Foreign Exchange Exposure

What is it and How it Affects the Multinational Firm?

By Vijay Mehta

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.

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.

n

ttt

k

CFEV

1

$,

1

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.

m

jtjtjt SECFECFE

1,,$,

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.

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.

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.

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 firm’s location.• These are really “future” transaction exposures which

are unknown today.– Economic exposure can have profound impacts on a global firm’s

competitive position and on the market value of that firm.

Operating exposure(Revenues and Costs)

The Two Channels of Economic Exposure

MNC’s Competitive

Position and Value

Impact on the home currency value of foreign assets and

liabilities

Impact on home currency amount of

future operating cash flows

Exchange Rate

Fluctuations

Foreign currency denominated asset

& liability exposure

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 system’s attempt

to measure foreign exchange “ex post” exposure.

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 firm’s

exposures will look like over the long term.– Specifically when they will take place and what the

amounts will be.

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.

To Hedge or Not to Hedge? • What are some of the factors that would influence a global

firm’s decision to hedge its exposures?– Perhaps the firm’s 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 Starbuck’s 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?

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)