Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: THEend8_
CRICOS code 00025B
FINM 7406
Lecture 6:
Exchange Rate Exposure I:
Transaction and Translation Exposure
• Risks firms face include:
• Interest Rate risk
• Relative Price Risk
• Political Risk
• Exchange rate risk – “is the variance of domestic-currency value of an asset, liability, or
operating income that is attributable to unanticipated changes in exchange rates.” (Adler
and Dumas, 1983)
Introduction
2
CRICOS code 00025B
Outline
3
• Transaction (Contractual) Exposure
• How is it measured?
• Methods of Hedging Transaction Exposure
• Financial instruments
• Operational Hedges
• Translation (Accounting) Exposure
CRICOS code 00025B
Type of Foreign Exchange Exposure
Unexpected changes in exchange rates may affect a firm’s cash flows and
market value
1. either through its effect on existing contracts ⇒ Transaction
Exposure (see next slide)
2. or through its impact on the future operating cash flows of the firm
⇒ Operating Exposure (aka Economic Exposure)
Exchange rate changes may have an impact
on accounting values
3. This is called Accounting or Translation Exposure
4
CRICOS code 00025B
Transaction Exposure
Transaction exposure measures gains or losses that arise from
the settlement of existing financial obligations (e.g., account
receivables, account payables) whose terms are stated in a
foreign currency.
A classic example of transaction exposure is a firm that has
signed a contract to ship goods overseas at a fixed foreign
currency price.
5
CRICOS code 00025B
Transaction Exposure Example
Suppose an Australian firm (Trident) sells merchandise on open account to
Belgian buyer for:
€1,800,000, payment to be made in 60 days.
S0 = $0.9000/€
The Australian seller expects to exchange the €1,800,000 for
$1,620,000 when payment is received
6
CRICOS code 00025B
Transaction Exposure Example
Transaction exposure arises because of the risk that the Australian seller will
receive something other than $1,620,000.
If the euro weakens to $0.8500/€, then Trident will receive $1,530,000
(€1.8mil * $0.85/€)
If the euro strengthens to $0.9600/€, then Trident will receive
$1,728,000 (€1.8mil * $0.96/€)
Thus, exposure is the chance of either a loss or a gain.
7
CRICOS code 00025B
Transaction Exposure Example
Transaction exposure arises from:
Purchasing or selling on credit goods or services whose prices are stated in
foreign currencies;
Borrowing or lending funds when repayment is to be made in a foreign
currency;
Being a party to an unperformed foreign exchange forward contract;
Otherwise acquiring assets or incurring liabilities denominated in foreign
currencies.
8
CRICOS code 00025B
Transaction Exposure: Inflows & Outflows
9
Inflows of FC
• Accounts receivable
denominated in a foreign
currency (FC)
• Long-term sales contracts
denominated in a FC
• Deposits, bonds, or notes
denominated in a FC
• Forward purchase of a FC
Outflows of FC
• Accounts payable
denominated in a FC
• Long-term purchase con-
tracts denominated in a FC
• Loans, bonds, or notes
due denominated in a FC
• Forward sales of a FC
Net Exposure by currency and date =
Total Inflows – Total Outflows
CRICOS code 00025B
Measuring Transaction Exposure (1)
It is the consolidated net amount in currency inflows and outflows
Example:
Currency Total inflow Total Outflow Net Inflow or outflow
GBP 17,000,000 7,000,000 +10,000,000
CAD 12,000,000 2,000,000 +10,000,000
HKD 20,000,000 120,000,000 -100,000,000
MEX 90,000,000 10,000,000 +80,000,000
10
CRICOS code 00025B
Measuring Exposure (2): Value-at-Risk
Aim – To estimate the potential maximum loss (over a certain period) on the
value of positions that are exposed to exchange rate movements
Blue Bossa Records has €10m position (receivable). The current spot rate is
$1.20/ €. What is its VaR?
