DES en Gestion - Année académique 2002-2003 1 Part 2 International Corporate Finance - Lecture n°...

DES en Gestion - Année académique 2002-20031

Part 2International

Corporate Finance -

Lecture n° 5Foreign exchange exposure

International Finance


International Corporate Finance

Part 2 : International Corporate Finance (10 hrs) Foreign Exchange Exposure (Chap. 6 & 7 - 3 hrs):

Transaction exposure + decision caseOperating exposure

Financing the Global Firm (Chap. 11 & 13 - 3 hrs): Global cost and availability of capitalFinancial structure and international debt

Foreign Investment Decision (Chap. 14 & 15 - 3 hrs): FDI theory and strategyMultinational capital budgeting Adjusting for risk in foreign investment + decision case

Managing Multinational Operations (Chap. 18 & 19 -3 hrs)Repositioning fundsWorking capital management + decision case


Foreign Exchange Exposure

Type of foreign exchange exposures The three main types of foreign exchange

exposure are: transaction, operating, and translation exposure.

Transaction exposureImpact of settling outstanding obligations entered

into before change in exchange rates but to be settled after change in exchange rates.

Operating exposureChange in expected future cash flows arising from

an unexpected change in exchange rates. Translation exposure

Changes in reported owner’s equity in consolidated financial statements caused by a change in exchange rates. “Accounting exposure”.



Hedge or not hedge? There is a debate between supporters and opponents

of FX hedging. Some arguments of the two groups are:

NOT hedge, because : Shareholders are much more capable of diversifying

currency risk than the management of the firm.Currency risk management does not increase the expected

cash flows of the firm, but rather decreases the variance of the CF, and decrease them as well by the hedging costs.

Managers cannot outguess the market, if and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging is zero.

In efficient markets, investors and analysts can see across the “accounting veil” and therefore have already factored the foreign exchange effect into a firm's market valuation.



Hedge or not hedge? HEDGE, because :

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

Management has comparative advantage over the individual shareholder in knowing the actual currency risk of the firm.

Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks. Management is in a better position than shareholders to take advantage of the one-time opportunities theses imperfections cause, to enhance the firm value through selective hedging.


Transaction exposure

Transaction exposure Transaction exposure arises from :

Purchasing or selling on credit goods or services when prices are stated in foreign currency.

Borrowing or lending funds when repayments is to be made in a foreign currency.

Being a party to an unperformed foreign exchange forward contract.

Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

Most common example :Transaction exposure of a firm has a receivable

denominated in a foreign currency.



Transaction exposure - example Sale of telecom equipment from Trident (US

multinational corporation) to a British company. Payment is made in £ : 1 MM due in three months. If the £ appreciate toward the $, Trident makes a

bigger profit, but if the £ depreciates, Tridents loses part (or all) of its margin : transaction exposure.

Spot rate = $1.7640/£. The budget rate, the lowest acceptable dollar per pound exchange rate is established at $1.70/£ to maintain acceptable margin.

Four alternatives available to Trident to manage the exposure:

• Remain unhedged• Hedge in the forward market• Hedge in the money market• Hedge in the options markets



Transaction exposure - example Forward market hedge

This involves a forward (or futures) contract and a source of funds to fulfill that contract.

The forward contract is entered into at the time the transaction exposure is created.

The sequence is as follows : • Day 0 : sell £1 MM forward at $1.7540 (fwd rate 3 mths)• In 3 mths : receive £1 MM (from buyer), deliver £1 MM

against forward sale, receive $1,754 MM (price of the fwd rate).

The forward contract is “covered” or “square”, the funds on hand or to be received are matched by the funds to be paid.



Transaction exposure - example Money market hedge

Like a forward market hedge, a money market hedge also includes a contract and a source of funds. The contract is here a loan agreement.

The firm seeking the hedge borrows in one currency and exchange the proceeds for another currency. If funds to fulfill the contract are generated by business operations, the hedge is “covered”. If the funds are to buy of the spot market, the hedge is “uncovered” or “open”.

The structure is similar to the forward hedge. Here, the price is determined by the interest rate differential between the two currencies, whereas in the fwd hedge, the price is the forward premium. In efficient fwd markets, interest rate parity states that these prices are the same.



