# Understanding Foreign Exchange Exposure

Document Sample

```					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.
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.
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
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).

```
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
 views: 0 posted: 7/30/2013 language: English pages: 20