Understanding Foreign Exchange Exposure

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					Lecture 10: Understanding Foreign
               Exchange Exposure
                   The Risk Associated with
                Foreign Exchange Exposure.
               The Specific Types of Foreign
                  Exchange Exposure Facing
                    Global Firms and Global
                                  Investors.
Where is this and Why is it
Important?
What is Foreign Exchange Exposure
and Exposure Risk?
n   Foreign exchange exposure comes about when a firm or
    investor has an open position in a foreign currency.
    q   Open position: Unhedged; subject to exchange rate risk
    q   Open long position: Expect to receive foreign currency in the
        future
    q   Open short position: Need to pay foreign currency in the future
n   Foreign exchange exposure risk refers to the possibility
    that a foreign currency may move in a direction which is
    financially detrimental to the global firm or global
    investor.
n   Important: Global firms and investors cannot have
    foreign exchange exposure in their home currencies.
    q   This suggests a strategy for managing exposure.
Risk with an Open Foreign
Currency Position
n   Open long position (when you expect to receive
    foreign currency in the future).
    q   Specific risk is that the foreign currency may weaken
        against your home currency, thus reducing the home
        currency equivalent of the long position.
n   Open short position (when you expect to pay
    foreign currency in the future).
    q   Specific risk is that the foreign currency may
        strengthen against your home currency (thus requiring
        more home currency to acquire the foreign currency).
        This increases the home currency equivalent of the
        short position.
Examples of FX Open Long
Position Risk
n   Assume a U.S. based multinational firm has
    an account receivable denominated in yen
    with an expected payment date 30 days in
    the future. The invoice totals ¥75,500,000.
n   The current spot rate (USD-JPY) is 90.2500
n   Now assume the following 2 FX outcomes:
    q   In 30 days the spot rate is 95.4500
    q   In 30 days the spot rate is 82.2200
n   Calculate the gain or loss in USD under both
    assumptions above.
Answers:
n   First calculate the USD value with an exchange
    rate of 90.2500:
    q   75,500,000/90.2500 = $836,565.09
n   Assume the FX rate goes to 95.4500
    q   Note: The yen weakened
    q   75,500,000/95.4500 = $790,990.04
    q   Loss of 790,990.04 – 836,565.09 = $45,575
n   Assume the FX rate goes to 82.2200
    q   Note: The yen strengthened
    q   75,500,000/82.2200 = $918,268.06
    q   Gain of 918,268.06 – 836,565.09 = $81,702.97
Examples of FX Open Short
Position Risk
n   Assume a U.S. based multinational firm has
    an account payable denominated in pounds
    with an expected payment date 30 days in
    the future. The invoice totals £6,750,000.
n   The current spot rate (GBP-USD) is 1.5250
n   Now assume the following 2 FX outcomes:
    q   In 30 days the spot rate is 1.5875
    q   In 30 days the spot rate is 1.4225
n   Calculate the gain or loss in USD under both
    assumptions above.
Answers:
n   First calculate the USD value with an exchange
    rate of 1.5250:
    q   6,750,000 x 1.5250 = $10,293,750
n   Assume the FX rate goes to 1.5875
    q   Note: The pound has strengthened
    q   6,750,000 x 1.5875 = $10,715,625
    q   Loss of 10,293,750 – 10,715,625 = $421,875
n   Assume the FX rate goes to 1.4225
    q   Note: The pound has weakened
    q   6,750,000 x 1.4225 = $9,601,875
    q   Gain of 10,293,750 – 9,601,875 = $691,875
Risks Associated with FX Exposure
n   There are three specific risks to global firms
    and/or global investors from their foreign
    exchange exposures:
    q   (1) Settlement Value Risk: Occurs because
        foreign currency denominated contracts and
        investments, in the home currency equivalent
        of the firm or investor, can be adversely
        affected by changes in exchange rates.
        n   Fixed income investments (e.g., bonds).
        n   Fixed income liabilities (e.g., bonds and bank loans)
        n   Accounts receivable held by multinationals.
        n   Accounts payable owed by multinationals.
Risks Associated with FX Exposure
q   (2) Future Cash Flow Risk: Occurs because the
    home currency equivalents of anticipated
    (expected) foreign currency cash flows can be
    adversely affected by changes in FX rates.
    n   Foreign currency cash inflows and outflows:
        q   Future revenues from ongoing multinational operations.
        q   Future costs associated with ongoing multinational operations.
    n   Note: the net impact of this cash flow exposure
        depends upon the net cash flow position of the firm.
        q   For example, if foreign currency revenues exceed foreign
            currency costs, a strong foreign currency with have a net
            positive effect on the net home currency equivalent.
        q   And if foreign currency costs exceed foreign currency
            revenues, a strong foreign currency will have a net negative
            effect on the net home currency equivalent.
Risks Associated with FX Exposure
q   (3) Global Competitive Risk: Occurs because the
    competitive position of a firm can be affected by
    adverse changes in exchange rates.
    n   Exporting firms are adversely affected if the currencies
        of their overseas markets weaken.
        q   More difficult to compete with domestic firms.
    n   Importing firms are adversely affected if the currencies
        of their overseas markets strengthen.
        q   May need to increase their home market selling prices.
    n   Overseas production is adversely affected if the
        currencies of these “outsourcing” countries
        strengthens.
        q   Home currency equivalent of producing offshore will increase.
Types of Foreign Exchange Exposure
Facing Global Firms
n   There are three types of foreign exchange exposures that
    global firms may face as a result of their international
    activities.
n   These foreign exchange exposures are:
    q   Transaction exposure
        n   Results from a global firm engaged in current transactions involving
            contractual arrangements in foreign currencies (e.g., invoices coming
            due, loans coming due, interest payments coming due, etc).
    q   Economic exposure
        n   Results from future and unknown transactions in foreign currencies
            resulting from a global firm’s long term involvement in a particular market
            (i.e., because of a long term physical presence in that foreign market).
    q   Translation exposure (sometimes called “accounting” exposure).
        n   Important for global firms with a physical presence in a foreign country
            needing to consolidate their individual country financial statements for
            reporting purposes.
Transaction Exposure
n   Transaction Exposure: Results when a firm
    agrees to “fixed” cash flow foreign currency
    denominated contractual agreements.
    q   Examples of transaction exposure:
        n   An Account Receivable denominate in a foreign
            currency.
        n   A maturing financial asset (e.g., a bond)
            denominated in a foreign currency.
        n   An Account Payable denominate in a foreign
            currency.
        n   A maturing financial liability (e.g., a loan)
            denominated in a foreign currency.
Incident of Exporting and Importing
Transaction Exposure By Global
Firm’s Home Country
Country           Exports in Home   Imports in Home
                  Currency (% of    Currency (% of
                  invoices)         invoices)

