Note packet for chapters 8-10

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Note packet for chapters 8-10 Powered By Docstoc
					Chapter 8 – Transaction Exposure
Companies conducting international business might supply
or receive goods in months when exchange rates are
changing. How can the manufacturer guarantee they receive
or pay a set amount of the proceeds in the future? Similar to
a farmer with a wheat forward.

  Transaction exposure arises from:
       Purchasing or selling on credit goods or services
       whose prices are stated in foreign currencies;
       Borrowing or lending funds when repayment is to be
       made in a foreign currency;
       Otherwise acquiring assets or incurring liabilities
       denominated in foreign currencies.
  Suppose a U.S. firm sells merchandise on open account to
  Belgian buyer for:
       Bf700,000, payment to be made in 60 days.
       S0 = 35 Bf/$
       The U.S. seller expects to exchange the Bf700,000
       payment for $20,000 when payment is received.

  Transaction exposure arises because of the risk that the
  U.S. seller will receive something other than $20,000.
       For example, if S60 = 38 Bf/$, U.S. seller receives only
       $18,421 = (Bf700,000) * (1$/38 Bf)
       On the other hand, if S60 = 33 Bf/$, U.S. seller receives
       $21,212 = (Bf700,000) * (1$/33 Bf)
       Thus, exposure is the chance of either a loss or a gain.

  In 1971, Great Britain’s Beecham Group borrowed SF100
  million (equivalent to £10.13 million).
  When the loan came due five years later, the cost of
  repayment of principal was £22.73 million – more than
  double the amount borrowed!

  We will discuss three ways to hedge transaction exposure.
       1. A forward hedge
       2. A money market hedge
       3. An option hedge.

Let’s begin.

Forward Market Hedge – Exporter (Accounts Receivable).
An example: Suppose your company is Raleigh bicycle and
you sell 750,000 euros of bicycles to an Italian wholesaler,
Colnago, payable in six months.
  UK interest rate 3%/6 mo.
  Italian interest rate 5.985%/6mo.
  Spot exchange rate 0.735 £/€
  Forward exchange rate 0.7143 £/€
How can you guarantee Raleigh will receive a set amount of
pounds in six months, and how much will Raleigh receive?
1. Sell forward 750,000€ in six months in exchange for
   pounds. In six months your company will have to deliver
   (pay) 750,000€ and will receive a set amount of pounds.
   How many pounds will Raleigh receive?

2. Use the 750,000€ receivable from Colnago to fulfill the
   750,000€ forward contract.

3. In the end Raleigh will take delivery of 535,725£ regardless
   of the exchange rate.

Exporter -- Money Market Hedge
  750,000 euro to be received in six months
     UK interest rate 3%/6 mo.
     Italian interest rate 5.985%/6mo.
     Spot exchange rate 0.735 £/€
     Forward exchange rate 0.7143 £/€
  1. With a money market hedge, borrow an amount today in
     the foreign currency that you can repay in the future with
     the accounts receivable.

  2. Convert the 707,647€ to £ at the spot rate.

  3. Invest the converted amount at the UK interest rate.

  4. Use the 750,000 euro from the receivable to repay the

Note: the forward hedge and money market hedge give the
same value. This is not coincidence, it is due to IRP.

For an importer, it is the opposite direction
If you expect to owe foreign currency in the future, you can
hedge by agreeing today to buy the foreign currency in the
future at a set price by entering into a long position in a
forward contract.
Importer’s Forward Market Hedge
E.G. Same info as before but now Colnogo must pay Raleigh
10,000£ for bike OEM parts in six months.

A Future Contract isn’t as Suitable for Hedging.
 Futures contracts are standardized, not taylor made.
  Issues with contract size, delivery, date, etc.
 Mark-to-market means there are interim CFs prior to
  maturity that may have to be invested/borrowed.

