Accounting Exposure. Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation. - PowerPoint PPT Presentation
Accounting Exposure Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation. Example: Consider a U.S. multinational company’s subsidiary in Great Britain whose balance sheet and income statement are translated to the parent’s functional currency—the U.S. dollar. The pound has devalued from $1.50/pound to $1.40/pound since the last translation.
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Accounting Exposure
Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation.
Example: Consider a U.S. multinational company’s subsidiary in Great Britain whose balance sheet and income statement are translated to the parent’s functional currency—the U.S. dollar. The pound has devalued from $1.50/pound to $1.40/pound since the last translation.
Impact of Translation Methods on U.K. Subsidiary of U.S. Firm Assuming Pound Devalues from $1.50/Pound to $1.40/Pound Current Monetary Temporal All current Non-current non-monetary rate In Millions £ $ £ $ £ $ £ $ Cash 15d 21 15 21 15 21 15 21 Marketable Securities 30 42 30 42 30 42 30 42 Receivables 40 56 40 56 40 56 40 56 Inventory 60 84 60 90 90 90 60 84 Long term assets 250 375 250 375 250 375 250 350 Total Assets 395 578 395 584 395 584 395 553 Payables 100 140 100 140 100 140 100 140 Long term Debt 145 217.5 145 203 145 203 145 203 Equity 150 220.5c 150 241c 150 241c 150 210c
Total Liabilities 395 578 395 584 395 584 395 553 Exposed Assets 145 85 85 395 Exposed liabilities 100 245 245 245 Net Exposure a £45 -£160 -£160 £150 CTAb - $4.5 +$16 +$16 -$15 a Exposed assets minus exposed liabilities b
Cumulative Translation Adjustment = (Net Exposure) ( St –St-1) c Stockholders equity adjusted to the new level after translation. For example, the net worth translated to dollar under the old exchange rate of $1.50/pound produces $225 million. However, the adjusted net worth after translation to dollar of $220.5 million under monetary nonmonetary method shows decline of -$4.5 million that is reflected in the CTA of the same magnitude. However, the stockholders equity under temporal method is $241 million after translation at the new exchange rate, an increase of $16 million as is evidenced by a CTA of the same magnitude.
A U.S. subsidiary in the United Kingdom believes that it will have a net translation exposure of -£160 million for the next translation period. Strategy The subsidiary buys £160 million three-month forward at $1.50/pound. The pound devalues to $1.40/pound for the next translation period. Forward loss: ($1.40/pound - $1.50/pound.) (£160 million) = -$16 million Translation Gains: ($1.40/pound - $1.50/pound.) (-£160 million) = +$16 Results: Paper gains are equal to real losses of $16 million. The above strategy appears to have neutralized the firm’s translation exposure to foreign exchange as the firm substitutes paper gains for real losses and vice versa. The above strategy is speculative in nature and value-maximizing firms will be better off to avoid such strategy.
Illustration 8.1
Hedging by Nike
Nike markets its products in over 140 countries with foreign sales revenue accounting for
46 percent of its total revenue in fiscal 2001.1 Given its huge presence in the foreign
market, Nike’s annual report states:
“It is the company’s policy to utilize derivative financial instruments to reduce foreign exchange risks where internal netting strategies cannot be effectively employed. Fluctuation in the value of the hedging instruments are offset by fluctuations in the value of the underlying exposures being hedged”. 1 See Nike 2001 Annual Report. Washington: 2001
Nike uses forward contracts for firm commitments to hedge receivables and payables as well as intercompany foreign currency transactions,
Nike uses currency options to hedge certain anticipated but not yet firmly committed export sales and purchase transactions expected in futures denominated in foreign currency.
Cross-currency swaps are employed to hedge foreign currency denominated payments related to intercompany loan agreements.
Transaction Exposure
Transaction exposure is defined as the impact of the unexpected change in the exchange
rate on the cash flow arising from all the contractual relationships entered prior to the
change in exchange rate at time (t1) to be settled after the change in exchange rate at time
(t2).
t1 t2 Time The contractual relationship is entered at time (t1) between two parties for exchange of
goods or services at a price denominated in foreign currency for delivery and settlement
at time (t2). The exchange rate is likely to change between t1 and t2 producing exposure to
the party who is expected to make or receive cash flow denominated in foreign currency.
Dupont Acquires AG
In December 1998 DuPont entered into a forward contract in the acquisition of the performance coating business of Hoechst AG for 3.1 billion deutsche marks (DM) at $1.9 billion.
The forward contract effectively locked the company at the forward exchange rate of 1.6316DM/$, insulating DuPont from adverse exchange rate movements that would likely have increased the dollar price of the acquisition.
Payoff and Variance of Hedged and Unhedged Cash Flow Frequency of Distributions Hedged Unhedged Expected Cash Flows
Structure of Money Market Hedge of Receivables
Pay P&I in £
Borrow £ £
Receive £
Note: P&I refers to principal and interest
Exporter ships the goods to the
Importer
Importer Issues IOU £3.5 million
for 120 days
Offshore Bank
Hedging with Futures Dupont has €12 million payable in 90 days for the supplies it purchased from a Finnish company on August 13. August 13 Spot rate $.97/euro December futures $.9735/euro Buy 96 December futures at $.9735/euro The proceeds per one contract is: 125,000x$.9735/€ = $121687.50 Total proceeds: 96x$121687.50 =$11,682,000 November 13 Spot market: Buy €12,000,000 @ $.9845/euro Close out futures by selling 96 December contracts @$.9858/euro The proceeds per one contract is: 125,000x$.9858/€ =$123,225 Results Spot market: pay $11,814,000 to settle the €12 million payable to Finnish firm Futures market: Gains per contract: $123,225-$121687.50 = $1,537.50 Total Gains: $1,537.50 x 96 = $147,600 Effective cost: $11,814,000 - $147,600 = $11,666,400 Effective rate: $11,666,400/€12,000,000 = $.9722/€
Consider the call option in Euro FX November futures at strike price of 98 cents. The quoted premium is 1.27 cents per euro as of August 23, 02 in the CME.
