International Financial Management P G Apte

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SOME TYPICAL CURRENCY RISK SITUATIONS

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It is December 1, 2009. An Indian pharmaceutical company has cleared a shipment of imported chemicals. The invoice is for $500,000 payable on March 3, 2010. The current exchange rate is Rs.46.60 per dollar. The recent history of the exchange rate shows a mixed trend with moderate volatility. During the latter half of 2007 dollar had shown considerable weakness against all currencies including the rupee. During early 2008, the rate was almost flat around Rs.40.00. Dollar was rising against the rupee in early 2009. An adverse movement in exchange rate will affect the firms cash flows. There is also the problem of how to value the imports for the purpose of product costing and pricing decisions. What should the firm do?
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RUPEE-DOLLAR EXCHANGE RATE NOVEMBER 2006-NOVEMBER 2009

60.0000 50.0000 40.0000 30.0000 20.0000 10.0000 0.0000
Au g07 No v07 Fe b08 M ay -0 8 Au g08 No v08 Fe b09 M ay -0 9 Au g09 No v09
4

No v-

b0

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M ay

Fe

-0 7

06

RUPEE-DOLLAR EXCHANGE RATE MARCH 1 - NOVEMBER 27 2009

54.0000 52.0000 50.0000 48.0000 46.0000 44.0000 42.0000
3/2/2009 4/2/2009 5/2/2009 6/2/2009 7/2/2009 8/2/2009 9/2/2009 10/2/2009 11/2/2009
5

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 A US firm has exported some computer peripherals to a German buyer. For customer relationship reasons the sale has been invoiced in buyers currency viz. Euro. The invoice is for 1,000,000 to be settled 90 days from now. The current exchange rate is $1.4715 per Euro. The recent history of the dollar-euro rate shows a mixed down - up trend with some fluctuations. The firms bankers are fairly bullish about the Euro despite the recessionary conditions in the major European economies viz. Germany and France. However US treasury secretary has expressed concern about the weak dollar.
What should the firm do?
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EURO-US DOLLAR EXCHANGE RATE JANUARY 2006 - NOVEMBER 2009

2.0000 1.5000 1.0000 0.5000 0.0000
n0 Ap 6 r -0 Ju 6 l-0 Oc 6 t -0 Ja 6 n0 Ap 7 r -0 Ju 7 l-0 Oc 7 t -0 Ja 7 n0 Ap 8 r -0 Ju 8 l-0 Oc 8 t -0 Ja 8 n09 Ap r -0 Ju 9 l-0 Oc 9 t -0 9
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Ja

EURO-US DOLLAR EXCHANGE RATE MARCH 2 - NOVEMBER 27 2009

1.6000 1.4000 1.2000 1.0000 0.8000 0.6000 0.4000 0.2000 0.0000
/ 20 09 10 /2/ 20 09 11 /2/ 20 09 / 20 09 / 20 09 / 20 09 / 20 09 / 20 09 / 20 09

3/2

4/2

5/2

6/2

7/2

8/2

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9/2

Caterpillar is an American firm which manufactures heavy construction equipment. At the start of the 1980s all its manufacturing operations were located in the US while it sold its products around the world priced in local currencies. Its nearest competitor was Komatsu of Japan. Around mid-1981 the US dollar started rising against all currencies and continued rising month after month. Caterpillar found that its revenues measured in dollars were shrinking while costs kept pace with US inflation. Margins shrank. It could not compensate by raising local currency prices in export markets because Komatsu was holding the price line. How could Caterpillar cope with this? [Link] INTERNATIONAL FINANCIAL MANAGEMENT
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French Franc and Deutschemark per USD January 1980 - December 1990
12.0000 10.0000 8.0000 6.0000 4.0000 2.0000 0.0000 1979-05- 1980-10- 1982-02- 1983-07- 1984-11- 1986-03- 1987-08- 1988-12- 1990-05- 1991-0925 06 18 03 14 29 11 23 07 19
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FFr per USD DEM per USD

