foreign exchange exposure - central and east...
TRANSCRIPT
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Financial Management in IB
Foreign Exchange Exposure
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Foreign Exchange Exposure
Exchange Rate Risk
• Exchange rate risk can be defined as the risk that a company’s
performance will be negatively affected by exchange rate
movements.
• Exposure to exchange rate fluctuations comes in three forms:
• Transaction exposure
• Economic exposure
• Translation exposure
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Foreign Exchange Exposure
Transaction Exposure
• The degree to which the value of future cash transactions can be
affected by exchange rate fluctuations is referred to as transaction
exposure.
• Two steps are involved in measuring transaction exposure:
• determine the projected net amount of inflows or outflows in
each foreign currency, and
• determine the overall risk of exposure to those currencies.
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Foreign Exchange Exposure
Transaction Exposure
• If the firm expects net inflows in foreign currency, the firm is in
so called “long position”.
• If the firm expects net outflows in foreign currency, the firm is in
so called “short position”.
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Foreign Exchange Exposure
Transaction Exposure
Long position
• If domestic currency gets stronger the value of the receivables falls
and the firm suffers a loss. If domestic currency depreciates the
value of the receivables rises and the firm realizes a profit.
Short position
• If domestic currency gets weaker the value of the payables rises
and the firm suffers a loss. If domestic currency appreciates the
value of payables falls and the firm realizes a profit.
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Foreign Exchange Exposure
Transaction Exposure Measurement
• To determine the overall risk, we have to assess the standard
deviations and correlations of the currencies, taking into account
the size of the firm’s position in each currency in terms of a
standard currency.
• The standard deviation statistic on historical data measures
currency variability. The variability may change over time.
• Correlation coefficients indicate the degree to which two currencies
move in relation to each other. They may change over time too.
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Foreign Exchange Exposure
Transaction Exposure Measurement
• A related method, the value-at-risk (VAR) method, incorporates
currency volatility and correlations to determine the potential
maximum one-day loss.
• Historical data is used to determine the potential one-day decline in
a particular currency. This decline is then applied to the net cash
flows in that currency.
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Foreign Exchange Exposure
Value at Risk
• Value at Risk is the method to determine the potential loss on
value of net position over certain period of time.
• It is based on the assumption that the percentage changes in the
exchange rate are normally distributed.
• Maximum expected loss on value of net position at the 95 %
confidence level is determined by the 5 % percentile of the
distribution which is about 1.65 standard deviations from the
expected percentage change in exchange rate.
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Foreign Exchange Exposure
Value at Risk
VaR has three parameters:
• The time horizon (period) to be analyzed. Typical periods using
VaR are 1 day, 10 days, or 1 year.
• The confidence level is the probability at which the VaR will not
be exceeded by the maximum loss. Commonly used
confidence levels are 99% and 95%.
• Value at risk(VaR) is given in a unit of the currency.
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Foreign Exchange Exposure
Transaction Exposure Management
If transaction exposure exists, the corporation should
• identify the degree of transaction exposure,
• decide whether to hedge and how much to hedge based on its
degree of risk aversion and exchange rate forecasts, and
• choose among the various hedging techniques available if it
decides to hedge.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Forward hedge
• A forward hedge involves the use of forward contracts by
corporations to hedge transaction exposure.
• Long position may be closed out by selling foreign currency on
the forward market.
• Short position may be closed out by buying foreign currency on
the forward market.
• Based on the firm’s degree of risk aversion, the decision about
whether to hedge can be made by comparing the known result
of hedging to the possible results of remaining unhedged.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Future hedge
• A futures hedge involves the use of currency futures to hedge
transaction exposure.
• Futures contracts represent a standardized number of units for
each currency with standardized maturities.
• Long position in $ may be closed out by selling US Dollar -
Euro Future contracts on LIFFE.
• Short position in $ may be closed out by buying US Dollar -
Euro Future contracts on LIFFE.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Future hedge
• A futures hedge involves the use of currency futures to hedge
transaction exposure.
• Futures contracts represent a standardized number of units for
each currency with standardized maturities.
• Long position in $ may be closed out by selling US Dollar -
Euro Future contracts on LIFFE.
• Short position in $ may be closed out by buying US Dollar -
Euro Future contracts on LIFFE.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Currency option hedge
• A currency option hedge involves the use of currency call or
put options to hedge transaction exposure.
• Option owner can choose not to exercise the contract.
• Hence, the firm will be insulated from adverse exchange rate
movements, but may benefit from favorable movements.
• However, the firm must assess whether the advantages are
worth the premium paid for the option.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Option Strategies
Vertical Spread
Objective:
• To reduce the hedging costs.
• With small speculation.
Substance:
• Corporation buys a call option a simultaneously sells a put option with the
same amount of underlying currency, maturity etc.
• Both options are „Out of the money“.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Zero-Cost Vertical Spread
Objective:
• Removal of hedging costs
• With a little bit higher risk
Substance:
• Corporation buys a call option a simultaneously sells a put option with the
same amount of underlying currency, maturity etc.
