Lecture 10: Understanding Foreign Exchange Exposure - PowerPoint PPT Presentation

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Lecture 10: Understanding Foreign Exchange Exposure

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Title: Lecture 10: Understanding Foreign Exchange Exposure


1
Lecture 10 Understanding Foreign Exchange
Exposure
  • The Types of Foreign Exchange Exposure Facing
    Global Firms and Global Investors

2
Where is this Financial Center?
3
4,000 year old Pyramids of Giza
4
At the Top -- 455 Ft
5
View From the Top
6
What is Foreign Exchange Exposure and Exposure
Risk?
  • Foreign exchange exposure comes about when a firm
    or investor has an open position in a foreign
    currency.
  • Open position Unhedged subject to exchange
    rate risk
  • Open long position Expect to receive foreign
    currency in the future
  • Open short position Need to pay foreign
    currency in the future
  • Foreign exchange exposure risk refers to the
    possibility that a foreign currency may move in a
    direction which is financially detrimental to the
    global firm or global investor.
  • Important Global firms and investors cannot
    have foreign exchange exposure in their home
    currencies.
  • Suggests a strategy for managing exposure.

7
Risk with an Open Foreign Currency Position
  • Open long position (when you expect to receive
    foreign currency in the future).
  • Specific risk is that the foreign currency may
    weaken against your home currency, thus reducing
    the home currency equivalent of the long
    position.
  • Open short position (when you expect to pay
    foreign currency in the future).
  • Specific risk is that the foreign currency may
    strengthen against your home currency (thus
    requiring more home currency to acquire the
    foreign currency). This increases the home
    currency equivalent of the short position.

8
The Risks Associated with FX Exposure
  • There are three specific risks to global firms
    and/or global investors from their foreign
    exchange exposures
  • (1) Settlement Value Risk Occurs because
    foreign currency denominated contracts and
    investments, in the home currency equivalent of
    the firm or investor, can be adversely affected
    by FX changes.
  • Fixed income investments (e.g., bonds).
  • Accounts receivable held multinationals.
  • Loans payable to banks.

9
Risks Associated with FX Exposure
  • (2) Future Cash Flows Risk Occurs because the
    home currency equivalents of anticipated foreign
    currency cash flows can be adversely affected.
  • Foreign currency cash inflows and outflows
  • Interest payments on fixed income securities.
  • Future revenues from ongoing multinational
    operations.
  • Future costs associated with ongoing
    multinational operations.
  • Note the net impact of this cash flow exposure
    depends upon the net cash flow position of the
    firm.
  • For example, if foreign currency revenues exceed
    foreign currency costs, a strong foreign currency
    with have a net positive effect on the net home
    currency equivalent.
  • And if foreign currency costs exceed foreign
    currency revenues, a strong foreign currency will
    have a net negative effect on the net home
    currency equivalent.

10
Risks Associated with FX Exposure
  • (3) Global Competitive Risk Occurs because the
    competitive position of a firm can be affected by
    adverse changes in exchange rates.
  • Exporting firms are adversely affected if the
    currencies of their overseas markets weaken.
  • More difficult to compete with domestic firms.
  • Importing firms are adversely affected if the
    currencies of their overseas markets strengthen.
  • May need to increase their home market selling
    prices.
  • Overseas production is adversely affected if the
    currencies of these outsourcing countries
    strengthens.
  • Home currency equivalent of producing offshore
    will increase.

11
Types of Foreign Exchange Exposure Facing Global
Firms
  • There are three types of foreign exchange
    exposures that global firms may face as a result
    of their international activities.
  • These foreign exchange exposures are
  • Transaction exposure
  • Results from a global firm engaged in current
    transactions involving contractual arrangements
    in foreign currencies (e.g., invoices coming due,
    loans coming due, interest payments coming due,
    etc).
  • Economic exposure
  • Results from future and unknown transactions in
    foreign currencies resulting from a global firms
    long term involvement in a particular market
    (i.e., because of a long term physical presence
    in that foreign market).
  • Translation exposure (sometimes called
    accounting exposure).
  • Important for global firms with a physical
    presence in a foreign country needing to
    consolidate their individual country financial
    statements for reporting purposes.

12
Transaction Exposure
  • Transaction Exposure Results when a firm agrees
    to fixed cash flow foreign currency denominated
    contractual agreements.
  • Examples of transaction 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.

