Fin 111 Chapter 8 Eiteman

Transaction Exposure• Foreign exchange exposure is a measure of the

potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.

• An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm.

• The effect on a firm when foreign exchange rates change can be measured in several ways.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

1-1

Exhibit 8.1 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure


1-2

Moment in time whenexchange rate changes

Translation exposure

Transaction exposure

Operating exposure

Time

Changes in reported owners’ equityin consolidated financial statementscaused by a change in exchange rates

Change in expected future cash flows arising from an unexpected change inexchange rates

Impact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates

Types of Foreign Exchange Exposure

• Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.

• Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations.


1-3


• Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates.


1-4


• Transaction exposure and operating exposure exist because of unexpected changes in future cash flows.

• The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.


1-5


• Accounting exposure, also called translation exposure, is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.


1-6


• The tax consequence of foreign exchange exposure varies by country.

• As a general rule, however, only realized foreign exchange losses are deductible for purposes of calculating income taxes.

• Similarly, only realized gains create taxable income.

• “Realized” means that the loss or gain involves cash flows.


1-7

Why Hedge?

• MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices.

• These three financial price risks are the subject of the growing field of financial risk management.

• Many firms attempt to manage their currency exposures through hedging.


1-8

Why Hedge?

• Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position.

• While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.


1-9

Why Hedge?

• The value of a firm, according to financial theory, is the net present value of all expected future cash flows.

• The fact that these cash flows are expected emphasizes that nothing about the future is certain.

• Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes.

• A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.


1-10

Exhibit 8.2 Impact of Hedging on the Expected Cash Flows of the Firm


1-11

Expected Value, E(V)Hedging reduces the variability of expected cash flows about the mean of the distribution.This reduction of distribution variance is a reduction of risk.

Net Cash Flow (NCF)NCF

Unhedged

Hedged

Why Hedge?• However, is a reduction in the variability of cash

flows sufficient reason for currency risk management? Opponents of hedging state (among other things):– Shareholders are much more capable of diversifying

currency risk than the management of the firm– Currency risk management does not increase the expected

cash flows of the firm– Management often conducts hedging activities that

benefit management at the expense of the shareholders (agency conflict)

– Managers cannot outguess the market


1-12

Why Hedge?

• Proponents of hedging cite:– Reduction in risk in future cash flows improves the

planning capability of the firm

– Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)

– Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

– Management is in better position to take advantage of disequilibrium conditions in the market


1-13

Measurement of Transaction Exposure

• Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.

• The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency.


1-14

Exhibit 8.3 The Life Span of a Transaction Exposure


1-15

t1 t2 t3 t4

Seller quotesa price to buyer

(in verbal or written form)

Buyer placesfirm order withseller at price

offered at time t1

Seller shipsproduct andbills buyer

(becomes A/R)

Buyer settles A/Rwith cash in

amount of currencyquoted at time t1

QuotationExposure

BacklogExposure

BillingExposure

Time between quotinga price and reaching a

contractual sale

Time it takes tofill the order aftercontract is signed

Time it takes toget paid in cash after

A/R is issued

Time and Events


• Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges.

• The main contractual hedges employ the forward, money, futures, and options markets.

• Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies.


1-16


• The term natural hedge refers to an off-setting operating cash flow, a payable arising from the conduct of business.

• A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap.

• Care should be taken to distinguish operating hedges from financing hedges.


1-17

Dayton Manufacturing’s Transaction Exposure

• With reference to Dayton Manufacturing’s Transaction Exposure, the CFO, Scout Finch, has four alternatives:– Remain unhedged;

– hedge in the forward market;

– hedge in the money market, or

– hedge in the options market.

• These choices apply to an account receivable and/or an account payable.


1-18


• A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract.

• In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date.

• This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract.

• The purchase of such funds at a later date is referred to as covering.


1-19


• A money market hedge also involves a contract and a source of funds to fulfill that contract.

• In this instance, the contract is a loan agreement.

• The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency.

• Funds to fulfill the contract – to repay the loan – may be generated from business operations, in which case the money market hedge is covered.

• Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge).


1-20


• Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk.

• The choice of option strike prices is a very important aspect of utilizing options as option premiums, and payoff patterns will differ accordingly.


1-21

Exhibit 8.5 Valuation of Cash Flows Under Hedging Alternatives for Dayton


1-22

1.68

Value in US dollars ofDayton’s £1,000,000 A/R

1.681.70 1.74 1.761.72 1.821.801.78 1.861.84

Ending spot exchange rate (US$/£)

1.70

1.72

1.74

1.76

1.78

1.80

1.82

1.84

Uncovered

Forward contract hedge

Money market hedge

ATM putoption hedge

Put option strikeprice of $1.75/£

Put option strikeprice of $1.71/£

OTM putoption hedge

Exhibit 8.6 Valuation of Hedging Alternatives for an Account Payable


1-23

1.68 1.70 1.74 1.761.72 1.821.801.78 1.861.84

Cost in US dollars ofDayton’s £1,000,000 A/P

1.68

Ending spot exchange rate (US$/£)

1.70

1.72

1.74

1.76

1.78

1.80

1.82

1.84

Uncovered costswhatever the ending

spot rate is in 90 days

Forward contract hedgelocks in a cost of $1,754,000

Money market hedgeLocks in a cost of $1,781,294

Forward rateis $1.7540/£

Call option strikeprice of $1.75/£

Call option hedge

Risk Management in Practice

• The treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center.

• The treasury function is not expected to add profit to the firm’s bottom line.

• Currency risk managers are expected to err on the conservative side when managing the firm’s money.


1-24

Risk Management in Practice• Firms must decide which exposures to hedge:

– Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy

– Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%

– An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures.

– Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties


1-25


• As might be expected, transaction exposure management programs are generally divided along an “option-line”; those that use options and those that do not.

• Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges.


1-26


• Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging.

• These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures.

• The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level.


1-27


• In addition to having required minimum forward-cover percentages, many firms also require full forward-cover when forward rates “pay them the points.”

• The points on the forward rate is the forward rate’s premium or discount.


1-28


• A further distinction in practice can be made between those firms that buy currency options (buy a put or buy a call) and those that both buy and write currency options.

• Those firms that do use currency options are generally more aggressive in their tolerance of currency risk.

• However, in many cases firms that are extremely risk-intolerant will utilize options to hedge backlog and/or anticipated exposures.


1-29


• Since the writer of an option has a limited profit potential with unlimited loss potential, the risks associated with writing options can be substantial.

• Firms that write options usually do so to finance the purchase of a second option.

• The most frequently used complex options are range forwards, participating forwards, break forwards, and average rate options.


1-30

Mini-Case Questions: Xian-Janssen Pharma

• How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures?


1-31

Mini-Case Questions: Xian-Janssen Pharma (cont’d)

• J&J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation in which XJP finds itself?


1-32

Mini-Case Questions: Xian-Janssen Pharma (cont’d)

• What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary’s financial results by the U.S. parent company?

• If you were Paul Young, what would you do?


1-33

Documents

Fin 111 Chapter 8 Eiteman