Managing Foreign Exchange Exposure

1
Chapter 13

• Managing Foreign Exchange Exposure

2

• For the reporting year ended October, 2005, the
  Foreign Exchange Committee of the New York
  Federal Reserve Board reported that the average
  daily volume in OTC foreign exchange options
  totaled 37 billion

3

• The Chicago Mercantile Exchange (CME) is the
  worlds largest and most diverse regulated
  foreign exchange trading market. CME is an
  international marketplace that brings together
  buyers and sellers on its CME Globex electronic
  trading platform and on its trading floors.

4

• In 2005, over 84 million foreign exchange
  contracts with a notional value of 10.2 trillion
  dollars traded at CME.
• In May, 2006, CME foreign exchange products
  averaged a record 501,000 contacts per day, up
  69 from the year earlier
• Electronic foreign exchange products set monthly
  records of 451,000 contracts per day, an increase
  of 90 from the previous year.

5

• Managing foreign exchange risk is a critical
  function, and as companies become more global,
  managing this risk becomes increasingly important

6
Outright Forward Market

• Forward contract is a contract between a foreign
  currency trader and a client for future sale or
  purchase of foreign currency
• Forward contract is a derivative because its
  future value is based on the current spot
  exchange rate
• During a period of stability, little difference
  may exist between the current spot and forward
  rates

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Outright Forward Market

• Example from The Wall Street Journal
• British Pounds
• 90-day forward 1.8983
• Spot 1.9077
• Points -94
• Spread is -.0094 or 94 points (discount)

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Outright Forward Market

• Premium (discount) Fo So x 12 x 100
• So N
• If forward rate lt spot rate, DISCOUNT
• If forward rate gt spot rate, PREMIUM
• Fo forward rate on the day that the contract is
  entered into
• So spot rate on that day
• N number of months forward
• 100 is used to convert the decimal to a

9
Outright Forward Market

• Example from The Wall Street Journal
• Premium 1.8983 1.9077 x 12 x 100
• 1.9077 3
• -1.97
• Pound is selling at a 1.97 discount below the
  dollar spot rate

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Swaps

• A swap is a simultaneous spot and forward
  transaction

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• Example Assume a U.S. company has received a
  dividend from a subsidiary in the E.U., but has
  no use of the euros for 30 days. They could
  deposit the euros in a French bank and earn
  interest for 30 days.
• Alternatively, they could convert the euros to
  dollars and also enter into a forward contract
  with the bank to deliver dollars in 30 days en
  exchange for euros at the forward exchange rate.

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• Variation Foreign currency swap that is driven
  by interest rate differentials.
• Japanese company would like to borrow U.S.
  dollars at a floating rate. U.S. company would
  like to borrow yen at a fixed rate. A financial
  intermediary pairs the two companies. The
  Japanese company issues a fixed rate bond and
  turns the yen over to the U.S. company. The U.S.
  company issues a floating rate obligation, and
  turns the dollars over to the Japanese company.
  The swap exchange rate is the rate at which the
  tow companies agree to exchange yen for dollars.

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Futures

• Specifies an exchange rate sometime in advance of
  the actual exchange of currency
• Traded on an exchange, not OTC
• Futures contract is for a specific amount and a
  specific maturity date, NOT tailored to the
  specific needs of the company (forward contract)
• Less valuable to a company than a forward
  contract
• May be useful to speculators and small companies
  that may not be able to negotiate a forward
  contract
• Contract months are March, June, Sept., Dec.
• Less flexible than forward contracts

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Options

• The right but not the obligation to trade foreign
  currency at a given exchange rate on or before a
  given date in the future
• Can be traded on an exchange or with a financial
  intermediary
• Two parties to an option
• Writer sells the option
• Holder buys the option, pays a premium to the
  writer
• Holder determines whether or not the option will
  be exercised

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• Option can be a put or a call
• A put option gives the holder the right to sell
  foreign currency to the writer of the option
• A call option gives the holder the right to buy
  foreign currency from the writer of the option
• The cost is the contract cost and a brokerage fee

