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Managing Foreign Exchange Exposure with Operational Hedges

Managing Foreign Exchange Exposure with Operational Hedges. In this lecture we will discuss the various operational arrangements which global firms and global investors can consider when managing open foreign exchange positions . Hedging Unknown Cash Flows.

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Managing Foreign Exchange Exposure with Operational Hedges

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  1. Managing Foreign Exchange Exposure with Operational Hedges In this lecture we will discuss the various operational arrangements which global firms and global investors can consider when managing open foreign exchange positions

  2. Hedging Unknown Cash Flows • In the previous lecture, the hedging techniques we discussed (forwards, options, money market hedges) are most appropriate for covering transaction exposure. • Why? • Because transaction exposures have known foreign currency cash flows and thus they are easy to hedge with financial contracts • However, economic exposures do not provide the firm with this “known” cash flow information.

  3. Dealing with Economic Exposure • Recall that economic exposure is long term and involves unknown future cash flows. • What can the firm do to manage this economic exposure? • Firm can employ an “operational hedge.” • One such strategy involves global diversification of production and/or sales markets to produce natural hedges for the firm’s unknown foreign exchange exposures. • As long as currencies associated with these different markets do not move in the same direction, the firm can “stabilize” its overall home currency equivalent cash flow.

  4. Are U.S. Companies Diversifying Globally? • Roughly 44% of the S&P 500's 2006 revenues came from international sources. This compares to 32% in 2001. • Examples include: • Starbucks: 21% of total revenue is earned outside the U.S. (2006) • Nike: 63% of net revenues is earned outside the U.S. (2005) • Coca-Cola: 77% of operating income is earned outside the U.S. (first 9 months of 2007)

  5. McDonald’s Global Diversification

  6. Balancing Costs and Revenues: Restructuring to Reduce Economic Exposure • Restructuring involves shifting the sources of costs or revenues to other locations in order to match cash inflows and outflows in foreign currencies. • Restructuring Decisions: • Should the firm attempt to increase or decrease sales (i.e., revenues)? • Should the firm attempt to increase or decrease dependency on foreign suppliers (i.e., cost) • Should the firm establish or eliminate production facilities in foreign markets (i.e., costs) • Should the firm increase or decrease its level of foreign currency denominated debt (i.e., costs)

  7. Nike’s Global Diversification of Manufacturing for Footwear, By Country, 2005 CountryPercent China 36 Vietnam 26 Indonesia 22 Thailand 15 Big Four 99 Others: Argentina, Brazil, India, Mexico, and South Africa Source: Nike, 2005 Annual report

  8. Nike’s Global Diversification of Sales by International Region (U.S. Dollars in Millions), 2005 MarketRevenuePercent United States $5,129.3 37.3% EMEA 4,281.6 31.2% Asia Pacific 1,897.3 13.8% Americas 695.8 5.1% Other 1,735.7 12.6% Total $13,739.7 Note: EMEA is Europe, Middle East and Africa

  9. Is Nike a Balanced Firm? • Foreign Currency Costs concentrated in: • Yuan, Dong, Rupiah, Baht • Foreign Currency Revenues concentrated in: • Euros, Pounds, Yen • What if the cost currencies strengthen and the revenue currencies weaken? • Possible solution: Adjust prices in revenue countries. • What if the cost currencies weaken and the revenue currencies strengthen?

  10. Translation Exposure • Translation exposure is commonly referred to as “accounting exposure” because it refers to the impact of exchange rate changes on the consolidated financial reports of a global firm. • These include impacts on assets and liabilities and profits which have been acquired or occurred in the past. • Why do global firms need to consolidate statements? • To report financial results to their shareholders. • To report income to taxing authorities. • The accounting approach for consolidating financial statements depends upon the accounting requirements of the firm’s headquartered country. • The U.S. is governed by FASB 52. • Balance sheet and income statement gains or losses associated with the consolidation process show up in the shareholders’ equity account

  11. Nike’s 2005 Financial Statement Summary • Consolidated Balance Sheet, Fiscal 2005 (millions of U.S. dollars) • Assets $8,793.6 • Liabilities $3,149.4 • Shareholders’ Equity $5,644.2 • Of which foreign currency translation adjustments were: 70.1* *This is a cumulative amount (e.g., in 2004 it was $27.5

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