Chapter 8 Transaction Exposure

1. Chapter 8 Transaction Exposure

2. 2 Overview: FX 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 of foreign exchange rates change on a firm can be measured in several ways.

3. 3 Exhibit 8.1 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure

4. 4 1. Types of Foreign Exchange Exposure Transaction exposure measures changes in the value of outstanding financial obligations due to a change in exchange rates. Transaction exposure deals with changes in cash flows that result from existing contractual obligations. Operating (economic, competitive, or strategic) exposure measures the change in the present value of the firm resulting from any changes in future operating cash flows of the firm caused by an unexpected change in exchange rates [via changes in sales volume, prices and costs.]

5. 5 Types of Foreign Exchange Exposure Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two: 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.

6. 6 Types of Foreign Exchange Exposure Translation (accounting) exposure is the potential for accounting-derived changes in owner�s equity. Translation exposure occurs in �translating� foreign currency financial statements of foreign subsidiaries into a worldwide consolidated financial statements.

7. 7 In general, only realized foreign exchange losses are deductible for income taxes. Similarly, only realized gains create taxable income. �Realized� means that the loss or gain involves cash flows.

8. 8 2. 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.

9. 9 Why Hedge? Definition of Hedging Hedging is the taking of a position 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. Then why hedge?

10. 10 Why Hedge? The value of a firm, according to financial theory, is the net present value of all expected future cash flows. 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.

11. 11 Exhibit 8.2 Impact of Hedging on the Expected Cash Flows of the Firm

12. 12 Why Hedge? Reasons not to 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 reduces the variance of the cash flows of the firm, but also uses valuable resources. Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging.

13. 13 Why Hedge? Reasons to 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

14. 14 3. Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations denominated in a foreign currency. The most common examples are account receivables or payables denominated in a foreign currency.

15. 15 Exhibit 8.3 the life span of a transaction exposure

16. 16 Measurement of Transaction Exposure 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.

17. 17 Measurement of Transaction Exposure 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. One needs to distinguish operating hedges from financing hedges.

18. 18 4. Dayton�s Transaction Exposure Dayton Manufacturing has four alternatives to hedge its transaction exposure: 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 an account payable.

19. 19 Dayton�s Transaction Exposure 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�.

20. 20 Dayton�s Transaction Exposure 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. The manager needs to choose an appropriate interest rate for the calculation of money market hedge.

21. 21 Dayton�s Transaction Exposure 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.

22. 22 Exhibit 8.5 Valuation of Cash Flows Under Hedging Alternatives for Dayton

23. 23 Exhibit 8.6 Valuation of Hedging Alternatives for an Account Payable

24. 24 5. Risk Management in Practice: which goals? 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.

25. 25 Risk Management in Practice: which exposures? 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 based on historical trends and past business relationship. Anticipated exposures are transactions for which there are � at present � no contracts or agreements between parties.

26. 26 Risk Management in Practice: which instruments? Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges.

27. 27 Risk Management in Practice Proportional hedge: Many MNEs 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. The selective hedging program is essentially speculation against currency market.

28. 28 Risk Management in Practice Forward points: In addition to having required minimum forward-cover percentages, many firms also require full forward-cover when forward rates �pay them the points.� Suppose you have a forward contract to sell �, and spot rate is $1.7640/�. If forward= $1.7675/�, then the forward rates �pay you the points�. If forward= $1.7540/�, then you are the one �paying the points�.

29. 29 Risk Management in Practice Use of options: Those firms that use currency options are generally more tolerant of currency risk. However, in many cases firms that are extremely risk-averse may utilize options to hedge backlog and/or anticipated exposures.

30. 30 Risk Management in Practice 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, i.e., write an out-of-the-money call option to finance partially the purchase of an at-the-money put option on pound. The most frequently used complex options are range forwards, participating forwards, break forwards, and average rate options.

31. 31 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?

32. 32 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?

33. 33 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?