page 1 international finance lecture 8. page 2 international finance course topics –foundations of...
Post on 18-Dec-2015
220 views
TRANSCRIPT
Page 2
International Finance• Course topics
– Foundations of International Financial Management
– World Financial Markets and Institutions
– Foreign Exchange Exposure– Financial Management for a
Multinational Firm
Page 4
Operating Exposure: Definition• The effect of random changes in exchange
rates on the firm’s __________________ (which is not readily measurable).– A good way to approximate operating
exposure is to study the extent to which the firm’s _______________________ are affected by the exchange rate.
Page 5
Operating Exposure• Examples
– Alberta skiing resorts. Weaker $US means skiing is not as cheap for US customers as it used to be, with lower demand for services in AB.
– Canadian retailers. Stronger Euro means higher cost of goods sold (COGS) for European shoes and clothing relative to revenues, thus lower profit margins and possibly lower sales in Canada.
Page 6
Economic Exposure
• Changes in exchange rates can affect not only international but also purely domestic firms.– Canadian bicycle manufacturer who
sources and sells only in Canada.– Since the firm’s product competes against
imported bicycles it is subject to foreign exchange exposure.
• Economic exposure can be defined as the extent to which the value of the firm would be affected by _______________changes in exchange rates.
Page 7
How to Measure Economic Exposure
• Economic exposure is the sensitivity of the future home currency value of the firm’s _________________ and the firm’s __________________ to random changes in exchange rates.
Page 8
How to Measure Economic Exposure
• If a U.S. MNC were to run a least squares regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form:
• P = a + bS + e
Where
a is the regression constant
e is the random error term with mean zero
The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.
Page 9
How to Measure Economic Exposure
• The exposure coefficient, b, is defined as follows:
Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.
Cov(P,S) Var(S)
b =
Page 10
How to Measure Economic Exposure
• The exposure coefficient shows that there are two sources of economic exposure:
Cov(P,S)
Var(S)b =
1. the variance of the exchange rate and
the covariance between the dollar value of the asset and exchange rate
Page 11
How to Measure Economic Exposure• How to actually do it:
– If historical data available, use regression. – If only probability estimates available (i.e. from
analysts’ forecasts), use probability theory• Regression
– In Excel: Tools Data Analysis Regression• If Data Analysis is not available, install it
from Add-Ins.
Page 12
How to Measure Economic ExposureDate Nortel Adj. Close* SPOT CAN $/US$
15-Mar-06 35.1 1.155316-Mar-06 33.9 1.15417-Mar-06 33.6 1.158720-Mar-06 33.1 1.162721-Mar-06 33.5 1.164722-Mar-06 33.3 1.165123-Mar-06 32.7 1.165724-Mar-06 34.2 1.1675
Coefficients Standard Error t Stat P-value Lower 95%Intercept -87.4943 14.55102742 -6.0129301 0.0000000 -116.193X Variable 1 100.7458 12.88846535 7.81674198 0.0000000 75.32631
Page 13
How to Measure Economic Exposure
State Probability Price, FC FX, DC/FC Price, DC
1 0.25 SFr. 980 $0.45 $441.00
2 0.20 SFr. 1,000 $0.52 $520.00
3 0.35 SFr. 1,050 $0.55 $577.50
4 0.20 SFr. 1,140 $0.60 $684.00
1.00 Mean= 0.53 $553.18
• Cov(Price DC, FX)=• Var(FX)=• Exposure coefficient b
=
Page 14
Economic exposure • Risk decomposition• Variance (Price DC) = b2 Var(FX) + error variance• Hedging = attempt to reduce Variance (Price DC).
– If we manage to reduce Var(FX) to zero, we will get Variance (Price DC) = error variance
– Key points: (i) by how much we can reduce FX exposure, and (ii) how costly hedging is
– Idea: fix the price of b units of foreign currency now by selling b units of foreign currency forward
• Result from Risk Management: optimal hedge ratio is the negative of the estimated coefficient b.
Page 15
Hedging economic exposure• Your subsidiary in foreign country is an _______,
therefore, to hedge we need to take a _______ position in the foreign currency forwards/futures.– If it were a __________, you would need a
_______ position.• The size of the position is b. • The dollar proceeds a company will receive is
b*(F-S)– F – forward rate you lock in now, S – spot rate
at maturity.• Total value of the hedged position at maturity
will be TVHP=Price DC +b*(F-S)• Assume F = $0.53 and recall that b = 1574
Page 16
Economic exposure
State Prob.Price, FC
FX,DC/FC
Price, DC
Hedge Payoff TVHP
1 0.25 SFr. 980 $0.45 $441.00 $125.89 $566.89
2 0.20 SFr. 1,000 $0.52 $520.00 $15.74 $535.74
3 0.35 SFr. 1,050 $0.55 $577.50 -$31.47 $546.03
4 0.20 SFr. 1,140 $0.60 $684.00 -$110.15 $573.85
1.00 Mean= 0.53 $553.18 $554.75
• Var(Price DC)=• Var(TVHP)=
Page 17
Economic Exposure
• The exposure has two components:– The Competitive Effect
• Changes in foreign currency operating cash flows due to competitive pressures on product prices, quantity demanded, costs etc.
