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Foreign Exchange Exposure

POST RAJ POKHAREL M.Phil. (TU) 01/2010)

EXPOSURE OF FOREIGN EXCHANGE

• Foreign exchange risk is related to the variability of domestic-currency values of assets or liabilities due to unanticipated changes in exchange rates

• Foreign exchange exposure is the amount that is at risk

• Foreign exchange exposure is the sensitivity of changes in the real domestic-currency value of assets or liabilities to changes in exchange rates

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EXPOSURE OF FOREIGN EXCHANGE RISK

Three types of Exposure:

- Translation or Accounting Exposure

- Transaction or Contractual Exposure

- Operating or Economic Exposure

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Translation or Accounting Exposure:

• Is the sensitivity of the real domestic currency value of Assets and Liabilities, appearing in the financial statements to unanticipated changes in exchange rates

• All firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiary from foreign to domestic currency.

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Transaction or Contractual Exposure:

Is the sensitivity of the real domestic currency value of Assets and Liabilities, when assets and liabilities are liquidated with respect to unanticipated changes in exchange rates for exporting, importing, or import substituting firms

A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency.

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Economic or Operating Exposure:

• Is the sensitivity of the real domestic currency value of Assets and Liabilities, or future operating incomes to unanticipated changes in exchange rates

• Such exchange rate adjustments can severely affect the firm's market position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good.

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TRANSLATION OR ACCOUNTING EXPOSURE

Why Accounting Exposure?:

• Managers, analysts and investors need some idea about the importance of the foreign business. Translated accounting data give an approximate idea of this.

• Performance measurement for bonus plans, hiring, firing, and promotion decisions.

• Accounting value serves as a benchmark to evaluate a discounted-cash flow valuation.

• For income tax purposes.

• Legal requirement to consolidate financial statements.

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TRANSLATION OR ACCOUNTING EXPOSURE

Four Methods to translate foreign currency to home currency:

1. Current/Non-Current Method: All current assets and current liabilities are translated at current exchange rate

2. Monetary/ Non-Monetary Method: All monetary assets and liabilities are translated at current exchange rate

3. Temporal Method: Same as Monetary/Non-Monetary method BUT inventory may be translated at current exchange rate IF it is shown at market value

4. Current Rate Method: All balance sheet and income statement items are translated at current exchange rate 8

How to manage Transaction/Translation Exposures? “Hedge”

Hedging Means: Substitution of an open future exchange risk with a presently known exchange rate (Fixed cost of hedging operation)

Alternatives:

1. Forward/Future Market Hedge

2. Money Market Hedge

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McDonnell Douglas just signed a contract to sell a DC 10 aircraft to Air France. Air France will be billed FF50 million which is payable in one year. The current spot exchange rate is $0.20/FF and the one-year forward rate is $0.19/FF. The annual interest rate is 6.0% in the U.S. and 9.5% in France. McDonnell Douglas is concerned with the volatile exchange rate between the dollar and the franc and would like to hedge exchange exposure. It is considering two hedging alternatives: • sell the franc proceeds from the sale forward or, • borrow francs from the Credit Lyonnaise against the franc

receivable. Which alternative would you recommend? Why?

IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is ¥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable. (a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

Suppose that a U.S. computer company has a wholly owned British subsidiary, Albion Computers PLC that manufactures and sells personal computers in the U.K. market. Albion Computers imports microprocessors from Intel, which sells them for $512 per unit. At the current exchange rate of $1.60 per pound, each Intel microprocessor costs £320. Albion Computers hires British workers and sources all the other inputs locally. Albion faces a 50 percent income tax rate in the U.K. The company expects to sell 50,000 units of personal computers per year at a selling price of £1,000 per unit. The unit variable cost is £650, which comprises £320 for the imported input and £330 for the locally sourced inputs. Needless to say, the pound price of the imported input will change as the exchange rate changes, which, in turn, can affect the selling price in the U.K. market. Each year, Albion incurs fixed overhead costs of £4 million for rents, property taxes, and the like, regardless of output level and £1millioin for depreciation.

Now, Assume that the pound may depreciate from $1.60 to $1.40 per pound and the price of the imported input changed. Now, calculate new operating cash flows both in pounds and dollars.