Madura: International Financial Management Chapter 10
Chapter
8 Chapter Objectives
• To discuss about the major foreign
Exchange Rate Risk Management exchange risks for an MNC.
• To explain the commonly used techniques
for managing foreign exchange risk
exposure.
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Types of Exposure Transaction Exposure
• Exposure to exchange rate fluctuations • Transaction exposure exists when the
comes in three forms: future cash transactions of a firm are
¤ Transaction exposure affected by exchange rate fluctuations.
¤ Economic exposure • The degree to which the value of future
¤ Translation exposure cash transactions can be affected by
exchange rate fluctuations is referred to
as transaction exposure.
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Policies for Hedging Transaction
Transaction Exposure
Exposure
• When transaction exposure exists, the • An MNC’s policy for hedging transaction
firm faces three major tasks: exposure depends in part on its
Identify its degree of transaction exposure, management’s degree of risk aversion.
Decide whether to hedge its exposure, and • An MNC may choose to hedge most of its
Choose among the available hedging transaction exposure or to hedge
techniques if it decides on hedging. selectively.
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Forward or Futures Hedge on
Hedging Exposure to Payables
Payables
• An MNC may decide to hedge part or all of its • A forward contract is negotiated between the firm
known payables transactions as a way of and a financial institution, so it can be tailored to
insulating itself from possible appreciation of the meet the firm’s specific needs.
currency. • The contract will specify:
• It may select from the following hedging ¤ the currency that the firm will pay,
techniques to hedge its payables: ¤ the currency that the firm will receive,
¤ Forward or futures hedge, ¤ the amount of currency to be received by the firm,
¤ Money market hedge, and ¤ the rate at which the MNC will exchange currencies
¤ Currency option hedge. (the “forward” rate), and
¤ the future date at which the exchange of currencies
will occur.
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Forward or Futures Hedge on
Money Market Hedge on Payables
Payables
• A money market hedge on payables involves taking
a money market position to cover a future payables
position.
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Call Option Hedge on Payables
• A currency call option provides the right to buy
a specified amount of a particular currency at a
specified price (called the strike price or
exercise price) within a given period of time.
• The MNC has the flexibility to let the option
expire and obtain the currency at the existing
spot rate when payables are due.
• However, a firm must assess whether the
advantages of a currency option hedge are
worth the price (premium) paid for it.
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Forward or Futures Hedge on
Hedging Exposure to Receivables
Receivables
• Forward or Futures Hedge on Receivables • Forward contracts and futures contracts allow an MNC to
lock in a specific exchange rate at which it can sell a
• Money Market Hedge on Receivables specific currency, thereby enabling it to hedge receivables
denominated in a foreign currency.
• Put Option Hedge on Receivables
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Money Market Hedge on
Put Option Hedge on Receivables
Receivables
• A money market hedge on receivables involves • A put option allows an MNC to sell a
borrowing the currency that will be received specific amount of currency at a specified
and then using the receivables to pay off the exercise price by a specified expiration
loan. date.
• An MNC can purchase a put option on the
currency denominating its receivables and
thus lock in the minimum amount that it
would receive when converting the
receivables into its home currency.
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Economic Exposure
• The overall sensitivity of a firm’s cash flows to
exchange rate movements is referred to as economic
exposure (also sometimes referred to as operating
exposure), which is a broader concept than transaction
exposure.
• Transaction exposure can be thought of as a subset of
economic exposure whereas transaction exposure
focuses on the impact of exchange rate movements on
an MNC’s contractual international transactions,
economic exposure encompasses all of the ways that
an MNC’s cash flows can be affected by exchange rate
movements.
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Economic Exposure Economic Exposure
• Managing Economic Exposure
¤ Selecting low-cost production sites
¤ Flexible sourcing policy
¤ Diversification of the market
¤ Product differentiation and R&D efforts
¤ Financial hedging
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Translation Exposure Translation Exposure
• The exposure of the MNC’s consolidated
financial statements to exchange rate
fluctuations is known as translation
exposure.
• In particular, subsidiary earnings
translated into the reporting currency on
the consolidated income statement are
subject to changing exchange rates.
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Translation Exposure Translation Exposure
Does Translation Exposure Matter? Does Translation Exposure Matter?
• Cash Flow Perspective - Translating • Stock Price Perspective - Since an MNC’s
financial statements for consolidated translation exposure affects its
reporting purposes does not by itself consolidated earnings and many investors
affect an MNC’s cash flows. tend to use earnings when valuing firms,
• However, a weak foreign currency today the MNC’s valuation may be affected.
may result in a forecast of a weak
exchange rate at the time subsidiary
earnings are actually remitted.
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Translation Exposure Translation Exposure
• In general, translation exposure is relevant • Hedging Translation Exposure with Forward
because Contracts
¤ Multinational corporations can use forward
some MNC subsidiaries may want to remit
contracts or futures contracts to hedge translation
their earnings to their parents now, exposure.
the prevailing exchange rates may be used ¤ Specifically, they can sell the currency forward that
to forecast the expected cash flows that will their foreign subsidiaries receive as earnings. In
result from future remittances, and this way, they create a cash outflow in the
consolidated earnings are used by many currency to offset the earnings received in that
currency.
investors to value MNCs.
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Impact of Exchange Rate Exposure
on an MNC’s Value
Transaction Exposure
Economic Exposure
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
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