MULTINATIONAL FINANCE & RISK MANAGEMENT

1. MULTINATIONAL FINANCE & RISK MANAGEMENT 13-14 January 2005 - II I. Ertürk

2. Types of Exposure • Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations. • Exposure to exchange rate fluctuations comes in three forms: • Transaction exposure • Economic exposure • Translation exposure

3. Translation Exposure • The exposure of a company’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. • In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.

8. Translation Exposure Does Translation Exposure Matter? • Cash Flow Perspective - Translating financial statements for consolidated reporting purposes does not by itself affect a company’s cash flows. • However, a weak foreign currency today may result in a forecast of a weak exchange rate at the time subsidiary earnings are actually remitted.

9. Translation Exposure • Stock Price Perspective - Since a company’s translation exposure affects its consolidated earnings and many investors tend to use earnings when valuing firms, the company’s valuation may be affected. Does Translation Exposure Matter?

10. Translation Exposure • In general, translation exposure is relevant because • some company subsidiaries may want to remit their earnings to their parents now, • the prevailing exchange rates may be used to forecast the expected cash flows that will result from future remittances, and • consolidated earnings are used by many investors to value companies.

11. Translation Exposure • A company’s degree of translation exposure is dependent on: • the proportion of its business conducted by its foreign subsidiaries, • the locations of its foreign subsidiaries, and • the accounting method that it uses.

12. Translation Exposure • According to World Research Advisory estimates, the translated earnings of U.S.-based MNCs in aggregate were reduced by $20 billion in the third quarter of 1998 alone simply because of the depreciation of Asian currencies against the dollar. • In 2000, the weakness of the euro also caused several U.S.-based MNCs to report lower earnings than expected.

13. Economic Exposure • Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. • Cash flows that do not require conversion of currencies do not reflect transaction exposure. Yet, these cash flows may also be influenced significantly by exchange rate movements.

14. Impact on Transactions Transactions that Influence the Firm’s Cash Inflows Local Currency Appreciates Local Currency Depreciates Decrease Decrease Decrease Decrease Increase Increase Increase Increase Local sales (relative to foreign competition in local markets) Firm’s exports denominated in local currency Firm’s exports denominated in foreign currency Interest received from foreign investments   Transactions reflecting transaction exposure. Economic Exposure

15. Impact on Transactions Transactions that Influence the Firm’s Cash Outflows Local Currency Appreciates Local Currency Depreciates No Change Decrease Decrease No Change Increase Increase Firm’s imported supplies denominated in local currency Firm’s imported supplies denominated in foreign currency Interest owed on foreign funds borrowed   Transactions reflecting transaction exposure. Economic Exposure

16. Economic Exposure • Even purely domestic firms may be affected by economic exposure if there is foreign competition within the local markets. • MNCs are likely to be much more exposed to exchange rate fluctuations. The impact varies across MNCs according to their individual operating characteristics and net currency positions.

17. Economic Exposure • One measure of economic exposure involves classifying the firm’s cash flows into income statement items, and then reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios. • In general, firms with more foreign costs than revenues will be unfavorably affected by stronger foreign currencies.

18. Economic Exposure • Another method of assessing a firm’s economic exposure involves applying regression analysis to historical cash flow and exchange rate data.

19. Economic Exposure PCFt = a0 + a1et + t PCFt = % change in inflation-adjusted cash flows measured in the firm’s home currency over period t et = % change in the currency exchange rate over period t t = random error term a0 = intercept a1 = slope coefficient

20. Economic Exposure • The regression model may be revised to handle multiple currencies by including them as additional independent variables, or by using a currency index (composite). • By changing the dependent variable, the impact of exchange rates on the firm’s value (as measured by its stock price), earnings, exports, sales, etc. may also be assessed.

21. Transaction Exposure • The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. • To measure transaction exposure: • project the net amount of inflows or outflows in each foreign currency, and • determine the overall risk of exposure to those currencies.