Japanese Yen per USD January 1980 - December 1990

300.00 250.00 200.00 150.00 100.00 50.00 0.00 1979-05- 1980-10- 1982-02- 1983-07- 1984-11- 1986-03- 1987-08- 1988-12- 1990-05- 1991-0925 06 18 03 14 29 11 23 07 19
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Gems and jewelry exporters from India face stiff competition from firms in Thailand, Indonesia and Malaysia. After the East Asian currency crisis in the summer of 1997, some of these currencies crashed against the US dollar by as much as 60-80%. While rupee also fell, its fall was much smaller. Indian exporters lost market share as the East Asian exporters reduced prices in the light of falling currencies. From time to time Indian exporters and their federations like FIEO clamor for steeper fall in the rupee to maintain their competitive position.
How can firms cope with this?
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KOREAN WON-DOLLAR EXCHANGE RATE JANUARY 1995 - DECEMBER 2000 (WON PER USD)
2000.00 1500.00 1000.00 500.00 0.00 1994-06-15

1995-10-28

1997-03-11

1998-07-24

1999-12-06

2001-04-19
13

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DOLLAR - THAI BAHT EXCHANGE RATE JANUARY 1995 - DECEMBER 2000 (BAHT PER USD)
60.000 50.000 40.000 30.000 20.000 10.000 0.000 1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
14

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DOLLAR-MALAYSIAN RINGGIT EXCHANGE RATE JANUARY 1995 - DECEMBER 2000 (RINGGIT PER USD)
5.0000 4.0000 3.0000 2.0000 1.0000 0.0000 1994-06-15 1995-10-28 1997-03-11 1998-07-24 1999-12-06 2001-04-19
15

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RUPEE-KOREAN WON EXCHANGE RATE JANUARU 1995 - DECEMBER 2000 (WON PER INR)
50 40 30 20 10 0 1994-06-15

1995-10-28

1997-03-11

1998-07-24

1999-12-06

2001-04-19
16

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RUPEE-THAI BAHT EXCHANGE RATE JANUARY 1995-DECEMBER 2000

1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1994-06-15 1995-10-28 1997-03-11 MANAGEMENT 1998-07-24 [Link] INTERNATIONAL FINANCIAL 1999-12-06 2001-04-19 17

RUPEE-MALAYSIAN RINGGIT EXCHANGE RATE JANUARY 1995 - DECEMBER 2000 (RS. PER RINGGIT)
16 14 12 10 8 6 4 2 0 1994-06-15

1995-10-28

1997-03-11

1998-07-24

1999-12-06

2001-04-19
18

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 A Swiss pharmaceutical firm has a US subsidiary. Financial statements of the subsidiary are denominated in US dollars. The financial year of the Swiss parent firm is September-August. On the balance sheet date it must translate the balance sheet and P-L account of its US subsidiary from dollars to Swiss francs.

During the last few months the US dollar has been weakening against the Swiss franc. On translation, the value of assets and liabilities would show a decline; if assets exceed liabilities, there would be a net loss.
Can anything be done about it? Should anything be 19 [Link] INTERNATIONAL FINANCIAL MANAGEMENT done? How should the gains/losses be accounted for?

DOLLAR-SWISS FRANC EXCHANGE RATE OCTOBER 2006-OCTOBER 2009

1.4000 1.2000 1.0000 0.8000 0.6000 0.4000 0.2000 0.0000
Apr-07 Apr-08 Aug-07 Aug-08 Apr-09 Aug-09
20

Oct-06

Oct-07

Oct-08

Dec-06

Dec-07

Dec-08

Feb-07

Jun-07

Feb-08

Jun-08

Feb-09

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Jun-09

Oct-09

5/1

1.1500 1.1000 1.0500 1.0000 0.9500 0.9000

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DOLLAR-SWISS FRANC EXCHANGE RATE MAY 1 - OCTOBER 30 2009

/ 20 09 5/1 5/ 2 5/2 009 9/ 2 6/1 009 2/ 2 6/2 009 6/ 2 7/1 009 0/ 2 7/2 009 4/ 2 00 9 8/7 / 20 09 8/2 1/ 2 0 9/4 09 / 20 09 9/1 8/ 2 10 009 /2/ 10 2009 /16 / 10 200 9 /30 /20 09

3.1 The Nature of Exposure and Risk

Macroeconomic environmental risks Core business risks While core business risks are specific to a firm, macroeconomic uncertainties affect all firms in the economy Extent and nature of impact of even macroeconomic risks crucially depend upon the nature of a firm's business
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3.1 The Nature of Exposure and Risk (contd.)

