Risk Management Strategy

1. Risk Management Strategy John Oruongo

2. Time Frame • Short Run • Intermediate Run • Long Run

3. Measure of Exposure • Translation exposure • Can be ignored • Transaction exposure • More important in the short run • Hedging possible • Economic exposure • Net worth exposure • Cash flow exposure

4. Exchange Rate Changes • Exchange risk declines with time • Reinforced by PPP and UIP • Short run characterized by high risk • No real exchange risk in the long run • Time effect on real and nominal exchange rate changes • Standard deviation ranges from 10-15%

5. Exchange Rate Changes • Using the standard deviation of 10 percentage points, the standard deviation of the average annual exchange rate change for two years is: • [Var(1/2X + 1/2Y)]1/2= [1/4(Var X + Var Y)]1/2 • [1/4(2 Var X)]1/2=[1/2 Var X]1/2=[1/2]1/2[Var X]1/2 • =[1/2]1/2[σ x] = [.7071][10] = 7.071 • Where X is exchange rate change in the first year and Y is the exchange rate change in the second year, and X and Y are both drawn from the same distribution with a standard deviation of 10

6. Weiner Amalgamated • Weiner Amalgamated is considering an investment in DM-denominated bonds. For simplicity, the term structure of German interest rates can be assumed to be flat at 6 percent. The annual standard deviation of percentage changes in $/DM exchange rate has historically been about 12 percentage points. • What is the range of dollar-equivalents returns on DM bonds for the 95% probability level if the investment is held for one year? • What is the range of dollar-equivalent average annual returns on DM bonds for the 95% probability level if the investment is held for ten years? • What is the range of dollar-equivalent average annual returns on DM bonds for the 95% probability level if the investment is held for twenty years?

7. Managing Foreign Exchange Risk • Short run – transaction exposure • Intermediate run – economic exposure • Risk represented by real exchange rate changes • Hedging is not a viable approach • Operating techniques are used to manage economic exposure

8. Summary of Foreign Exchange Risk • Short Run • Intermediate Run • Long Run

9. Short Run • Focus on transaction exposure • Hedging is easy • Exchange rate volatility is high • Deviations from PPP and UIP are common • Exchange risk is predominantly nominal • Transactions management important • Marketing and productions plans are fixed

10. Lufthansa Example In 1986 the financial press reported that Lufthansa purchased $500 million of new U.S. aircraft in early 1985 with payment due in early 1986, one year later. The transaction hit the news because Lufthansa reportedly paid about DM 1,364 million which was more than the $500 million liability converted at the prevailing rate, $.447/DM or DM 1,118 million. This happened because Lufthansa decided to hedge half of the purchase price using forward contracts at a time when the dollar subsequently depreciated against the DM. Forward contract obligated Lufthansa to purchase dollars at $0.31/DM The dollar however depreciated from $0.30/DM in March of 1985 to $0.45/DM in March of 1986

11. Lufthansa cont’d Payment in 1986 with 50% hedge (500*0.5)/0.31 + (500*0.5)/0.45 = DM 1,362 million Full hedge 500/0.31 =DM 1,613 million No hedge 500/0.45 =DM 1,111 million • Was economic exposure associated with transaction exposure when Lufthansa purchased this aircraft? • How are Lufthansa’s ongoing cash flows affected by dollar/DM exchange rate changes

12. Lufthansa: Economic Exposure • What happens to the value of the asset as exchange rate changes? • Loss on outflow can be offset by gain on value of assets and vice versa • Market valuation of assets • Introduced economic exposure where none previously existed

13. Lufthansa: Cash Flow Effect • Revenue tied to what currency • Dollar depreciation • How the two above may interrelate • Dollar depreciation increasing DM receipts e.g. stimulate visits to US • Dollar depreciation may result in reduced fuel costs and vice versa affecting present value of profits

14. Intermediate Run • Focus on economic exposure • Hedging is more difficult • Exchange rate volatility is moderate • Deviations from PPP and UIP exist • Exchange risk is predominantly real • Operations management important • Marketing and production plans are flexible

15. Long Run • Exchange rate volatility is low and approaches zero • PPP and UIP hold • No exchange risk • No risk management necessary • Marketing and production plans are in long-run equilibrium

16. Short Run Transactions Management • Centralization vs. Decentralization • Diversification • Routing of Cash Balances • Payments Netting • Leading and Lagging • Reinvoicing

17. Waterford Crystal Example Waterford Crystal, of Kilbarry, Ireland, exports specialty glassware to the U.S. It faces a potential disastrous situation in 1985 as the U.S. dollar began to sink against the Irish pound. A wine decanter that sold in the U.S. for $150 translated into 148 pounds in 1985, but by 1986 it translated to just 106 pounds Waterford, however, locked in an exchange rate for a significant part of its anticipated U.S. receivables by buying forward contracts on the Irish pound in 1985. The forward position stretched out for two years or until 1987. In 1986, Waterford was able to translate $50 million in U.S. sales into 48 million pounds instead of the 37 million it would have reported at the current exchange rate. Financial hedges clearly cannot be sustained beyond the short run, however.

18. Waterford cont’d • After 1987, Waterford was forced to make changes to cope with falling dollar • It diversified into other regions • Bought British china maker Wedgwood Plc • Reduce exposure to fluctuations between U.S. dollar and Irish pound • Diversified cost structure, since British pound and Irish pound are not highly correlated vis-à-vis any of the other currencies in which revenues are received

19. Routing of Cash Balances • Central cash depository route cash balances among subsidiaries • Increases value by taking advantage of interest rate differences • Balances high borrowing rates and low lending rates • Lower transactions costs due to size

20. Payments Netting • Reduces number of intracompany payments • A owes B $1million and B owes A $2million. B pays only $1million to A – bilateral payments netting • A owes B $1million, B owes A $2million, and C owes B $1million. C pays A $1million, despite lack of prior transactions – multilateral payments netting • May face government restrictions – dealing with multiple currencies

21. Leading and Lagging • Accelerate payments to affiliates needing cash, and delay receipts from same affiliates that are due to other affiliates • Increases and reduces liquidity to affiliates • Governments are suspicious – resembles intracorporate loan • US tax law – subsidiaries pay/receive no interest for up to six months

22. Reinvoicing • Useful in import and export transactions • Central cash facility can buy inputs for an affiliate, and sell the same to another • Central cash management takes on transaction exposure • Affiliates operate exclusively on local currency • Foreign risk management is centralized in one location • Government limits to reinvoicing • Prevent shifting profits to low tax jurisdictions

23. Summary • Looked at time horizons and different techniques to manage risk • Examples to illustrate our discussion • Looked at short run transactions management techniques