Importer’s Money Market Hedge
   This is the same idea as covered interest arbitrage.
   To hedge a foreign currency payable, buy the present
    value of that foreign currency payable today and put it in
    the bank at interest.
       – Buy the present value of the foreign currency payable
         today at the spot exchange rate.
       – Invest that amount at the foreign rate.
       – At maturity your investment will have grown enough
         to cover your foreign currency payable.
  A U.S.–based importer of Italian bicycles owes €100,000 to
  an Italian supplier in one year.
       – The spot exchange rate is $1.50 = €1.00.
       – The one-year interest rate in Italy is i€ = 4%.
       – The one-year interest rate in US is i$ = 3%.
  1. How many dollars would the importer need today to meet
     this obligation?

  2. If the importer borrowed the $144,230.77, how much
     would he need to repay the bank in one year?

Options – One shortcoming for forward and money market
hedges is that the firm has to forgo the opportunity to benefit
from favorable exchange rate changes. Not so with options.
   Suppose Litespeed sells titanium bicycle frames to an
    English firm and is due £10 million in one year. The
    interest rate is 6.1%. The current spot price is $1.46/£ and
    the put option premium is $0.02 per pound.
        Litespeed could pay $200,000 ($0.02x10 million) for a
         put option. This gives Litespeed the right to sell up to
         £10 million for $1.46/£ regardless of the future spot
   Suppose spot price changes to $1.30/£ in one year.
        Litespeed would receive $13 M instead of $14.6 M.
        However, Litespeed will make $0.16/option contract,
         resulting in $1.6 in addl wealth, totaling $14.6M.
        Since the option cost is $0.2122M ($200,000*1.061),
         Litespeed is guaranteed $14.3878M.
   If the spot price changes to $1.60/£ in one year, Litespeed
    would receive $16 M instead of the $14.6 M. They would
    let the option expire worthless for net proceeds of
    $15.7878M ($16 - $0.2122M).

Summary -- Hedging Foreign Currency Payables
 Suppose the following:
  US interest rate 6%/year
  UK interest rate 6.5%/year
  Spot exchange rate $1.80/£
  Forward exchange rate $1.75/£
 Boeing decides to hedge a £5M payable due in 1 year.
     Using a forward contract.

     Using a Money Market Instrument.

     Is the Forward or the MM Hedge preferable in this

     For an option hedge assume X = $1.80/£ and the
      premium is $0.018/£.

Cross-Hedging Minor Currency Exposure
 The major world currencies are the U.S. dollar, Canadian
  dollar, British pound, euro, Swiss franc, Mexican peso, and
  Japanese yen.
 Everything else is a minor currency (for example, the
  Swedish krona).
 It is difficult, expensive, and sometimes even impossible to
  use financial contracts to hedge exposure to minor
 Cross-hedging involves hedging a position in one asset by
  taking a position in another asset.

   The effectiveness of cross-hedging depends upon how well
    the assets are correlated.
        An example would be a U.S. importer with liabilities
         in Swedish krona hedging with long or short forward
         contracts on the euro. If the krona is expensive when
         the euro is expensive, or even if the krona is cheap
         when the euro is expensive, it can be a good hedge.
         But they need to co-vary in a predictable way.

Hedging Recurrent Exposure with Swaps
   Swap contracts are an agreement to exchange one
    currency for another at a predetermined exchange rate on
    a sequence of future dates. It is a portfolio of forward
    contracts with agreed upon exchange rates.
        Swaps are lower cost than hedging each exposure as
         it comes along.
        Swaps are available in longer-terms than futures and
   E.G. Boeing is to receive £10 M from British Air for each of
    the next five years in exchange for airplane parts. Boeing
    finds a counterparty that agrees to a swap an exchange
    rate of $1.50/£ for each of the next five years. Boeing is
    then guaranteed $15 M /year for the next five years.
  Exposure Netting
   A multinational firm should not consider deals in isolation,
    but should focus on hedging the firm as a portfolio of
    currency positions.

Other Hedging Strategies
   Hedging through invoice currency.
       – The firm can shift, share, or diversify:
            • Shift exchange rate risk by invoicing foreign sales
              in home currency
            • Share exchange rate risk by pro-rating the
              currency of the invoice between foreign and
              home currencies
            • Diversify exchange rate risk by using a market
              basket index
   Hedging via lead and lag.
       – If a currency is appreciating, pay those bills
         denominated in that currency early; let customers in
         that country pay late as long as they are paying in
         that currency.

