IFM8

Currency Risk:
The Measurement of Corporate

Exposure
Prof. Ian Giddy
New York University
Measuring and Managing Exposure
Transactions exposure
Case study: G.E.s Yen Payables
Translation exposure
Economic exposure
Case study; U.S. Semiconductor

Transactions
Transactions
Exposure
Exposure
Translation
Translation
Exposure
Exposure
Copyright 2000 Ian H. Giddy
Economic
Economic
Exposure
Exposure
Corporate Exposure 2
Transactions Exposure
Transactions exposure results from particular

transactions such as an export where a known
cash flow in a given currency will take place at a
certain date
Example: If Intel invoices a German company in
Deutsche marks for a semiconductor shipment
then the firm has German mark exposure and
can hedge this by borrowing marks.
This kind of exposure is readily hedgable using
forwards, futures or debt
Exchange Rate Risk: Transactions

Transactions exposure arises when a
company must pay or receive a foreign
currency at an unknown future
exchange rate
It is contractual
It affects the income statement
It can often be hedged directly using
forwards, futures or currency options
Transactions Exposure: Hedging

Reeves International (CT) has a
subsidiary in Italy. It makes printing
blankets for sale in Europe.
Reeves Italy has to pay a dividend of
approximately ITL 24 m. in December.
How should Reeves hedge this?
Forwards?
Futures?
Money
market hedge?
Do nothing?
Hedging Transactions Exposure

Types of exposure
One-shot exposure
Hedging approaches:
Open
Forward
Money
market
Futures
Options
Ongoing transactions exposure
International Profits
Covered under FASB No. 52 which requires

only certain transactional gains or losses to
be reflected in the income statement.
Income statement risk is dependent upon
exchange rate fluctuations.
In general, if a subsidiary has a positive
income flow, the income statement risk will be
positive.
Recognition of Exchange Gains & Losses

Exchange Gain/Loss
Transaction Gain/Loss
Transaction
Date
Financial
Statement
Date
Translation Gain/Loss
Settle
ment
date
Financial
Statement
Date
Financial
Satement
date
Translation
Transaction
Linkages Between Interest Rates
Covered interest
rate parity
Interest
Interest rate
rate
differential
differential
Uncovered interest
rate parity
Expected
Expected
%
% change
change in
in
exchange
exchange rate
rate
Forward
Forward
premium
premium
Unbiased
forward rate
Cost of Hedging
Type of Hedge
Cost of Hedging
Forward
Forward premium
Money Market Hedge Interest rate

(Borrow to match
differential
assets)
Do nothing
Expected rate of
change of
exchange rate
GEs Yen Payables
VCRs imported
Yen due in 90 days
GEs Yen Payables
VCRs
Yen
Yen:
Yen:
Spot
Spot
250
250
Forward
Forward
246
246
(6.5%
(6.5% premium)
premium)
US$
US$ Debt
Debt 15.5%,
15.5%, Yen
Yen interest
interest 9.0%
9.0%
What Happens to GE If Rises?
VCRs
Yen
IfIf US
US VCR
VCR prices
prices are
are fixed:
fixed: GE
GE is
is exposed.
exposed.
Hedging
Hedging is
is safer.
safer.
IfIf US
US VCR
VCR prices
prices are
are flexible,
flexible, and
and obey
obey PPP,
PPP,
then
then GE
GE is
is not
not exposed,
exposed, and
and itit would
would be
be risky
risky
to
to hedge!
hedge!
The Exposure Triangle

Transactions
Transactions
Exposure
Exposure
Translation
Translation
Exposure
Exposure
Economic
Economic
Exposure
Exposure
Balance Sheet Exposure
Balance sheet exposure (or translation or

accounting exposure) results from the way
accounting conventions dictate that a
companys foreign assets and liabilities should
be booked.
Example: If Intels assets in Ireland are
regarded as denominated in Irish punts, then
the subsidiarys accounting value is exposed to
the punt and the firm may wish to hedge this
exposure by financing in punts.
Exchange Rate Risk: Translation
Translation exposure arises when a

company has assets and/or liabilities in
a foreign currency, which must be
translated at an unknown future
exchange rate
It affects the balance sheet

