MULTINATIONAL

FINANCE

Foreign Exchange Risk

Management
(Chapter 10 & 11)

Outline of Lecture
1) Define different types of exchange rate
exposures
2) Managing exchange rate exposure
1) Hedging
2) Managing Translation Exposure
3) Managing Transaction Exposure
4) Managing Operating Exposure

Foreign exchange exposure

‰“A measure of the potential change in a firm’s
profitability, net cash flow, and market value
because of a change in exchange rates”
‰Focus of lecture: Measure foreign exchange
exposure and manage it so as to maximize the
profitability, net cash flow, and market value of
the firm
‰The effects can be measured in several ways.

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 Alternative measures of foreign exchange
exposure
Translation Exposure Operating Exposure
Changes in reported owners’ equity Change in expected future cash flows
in financial statements caused by a arising from an unexpected change in
changes in exchange rate exchange rates (future sales, future
production costs and so on)

Change in
Accounting Exposure exchange rate Economic Exposure Time

Transaction Exposure
Changes in the value of outstanding (unsettled) foreign currency-denominated
contracts (contracts that will give rise to cash flows in the future – after the
exchange rate change – but entered into before the exchange rate change)
caused by the exchange rate change

Translation exposure
‰ Translation exposure, also called accounting exposure:
Accounting-based changes in financial statements caused by a
change in exchange rates. It has an influence on the official total
shown by the balance sheet
‰ Assets, liabilities, revenues and expenses originally measured in a
foreign currency are reported and valuated in the home currency in
order to be consolidated in the accounts
‰ Four principal translation methods are used:
¾ the current/non current method
¾ the monetary/non monetary method
¾ Temporal method
¾ The current rate method (US practice)

Translation Exposure
Current/Noncurrent Method
‰All foreign subsidiary’s current assets and
liabilities are translated into home currency
at the current exchange rate
‰Each noncurrent asset or liability is
translated at its historical exchange rate,
i.e. the exchange rate in effect at the time
the asset or liability was incurred

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 Translation Exposure
Monetary/Nonmonetary method
‰Differentiates between monetary assets and
liabilities (cash, accounts payable and
receivable and long term debt) and nonmonetary
items (inventory, fixed assets and long term
investments)
¾ Monetary items are translated at the current
exchange rate
¾ Nonmonetary items are translated at historical rates

Translation exposure
Temporal method
‰Same as monetary/nonmonetary method
but inventory (normally translated at
historical rates) can be translated at
current rate if the inventory is shown on
the balance sheet at market values

Translation Exposure
Current rate method
‰All balance sheet and income items are
translated at the current exchange rate

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 ‰The translation gain or loss due to changes in
exchange rates depends on the chosen translation
method
Example:

(Exhibit continues on next slide)

Transaction Exposure
‰ Is often included by firms as part of the translation
(accounting) exposure but sometimes included (more
logical) as part of the economic exposure (operating
exposure + transaction exposure)
‰ Transaction exposure measures changes for
operations that are incurred prior to a change in
exchange rates but that must be settled after a change in
exchange rates. It has an influence on the cash
management
‰ This exposure deals with changes in cash flows as the
result from existing contractual obligations

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 Transaction exposure
‰Arises from possibility of exchange rate
gains and losses from the transaction
‰Measured currency by currency and
equals the difference between:
¾The contractually-fixed invoice amount in a
specific currency
¾The final payment amount denominated in
current exchange rate for the specific
currency

Transaction exposure

t1 t2 t3 t4
Seller quotes Buyer places Seller ships Buyer settles
a price to order with product and with cash in
buyer seller at price bills buyer amount of
offered at currency quoted
time t1 at time t1

Quotation exposure Backlog exposure Billing exposure

Time between Time it takes to fill Time it takes to get

quoting a price and the order after paid in cash
reaching a contract is signed
contractual sale

Operating Exposure
‰Operating exposure, measures change
in expected future cash-flows (from future
sale and production) due to an unexpected
change in exchange rates
‰It affects the firm’s present value. It has a
major influence on the stock price for listed
companies

