4 types of exposure

• Exposure (to FX risk): firm is affected by a change in the exchange rate

• Transactions Exposure: firm’s cash flow

• Operating Exposure: firm’s cash flow

• Accounting Exposure: firm’s financial statements

• Translation Exposure: firm’s financial statements

Transactions Exposure

• Contractual: contract exists that specifies a certain amount of FX will be received/paid e.g. export/import, debt denominated in FX.

• Change in the FX rate results in gain/loss.• FX receipt worry: FX depreciation• FX payment worry: FX appreciation • Transactions exposure is reflected in the firm’s

financial statements, i.e. firm with transactions also has accounting exposure.

Hedging a future FX receipt

• Worry: FX depreciation• Sell the FX forward: sign contract now with bank

committing to sell the FX at the future date at a rate set now

• Will receive Y10 million at year end• Hedge by selling Y10 million one-year forward at

one-year forward rate• The C$-value of the Y10 million is now set, i.e.

now know the C$-value

Hedging a future FX payment

• Worry: FX appreciation• Buy the FX forward: sign contract now with bank

committing to buy the FX at the future date at a rate set now

• E.g. will pay Y10 million at year end• Hedge by buying Y10 million one-year forward at

one-year forward rate.• The C$-value of the Y10 million is now set, i.e.

now know the C$-value of the FX payment

Operating Exposure

• Non-contractual: no contract exists, yet firm is exposed

• Change in the exchange rate results in gain or loss of competitive advantage

• Explored in 3 vignettes document• Effects of operating exposure do not appear on

the firm’s financial statements• Explored in Canuck Ltd.’s accounting exposure

3 operating exposure vignettes

• 1. Aspen Skiing (US firm): Revenues exhibited positive operating exposure to French franc, C$, Italian lira, etc.

• 2. Laker Airways (UK firm): Ditto, but negative operating exposure to U$.

• 3. Canuck Ltd. (Canadian firm): Positive operating exposure to UK pound sterling.

Aspen Skiing

• Colorado resort: all balance sheet items and cash flows in greenbacks.

• Yet exposed to C$, FFr, etc.

• In 1983, U$ appreciated, I.e. C$, FFr depreciated.

• Domestic and foreign clientele shifted holidays to Banff, Chamonix, Chicopee.

Aspen Skiing

Y-axis: Cash flows in U$; X-axis: S(U$/C$)

Aspen Skiing: Lesson Gleaned

Although you operate exclusively domestically, if your clientele has the option of purchasing in a foreign market, you exhibit positive exposure to that foreign market’s currency. A U.S. firm with Aspen Skiing as client likewise possesses the same type of exposure.

Aspen Skiing: Two Hedges

• Hedge positive operating exposure of cash flows to C$, FFr, etc.

• Denominate some debt in C$, FFr, etc. Result: negative transactions exposure of debt offsets positive operating exposure of revenues.

• Buy resorts in Canada, France, etc. Result: some revenue streams rise, other fall with rise in C$, FFr, etc.

Laker Airways

• Early exploiter of air transport deregulation in late 70’s. Target market: Price conscious Brit tourists vacationing in Florida.

• Cost structure: jet fuel U$-denominated.• Financed jets with cheap U$-debt provided

by US Ex-Im Bank.• Steep U$ appreciated in early 80’s spelled

doom for Laker Airways.

Laker Airways’ Exposures

• Jet fuel: both transactions and operating exposure to U$.

• Debt: transactions exposure to U$.

• Revenues: negative operating exposure to U$. When U$ appreciated target clientele shifted holidays from Florida to Palma de Mallorca, Islas Canarias, Marbella, etc.

Laker Airways: Lessons Gleaned

• If your business involves assisting a domestic clientele purchase goods/services in a foreign country, you have negative operating exposure to that foreign country’s currency.

• Dollar denomination of debt aggravated the firm’s negative exposure to the greenback.

Sir Freddie’s Egregious Error

• Error: Denominated debt in U$’s.

• Appreciation of U$ resulted in: Sterling value of costs and debt service increasing; Sterling value of revenues decreasing.

• Sir Freddie got squeezed!

• Hedges: debt denominated in Sterling; cater to Yank clientele vacationing in UK.

Canuck Ltd.

• Canadian firm operating exclusively in Canada with no FX denominated assets/contracts.

• Major competitor in Canada sources product in the UK.

• Canuck Ltd. has positive exposure to the Pound Sterling, PS. If PS appreciates, Canuck gains competitive advantage.

• Hedge with PS denominated debt.

Accounting Exposure

• Effects of FX rate changes that are reflected in the firm’s financial statements.

• Transactions exposure is reflected.

• Translation exposure is reflected.

• Operating exposure is not reflected.

• Accounting Exp. comprised of Transactions Exp. & Translation Exp

Translation Exposure

• Parent company has a foreign subsidiary• Foreign subsidiary’s financial statements must

be consolidated (combined) with those of parent• E.g. Canadian parent (C$) vs. Chinese

subsidiary (RMB) currency• Subsidiary’s statements are FX denominated• If FX (RMB) rate changes, consolidated

statements are impacted: translation exposure!

Subsidiary’s Functional Currency

• Primary currency of the subsidiary’s activities, i.e. in which cash flows are generated

• 2 possibilities: parent’s currency (C$) versus subsidiary’s currency (RMB)

• Distinction: subsidiary’s currency versus subsidiary’s functional currency

Subsidiary is self-sustaining

• Most foreign subsidiary’s sales in the foreign country. It is a freestanding entity with self-contained operations

• Functional currency is foreign (RMB)

• Translation via current rate method

• All assets / liabilities translated at the rate prevailing on the balance sheet date

Subsidiary is integrated with parent

• Most foreign subsidiary’s sales in the parent country; a mere extension of parent, i.e. not freestanding

• Subsidiary’s functional currency is parent’s currency (C$)

• Translation via temporal method• Only monetary assets / liabilities translated at

the rate that prevails on the balance sheet date.

Subsidiary’s Monetary

• Assets: cash, marketable securities, accounts receivable

• Liabilities: current liabilities, all debt (short term and long term)

• Monetary means promises a fixed amount of currency

• Nonmonetary: inventory, fixed assets, equity

Hedging Translation Exposure

• Net Translation Exposure (NTE) in FX

• Sell the amount of NTE forward: write contract now with bank committing to sell the amount of NTE at year-end

• E.g. NTE=Y10 million; Hedge by selling Y10 million one-year forward

• If NTE=-Y4 million, buy Y4 million forward; selling a negative quantity means buying