International Finance

Prof. Ph.d. Xiaoni Li

Department of Business Management

Universitat Rovira i Virgili

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Topic 2: Foreign Exchange Risk Management

1. Foreign Exchange Risk Exposure

2. Transaction Exposure

3. Operating Exposure

4. Translation Exposure
Currency Risk and Currency Risk Exposure

What is currency risk and currency risk exposure?

Prof. Ph.d. Xiaoni Li International Finance

Currency Risk and Currency Risk Exposure

I Currency risk (or foreign exchange risk) is the risk of unexpected changes in
foreign currency exchange rates.

I Currency risk exposure is a measure of the potential for a firm’s value change in
assets and/or liabilities because of a change in exchange rates. Currency risk
exposure depends on how much the firm is at currency risk.

Prof. Ph.d. Xiaoni Li International Finance

Currency Risk and Currency Risk Exposure

An important task of the financial manager is to measure foreign exchange exposure

and to manage it so as to maximize the profitability, net cash flow, and market value
of the firm.

Prof. Ph.d. Xiaoni Li International Finance

Types of Foreign Exchange Exposure

I Transaction exposure measures changes in the value of contractual cash flows

from unexpected changes in exchange rates.

I Operating exposure measures changes in the value of non-contractual cash flows

from unexpected changes in exchange rates.

I Translation exposure measures changes in financial statements from unexpected

changes in exchange rates.

Prof. Ph.d. Xiaoni Li International Finance

Types of Foreign Exchange Exposure

I Transaction exposure and operating exposure are also called Economic Exposure
since they both measure changes in the value of all future cash flows from
unexpected changes in exchange rate.

I Translation exposure is also called Accounting Exposure because of the need to

”translate” foreign currency financial statements of foreign subsidiaries into a
single reporting currency to prepare worldwide consolidated financial statements.

Prof. Ph.d. Xiaoni Li International Finance

Economic Exposure: a look from the market value balance sheet

Monetary  Assets  

Monetary  Liabili1es  

Real    Assets  
Common  equity  

Prof. Ph.d. Xiaoni Li International Finance

Contractual Vs Noncontractua

I Monetary assets and liabilities are assets and liabilities with contractual payoffs,
such as accounts receivable, bank deposits, marketable securities, cash inflow side
of forwards etc.

I Real assets and liabilities are all assets and liabilities that are not monetary or
contractual in nature, such as inventory, manufacturing plant, patent, copyright
etc.

Prof. Ph.d. Xiaoni Li International Finance

Contractual Vs Noncontractua

What about common equity?

Prof. Ph.d. Xiaoni Li International Finance

Contractual Vs Noncontractua

Common equity is a non-monetary liability since cash flows that accrue to equity
depend on the non-contractual (operating) cash flows of the firm’s real assets as well
as the contractual cash flows of firm’s monetary assets and liabilities.

Prof. Ph.d. Xiaoni Li International Finance

A Survey of Corporate Treasurers

Managing is importnat.

Mean Score
Transaction exposure 1.4
Operating exposure 1.8
Translation exposure 2.4

Where 1=strongly agree...3=neutral...5=strongly disagree

Prof. Ph.d. Xiaoni Li International Finance

A Survey of Corporate Treasurers

Transaction exposure is viewed by corporate treasurers as the most important currency

risk exposure.

Source: Jesswein, Kwok and Folks, “Adoption of Innovative Products in Currency Risk
Management: Effects of Management Orientations and Product Characteristics,”
Journal of Applied Corporate Finance (1995).

Prof. Ph.d. Xiaoni Li International Finance

Foreign Exchange Exposure Management: Hedging

To hedge or not to hedge: that is the question.

Prof. Ph.d. Xiaoni Li International Finance

Foreign Exchange Exposure Management: Hedging

What is hedging?

