Foreign Exchange

Risk Management
Foreign Exchange Risks
Transaction Risk
Translation Risk
Economic Risk
Transaction Risk
The risk of changes in the expected value of a
contract between its signing and its execution as a
result of unexpected changes in foreign exchange
rates.
Whoever makes a contract denominated in a
foreign currency bears transaction risk.
Ocean Drilling has transaction risk if it borrows
money in French francs or Japanese yen, and
Hintz-Kessels-Kohl has transaction risk if it agrees
to accept future payments for its vehicles in U.S.
dollars.

Translation Risk
Gains or losses from exchange rate changes that
occur as a result of converting financial statements
from one currency to another in order to
consolidate them.
Every company having at least one subsidiary
using a different functional currency bears
translation risk.
MSDI has translation risk from having a
subsidiary, MSDI Alcala de Henares, whose
financial statements are kept in Spanish pesetas
and not in U.S. dollars.

Economic Risk
Changes in competitive position as a result of
permanent changes in exchange rates.
Every company buying or selling abroad or even
just competing with foreign companies has
economic risk.
Maybach has economic risk from manufacturing
its automobiles in Germany for export to the
United States, where it competes with Rolls
Royces manufactured in England.
Transaction Risk
Passive Transaction Risk
Management
Denominate all contracts in domestic
currency. This is a possible strategy for
companies with market power.
Do nothing about transaction risk. This is a
possible strategy for companies with a large
number of small contracts in a large number
of currencies.
Natural Transaction Risk Hedging
Centralize cash management to net all
offsetting transactions, transactions which
are long and short the same currency.
Time, lead and lag, offsetting business
transactions in the same currency.
Create offsetting business transactions in
the same currency.
Market Transaction Risk
Hedging
Forward Markets
Futures Markets
Money Markets
Swaps Markets
Options Markets
Hedging
Insuring against transaction risk to reduce or
eliminate the effects of unexpected changes in
exchange rates.
You can hedge only at market rates. The effects
of expected changes in exchange rates are
incorporated in these market rates.
Hedging is insurance. The purpose of hedging
is to reduce or eliminate risks, not to make
profits.
Reasons Not To Hedge
Since no one can out-guess the market, the expected value
of hedging, not including the direct costs, is zero. With the
direct costs, hedging is expected to lose money. But are
there offsetting benefits?
Hedging affects the appearance of a company but not the
economic reality. Investors can see through the accounting
statements to the underlying economics. But do investors
really have enough information to do this?
Hedging stabilizes financial performance, which benefits
the managers of a company but not the owners. The
owners can diversify away the risk in their investment
portfolios. But is such diversification always possible?
Reasons To Hedge
Hedging reduces the risk of the extraordinary
costs of extreme financial distress.
Hedging facilitates the execution of complex
operational and financial plans.
Hedging prevents changing economic conditions
from destroying the effectiveness of performance
evaluation systems.


Translation Risk
Example of Translation Risk
Narodno Pivo intends to set up a marketing
subsidiary in the United States.
It loans this subsidiary 125,000,000 SIT when the
exchange rate is 250 SIT/USD.
The 500,000 USD (125,000,000/250) is deposited
in an account at a U.S. bank.
Narodno Pivo credits cash and debits a new asset,
loan to subsidiary, for 125,000,000 SIT.
The subsidiary debits cash and credits a new
liability, loan from parent, for 500,000 USD.
Financial Statement
Consolidation
No other transactions have occurred, and the cash
remains in the account at the U.S. bank.
The tolar has strengthened, and the exchange rate
is now 200 SIT/USD.
The financial statements of Narodno Pivo and its
subsidiary must be consolidated for financial
reporting at the end of the fiscal year.
Convert at Current Rate
The cash is worth 100,000,000 SIT (500,000 x
200).
On the subsidiary statements, the loan from parent
is also worth 100,000,000 SIT (500,000 x 200).
The subsidiary balance sheet balances.
But on the Narodno Pivo statements, the loan to
subsidiary is still 125,000,000 SIT.
The loan to subsidiary and the loan from parent
no longer offset each other.
Convert at Historical Rates
The cash is worth 100,000,000 SIT (500,000 x 200).
On the subsidiary statements, the loan from parent is still
worth 125,000,000 SIT (500,000 x 250).
On the Narodno Pivo statements, the loan to subsidiary is
still 125,000,000 SIT.
The loan to subsidiary and the loan from parent still offset
each other.
But the subsidiary balance sheet does not balance in SIT.
The asset is 100,000,000 SIT and the liability is
125,000,000 SIT.
Solutions
If current rates were used for consolidation, the
value of the loan to subsidiary on Narodno Pivos
balance sheet must be written down by 25,000,000
SIT (125,000,000 - 100,000,000).
If historical rates were used for consolidation, a
25,000,000 SIT loss (125,000,000 - 100,000,000)
must be recognized in order to make the Narodno
Pivo consolidated balance sheet balance.
Is the Loss Real?
Yes. Narodno Pivo has lost 25,000,000 SIT in tolar value
as a result of transaction risk; that is, making a loan
denominated in a foreign currency. Had they kept that
money in Slovenia, they could be doing more with it now.
No. Narodno Pivo has lost nothing in dollar value. The
ability of the subsidiary to perform its economic function
has not changed as a result of the exchange rate change.
Had the subsidiary belonged to a U.S. company, the
exchange rate change would have been completely
irrelevant. Narodno intended the subsidiary to be
successful and did not intend to get the cash back. It cannot
lose what it never intended to have.
Hedging Translation Risk
Translation risk is hedged in the same ways as
transaction risk.
Does it make sense to create a real risk (a natural
or market hedge) to offset a translation risk that
may or may not be real?
It appears as if investors are indifferent to foreign
currency translation gains and losses.

Market Transaction Risk
Hedging
Forward Markets
Futures Markets
Money Markets
Forward and Futures Markets
Any currency, any amount,
any maturity
Illiquid
Self-regulated OTC market
Contract with dealer
Requires credit-worthiness
Cash flow only at maturity
Settled by executing contract
Hedge by buying forward the
short currency or selling
forward the long currency

Selected currencies, standard
contracts, standard maturities
Liquid
Government-regulated
exchange-based market
Contract with exchange
Requires margin account
Marked to market daily
Settled by offsetting trade
Hedge by making a transaction
whose gains or losses offset
those of the underlying
position

Forward and Money Markets
Money markets can always be used to synthesize
forward markets.
Money market rates are used to set forward market
rates.
Money market transactions are likely to be more
costly than forward market transactions, since
three transactions having their own bid-ask
spreads are required to duplicate one forward
market transaction with one bid-ask spread.
Money market transactions appear on the balance
sheet; forward market transactions do not.