Exchange rate exposure

by Nguyen Diep Ha
11/22/14

By NDH

References
Chapter 10, 11, 12 Jef
Chapter 10, 11, 12 Eiteman

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Is Exchange Rate Risk

Relevant?
Purchasing Power Parity Argument
Exchange rate movements will be matched by

price movements.
PPP does not necessarily hold.

The Investor Hedge Argument

MNC shareholders can hedge against exchange

rate fluctuations on their own.

The investors may not have complete
information on corporate exposure. They may
not have the capabilities to correctly insulate
their individual exposure too.
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Is Exchange Rate Risk

Relevant?
Currency Diversification Argument
An MNC that is well diversified should not be

afected by exchange rate movements because

of ofsetting efects.
This is a naive presumption.

Stakeholder Diversification Argument

Well diversified stakeholders will be somewhat

insulated against losses experienced by an

MNC due to exchange rate risk.
MNCs may be afected in the same way
because of exchange rate risk.
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Is Exchange Rate Risk

Relevant?
Response from MNCs
Many MNCs have attempted to
stabilize their earnings with hedging
strategies, which confirms the view
that exchange rate risk is relevant.

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Types of exchange rate

exposures
Although exchange rates cannot be
forecasted with perfect accuracy, firms
can at least measure their exposure to
exchange rate fluctuations.
Exposure to exchange rate fluctuations
comes in three forms:
Transaction exposure
Economic exposure
Translation exposure
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Types of exchange rate

exposures
The degree to which the value of future
cash transactions can be afected by
exchange rate fluctuations is referred to as
transaction exposure.
Economic exposure refers to the degree to
which a firms present value of future cash
flows can be influenced by exchange rate
fluctuations.
The exposure of the MNCs consolidated
financial statements to exchange rate
fluctuations is known as translation
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exposure.

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Measure
Manage

TRANSACTION EXPOSURE

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Measuring transaction
exposure
1. Project the net amount of inflows or

outflows which are normally shortterm and contractual in each foreign

currency, and
2. Determine the overall risk of
exposure to those currencies.

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Range
Standard deviation
Value at Risk (VaR)
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Measuring transaction
exposure

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Range

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Standard deviation

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Standard deviation
Quarterly standard deviation
(ratesfx.com)
Currency
2004-2008
British pound
Canadian dollar
Indian rupee
Japanese yen
Mexican peso
Swedish krona
Swiss franc
Singapore dollar
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2001-1993
0.309
0.100
0.219
0.279
0.289
0.287
0.330
0.111

0.148
0.10
0.168
0.298
0.190
0.195
0.246
0.174
14

Standard deviation
Correlation coefficients

Can$

SwF
British
pound ()
1.00
Canadian
dollar (Can$) .181.00
Japanese
yen ()
.45.061.00
Mexican peso
(MXP)
.39.20 .331.00
Swedish
krona (Sk)
.62.16 .46.331.00
Swiss franc
(SwF)
.63.12 .61.37 .701.00
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MXP

15

Sk

VaR
The Value at Risk measures the
potential maximum loss in value of an
asset or portfolio over a defined period
for a given confidence interval.
Diferent types of VaR:
Parametric
Historical
Monte-Carlo..
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Parametric VaR
VaR for 1 day horizon: VaR = (E(e) z* i )*V
Ex1: Celia Co. will receive 10 million Mexican pesos
(MXP) tomorrow as a result of providing consulting
services to a Mexican firm. It wants to determine the
maximum one-day loss due to a potential decline in
the value of the peso, based on a 95 percent
confidence level. It estimates the standard deviation
of daily percentage changes of the Mexican peso to
be 1.2 percent over the last 100 days. Assuming
these daily percentage changes are normally
distributed ~ N(0,)
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Parametric VaR
VaR over t-day horizon:
VaR = E(e) z*

*i

Ex: Similarly, Celia will collect the

money in 10 days

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Transaction exposure
management
Hedging
Other alternatives
Leading and Lagging
Currency diversification
Reinvoicing
Parallel loans
Currency swap

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Hedging techniques
1. Forward (future) hedge,
2. Money market hedge,
3. Currency option hedge.
Assuming today, Boeing sells a Boeing 747 to
British Airlines for 10m payable in 1 year in
Dec 2014.
. US market rate: 6,1%
. UK market rate: 9%
. Spot rate: 1.500$ = 1
. 1-year forward rate: 1.460$ = 1
. Dec future contract is priced at 1.454$ = 1
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Forward
No hedge

Value

Hedge using
forward

14.600.000$
Forward to sell
GBP

X=1,460

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ST

21

Future vs. Forward

Pros:
Future contracts are more cost efficient
for small transactions

Cons:
Forward contracts can be negotiable and
tailored to the companys requirements
perfect hedge
Marked-to-market in future market
some cash flow risk with margin call
Products in future markets are quite
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limited.

Money market hedge

Spot CF
1. Borrow GBP

9,174,312

2. Convert into
USD
3. Invest the USD
4. At maturity
Net CF
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$13,761,468
- 9,174,312
$13,761,468
0

CF at
maturity
10,000,000

$14,600,918
10,000,000
14,600,918
23

Option
A put or a call?
No hedge

Value

Hedge using
option

14.387.800$
Put option on
GBP

ST

X=1,46

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Decision
Calculate and compare expected CF
Scenar
io

Prob

0.69

30%

0.71

40%

0.74

30%

Forwar
d

Money
market

Option

Expected cashflow

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No
hegde

Decision
No hedge
Option

14.600.918$
14.600.000$
14.387.800$

Money market
Forward

The decision depends on firms risk tolerance,

their market expectation, their confidence in their
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forecast and theirBy NDH
target.

Other alternatives
Leading and lagging
Adjust the timing of payment in accordance with
expectation of exchange rate movements
Leading: push up the payment before the foreign
currency appreciate
Lagging: delay payment until the foreign currency
depreciate
Barely feasible for receivables

Cross-hedge:
when there is no active market for the currency i.e.
forward or option is not available, the firm can use other
assets which is highly correlated to the currency e.g. oil
price and the peso, Korean won and Japanese yen,.
The efectiveness depends on the correlation

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Other alternatives
Currency diversification
More applicable for large MNCs whose
presence is among numerous countries.
Risk sharing:
Buyer and seller agrees to share or split
currency movement impact on payments
between them.
More suitable for longterm relationship
Only helps smooth out the fluctuation

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Other alternatives
Parallel loans: no need to use the foreign
exchange market

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British parent
company

Dutch parent
company

Dutch
companys
British
subsidiary

British
companys
Dutch subsidiary

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Other alternatives
Reinvoicing center: cost-benefit analysis
Benefit: efectively eliminate the exchange rate risk
Trident Brazil
(finish the local
sales)

Trident USA
(manufacture
unfinished goods)

Reinvoicin
g Center

After netting,
only need to
hedge the
residual exposure
Cost: set-up cost, operation expenses, professional

cost especially those related to tax and legal services

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Other alternatives
Currency swaps: like parallel loans but it
does not appear on the balance sheet
translation exposure is avoided as well.
Japanese
corporation

U.S. corporation

Swap
dealer
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Problems
33 chap 10 Jef
33, 45, 46,47 chap 11 Jef

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