1. INTERNATIONAL FINANCE Lecture 25

2. Review – Identify its degree of transaction exposure. – Decide whether to hedge this exposure. – Choose a hedging technique if it decides to hedge part or all of the exposure. Hedging Techniques – Futures hedge, – Forward hedge, – Money market hedge, and – Currency option hedge. Source: Adopted from South-Western/ Thomson Learning 2006

3. MANAGING TRANSACTION, ECONOMIC AND TRANSLATION EXPOSURE Lecture 25

4. If the real cost of hedging is negative, then hedging is more favorable than not hedging. To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate. Then use it to develop a probability distribution for the real cost of hedging. Real Cost of Hedging

5. Nominal Cost Nominal Cost Real Cost Probability With Hedging Without Hedging of Hedging 5%$1.40 $1.30 10$1.40 $1.32 15$1.40 $1.34 20$1.40 $1.36 20$1.40 $1.38 15$1.40 $1.40 10$1.40 $1.42 5$1.40 $1.45 For each £ in payables, expected RCH =  P i  RCH i = $0.0295 The Real Cost of Hedging for Each £ in Payables

6. There is a 15% chance that the real cost of hedging will be negative. The Real Cost of Hedging for Each £ in Payables Probability

7. A money market hedge involves taking a money market position to cover a future payables or receivables position. For payables:  Borrow in the home currency (optional)  Invest in the foreign currency For receivables:  Borrow in the foreign currency  Invest in the home currency (optional) Money Market Hedge

8. If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same results as a forward hedge. This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies. Money Market Hedge

9. A currency option hedge uses currency call or put options to hedge transaction exposure. Since options need not be exercised, they can insulate a firm from adverse exchange rate movements, and yet allow the firm to benefit from favorable movements. Currency Option Hedge

10. Comparison of Hedging Techniques Hedging techniques are compared to identify the one that minimizes payables or maximizes receivables. Note that the cash flows associated with currency option hedging are not known with certainty but have to be forecasted. Several alternative currency options with different exercise prices are also usually available.

11. In general, an MNC’s hedging policy varies with the management’s degree of risk aversion. An MNC may choose to hedge most of its exposure or none of its exposure. The MNC may also choose to hedge selectively, such as hedging only when it expects the currency to move in a certain direction. Hedging Policies

12. Limitations of Hedging Some international transactions involve an uncertain amount of foreign currency, such that over hedging may result. – One solution is to hedge only the minimum known amount. Additionally, the uncertain amount may be hedged using options. In the long run, the continual short-term hedging of repeated transactions may have limited effectiveness too.

13. Hedging for Transaction Exposure in Long-Term MNCs that can accurately estimate foreign currency cash flows for several years may use long-term hedging techniques.  Long-term forward contracts, or long forwards, with maturities of up to five years or more, can be set up for very creditworthy customers.

14.  In a currency swap, two parties, with the aid of brokers, agree to exchange specified amounts of currencies on specified dates in the future.  A parallel loan, or back-to-back loan, involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified exchange rate and future date. Hedging for Transaction Exposure in Long-Term

15. Review If the real cost of hedging is negative, then hedging is more favorable than not hedging. Money Market Hedge – For payables: Borrow in the home currency – For receivables:Borrow in the foreign currency Currency Option Hedge MNCs Policies to Hedge Currency swap Parallel loan Source: Adopted from South-Western/ Thomson Learning 2006

16. Alternative Hedging Techniques Sometimes, a perfect hedge is not available (or is too expensive) to eliminate transaction exposure. To reduce exposure under such conditions, the firm can consider: – leading and lagging, – cross-hedging, or – currency diversification.

17. Leading and Lagging Leading and lagging strategies involve adjusting the timing of a payment request or disbursement to reflect expectations about future currency movements. Expediting a payment is referred to as leading, while deferring a payment is termed lagging.

18. Cross-Hedging When a currency cannot be hedged! Another currency that can be hedged and is highly correlated may be hedged instead. The stronger the positive correlation between the two currencies, the more effective the cross-hedging strategy will be.

19. Currency Diversification An MNC may reduce its exposure to exchange rate movements when it diversifies its business among numerous countries. Currency diversification is more effective when the currencies are not highly positively correlated.

20. Economic Exposure Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. Some of these affected cash flows do not require currency conversion. Even a purely domestic firm may be affected by economic exposure if it faces foreign competition in its local markets.

21. Economic exposure can be measured by assessing the sensitivity of the firm’s earnings to exchange rates. – This involves reviewing how the earnings forecast in the firm’s income statement changes in response to alternative exchange rate scenarios. In general, firms with more foreign costs than revenues tend to be unfavorably affected by stronger foreign currencies. Transaction exposure is a subset of economic exposure. But economic exposure also includes other ways in which a firm’s cash flows can be affected by exchange rate movements. Economic Exposure

22. Economic exposure can also be measured by assessing the sensitivity of the firm’s cash flows to exchange rates through regression analysis. For a single foreign currency: Economic Exposure PCF t = a 0 + a 1 e t +  t PCF t =%  in inflation-adjusted cash flows measured in the firm’s home currency over period t e t =%  in the exchange rate over period t

23. The model may be revised to handle additional currencies by including them as additional independent variables. By replacing the dependent variable (cash flows), the impact of exchange rates on the firm’s value (as measured by its stock price), earnings, exports, sales, etc. may also be assessed. Economic Exposure

24. The economic impact of currency exchange rates on us is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions, and other factors. These changes, if material, can cause us to adjust our financing and operating strategies. PepsiCo Economic Exposure

25. An MNC can determine its exposure by assessing the sensitivity of its cash inflows and outflows to various possible exchange rate scenarios. The MNC can then reduce its exposure by restructuring its operations to balance its exchange-rate-sensitive cash flows. Note that computer spreadsheets are often used to expedite the analysis.

