Title: Lecture 10: Understanding Foreign Exchange Exposure
1Lecture 10 Understanding Foreign Exchange
Exposure
- The Types of Foreign Exchange Exposure Facing
Global Firms and Global Investors
2Where is this Financial Center?
34,000 year old Pyramids of Giza
4At the Top -- 455 Ft
5View From the Top
6What 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.
7Risk 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.
8The 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.
9Risks 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.
10Risks 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.
11Types 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.
12Transaction 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.
13Incident 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
14Economic 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.
15Economic 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.
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17Translation 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.
18Foreign 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.
19Risk 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.
20Exchange 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
21Risk 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.
22Exchange 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).