Hedging foreign exchange risk

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Foreign exchange risk
Overseas investments and international business
involve foreign exchange risk
Foreign exchange risk is the risk of loss due to changes
in the relative value of world currencies
Modest changes in exchange rates can result in
significant dollar differences

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Foreign exchange risk
Example
Assume Boeing company sells an airplane to a
Japanese buyer: Boeing must receive $1,000,000 to
cover costs and profits. Since payment usually in
buyers currency, priced in Yen () and at current
exchange rate of 100.00/$; the price of airplane
therefore 100,000,000.
Case 1: If delivery and payment occur immediately, just
exchange 100,000,000 for $1,000,000 on spot
market. Thus, there is no foreign exchange risk.

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Foreign exchange risk
Case 2: If price is set today, but delivery is in 6
months, Boeing is exposed to significant foreign
exchange risk unless it hedges that risk.
Thus, firms should identify events that expose to
foreign exchange risk
A survey of corporate treasurers indicates that the
primary corporate use of derivative assets is
hedging foreign exchange exposure

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Foreign Exchange exposure
Exposure is the extent to which a firm face foreign
exchange risk
There are three types of exposure:
Transaction exposure
Operating/Economic exposure
Translation /Accounting exposure

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Decision on Foreign Exchange exposure
The portfolio manager needs to decide whether
to:
Ignore the exposure,
Eliminate the exposure, or
Hedge the exposure

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Ignore the exposure
Investors may be aware of economic
exposure but accept it as a fact of life
Ignoring the exposure may be appropriate if
the amount of the exposure is relatively
small
Ignoring the exposure may be appropriate if
the home currency (U S exporter dollar) is
expected to depreciate

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Reduce or Eliminate the Exposure
Amounts to selling the foreign security or
reducing the size of the position
May be appropriate if the home currency
(U S exporter dollar) is expected to
appreciate dramatically

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Hedging the exposure
Hedging Defined
A firm or an individual hedges by taking a
position, that will rise (or fall) in value to offset a
drop (or rise) in value of an existing position.
A perfect hedge is one eliminating the
possibility of future gain or loss due to unexpected
changes in the value of the existing position.

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How to Hedge foreign exchange risk
Use forward contracts, futures or options.
Use the domestic currency
Speed up payments (collections) of currencies
expected to appreciate (depreciate)
Slow down payments (collections) of currencies
expected to depreciate (appreciate)

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Hedging strategies
Recall that most firms (except for those involved in
currency-trading) would prefer to hedge their
foreign exchange exposures.
But, how can firms hedge?
(1) Financial Contracts for transaction exposure
Forward contracts (also futures contracts)

Options contracts (puts and calls)

Borrowing or investing in local markets.

(2) Operational Techniques for economic exposure

Geographic diversification (spreading the risk)

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Transaction exposure
Transaction exposure results from transactions
involving the purchase or sale of goods or services with
the price stated in foreign currency
Exists until the payable or receivable is liquidated
E.g., a U.S. importer must pay a European supplier in
Swiss francs
Transaction exposure: uncertainty in the domestic
currency value of the transaction using foreign
currency

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Forward rate
Before applying hedging technique for
transaction exposure, better to know the
concepts of:
Purchasing power parity
Interest rate parity

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Forward rate
The spot exchange rate is the current exchange rate for
two currencies
The forward exchange rate is a contractual rate
between a commercial bank and a client for the future
delivery of a specified quantity of foreign currency
Forward exchange rates are normally quoted on the
basis of one, two, three, six, and twelve months
The difference between the forward and spot rates
can be quoted as an annual premium or discount:

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Difference b/n forward and spot rates

Pforward Pspot 12
Direct Quotation : 100
Pspot # months forward
Pspot Pforward 12
Indirect Quotation : 100
Pforward # months forward

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Purchasing power parity
Purchasing power parity is an arbitrage-based idea
that in a world of perfect markets, the same good
should sell for the same price in different countries
Assumes there are no trade barriers, no taxes,
etc.
Unexpected inflation causes the value of the
home currency to fall
Differentials in international inflation rates can
be a source of foreign exchange risk
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Interest rate parity
Interest rate parity states that differences in
national interest rates will be reflected in the
currency forward market
Two securities of similar risk and maturity will
show a difference in their interest rates equal to
the forward premium or discount, but with the
opposite sign
According to Interest rate parity;

