Foreign Exchange Exposure - Central and East …cesp.vse.cz/wp-content/uploads/2010/01/Lessons-6-72.pdf2 Foreign Exchange Exposure Exchange Rate Risk • Exchange rate risk can be

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Financial Management in IB

Foreign Exchange Exposure

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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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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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• 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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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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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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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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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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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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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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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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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 -


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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 -


• Short position in $ may be closed out by buying US Dollar -


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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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.

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Foreign Exchange Exposure - Central and East …cesp.vse.cz/wp-content/uploads/2010/01/Lessons-6-72.pdf2 Foreign Exchange Exposure Exchange Rate Risk • Exchange rate risk can be