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Accounting Exposure

Accounting Exposure. Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation.

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Accounting Exposure

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  1. Accounting Exposure • Translation exposure measures the change in the book value of the assets and liabilities excluding stockholders equity as residual due to changes in the exchange rate from the last translation. • Example: Consider a U.S. multinational company’s subsidiary in Great Britain whose balance sheet and income statement are translated to the parent’s functional currency—the U.S. dollar. The pound has devalued from $1.50/pound to $1.40/pound since the last translation.

  2. Hedging in Practice: Nike • Nike markets its products in over 140 countries with foreign sales revenue accounting for 46 percent of its total revenue in fiscal 2001. Given its huge presence in the foreign market, Nike’s annual report states: • “It is the company’s policy to utilize derivative financial instruments to reduce foreign exchange risks where internal netting strategies cannot be effectively employed. Fluctuation in the value of the hedging instruments are offset by fluctuations in the value of the underlying exposures being hedged”

  3. Nike uses forward contracts for firm commitments to hedge receivables and payables as well as inter-company foreign currency transactions, • Nike uses currency options to hedge certain anticipated but not yet firmly committed export sales and purchase transactions expected in futures denominated in foreign currency. • Cross-currency swaps are employed to hedge foreign currency denominated payments related to inter-company loan agreements.

  4. Transaction Exposure • Transaction exposure is defined as the impact of the unexpected change in exchange rate on the cash flow arising from all the contractual relationships entered prior to the change in exchange rate at time (t1) to be settled after the change in exchange rate at time (t2).

  5. Dupont Acquires AG • In December 1998 DuPont entered into a forward contract in the acquisition of the performance coating business of Hoechst AG for 3.1 billion deutsche marks (DM) at $1.9 billion. • The forward contract effectively locked the company at the forward exchange rate of 1.6316DM/$, insulating DuPont from adverse exchange rate movements that would likely have increased the dollar price of the acquisition.

  6. As the graph shows, distribution of hedged cash flows is tighter than its unhedged counterpart.

  7. In the above structure exporter having shipped the goods and received letter of credit in the form of say banker’ acceptance, or time draft to be paid by importer bank in 120 days. Export uses the time draft as collateral in offshore bank and secures pound loan that is equal to the present value of the face value discounted at the borrowing rate of offshore bank. Converts the borrowed pound to the US dollar and investing the dollar at the lending rate of the home country (lending rate). At the end of 120 days exporters pays off the offshore bank with the proceeds of the time draft (IOU). The ratio of the receivables in dollar and pound establishes synthetic forward rate that can be compared to actual 120-day forward rate.

  8. Example • Consider the call option in Euro FX November futures at strike price of 98 cents. The quoted premium is 1.27 cents per euro as of August 23, 02 in the CME. • Each contract is for delivery of 125,000 units of euro. • The spot euro is $.9731/pound. The Dupont treasurer in Exhibit 8.9 can buy 96 call options to hedge against the possible appreciation of the euro in the next three months. • The premium for one call option will be equal to $1,587.50, and to hedge the entire exposure requires an upfront premium of $152,400. • The call option is providing protection by imposing a ceiling on the exchange rate that is equal to the strike price plus the premium for the call as follows:

  9. VALUE AT RISK • Value at risk (VAR) provides a framework for analysis of the maximum potential loss in the fair value of an exposed position over a specific period assuming normal market conditions and a given confidence interval. • MNCs have various exposures due to interest rate changes, foreign exchange rate changes, as well as to the changes in the commodity prices that could adversely affect the value of the firm. • VAR analysis uses simulation models by assuming various scenarios to generate the amount of maximum loss that could be realized in a given period for a given confidence interval. • VAR= amount of exposure*volatility*confidence interval

  10. Example VAR • For example, a bond portfolio with market value of $250 million might have VAR at 95 percent confidence interval of $15.6176 million over the next 10 days assuming standard deviation of the exposed portfolio is equal to 16 percent per annum. • The volatility is usually quoted in year, however, for the purpose of estimating the VAR of an asset, the volatility of the asset is quoted on a daily basis as volatility per day as follows: • σd =σy / (252) 1/2 • One-day VAR = .010079 x1.65x $250 • = $4.1575 million. • 10-day VAR = One-day VAR. • 10-day VAR = $4.1575 • = $13.1471 million • This portfolio is likely to suffer at least a loss of $4.1575 million in 5 out of 100 days (one –day VAR with 95 percent confidence interval).