Need to specify reference probability and horizon
Need an estimate of the distribution of dollars exchange rate,
e.g. Normal distribution with μ = 0 and σ = 6% per month
With the normal distribution, the 5% tail probability of adverse move starts at
1.65 standard deviation below the mean
x = μ – 1.65 * σ
11
CRICOS code 00025B
Value-at-Risk (cont.)
With the normal distribution, the 5% tail probability of adverse move starts at
1.65 standard deviation below the mean.
x = μ – 1.65 * σ
So, x= 0 – 1.65 * 0.06 = - 0.099
For the $12m position, VaR is -0.099 * $12m is –$1,188,000
[i.e. there is 5% chance of losing $1,188,000] over the next month.
Problems with VaR?
12
CRICOS code 00025B
Why Hedge?
Hedging is the taking of a position, either acquiring a cash flow or an asset or a
contract (including a forward contract) that will rise (fall) in value and
- offset a drop (rise) in value of an existing position.
Hedging, therefore, protects the owner of the existing asset from loss (but it also
eliminates any gain resulting from changes in exchange rates on the value of
the exposure).
13
CRICOS code 00025B
Why Hedge?
14
Expected Value, E(V) Net Cash Flow (NCF)NCF
Unhedged
Hedged
Hedging reduces the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk.
CRICOS code 00025B
The Impact of Hedging on Expected Cash Flows
15
Unhedged
Hedged
$250,000
15%
10%
$0 $1,000,000
25%
50%
Net Cash FlowExpected Value
Probability
CRICOS code 00025B
Why Hedge?
Is the reduction of variability of cash flows then sufficient reason for
currency risk management?
• This question is actually a continuing debate in multinational financial
management and corporate finance.
• There are several schools of thought.
16
CRICOS code 00025B
Opponents of Hedging
Opponents of currency hedging commonly make the following arguments:
• Stockholders are much more capable of diversifying currency risk than
the management of the firm.
• Currency risk management does not add value to the firm, and it incurs
costs.
• Hedging might benefit corporate management more than shareholders.
17
CRICOS code 00025B
Opponents of Hedging (cont.)
Managers cannot outguess the market.
• If and when markets are in equilibrium with respect to parity conditions,
the expected NPV of the hedging is zero.
Management’s motivation to reduce variability is sometimes driven by
accounting reasons.
• However, efficient market theorists believe that investors can see
through the “accounting veil” and therefore have already factored the
foreign exchange effect into a firm’s market valuation.
18
CRICOS code 00025B
Proponents of Hedging
Reduction of risk in future cash flows improves the planning capability of the
firm.
• If the firm can more accurately predict future cash flows, it may be able
to undertake specific investments or activities that it might otherwise not
consider.
Example of MERCK & Co. [Lewent and Kearney, 1990]
• External concerns were not important
• Internal concerns such as a “large proportion of overseas earnings and
cash flows” and the impact of cash flow volatility on MERCK’s strategic
plan (R&D) drove it to hedge against exchange risk
19
CRICOS code 00025B
Proponents of Hedging
Risk Profile of Investments (Agency Costs):
• Debtholders vs. Shareholders vs. Managers
• Shareholders hold an option on the value of the firm and would prefer riskier projects.
• Since, riskier projects reduce the value of bondholders’ claims, bondholders are likely
to require compensation in the form of a higher returns.
• If shareholders can credibly commit not to unduly increase risks, a lower cost of debt
financing could result.
• Additional sources of agency costs come from managers’ preference for less risky
projects (job security).
Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall
below a necessary minimum (and put the firm in financial distress).
20
CRICOS code 00025B
Hedging and Financial Distress
21
Net Cash FlowExpected Value
Unhedged
HedgedPoint of
Financial
Distress
CRICOS code 00025B
Proponents of Hedging
Individuals and corporations do not have same access to hedging instruments
or same cost.
Management has a comparative advantage over the individual stockholder in
knowing the actual currency risk of the firm.
Hedging reduces expected cash flows if taxes are convex rather than linear
functions of income.