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Interest rate parity
F 1 Rforeign

S 1 Rdomestic
where
F forward rate, expressed in foreign currency per $
S spot rate, expressed in foreign currency per $
Rdomestic the home - country riskless rate
Rforeign the foreign riskless rate

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Interest rate parity
Computing Implied Foreign Interest Rates
It is now January 2, 2004. The six-months
forward rate for the British pound is 0.5658/$;
the spot rate is 0.5576/$. Also, the six-month
T-bill rate is 1.01%.
What is the implied British 6-month interest
rate based on the interest rate parity
relationship?
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Interest rate parity

0.5658 1 RUK

0.5576 1 .0101
2
RUK .0198 2 3.96%

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Forward contracts
These are foreign exchange contracts offered
by market maker banks.
They will sell foreign currency forward, and
They will buy foreign currency forward
Market maker banks will quote exchange rates
today at which they will carry out these forward
agreements.

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Forward contracts
These forward contracts allow the global firm to
lock in a home currency equivalent of some fixed
contractual foreign currency cash flow.
These contracts are used to offset the foreign
exchange exposure resulting from an initial
commercial or financial transaction.

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Example 1: The Need to Hedge
U.S. firm has sold a manufactured product to
a German company and as a result of this
sale, the U.S. firm agrees to accept payment
of 100,000 in 30 days.
What type of exposure does the U.S. firm
have?
Transaction exposure; an agreement to receive
a fixed amount of foreign currency in the future.

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Example 1: The Need to Hedge
What is the potential problem for the U.S.
firm if it decides not hedge (i.e., not to
cover)?
Problem for the U.S. firm is in assuming the
risk that the euro might weaken over this
period, and in 30 days it will be worth less (in
terms of U.S. dollars) than it is now.
This would result in a foreign exchange loss
for the firm.

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Hedging Example 1 with a Forward
So the U.S. firm decides it wants to hedge (cover)
this foreign exchange transaction exposure.
It goes to a market maker bank and requests a 30
day forward quote on the euro.
The market marker bank quotes the U.S. firm a
bid and ask price for 30 day euros, as follows:
EUR/USD 1.23/1.24.
What do these quotes mean:
Market maker will buy euros in 30 days for $1.23
Market maker will sell euros in 30 days for $1.24
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Example 2: The Need to Hedge
U.S. firm has purchased a product from a
British company.
And as a result of this purchase, the U.S. firm agrees
to pay the U.K. company 100,000 in 30 days.
What type of exposure is this for the U.S. firm?
Answer: Transaction exposure; an agreement to pay a fixed
amount of foreign currency in the future.

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Example 2: The Need to Hedge
What is the potential problem if the firm does
not hedge?
Problem for the U.S. firm is in assuming the
risk that the pound might strengthen over
this period, and in 30 days it take more U.S.
dollars than now to purchase the required
pounds.
This would result in a foreign exchange loss
for the firm.

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Hedging Example #2 with a Forward
So the U.S. firm decides it wants to hedge (cover) this
foreign exchange transaction exposure.
It goes to a market maker bank and requests a 30 day
forward quote on pounds.
The market maker quotes the U.S. firm a bid and ask
price for 30 day pounds as follows:
GBP/USD 1.7500/1.7600.
What do these quotes mean:
Market maker will buy pounds in 30 days for $1.7500
Market maker will sell pounds in 30 days for $1.7600

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So What will the Firm Accomplished with
the Forward Contract?
Example #1: The firm with the long position in
euros:
Can lock in the U.S. dollar equivalent of the sale to the
German company.
It knows it can receive $123,000
At the forward bid: $1.2300/$1.2400
Example #2: The firm with the short position in
pounds:
Can lock in the U.S. dollar equivalent of its liability to
the British firm:
It knows it will cost $176,000
At the forward ask price: $1.7500/$1.7600

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Advantages and Disadvantages of the
Forward Contract
Contracts written by market maker banks to the
specifications of the global firm.
For some exact amount of a foreign currency.
For some specific date in the future.
No upfront fees or commissions.
Bid and Ask spreads produce round transaction profits.
Global firm knows exactly what the home currency
equivalent of a fixed amount of foreign currency will
be in the future.
However, global firm cannot take advantage of a
favorable change in the foreign exchange spot rate

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Foreign Exchange Options Contracts
One type of financial contract used to hedge
foreign exchange exposure is an options
contract.
Definition: An options contract offers a global firm
the right, but not the obligation, to buy (a call
option) or sell (a put option) a given quantity of
some foreign exchange, and to do so:
at a specified price (i.e., exchange rate), and
at some date in the future.

