exposure management

7/31/2019 Exposure Management

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Transaction Exposure Transaction exposure arises when a firm faces contractual cash

flows that are fixed in a foreign currency - Receive or pay a fixedamount of foreign currency in the future

Receive or pay a fixed amount of foreign currency in the future,i.e. any receivable (AR), or payable (AP) in a foreign currency.

Source of currency risk from transaction exposure for MNCcould be either: a) export/import activities, or b)

borrowing/lending activities - anytime future CFs (to be paid orreceived) are fixed in a foreign currency.

Internal & external Techniques of Exposure Management


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Currency Invoicing

The firm can shift, share, or diversifyexchange risk byappropriately choosing the currency of invoice.

ExampleAssume that Boeing has a contract to build five 747s forBritish Airways, and deliver one each year for the next 5 years,and receive 10m per plane.

a) If Boeing can invoice in USD, then it has eliminatedcurrency risk for itself and shifted it to British Airways. Nowif S = $1.50/, British Airways has a $15m AP and Boeing has a$15m AR


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Currency Invoicing b) Boeing could share the currency risk with British

Airways by invoicing 50% in USD and 50% in BP: $7.5m +5m for each plane, and each company shares half therisk. "

c) Invoice in a basket of currencies to diversify andreduce currency risk with a portfolio of currencies: e.g.SDRs ($, , , ; weights are 44%, 34%, 11%, 11%) or in thepast, ECUs (11 currencies). Companies can issue bondsdenominated in SDRs or ECU (prior to euro) to diversify

risk, Egyptian govt. charges fees in SDRs for passagethrough the Suez Canal.Invoicing in currency baskets can be a useful hedging tool

when no forward or currency contracts are available


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Exposure NettingA multinational firm should not consider deals in

isolation, but should focus on hedging the firm as aportfolio of currency positions.

As an example, consider a U.S.-based multinational withKorean won receivables and Japanese yen payables.Since the won and the yen tend to move in similar

directions against the U.S. dollar, the firm can just waituntil these accounts come due and just buy yen with wonEven if its not a perfect hedge, it may be too expensive orimpractical to hedge each currency separately.


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Exposure Netting Many multinational firms use a reinvoice center.

Which is a financial subsidiary that nets out theintrafirm transactions.

Once the residual exposure is determined, then thefirm implements hedging.


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Exposure Netting: An exampleBilateral Netting would reduce the number of foreignexchange transactions by half:

$10 $35 $40$30

$20

$25

$60

$40

$10

$30

$20

$30


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Exposure Netting

$25 $10$15$20

$10

$10


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Leading and lagging FX transactions-Leading

Changing the timing of a cash flow so that it takes place prior to theoriginally agreed date

If foreign currency appreciates, lead/lag the payable/receivable

-LaggingDelaying the timing of an existing FX cash flow

If foreign currency depreciates, lag/lead the payable/receivable

-Need to assess costs/impact of strategies, e.g. unpredictable

payment behavior

Used in intra firm payables and receivables, such as materialcosts, rents, royalties, interests, and dividends, among

subsidiaries of the same multinational corporation 9


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Currency Risk Sharing

Developing a customized hedge contract

The contract typically takes the form of a Price

Adjustment Clause,whereby a base price is adjusted to

reflect certain exchange rate changes

Parties would share the currency risk beyond a neutralzone of exchange rate changes

The neutral zone represents the currency range inwhich risk is not shared

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The Zone

Take no actions

$1.50/ $1.60/

Take no

action

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1. Forward Market Hedge

2. Currency Futures Hedge

3. Money Market Hedge

4. Options Market Hedge

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Forward Market Hedge

An over-the-counter contract between parties to exchange currencyat an agreed exchange rate, to be paid or received on an

obligation at a specified future date.

If you are going to owe foreign currency in the future, agree tobuy the foreign currency now by entering into long position in aforward contract.

If you are going to receive foreign currency in the future, agree tosell the foreign currency now by entering into short position in aforward contract.

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Currency Futures Hedge

A currency futures contract is a transferable futurescontract that specifies the price at which a currencycan be bought or sold at a future date

Currency future contracts allow investors to hedgeagainst foreign exchange risk

Unlike forward contracts that are tailor made to thefirms specific needs, futures contracts arestandardized instruments in terms of contract size,

delivery date, and so forth. 14


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Money Market Hedge

The use of borrowing and lending transactions in foreigncurrencies to lock in the home currency value of aforeign currency transaction

The firm may borrow (lend) in foreign currency to hedgeits foreign currency receivables (payables), therebymatching its assets and liabilities in the same currency.

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Options Market HedgeA contract that grants the holder the right, but not the

obligation, to buy or sell currency at a specifiedexchange rate during a specified period of time

For this right, a premium is paid which will varydepending on the number of contracts purchased

Currency options are one of the best ways forcorporations or individuals to hedge against adversemovements in exchange rates.

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Translation Exposure It arises from the need, for purposes of reporting

and consolidation, to convert the results of foreign

operations from the local currency to the homecurrency.

Paper exchange gains or losses

Retrospective in nature

Short-term in nature

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Measuring Translation Exposure The difference between exposed assets and exposed

liabilities.

Exposed assets and liabilities are translated at thecurrent exchange rate.

Non-exposed assets and liabilities are translated at thehistorical exchange rate.

