure Step 3: Assessing the Impact of Forecasted Exchange Rates on Company’s Home Currency Equivalents (What is the Measured Risk?).  Impact on earnings, cash flow, liabilities (positive or negative?)  Go to Step 4 Step 4: Deciding Whether to Hedge or Not  Determine whether the anticipated impact of the forecasted exchange rate change merits the need to hedge.  Perhaps the estimated negative impact on home currency equivalent is so small as not to be of a concern.  But, if impact is unacceptable, go to Step 5  Or, perhaps the firm feels it can benefit from its exposure.  If this is the case, go to Step 6

A Comprehensive Approach or Assessing and Managing Foreign Exchange Exposure Step 5: Selecting the Appropriate Hedging Instruments if Risk is Unacceptable.  Consider: Which hedge is appropriate for the type of exposure?  Financial and/or operational Firm’s familiarity and comfort level with types of hedging strategies. Review the cost involved with different financial contracts. Step 6: Selecting the Appropriate Strategy to Position the Firm to Take Advantage of a Favorable Exchange Rate Change.  Consider: Partial “open” position versus complete “open” position. Which financial contract will achieve your objective?

Appendix 1 The following slides illustrate how companies deal with and report translation exposures

Translation Exposure Translation exposure is commonly referred to as “accounting exposure” b ecause it refers to the impact of exchange rate changes on the consolidated financial reports of a global firm.  These include impacts on assets and liabilities and profits which have been acquired or occurred in the past. Why do global firms need to consolidate statements? To report financial results to their shareholders. To report income to taxing authorities.  The accounting approach for consolidating financial statements depends upon the accounting requirements of the firm’s headquartered country. The U.S. is governed by FASB 52.  Balance sheet and income statement gains or losses associated with the consolidation process show up in the shareholders’ equity account

Nike’s 2005 Financial Statement Summary Consolidated Balance Sheet, Fiscal 2005 (millions of U.S. dollars) Assets$8,793.6 Liabilities$3,149.4 Shareholders’ Equity $5,644.2  Of which foreign currency translation adjustments were: 70.1* *This is a cumulative amount (e.g., in 2004 it was $27.5