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Foreign Exchange Options Contracts
Options contracts are either written by global banks
(market maker banks) or purchased on organized
exchanges (e.g., the Chicago Mercantile Exchange).
Options contracts provide the global firm with:
(1) Insurance (floor or ceiling exchange rate) against
unfavorable changes in the exchange rate, and additionally
(2) the ability to take advantage of a favorable change in the
exchange rate.
This latter feature is potentially important as it is something a
forward contract will not allow the firm to do.
But the global firm must pay for this right.
This is the option premium (which is a non-refundable fee).

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A Put Option: To Sell Foreign Exchange
It allows a global firm to sell a (1) specified amount of
foreign currency at (2) a specified future date and at
(3) a specified price (i.e., exchange rate) all of which
are set today.
Put option is used to offset a foreign currency long
position (e.g., an account receivable).
Provides the firm with an lower limit (floor) price for
the foreign currency it expects to receive in the future.
If spot rate proves to be advantageous, the holder will
not exercise the put option, but instead sell the
foreign currency in the spot market.
Firm will not exercised if the spot rate is worth
more.
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A Call Option: To Buy Foreign Exchange
Allows a global firm to buy a (1) specified amount of
foreign currency at (2) a specified future date and at a
(3) specified a price (i.e., at an exchange rate) all of
which are set today.
Call option is used to offset a foreign currency short position
(e.g., an account payable).
Provides the holder with an upper limit (ceiling) price for the
foreign currency the firm needs in the future.
If spot rate proves to be advantageous, the holder will not
exercise the call option, but instead buy the needed foreign
currency in the spot market.
Firm will not exercise if the spot rate is cheaper.

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Overview of Options Contracts
Important advantage:
Options provide the global firm which the potential to take
advantage of a favorable change in the spot exchange rate.
Recall that this is not possible with a forward contract.
Important disadvantage:
Options can be costly:
Firm must pay an upfront non-refundable option premium which
it loses if it does not exercise the option.
Recall there are no upfront fees with a forward contract.
This fee must be considered in calculating the home currency
equivalent of the foreign currency.
This cost can be especially relevant for smaller firms and/or
those firms with liquidity issues.

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Hedging Through Borrowing or
Investing in Foreign Markets
Another strategy used to hedge foreign exchange
transaction exposure is through the use of borrowing
or investing in foreign currencies.
Global firms can borrow or invest in foreign currencies
as a means of offsetting foreign exchange exposure.
Borrowing in a foreign currency is done to offset a long
position.
Investing in a foreign currency is done to offset a short
position.

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Specific Strategy for a Long Position
Global firm expecting to receive foreign currency in the
future (long position):
Will take out a loan (i.e., borrow) in the foreign currency equal to
the amount of the long position.
Will convert the foreign currency loan amount into its home
currency at the spot exchange rate.
And eventually use the long position to pay off the foreign currency
denominated loan.
What has the firm accomplished?
Has effectively offset its foreign currency long position (with the
foreign currency loan, which is a short position).
Plus, immediate conversion of its foreign currency long position
into its home currency.

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Specific Strategy for a Short Position
Global firm needing to pay out foreign currency in the
future (short position).
Will borrow in its home currency (an amount equal to its
short position at the current spot rate).
Will convert the home currency loan into the foreign
currency at the spot rate.
Will invest in a foreign currency denominated asset
And eventually use the proceeds from the maturing financial
asset to pay off the short position.
Global firm has:
Offset its foreign currency short exposure (with the foreign
currency denominate asset which is a long position)
Plus immediate conversion of its foreign currency liability
into a home currency liability.

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Example of Borrowing or Investing in Foreign
Markets
With 1,000,000 accounts receivable in 90 days, a one-
time transaction, the MNE a money market hedge by
borrowing the present equivalent of 1,000,000. If you
can borrow euros for 90 days at 2 percent quarterly
interest. How many euros would you need to borrow
today?