– The Conversion Effect• Changes in domestic currency values of
foreign COGS and/or revenues in response to unexpected changes in FX rates.
Page 18
Operating exposure• Measuring the operating exposure of a firm
requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposure of all the firm’s competitors and potential competitors– Example: Eastman Kodak has economic exposures from
present and future sales abroad– The sum of these future exposures will have an effect on
Kodak’s cash flows as exchange rates change– Kodak’s value and competitiveness depends on (1) the
structure of the market in which it sources it inputs such as labor and materials and sells its products and (2) whether or not it can manage them better than their competition
• This long term view is the objective of operating exposure analysis
Page 19
Operating exposure• A profit margin of a firm depends on
– the effect of exchange rate on the cost of inputs
– How much of that cost change is passed through to product prices
– Elasticity of product demand
Page 21
Demand elasticity• Recall from microeconomics, ε = %ΔQ / %ΔP
– ε - price elasticity of demand– %ΔQ – percentage change in quantity demanded, =
change in quantity (Q1-Q0) ÷ midpoint quantity (Q1+Q0)/2
– %ΔP – percentage change in price, = change in price (P1-P0) ÷ midpoint price (P1+P0)/2
•
• For example, if you are DaimlerChrysler and your company was selling 50 Mercedes Benz cars per week in Canada at $70,000 and 70 cars per week at $60,000, then the demand elasticity for your cars is
ε=[(70-50)/(70+50)/2]÷[(60,000-70,000)/(60,000+70,000)/2] = _______
Page 22
Definition of Cash flows for Capital Budgeting
• Operating Cash Flow (OCF) in period t:• OCFt = (PtQt-FCt-cQt-Deprt)(1-) +Deprt =
– P is the price per unit of output– Q is the demanded quantity– c is production cost per unit, FC is fixed
cost is the tax rate on corporate profit in
Germany– Depr is the depreciation expense per
year• The last term is known as depreciation tax
shield.
Page 23
Working Capital Dynamics
• Our working assumption is as follows:
• ∆WC is the change in Working Capital• Working Capital is completely
recovered at the end of the project life.
• Total Cash Flow, CF:
0 T
∆WC>0 ∆WC<0
1
Page 24
Algebra of Exposures
• S0 – current exchange rate
• X – exposed variable (e.g., CF denominated in FX)
• Change of dollar equivalent CF in response to an unexpected change in S is then:
• ∆(SX) = (S0 + ∆S)(X0 + ∆X) – S0X0 =
Page 26
Example: Operating Exposure
• Carlton derives much of its reported profits from its German subsidiary, and there has been an unexpected depreciation of the euro thus affecting Carlton Germany significantly.
• Carlton’s German subsidiary is operating in a euro-denominated competitive environment– The subsidiary’s profitability and performance
will be impacted by any changes in performance and pricing from its suppliers and customers as a result of changes in the US$/euro exchange rate
Page 27
Carlton Germany Data
• Carlton Europe manufactures in Germany from European material and labor.
• Half of production is sold within Europe, the other half is exported to non-European countries.
• All sales are invoiced in euros and accounts receivable (AR) are 25% of sales.
• Inventories are 25% of sales.• Cost of capital is 20%.• Corporate tax rate in Germany is 34%.
Page 28
Base Case• Carlton Germany: S0 = $/€ 1.2• P = €12.80; Q = 1 mil units• c = € 9.60• FC = € 0.89 mil, Depr = € 0.6 mil = 34%• Base case: _______________ to
exchange rates. Relevant horizon for assessing the impact of exchange rate fluctuations is 5 years.
Page 29
Base Case Cash Flows
• Base case CF (€ mil).• t=1:
– OCF = [(€12.80-9.6)*1 - € 0.89]*0.66 + 0.34*0.6 = € 1.7286
• t=2-4:
• t=5:
Page 30
Possible Scenarios• There are various possible scenarios
in terms of management actions in response to an unexpected € _____________ from $/€1.2 to $/€ 1.0 :– Can afford to raise domestic sales prices
without hurting demand; this is because competing imports are more expensive to locals
– Same thing can be done with export prices
– Alternatively, they could fix the price and let the volume change; what they will do will depend on the price elasticity of demand.