13
Incident of Exporting and Importing Transaction
Exposure By Global Firms Home Country
Country Exports in Home Currency ( of invoices) Imports in Home Currency ( of invoices)
United States 96.0 85.0
Germany 81.5 52.6
France 58.5 48.9
United Kingdom 57.0 40.0
Italy 38.0 27.0
Japan 34.3 13.3
Note 1988 Data
14
Economic Exposure
  • Economic Exposure Results from the physical
    entry of a global firm into a foreign country.
  • This is a long term foreign exchange exposure
    resulting from a previous FDI location decision.
  • Economic exposure impacts the firm through
    contracts and transactions which have yet to
    occur, but will, in the future. These are really
    future transaction exposures which are unknown
    today.
  • Economic exposure also impacts the firm through
    its operating income (revenue) and costs which
    are denominated in the currency of the foreign
    country.

15
Economic Exposure of U.S. Firms
  • Empirical studies of large U.S. multinational
    firms (with significant foreign operations) have
    generally found low or negligible foreign
    exchange exposure, i.e., little variation in home
    currency equivalent profits associated with
    exchange rate changes.
  • Explanation 1 U.S. multinationals might be
    very successful in hedging their exposures.
  • Explanation 2 U.S. multinational firms with a
    relatively balanced revenue and cost in foreign
    currencies may have a natural offset. Whereas
    unbalanced firms (without hedging) could be
    subject to more foreign exchange exposure.
  • Explanation 2 referred to as Operational
    Hedging.

16
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17
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 in local currencies (i.e.,
    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.

18
Foreign Exchange Exposure for a Global Investor
  • Foreign exchange exposure for a global investor
    results from the acquisition of financial assets
    denominated in a currency other than the home
    currency of the investor.
  • FX exposure can affect
  • (1) The home currency equivalent market price of
    those assets and
  • (2) The home currency equivalent cash flows
    (dividends and interest) associated with
    particular financial assets.

19
Risk Elements for Global Investors in Equities
  • The specific risk components associated with
    common stock (equities)
  • Company risk (micro risk)
  • Decisions of management changes in management
    success or failure of (new) products.
  • Environment risk (macro risk)
  • Risk produced by the industry (competition),
    governments (regulation), country (business
    cycles) and global environment in which the
    company operates.
  • Market risk (systematic risk)
  • Associated with movements in the overall equity
    market of a country. Under CAPM, measured by the
    stocks beta.
  • Exchange rate risk
  • Associated with investing in equities whos
    market price and dividends are denominated in
    other than the home country of the investor.

20
Exchange Rate Impacts on Equity Returns Dec 31,
2010 Oct 15, 2011
Country or Area L.C. Return USD Return Stock Index
United States -0.5 -0.5 DJIA
Egypt -42.8 -44.4 CASE
Japan -16.2 -12.1 Topix
China -13.8 -10.6 SSEA
Britain -7.8 -7.1 FTSE 100
Canada -10.5 -12.5 TSX
Germany -13.3 -10.8 DAX
Switzerland -10.2 -6.4 SMI
Australia -12.0 -14.3 All Ord.
Pakistan 0.8 -1.0 KSE
South Africa -3.1 -17.7 JSE
Hong Kong -20.4 -20.5 Hang Seng
Saudi Arabia -7.8 -7.8 Tadawul
21
Risk Elements for Global Investors in Bonds
  • The specific risk components associated with
    bonds (i.e., fixed income securities)
  • Default risk (credit risk) Risk that issuer will
    not be able to repay debt as contracted.
  • Corporates Cash flow issues.
  • Sovereigns Governmental debt servicing issues.
  • Market risk (price risk)
  • Associated with changes in the markets overall
    assessment of risk and willingness to take risk
    (or avert risk).
  • Contagion risk
  • Associated with spillover effects from other
    countries.
  • Exchange rate risk
  • Associated with investing in bonds whos market
    price and interest payments are denominated in
    other than the home country of the investor.

22
Exchange Rates and Bond Yields
  • The gap between the U.S. dollar un-hedged and
    hedged Global Treasuries shows the effect
    currency has played in these annual returns. In
    most years (with the exception of 2005 and the
    first quarter of 2009), currency moves
    (represented by unhedged returns) benefited the
    U.S. investor (this is shown by the difference
    between the un-hedged and hedge indexes).
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