  11. Value at Risk • Notional amount • Sensitivity Analysis, Duration ignores non-linearity in the price yield relationship • Scenario Analysis, allows investor to investigate nonlinear extreme effect on price, but fails to associate risk with a probability. • Both sensitivity and scenario analysis do not allow for the aggregation of risk across different markets. • Value at risk achieves all of the above.

  12. Value at Risk (VAR) • VAR provides a framework for the analysis of potential unexpected loss over a specific horizon and a given confidence interval. • VAR estimate recognizes various sources of risk and expresses loss in terms of probability. • VAR= amount of exposure*volatility*confidence interval • VAR (dP) = D.P x VAR(dy)

  13. VAR • Consider a hedge fund is contemplating on Japanese yen devaluation against US dollar. The hedge funds sells $5 billion worth of Japanese yen at the CME. Using 10 years of data from 1985-1994, we estimated VAR at 95 percent confidence Interval. • 2512 observations of daily returns are used to generate estimate of VAR. • VAR=$47,401,685

  14. Distribution of Losses Left Tail

  15. Distribution of Losses and Gains

  16. Margin Setting • CME or CBOT has set as of March 12, 2007, the initial margin in JPY/USD futures at $1350. The size of contract is ¥ 12,500,000. The spot exchange on march 12 was ¥116/$. The volatility of the exchange rate is estimated to be 8.4%. • What is the 1-day VAR at 99% confidence interval? VAR=2.33(8.4%/ )x 12,500000/116= $1300 • In the OTC market the level of margin is related to the amount of volatility and exchange rate.

  17. VAR: Caveats • Shortcomings: • VAR does not define the worst loss • VAR does not describe the losses on the left tail, it does not say anything about the distribution of the losses. • VAR is measured with some error • VAR(T days)=VAR(1-day)*T^1/2

  18. Lufthansa Buys Aircraft from Boeing • Lufthansa purchased 20 aircraft from Boeing at the cost of $500 million payable in one year in January 1986. The spot and one-year forward exchange rates at the time the contract entered into was $.3125/deutsche marks. • Lufthansa by agreeing to pay dollars for the aircrafts accepted all the exchange rate risk and reward for the above contract. • To manage exposure to dollar appreciation the company decided to leave half of the liability exposed to foreign exchange risk and purchased the other half, $250 million, in the forward market at the forward rate of $.3125/deutsche mark or 3.2 DM/$. By hedging half of the exposure the company effectively locked at the forward rate of $.3125/deutsche mark, to pay DM800 million for buying $250 million forward.

  19. Hedging Alternatives • Hedging Alternatives: • 1. Remain unhedged • 2. Fully cover the exposure: buy dollars forward • 3. Manage some of the exposure, leaving some exposed • 4. Use call options in dollar/deutsche mark or its equivalent the put options in deutsche mark/dollar • 5. Buy caps in dollars or floors in deutsche marks (in the over the counter market from a bank or insurance company) • 6. Money market hedge of payables. • By January 1986, the deutsche mark appreciated and the dollar weakened to $.45/deutsche mark and the forward hedging turned out to be very costly ex-post.

  20. Managing Operating Exposure • The operating exposure arises due to the impact of unexpected change in the exchange rate on the firm’s input price, that is, raw materials, labor costs, and out put prices such as prices of the goods and services produced. Operating exposure is long term in nature and therefore can only be managed through operating hedges.. • Operating hedges can be achieved as follows: • 1) Increasing Flexibility of Operating Net Works:Provide MNCs the flexibility to arbitrage institutional restrictions, such as regulatory impediments, various requirements by regulatory agencies as well as to arbitrage taxes and factors of productions across international boundaries.] • 2) Diversifying Operations:This type of diversification naturally hedges cash flow derived from various operations overseas; however, it is expensive in terms of cost and lengthy in implementation. • 3) Diversifying Financing with Matching Cash Flows:This approach is similar to the money market hedging discussed earlier in the chapter. The exporter selling goods and services overseas in this scenario has accepted the foreign currency for the receivables and therefore is exposed to foreign exchange risk.

  21. In the above structure exporter manages foreign exchange risk (foreign denominated receivables) by hedging the foreign denominated cash flows with foreign denominated debt secured in offshore bank using the receivables as collateral.

  22. Parallel loans as portfolio of two forward foreign denominated debts, creates synthetic interest rate swaps. Minnesota Mining and Manufacturing borrows dollar in the US capital market and funnels the fund to the subsidiary of Allied Lyon in New York. Allied Lyon does the same thing using its high credit rating by borrowing the pound in UK capital market and passing the fund to MMM subsidiary in London.

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