1. “Wide German Protests Planned Today in Dispute on Sick Pay” (New York Times, 10-24-96) u u “IG Metall, Germany’s largest union, said today that big rallies were planned nationwide on Thursday to protest possible cuts in sick pay, after the collapse of talks with employers aimed at resolving the matter.”

2. “Wide German Protests Planned Today in Dispute on Sick Pay” (New York Times, 10-24-96) u u “Given German tradition, it is difficult to see companies in one industry having many different policies.” Wages and labor policy in Germany have traditionally been settled through industry-wide contracts, not company by company.

3. “Wide German Protests Planned Today in Dispute on Sick Pay” (New York Times, 10-24-96) u u German industry wants to reduce sick-pay coverage to 80 percent of base wages, in line with a new legal minimum passed last month. Until now, sick pay has been 100 percent of wages plus average overtime.

4. “Wide German Protests Planned Today in Dispute on Sick Pay” (New York Times, 10-24-96) u u Days after Parliament passed the legislation on Sept. 13, Daimler- Benz announced that it would cut sick pay for its 220,000 German employees. A number of large companies followed with similar announcements.

5. “Sweden’s cradle-to-grave welfare starts to get ill” [Intl. Herald Tribune, 9-25-02] u u “…one in 20 Swedish workers were on sick leave for more than a week last year, double the European Union average, and that paid sick leave averaged nearly 25 days, up from 14 days in 1998.”

6. “Sweden’s cradle-to-grave welfare starts to get ill” [Intl. Herald Tribune, 9-25-02] u u “An average of 430,000 Swedish employees, 10 percent of the country’s work force is on sick leave at any given time.”

7. “Sweden’s cradle-to-grave welfare starts to get ill” [Intl. Herald Tribune, 9-25-02] u u “The government pays a benefit equal to 80 percent of a person’s salary during sick leave, no matter how long, and an additional 10 percent in what is called “contract insurance” for the first three months.”

8. Average number of days a Swedish worker is on sick leave

9. Measuring and Managing Translation and Transaction Exposure [Shapiro: Chapter 9]

10. Problems: Chapter 10 u 10.2

11. Foreign Exchange Exposure u u Accounting Exposure u u Transaction Exposure u u Operating Exposure

12. Accounting Exposure [Terminology] u u “Exposure” - need to convert financial statements of foreign operations from local currency to the home currency. u u “Translation” - restatement of accounts due to exchange rate changes.

13. Accounting Exposure [Terminology] u u “Translation Exposure” - u u Difference between exposed assets and exposed liabilities u u Which assets & liabilities are exposed? u u When should gains and losses be recognized on the income statement?

14. Transaction Exposure u u “… results from transactions that give rise to known, contractually binding future foreign currency-denominated cash inflows or outflows.”

15. Operating Exposure u u “… measures the extent to which currency fluctuations can alter a company’s future operating cash flows.”

16. Translation Methods u u Current / Noncurrent u u Monetary / Nonmonetary u u Temporal (FASB 8) u u Current Rate (FASB 52)

17. Current Rate Method u u All balance sheet and income statement items are translated at the current rate

18. Current Rate Method u u If assets > liabilities: – – devaluation = translation loss – – revaluation = translation gain u u If assets < liabilities: – – devaluation = translation gain – – revaluation = translation loss

19. FASB No. 52 (1981) u u Replaced FASB No. 8 (1976) u u Required current rate method for assets and liabilities u u Income Statement: – – exchange rate when items recognized – – weighted average rate for the period

20. FASB No. 52 u u Gains and Losses: – – generally bypass income statement – – accumulate on balance sheet in a separate equity account – – account title: “cumulative translation adjustment”

21. FASB No. 52 u u Functional vs. reporting currency u u “Functional” - primary economic environment u u “Reporting” - parent firm’s financial statements

22. Shapiro: Problem 10.2 u u Rolls-Royce: u u A/R = $1.5 Billion u u A/P = $740 million u u Borrowings of $600 million u u Current spot rate = $1.5128/£

23. Shapiro: Problem 10.2 u u What is Rolls-Royce dollar translation exposure in dollar terms? In Pound terms? u u $1.5 Bil. - $740 -$600 = $160 u u $160 / 1.5128 = £105.76

24. Shapiro: Problem 10.2 u u £ appreciates to $1.7642 / £ u u $160 / 1.7642 = £90.69 u u £90.69 - £105.76 = -£15.07

25. Hedging u u “... establishing an offsetting currency position... u u... whatever is lost or gained on the original currency exposure... u u is exactly offset by a corresponding foreign exchange gain or loss... u u on the currency hedge.”

26. Hedging u u “Regardless of what happens to the future exchange rate... u u hedging locks in a dollar (home currency) value for the currency exposure.”

27. Managing Transaction Exposure u u Which exposures to manage? u u Those that are: – –large in size – –involve volatile currencies – –extend over long periods of time

28. Managing Transaction Exposure u u Which exposures to manage? u u How to manage the position? u u How much of the position to hedge? u u Which exposure-reducing techniques to employ?

29. Transaction Exposure u u Committed to a foreign currency- denominated transaction u u Future foreign currency cash inflow or outflow u u Risk: exchange rate may vary u u Hedge: offsetting cash flows

30. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting u u Pricing decisions u u Exposure netting u u Currency risk sharing u u Currency collars u u Currency options

31. General Electric Example u u Jan. 1: contract for € 10 million u u Dec 31: payment to be received u u Current spot price: € =$1.3382 u u One-year forward: € =$1.2800 u u What are the risks to GE? u u How would you manage those risks?

