measuring and managing the risk in international financial positions prices and policies second...

Measuring and Managing the Risk in International Financial Positions

Prices and Policies

Second Edition ©2001

Richard M. Levich

16

McGraw Hill / Irwin

International Financial Markets

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McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview

The Corporate Treasurer’s Financial Risk Management Problem The Market Value of the Firm and Channels of Risk

Accounting Measures of Foreign Exchange Exposure Exposure of the Balance Sheet: Translation Exposure Exposure of the Income Statement: Transaction

Exposure U.S. Accounting Conventions: Reporting

Accounting Gains and Losses

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Overview

Economic Measures of Foreign Exchange Exposure The Regression Approach The Scenario Approach

Empirical Evidence on Firm Profits, Share Prices, and Exchange Rates

Arguments for Hedging Risks at the Corporate Level

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Overview

Financial Strategies Toward Risk Management The Currency Profile and Suitable Financial Hedging

Instruments

Policy Issues - International Financial Managers Problems in Estimating Economic Exposure Picking an Appropriate Hedge Ratio The International Investor’s Currency Risk

Management Problem The Value at Risk Approach

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Overview

Policy Issues - Public Policymakers Disclosure of Financial Exposure Financial Derivatives and Corporate Hedging

Policies

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The Corporate Treasurer’sFinancial Risk Management Problem

Corporate treasurers are directly responsible for managing the firm’s exposure to financial risk.

The risks that remain are held by the investor, who can reduce these risks through a diversified portfolio of shares, or by applying some of the same hedging techniques available to the corporate treasurer.

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The Market Value of the Firm

The market value of a firm at time t (MVt) is the

summation of the firm’s cash flows (CF) over time discounted back to their present value by an appropriate discount factor (i):

T

tt

t

tt

i

CFMV

0 1

Cash flows in each currency are discounted at their own appropriate interest rate and multiplied by a spot exchange rate.

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The Market Value of the Firm

The sensitivity of the market value of the firm to a change in an exchange rate measures exchange rate exposure.

For the $/€ exchange rate, the sensitivity measure can be expressed as:

/$S

MV

€

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Channels of Exposure toForeign Exchange Risk

Direct EconomicExposure

Home CurrencyStrengthens

Home CurrencyWeakens

Sales Abroad Unfavorable FavorableRevenue worth less in home currency

terms

Revenue worth more

Source Abroad Favorable UnfavorableInputs cheaper in

home currency terms

Inputs more expensive

Profits Abroad Unfavorable FavorableProfits worth less Profits worth more

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Channels of Exposure toForeign Exchange Risk

Indirect EconomicExposure

Home CurrencyStrengthens

Home CurrencyWeakens

Competitor that Unfavorable Favorablesources abroad Competitor’s

margins improveCompetitor’s

margins decrease

Supplier that Favorable Unfavorablesources abroad Supplier’s margins

improveSupplier’s margins

decrease

Customer that Unfavorable Favorablesells abroad Customer’s margins

decreaseCustomer’s

margins improve

Customer that Favorable Unfavorablesources abroad Customer’s margins

improveCustomer’s margins

decrease

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The Market Value of the Firm and Channels of Risk

Note that virtually any firm could be exposed to exchange rate risk through a financial channel.

In the long run however, The firm can make changes in response to an

unexpected exchange rate change. Other economic events that follow the exchange

rate change may lessen the impact on the firm.

Nevertheless, the short-run exposure is critical since the firm must survive the shock to get to the long run.

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Accounting Measures ofForeign Exchange Exposure

Net = exposed – exposedexposure assets liabilities

Accounting exposure can be subdivided into translation and transaction exposures.

Translation exposure focuses on the book value of assets and liabilities as measured in the firm’s balance sheet.

Transaction exposure focuses on the economic value of transactions denominated in foreign currency that are planned or forecast to occur in the next reporting period.

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U.S. Accounting ConventionsReporting Accounting Gains and Losses

Under Statement 52 of the Financial Accounting Standards Board (FASB-52), translation gains and losses are accumulated in a translation adjustment account.

FASB-52 focuses on a parent’s net investment in a foreign operation to measure the effect of exchange rate changes.

Transaction gains and losses represent realized exchanges and are reported in current income.

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U.S. Accounting ConventionsReporting Accounting Gains and Losses

Under FASB-133, derivatives that do not qualify as hedges of the underlying exposures must be marked-to-market, with the resulting gains or losses included in either current or deferred income.

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Economic Measures ofForeign Exchange Exposure

Economic exposure captures the entire range of effects on the future cash flows of the firm, including the effects of exchange rate changes on customers, suppliers, and competitors.

MV/S reflects economic exposure. Two approaches for measuring economic exposure are the regression approach and the scenario approach.

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The Regression Approach

The regression approach directly measures the exposure of a firm to exchange rate changes by estimating the relationship between the firm’s market value at time t (MVt)and the spot rate

(St) using the equation:

MVt = a + b St + et

The coefficient b measures the sensitivity of the market value of the firm to the exchange rate.

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To interpret the regression analysis, three results need to be examined: The magnitude of b.

• b > 0 an asset exposure in the foreign currency• b < 0 a liability exposure• b = 0 no exposure to the exchange rate

The t-statistic of b.• Statistical significance is necessary for confidence

in the results. The R2 of the regression.

• R2 measures the percentage of variation in the market value explained by the exchange rate.