    – If a currency is depreciating, give incentives to
      customers who owe you in that currency to pay early;
      pay your obligations denominated in that currency as
      late as your contracts will allow.

Should the Firm Hedge?
 Not everyone agrees that a firm should hedge.
    – Hedging by the firm may not add to shareholder
      wealth if the shareholders can manage exposure
    – Hedging may not reduce the non-diversifiable risk of
      the firm. Therefore, shareholders who hold a
      diversified portfolio are not benefitting when
      management hedges.

What Risk Management Products do Firms Use?
 Most U.S. firms use forward, swap, and options contracts.
 The greater the degree of international involvement, the
  greater the firm’s use of foreign exchange risk

Chapter 9 – Economic Exposure

Economic Exposure – How do exchange rates affect a
business’s competitiveness vis-à-vis their competition.
 Changes in exchange rates can affect not only firms that
  are directly engaged in international trade but also purely
  domestic firms.
 If the domestic firm’s products compete with imported
  goods, then their competitive position is affected by the
  strength or weakness of the local currency.
 Consider a U.S. bicycle manufacturer who sources,
  produces, and sells only in the U.S.
 Since the firm’s product competes against imported
  bicycles, it is subject to foreign exchange exposure. Their
  customers are comparing the cost and features of the
  domestic bicycle against Japanese, British, and Italian
 Economic exposure can be defined as the extent to which
  the value of the firm would be affected by unanticipated
  changes in exchange rates. Any anticipated changes in the
  exchange rates would already have been discounted and
  reflected in the firm’s value.

Economic Exposure
 The home currency value of assets and liabilities (asset
 The home currency value of a firm’s operating CFs due to
  random changes in exchange rates (operating exposure)

Asset exposure -- a statistical measurement of sensitivity.
    – Sensitivity of the future home currency values of the
      firm’s assets and liabilities to random changes in
      exchange rates.
 If a U.S. MNC were to run a regression on the dollar value
  (P) of its British assets on the dollar-pound exchange rate,
  S($/£), the regression would be of the form: P = a + b×S + e
Where a is the regression constant, e is the random error
term with mean zero. The regression coefficient b measures
the sensitivity of the dollar value of the assets (P) to the
exchange rate, S. The exposure coefficient, b, is defined as

Operating Exposure.
   The extent to which the firm’s operating cash flows or
    competitive position are affected by random changes in
    exchange rates.
        Competitive effect – A pound depreciation can affect
         operating CFs in pounds by altering the firm’s
         competitive position in the marketplace.
        Conversion effect – A given operating CF in pounds
         will be converted into a lower dollar amount after the
         pound depreciation.

An Illustration of Operating Exposure
   Case 1 – No variables change except the price of imported
       – Increased costs of raw material
       – Leads to decreased operating CF
       – The degree to which the firm can pass the increased
         costs along to customers depends on substitutes and
         price elasticity.

   Case 2 – Selling price as well as the price of the imported
    inputs changes, with no other changes.
       – Since the firm can pass costs along to customers
         (inelastic demand), this case shows that a pound
         depreciation need not lead to a lower dollar
         operating CF.

   Case 3 – All variables change, selling price, sales volume,
    prices of both locally sourced and imported inputs change
    following depreciation in the pound.
       – Assume elastic demand – then increases in prices lead
         to fewer units sold and CFs are reduced.