Prof. Ph.d. Xiaoni Li International Finance

Foreign Exchange Exposure Management: Hedging

Hedging is the taking of a position in either acquiring a cash flow, an asset, or a

contract (e.g.a forward contract) that will rise (or fall) in value and offset a fall (or
rise) i the value of an existing position. Hedging protects the owner of the existing
asset from loss, however it also eliminates any gain from an increase in the value of
the asset hedged against.

Prof. Ph.d. Xiaoni Li International Finance

Reasons Not to Hedge

I Shareholders are much more capable of diversifying currency risk than the
management of the firm.

I Hedging is not ”free”, which means that it consumes some of a firm’s resources
and so reduces cash flow.

I Management often conducts hedging activities that benefit management at the

expense of the shareholders.

I Financial managers can not outguess the market.

I Management’s motivation to reduce variability is sometimes driven by accounting

reasons.

Prof. Ph.d. Xiaoni Li International Finance

Reasons to Hedge

I Reduction in risk in future cash flows improves the planning capability of the firm.

I Reduction of risk in future cash flows reduces the likelihood that the firm’s cash
flows will fall below a necessary minimum.

I Management has a comparative advantage over the individual shareholder in

knowing the actual currency risk of the firm.

I Management is in a better position than shareholders to recognize disequilibrium

conditions and to take advantage of on-time opportunities to enhance firm value
through selective hedging.

Prof. Ph.d. Xiaoni Li International Finance

Risk Management Policy

Financial managers must be actively involved in formulating risk management policy

and monitoring its implementation so as to ensure that the corporate’s hedging and
risk management strategies are consistent with the overall goals of the firm.
Corporates can decide whether it will take an active or a passive approach to hedge its
exposures to currency risk.

Prof. Ph.d. Xiaoni Li International Finance

Risk Management Policy

Risk  Management  Policy  

Ac3ve  Management   Passive  Management  

Prof. Ph.d. Xiaoni Li International Finance

Active Vs Passive Management

I Active management selectively hedges currency risk exposures depending on the

financial manager’s market view, so that actual positions can diverge from the
corporate’s average or benchmark position.

I Passive management does not intend to anticipate currency movements,

assuming that financial markets are informationally efficient.

Prof. Ph.d. Xiaoni Li International Finance

Risk Management Policy

Risk  Management  Policy  

Ac3ve  Management   Passive  Management  

Technical   Fundamental   Dynamic  

Sta3c  approach  
forecasts   forecasts   approach  

Prof. Ph.d. Xiaoni Li International Finance

Currency Risk Management Program

Currency risk management starts with a forecast of future exchange rates and
volatilities. Given these forecasts, a currency risk management program can be
considered as:

1. Identify exposures.
2. Estimate sensitivities.
3. Decide to hedge or not.
4. Evaluate alternatives.
5. Monitor performance.

Prof. Ph.d. Xiaoni Li International Finance

Transaction Exposure
Transaction exposure is defined as change in the value of monetary (contractual) cash
flows due to an unexpected change in exchange rates. Almost every foreign currency
transaction is exposed to this risk at certain time.

Monetary  Assets  

Monetary  Liabili1es  

Real    Assets  
Common  equity  

Prof. Ph.d. Xiaoni Li International Finance

The Example of Transaction Exposure

One U.S. exporter is expected to receive 1million pounds sterling from a UK customer
in one year. The spot rate expected to prevail in one year is $1.5/£. The actual spot
at year one equals to $1.25/£. What is the net loss for this U.S. exporter from its
original position? Can you draw a risk profile of this underlying exposure?

Prof. Ph.d. Xiaoni Li International Finance

The Example of Transaction Exposure

Expected  receipt  in  pounds  in  one  year  at  

expected  spot  rate  $1.5/£.    
+£  1,000,000  

0 1

=+$  1,500,000            ?  
Actual  exchange  rate  in  year  one  is  $1.25/£.    

+£  1,000,000  

0 1
=+$  1,250,000            !  