It can be hedged using forwards, futures or
currency swaps
But translation exposure can mislead!
Stora in Australia
Assets
Cash
Accounts receivable
Inventory
Property, plant and
equipment
Liabilities
Accounts payable
Bank debt
Bonds issued
Equity (owned by
parent company in
Sweden)
Net translation exposure = Value of foreign

currency assets - Value of foreign currency
liabilities.
Translation of Individual Accounts
For US companies, governed by FASB No. 52

which specifies the current rate method
First, each entity's balance sheet and income
statement are measured in terms of their
Functional Currency, which is the currency of the
economic environment in which the entity primarily
operates and maintains records
Next, the functional-currency-denominated
financial statements are translated into the parent's
currency using the All-Current-Rate Method, which
reports balance sheet items at the closing rate and
income statement items at their average rates.
Key Features of FAS 52
Objective of translation: Local subsidiary perspective

(preserve foreign currency financial results and relationships
in consolidated statements)
Functional currency: Primary currency of economic
environment in which foreign entity operates
Translation method:
If functional currency is US$: Temporal method

If functional currency is foreign currency: Current rate method
Transaction gains & losses: Recognized in current income

except those on intercompany transactions of long-term
nature
Translation gains & losses: Recognized in separate
owners' equity account.
Sweden Down Under

Stora,
the Swedish
pulp & paper company,
has a plant in
Melbourne, and sells in
Australian dollars
But newsprint is a
world-wide, dollartraded commodity
So the revenues are
effectively in dollars,
not Ozzies.
Stora in Australia: Whats Exposed?

Assets
A$ Cash
Accounts receivable
Inventory
Property, plant and
equipment
Liabilities
A$ Accounts payable
A$ Bank debt
A$ Bonds issued
Equity (owned by
parent company in
Sweden)
Net translation exposure = Value of foreign

currency assets - Value of foreign currency
liabilities.
Criteria Favoring Local Currency As

Functional Currency
Cash flows
Sales price
Sales market
Expenses
Financing
Intercompany
transactions
Mainly in local currency and do not

impact parent's cash flows
Irresponsive to exchange rate
changes and governed by local
competition
Largely in host country and
denominated in local currency
Incurred primarily in local
environment
Primarily local currency financing
Neither frequent nor extensive
Purchasing Power Parity:

Theory and Evidence
S t=1-St
St
I-I*
1+I*
EXCHANGERATE
CHANGE
MEXICO 1994
RELATIVE
INFLATION
JAPAN 1995
Case Study: Araucos 1993 Forex Loss
1992
1st Q
1993
1st Q
Net income Price-level

($m)
restatement
37.6
9.2
(4.1)
(54.4)
ARAUCO
Case Study: Araucos 1993 Forex Loss
1992
1st Q
1993
1st Q
Net income Price-level

($m)
restatement UF
US$
37.6
9.2
2.2% -6.5%
(4.1)
(54.4)
1.0% +4.9%
ARAUCO
Foreign Currency Translation

All
Current
Assets
Cash
A/R
Inventory
Fixed assets
Liabilities
Short-term Debt
Long-term Debt
Equity
C
C
C
C
C
C
Residual
Assets
Cash
A/R
Inventory
Fixed assets
Liabilities
Short-term Debt
Long-term Debt
Equity
All
Current
Current/
Noncurrent
C
C
C
C
C
C
C
H
C
C
Residual
C
H
Residual
Assets
Cash
A/R
Inventory
Fixed assets
Liabilities
Short-term Debt
Long-term Debt
Equity
All
Current
Current/
Noncurrent
Monetary/
Nonmonetary
C
C
C
C
C
C
C
H
C
C
H
H
C
C
Residual
C
H
Residual
C
C
Residual
Exposed or Not Exposed?
Balance Sheet
Item
1. Fixed Assets
Exchange Net
Prices Rates
Effect
2. Inventories
3. Monetary Items
Exposed or Not Exposed?
Balance Sheet
Item
1. Fixed Assets
Exchange Net
Prices Rates
Effect
2. Inventories
3. Monetary Items
Currency Risk: Economic Exposure