32. Managing Transaction Exposure u u Forward market hedge: – – if long, sell currency forward – – if short, buy currency forward u u Fix the dollar value of future foreign currency cash flow

33. GE Forward Market Hedge Spot Rate (12/31)OriginalReceivable Gain (Loss) On Contract Total Cash Flow ($) = $1.3382 € = $1.338213,382,000(582,000)12,800,000

34. GE Forward Market Hedge Spot Rate (12/31)OriginalReceivable Gain (Loss) On Contract Total Cash Flow ($) = $1.3382 € = $1.338213,382,000(582,000)12,800,000 = $1.280 € = $1.28012,800,000012,800,000

35. GE Forward Market Hedge Spot Rate (12/31)OriginalReceivable Gain (Loss) On Contract Total Cash Flow ($) = $1.338 € = $1.33813,382,000(582,000)12,800,000 = $1.280 € = $1.28012,800,000012,800,000 = $1.250 € = $1.25012,500,000300,00012,800,000

36. GE Forward Market Hedge Spot Rate (12/31)OriginalReceivable Gain (Loss) On Contract Total Cash Flow ($) = $1.338 € = $1.33813,382,000(582,000)12,800,000 = $1.280 € = $1.28012,800,000012,800,000 = $1.250 € = $1.25012,500,000300,00012,800,000 = $1.400 € = $1.400 14,000,000(1,200,000)12,800,000

37. Managing Transaction Exposure u u Forward market hedge u u Money market hedge

38. Money Market Hedge u u Simultaneous borrowing and lending in... u u two different currencies to... u u lock in the dollar value of a future foreign currency cash flow.

39. Money Market Hedge u € interest rate = 15% u $US interest rate = 10% u GE borrows € 8.70 (10/1.15) million for one year u Convert € into $11.64 million (8.7 X 1.3382)

40. Money Market Hedge u u Invest $11.64 million for one year @ 10% u u On 12/31, GE receives $11.64 x 1.10 = $12.8 million u u GE collects its receivable from Lufthansa: € 10 million u u GE repays the € 10 million it owes (€ 8.7 x 1.15)

41. GE Money Market Hedge Spot Rate (12/31)OriginalReceivable Gain (Loss) On Hedge Total Cash Flow ($) = $1.338 € = $1.33813,382,000(582,000)12,800,000 = $1.280 € = $1.28012,800,000012,800,000 = $1.250 € = $1.25012,500,000300,00012,800,000 = $1.400 € = $1.400 14,000,000(1,200,000)12,800,000

42. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting

43. Risk Shifting u u Price transaction in dollars u u Doesn’t eliminate currency risk u u Shifts it from GE to Lufthansa u u Zero-sum game

44. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting u u Pricing decisions

45. Pricing Decisions u u € 10,000,000 X $1.3382 = $13,382,000 u u What is the “real worth” of the contract with Lufthansa? Why? u u € 10,000,000 X $1.28 = $12,800,000 u u $13,382,000 / 1.28 = € 10,454,688

46. Pricing Decisions u u “The general rule on credit sales overseas is to convert between the foreign currency price and the dollar price by using the forward rate, not the spot rate.”

47. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting u u Pricing decisions u u Exposure netting

48. Exposure Netting u u “...the net gain or loss on the entire currency exposure portfolio is what matters, rather than the gain or loss on any individual monetary unit.”

49. Exposure Netting u u Portfolio approach to hedging u u Portfolio risk less than the sum of individual risk positions

50. Exposure Netting [Possible outcomes]   Offset long and short positions in the same currency   Offset long and short positions in positively correlated currencies   Offset long (or short) positions in negatively correlated currencies

51. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting u u Pricing decisions u u Exposure netting u u Currency risk sharing

52. Currency Risk Sharing u u Imbedded hedge contract u u Price adjustment clause u u Base price adjusted for certain exchange rate changes u u Risk is shared beyond “neutral zone”

53. Currency Risk Sharing u u Base rate: € 1 = $1.33 u u Neutral zone: $1.30 - $1.36 u u What happens at € 1 = $1.22? u u Rate used = $1.29 : € 1 u u $1.29 = ($1.33 – (.08 / 2)) u u € 10,000,000 X 1.29 = $12,900,000 u u $12,900,000 ÷ $1.22 = € 10,573,770

54. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting u u Pricing decisions u u Exposure netting u u Currency risk sharing u u Currency collars

55. Currency Collars [“Range Forward”] u u GE accepts some but not all risk u u GE buys protection outside a range u € u Range: € = $1.28 - $1.38 u u If e 1 < $1.28, then RF = $1.28 u u If $1.28 ≤ e 1 ≤ $1.38, then RF = e 1 u u If e 1 > $1.38, then RF =$1.38

56. Managing Transaction Exposure u u Forward market hedge u u Money market hedge u u Risk shifting u u Pricing decisions u u Exposure netting u u Currency risk sharing u u Currency collars u u Foreign currency options

57. Foreign Currency Options u Uncertain foreign currency flows u Example: competitive bid contract u GE buys a € 10 million put option ($1.28/€) for $100,000 u GE loses bid; maximum loss = $100,000 u GE wins bid; e 1 > $1.28; let option expire, sell at spot

58. Managing Translation Exposure u u Adjusting Fund Flows

59. Basic Strategy for Hedging Translation Exposure

64. AssetsLiabilities Hard Currencies (Likely to Appreciate) IncreaseDecrease Soft Currencies (Likely to Depreciate) DecreaseIncrease