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 Operating Exposure
‰The exchange rate changes that give rise to
operating exposure are real exchange rate
changes
‰A dramatic change in the nominal exchange
rate accompanied by an equal change in the
price level (no real exchange rate change)
should have no effects on the relative
competitive position of domestic firms and their
foreign competitors – i.e. will not alter cash flows

Operating exposure
‰A real exchange rate change alters the relative
price of domestic and foreign goods
¾ Affects the relative competitiveness of firms

(1 + i f ,t )
etr = et ×
(1 + ih,t )
where etr = the real exchange rate,
et = the nominal exchange rate,
i f ,t = foreign inflation (0 - t)
ih,t = domestic inflation (0 - t)

Operating exposure
‰Need to consider both nominal exchange rate
changes as well as relative inflation rates in
order to estimate the operating exposure
‰In general:
¾ a decline in the real value of a currency makes its
exports and import-competing firms more competitive
¾ An increase in real value of a currency hurts the
exporting firms and those competing with imports

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 Operating exposure
‰How a specific firm is affected depends
importantly on the firms:
1) Pricing flexibility
2) Production flexibility

Operating exposure
1) Pricing flexibility
‰A changing real exchange rate alters relative
prices that lead to questions like:
¾ Can the firm maintain its profit margin home and
abroad?
¾ Can the firm maintain its home price on domestic
sales in the face of lower-priced foreign goods
(appreciating currency)?
¾ Can the firm raise its foreign currency selling price
sufficiently to preserve its home country profit margin
(appreciating currency)?

Operating exposure
Price-elasticity of demand
‰Less price elastic demand – more price
flexibility for the firm
¾Depends on number of competitors in the
market and their location
– Less competition more price flexibility
¾Depends on product differentiation
– The more distinct/differentiated from other
products – less price sensitive

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 Operating exposure
‰Higher price elasticity – decreased price
flexibility for the firm
¾High competition
¾Less differentiated products

‰Less pricing flexibility → Greater

exchange rate risk

Operating exposure
2) Production flexibility
‰Move production geographically
¾Home versus foreign production
‰Alter production inputs
¾Change sourcing to different countries, different input
substitutes
‰Higher production flexibility → less
exchange rate risk

Operating exposure
Identification of economic exposure:
‰A real exchange rate change affects a
number of aspects of a firms operations
‰Need to identify these aspects:
¾Pose the right questions

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 Managing Exchange Rate
Exposure
Hedging
‰“establishing an offsetting currency position so
as to lock in the home currency value for the
currency exposure and thereby eliminate the risk
posed by currency fluctuations”

‰Whatever is lost or gained on the original

currency exposure is exactly offset by a
corresponding foreign exchange gain or loss on
the currency hedge

Managing Exchange Exposure

Designing a hedging strategy
‰Identify and determine the types of exposure to
be monitored
‰Strategies a function of management’s
objectives and should be consistent with
maximizing shareholder value
‰Hedging’s basic objective: reduce/eliminate
volatility of earnings as a result of exchange rate
changes

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 Basic Hedging Strategies

Managing Exchange Exposure

‰Hedging exchange rate risk
¾Costs money
¾Should be evaluated as any other purchase of
insurance

Hedging Costs

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 Managing Exchange Exposure
‰Hedging should be used only if it increases the
value of the firm – is consistent with the goal of
management
‰If market expects a future devaluation/
depreciation or revaluation/appreciation this is
likely reflected in forward, futures and currency
option prices – hence using these instruments
for hedging will probably be a failure
‰Hedging is useful if firm has a deviating (from
the market) expectation about future exchange
rate changes or against unexpected changes

Managing Translation Exposure

‰ 3 Available Methods

1) Adjusting fund flows

‰ altering either the amounts or the
currencies of the planned cash flows
of the parent or its subsidiaries to
reduce the firm’s local currency
accounting exposure.