22. Transaction Exposure • Companies can usually anticipate foreign cash flows for an upcoming short-term period with reasonable accuracy. • After the consolidated net currency flows for the entire company has been determined, each net flow is converted into either a point estimate or a range of a chosen currency, so as to standardize the exposure assessment for each currency.

23. Transaction Exposure • A company’s overall exposure can be assessed by considering each currency position together with the currency’s variability and the correlations among the currencies. • The standard deviation statistic on historical data serves as one measure of currency variability. Note that currency variability levels may change over time.

24. Transaction Exposure –USD perspective Standard Deviations of Exchange Rate Movements Based on Monthly Data Currency 1981-1993 1994-1998 British pound 0.0309 0.0148 Canadian dollar 0.0100 0.0110 Indian rupee 0.0219 0.0168 Japanese yen 0.0279 0.0298 New Zealand dollar 0.0289 0.0190 Swedish krona 0.0287 0.0195 Swiss franc 0.0330 0.0246 Singapore dollar 0.0111 0.0174

25. Transaction Exposure • The correlations among currency movements can be measured by their correlation coefficients, which indicate the degree to which two currencies move in relation to each other. coefficient perfect positive correlation 1.00 no correlation 0.00 perfect negative correlation -1.00

26. Transaction Exposure –USD perspective Correlations Among Exchange Rate Movements £ Can$ ¥ NZ$ Sk SwF British pound (£) 1.00 Canadian dollar (Can$) .18 1.00 Japanese yen (¥) .45 .06 1.00 New Zealand dollar (NZ$) .39 .20 .33 1.00 Swedish krona (Sk) .62 .16 .46 .33 1.00 Swiss franc (SwF) .63 .12 .61 .37 .70 1.00

27. Transaction Exposure • The point in considering correlations is to detect positions that could somewhat offset each other. • For example, if currencies X and Y are highly correlated, the exposures of a net X inflow and a net Y outflow will offset each other to a certain degree. • Note that the corrrelations among currencies may change over time.

28. $/10 Indian rupees $/100 ¥ $/Canadian$ $ per unit $/Singapore$ $/5 Swedish krona $/Chinese yuan Movements of Selected CurrenciesAgainst the Dollar

29. Transaction Exposure • Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. • When transaction exposure exists, the firm faces three major tasks: • Identify its degree of transaction exposure, • Decide whether to hedge its exposure, and • Choose among the available hedging techniques if it decides on hedging.

30. Identifying Net Transaction Exposure • Centralized Approach - A centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s). • Note that sometimes, a firm may be able to reduce its transaction exposure by pricing some of its exports in the same currency as that needed to pay for its imports.

31. Techniques to Eliminate Transaction Exposure • Hedging techniques include: • Futures hedge, • Forward hedge, • Money market hedge, and • Currency option hedge. • MNCs will normally compare the cash flows that could be expected from each hedging technique before determining which technique to apply.

32. Techniques to Eliminate Transaction Exposure • A futures hedge involves the use of currency futures. • To hedge future payables, the firm may purchase a currency futures contract for the currency that it will be needing. • To hedge future receivables, the firm may sell a currency futures contract for the currency that it will be receiving.

33. Techniques to Eliminate Transaction Exposure • A forward hedge differs from a futures hedge in that forward contracts are used instead of futures contract to lock in the future exchange rate at which the firm will buy or sell a currency. • Recall that forward contracts are common for large transactions, while the standardized futures contracts involve smaller amounts.

34. Techniques to Eliminate Transaction Exposure • An exposure to exchange rate movements need not necessarily be hedged, despite the ease of futures and forward hedging. • Based on the firm’s degree of risk aversion, the hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged.

35. Techniques to Eliminate Transaction Exposure Real cost of hedging payables (RCHp) = + nominal cost of payables with hedging – nominal cost of payables without hedging Real cost of hedging receivables (RCHr) = + nominal home currency revenues received without hedging – nominal home currency revenues received with hedging

36. Techniques to Eliminate Transaction Exposure • If the real cost of hedging is negative, then hedging is more favorable than not hedging. • To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging.