Transaction exposure - example Money market hedge

The sequence is as follows : • Day 0 : borrow enough to repay £1 MM in 3mths; that

is : £1MM / 1+0.25 = £ 975,610.

• Day 0 : exchange £ 975,610 against $ at spot rate (1.7640), that is $1,720,976

• In 3 mths : receive £1 MM (from buyer), deliver £1 MM to repay the loan, that is £ 975,610 principal + £ 24,390 interests.

Depending on the relative prices of forward markets and interest rates differences, the money market hedge or the forward hedge will be preferable.



Transaction exposure - example Option market hedge

The transaction exposure could also be covered by a £ 1 MM put option. This technique allows speculation on the upside appreciation of the pound while limiting the downside risk to a know amount (the premium of the option).

The sequence is as follows : • Day 0 : buy put option to sell pounds at $1.75/£, pay

$26,460 for the option.• Option cost = (size of option)x(premium)x(spot rate) =

£1,000,000 x 0.015 x $1.7640 = $ 26,460• In 3 mths : receive £1 MM. Either deliver £1 MM against

put, receiving $1,750,000 or sell £1 MM spot if current spot rate > $1.75/£



Transaction exposure - example Comparison of alternatives

In order to evaluate the full cost of the option hedge, one has to include the opportunity cost of the premium paid.

If one considers 12% of cost of capital ,it makes 3% a quarter. The full premium cost of the option is thus: $26,460x1.03 = $27,254. In contrast, the downside risk is limited to the premium cost incurred, in case of an option hedge. But the upside gain is unlimited.

We can calculate the trading range for the £ that defines the break-even for the option compared to others alternatives.

The upper bound of the range is determined compared to the forward rate. The £ must appreciate enough above the forward rate to cover the 0.0273$/£ to cover the cost of the option : $1.7540 + $0.0273 = $1.7813/£.

The lower bound is is determined compared to the unhedged strategy. If the spot rate falls below $1.75/£, the option is exercised.



Transaction exposure - example Comparison of alternatives

One can thus compare the various gains or losses brought by the hedge at strike price £1.75/$, depending on the realized FX rate :

• Option cost (future value) : $27.254• Proceeds if exercises : $1,750,000• Minimum net proceeds : $1,722,746 (proceeds at strike -

cost)• Maximum net proceeds : unlimited• Break-even spot rate (upside) : $1.7813/£• Break-even spot rate (downside) : $1.75/£

Strategy choice and OutcomeTwo selection criteria : risk tolerance & expectations of

the direction and distance the exchange rate will move the period considered.



1.68 1.70 1.74 1.761.72 1.821.801.78 1.861.84

Value in US dollars ofTrident’s £1,000,000 A/R

1.68

Ending spot exchange rate (US$/£)

1.70

1.72

1.74

1.76

1.78

1.80

1.82

1.84

Money market

Forward rateis $1.7540/£

Forward contract

Uncovered

ATM put option



Risk Management in practiceNo real consensus seems to emerge, according to

international surveys.In most firms, treasury functions are responsible for

transaction exposure management and usually considered a cost function. Expected to act as conservative.

Transaction exposure generally allowed to be hedged once actually booked as receivables and payables (transaction certain).

Transaction management programs divided among those using options, and those who do not. The latter rely almost exclusively on fwd contracts and money market hedges.

Many firms establish risk mgt policy requiring proportional hedging on a % of the total exposure. The remainder is selectively hedged on the basis of expectations and views.



Risk Management in practice - Decision Case See : Lufthansa’s purchase of Boeing 737


Operating exposure

Definition Operating exposure (OE) measures any change in

the present value of a firm resulting from changes in future operating ash flows caused by any unexpected change in exchange rates.

Operating exposure analysis examines the consequences of changing FX rates on a firm’s own operations over the coming months and years and on its competitive position relative to other firms.

Operating exposure and transaction exposure are both related to future cash-flows. They differ in terms of which CF are considered and why they change when FX rates change.


Operating exposure

Attributes of Operating exposure Measuring the OE of a firm requires forecasting and

analyzing all the firm’s future exposures of all the firm’s competitors and potential competitors worldwide. OE is far more important for the long-run health of a business than transaction exposure or translation exposure.

The CF can be divided in operating cash-flows and financial cash-flows.