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• The contract cost is nonrefundable
• If the contract is not exercised, the option
  writer retains the option price

17
Foreign Exchange Markets

• Central Bank survey by the Bank of International
  Settlement in Basel, Switzerland
• Global net turnover of foreign exchange is
  estimated to be 1.9 trillion per business day
• Interbank market is the most important market in
  trading foreign exchange
• Banks also deal indirectly with each other
  through foreign exchange brokers
• Movement toward computer-based trades
• Foreign exchange is traded on
• Specialized market International Monetary Fund
  of the Chicago Mercantile Exchange
• OTC revolves around investment banks like Goldman
  Sachs

18
Foreign Exchange Markets

• Most widely traded instrument is swaps, followed
  by spot transactions and outright forwards

19
The International Monetary System

• International Monetary Fund (IMF) created in 1944
  to promote exchange stability
• Exchange Rate Arrangements
• IMF permits countries to select and maintain an
  arrangement of their choosing as long as they
  communicate the arrangement to the fund
• Some countries lock their currencies onto another
  currency Ecuador and the U.S. dollar, Belize
  and the U.S. dollar
• Other countries adopt a free float or a managed
  float
• Importance lies in the relation of the home
  office currency to the currencies in countries
  where the company has operations
• Example U.S. dollar was stable against the
  Chinese yuan , but weak against the euro, pound,
  and yen in 2004 The euro, pound, and yen float,
  but the yuan is pegged to a market basked of
  currencies.

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The Determination of Exchange Rates

• Fisher Effect A theory describing the long-run
  relationship between inflation and interest
  rates.   This equation tells us that, all things
  being equal, a rise in a country's expected
  inflation rate will eventually cause an equal
  rise in the interest rate (and vice versa).
• The nominal interest rate equals the real rate of
  interest worldwide plus the expected inflation
  rate
• International Fisher Effect
• The country with the higher nominal interest rate
  should have a higher rate of inflation
• The country with the higher nominal interest rate
  should expect its currency to weaken against a
  low-interest-rate (low-inflation) country

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The Determination of Exchange Rates

• Important factors affecting exchange rates
• Purchasing power parity (PPP) or inflation
  differentials
• Relative interest rates
• The forward exchange rate
• According to PPP, a change in relative inflation
  must result in a change in exchange rates to keep
  the prices of goods in two countries similar,
  taking into consideration transportation costs.
• PPP is a good long-run indicator of exchange rate
  differences

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The Determination of Exchange Rates

• Higher inflation weakening currency
• Lower inflation stronger currency

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The Determination of Exchange Rates

• The forward rate differs from the spot rate by a
  percentage equal to the interest rate
  differential. If monetary units can earn more
  interest in euros over a 90 day period than if
  the monetary units are maintained in dollars,
  this interest rate differential will be impounded
  in the difference between the spot rate and the
  forward rate.
• The forward rate is also an unbiased predictor of
  the spot rate that will exist in the future,
  which means that it is neither systematically
  above or below the actual future spot rate.

24
The Determination of Exchange Rates

• Political issues can change exchange rate
  differentials, particularly in the short run
• Example 2002 Presidential election in Brazil
• Brazilian real fell against the U.S. dollar
  because of a perceived leftist president
• When the president turned out to be conservative,
  the real strengthened against the dollar

25
Unbiased Forward Rate Theory
26
Transaction Exposure

• When a company engages in foreign currency
  transactions, a foreign exchange risk is incurred
• Example
• If a U.S. exporter receives payment in U.S.
  dollars from a British importer, there is no
  immediate impact on the exporter if the exchange
  rate changes
• The British importer has a cash flow gain/loss
  from the change in exchange rates because their
  accounts payable would change in value as the
  exchange rate changes

27
Translation or Accounting Exposure

• Accounting exposure arises when a company
  translates its financial statements from one
  currency to another for consolidation purposes
• If current rate method is used, all accounts
  except owners equity change in value with the
  exchange rate
• If the temporal method is used, only the monetary
  accounts are translated into dollars at the
  current rate method and exposed to exchange gains
  and losses