26. Original Impact of Exchange Rate Movements on Earnings: Madison, Inc. (In Millions)

27. Economic Exposure Madison’s earnings before taxes is inversely related to the Canadian dollar’s strength, since the higher expenses more than offset the higher revenue when the Canadian dollar strengthens. Madison may reduce its exposure by increasing Canadian sales, reducing orders of Canadian materials, and borrowing less in Canadian dollars.

28. Restructuring Reduce Economic Exposure Restructuring to reduce economic exposure involves shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. The proposed structure is then evaluated by assessing the sensitivity of its cash inflows and outflows to various possible exchange rate scenarios.

29. Issues in Restructuring Restructuring operations is a long-term solution to reducing economic exposure. It is a much more complex task than hedging any foreign currency transaction. MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high reversal costs.

30. Restructuring may involve:  increasing/reducing sales in new or existing foreign markets,  increasing/reducing dependency on foreign suppliers,  establishing/eliminating production facilities in foreign markets, and/or  increasing/reducing the level of debt denominated in foreign currencies. Issues in the Restructuring

31. Restructure Operations to Balance the Impact on Cash Inflows and Outflows Proportion ofRestructure debtRestructure debt foreign debtto increase debtto reduce debtpayments inforeign currency Recommended Action When a Foreign Currency Has a Greater Impact on Type of Operation Cash InflowsCash Outflows Sales in foreignReduce foreignIncrease foreign currency unitssalessales Reliance onIncrease foreignReduce foreign foreign suppliessupply orderssupply orders

32. Hedging Economic Exposure Case Study Savor Co., a U.S. firm, has three independent units that conduct some business in Europe. It is concerned about its exposure to the euro. To determine whether it is exposed and the source of the exposure, Savor applies a series of regression analysis to its cash flows and the euro’s movements.

33. Assessment of Savor’s Exposure: %  TotalCashFlow t = a 0 + a 1 %  euro t +  t The slope coefficient, a 1, is found by regression analysis to be positive and statistically significant.  Savor is exposed to the euro’s movements. A Case Study in Hedging Economic Exposure

34. Assessment of Each Unit’s Exposure: %  UnitCashFlow t = a 0 + a 1 %  euro t +  t A Case Study in Hedging Economic Exposure  Unit C is exposed to the euro’s movements. UnitSlope CoefficientR-squared Statistic ANot significant6.8% BNot significant6.7% CStatistically significant93%

35. Economic Exposure: Case Study Identifying the Source of Unit C’s Exposure: Savor believes that Unit C’s cash flows are mainly affected by income statement items. Savor thus applies regression analysis to each income statement item, and finds a significant positive relationship between Unit C’s revenue and the euro’s value.  Savor’s economic exposure could be due to foreign competition.

36. Possible Hedging Strategies: Pricing policy – Reduce prices when the euro depreciates. Hedging with forward contracts – Sell euros forward to hedge against the adverse effects of a weak euro. Purchasing foreign supplies – Costs will be reduced during a weak-euro period. Economic Exposure: Case Study

37. Financing with foreign funds – Costs will be reduced during a weak-euro period. Revising the operations of other units – So as to offset the exposure of Unit C. Possible Hedging Strategies: Economic Exposure: Case Study

38. Hedging Exposure to Fixed Assets When an MNC has fixed assets (such as buildings or machinery) in a foreign country, the cash flows to be received from the sale of these assets is subject to exchange rate risk. A sale of fixed assets can be hedged by creating a liability that matches the expected value of the assets at the point in the future when they will be sold.

39. Translation Exposure The exposure of an MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.

40. Translation Exposure An MNC creates its financial statements by consolidating all of its individual subsidiaries’ financial statements. A subsidiary’s financial statement is normally measured in its local currency. To be consolidated, each subsidiary’s financial statement must be translated into the currency of the MNC’s parent. Since exchange rates change over time, the translation of the subsidiary’s financial statement into a different currency is affected by exchange rate movements. The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure.

41. Determinants of Translation Exposure MNC’s degree of translation exposure is dependent on the following: The proportion of its business conducted by foreign subsidiaries The locations of its foreign subsidiaries The accounting methods that it uses

42. An MNC’s degree of translation exposure is dependent on:  the proportion of its business conducted by foreign subsidiaries,  the locations of its foreign subsidiaries, and  the accounting methods that it uses. Translation Exposure

43. In the 2000–2001 period, the weakness of the euro caused several U.S.-based MNCs to report lower earnings than what they had expected. In 2002 and 2003, however, the euro strengthened, and the consolidated income statements of these U.S.-based MNCs improved. Translation Exposure

44. Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings. Translation Exposure

45. Use of Forward Contracts to Hedge Translation Exposure To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency.

46. Example: – A U.S.-based MNC has a British subsidiary. – The forecasted British earnings of £20 million (to be entirely reinvested) will be translated at the weighted average £ value over the year. – To hedge this expected earnings, the MNC sells £20 million one year forward. – If the £ depreciates, the gain generated from the forward contract position will help to offset the translation loss. Use of Forward Contracts to Hedge Translation Exposure

47. Limitations of Hedging Translation Exposure  Inaccurate earnings forecasts  Inadequate forward contracts for some currencies  Accounting distortions – Translation gains/losses are based on the average exchange rate (which is unlikely to be the same as the forward rate). – Translation losses are also not tax deductible.

48. Limitations of Hedging Translation Exposure  Increased transaction exposure – If the foreign currency appreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. – The translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss.