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TOPIC 6: FX Exposure & Management

(Shapiro, Chapter 10 & 11)


Foreign exchange exposure is the degree to
which a company is affected by exchange
rate changes.
Measures of Foreign Exchange Exposure:
TYPES (shapiro page 355-357)
1. Accounting Exposure (or translation

exposure): arises when reporting and


consolidating financial statements
require conversion from subsidiary to parent
currency.
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2. Economic Exposure: arises because


exchange rate changes alter the value of
future revenues and costs
(operating exposure).

Economic Exposure = Transaction Exposure +


Operating Exposure
- Transaction exposure is the sensitivity of the
firms contractual transactions in foreign
currencies to exchange rate changes.
- Operation exposure measures the degree to
which an exchange rate change, in combination
with price changes, will alter a companys future
operating cash flows.
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How Accounting Exposure Arises


Accounting exposure is the change in the value of a
firms foreign-currency-denominated accounts due
to a change in exchange rates
Translation Risk
Japan

United States

A$

Subsidiary
Financials

Headquarters A$
Consolidated
Financials

Subsidiary
Financials
US$

A$

Germany

Subsidiary Financials
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Accounting vs Economic Exposure


Measurement of exchange rate risk indicates
major difference exists:

A. Accounting exposure
reflects past decisions of the firm.
B. Economic exposure
1. Focuses on future impact of
exchange rate changes.
2. Not all future cash flows appear on
the firms balance sheet.

Example: Suppose on Jan 1, American Golfs


subsidiary in France showed:
Current assets of EUR1 million;
Current liabilities of EUR300,000;
Total assets = EUR2.5 million;
Total liabilities = EUR900,000
Exchange rate on Jan 01 = $0.1270
on Dec 31= $0.1180
What is the exposure if the EUR is the functional
currency?
Functional currency is the currency of the primary
economic environment in which the affiliate
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generates and expends cash.

All assets & liabilities translated at current


rate.
At beginning of the year:
EUR2500000 - EUR900000 = EUR1600000
1600000 x $0.1270 = $203200

At the end of the year:


1600000 x $0.1180 = $188800
This involves a translation loss of:
$188,800 - $203,200 = -$14,400
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Managing Translation & Transaction


Exposure:
DESIGNING A HEDGING STRATEGY
A. Strategies: a management objective
B. Hedgings basic objective:
to reduce/eliminate volatility of earnings
as a result of exchange rate changes.
C. Hedging exchange rate risk
1. Incurs a cost
2. Should be evaluated as a purchase of
insurance.
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MANAGING OPERATING EXPOSURE


METHODS OF HEDGING

A.
B.
C.
D.
E.
F.

Risk shifting
Currency risk sharing
Currency collars
Cross-hedging
Exposure netting
Forward market hedge or money
market hedge (MMH)
G. Foreign currency options
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A. RISK SHIFTING
1.
2.
3.
4.

Home currency invoicing


Zero sum game
Common in global business
Firm will invoice exports in strong
currency, imports in weak currency
5. Drawback: it is not possible with
informed customers or suppliers.

B. CURRENCY RISK SHARING


1. Developing a customized hedge
contract.
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2. The contract typically takes the form of


a Price Adjustment Clause, whereby a
base price is adjusted to reflect certain
exchange rate changes.
3. Parties would share the currency risk
beyond a neutral zone of exchange
rate changes.
4. The neutral zone represents the
currency range in which risk is not
shared.

C. CURRENCY COLLARS
1. Collar contracts
- bought to protect against currency
moves outside the neutral zone.

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2. Firm would convert its foreign


currency denominated receivables at
the zone forward rate.
D. CROSS-HEDGING
1. Often forward contracts not available
in a certain currency.
2. Solution: a cross-hedge
- a forward contract in a related
currency.
3. Correlation between 2 currencies is
critical to success of this hedge.
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E. EXPOSURE NETTING
1. Protection can be gained by selecting
currencies that minimize exposure
2. Netting: MNC chooses currencies that
are not perfectly positively correlated.
3. Exposure in one currency can be
offset by the exposure in another.

F.Forward market hedge or money market


hedge. An alternative to forward hedge is
money market hedge which is the use of
simultaneous borrowing and lending
transactions in two different currencies to lock
in the home currency value of a foreign
currency transaction.
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Money Market Hedge (MMH)


(a) To hedge export receivable in USD
(i) borrow the present value of USD
(ii) convert the USD to AUD in spot
market (this allows you to know how
much AUD you will get for the
receivable, therefore hedged)
(iii) The future value of this AUD is
equivalent to the USD receivable, an
implied forward rate is obtained.
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(b) To hedge import payable in USD


(i) borrow AUD (pay AUD interest rate)
(ii) convert the AUD in spot to USD
(iii) invest the USD to earn USD
interest. This will give sufficient
USD later to make payment for the
payable.

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MMH for payable is slightly more complicated.