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Translation or Accounting Exposure

• Current rate method is likely to have an exposed
  asset position all assets and liabilities
  translate at the same rate assets exceed
  liabilites
• Temporal method is likely to have an exposed
  liability position most liabilities translate
  at the current rate, while some assets translate
  at the current rate and some translate at the
  historical rate.
• Firms are positively exposed with income earned
  in a strong currency country
• Income earned in a weak currency country will be
  reduced by the weak exchange rate
• Dividend flows follow the same pattern as income
• Results under the temporal method will be mixed

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Economic (Operating) Exposure

• Economic exposure is the potential for change in
  expected cash flows
• Economic exposure arises from
• Pricing of products
• Sourcing and cost of inputs
• Location of investments

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Economic (Operating) Exposure

• Example by Aeppel, 2005
• Superior Products Inc., a U.S. company, found
  that prices for valves it was sourcing from
  Germany were continuing to rise. As a result,
  Superiors management decided to begin producing
  the valves itself and selling them to U.S.
  customers. When the Germans realized what was
  happening, they lowered their prices, but it was
  too late.

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Economic (Operating) Exposure

• Future events have more economic exposure than
  transactions exposure because of the different
  ways to account for and hedge them
• Currency of a country could affect its
  competitiveness as a production location
• Example (Aeppel, 2005)
• Bison Gear and Engineering Corp. closed down its
  facility in Holland when the dollar was weak,
  manufactured its products in the U.S., and sold
  them back into Europe.

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Hedging Strategies

• Duffeys Six Reasons Why Management Does Nothing
  (2003)
• Managers do not take time to understand the issue
• Managers claim that exposure cannot be measured
• Managers say that the firm is hedged through
  hedging of transactions, without understanding
  the broader economic exposure
• Managers say that the firm does not have any
  exchange risk because it does all of its
  transactions in the reporting currency.
  Management ignores economic risk
• Management argues that doing business is risky
  and the firm gets rewarded for bearing both
  business and financial risks
• The balance sheet is hedged on an accounting
  basis, especially when the functional currency is
  the reporting currency

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Financial Strategies

• Hedge exposure by use of derivatives
• Enter into foreign currency debt
• Use derivatives to hedge income statement or
  balance sheet exposure
• If a company is in a net monetary asset position,
  it will enter a contract to sell foreign
  currency.
• If a company is in a net liability position, it
  will enter a contract to buy foreign currency

34
Operating Strategies

• Operating hedges are usually
• More complicated and costly than financial hedges
• Involved in betting on the exposure of the entire
  firm rather than just specific financial
  transactions
• Companies can balance costs with revenues
• Examples
• A company that sells to a European customer might
  consider manufacturing in Europe so expenses are
  in euros and can offset euro revenues.
• A company might also incur costs in euros so that
  it can use euro revenues to pay its euro costs.

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Foreign Exchange Risk Management Strategies

• Four steps to protect against exchange rate
  exposure
• Define and measure exposure
• Organize and implement a reporting system that
  monitors exposure and exchange-rate movements
• Adopt a policy assigning responsibility for
  minimizing or hedging exposure
• Formulate strategies for hedging exposure

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Define and Measure Exposure

• Differentiate between transactions, translation,
  and economic exposure
• Each type of exposure may require a different
  hedging response

37
Organize and Implement a Reporting System

• System must monitor exposure and exchange-rate
  movements
• System must forecast exposure to establish a good
  hedging strategy
• Management should set up a uniform reporting
  system for all subs that identifies
• Exposed accounts that the company wants to
  monitor
• Amount of exposure by currency of each account
• Different time periods in consideration

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Adopt a Policy Assigning Responsibility

• Determine who is ultimately responsible for
  protecting the company from exchange rate
  movements
• Multidomestic companies usually delegate hedging
  strategies to national organizations
• Global companies are more likely to centralize
  hedging strategies
• Corporate should determine overall policy
• Corporate should provide forecasts on exchange
  rate movements to help local management