Determinants of Operating Exposure
   The firm’s operating exposure is determined by:
       – How competitive or how monopolistic the market
         structure of inputs and products is. If the firm can
         adjust its markets, product mix, and sourcing it can
         mitigate the effect of exchange rate changes.
       – A firm is subject to a high degree of operating
         exposure when either costs or price is sensitive to
         exchange rate changes. When both cost and price
         are sensitive or insensitive to exchange rate changes,
         the firm has no major operating exposure.
       – (E.G. Ford Mexicano). Inflation US = 4%; Inflation
         Mexico = 15%; Dollar appreciates by 11%.
         Suppose the Peso price of Ford cars appreciates by
         15%, reflecting a 4% increase in the $ price of cars
         and an 11% dollar appreciation. Since peso price of
         both Ford and locally produced cars rises by the same
         15%, the 11% appreciation of the dollar will not affect
         the competitive position of Ford relative to local car
         makers. Therefore, Ford does NOT have operating
       – Generally, companies pass through some but not all
         price changes.

Managing Operating Exposure – Objective is to Stabilize CFs in
Face of Fluctuating Exchange Rates.
   Strategies
        Selecting Low Cost Production Sites – Toyota
         produces in US for US sales.
   Flexible Sourcing Policy – Low cost material inputs.

 Diversification of the Market – Sell in several markets and
  if pricing becomes unfavorable in one market, hopefully it
  will become more favorable in another market.
 R&D and Product Differentiation – Limit chance of
  substitutes and focus on cutting costs through R&D.
  Successful product differentiation gives the firm less
  elastic demand—which may translate into less exchange
  rate risk.
 Financial Hedging – An approximate solution.

Chapter 10 – Translation Exposure
This is frequently called accounting exposure as it refers to
the effect that an unanticipated change in exchange rates
will have on consolidated financial statements.
There are four methods of foreign currency translation
 Current/Noncurrent Method
 Monetary/Nonmonetary Method
 Temporal Method
 Current Rate Method

International Accounting Standards
 IAS 21, The Effects of Changes in Foreign Exchange Rates is
  the European standard for handling foreign currency
 IAS 21 most closely resembles the monetary/nonmonetary
  translation method.

Monetary/Nonmonetary Method
 The underlying principle is that monetary accounts have a
  similarity because their value represents a sum of money
  whose value changes as the exchange rate changes.
 All monetary balance sheet accounts (cash, marketable
  securities, accounts receivable, etc.) of a foreign subsidiary
  are translated at the current exchange rate.
 All other (nonmonetary) balance sheet accounts (owners’
  equity, land, etc.) are translated at the historical exchange
  rate in effect when the account was first recorded.

 All monetary balance sheet accounts are translated at the
  current exchange rate. e.g. €2 = $1. All other balance
  sheet accounts are translated at historical exchange rate in
  effect when the account was first recorded. e.g. €3 = $1
       Balance Sheet         Local           Monetary/
                            Currency        Nonmonetary

    Cash                        € 2,100           $1,050
    Inventory                   € 1,500             $500
    Net fixed assets            € 3,000           $1,000
            Total Assets        € 6,600           $2,550
    Current liabilities         € 1,200             $600
    Long-Term debt              € 1,800             $900
    Common stock                € 2,700             $900
    Retained earnings             € 900                $0
    CTA                          --------         --------
        Total Liabilities       € 6,600           $2,400
              and Equity

Translation Exposure versus Transaction Exposure
 Translation exposure -- The effect that unanticipated
  changes in exchange rates has on the firm’s consolidated
  financial statements. An accounting issue.
 Transaction exposure -- The effect that unanticipated
  changes in exchange rates has on the firm’s cash flows.

 It is generally not possible to eliminate both translation
  exposure and transaction exposure.
 If the managers of the firm wish to manage their
  accounting numbers as well as their business, they have
  two methods for dealing with translation exposure:
   Balance sheet hedge -- Eliminates the mismatch
    between net assets and net liabilities denominated in
    the same currency. May create transaction exposure.
   Derivatives hedge -- An example would be the use of a
    forward contract with a maturity of the reporting period
    to attempt to manage the accounting numbers.
        Using a derivatives hedge to control translation
         exposure involves speculation about foreign
         exchange rate changes.

Translation Exposure versus Operating Exposure
 The effect that unanticipated changes in exchange rates
  has on the firm’s ongoing operations.
 Operating exposure is a substantive issue with which the
  management of the firm should concern itself with.


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