Change in the economic value of the firm
resulting from unanticipated exchange rate
changes.
Booked vs. anticipated transactions
Expected vs. unexpected changes; the "cost of
hedging"
Exposure and the parity assumptions: "We are
not exposed in the long run"
Currency of denomination vs currency of
determination; compet., elasticities, etc.
Economic Exposure
Economic exposure is how the firms revenues

and costs will respond to exchange rate
changes.
Example:
Even though Intel invoices German customers in

marks, its future revenues may be unaffected by fluctuations
in the mark if the currency of determination of prices in the
semiconductor business is the dollar or even the yen.
The currency of determination is the currency

in which most of the competition prices similar
products.
Example:
General Electrics Yen Payables
Operational Aspects of Exchange Risk

1.VOLUME EFFECTS (compensate for
changes in profit margins)
2.PRICING FLEXIBILITY (change in
margins to offset effect of exchange rate
change)
3.DIVERSIFICATION of markets for inputs
and outputs
4.FLEXIBILITY (ability to shift markets
and sources quickly)
Translation vs Economic Exposure

Accounting exposure
Exposure = "Exposed" assets - "exposed"
liabilities
Economic exposure
Exposure = How will an unanticipated exchange
rate change affect the cash flows of the firm?
Domestic
sales
Exports
Domestic
costs
Import costs
A Realistic Approach
Banks versus corporations: To the extent that the

firm is like a bank, do bank-style hedging. Match
financial assets with liabilities of the same kind.
Seek to identify economic exposure using product
cost-and-market analysis, industry competitive
analysis, or statistical analysis on the sensitivity of
the companys value to exchange rate changes.
Hedge economic exposure using debt/swaps for
long term exposure, short term instruments for
uncertain exposure, and options for disaster
insurance
Case Study: US Semiconductor

CHIPS
US DOLLARS
Case Study: US Semiconductor

The transactions: a cost comparison
Translation of assets and liabilities
The economic risks
US Semiconductor: The Transaction

USD interest rate:
GBP interest rate:
Spot dollar/pound:
5-yr forward $/pound:
Diff, % per annum:
8%
12%
2.40
1.97
-3.87%
Borrow GBP & hedge: 12%-3.6%=8.13%
US Semiconductor:
Translation Exposure
CURR/NON
CURR
MON/NON
MON (FAS 8)
TEMPORAL
(FAS 52)
CHIPS
YELLOW
TRUCKS
WAREHOUSE
A/R
US Semiconductor: Economic Exposure
SOLD IN UK
INVOICED IN GBP
LAND
WAREHOUSE
TRUCKS
GBP?
CHIPS
LAND
WAREHOUSE
TRUCKS
CHIPS
SOLD IN UK
INVOICED IN GBP
GBP?
SOLD IN
WORLDWIDE MARKET
USD?
LAND
WAREHOUSE
TRUCKS
CHIPS
SOLD IN UK
INVOICED IN GBP
GBP?
SOLD IN
WORLDWIDE MARKET
USD?
DETERMINED BY
COMPETITION
JPY?
Summary: Types of Exposure

Transactions
Transactions
Exposure
Exposure
Translation
Translation
Exposure
Exposure
Economic
Economic
Exposure
Exposure
Which Instrument?
Identifiable
Debt, swaps,
exposure
forward contracts
Uncertain exposure Instruments with
flexibility, such as
forwards and futures
Exposure that
Deep-out-of-thethreatens financial money options
distress
A Corporate Foreign Exchange