The firm is "exposed" to uncertain changes in a number of variables in its environment - Risk Factors Long run response of the firm to these risks can involve significant changes in the firm's strategic posture Exchange rates and interest rates are two of the key macroeconomic risk factors

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3.1 The Nature of Exposure and Risk (contd.)

Exchange rates, interest rates and inflation rates are intimately interrelated Exposure and Risk Exposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor risk is a measure of the variability of the value of the performance measure attributable to the risk factor
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3.1 The Nature of Exposure and Risk (contd.)

The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g. Exchange rate risk depends on how sensitive is the performance indicator to exchange rate fluctuations and what is the extent of likely fluctuations in the exchange rate.

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Risk Management and Wealth Maximization

What should be the attitude of the firm's management regarding firm-specific risks? Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive; however they affect different firms in different ways and are therefore firm-specific or idiosyncratic. Should the firm spend resources to manage such risks?
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Why Hedge?
The value of a firm, according to financial theory, is the net present value of all expected future cash flows. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
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Arguments against active hedging:

Removing unsystematic risks does not add value. Stockholders can diversify

M&M thesis: Shareholders can do it themselves

Firm cannot beat efficient markets Risk removal is costly those who take on the risk must be compensated. Will there be value addition after paying these costs? Active risk management must alter character of cash flows in a manner beneficial to shareholders and do it cheaper than what they can do on their own.
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Why Hedge? Reasons not to hedge

However, is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things):
Currency risk management reduces the variance of the cash flows of the firm, but also uses valuable resources. Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging. 29 [Link] INTERNATIONAL FINANCIAL MANAGEMENT

Arguments for Hedging: Investment-Internal Finance linkage Costs of being perceived as being in financial distress

Agency theoretic arguments

Convex tax schedules

Managers have better information and access to various financial markets than shareholders
For an MNC with global shareholders with different currency habitats it is not clear that hedging benefits all shareholders
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Why Hedge? Reasons to hedge

Proponents of hedging cite:
Reduction in risk in future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firms cash flows will fall below a necessary minimum (the point of financial distress) Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm Management is in better position to take advantage of disequilibrium conditions in the market
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Is Exchange Rate Risk Relevant?

Purchasing Power Parity Argument:

Exchange rate movements will be matched by price movements. PPP does not necessarily hold.

The Investor Hedge Argument:

MNC shareholders can hedge against exchange rate fluctuations on their own. The investors may not have complete information on corporate exposure. They may not have the capabilities to correctly insulate 32 [Link] INTERNATIONAL FINANCIAL MANAGEMENT themselves too.

Is Exchange Rate Risk Relevant?

Currency Diversification Argument:

An MNC that is well diversified should not be affected by exchange rate movements because of offsetting effects. This is a naive presumption.

Stakeholder Diversification Argument:

Well diversified stakeholders will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. MNCs may be affected in the same way because 33 [Link] INTERNATIONAL FINANCIAL MANAGEMENT of exchange rate risk.

The Nature of Exposure and Risk

Core business risks Macroeconomic Environmental Risks Risk Factors Exchange rates and interest rates are two of the key macroeconomic risk factors Long run response of the firm to these risks can involve significant changes in the firm's strategic posture Exchange rates, interest rates and inflation rates are intimately interrelated

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The Nature of Exposure and Risk

Exposure and Risk Exposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor

Risk is a measure of the variability of the value of the performance measure attributable to the risk factor
The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g. exchange rate
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Exposure and Risk: A Formal Approach

Exposure of a firm to a risk factor is the sensitivity of the real value of a firm's assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in the risk factor V : Change in the real domestic currency value of an item S : The current value of the risk factor Su : Unanticipated change in the value of the risk factor e.g. exchange rate Then exposure = V/ Su
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An Example : A company has a US$ 500000 receivable from an American customer to be received 3 months from today. The current rupee-dollar rate is 47.50; The market is quoting a 3month forward rate at 48.00; The forward rate can be taken as markets expectation of what the rupee-dollar rate will be 3 months from now. Thus the expected change in exchange rate is (48.00-47.50) or +0.50. Three months later, the rupee-dollar rate falls to 46.80.