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Translation Methods Current/Noncurrent Method

Monetary/Nonmonetary Method

Temporal Method

Current Rate Method

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Current/Noncurrent Method

The underlying principal is that assets and liabilitiesshould be translated based on their maturity.

Current assets translated at the spot rate.

Noncurrent assets translated at the historical rate ineffect when the item was first recorded on the books.

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Monetary/Nonmonetary

Method The underlying principal is that monetary accounts

have a similarity because their value represents a sum ofmoney whose value changes as the exchange ratechanges

All monetary balance sheet accounts (cash, marketablesecurities, accounts receivable, etc.) of a foreignsubsidiary are translated at the current exchange rate.

All other (nonmonetary) balance sheet accounts(owners equity, land) are translated at the historicalexchange rate in effect when the account was first

recorded. 21

d


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Operating Exposure - Introduction

Also known as Economic Exposure, CompetitiveExposure & Strategic Exposure

Measures a change in the present value of a firm

resulting from any change in future expectedoperating cash flows caused by unexpected changes inexchange rates

Arises when a firm invests in new productdevelopment, establishes foreign supply contracts,manufactures products abroad, etc

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Operating Exposure - Example Suppose /$ exchange rate is 1.0. Hence an Apple costs $1 in

US and 1 in France

Euro depreciation to 1.20 increases the cost to 1.20 if theexporter does not adjust the $

Demand for the Apple in France will go down due to 20%hike in price

If price in France is kept at 1, then the exporter receives1/1.20 = $0.83 for the Apple

In practice, we are somewhere in between these twoextremes

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Managing Operating Exposure

The following techniques are used:

1. Marketing Managment

2. Production Managment

3. Financial Hedging

4. Proactive Managment

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The marketing manager analyzes the effect of a change in

the exchange rate and evaluates the strategy required to

manage the exposure.

The four strategies available:

Market selection,

Pricing strategy,Promotional strategy, and

Product strategy.

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Market Selection

Involves selection of the markets in which the firm

wishes to market its products and providing relevant

services to provide the firm an edge in these markets

This strategy is useful when the actual or anticipated

change in the real exchange rate is likely to persist for a

medium/long time The decision also depends on the fixed cost associated

with establishing or increasing market share

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Pricing StrategyFrequency of price adjustments:

Exchange rates move even on a minute-to-minute basis. A

firms sales may get affected by frequent price changes

On the other hand, a firm may lose on account of unfavorable

exchange rate movements if it delays the change in the price

of its product

Finally, a balance between the two needs to be arrived at:

level of uncertainty the firms customers are ready to face

duration for which the exchange rate movement is likely to

persist

loss expected to be incurred by not changing the prices 28


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Promotional Strategy

Essential issue in any marketing program - promotional

budget

Change in the exchange rate would change the domestic-

currencycost of overseas promotion

Effect of exchange rate movements on promotional costs is

also in the form of the expected revenues that can be

generated per unit of expenditure on promotion

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Product Strategy

Timing of introduction of new products

Introduce a new product when there is a priceadvantage(e.g. in case of an exporting firm, when

the domestic currency has depreciated) Hold back the products from the market when the

conditions are not favorable

Product Innovation

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Production Strategies

Exchange rate movements are too large and long

lasting

Marketing strategies are not effective

Long-term decisions to protect the firm from harmful

effects of an unfavorable exchange rate movement

Strategies

Product sourcing

Plant location

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Product Sourcing Distribute production among different production

centers(in different countries)

Firm can reallocate production to increase the

quantity produced in the country whose currency hasdepreciated, and reducing production in countries

whose currency has appreciated

Due to this flexibility, an MNC faces less economic

exposure than a company having production facilities

in only one country

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Plant Location Companies, which do not have multiple production

facilities, may be forced to set up such facilities abroad

as a response to exchange rate movements (which

change the relative cost advantages of countries) Firms may even decide to set up production facilities

in third-world countries for labor-intensive products

due to the low labor cost there, without there beingany specific advantage due to exchange rate

movements

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Financial Hedging

It involves the use of currency swaps, currency futures,

currency forwards, and currency options

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Proactive Managment Its generally a long term hedging tool

Some of the commonly used Proactive policies are:

1. Matching currency cash f lows

2. Risk-sharing agreements

3. Back-to-Back Loans

4. Currency Swaps

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Matching Currency Cash Flows One way to offset an anticipated continuous exposure

to a particular currency is to acquire debt denominatedin that currency

This policy results in a continuous receipt of paymentand a continuous outflow in the same currency

This can sometimes occur through the conduct of

regular operations and is referred to as a natural hedge

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Risk Sharing Agreements

Risk-sharing is a contractual arrangement in which thebuyer and seller agree to share or split currency

movement impacts on payments

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Back-to-Back Loans

Also referred to as aparallel loan or credit swap, occurs

when two firms in different countries arrange toborrow each others currency for a specific period oftime

The operation is conducted outside the FOREXmarkets, although spot rates may be used to decide theequivalent amount

This swap creates a covered hedge against exchangeloss, since each company, on its own books, borrowsthe same currency it repays

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Currency Swaps Also called a cross-currency swap

Currency swaps resemble back-to-back loans except that itdoes not appear on a firms balance sheet

In a currency swap, a dealer and a firm agree to exchange anequivalent amount of two different currencies for aspecified period of time Currency swaps can be negotiated for a wide range of

maturities

A typical currency swap requires two firms to borrow fundsin the markets and currencies in which they are bestknown or get the best rates

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