Foreign Exchange Exposure

1
Foreign Exchange Exposure

• What is it and How it Affects the Multinational
  Firm?

2
What is Foreign Exchange Exposure?

• Simply put, foreign exchange exposure is the risk
  associated with activities that involve a global
  firm in currencies other than its home currency.
• Essentially, it is the risk that a foreign
  currency may move in a direction which is
  financially detrimental to the global firm.
• Given our observed potential for adverse exchange
  rate movements, firms must
• Assess and Manage their foreign exchange
  exposures.

3
Does Foreign Exchange Exposure Matter? What do
Global Firms Say

• Nike Our international operations and sources
  of supply are 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 the weakening U.S. dollar against both
  the Canadian dollar and 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
FX Exposure and the Valuation of a MNC

• where E(CF,t) represents expected cash flows to
  be received at the end of period t,
• n represents the number of periods into the
  future in which cash flows are received, and
• k represents the required rate of return by
  investors.

5
Impact of Foreign Exchange Exposure

• where CFj,t represents the amount of cash flow
  denominated in a particular 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 be converted to dollars
  at the end of period t.

6
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
  operations can be adversely affected.
• Revenues (profits) and Costs
• Settlement value of foreign currency denominated
  contracts, in home currency equivalents, can be
  adversely affected.
• For Example Loans in foreign currencies.
• The global competitive position of the firm can
  be affected by adverse changes in exchange rates.
• Influence on required return.
• End Result The value (market price) of the firm
  can be adversely affected.

7
Types of Foreign Exchange Exposure

• There are three distinct types of foreign
  exchange exposures that global firms may face as
  a result of their international activities.
• These foreign exchange exposures are
• Transaction exposure
• Any MNC engaged in current transactions involving
  foreign currencies.
• Economic exposure
• Results for future and unknown transactions in
  foreign currencies resulting from a MNC long term
  involvement in a particular market.
• Translation exposure (sometimes called
  accounting exposure).
• Important for MNCs with a physical presence in a
  foreign country.
• We will develop each of these in the slides which
  follow.

8
Transaction Exposure

• Transaction Exposure Results from a firm taking
  on fixed cash flow foreign currency denominated
  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
Economic Exposure

• Economic Exposure Results from the physical
  entry (and on-going presence) of a global firm
  into a foreign market.
• 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 foreign
  country.
• 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
The Two Channels of Economic Exposure
Impact on the home currency value of foreign
assets and liabilities
MNCs Competitive Position and Value
Exchange Rate Fluctuations
Impact on home currency amount of future
operating cash flows
11
Translation Exposure

• Translation Exposure Results from the need of a
  global firm to consolidated its financial
  statements to include results from foreign
  operations.
• Consolidation involves translating subsidiary
  financial statements from local currencies (in
  the foreign markets where the firm is located) to
  the home currency of the firm (i.e., the parent).
• Consolidation can result in either translation
  gains or translation losses.
• These are essentially the accounting systems
  attempt to measure foreign exchange ex post
  exposure.

12
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 firms
  exposures will look like over the long term.
• Specifically when they will take place and what
  the amounts will be.

13
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
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 a strong 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 on currency moves?
• Obviously, this is different from a company
  managing a hedge fund, or a currency trading
  floor?

15
Hedging Strategies

• It appears that most MNC firms (except for those
  involved in currency-trading) would prefer to
  hedge their 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)