Net  loss  from  original  posiEon    

=  -­‐  $  250,000  
0 1

Prof. Ph.d. Xiaoni Li International Finance

Transaction Exposure Management

I Managing transaction exposure internally

I Managing transaction exposure in financial markets

Prof. Ph.d. Xiaoni Li International Finance

Managing Transaction Exposure Internally

Multinational corporation can manage currency risk exposures internally through:

I Multinational netting

I leading and lagging

Prof. Ph.d. Xiaoni Li International Finance

Multinational Netting

Multinational netting allows currency transactions from within the multinational

corporation to be offset and then netted so that multinational treasury can identify
the exposure of the corporation as a whole by consolidating and netting the exposures
of the firm’s operating units.

Prof. Ph.d. Xiaoni Li International Finance

An Example of Multinational Netting

£100m $75m
U.K.
parent £200m
€60m

German
€150m U.S.
subsidiary $125m subsidiary

Cross rates €1.5000/£

$1.2500/£
$0.8333/€

Prof. Ph.d. Xiaoni Li International Finance

An Example of Multinational Netting

Cash  flows  before  [Link]    

£100m £60m
U.K.
parent £200m
£40m

German
£100m U.S.
subsidiary £100m subsidiary

Prof. Ph.d. Xiaoni Li International Finance

An Example of Multinational Netting

Cash  flows  a)er  ne-ng  

£60m £140m
U.K.
parent

German U.S.
subsidiary subsidiary

Prof. Ph.d. Xiaoni Li International Finance

Leading and Lagging

Leading and lagging refers to altering the timing of cash flows within the corporation
to offset foreign exchange exposures:

I Leading if a parent firm is short euros, it can accelerate euro payments from its
subsidiaries.

I Lagging if a parent firm is long euros, it can accelerate euro payments to its
subsidiaries.

Prof. Ph.d. Xiaoni Li International Finance

Leading and Lagging

Underlying cash flows

+€7.5 million +€7.5 million +€7.5 million

-€10 million -€10 million -€10 million

Leading

Lagging

Jan Feb Mar Apr May June July Aug

Prof. Ph.d. Xiaoni Li International Finance

Managing Transaction Exposure in Financial Markets

Examples of financial market hedging instruments used for hedging transaction

exposure are:

I Currency forwards

I Currency futures

I Money market hedges

I Currency swaps

I Currency options

Prof. Ph.d. Xiaoni Li International Finance

Currency Forward Contracts

I Advantages: forwards can provide a perfect hedge of transactions of known size

and timing.

I Disadvantages:
I bid-ask spread can be large on small transactions, long-dated contracts, or infrequently
traded currencies.

I A pure credit instrument, so currency forward contracts have credit risk.

Prof. Ph.d. Xiaoni Li International Finance

Currency Futures Contracts

Currency futures contract in the futures markets for exchange of currencies at a

specific exchange rate. A futures contract is a standard contract, hedging against
currency risk, for purchase of standard amounts of a specific currency (normally major
currencies).

Prof. Ph.d. Xiaoni Li International Finance

Currency Futures Contracts

The futures contract solution to the default risk of the forward contracts

I An exchange clearinghouse takes one side of every transaction

I Futures contracts are marked-to-market on a daily basis

I Initial and maintenance margins are required on futures contracts

Prof. Ph.d. Xiaoni Li International Finance

FX Forwards Vs Futures Contracts

Forwards Futures
Counterparty Bank Futures Exchange Clearinghouse
Maturity Negotiated Standardized
Amount Negotiated Standardized
Fees Bid-Ask Comissions
Collateral Negotiated Margin Account

Prof. Ph.d. Xiaoni Li International Finance

Currency Futures Contracts

I Advantages:

I Low cost if the size, currency and maturity match the underlying exposure
I Low credit risk with daily marking-to-market

I Disadvantages:

I Costs increase linearly with transaction size

I Exchange-traded futures come in limited currencies and maturities
I Daily marking-to-market can cause a cash flow mismatch