Page 31
Case 1
• There is ______________________ change from 1.2$/€ to 1.0 $/€. There are no real changes (no changes in functional currency, i.e., € cash flows).
Page 32
Case 1 Cash Flows• ∆(S*CF) = ∆S*CFbase + Snew ∆CF =
= ∆S*CFbase
• Total cash flow (including changes in WC) at t=1:
– CFbase = OCF - ∆WC = € 1.7286 – € 5.6 = ______________
• Incremental $ cash flow:• ∆(S*CF) = ∆S*CFbase = -0.2*(- € 3.8714
mil) = ________________
Page 33
Case 1 Cash Flows
• What about the Incremental Cash Flow for the years 2 through 4?
• In each of the years 2-4 Operating Cash Flow in € is still:
• OCF = € 1.7286 mil• ∆WC = 0 (because sales do not
change)
• ∆(S*CF) = ∆S*CF = -0.2* € 1.7286
mil = ______________
Page 34
Case 1 Cash Flows• Incremental Cash Flow for year 5?
• Operating Cash Flow is still:• OCF = € 1.7286 mil• ∆WC = - € 5.6 mil
• CF = OCF - ∆WC = € 7.3286 mil
• ∆(S*CF) = ∆S*CF = -0.2* € 7.3286
mil = ________________
Page 35
Case 2• _____________________________, both in
Europe and export, in response to exchange rate change from 1.2$/€ to 1.0 $/€.
• Carlton Germany:• P = €12.80; ∆Q = 1 mil units• c = € 9.60• FC = € 0.89 mil, Depr = € 0.6 mil = 34%• _____________________________________
Page 36
Case 2
• Two effects now:• ∆(S*CF) = ∆S*CFbase + Snew ∆CF
• Need CFbase (already know) and ∆CF= ∆OCF - ∆WC to compute the effect.
Page 37
Case 2
• Incremental OCF in €:• ∆OCF=(P-c)*∆Q*(1-) (why?)• ∆OCF = = (€12.80-9.6)*1 *0.66= €
2.112 mil• Incremental WC adjustment in €
:• Change in WC adjustment = € 11.2-
€ 5.6 = € 5.6 mil in year 1• Change in WC adjustment = -€
11.2+€ 5.6 = -€ 5.6 mil in year 5
Page 38
Case 2
• Incremental Euro denominated Cash Flow :
• ∆CF1= ∆OCF1 - ∆WC = 2.112 - 5.6 =
• ∆CF2= ∆OCF2 - ∆WC = 2.112 =
• ∆CF1= ∆OCF1 - ∆WC = 2.112 + 5.6 =
Page 39
Case 2• Incremental Dollar denominated
Cash Flows:• year 1:
– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(- € 3.8714 mil) +1.00(- € 3.488 mil) = _______________
• years 2-4:– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(- €
1.7286 mil) +1.00(€ 2.112 mil) = __________________
• year 5:– ∆(S*CF) = ∆S*CF + Snew ∆CF = (-0.2)(€7.3286
mil) +1.00(€ 7.712 mil) = ____________________
Page 40
Example: PV of incremental Cash Flows
• Present Value of the incremental year-end cash flows:
• Case 1:
• Case 2:
76.447,591$2.1
720,465,1720,345
2.1
280,7745
4%20 AFPV
47.420,132,5$2.1
280,246,6720,457,2
2.1
720,713,25
4%20
AFPV
Page 41
Strategic Management of OE
• The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows
• To meet this objective, management can diversify the firm’s _____________ and _____________________.
Page 42
Strategic Management of OE
• Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources
• Diversifying the financing base means raising funds in more than one capital market and in more than one currency
Page 43
Proactive Management of OE
• Operating and transaction exposures can be _____________________ by adopting operating or financing policies that offset anticipated currency exposures
• Four of the most commonly employed proactive policies are– Matching currency cash flows– Risk-sharing agreements– Back-to-back or parallel loans (already
considered)– Currency swaps (already considered)
Page 44
Cash Flow Matching
Principal and interestpayments on debt
in Canadian dollars
CanadianBank
(loans funds)
US Corp borrowsCanadian dollar debtfrom Canadian Bank
Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars
U.S.Corporation
CanadianCorporation(buyer of goods) Exports
goods toCanada
Payment for goodsin Canadian dollars
Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars
Page 45
Risk-Sharing• Risk-sharing is a contractual arrangement
in which the buyer and seller agree to “share” or split currency movement impacts on payments– Example: Ford purchases from Mazda in
Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$.
– If the spot rate falls outside of this range, Ford and Mazda will share the difference equally
– If on the date of invoice, the spot rate is ¥110/$, then Mazda would agree to accept a total payment which would result from the difference of ¥115/$- ¥110/$ (i.e. ¥5)