37. Nominal Cost Nominal Cost Real Cost Probability With Hedging Without Hedging of Hedging 5 % $1.40 $1.30 $0.10 10 $1.40 $1.32 $0.08 15 $1.40 $1.34 $0.06 20 $1.40 $1.36 $0.04 20 $1.40 $1.38 $0.02 15 $1.40 $1.40 $0.00 10 $1.40 $1.42 -$0.02 5 $1.40 $1.45 -$0.05 The Real Cost of Hedging for Each £ in Payables Expected RCHp =  PiRCHi = $0.0295

38. Probability The Real Cost of Hedging for Each £ in Payables There is a 15% chance that the real cost of hedging will be negative.

39. Techniques to Eliminate Transaction Exposure • If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero. • If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average.

40. RCH (payables) RCH (receivables) The Real Cost of Hedging British Pounds Over Time

41. Techniques to Eliminate Transaction Exposure • A money market hedge involves taking one or more money market position to cover a transaction exposure. • Often, two positions are required. • Payables: Borrow in the home currency, and invest in the foreign currency. • Receivables: borrow in the foreign currency, and invest in the home currency.

42. Borrows at 8.40% for 30 days 1. Borrows £646,766 3. Pays £651,293 Effective exchange rate £0.6513/NZ$ Exchange at £0.6500/NZ$ Lends at 6.00% for 30 days 2. Holds NZ$995,025 3. Receives NZ$1,000,000 Techniques to Eliminate Transaction Exposure A firm needs to pay NZ$1,000,000 in 30 days.

43. Borrows at 8.00% for 90 days 1. Borrows S$392,157 3. Pays S$400,000 Effective exchange rate £0.5489/S$ Exchange at £0.5500/S$ Lends at 7.20% for 90 days 2. Holds £215,686 3. Receives £219,568 Techniques to Eliminate Transaction Exposure A firm expects to receive S$400,000 in 90 days.

44. Techniques to Eliminate Transaction Exposure • Note that taking just one money market position may be sufficient. • A firm that has excess cash need not borrow in the home currency when hedging payables. • Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables.

45. Techniques to Eliminate Transaction Exposure • For the two examples shown, the known results of money market hedging can be compared with the known results of forward or futures hedging to determine which the type of hedging that is preferable.

46. Techniques to Eliminate Transaction Exposure • If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same result as a forward hedge. • This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies.

47. Techniques to Eliminate Transaction Exposure • A currency option hedge involves the use of currency call or put options to hedge transaction exposure. • Since options need not be exercised, firms will be insulated from adverse exchange rate movements, and may still benefit from favorable movements. • However, the firm must assess whether the premium paid is worthwhile.

48. British Pound Call Option: Exercise Price = $1.60, Premium = $.04. For each £ : Nominal Cost Nominal Cost Scenario without Hedging with Hedging = Spot Rate = Min(Spot,$1.60)+$.04 1 $1.58 $1.62 2 $1.62 $1.64 3 $1.66 $1.64 Using Currency Call Options for Hedging Payables

49. New Zealand Dollar Put Option: Exercise Price = $0.50, Premium = $.03. For each NZ$ : Nominal Income Nominal Income Scenario without Hedging with Hedging = Spot Rate = Max(Spot,$0.50)-$.03 1 $0.44 $0.47 2 $0.46 $0.47 3 $0.51 $0.48 Using Put Options for Hedging Receivables

50. Techniques to Eliminate Transaction Exposure Hedging Payables Hedging Receivables Futures Purchase currency Sell currency hedge futures contract(s). futures contract(s). Forward Negotiate forward Negotiate forward hedge contract to buy contract to sell foreign currency. foreign currency. Money Borrow local Borrow foreign market currency. Convert currency. Convert hedge to and then invest to and then invest in foreign currency. in local currency. Currency Purchase currency Purchase currency option call option(s). put option(s).