Multinational Business Finance

Yinghong.chen@liu.se

5/21/2013

11-1

Transaction Exposure
Foreign exchange exposure is a measure of how a firms profitability, net cash flow, and market value will 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.

5/21/2013

Types of Foreign Exchange Exposure

Transaction exposure measures changes in the value of outstanding financial obligations This type of exposure deals with changes in cash flows the result from existing contractual obligations.

5/21/2013

11-3

Economic Exposure
Operating exposure, and transaction exposure are called economic exposure, measures the change in the expected value of the firm resulting from an unexpected change in exchange rates. Expected changes in exchange rate can be calculated through Parity conditions. The rest is unexpected.
5/21/2013 11-4

Types of Foreign Exchange Exposure

Transaction exposure and operating exposure exist because of unexpected changes in future cash flows due to a exchange rate change. The difference between the two is that transaction exposure is a contractual obligation, while operating exposure focuses on foreign currency cash flows generated from operation that might change because a change of exchange rates.
5/21/2013 11-5

Types of Foreign Exchange Exposure

Translation exposure, also called accounting exposure, is the potential for accounting-derived changes in owners equity to occur because of the need to translate the owners equity to home currency to report consolidated financial statements. The exposure is not real, it is called Balance sheet loss or gain. It only becomes material when the subsidiary closes.
5/21/2013 11-6

Exhibit 11.1 Conceptual Comparison of Transaction, Operating, and Translation Foreign Exchange Exposure

5/21/2013

11-7

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.
5/21/2013 11-8

Why Hedge?
Hedging is the taking of a position, i.e. a cash flow, an asset, or a contract (including a forward contract) 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.
5/21/2013 11-9

Why Hedge?
The value of a firm, according to financial theory, is the net present value of all expected future cash flows. Nothing is certain yet. Currency risk is defined roughly as the changes 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.

5/21/2013

11-10

Exhibit 11.2 Impact of Hedging on the Expected Cash Flows of the Firm

5/21/2013

11-11

Why 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 does not increase the expected cash flows of the firm Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict) Managers cannot outguess the market

5/21/2013

11-12

Why 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 firms 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

5/21/2013

11-13

Measurement of Transaction Exposure

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency.

5/21/2013

11-14

Exhibit 11.3 The Life Span of a Transaction Exposure

5/21/2013

11-15

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.

5/21/2013

11-16

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. Care should be taken to distinguish operating hedges from financing hedges.
5/21/2013 11-17

Tridents Transaction Exposure

With reference to Tridents Transaction Exposure, the CFO, Maria Gonzalez, has four alternatives:
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/or an account payable.

5/21/2013 11-18

Tridents 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 and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract. The purchase of such funds at a later date is referred to as covering.
5/21/2013 11-19

Tridents Transaction Exposure

A money market hedge also involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement. 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. Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge).
5/21/2013 11-20

Tridents 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.

5/21/2013

11-21

Exhibit 11.5 Tridents Hedging Alternatives, Including an ATM Put Option

5/21/2013

11-22

Risk Management in Practice

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 firms bottom line. Currency risk managers are expected to be conservative when managing the firms money.
5/21/2013 11-23

Risk Management in Practice

As might be expected, transaction exposure management programs are generally divided along an option-line; those that use options and those that do not. Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges.

5/21/2013

11-24

Risk Management in Practice

Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. These contracts generally 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 firms risk tolerance, view of exchange rate movements, and confidence level.
5/21/2013 11-25

Exhibit 11.4 Valuation of Cash Flows by Hedging Alternative for Trident

5/21/2013

11-26

Exhibit 11.6 Valuation of Hedging Alternatives for an Account Payable

5/21/2013

11-27

OPERATING EXPOSURE MANAGEMENT

5/21/2013

11-28

What is Operating Exposure?

Operating exposure (also called competitive exposure, and strategic exposure) measures the change in the firms present value resulting from the expected changes in future operating cash flows denominated in foreign currency (caused by an unexpected change in exchange rates).
5/21/2013 11-29

How to measure Operating Exposure? Two difficulties

Measuring the operating exposure of a firm requires forecasting and analyzing all the firms future individual transaction exposures together with the future exposures of all the firms competitors and potential competitors worldwide. To analyze the longer term exchange rate changes that are unexpected and its impact on the firm is the goal of operating exposure analysis.
5/21/2013 11-30

Operating cash flows and financing cash flows

Differentiating cash flows of MNEs: Operating cash flows arise from business activities: that is, from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments, royalty and license fees and management fees. Financing cash flows are from financing activities, that is payments for loans (principal and interest), equity injections and dividends.

5/21/2013

11-31

Exhibit 12.1 Financial and Operating Cash Flows Between Parent and Subsidiary

5/21/2013

11-32

Attributes of Operating Exposure

Operating exposure is important for the long-run health of a business. However, operating exposure is inevitably subjective because it depends on estimates of future cash flow changes over an arbitrary time horizon. Planning for operating exposure is a management responsibility because it relates to the interaction of strategies in finance, marketing, purchasing and production.