Prof. Ph.d. Xiaoni Li International Finance

Money Market Hedges

I Advantages: Synthetic forward positions can be build in currencies for which

there are no forward currency markets

I Disadvantages:
I Relatively expensive hedge

I Might not be feasible if there are constraints on borrowing or lending

Prof. Ph.d. Xiaoni Li International Finance

Active Management of FX risk

Sometimes

Frequently

51% 49%

26%

10% 10% 6%

Alter the size Alter the timing Actively take

of a hedge of a hedge positions

Prof. Ph.d. Xiaoni Li International Finance

Active Management of FX risk

Source: Bodnar, Hayt and Marston, ”1998 Wharton Survey of Derivatives Usage by
U.S. Non-Financial Firms,” Financial Management (1998)

Prof. Ph.d. Xiaoni Li International Finance

Currency Risk Management Benchmarks

42%

24%
17% 17%

Beginning-of- Beginning-of- Bas eline Other

period forward period s pot percent benchm ark
rates rates hedged
s trategy

Prof. Ph.d. Xiaoni Li International Finance

Performance Evaluation

40%

21% 22%
18%

Reduced Risk-adjusted Absolute profit Increased

volatility performance or loss profit relative
relative to a to a
benchmark benchmark

Prof. Ph.d. Xiaoni Li International Finance

Operating Exposure

Operating exposure refers to changes in the value of operating cash flows

(non-contractual) generated by the firm’s real assets due to unexpected changes in
exchange rates.

Prof. Ph.d. Xiaoni Li International Finance

Operating Exposure

Monetary  Assets  

Monetary  Liabili1es  

Real    Assets  
Common  equity  

Prof. Ph.d. Xiaoni Li International Finance

Operating Exposure and Market Integration

Operating exposure to currency risk depends on the extent of market segmentation or

integration for the firm’s inputs and outputs:

I In an integrated market, purchasing power parity holds so that equivalent assets

trade for the same price regardless of where they are traded.
I In a completely segmented market, prices are locally determined.
I Real world markets fall somewhere between these extremes.

Prof. Ph.d. Xiaoni Li International Finance

Operating Exposure and Market Integration

The degree of market integration determines the extent to which the values of the
firm’s real assets move with foreign exchange rates.

Prof. Ph.d. Xiaoni Li International Finance

Operating Exposure and Market Integration

Revenues
Local Global
Operating expenses Local Domestic firms (0) Exporters (+)
Global Importers (-) Global MNCs (+,-,0)

Prof. Ph.d. Xiaoni Li International Finance

Equity Exposure to Foreign Exchange Risk

Shareholders’ equity has a residual claim on the assets of the firm after all the
financial obligations have been satisfied. Equity absorbs the transaction exposure of
monetary assets and liabilities, as well as the operating exposure of real assets.

I Net monetary assets are defined as monetary assets less monetary liabilities. Net
monetary assets exposed to currency equals to the exposed monetary assets less
exposed monetary liabilities.
I Equity exposure to currency risk is the sum of the transaction exposure of net
monetary assets exposed to currency risk plus the operating exposure of the
firm’s real assets.

Prof. Ph.d. Xiaoni Li International Finance

Equity Exposure to Foreign Exchange Risk: An Example

Foreign currency
monetary liabilities
Foreign currency (20¢)
monetary assets
Net exposed
(40¢)
monetary assets
Domestic currency (20¢)
monetary liabilities
Domestic currency (40¢)
monetary assets
(25¢)

Real assets
exposed to Real assets Equity
fx risk (35¢) (40¢)
(35¢)

Prof. Ph.d. Xiaoni Li International Finance

Market-Based Measures of the Exposure of Shareholders’ Equity

The exposure of equity to currency risk can be estimated by the slope coefficient in a
regression of stock returns on changes in the spot exchange rate as:

d
rtd = αd + β f · stf + εdt

I Where rtd = equity return in the domestic currency d in period t

d
I stf = percentage change in the spot exchange rate durng period t

Prof. Ph.d. Xiaoni Li International Finance

Market-Based Measures of the Exposure of Shareholders’ Equity

An example of Ford Company’s Equity Exposures:

$ $ $
rt$ = α$ + β Yen · stYen + β Euro · stEuro + β Pound · stPound + ε$t

$ $ $
rt$ = 0.06 + 0.02 · stYen + 0.01 · stEuro + (−0, 01) · stpound + ε$t

$ $
What is the expected return on Ford stock when stYen = +10%, stEuro = +8%,
$
Pound
st = +8%?

Prof. Ph.d. Xiaoni Li International Finance

Accounting-Based Estimates of Equity Exposure

Managers can develop a better sense of the sensitivity of the firm’s operating cash
flows to currency risk by separating revenues and expenses of the firm and examining
the sensitivity of each to changes in exchange rates as:

d
Revtd = αdrev + βrev
f
· stf + εdr

d
Exptd = αdexp + βexp
f
· stf + εdr

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure in the Financial Markets

An exporter’s hedging alternatives:

I Sell the foreign currency with long-dated forward contracts

I Finance a foreign project with foreign debt capital
I etc.

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure in the Financial Markets

An importer’s hedging alternatives:

I Buy the foreign currency with long-dated forward contracts

I Invest in long-dated foreign bonds
I etc.

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure in the Financial Markets

Advantages of managing operating exposure in the financial markets:

I Most financial market instruments are actively traded and liquid

I If financial prices reflect true value, then financial market hedging are zero-NPV
transactions

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure in the Financial Markets

Disadvantages of managing operating exposure in the financial markets:

I A financial market hedge provides an imperfect hedge of operating exposure to

currency risk
I The contractual cash flows of a financial market hedge can not fully hedge the
uncertain operating cash flows of the firm’s real assets

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure through Operations

Take advantage of the MNC’s ability to respond to differences in real foreign exchange
rates:

I Plant location: gain access to low-cost labor or capital resources

I Product sourcing: shift production to countries with low real costs
I Market selection: shift marketing efforts toward countries with higher demand or
”overvalued” currencies

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure through Operations

Advantages of managing operating exposure through operations:

I Operating hedges create a fundamental change in the way the MNC does
business and thus a long-lasting change to the company’s currency risk exposure
I With established international relations, the MNC is in a better position to take
advantage of opportunities in international markets

Prof. Ph.d. Xiaoni Li International Finance

Managing Operating Exposure through Operations

disadvantages of managing operating exposure through operations:

I Operating hedges are seldom zero-NPV transactions

Prof. Ph.d. Xiaoni Li International Finance

Pricing Strategy in International Markets

I An example: for the classic Japanese exporter, an appreciation of the euro

increases the purchasing power of euro-zone customers

I Pricing alternatives include:

I Hold the euro price constant
I Hold the yen price constant

Prof. Ph.d. Xiaoni Li International Finance

Pricing Strategy in International Markets

I Hold the euro price constant:

I Sell the same quantity
I Bigger yen profit margin per unit

I Hold the yen price constant

I Lower euro price
I Higher sales volume

Prof. Ph.d. Xiaoni Li International Finance

Translation Exposure

Translation (or accounting) exposure refers to the impact of exchange rate changes
on the parent firm’s consolidated financial statements.

Prof. Ph.d. Xiaoni Li International Finance

Translation Exposure

Why would translation exposure occur?

Prof. Ph.d. Xiaoni Li International Finance

Translation Exposure

Foreign currency financial statements must be restated in the parent firm’s reporting
currency for consolidation purposes.

I If the same exchange rate is used to remeasure each and every line item on the
individual statement (income statement and balance sheet), there would be no
imbalances resulting from the remeasurement.

I If a different exchange rate is used for different line items on an individual

statement, an imbalance would result.