Total change: (46.80-47.50) = -0.70;

Unexpected change : -1.20

Expected change : +0.50

Change in the value of receivable: (46.80-48.00)(500000) Exposure : [(46.80-48.00)($500000)]/(-1.20) = $500000

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Currency Exposure: A Foreign Currency Liability

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Currency Exposure: A Foreign Currency Asset

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Exposure and Risk: A Formal Approach

The relation between V and Su can be represented by the following equation
V = 0 + 1(Su) 1 is a measure of the sensitivity of V to changes in S Exposure V is in million rupees and Su is in rupees per dollar, the units of measurement for the exposure, 1, are millions of dollars
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Exposure and Risk: A Formal Approach

Risk is the variance of the real domestic currency value of assets, liabilities or operating income attributable to unanticipated changes in exchange rates Vs = 0 + 1(Su) Vs is the change in value attributable to unanticipated change in the exchange rate Foreign exchange risk is defined as the variance of Vs var(Vs) = 12[var(Su)]
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TAXONOMY OF CURRENCY EXPOSURE

Effect of exchange rate changes on anticipated transactions

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Taxonomy of Currency Exposure

Currency Exopsure Short Term Cash Flow Accounting
(Translation)

LongTerm Strategic Operating

Contractual

Anticipated
43

(Transactions) [Link] INTERNATIONAL FINANCIAL MANAGEMENT

Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure

Moment in time when exchange rate changes

Translation exposure
Changes in reported owners equity in consolidated financial statements caused by a change in exchange rates

Operating exposure
Change in expected future cash flows arising from an unexpected change in exchange rates

Transaction exposure
Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time
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Exchange Rates Used in Various Translation Methods

Current Temporal NonCurrent Cash, Current Receivables & Payables C C Inventory C C or H Fixed Assets H H Long-Term Receivables & Payables H C Monetary Current NonMonetary Rate

C H H

C C C

Note : "C" denotes current rate, "H" denotes historical rate.

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Translation Exposure: Illustration

In the illustration, it is assumed that an Indian company is translating the balance sheet of a foreign entity into rupees. The "current rate", which is the rate on the balance sheet date of the parent is assumed to be LC 1 = Rs.1.50 while the "historical rate" is assumed to be LC 1 = Rs.1.00. Here "LC" stands for "Local Currency and HC for parents home currency

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Current Monetary Current Temporal Non NonRate Method Current Monetary (Rs.) (Rs.) (Rs.) (Rs.) ______________________________________________________ Cash 200 300 300 300 300 Inv. 300 450 300 450 450 Fixed Assets 800 800 800 1200 800 ---------------------------------1300 1550 1400 1950 1550 Curr.

LC

Liab.
LT Debt NW

200

300

300

300

300

300 800

300 950

450 650

450 1200

450 800
47

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The life span of a transaction exposure

Time and Events

t1
Seller quotes a price to buyer (in verbal or written form)

t2
Buyer places firm order with seller at price offered at time t1

t3
Seller ships product and bills buyer (becomes A/R)

t4
Buyer settles A/R with cash in amount of currency quoted at time t1

Quotation Exposure

Backlog Exposure

Billing Exposure

Time it takes to fill the order after contract is signed [Link] INTERNATIONAL FINANCIAL MANAGEMENT

Time between quoting a price and reaching a contractual sale

Time it takes to get paid in cash after A/R is issued

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Classification of Currency Exposure

An alternative but similar in spirit approach to classification of currency exposure focuses on the length of the time horizon and whether or not the exposure impacts on the end-of-the horizon financial statements Accounting exposure is used for short-term exposures which will have an impact on the financial results Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rate and is horizon is medium term Strategic exposure refers to a still longer horizon and contemplates longer-term operational flexibility such as changing product-market mix, shifting location of operations and adopting new technologies
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Classification of Currency Exposure

Value-based" exposure which focuses on the impact of currency fluctuations on market value of the firm that takes into account both short-term accounting exposures as well as operating and strategic flexibility in responding to currency movements

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A survey of corporate treasurers and financial officers

Do you agree or disagree with the following statements?
Mean Score Managing transaction exposure is important. Managing economic exposure is important. Managing translation exposure is important. 1.4 1.8 2.4

Key: 1= strongly agree, ... 3=neutral, ... 5= strongly disagree

Transaction exposure is viewed as the most

important currency risk exposure
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3.3 Exposure and Risk: A Formal Approach

Denote the spot rate by S0, and the spot rate 90days from today by S3. The total change in exchange rate from today to 90-days from today is (S3 - S0). This can be broken down into S3 - S0 = [S3 - E(S3)] + [E(S3) - S0] = Su + Sa E(S3) means "expected value of S3" Su is the unanticipated component of the change and Sa is the anticipated component
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3.3 Exposure and Risk: A Formal Approach (contd.)