Managing Translation Exposure

2) Forward contracts
‰ Reducing a firm’s translation
exposure by creating an offsetting
asset or liability in the foreign
currency

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Managing Translation Exposure
3 Exposure netting
‰ Offsetting exposures in one currency
with exposures in the same or
another currency
¾gains and losses on the two currency
positions will offset each other

Managing Translation Exposure

‰Basic hedging strategy for reducing translation
exposure (through 1-3 accomplish):
¾increasing hard-currency (likely to appreciate)
assets
¾decreasing soft-currency (likely to depreciate)
assets
¾decreasing hard-currency liabilities
¾increasing soft-currency liabilities
– i.e. reduce the level of cash, tighten credit terms to decrease
accounts receivable, increase LC borrowing, delay accounts
payable, and sell the weak currency forward.

Managing Transaction Exposure

METHODS OF HEDGING
A. Forward market hedge
B. Money market hedge
C. Risk shifting
D. Pricing decision
E. Exposure netting
F. Currency risk sharing
G. Currency collars
H. Cross-hedging
I. Foreign currency options

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 Managing Transaction Exposure
A. FORWARD MARKET HEDGE
‰consists of offsetting a receivable or
payable in a foreign currency using a
forward contract:
¾to sell or buy that currency at a set delivery
date which coincides with receipt of the
foreign currency
¾Will also offset the possibilities of profits from
exchange rate changes

Managing Transaction Exposure

NOTE: The real cost of Hedging:
‰The opportunity cost depends upon future
spot rate at settlement

f1 − e1
eo
where f1 = forward rate,
e o = current spot rate,
e1 = future spot rate

Managing Transaction Exposure

B. MONEY MARKET HEDGE

‰Definition: simultaneous borrowing and
lending activities in two different
currencies to lock in the dollar value of a
future foreign currency cash flow

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 Managing Transaction Exposure
C. RISK SHIFTING
‰home currency invoicing – shifts risk from one
firm to the other
¾firm will invoice exports in strong
currency
¾import in weak currency
‰Drawback: it is not possible with informed
customers or suppliers – only if they have
different exchange rate expectations

Managing Transaction Exposure

D. PRICING DECISIONS
‰The general rule on credit sales overseas
is to convert between the foreign currency
price and the dollar price by using the
forward rate, not spot rate
¾if the dollar price is high/low enough the
exporter/importer should follow
through with the sale

Managing Transaction Exposure

E. EXPOSURE NETTING
‰Protection can be gained by selecting
currencies that minimize exposure
‰Netting: MNC chooses currencies that are
not perfectly positively correlated
‰Exposure in one currency can be
offset by the exposure in another

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 Managing Transaction Exposure
F. CURRENCY RISK SHARING
‰Developing a customized hedge contract
‰The contract typically takes the form of a
Price Adjustment Clause, whereby a base
price is adjusted to reflect certain
exchange rate changes
‰The buyer and seller agree on splitting the
exchange rate risk

Managing Transaction Exposure

F. CURRENCY RISK SHARING (con’t)
‰Parties would share the currency risk
beyond a neutral zone of exchange rate
changes
‰The neutral zone represents the currency
range in which risk is not shared
¾For example: $0.98-1.02/€
¾If exchange rate moves out of the range the
parties share the gain/loss

Managing Transaction Exposure

G. CURRENCY COLLARS
‰Also called a range forward
‰Contract bought (from bank) to protect against
currency moves outside an agreed-upon range
‰Example: “Euro receivable”
¾ If future spot rate is in the range $0.95-$1.05/€ it will
be converted at the future spot rate
¾ If future spot rate is above $1.05/€ it will be converted
at $1.05/€ (bank profits)
¾ If future spot rate is below $0.95/€ it will be converted
at $0.95/€ (bank losses)

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 Managing Transaction Exposure
H. CROSS-HEDGING
‰Often futures contracts not available in a certain
currency
‰Solution: a cross-hedge
¾ a futures contract in a related currency
¾ Use regression to obtain correlation between the
currencies
‰Correlation between 2 currencies is critical to
success of this hedge

Managing Transaction Exposure

I. Foreign Currency Options
‰ When transaction is uncertain, currency
options are a good hedging tool in situations
in which the quantity of foreign exchange to
be received or paid out is uncertain.

