Foreign Exchange Exposurehj

8/2/2019 Foreign Exchange Exposurehj

1/15

Foreign Exchange Exposure

What is it and How it Affects the

Multinational Firm?


2/15

What is Foreign Exchange Exposure? Simply put, foreign exchange exposure is the

risk associated with activities that involve aglobal firm in currencies other than its homecurrency.

Essentially, it is the risk that a foreign currencymay move in a direction which is financiallydetrimental to the global firm.

Given our observed potential for adverse

exchange rate movements, firms must: Assess and Manage their foreign exchangeexposures.


3/15

Does Foreign Exchange Exposure Matter? What do Global Firms Say

Nike: Our international operations and sources of supplyare subject to the usual risks of doing business abroad,such as possible revaluation of currencies (2005).

Starbucks: In fiscal 2004, international company revenue[in US dollars] increased 32%, [in part] because of theweakening U.S. dollar against both the Canadian dollarand the British pound. (2005).

McDonalds: In 2000, the weak euro, British pound and

Australian dollar had a negative impact upon reported*US dollar+ results. (2000).


4/15

4

FX Exposure and the Valuation of aMNC

where E (CF $,t ) represents expected cash flows to bereceived at the end of period t,

n represents the number of periods into the future in whichcash flows are received, and

k represents the required rate of return by investors.

n

t

t t

k

CF E V

1

$,

1


5/15

5

Impact of Foreign Exchange Exposure

where CFj,t represents the amount of cash flow denominated in aparticular foreign currency j at the end of period t,

Sj,t represents the exchange rate at which the foreign currency(measured in dollars per unit of the foreign currency) can beconverted to dollars at the end of period t .

m

jt jt jt S E CF E CF E

1,,$,


6/15

Global Companies and FX Exposure What are the specific risks to a global firm from

foreign exchange exposure? Cash inflows and outflows, as measured in home

currency equivalents, associated with foreign operationscan be adversely affected.

Revenues (profits) and Costs Settlement value of foreign currency denominated

contracts, in home currency equivalents, can beadversely affected.

For Example: Loans in foreign currencies.

The global competitive position of the firm can beaffected by adverse changes in exchange rates. Influence on required return.

End Result: The value (market price) of the firm can beadversely affected.


7/15

Types of Foreign Exchange Exposure

There are three distinct types of foreign exchangeexposures that global firms may face as a result of theirinternational activities.

These foreign exchange exposures are: Transaction exposure

Any MNC engaged in current transactions involving foreigncurrencies.

Economic exposure Results for future and unknown transactions in foreign currencies

resulting from a MNC long term involvement in a particularmarket.

Translation exposure (sometimes called accountingexposure).

Important for MNCs with a physical presence in a foreign country. We will develop each of these in the slides which

follow.


8/15

Transaction Exposure Transaction Exposure: Results from a firm

taking on fixed cash flow foreign currencydenominated contractual agreements.

Examples of translation exposure: An Account Receivable denominate in a foreign

currency. A maturing financial asset (e.g., a bond) denominated

in a foreign currency. An Account Payable denominate in a foreign currency. A maturing financial liability (e.g., a loan) denominated

in a foreign currency.


9/15

Economic Exposure Economic Exposure: Results from the physical entry

(and on-going presence) of a global firm into a foreignmarket. This is a long term foreign exchange exposure resulting from a

previous FDI location decision. Over time, the firm will acquire foreign currency

denominated assets and liabilities in the foreigncountry. The firm will also have operating income and operating

costs in the foreign country. Economic exposure impacts the firm through contracts and

transactions which have yet to occur, but will, in the future,because of the firms location. These are really future transaction exposures which

are unknown today. Economic exposure can have profound impacts on a global firms

competitive position and on the market value of that firm.


10/15

Operating exposure(Revenues and Costs)

The Two Channels of Economic Exposure

MNCs

CompetitivePosition and Value

Impact on the homecurrency value of foreign assets and

liabilities

Impact on homecurrency amount of

future operating

cash flows

ExchangeRate

Fluctuations

Foreign currencydenominated asset

& liability exposure


11/15

Translation Exposure

Translation Exposure: Results from the need of a global firm to consolidated its financialstatements to include results from foreignoperations.

Consolidation involves translating subsidiaryfinancial statements from local currencies (in theforeign markets where the firm is located) to thehome currency of the firm (i.e., the parent).

Consolidation can result in either translation gainsor translation losses.

These are essentially the accounting systems attemptto measure foreign exchange ex post exposure.


12/15

Assessing Foreign Exchange Exposure All global firms are faced with the need to analyze their

foreign exchange exposures. In some cases, the analysis of foreign exchange exposure is

fairly straight forward and known. For example: Transaction exposure.

There is a fixed (and thus known) contractual obligation(in some foreign currency) . While in other cases, the analysis of the foreign exchange

exposure is complex and less certain. For example: Economic exposure

There is great uncertainty as to what the firmsexposures will look like over the long term.

Specifically when they will take place and what theamounts will be.


13/15

Using a Hedge to Deal with Exposures In using a hedge, a firm establishes a situation opposite

to its initial foreign exchange exposure. A firm with a long position: i.e., it expects to receive

foreign currency in the future, will: Offset that position with a short position (i.e., a

payment in the future) in the same currency. A firm with a short position: i.e., it expects to pay foreign

currency in the future, will: Offset that position with a long position in the same

currency. In essence, the firm is covering (offsetting) the original

foreign exchange position. Since the firm has two opposite foreign exchange

positions, they will cancel each other out.


14/15

To Hedge or Not to Hedge? What are some of the factors that would influence a global

firms decision to hedge its exposures? Perhaps the firms assessment of the future strength or weakness

of the foreign currency it is exposed in. This involves forecasting and how comfortable the firm is with the

results of the forecast. For example; If the firm has a long position in what they think will be astrong currency they may decide not to hedge, or do a partial hedge.

Under these assumptions, a firm might accept an open position. On the other hand, firms may decide not have any currency

exposures and simply focus on their core business. Does Starbucks want to sell coffee overseas or speculate oncurrency moves?

Obviously, this is different from a company managing a hedge fund, ora currency trading floor?


15/15

Hedging Strategies It appears that most MNC firms (except for those

involved in currency-trading) would prefer to hedgetheir foreign exchange exposures.

But, how can firms hedge?

(1) Financial Contracts Forward contracts (also futures contracts) Options contracts (puts and calls) Borrowing or investing in local markets.

(2) Operational Techniques Geographic diversification (spreading the risk)

Foreign Exchange Exposurehj

Documents

Transcript of Foreign Exchange Exposurehj