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Formulate Hedging Strategies

• Choice of exposures to be hedged depends
• On risk aversion of the company
• On managements confidence in predicting
  exposures
• Dell Example
• Dell hedges everything
• Dells Brazilian operations hedge about 80 of
  forecasted revenues

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Adopt a Policy Assigning Responsibility

• Local management must develop good capabilities
  in foreign exchange risk management
• Local banking relationships can help local
  management develop forecasts of exchange rate
  movements
• Local management must establish strategies that
  fit within corporate guidelines
• The more centralized the strategy, the more
  corporate will take responsibility for hedging
  strategies
• Local management will then be free to focus on
  operations

41
Hedging Standards

• IAS 39 and SFAS 133 are very similar
• A derivative is defined by three characteristics
• Has one or more underlyings (foreign exchange)
  and one or more notional amounts (units of
  foreign currency traded) or payment provisions or
  both
• Requires no initial net investment or one that is
  smaller that would be required for other
  contracts that would have a similar response to
  changes in market factors
• Terms require or permit net settlement, it can be
  readily net by a means outside the contract, or
  provides for delivery of an asset that puts the
  recipient in a position close to net settlement

42
Hedging Standards

• IAS 39 and SFAS 133 require
• All derivatives be recognized as assets or
  liabilities on the balance sheet at fair value
• Changes in FV are recorded in comprehensive
  income
• Three kinds of hedges
• Fair-value hedge
• Cash flow hedge
• Foreign-currency hedge
• Hedge accounting matches the recognition of the
  gain or loss of the derivative with the gain or
  loss on the underlying transaction

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The Use of a Forward Contract to Hedge a
Transaction
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Illustration A Forward Contract to Hedge a
Foreign Currency Transaction

• Redex Imports, a U.S. company, bought
• inventory from a British supplier on May 1,
• incurring a liability of 50,000 that must be
  paid
• on June 30.
• 1.8500 spot rate on May 1
• 1.8700 forward rate quoted on May 1 for
• delivery on July 30
• 1.8800 spot rate on June 30
• 1.8900 forward rate quoted on June 30 for
• delivery on July 30
• 1.9000 spot rate on July 30

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Illustration A Forward Contract to Hedge a
Foreign Currency Transaction

• May 1 Purchases 92,500
• A/P 92,500
• to record the purchase at the spot
• rate of 1.8500
• A memorandum entry is made to record
• Redexs commitment to deliver dollars to the
• bank and receive 50,000 at the rate of 1.87

46
Illustration A Forward Contract to Hedge a
Foreign Currency Transaction

• June 30 Foreign Exchange Loss 1,500
• A/P 1,500
• 50,000 x (1.88-1.85)
• Forward contract 1,000
• Foreign exchange gain 1,000 50,000 x
  (1.89-1.87)

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Illustration A Forward Contract to Hedge a
Foreign Currency Transaction

• July 30 A/P 94,000
• Loss 1,000
• Cash 95,000
• Forward Contract 500
• Gain 500
• 50,000 x (1.90-1.89)
• Cash 1,500
• Forward contract 1,500
• Assuming a 6 discount rate, PV for one month
  (June 30 July 30) is
• 1.8900-1.8700 .02 x 50,000 1,000/(1
  .06/12) 995

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The Use of a Forward Contract to Hedge a
Commitment
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Illustration A Forward Contract to Hedge a Firm
Commitment

• Redex Imports enters into a commitment to
• purchase capital equipment for 1,000,000
• from a British manufacturer with delivery to take
  
• place on April 30 and payment to be made on
• May 31.
• Spot rates Forward rates
• 1.4900 March 1 1.5700 March 1
• 1.5200 March 31 1.5850 March 31
• 1.5500 April 30 1.5900 April 30
• 1.5950 May 31

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Illustration A Forward Contract to Hedge a Firm
Commitment