Roadmap
UNDERSTANDING
UNDERSTANDINGTHE
THEEXCHANGE
EXCHANGE
RISK
MANAGEMENT
PROBLEM
RISK MANAGEMENT PROBLEM
Value of hedging
Value of hedging
Goals
Goals
Nature of the business
Nature of the business
MEASUREMENT
MEASUREMENTOF
OFEXPOSURE
EXPOSURE
ACCOUNTING
ACCOUNTING
Examples:
Examples:
Sourcing
Sourcingflexibility
flexibility
Pricing
Pricingstrategy
strategy
Market
Market
diversification
diversification
ECONOMIC
ECONOMIC
NATURE
NATUREOF
OFTHE
THECASH
CASHFLOW
FLOWEXPOSURE:
EXPOSURE:
One-shot?
One-shot?
Linear?
Linear?
Contingent on exchange rates?
Contingent on exchange rates?
Contingent on other events?
Contingent on other events?
HEDGING
HEDGINGMETHODS
METHODS
OPERATIONAL
OPERATIONAL
TRANSACTION
TRANSACTION
FINANCIAL
FINANCIAL
Linear
Linear
Forwards
Forwards
Futures
Futures
Debt
Debt
Currency
Currencyswaps
swaps
Exchange-rate
Exchange-rate
contingent
contingent
Options
Options
Debt
Debtwith
withoption
option
features
features
Contingent
Contingenton
on
other
events
other events
Event
Eventoptions
options
Probability-based
Probability-based
hedging
hedging
Local Exposure

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Currency Risk:

The Measurement of Corporate

Measuring and Managing Exposure

Case study: G.E.s Yen Payables

Case study; U.S. Semiconductor

Transactions exposure results from particular

Copyright 2000 Ian H. Giddy

Exchange Rate Risk: Transactions

Copyright 2000 Ian H. Giddy

Transactions Exposure: Hedging

Hedging Transactions Exposure

Ongoing transactions exposure

Copyright 2000 Ian H. Giddy

Covered under FASB No. 52 which requires

Copyright 2000 Ian H. Giddy

Recognition of Exchange Gains & Losses

Copyright 2000 Ian H. Giddy

Linkages Between Interest Rates

Money Market Hedge Interest rate

GEs Yen Payables

Yen due in 90 days

Copyright 2000 Ian H. Giddy

GEs Yen Payables

What Happens to GE If Rises?

The Exposure Triangle

Copyright 2000 Ian H. Giddy

Balance Sheet Exposure

Balance sheet exposure (or translation or

Copyright 2000 Ian H. Giddy

Exchange Rate Risk: Translation

Translation exposure arises when a

It affects the balance sheet

Copyright 2000 Ian H. Giddy

Net translation exposure = Value of foreign

Translation of Individual Accounts

For US companies, governed by FASB No. 52

Copyright 2000 Ian H. Giddy

Key Features of FAS 52

Objective of translation: Local subsidiary perspective

If functional currency is US$: Temporal method

Transaction gains & losses: Recognized in current income

Copyright 2000 Ian H. Giddy

Sweden Down Under

Stora in Australia: Whats Exposed?

Net translation exposure = Value of foreign

Criteria Favoring Local Currency As

Mainly in local currency and do not

Purchasing Power Parity:

Copyright 2000 Ian H. Giddy

Case Study: Araucos 1993 Forex Loss

Net income Price-level

Copyright 2000 Ian H. Giddy

Case Study: Araucos 1993 Forex Loss

Net income Price-level

Copyright 2000 Ian H. Giddy

Foreign Currency Translation

Foreign Currency Translation

Foreign Currency Translation

Exposed or Not Exposed?

Copyright 2000 Ian H. Giddy

Exposed or Not Exposed?

Copyright 2000 Ian H. Giddy

Currency Risk: Economic Exposure

Economic exposure is how the firms revenues