Prof. Ph.d. Xiaoni Li International Finance

Translation Methods

Three basic methods for the translation of foreign subsidiary financial statements are
employed worldwide:

I The current/noncurrent method

I The monetary/nonmonetary or temporal method

I The current rate method

Prof. Ph.d. Xiaoni Li International Finance

The Current/Noncurrent Method

I Current assets and liabilities are translated at the current exchange rate.

I Noncurrent assets and liabilities are translated at the historical exchange rate.

I Most income statement items are translated at the average exchange rate over
the reporting period.

I Depreciation is translated at historical exchange rates.

Prof. Ph.d. Xiaoni Li International Finance

The Current/Noncurrent Method

I The current/noncurrent method correctly values current assets and liabilities that
are monetary in nature.

I The current/noncurrent method misvalues long-term debt since long-term debt is

a monetary liability that should be translated at the current exchange rate.

I Gains or losses from translation exposure are absorbed into net worth (equity) in
the balance sheet under the current/noncurrent method, but are not reflected in
net income.

Prof. Ph.d. Xiaoni Li International Finance

The Monetary/Nonmonetary or Temporal Method

I Monetary assets and liabilities are translated at the current exchange rate.

I All other assets and liabilities are translated at the historical exchange rate.

I Most income statement items are translated at the average exchange rate over
the reporting period.

I Depreciation is translated at historical exchange rates.

Prof. Ph.d. Xiaoni Li International Finance

The Monetary/Nonmonetary or Temporal Method

I The temporal method correctly values monetary assets and liabilities at the
current exchange rate.

I Translation gains or losses were reflected in reported earnings on the income

statement. Changes in translated balance sheet accounts could overwhelm
operating performance, resulting in operating losses even during profitable years.

Prof. Ph.d. Xiaoni Li International Finance

The Current Rate Method

I All assets and liabilities except common equity are translated at the current
exchange rate.

I Common equity is translated at the historical exchange rate.

I Income statement items are translated at the current exchange rate.

I Any imbalance between the book value of assets and liabilities is recorded as a
separate equity account called the Cumulative Translation Adjustment (CTA).

Prof. Ph.d. Xiaoni Li International Finance

The Current Rate Method

I From a financial perspective, valuing real assets at current exchange rates better
reflects the exposure of most real assets.

I From a practical perspective, the cumulative translation adjustment account

allows balance sheet gains or losses to be isolated from reported income.

Prof. Ph.d. Xiaoni Li International Finance

A Comparison of Translation Methods

       
   Current-­‐  Monetary-­‐  Current  
   noncurrent  nonmonetary  rate    
Assets  
 ST  financial  assets  current  current  current  
 LT  financial  assets  historical  current  current  
 Real  assets  
 
 historical    historical  current  
Liabili5es  and  owners’  equity  
 ST  financial  liabili4es  current    current    current  
 LT  financial  liabili4es  historical    current  current  
 Net  worth  (equity)
 
 historical    historical    historical  
Transla5on  gains    flowed  through  flowed  through  accumulated  
or  losses    the  income  the  income  as  a  CTA  
   statement  statement  

Prof. Ph.d. Xiaoni Li International Finance

Hedging Translation Exposure

I The firm should only consider hedging risk exposures that are related to firm
value

I Hedging can increase firm value by reducing expected taxes, costs of financial distress,
or agency costs.

I There is no value in hedging non-cash transactions that do not cost or risk cash.

I Translation exposure may or may not involve cash flows.

Prof. Ph.d. Xiaoni Li International Finance

Information-based Reasons for Hedging Translation Exposure

I Costly or restricted access to information on the part of investors or information

providers can provide value-related justifications for hedging:

I Satisfying loan convenants

I Meeting profit forecasts

I Retaining a credit rating

Prof. Ph.d. Xiaoni Li International Finance

 International Finance

Prof. Ph.d. Xiaoni Li

Department of Business Management

Universitat Rovira i Virgili

Reus