Managing Foreign Exchange Exposure

1. Chapter 13 Managing Foreign Exchange Exposure

2. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black

3. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Chicago Mercantile Exchange (CME) is the world�s largest and most diverse regulated foreign exchange trading market. CME is an international marketplace that brings together buyers and sellers on its CME Globex electronic trading platform and on its trading floors.

4. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black In 2005, over 84 million foreign exchange contracts with a notional value of $10.2 trillion dollars traded at CME. In May, 2006, CME foreign exchange products averaged a record 501,000 contacts per day, up 69% from the year earlier Electronic foreign exchange products set monthly records of 451,000 contracts per day, an increase of 90% from the previous year.

5. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Managing foreign exchange risk is a critical function, and as companies become more global, managing this risk becomes increasingly important

6. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Outright Forward Market Forward contract is a contract between a foreign currency trader and a client for future sale or purchase of foreign currency Forward contract is a derivative because its future value is based on the current spot exchange rate During a period of stability, little difference may exist between the current spot and forward rates

7. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Outright Forward Market Example from The Wall Street Journal British Pounds 90-day forward $1.8983 Spot $1.9077 Points -94 Spread is -.0094 or 94 points (discount)

8. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Outright Forward Market Premium (discount) = Fo � So x 12 x 100 So N If forward rate < spot rate, DISCOUNT If forward rate > spot rate, PREMIUM Fo = forward rate on the day that the contract is entered into So = spot rate on that day N = number of months forward 100 is used to convert the decimal to a %

9. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Outright Forward Market Example from The Wall Street Journal Premium = 1.8983 � 1.9077 x 12 x 100 1.9077 3 = -1.97% Pound is selling at a 1.97% discount below the dollar spot rate

10. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Swaps A swap is a simultaneous spot and forward transaction

11. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Example: Assume a U.S. company has received a dividend from a subsidiary in the E.U., but has no use of the euros for 30 days. They could deposit the euros in a French bank and earn interest for 30 days. Alternatively, they could convert the euros to dollars and also enter into a forward contract with the bank to deliver dollars in 30 days en exchange for euros at the forward exchange rate.

12. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Variation: Foreign currency swap that is driven by interest rate differentials. Japanese company would like to borrow U.S. dollars at a floating rate. U.S. company would like to borrow yen at a fixed rate. A financial intermediary pairs the two companies. The Japanese company issues a fixed rate bond and turns the yen over to the U.S. company. The U.S. company issues a floating rate obligation, and turns the dollars over to the Japanese company. The swap exchange rate is the rate at which the tow companies agree to exchange yen for dollars.

13. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Futures Specifies an exchange rate sometime in advance of the actual exchange of currency Traded on an exchange, not OTC Futures contract is for a specific amount and a specific maturity date, NOT tailored to the specific needs of the company (forward contract) Less valuable to a company than a forward contract May be useful to speculators and small companies that may not be able to negotiate a forward contract Contract months are March, June, Sept., Dec. Less flexible than forward contracts

14. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Options The right but not the obligation to trade foreign currency at a given exchange rate on or before a given date in the future Can be traded on an exchange or with a financial intermediary Two parties to an option Writer � sells the option Holder � buys the option, pays a premium to the writer Holder determines whether or not the option will be exercised

15. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Option can be a �put� or a �call� A put option gives the holder the right to sell foreign currency to the writer of the option A call option gives the holder the right to buy foreign currency from the writer of the option The cost is the contract cost and a brokerage fee

16. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The contract cost is nonrefundable If the contract is not exercised, the option writer retains the option price

17. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Foreign Exchange Markets Central Bank survey by the Bank of International Settlement in Basel, Switzerland Global net turnover of foreign exchange is estimated to be $1.9 trillion per business day Interbank market is the most important market in trading foreign exchange Banks also deal indirectly with each other through foreign exchange brokers Movement toward computer-based trades Foreign exchange is traded on Specialized market � International Monetary Fund of the Chicago Mercantile Exchange OTC revolves around investment banks like Goldman Sachs

18. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Foreign Exchange Markets Most widely traded instrument is swaps, followed by spot transactions and outright forwards

19. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The International Monetary System International Monetary Fund (IMF) created in 1944 to promote exchange stability Exchange Rate Arrangements IMF permits countries to select and maintain an arrangement of their choosing as long as they communicate the arrangement to the fund Some countries lock their currencies onto another currency � Ecuador and the U.S. dollar, Belize and the U.S. dollar Other countries adopt a free float or a managed float Importance lies in the relation of the home office currency to the currencies in countries where the company has operations Example � U.S. dollar was stable against the Chinese yuan , but weak against the euro, pound, and yen in 2004 The euro, pound, and yen float, but the yuan is pegged to a market basked of currencies. Do I need a citation for the example?Do I need a citation for the example?

20. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Determination of Exchange Rates Fisher Effect �A theory describing the long-run relationship between inflation and interest rates. � This equation tells us that, all things being equal, a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate (and vice versa). The nominal interest rate equals the real rate of interest worldwide plus the expected inflation rate International Fisher Effect The country with the higher nominal interest rate should have a higher rate of inflation The country with the higher nominal interest rate should expect its currency to weaken against a low-interest-rate (low-inflation) country Do I need a citation here?Do I need a citation here?

21. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Determination of Exchange Rates Important factors affecting exchange rates Purchasing power parity (PPP) or inflation differentials Relative interest rates The forward exchange rate According to PPP, a change in relative inflation must result in a change in exchange rates to keep the prices of goods in two countries similar, taking into consideration transportation costs. PPP is a good long-run indicator of exchange rate differences

22. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Determination of Exchange Rates Higher inflation = weakening currency Lower inflation = stronger currency

23. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Determination of Exchange Rates The forward rate differs from the spot rate by a percentage equal to the interest rate differential. If monetary units can earn more interest in euros over a 90 day period than if the monetary units are maintained in dollars, this interest rate differential will be impounded in the difference between the spot rate and the forward rate. The forward rate is also an unbiased predictor of the spot rate that will exist in the future, which means that it is neither systematically above or below the actual future spot rate. Citation needed for example?Citation needed for example?

24. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Determination of Exchange Rates Political issues can change exchange rate differentials, particularly in the short run Example � 2002 Presidential election in Brazil Brazilian real fell against the U.S. dollar because of a perceived leftist president When the president turned out to be conservative, the real strengthened against the dollar

25. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Unbiased Forward Rate Theory

26. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Transaction Exposure When a company engages in foreign currency transactions, a foreign exchange risk is incurred Example If a U.S. exporter receives payment in U.S. dollars from a British importer, there is no immediate impact on the exporter if the exchange rate changes The British importer has a cash flow gain/loss from the change in exchange rates because their accounts payable would change in value as the exchange rate changes Citation needed for example?Citation needed for example?

27. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Translation or Accounting Exposure Accounting exposure arises when a company translates its financial statements from one currency to another for consolidation purposes If current rate method is used, all accounts except owners� equity change in value with the exchange rate If the temporal method is used, only the monetary accounts are translated into dollars at the current rate method and exposed to exchange gains and losses Third bullet doesn�t quite make senseThird bullet doesn�t quite make sense

28. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Translation or Accounting Exposure Current rate method is likely to have an exposed asset position � all assets and liabilities translate at the same rate; assets exceed liabilites Temporal method is likely to have an exposed liability position � most liabilities translate at the current rate, while some assets translate at the current rate and some translate at the historical rate. Firms are positively exposed with income earned in a strong currency country Income earned in a weak currency country will be reduced by the weak exchange rate Dividend flows follow the same pattern as income Results under the temporal method will be mixed

29. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Economic (Operating) Exposure Economic exposure is the potential for change in expected cash flows Economic exposure arises from Pricing of products Sourcing and cost of inputs Location of investments

30. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Economic (Operating) Exposure Example by Aeppel, 2005 Superior Products Inc., a U.S. company, found that prices for valves it was sourcing from Germany were continuing to rise. As a result, Superior�s management decided to begin producing the valves itself and selling them to U.S. customers. When the Germans realized what was happening, they lowered their prices, but it was too late.

31. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Economic (Operating) Exposure Future events have more economic exposure than transactions exposure because of the different ways to account for and hedge them Currency of a country could affect its competitiveness as a production location Example (Aeppel, 2005) Bison Gear and Engineering Corp. closed down its facility in Holland when the dollar was weak, manufactured its products in the U.S., and sold them back into Europe.

32. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Hedging Strategies Duffey�s Six Reasons Why Management Does Nothing (2003) Managers do not take time to understand the issue Managers claim that exposure cannot be measured Managers say that the firm is hedged through hedging of transactions, without understanding the broader economic exposure Managers say that the firm does not have any exchange risk because it does all of its transactions in the reporting currency. Management ignores economic risk Management argues that doing business is risky and the firm gets rewarded for bearing both business and financial risks The balance sheet is hedged on an accounting basis, especially when the functional currency is the reporting currency Check 3rd bulletCheck 3rd bullet

33. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Financial Strategies Hedge exposure by use of derivatives Enter into foreign currency debt Use derivatives to hedge income statement or balance sheet exposure If a company is in a net monetary asset position, it will enter a contract to sell foreign currency. If a company is in a net liability position, it will enter a contract to buy foreign currency

34. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Operating Strategies Operating hedges are usually More complicated and costly than financial hedges Involved in betting on the exposure of the entire firm rather than just specific financial transactions Companies can balance costs with revenues Examples A company that sells to a European customer might consider manufacturing in Europe so expenses are in euros and can offset euro revenues. A company might also incur costs in euros so that it can use euro revenues to pay its euro costs. Does the example need a citation?Does the example need a citation?

35. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Foreign Exchange Risk Management Strategies Four steps to protect against exchange rate exposure Define and measure exposure Organize and implement a reporting system that monitors exposure and exchange-rate movements Adopt a policy assigning responsibility for minimizing � or hedging � exposure Formulate strategies for hedging exposure

36. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Define and Measure Exposure Differentiate between transactions, translation, and economic exposure Each type of exposure may require a different hedging response Is a citation needed here?Is a citation needed here?

37. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Organize and Implement a Reporting System System must monitor exposure and exchange-rate movements System must forecast exposure to establish a good hedging strategy Management should set up a uniform reporting system for all subs that identifies Exposed accounts that the company wants to monitor Amount of exposure by currency of each account Different time periods in consideration

38. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Adopt a Policy Assigning Responsibility Determine who is ultimately responsible for protecting the company from exchange rate movements Multidomestic companies usually delegate hedging strategies to national organizations Global companies are more likely to centralize hedging strategies Corporate should determine overall policy Corporate should provide forecasts on exchange rate movements to help local management

39. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Formulate Hedging Strategies Choice of exposures to be hedged depends On risk aversion of the company On management�s confidence in predicting exposures Dell Example Dell hedges everything Dell�s Brazilian operations hedge about 80% of forecasted revenues Does the Dell Example need a citation?Does the Dell Example need a citation?

40. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Adopt a Policy Assigning Responsibility Local management must develop good capabilities in foreign exchange risk management Local banking relationships can help local management develop forecasts of exchange rate movements Local management must establish strategies that fit within corporate guidelines The more centralized the strategy, the more corporate will take responsibility for hedging strategies Local management will then be free to focus on operations Citation needed here?Citation needed here?

41. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Hedging Standards IAS 39 and SFAS 133 are very similar A derivative is defined by three characteristics Has one or more underlyings (foreign exchange) and one or more notional amounts (units of foreign currency traded) or payment provisions or both Requires no initial net investment or one that is smaller that would be required for other contracts that would have a similar response to changes in market factors Terms require or permit net settlement, it can be readily net by a means outside the contract, or provides for delivery of an asset that puts the recipient in a position close to net settlement Do the 3 characteristics need a citation?Do the 3 characteristics need a citation?

42. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Hedging Standards IAS 39 and SFAS 133 require All derivatives be recognized as assets or liabilities on the balance sheet at fair value Changes in FV are recorded in comprehensive income Three kinds of hedges Fair-value hedge Cash flow hedge Foreign-currency hedge Hedge accounting matches the recognition of the gain or loss of the derivative with the gain or loss on the underlying transaction Citation needed here?Citation needed here?

43. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Use of a Forward Contract to Hedge a Transaction

44. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign Currency Transaction Redex Imports, a U.S. company, bought inventory from a British supplier on May 1, incurring a liability of �50,000 that must be paid on June 30. $1.8500 spot rate on May 1 $1.8700 forward rate quoted on May 1 for delivery on July 30 $1.8800 spot rate on June 30 $1.8900 forward rate quoted on June 30 for delivery on July 30 $1.9000 spot rate on July 30

45. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign Currency Transaction May 1 Purchases 92,500 A/P 92,500 to record the purchase at the spot rate of $1.8500 A memorandum entry is made to record Redex�s commitment to deliver dollars to the bank and receive �50,000 at the rate of $1.87

46. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign Currency Transaction June 30 Foreign Exchange Loss 1,500 A/P 1,500 �50,000 x (1.88-1.85) Forward contract 1,000 Foreign exchange gain 1,000 �50,000 x (1.89-1.87)

47. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign Currency Transaction July 30 A/P 94,000 Loss 1,000 Cash 95,000 Forward Contract 500 Gain 500 �50,000 x (1.90-1.89) Cash 1,500 Forward contract 1,500 Assuming a 6% discount rate, PV for one month (June 30 � July 30) is $1.8900-1.8700 = .02 x 50,000 = $1,000/(1 + .06/12) = $995

48. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black The Use of a Forward Contract to Hedge a Commitment

49. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Firm Commitment Redex Imports enters into a commitment to purchase capital equipment for �1,000,000 from a British manufacturer with delivery to take place on April 30 and payment to be made on May 31. Spot rates Forward rates $1.4900 March 1 $1.5700 March 1 $1.5200 March 31 $1.5850 March 31 $1.5500 April 30 $1.5900 April 30 $1.5950 May 31

50. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Firm Commitment PV of forward contract for March 31 � May 31 1.5850 � 1.5700 = .015 x 1,000,000 = $15,000/(1 + .06/6) = $14,851 March 31 Forward Contract 14,851 Gain on forward contract 14,851 Loss on firm commitment 14,851 Firm commitment 14,851

51. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Firm Commitment PV of the contract for March 31 � April 30 $1.59-1.57 = .02 x 1,000,000 = $20,000/(1+.06/12) = $19,900 April 30 Forward contract 5,049 Gain on forward contract 5,049 Loss on firm commitment 5,049 Firm commitment 5,049 Equipment 1,530,100 Purchase commitment 19,900 A/P 1,550,000

52. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Firm Commitment Value of the forward contract on May 31 $1.5950 - $1.5700 = .025 x 1,000,000 = $25,000 May 31 Forward contract 5,100 Gain on forward contract 5,100 Foreign exchange loss 45,000 A/P 45,000 A/P 1,595,000 Forward contract 25,000 Cash 1,570,000

53. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale On March 1, XYZ company estimates it will sell �1,000,000 of inventory to British customers effective April 30. XYZ enters into a forward contract to hedge the British pounds receivable Spot Rate Forward Rate for April 30 March 1 $1.4772 $1.4900 March 31 $1.4950 $1.5050 Date of sale $1.5100 $1.5100

54. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale Nominal Value FV Gain/Loss Mar 1 0 0 0 Mar 31 ($15,000) ($14,925) ($14,925) Apr 30 ($20,000) ($20,000) ($5,075) Fair Value adjustment on March 31 15,000/[1 + (.06/12)] = 14,925

55. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale March 1 No entry March 31 Other comprehensive income 14,925 Forward contract 14,925 April 30 Other comprehensive income 5,075 Forward contract 5,075 Foreign currency 1,510,000 Sales 1,510,000

56. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale April 30 Forward contract 20,000 Cash 1,490,000 Foreign currency 1,510,000 Sales 20,000 Other comp. income 20,000

57. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Illustration: An Option Contract to Hedge Foreign-Currency Forecasted Sale XYZ enters into a put option for �1,000,000 on March 1 at a strike price of $1.4900 and a premium of $20,000. The sale is expected to take place on June 30, the same time the option contract expires. March 1 Foreign-currency options 20,000 Cash 20,000 The option will be adjusted to FV and the adjustment will go to comprehensive income. When the sale is recorded, this adjustment will be taken from other comp. income and used to adjust the amount of sales. Sales revenue and cash received will be at least $1,490,000. �this adjustment� or �these adjustments?��this adjustment� or �these adjustments?�

58. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Use of Derivatives to Hedge a Net Investment SFAS 133 allows hedge accounting for the hedge of a net investment Gains and losses are taken to a separate component of stockholders� equity The gain or loss may be included in the cumulative translation adjustment to the extent the changes represent an effective hedge of the net investment Citation needed for the 1st bullet?Citation needed for the 1st bullet?

59. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Disclosure of Derivative Financial Instruments Derivatives are subject to the following Market risk � the risk of loss due to unexpected changes in interest and exchange rates Credit risk � the potential loss from counterparty nonperformance Liquidity risk � related to market liquidity of instruments held; closely related to market risk Operating risk � linked to inadequate controls that ensure following a properly defined corporate policy Semicolon needed?Semicolon needed?

60. International Accounting & Multinational Enterprises � Chapter 13 � Radebaugh, Gray, Black Disclosure of Derivative Financial Instruments Must disclose the extent of the risk to users Must provide qualitative and quantitative information about derivatives Must disclose Objectives for holding derivatives Context needed to understand objectives Strategies for achieving the objectives Separate information should be provided for Fair-value hedges Cash-flow hedges Foreign currency hedges To or For?To or For?