One needs to compute the PV of the payable,
and then use the spot exchange rate to find
out the equivalent AUD that needs to be
borrowed for the hedge.
The future value of the AUD is equivalent to the
USD payable, therefore, an implied forward
rate is obtained.
MMH is similar to CIA, but one is hedging and
the other is arbitrage. An example is
available in tutorial.
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Example: Import payables: EUR1 million due in one


year. 1-year interest rates for Australian dollar and
euro are 5.5% and 2%, spot exchange rate is
EUR0.5854/AUD.
MMH: First, calculate the present value of EUR1
million which equals 1m/1.02 = EUR0.980392m.
Second, calculate the equivalent in AUD, ie.,
0.980392/0.5854 = AUD1.6747389m. Therefore,
to conduct a money market hedge, one would
borrow AUD1.6747389 and convert it to EUR at
0.5854 and then invest the EUR at 2% pa for one
year. In one year it will accumulate to EUR1 million,
sufficient to pay off the debt:
1.6747389(0.5854)(1.02) = EUR1 million
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In the MMH above, the one year future value


of AUD1.6747389 million = 1.6747389(1.055)
= AUD1.7668495 million, is equivalent to
EUR1 million payable. Therefore, the
implied forward rate is 1/1.7668495 =
EUR0.5660/AUD.

If interest rate parity holds, there is no


difference between forward hedge and
money market hedge.

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In the above example, if the EUR1 million is


export receivable, to conduct MMH:
1. Borrow the PV of EUR1m: 1/(1.02) =
EUR0.980392m (against the receivable)
2. Convert to AUD: 0.980392m/0.5854 =
AUD1.674739m (you are certain to receive)
3. Implied forward rate:
1m/1.674739m(1.055) = EUR0.5660/AUD

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MANAGING TRANSLATION EXPOSURE


A. Choices faced by the MNC:
1. Adjusting fund flows:
Altering either the amounts or the
currencies of the planned cash
flows of the parent or its subsidiaries
to reduce the firms local currency
accounting exposure.
2. Forward contracts:
Reducing a firms translation exposure
by creating an offsetting asset or
liability in the foreign currency.
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3. Exposure netting
a. Offsetting exposures in one
currency with exposures in the
same or another currency
b. Gains and losses on the two currency
positions will offset each other.

B.Basic hedging strategy for reducing


translation exposure:
1. Increasing hard-currency (likely to
appreciate) assets.
2. Decreasing soft-currency (likely to
depreciate) assets.
3. Decreasing hard-currency liabilities.
4. Increasing soft-currency liabilities.
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FOREIGN EXCHANGE RISK


A. Economic exposure focuses on the
impact of currency fluctuations on
firms value.
1. The most important aspect of foreign
exchange risk management:
Incorporate expectations about the
risk into all basic decisions of the firm.
2. Definition: Economic exposure =
Transaction exposure + Operating
exposure: arises because currency
fluctuations alter a companys future
revenues and expenses.
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To measure operating exposure requires a


longer-term perspective. i.e., cost and price
competitiveness could be affected by
exchange rate changes
Operating Exposure begins the moment a
firm starts to invest in a market subject to
foreign competition or in sourcing goods or
inputs abroad.
B. Real Exchange Rates Changes & Risk:
Real exchange rate is nominal exchange
rate adjusted for price changes.
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C. Implications:
1. If nominal rates change with an equal
price change, no alteration to cash
flows.
2. If real rates change, it causes relative
price changes and changes in
purchasing power.
A decline in the real value of a currency makes
exports and import-competing goods more
competitive.
An appreciating currency makes imports and
export-competing goods more competitive.

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During an appreciation of home currency


exporters face two choices: Keep prices
constant (but lose sales) or adjust prices to
foreign currency to maintain market share
(lose profits).
SUMMARY:
(a) The economic impact of a currency
change depends on the offset by the
difference in inflation rates or the
change in real exchange rates.
(b) It is the relative price changes that
ultimately determine a firms long-run
exposure.

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ECONOMIC CONSEQUENCES
The impact on operating exposure of a real
rate change depends upon pricing flexibility
and
1. Price elasticity of demand
2. Degree of product differentiation
3. The ability to shift production
and the substitution of inputs

MANAGING OPERATING EXPOSURE

Operating exposure management requires


long-term operating adjustments and the
involvement of all departments.
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Planning For Exchange-Rate Changes


Develop contingency plans with plausible
scenarios before the impact of a currency
change makes itself felt, e.g., flexible
manufacturing systems

Financial Management of Exchange Rate


Risk: Financial managers role
Structure the firms liabilities in such a way that
the reduction in asset earnings is matched by
corresponding decrease in cost of servicing
liabilities.
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A. Provide the local manager with forecasts of


inflation and exchange-rate changes.
B. Identify and focus on competitive exposure.
C. Design the evaluation criteria so that
operating managers neither rewarded or
penalized for unexpected exchange-rate
changes.

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