Professional Documents
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Foreign exchange exposure means the risk of loss stemming from exposure to
adverse foreign exchange rate movements.
“A measure of the potential change in a firm’s profitability, net cash flow, and
market value because of a change in exchange rates”
– These three components (profits, cash flow and market value) are the
key financial elements of how we view the relative success or failure
of a firm
– While finance theories tell us that cash flows matter and accounting
does not, we know that currency-related gains and losses can have
destructive impacts on reported earnings – which are fundamental to
the markets opinion of that company
The foreign exchange rate exposure of a firm is a measure of the sensitivity of its
cash flows to changes in exchange rates. Since cash flows are difficult to measure,
most researchers have examined exposure by studying how the firm’s market
value, the present value of its expected cash flows, responds to changes in
exchange rates
Transaction exposure measures gains or losses that arise from the settlement of
existing financial obligations whose terms are in a foreign currency. The situations
include
Purchasing or selling on credit goods or services when prices are stated in
foreign currencies
Borrowing or lending funds when repayment is to be made in a foreign
currency
Being a party to an unperformed forward contract
Acquiring assets or incurring liabilities denominated in foreign currencies
Example (purchasing or selling): Leo Srivastava is the director of finance for Pixel
Manufacturing, a U.S.-based manufacturer of hand-held computer systems for
inventory management. Pixel has completed the sale of a bar-code system to a
British firm, Grand Metropolitan (UK), for a total payment of £1,000,000. The
following exchange rates were available to Pixel on the following dates
corresponding to the events of this specific export sale. Assume each month is 30
days.
(a) Assume Leo decides not to hedge the transaction exposure. What is the value of
the sale as booked? What is the foreign exchange gain (loss) on the sale?
The sale is booked at the exchange rate existing on June 1, when the product is
shipped to Grand Met, and the shipment is categorized as an account
receivable(A/R).
Value as settled = £1,000,000* $1.7290/£ = $1,729,000
Value as booked = £1,000,000* $1.7689/£ = $1,768,900
Foreign exchange loss = ($1,729,000 - $1,768,900) = -$39,900
(b) Assume Leo decides to hedge the transaction exposure using a forward contract
when the product is shipped. What is the value of the sale as booked? What is the
foreign exchange gain (loss) on the sale if hedged with a forward contract?
The sale is booked at the exchange rate existing on June 1, when the product is
shipped to Grand Met.
Value as forward settlement = £1,000,000* $1.7602/£ = $1,760,200
Value as booked = £1,000,000* $1.7689/£ = $1,768,900
Foreign exchange loss = ($1,760,200 - $1,768,900) = -$8,700
Example (purchasing or selling):
Suppose Trident Corporation sells products to a Belgian buyer for €1,800,000
payable in 60 days. The current spot rate is $1.20/€ and Trident expects to
exchange the Euros for €1,800,000*$1.20/€ = $2,160,000 when payment is
received.
Transaction exposure arises because of the risk that Trident will receive
something other than $2,160,000 expected
If the euro weakens to $1.10/€, then Trident will receive $1,980,000
If the euro strengthens to $1.30/€, then Trident will receive $2,340,000
2. Why hedge?
Hedging protects the owner of an asset (future stream of cash flows) from loss.
However, it also eliminates any gain from an increase in the value of the asset
hedged against.
Since the value of a firm is the net present value of all expected future cash
flows, it is important to realize that variances in these future cash flows will
affect the value of the firm and that at least some components of risk (currency
risk) can be hedged against.
Example: Suppose there is a company drilling oil and it plans on selling 2 million
barrels of oil in 60 days. How can the firm hedge the exposure to changes in oil
prices?
- sell a futures contract on oil deliverable in 60 days
Example 1 (managing account receivable; A/R): Maria Gonzalez, CFO of Trident,
has just concluded a sale to Regency, a British firm, for £1,000,000. The sale is
made in March with payment due in June (3 months). Assumptions for Maria’s
currency exposure problem are:
- Spot rate is $1.7640/£
- 3-month forward rate is $1.7540/£
- Trident’s cost of capital is 12.0%
- UK 3 month borrowing rate is 10.0% p.a. (per annum)
- UK 3 month investing rate is 8.0% p.a.
- US 3 month borrowing rate is 8.0% p.a.
- US 3 month investing rate is 6.0% p.a.
- June put option in the OTC market (bank) for £1,000,000; strike price $1.75;
1.5% for option premium
- Trident’s foreign exchange advisory service forecasts future spot rate in 3 months
to be $1.76/£
Trident operates on narrow margins and Maria wants to secure the most amount of
US dollars; her budget rate (lowest acceptable amount) is $1.70/£, below which
Trident actually lose money on the transaction. Maria faces four possibilities:
– Remain un-hedged
– Hedge in the forward market
– Hedge in the money market
– Hedge in the options market
- If Maria wants to cover this exposure with a forward contract, then she will sell
£1,000,000 forward today at the 3-month forward rate of $1.7540/£
- She is now “covered” and Trident no longer has any transaction exposure
- In 3 months, Trident will receive £1,000,000 and exchange those pounds at
$1.7540/£ receiving $1,754,000.
- This would be recorded in Trident’s books as a foreign exchange loss of $10,000
($1,764,000 as booked, $1,754,000 as settled)
- Conclusion: If Maria can invest the loan proceeds at a rate equal to or greater
than 7.68% p.a., then the money market hedge will be superior to the forward
hedge.
Accounting Exposure
1. A backward-looking concept: it reflects past decisions as reflected in the
subsidiary's assets and liabilities.
3. Changes the firm's accounting value, but not necessarily its market value.
4. Depends on the accounting rules chosen. This is because the subsidiary's own
internal rules affect its accounting values (e.g., type of depreciation, or inventory
valuation methods) and also because the translation process itself can be done in
different ways (see below).
5. Accounting exposure only exists in the case of foreign direct investment, since
pure exporting or import-substituting firms have no foreign subsidiaries.
A firm which has subsidiaries and assets in another country is subject to translation
exposure. Translation exposure results as a consequence of the fact that a parent
company must consolidate all of the operations of its subsidiaries into its own
financial statements. Since a foreign subsidiary’s assets are carried on its books in
a foreign currency, it is necessary to convert the foreign values into domestic
currency for combining with the parent’s assets. Fluctuating exchange rates results
in gains and losses occurring during the translation process. Since this type of
exposure is related to balance sheet assets and liabilities, it is often referred to as
accounting exposure.
The primary issue related to the translation of foreign asset values has to do with
whether the proper exchange rate to use is the current rate of exchange or the
historic rate of exchange that existed at the time that an asset was acquired
When converting financial statement items (transactions) denominated in
currencies other than the parent currency, two choices of exchange rate are
possible:
• The historical rate, the exchange rate prevailing at the time of the
transaction
• The current rate, the exchange rate prevailing at the balance sheet date or
during the income statement period