January April December Time

Bid Decision of the Payment (receive

bidding process € 10 million)

Managing Transaction Exposure

I. Foreign currency options
‰ A call option is valuable when a firm has
offered to buy a foreign asset at a fixed
foreign currency price but is uncertain
whether its bid will be accepted or not
‰ The firm can lock in a maximum dollar
price for its tender offer, while limiting its
downside risk to the call premium in the
event its bid is rejected

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 Managing Transaction Exposure

‰A put option allows the company to insure

its profit margin against adverse
movements in the foreign currency while
limiting the downside risk to the premium if
they lose the bidding process

Managing Operating Exposure

‰Because currency risk affects all facets of a
company’s operations it should not be the
concern of financial managers alone
‰Operating exposure (competitive exposure)
management requires in addition to financial
hedging techniques long-term operating
adjustments
‰Relative price changes (changes in the real
exchange rate) leads to marketing and/or
production revisions

Managing Operating Exposure

Proactive Marketing Initiatives
1) Market selection
¾use competitive advantage due to favorable
exchange rate to carve out market shares
¾Market segmentation – pull out of unprofitable
markets devote more attention to profitable
markets (caused by different exchange rate
levels)

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 Managing Operating Exposure
Proactive Marketing Initiatives
2) Product strategy
¾Exchange rate changes may alter:
– The timing of new product introductions
(competitive advantage – after devaluation)
– Product deletion (not competitive)
– Product innovation (high-quality products - strong
home currency)

Managing Operating Exposure

Proactive Marketing Initiatives
3) Pricing strategy
‰Key issue to be addressed: Emphasize
market share or profit margin
¾Following a home currency depreciation
(competitive advantage for home exporter)
– Raising its home currency price and boosting profit
margins or keeping its home currency price
expanding its market shares?

Managing Operating Exposure

Proactive Marketing Initiatives
‰Decision (profit margin vs market shares)
depends on:
¾ Temporal advantage?
¾ Economics of scale in production (emphasize market
share)
¾ Cost structure for expanding production
¾ Consumer price sensitivity (high price elasticity –
keep price low)
¾ Attracting competition (through high unit profits)

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 Managing Operating Exposure
Proactive Marketing Initiatives
4) Promotional strategy
‰Devote resources to promote products
that have a strong competitive position
(due to favorable exchange rate) to gain
market shares

Managing Operating Exposure

Proactive Production Initiatives
1) Product sourcing
¾input mix (increased use of foreign inputs – if
strong home currency)
¾Shifting production among a firms plants
– Increasing production in nations whose currency
has devalued
– Decreasing production in nations whose currency
has revalued

Managing Operating Exposure

Proactive Production Initiatives
2) Plant location
¾ Strong home currency may warrant new plants to be
located abroad (in a weaker currency country)

3) Raising productivity
¾ Raising competitiveness by improving productivity
– Closing inefficient plants
– Automating heavily (decrease labor usage)
– Negotiating wage and benefit cutbacks

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 Managing Operating Exposure
Planning For Exchange-Rate Changes
‰With better planning and more competitive
options, firms can change strategies
substantially before the impact of a currency
change makes itself felt
‰With better planning ahead (prepare for different
scenarios) the firm may act quicker and can be
more flexible

Financial Management of
Exchange Rate Risk:
‰Financial manager’s role in marketing and
production:
¾ Provide local manager with forecasts of inflation and
exchange rate changes
¾ Identify and focus on competitive exposure
¾ Design the evaluation criteria so that operating
managers neither are rewarded or penalized for
unexpected exchange-rate changes
¾ Estimate and hedge the operating exposures after
adjustments made (marketing, production)

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