United States     96.0%             85.0%
Germany           81.5%             52.6%
France            58.5%             48.9%
United Kingdom    57.0%             40.0%
Italy             38.0%             27.0%
Japan             34.3%             13.3%
Note: 1988 Data
Economic Exposure
n   Economic Exposure: Results from the “physical”
    entry of a global firm into a foreign country.
    q   This is a long term foreign exchange exposure
        resulting from a previous FDI location decision.
n   Economic exposure impacts the firm through
    contracts and transactions which have yet to
    occur, but will, in the future. These are really
    “future” transaction exposures which are
    unknown today.
n   Economic exposure also impacts the firm
    through its operating income (revenue) and costs
    which are denominated in the currency of the
    foreign country.
Translation Exposure
n   Translation Exposure: Results from the need
    of a global firm to consolidated its financial
    statements to include results from foreign
    operations.
    q   Consolidation involves “translating” subsidiary
        financial statements in local currencies (i.e., in the
        foreign markets where the firm is located) to the
        home currency of the firm (i.e., the parent).
    q   Consolidation can result in either translation gains
        or translation losses.
        n   These are essentially the accounting system’s attempt to
            measure foreign exchange “ex post” exposure.
Foreign Exchange Exposure for a
Global Investor
n   Foreign exchange exposure for a global
    investor results from the acquisition of
    financial assets denominated in a currency
    other than the home currency of the investor.
n   FX exposure can affect:
     n   (1) The home currency equivalent market
         price of those assets and
     n   (2) The home currency equivalent cash
         flows (dividends and interest) associated
         with particular financial assets.
Risk Elements for Global Investors in
Equities
n   The specific risk components associated with
    common stock (equities):
    q   Company risk (micro risk):
        n   Decisions of management; changes in management; success
            or failure of (new) products.
    q   Environment risk (macro risk):
        n   Risk produced by the industry (competition), governments
            (regulation), country (business cycles) and global environment
            in which the company operates.
    q   Market risk (systematic risk):
        n   Associated with movements in the overall equity market of a
            country. Under CAPM, measured by the stock’s beta.
    q   Exchange rate risk:
        n   Associated with investing in equities who’s market price and
            dividends are denominated in other than the home country of
            the investor.
Risk Elements for Global Investors in
Bonds
n   The specific risk components associated with
    bonds (i.e., fixed income securities):
    q   Default risk (credit risk): Risk that issuer will not be
        able to repay debt as contracted.
        n   Corporates: Cash flow issues.
        n   Sovereigns: Governmental debt servicing issues.
    q   Market risk (price risk):
        n   Associated with changes in the market’s overall assessment
            of risk and willingness to take risk (or avert risk).
    q   Contagion risk:
        n   Associated with spillover effects from other countries.
    q   Exchange rate risk:
        n   Associated with investing in bonds who’s market price and
            interest payments are denominated in other than the home
            country of the investor.
Exchange Rates and Bond Yields
n   The gap between the U.S. dollar un-hedged and hedged Global Treasuries shows
    the effect currency has played in these annual returns. In most years (with the
    exception of 2005 and the first quarter of 2009), currency moves (represented by
    unhedged returns) benefited the U.S. investor (this is shown by the difference
    between the un-hedged and hedge indexes).

				
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posted:7/30/2013
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