Suppose the spot rate 90 days hence is 28.90

The total change is Rs.0.90 (S3-S0), anticipated change is 0.50 [E(S3)-S0] and unanticipated change is 0.40 [S3-E(S3)]
Since S3 has a normal distribution with mean 28.50 and standard deviation Rs.0.05, [S3 - E(S3)] will have a normal distribution with mean zero and standard deviation of Rs.0.05
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3.3 Exposure and Risk: A Formal Approach (contd.)

Since the unanticipated change in the rupee value of the payable is given by 100000(Su), it will also have a normal distribution with mean zero and standard deviation of Rs.5000 One can say with 95% confidence that the unanticipated change in the value of the payable will lie between -10000 and +10000.

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3.3 Exposure and Risk: A Formal Approach (contd.)

Instead of variance, one can estimate the possible range i.e. the difference between the highest and lowest values of the item given certain assumptions about the possible range of variation in the exchange rate One can construct alternative scenarios of exchange rate movements The "best case" and the "worst case" scenarios
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Transactions Exposures result from an unanticipated change in the exchange rate which has an impact - favorable or adverse - on the firms cash flows during the upcoming accounting period. Most often, the term is used to denote exposures on items the foreign currency values of which are contractually fixed export receivables, import payables, interest payable etc.
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Transaction risk can be defined as a measure of variability in the value of assets and liabilities when they are liquidated Points to be noted are Transactions exposures usually have short time horizons; Operating cash flows are affected; exchange gains/losses have tax implications
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Anticipated cash flow exposure is the case when a transaction is being negotiated, all the terms have been more or less finalized but a contractual arrangement is yet to be entered into Translation Exposure also called Balance Sheet Exposure: It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Translation exposure arises when a firm has

A foreign operation such as a branch, a joint venture or 100% subsidiary in a foreign currency.
The home country law requires that the parent must translate financial statements of foreign operations from foreign to home currency and consolidate with parent financial statements.

Foreign currency fluctuations lead to translation gains or losses. No cash flow implications
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Two relevant considerations: - What rate to use for translation current, historical, average? - how to report translation gains/losses? Finance theorists argue that translation losses and gains are only notional accounting losses and gains. No cash flow impact. Published financial statements are affected.
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Translation Methods
For translating a foreign entity's balance sheet into the parent's currency of reporting various methods can be followed
Closing rate method uses the rate prevailing on the parent's balance sheet date Current-non current method uses the closing rate for current assets and liabilities and historical rates for noncurrent assets and liabilities Monetary-non monetary method translates monetary assets and liabilities at the closing rate while non- monetary assets and liabilities such as inventories are translated at historical rates Temporal method current rate for items reported at current market value; historical rate otherwise.
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Exchange rate impact on future revenues, costs, operating cash flows operating exposure In the long run, exchange rate effects can even undermine a firm's competitive advantage by raising its costs above those of its competitors or affecting its ability to service its market in other ways Such competitive exposure is often referred to as "Strategic Exposure" because it has significant implications for some strategic business decisions such as choice of markets, sourcing, location etc.
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Even if a firm has no direct involvement in any cross-border transactions it is not immune to exchange rate exposure Indirect" exposure is also in the nature of operating exposure faced by the firm where changes in exchange rates will most likely have an impact on its customers, suppliers and competitors which in turn will force the firm to alter its operations and strategies
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

An alternative but similar in spirit approach to classification of currency exposure focuses on the length of the time horizon and whether or not the exposure impacts on the end-of-the horizon financial statements Accounting exposure is used for short-term exposures which will have an impact on the financial results
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rate and is horizon is medium term Strategic exposure refers to a still longer horizon and contemplates longer-term operational flexibility such as changing product-market mix, shifting location of operations and adopting new technologies
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3.4 Classification of Foreign Exchange Exposure and Risk (contd.)

Value-based" exposure which focuses on the impact of currency fluctuations on market value of the firm that takes into account both shortterm accounting exposures as well as operating and strategic flexibility in responding to currency movements

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3.5 Accounting Treatment of Transaction and Translation Exposure (contd.)

Apart from the transparency and information content of the financial statements, the key consideration in choosing the accounting treatment of transaction and translation exposures is its tax implications for the company as whole

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