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To measure the firm’s exposure to multiple exchange rates, a multiple regression can be estimated:

MVt = a + b1 S$/€,t + b2 S$/£,t + b3 S$/¥,t + et

If the firm has data on cash flows at the level of a subsidiary or project, the exposure of these smaller units can also be measured:

CFt = a + b St + et

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Note that exposure tends to be lower in the long run due to PPP (which tends to hold better in the longer run) and the ability of firms to make adjustments in response to exchange rate changes.

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The Scenario Approach

Given a scenario, we can estimate the firm’s cash flows (and its market value) conditional on an exchange rate path.

The scenario approach is well suited to a spreadsheet analysis where one is encouraged to ask a variety of “what-if” questions.

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A

O

A*

- 15% - 10% - 5% 15%10%5%$/A$ $0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188A$/$ A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39

$39.577$35.222

Pre

sen

t V

alu

e of

Cas

h F

low

s

(

Mill

ion

s)

Consider the impact of a permanent 5% appreciation of the US$, holding all other factors constant.

The slope measures the exposure of the firm at the initial exchange rate.

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A

O

A*

- 15% - 10% - 5% 15%10%5%$/A$ $0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188A$/$ A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39

$39.577$35.222

Pre

sen

t V

alu

e of

Cas

h F

low

s

(

Mill

ion

s)

Suppose the firm can pass along part of the exchange rate changeto its Australian customers.

B*

B

The slope of BOB* is flatter than AOA* since the firm has less exposure now.

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Empirical Evidence onFirm Profits, Share Prices, & Exchange Rates

During the Bretton Woods pegged-rate period, the general stock market index tended to move up (down) immediately after a devaluation (revaluation) of the local currency.

Studies also indicated that exposure coefficients vary from firm to firm within the same industry and over time, and that exchange rate changes can have a substantial impact on the overall economy.

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Arguments forHedging Risks at the Corporate Level

Shareholders may not favor hedging since they can select well-diversified portfolios to rid themselves of firm-specific risks.

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However, in view of transaction costs and taxes, hedging that reduces the volatility of cash flows may be favored. If the tax credits of a firm which has incurred losses

over several successive periods cannot be carried forward to reduce future tax payments, then another firm with a less volatile pattern of earnings will enjoy greater after-tax cash flows and a higher market value.

A firm with more volatile cash flows is also more open to the costs of financial distress.

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For the same reasons, banks and bondholders will prefer firms with less volatile cash flows (holding average cash flows equal) and reward them with greater borrowing capacities and higher credit ratings.

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Financial StrategiesToward Risk Management

An important step in the process of determining the appropriate financial hedging instruments for a firm is to analyze the nature of the firm’s currency cash flows.

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Characteristics ofCurrency Exposure

Suitable FinancialHedging Instruments

Frequency of cash flows

Single period

Multiple periods

Single contract (futures/options)

Sets (“strips”) of contracts/swaps or present value hedge

Currency dimension

Single currency

Multiple currencies

Contracts on one currency

Contracts on an index (ECU, US$) or synthetic hedge

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Characteristics ofCurrency Exposure

Suitable FinancialHedging Instruments

Certainty about cash flows

Certain, contractual cash flows

Uncertain, estimated cash flows

Naïve hedge to match contract size of financial instrument and exposure

Option hedge or dynamic futures hedge to match probability of cash flows

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Note that a hedging strategy may offset certain risks, while leaving open or increasing other risks.

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Policy IssuesInternational Financial Managers

Problems in Estimating Economic Exposure Using market data presumes that financial markets

are efficient, and that share prices respond quickly and appropriately to exchange rate changes.

The approach is unsuitable for newly organized or reorganized firms for which there is not a large sample of consistent observations.

For the exposure coefficient to be useful, the relationship between exchange rate changes and market value must remain stable in the future.

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Picking an Appropriate Hedge Ratio If the exchange rate is expected to change

favorably, hedging may not be desirable. Complete hedging may be achieved by taking

offsetting positions (-bi).

Otherwise, an intermediate solution may be chosen, with hedge positions in between 0 and bi.

Note that the more direct approach is to restructure the firm’s long-term financing, so as to permanently alter the firm’s financial exposure.

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The International Investor’s Currency Risk Management Problem A portfolio’s exposure to foreign exchange risk can

be measured using the regression approach in much the same way as the treasurer measures the firm’s exposure.

The investor can hedge foreign exchange risk using forward contracts, or retain the risk using a risk-return decision criteria.

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The Value at Risk (VAR) Approach The VAR approach is a relatively new approach for

measuring the exposure of financial assets. It can be applied to any portfolio of assets (and

liabilities) whose market values are available on a periodic basis and whose price volatilities () can be estimated.

Assuming normal price distributions, calculate the loss in value of the portfolio if an unlikely (say, 5% chance) adverse price movement occurs. The result of this calculation is the value at risk.

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Policy Issues - Public Policymakers

Disclosure of Financial Exposure The possibility that individual firms may face

substantial exposure to exchange rate changes, as well as the increased trading in financial derivatives in recent years, create a genuine concern among investors and regulators regarding corporate exposure to financial risks.

Note that a firm without a financial position may still face substantial currency and interest rate risk due to its ongoing operations.

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Policy Issues - Public Policymakers

Financial Derivatives and Corporate Hedging Policies The findings of various studies were consistent with

the notion that firms used derivatives to lower the variability of their cash flows or earnings.

It was also found that the likelihood of using derivatives was positively related to foreign pretax income, foreign sales, and foreign-denominated debt.

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