Measuring and Managing Exposure to Exchange Rates

1
Measuring and Managing Exposure to Exchange Rates

• Chapters 10 and 11

2
Types of Exposure

• Three types
• Transaction exposure
• Economic exposure
• Translation exposure

3
Measuring Transaction Exposure

• Measuring transaction exposure
• 2 methods
• 1. Measuring exposure based on range of exchange
  rates
• a. Identify currencies to which you are exposed
• b. Estimate net inflows/outflows by currency
• c. Estimate range of net inflows/outflows based
  on range of exchange rates

4
Measuring Transaction Exposure

• 2. Measuring exposure based on the correlation
  coefficient (r)
• r 1
• r -1
• (see handout)

5
Managing Transaction Exposure

• Transaction exposure can be managed using
  quantitative and qualitative tools. We look at 4
  quantitative tools for managing transaction
  exposure
• Futures contracts
• Forward contracts
• Money market hedges
• Options contracts

6
Managing Transaction Exposure

• 1. Futures contract hedge (Chapter 5)
• 2. Forward contract hedge
• Assume MNC has 500,000 in receivables
  denominated in the Thai Baht to be collected 1
  year from now. The Thai baht 1 year forward rate
  is 0.056. How much would firm receive?

7
Managing Transaction Exposure

• How does the firm decide whether to hedge with
  forward or leave unhedged? Assume firm has a
  payable.

Real cost of hedging payables
Nominal cost of payables with hedging
Nominal cost of payables without hedging

-
RCHp

NCHp - NCp

• 0 implies ____________

8
Managing Transaction Exposure

• To illustrate
• Expect to pay 50,000 Jordanian Dinar in 90 days
• 90 day forward rate on Dinar 1.70
• Hedged cost (NCHp) 50,000(1.70) 85,000
• Compare hedged and unhedged scenarios

Possible spot of in 90 days
NCp (not hedging)
NCHp for 50,000
Real Cost of hedging
Probability
1.75 1.71 1.65
30 40 30
85,000 85,000 85,000
87,500 85,500 82,500
( 2500) 0 2500
9
Managing Transaction Exposure

• Should the firm hedge its payables in this case?
  Explain.
• Note that the receivables perspective is just the
  opposite logic!

10
Managing Transaction Exposure

• 3. Money market hedge
• What is a money market hedge?
• Payables perspective on money market hedge
• Expect to pay 100,000 Swiss francs (SF) in 30
  days
• 30 day deposit rate in Switzerland 0 .5
• 30 day borrowing rate in Switzerland 0.55
• 30 day borrowing rate in US 0.7
• 30 day deposit rate in the US 0.6
• Spot rate on SF 0.70

11
Managing Transaction Exposure

• Steps
• 1. Convert dollars to currency denominating
  payables (SF) today
• 2. Invest in foreign securities until needed to
  cover SF payable
• 3. Use proceeds from maturing investment to pay
  the SF payable

12
Managing Transaction Exposure

• 100,000 (1.005) X
• X 100,000/1.005 99,502.49
• What does this number mean?
• 99,502.490.70 69,651.74
• What does this number mean?
• Where are we on the timeline?

13
Managing Transaction Exposure

• To bring the cashflows to the future (30 days)
  and make it comparable to the other instruments
  we make one of two assumptions.
• (a) firm had excess cash
• (b) firm had no excess cash so it had to
  borrow the dollars necessary to execute the
  hedge

14
Managing Transaction Exposure

• If we assume(a) - firm had excess cash
• FV 69,651.74 (1.006) 70,069.65
• Meaning
• If we assume (b) -firm had no excess cash so it
  had to borrow the dollars necessary to execute
  the hedge
• FV 69,651.74 (1.007) 70,139.30
• Meaning

15
Managing Transaction Exposure

• Have we removed the exchange rate risk?
• How would we compare this to a forward contract?

16
Managing Transaction Exposure

• Receivables perspective on money market hedge
• Assume US firm will receive 100,000 Peruvian
  New Sols (NS) in 90 days
• 90 day deposit rate in Peru 2
• 90 day borrowing rate in Peru 3
• 90 day deposit rate in the US 4
• 90 borrowing rate in the US 5
• NS spot rate 0.27

17
Managing Transaction Exposure

• Receivables perspective on money market hedge
• Hedge would be executed as follows
• Borrow money (X) in Peru today
• X(1.03) 100,000
• X 97,087.38 NS
• Convert to US dollars
• 97,087.380.27 26,213.59

18
Managing Transaction Exposure

• Receivables perspective on money market hedge
• Invest in US for 90 days 26,213.59(1.04
  ) 27,262.14
• Meaning
• Note the assumption of investing is
  necessary to find the FV and make it comparable
  to the other instruments in terms of the
  timing.

19
Managing Transaction Exposure

• Receivables perspective on money market hedge
• How will the loan in Peru be paid off?
• Have we removed the exchange rate risk?
• How would we compare this to a forward
  contract?

20
Managing Transaction Exposure

• Options contracts (Chapter 5)
• Same principles as before but in order to bring
  all the cashflows to the same point on the
  timeline (so we can compare all 4 instruments) we
  will find the FV of the premium.
• In other words, the premium is paid today (time
  0) but the option is exercised in the future. So
  we find the FV of the premium to bring it to the
  same point on the timeline as the proceeds from
  exercising the option. We will illustrate using
  the examples in the textbook.

21
Managing Transaction Exposure

• There are also qualitative tools for managing
  transaction exposure. They include
• Leading and lagging
• Currency diversification
• Cross hedging

22
Measuring Economic Exposure

• What is economic exposure?
• Economic exposure can result in
• Competitive effects
• Conversion effects

23
Measuring Economic Exposure

• Generally, a firm will have a higher level of
  economic exposure if either its costs or its
  prices are sensitive to exchange rates
• Economic exposure can be measured by assessing
  the sensitivity of the firms revenues and costs
  to exchange rate changes
• (see problem in text)

24
Managing Economic Exposure

• Select low cost production sites
• Select low cost suppliers
• Diversify market for firms products
• Differentiate product

25
Summary

• Exchange rate changes can systematically affect
  the value of the firm
• Measuring and managing the different types of
  exposure is extremely important for the MNC
• The MNC can use both financial and strategic
  tools to manage exposure