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Example of Borrowing or
Investing in Foreign Markets
To hedge the long position in pounds using a money
market hedge, borrow euros today for 90 days, and sell
them in the spot market.
In 90 days, repay your loan with the 1,000,000
accounts receivable.

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Example of Borrowing or Investing
in Foreign Markets
Borrow exactly 1,000,000/1.02=980,392.16 euros today,
and repay the loan with 1,000,000 in 90 days.
This is a perfect hedge using the money market.
Be sure to sell the euros you borrow in the spot
marketotherwise you are acquiring another long
position in euros.

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Operational techniques
In addition to financial contract hedging, transaction
exposure can be hedge by using the ff Operational
techniques
Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging through Invoice Currency
Etc

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Hedging Unknown Cash Flows
Up to this point, the hedging techniques we have
covered (forwards, options, borrowing and investing)
have been most appropriate for covering transaction
exposure.
Why? Because transaction exposures have known
foreign currency cash flows and thus they are easy to
hedge with financial contracts
However, economic foreign exchange exposures do
not provide the firm with this known cash flow
information.
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Dealing with Economic exposure
Recall that economic exposure is long term and
involves Unknown future cash flows.
So this type of exposure is difficult to hedge with
the financial contracts we have discussed so far.
What can the firm do to manage this economic
exposure?

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Dealing with Economic exposure
Firm can employ an operational hedge.

This strategy involves global diversification of

production and/or sales markets to produce natural
hedges for the firms unknown foreign exchange
exposures.

As long as exchange rates with respect to these different

markets do not move in the same direction, the firm can
stabilize its overall cash flow.

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operating exposure
While many managers understand the effects of random
exchange rate changes on the dollar value of their firms
assets and liabilities denominated in foreign currencies,
they often do not fully understand the effect of volatile
exchange rates on operating cash flows.
As the economy becomes increasingly globalized, more
firms are subject to international competition.
Fluctuating exchange rates can seriously alter the relative
competitive positions of such firms in domestic and foreign
markets, affecting their operating cash flows.

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operating exposure
Formally, operating exposure can be defined as the
extent to which the firms operating cash flows would
be affected by random changes in exchange rates.
A firms operating exposure is determined by
(1) the structure of the markets in which the firm
sources its inputs, such as labor and materials, and
sells its products, and
(2) the firms ability to mitigate the effect of exchange
rate changes by adjusting its markets, product mix,
and sourcing.
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Managing Operating Exposure
1. Selecting low-cost production sites.
2. Flexible sourcing policy.
3. Diversification of the market.
4. Product differentiation and R&D efforts.
5. Financial hedging

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Translation / Accounting Exposure
Translation exposure results from translating
foreign assets and liabilities into U.S. dollars on
the consolidated balance sheet
Translation exposure, also frequently called
accounting exposure, refers to the effect that an
unanticipated change in exchange rates will have on
the consolidated financial reports of a MNC.

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Translation / Accounting Exposure
When exchange rates change, the value of a foreign
subsidiarys assets and liabilities denominated in a
foreign currency change when they are viewed from
the perspective of the parent firm.
Consequently, there must be a mechanical means for
handling the consolidation process for MNCs that
logically deals with exchange rate changes.
Translation exposure = (foreign-currency denominated
assets) (foreign-currency denominated liabilities)

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Translation Methods
Four methods of foreign currency translation have
been used in recent years:
1. the current/noncurrent method,
2. the monetary/nonmonetary method,
3. the temporal method, and
4. the current rate method

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The current/noncurrent method
generally accepted in the United States from the 1930s until
1975, when FASB 8 became effective
Current assets and liabilities, which by definition have a
maturity of one year or less, are converted at the current
exchange rate.
Noncurrent assets and liabilities are translated at the
historical exchange rate in effect at the time the asset or
liability was first recorded on the books.
Under this method, a foreign subsidiary with current assets
in excess of current liabilities will cause a translation gain
(loss) if the local currency appreciates (depreciates).
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The current/noncurrent method
The opposite will happen if there is negative net
working capital in local terms in the foreign
subsidiary.
Most income statement items under this method are
translated at the average exchange rate for the
accounting period.
However, revenue and expense items that are
associated with noncurrent assets or liabilities,
such as depreciation expense, are translated at the
historical rate that applies to the applicable balance
sheet item.