Each contract is for delivery of 125,000 units of euro. The spot euro is $.9731/pound. The Dupont treasurer in Exhibit
8.9 can buy 96 call options to hedge against the possible appreciation of the euro in the next three months.
The premium for one call option will be equal to $1,587.50, and to hedge the entire exposure requires an upfront premium of $152,400.
The call option is providing protection by imposing a ceiling on the exchange rate that is equal to the strike price plus the premium for the call as follows:
Value at risk (VAR) provides a framework for analysis of the maximum potential loss in the fair value of an exposed position over a specific period assuming normal market conditions and a given confidence interval.
MNCs have various exposures due to interest rate changes, foreign exchange rate changes, as well as to the changes in the commodity prices that could adversely affect the value of the firm.
VAR analysis uses simulation models by assuming various scenarios to generate the amount of maximum loss that could be realized in a given period for a given confidence interval.
Example VAR
For example, a bond portfolio with market value of $250 million might have VAR at 95 percent confidence interval of $15.6176 million over the next 10 days assuming standard deviation of the exposed portfolio is equal to 16 percent per annum.
The volatility is usually quoted in year, however, for the purpose of estimating the VAR of an asset, the volatility of the asset is quoted on a daily basis as volatility per day as follows:
σd = σy / (252) ½
VAR= amount of exposure*volatility*confidence interval
One-day VAR = .010079 x1.96x $250 Million = $4.9387 million. 10-day VAR = One-day VAR.(10)^1/2 10-day VAR = $4.9387*(10)^1/2 = $15.6176 million
Lufthansa purchased 20 aircraft from Boeing at the cost of $500 million payable in one year in January 1986. The spot and one-year forward exchange rates at the time the contract entered into was $.3125/deutsche marks.
Lufthansa by agreeing to pay dollars for the aircrafts accepted all the exchange rate risk and reward for the above contract.
To manage exposure to dollar appreciation the company decided to leave half of the liability exposed to foreign exchange risk and purchased the other half, $250 million, in the forward market at the forward rate of $.3125/deutsche mark or 3.2 DM/$. By hedging half of the exposure the company effectively locked at the forward rate of $.3125/deutsche mark, to pay DM800 million for buying $250 million forward.
Hedged $250 million at $.3125 for DM800 million Exposed $250 million at the prevailing exchange rate in January 1986. By January 1986, the deutsche mark appreciated and the dollar weakened to
$.45/deutsche mark and the forward hedging turned out to be very costly ex-post. Hedging Alternatives: 1. Remain unhedged 2. Fully cover the exposure: buy dollars forward 3. Manage some of the exposure, leaving some exposed 4. Use call options in dollar/deutsche mark or its equivalent the put options in deutsche
mark/dollar 5. Buy caps in dollars or floors in deutsche marks (in the over the counter market from a
bank or insurance company) 6. Money market hedge of payables
Lufthansa’s Payables with Various Hedging Alternatives
Summary of the Lufthansa’s Payable Under Various Alternatives Ex-Post Uncovered 2.3 DM/$ x $500 M = 1.15 billion DM Forward hedging 100 percent of the exposure 3.2 DM/$ x $500 M = 1.6 billion DM Partial hedging 50 percent of the exposure 3.2 x $250 +2.3x$250 M = 1.375 billion DM Options hedging 1.15 billion DM + 96 million DM =1.246 billion DM Partial hedging 50 percent of the exposure through rollover 1.275 billion DM
Managing Operating Exposure
The operating exposure arises due to the impact of unexpected change in the exchange rate on the firm’s input price, that is, raw materials, labor costs, and out put prices such as prices of the goods and services produced. Operating exposure is long term in nature and therefore can only be managed through operating hedges..
Operating hedges can be achieved as follows: 1) Increasing Flexibility of Operating Net Works: Provide MNCs the flexibility to
arbitrage institutional restrictions, such as regulatory impediments, various requirements by regulatory agencies as well as to arbitrage taxes and factors of productions across international boundaries.]
2) Diversifying Operations: This type of diversification naturally hedges cash flow derived from various operations overseas; however, it is expensive in terms of cost and lengthy in implementation.
3) Diversifying Financing with Matching Cash Flows: This approach is similar to the money market hedging discussed earlier in the chapter. The exporter selling goods and services overseas in this scenario has accepted the foreign currency for the receivables and therefore is exposed to foreign exchange risk.
Matching Cash Flow
Receive kron
Pay kron
Export Goods
Norwegian kron
U.S.A Exporter Ships goods to Oslo
Importer Norway
Off-Shore Bank
Parallel Loans
$152 million £100 million
Direct loan Periodic Interest Return of the Principal
MMM U.S.A Parent
Allied Lyon Subsidiary in
New York
MMM Subsidiary in
London
Allied Lyon U.K
Parent Indirect Financing
Indirect Financing
Back to Back Loans
$ 6.5% $ £ £
Principal
U.S.A Capital Market
UK Capital Market
MMM U.S.A
Allied Lyons U.K
$
£ £
LIBOR+1 £
$ 6.5%
Principal Borrowed Periodic interest Return of the Principal