• PV of forward contract for March 31 May 31
• 1.5850 1.5700 .015 x 1,000,000
• 15,000/(1 .06/6) 14,851
• March 31 Forward Contract 14,851
• Gain on forward contract 14,851
• Loss on firm commitment 14,851
• Firm commitment 14,851

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Illustration A Forward Contract to Hedge a Firm
Commitment

• PV of the contract for March 31 April 30
• 1.59-1.57 .02 x 1,000,000
• 20,000/(1.06/12) 19,900
• April 30 Forward contract 5,049
• Gain on forward contract 5,049
• Loss on firm commitment 5,049
• Firm commitment 5,049
• Equipment 1,530,100
• Purchase commitment 19,900
• A/P 1,550,000

52
Illustration A Forward Contract to Hedge a Firm
Commitment

• Value of the forward contract on May 31
• 1.5950 - 1.5700 .025 x 1,000,000
• 25,000
• May 31 Forward contract 5,100
• Gain on forward contract
  5,100
• Foreign exchange loss 45,000
• A/P 45,000
• A/P 1,595,000
• Forward contract 25,000
• Cash 1,570,000

53
Illustration A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale

• On March 1, XYZ company estimates it will sell
• 1,000,000 of inventory to British customers
• effective April 30. XYZ enters into a forward
• contract to hedge the British pounds receivable
• Spot Rate Forward Rate for April 30
• March 1 1.4772 1.4900
• March 31 1.4950 1.5050
• Date of sale 1.5100 1.5100

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Illustration A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale

• Nominal Value FV Gain/Loss
• Mar 1 0 0 0
• Mar 31 (15,000) (14,925) (14,925)
• Apr 30 (20,000) (20,000) (5,075)
• Fair Value adjustment on March 31
• 15,000/1 (.06/12) 14,925

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Illustration A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale

• March 1 No entry
• March 31 Other comprehensive income 14,925
• Forward contract
  14,925
• April 30 Other comprehensive income 5,075
• Forward contract
  5,075
• Foreign currency 1,510,000
• Sales 1,510,000

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Illustration A Forward Contract to Hedge a
Foreign-Currency Forecasted Sale

• April 30 Forward contract 20,000
• Cash 1,490,000
• Foreign currency 1,510,000
• Sales 20,000
• Other comp. income 20,000

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Illustration An Option Contract to Hedge
Foreign-Currency Forecasted Sale

• XYZ enters into a put option for 1,000,000 on
• March 1 at a strike price of 1.4900 and a
• premium of 20,000. The sale is expected to
• take place on June 30, the same time the
• option contract expires.
• March 1 Foreign-currency options 20,000
• Cash 20,000
• The option will be adjusted to FV and the
  adjustment will go to comprehensive income. When
  the sale is recorded, this adjustment will be
  taken from other comp. income and used to adjust
  the amount of sales. Sales revenue and cash
  received will be at least 1,490,000.

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Use of Derivatives to Hedge a Net Investment

• SFAS 133 allows hedge accounting for the hedge of
  a net investment
• Gains and losses are taken to a separate
  component of stockholders equity
• The gain or loss may be included in the
  cumulative translation adjustment to the extent
  the changes represent an effective hedge of the
  net investment

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Disclosure of Derivative Financial Instruments

• Derivatives are subject to the following
• Market risk the risk of loss due to unexpected
  changes in interest and exchange rates
• Credit risk the potential loss from
  counterparty nonperformance
• Liquidity risk related to market liquidity of
  instruments held closely related to market risk
• Operating risk linked to inadequate controls
  that ensure following a properly defined
  corporate policy

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Disclosure of Derivative Financial Instruments

• Must disclose the extent of the risk to users
• Must provide qualitative and quantitative
  information about derivatives
• Must disclose
• Objectives for holding derivatives
• Context needed to understand objectives
• Strategies for achieving the objectives
• Separate information should be provided for
• Fair-value hedges
• Cash-flow hedges
• Foreign currency hedges