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Monetary/Nonmonetary Method
all monetary balance sheet accounts (for example,
cash, marketable securities, accounts receivable, notes
payable, accounts payable) of a foreign subsidiary are
translated at the current exchange rate.

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Monetary/Nonmonetary Method
All other (nonmonetary) balance sheet accounts,
including stockholders equity, are translated at the
historical exchange rate in effect when the account was
first recorded.
In comparison to the current/noncurrent method, this
method differs substantially with respect to accounts
such as inventory, long-term receivables, and long-
term debt.

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Monetary/Nonmonetary Method
Under this method, most income statement accounts
are translated at the average exchange rate for the
period.
However, revenue and expense items associated with
nonmonetary accounts, such as cost of goods sold
and depreciation, are translated at the historical rate
associated with the balance sheet account.

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The temporal method
Under the temporal method, monetary accounts such as
cash, receivables, and payables (both current and
noncurrent) are translated at the current exchange rate.
Other balance sheet accounts are translated at the
current rate, if they are carried on the books at current
value;
if they are carried at historical costs, they are translated at
the rate of exchange on the date the item was placed on
the books.
Since fixed assets and inventory are usually carried at
historical costs, the temporal method and the
monetary/nonmonetary method will typically provide the
same translation.

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The temporal method
Nevertheless, the underlying philosophies of the two
methods are entirely different.
Under current value accounting, all balance sheet
accounts are translated at the current exchange rate.
Under the temporal method, most income statement
items are translated at the average exchange rate for
the period.
Depreciation and cost of goods sold, however, are
translated at historical rates if the associated balance
sheet accounts are carried at historical costs.
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The current rate method
Under the current rate method, all balance sheet
accounts are translated at the current exchange
rate, except for stockholders equity.
This is the simplest of all translation methods to apply.
The common stock account and any additional paid-in
capital are carried at the exchange rates in effect on the
respective dates of issuance.
Year-end retained earnings equal the beginning
balance of retained earnings plus any additions for the
year.

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The current rate method
A plug equity account named cumulative
translation adjustment (CTA) is used to make the
balance sheet balance, since translation gains or losses
do not go through the income statement according to
this method.
Under the current rate method, income statement
items are to be translated at the exchange rate at the
dates the items are recognized.
Since this is generally impractical, an appropriately
weighted average exchange rate for the period may
be used for the translation.

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Hedging Translation Exposure
1. Balance Sheet Hedge
Note that translation exposure is not entity specific; rather,
it is currency specific. Its source is a mismatch of net assets
and net liabilities denominated in the same currency.
A balance sheet hedge eliminates the mismatch.
Example: total asset in one currency should have equal total
liability in the same foreign curreny
2. derivatives hedge
using a derivatives hedge to control translation
exposure really involves speculation about foreign
exchange rate changes -forward

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A Comprehensive Approach for Assessing
and Managing Foreign Exchange Exposure
Step 1: Determining Specific Foreign Exchange
Exposures.
By currency and amounts (where possible)
Step 2: Exchange Rate Forecasting
Determining the likelihood of adverse currency
movements.
Important to select the appropriate forecasting model.
Perhaps a range of forecasts is appropriate here (i.e.,
forecasts under various assumptions)

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A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure
Step 3: Assessing the Impact of the Forecasted
Exchange Rates on Companys Home Currency
Equivalents
Impact on earnings, cash flow, liabilities
Step 4: Deciding Whether to Hedge or Not
Determine whether the anticipated impact of the forecasted
exchange rate change merits the need to hedge.
Perhaps the estimated impact is so small as not to be of a
concern.
Or, perhaps the firm is convinced it can benefit from its
exposure.

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A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure
Step 5: Selecting the Appropriate Hedging
Instruments.
What is important here are:
Firms desire for flexibility.
Cost involved with financial contracts.
The type of exposure the firm is dealing with.

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 End of Chapter Six

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A Business Example of Economic Exposure (contd)
Assume the following exchange rates exist today:
$ per CHF = $0.8073 (direct quotation)
CHF per $ = CHF 1.2387 (indirect quotation)

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