Operating cash flows arise from intercompany and intracompany receivables and payables, rent and lease payments of facilities, royalties and license fees, etc.

Financial cash flows are payments for the use of intercompany and intracompany loans and stockholders equity.

Each of these CF can occur in different time intervals, amounts, currencies and denomination, and each has a different predictability of occurrence.


Operating exposure

Attributes of Operating exposure Financial and Operating Cash Flows between a

Parent and Affiliate


Operating exposure

Attributes of Operating exposure An expected change in FX rates is not included in the

definition of OE, because it has already been included in the firm’s valuation parameters. Only unexpected changes in FX rate, or inefficient foreign exchange market should cause market value to change.

OE is not just the sensitivity of a firm’s future CF to unexpected change in FX rates, but also its sensitivity to other key macroeconomic variables.

Illustrating of Operating Exposure : Trident Suppose an MNE US Corp. Deriving much of its profits from

its German subsidiary. If the euro unexpectedly falls in value :

How will Trident Europe’s revenue change (prices in euro terms and volumes) ?

How will its costs change (input costs in euro) ?How will its competitors react ?


Operating exposure

Illustrating of Operating Exposure : Trident Imagine that input are bought in Europe, labeled in

Euro. Half of the production is sold in Europe, half is exported to non-European countries. All sales are invoiced in Euros, and the average collection of period account receivables is 90 days.

Following a Euro depreciation, Trident might choose to :maintain its domestic price constant in euro termstry to raise domestic prices because competing

imports are now priced higher in Europekeep exports prices constant in terms of foreign

currencies, in terms of euro, or some where in between (partial pass-through)


Operating exposure

Illustrating of Operating Exposure : Trident The strategy undertaken depends largely on

management's opinion about the price elasticity of demand.

On the cost side, Trident Europe might raise price because of more expensive imported raw material or components.

Trident’s domestic sales and costs might also be partly determined by the effect of the euro devaluation on demand.


Operating exposure

Strategic Management of Operating Exposure The objective of both transaction and operating exposure

management is to anticipate and to influence the effect of the changes in FX rates on a firm’s future cash-flows.

To this end, management can :Diversify operations : sales, location of production

facilities, and raw material sources. Flexibility can allow firms to change its operating structure according to international changes (ex. Goodyear and the Mexican Peso devaluation)

Diversify financing : raise funds in more than one capital market and in more than one currency.

A diversification strategy permits the firm to react either actively or passively, depending on management’s risk preferences, and to opportunities presented by disequilibirum conditions in the FX, capital, or products markets.


Operating exposure

Proactive Management of Operating Exposure Operating and transaction exposures can be

partially managed by adopting policies that partially offset the effect of FX changes. The four most common used techniques are the following :

1. Matching currency cash-flow : Ex : exporting US firm in Canada : match the in flows of CAD from its sales by the outflows of part of its debt labeled in CAD.

2. Risk sharing agreements : contractual arrangements in which the buyer and the seller agree to split currency movements impacts on payments between them.


Operating exposure

Proactive Management of Operating Exposure 3. Back-to-back or parallel loans, or credit swaps : two

business firms in separate countries agree to borrow each other’s currency from a limited period of time. At an agreed terminal date, they return to their borrowed currencies. The transaction takes place outside of the FX markets, although the spot quotation can be used as a reference point.

4. Currency swaps : similar to a back-to-back loan but off balance sheet. Agreement between two parties to exchange a given amount of one currency for another and, after a period of time, to give back the original amounts swapped. Currency swaps can be negotiated for a wide range of maturities and currencies. The swap dealer or swap bank acts as a middleman in setting up the swap agreement.


Operating exposure

Proactive Management of Operating Exposure 4. Currency swaps :

Wishes to enter into a swap to“pay dollars” and “receive yen”

JapaneseCorporation

Assets Liabilities & Equity

Debt in yenSales to US

Swap DealerReceivedollars

Paydollars

Payyen

Receive yen

Wishes to enter into a swap to“pay yen” and “receive dollars”

United StatesCorporation

Debt in US$

Assets Liabilities & Equity

Sales to JapanInflow

of yen

Inflow

of US$

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DES en Gestion - Année académique 2002-2003 1 Part 2 International Corporate Finance - Lecture n°...

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