5/21/2013

11-33

Attributes of Operating Exposure

An expected change in foreign exchange rates is not of concern. From an investors perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firms market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.
5/21/2013 11-34

Example:
We discuss the dilemma facing Trident as a result of an unexpected change in the value of the euro, , the currency of denomination for Tridents German subsidiary. There is concern over how the subsidiarys revenues (price and volumes in euro terms), costs (input costs in euro terms), and competitive landscape will change with a fall in the value of the euro.
5/21/2013 11-35

Exhibit 12.2 Trident Corporation and Its European Subsidiary: Operating Exposure of the Parent and Its Subsidiary

5/21/2013

11-36

Measuring the Impact of Operating Exposure

Trident Europe:
Case 1: Euro Devaluation , no change in any variable. Case 2: Increase in sales volume; other variables remain constant. Case 3: Increase in sales price; other variables remain constant.

5/21/2013

11-37

 The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firms future cash flows. To meet this objective, management can diversify the firms operating and financing base. Management can also change the firms operating and financing policies.
5/21/2013 11-38

The objective of the Operating Exposure management

Benefits of diversification
Management team is prepositioned both to recognize disequilibrium when it occurs and to react competitively if the firms operations are diversified internationally . Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. Domestic firms do not have the option to react in the same manner as an MNE.

5/21/2013

11-39

Benefits of diversification
If a firms financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect. i$ i =PUS -PEU However, to switch financing sources from one capital market to another, a firm must have the ability to operate in the international investment community. Again, this would not be an option for a domestic firm.
5/21/2013 11-40

6 Proactive policies of Management of Operating Exposure

Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. The six most commonly employed proactive policies are:
Matching currency cash flows Risk-sharing agreements Back-to-back ( parallel loans), or credit swaps. Currency swaps Leads and lags Reinvoicing center

5/21/2013

11-41

Proactive Management of Operating Exposure

Example: a US firm has a continuing export sales to Canada. In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Canadian dollars month after month. This series of transaction exposures could be continually hedged with forwards, futures or options, etc. Or using operating exposure management methods described as follows:

5/21/2013

11-42

Matching currency cash flows

One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). Alternatively, the US firm could seek out potential suppliers of raw materials or components in Canada as a substitute for US and other foreign firms. In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.
5/21/2013 11-43

Exhibit 12.4 Matching: Debt Financing as a Financial Hedge

5/21/2013

11-44

Proactive Management of Operating Exposure: Risk Sharing

Currency Risk-Sharing:

a method to manage a long-term cash flow exposure. This is a contractual arrangement in which the buyer and seller agree to share or split currency movement impacts on payments between them. This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements.
5/21/2013 11-45

Risk Sharing: Ford and Mazda

Risk Sharing Agreement between Mazda and Ford. Ford agrees to pay all purchases in Japanese Yen to Mazda as long as the spot exchange rate on the day of invoice is between 115 yen/$ to 125 yen/$. If however the exchange rate falls out of this range, Mazda and Ford will share the difference equally. What happens if the rate falls to 110 yen/$?
5/21/2013 11-46

Proactive Management of Operating Exposure

Back-to-Back Loans:
A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow foreign currency for a specific period of time, but totally circumvent the foreign exchange market . See the following slides. At an agreed terminal date they return the borrowed currencies. Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays.
5/21/2013 11-47

Exhibit 12.5 Using a Back-to-Back Loan for Currency Hedging

5/21/2013

11-48

Proactive Management of Operating Exposure

There are risks involved in the widespread use of the back-to-back loan:
1. It is difficult for a firm to find a partner, termed a counterparty for the currency amount and timing desired. 2. A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity although each party has 100% collateral (denominated in a different currency).
5/21/2013 11-49

Proactive Management of Operating Exposure

Currency Swaps:
A currency swap resembles a back-to-back loan except that it does not appear on a firms balance sheet. In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time.

5/21/2013

11-50

Exhibit 12.6 Using a Cross-Currency Swap to Hedge Currency Exposure

5/21/2013

11-51

Proactive Management of Operating Exposure

Leads and Lags: Re-timing the transfer of funds
Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group. Intercompany leads and lags requires the time preference of one independent firm to be imposed on another.

5/21/2013

11-52

Proactive Management of Operating Exposure

Reinvoicing Centers: There are three basic benefits arising from the creation of a reinvoicing center:
Managing foreign exchange exposure Guaranteeing the exchange rate for future orders Managing intrasubsidiary cash flows

5/21/2013

11-53

Exhibit 12.7 Use of a Reinvoicing Center

5/21/2013

11-54

Proactive Management of Operating Exposure

Some MNEs now attempt to hedge their operating exposure with contractual hedges. Merck and Eastman Kodak have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse exchange rate changes. The ability to hedge the unhedgeable is dependent upon:
Predictability of the firms future cash flows Predictability of the firms competitors responses to exchange rate changes

5/21/2013

11-55

Mini-Case Questions: Toyotas European Operating Exposure

Why do you think Toyota waited so long to move much of its manufacturing for European sales to Europe? If Britain were to join the European Monetary Union, would the problem be resolved? How likely do you think it is that Britain will join? If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a short-term and what was a long-term problem? What measures would you recommend Toyota Europe take to resolve the continuing operating losses?

5/21/2013

11-56

Exhibit 12.3 Trident Europe

5/21/2013

11-57

Exhibit 1 Toyota Motors European Currency Operating Structure

5/21/2013

11-58

Exhibit 2 Daily Exchange Rates: Japanese Yen per Euro

5/21/2013

11-59

Exhibit 3 Daily Exchange Rates: British Pounds per Euro

5/21/2013

11-60