• Both options are “Out of the money” and have the same price.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Money market hedge
• A money market hedge involves taking one or more money market
position to cover a future payables or receivables position.
• Often, two positions are required:
• For payables, (1) borrow the home currency representing
future payables, and (2) invest in the foreign currency.
• For receivables, (1) borrow the foreign currency representing
future receivables, and (2) invest in the home currency.
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Example: receivables of $100,000 with maturity 90 days
Effective Exchange Rate
$1,2059/€
2. €82,102
Exchange Rate: $1,2000/€
1. Credit $98,522
Borrowing at 6%, p.a. for 90 Days
4. Repayment $100,000
3. Revenues €82,923
Lending at 4% p.a. for 90 Days
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Foreign Exchange Exposure
Techniques to Eliminate Transaction Exposure
Money market hedge
• If interest rate parity (IRP) exists, and transaction costs do not
exist, the money market hedge will yield the same results as the
forward hedge.
• This is so because the forward premium on the forward rate
reflects the interest rate differential between the two currencies.
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Foreign Exchange Exposure
Alternative Techniques
• Sometimes, a firm may not be able to eliminate its transaction
exposure completely because it cannot accurately predict its cash
flows, or because the costs of hedging are too high.
• To reduce exposure under such conditions, the firm can consider
leading and lagging, cross-hedging, currency diversification or
netting.
• The act of leading and lagging refers to an adjustment in the timing
of payment request or disbursement to reflect expectations about
future currency movements.
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Foreign Exchange Exposure
Alternative Techniques
• When a currency cannot be hedged, cross-hedging may be
practiced. With cross-hedging, a currency that is highly correlated
with the currency of concern is hedged instead. The stronger the
positive correlation, the more effective the strategy will be.
• With currency diversification, the firm diversifies its business
among numerous countries whose currencies are not highly
correlated.
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WechselExchange Raterisiko: Absicherung
Netting (bilateral, multilateral) reduces transaction costs and risk
Subsidiary company
USA
Parent corporation
Germany
USD 500,000
EUR 300,000
Subsidiary company
USA
Parent corporation
Germany
Without Netting
With Netting:
Fix Exchange Rate (for bilateral Netting): EUR/ USD 1,20
USD 140,000
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Foreign Exchange Exposure
Economic Exposure
• Economic exposure refers to the degree to which a firm’s present
value of future cash flows can be influenced by exchange rate
fluctuations.
• Cash flows that do not require conversion of currencies do not
reflect transaction exposure. Yet, these cash flows may also be
influenced significantly by exchange rate movements.
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Foreign Exchange Exposure
Economic Exposure
Transactions that Influence the Firm’s
Local Currency Inflows
Impact of Local Currency Appreciation
Impact of Local Currency Depreciation
Local sales (relative to foreign competition in local markets)
Firm’s exports denominated in local currency
Firm’s exports denominated in foreign currency
Interest received from foreign investments
Decrease
Decrease
Decrease Decrease
Increase
Increase
Increase Increase
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Foreign Exchange Exposure
Economic Exposure
Transactions that Influence the Firm’s
Local Currency Outflows
Impact of Local Currency Appreciation
Impact of Local Currency Depreciation
Firm’s imported supplies denominated in local currency
Firm’s imported supplies denominated in foreign currency
Interest owed on foreign funds borrowed
No Change
Decrease
Decrease
No Change
Increase
Increase
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Foreign Exchange Exposure
Economic Exposure Management
• The management of economic exposure tends to result in a long-
term solution.
• A firm can assess its economic exposure by determining the
sensitivity of its expenses and revenues to various possible
exchange rate scenarios.
• The firm can then reduce its exposure by restructuring its
operations.
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Foreign Exchange Exposure
Economic Exposure Management
For example, a firm may attempt to balance its exchange-rate
sensitive revenues and expenses by:
• Increasing or reducing sales in new or existing foreign markets.
• Increasing or reducing its dependency on foreign suppliers.
• Establishing or eliminating production facilities in foreign markets.
• Increasing or reducing its level of debt denominated in foreign
currencies.
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Foreign Exchange Exposure
Translation Exposure
• The exposure of the MNC’s consolidated financial statements to
exchange rate fluctuations is known as translation exposure.
• Translation exposure may not be relevant because translating
financial statements for consolidated reporting purposes does not
affect an MNC’s cash flows.
• In reality however, translation exposure may affect the stock price
of a firm through its impact on consolidated earnings.
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Foreign Exchange Exposure
Translation Exposure
• Note that the current translation of earnings may be a useful base
to derive the expected future cash flows when earnings are
remitted by the foreign subsidiaries to the parent.
• Translation exposure is dependent on:
• the degree of foreign involvement by foreign subsidiaries,
• the locations of foreign subsidiaries, and
• the accounting methods used.
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Foreign Exchange Exposure
Translation Exposure Management
• To hedge translation exposure, forward contracts can be used.
• Hedging translation exposure is limited by:
• inaccurate earnings forecasts,
• inadequate forward contracts for some currencies,
• accounting distortions, and
• Increased transaction exposure.