Lecture 12: Managing Foreign Exchange Exposure with Operational Hedges

1. Lecture 12: Managing Foreign Exchange Exposure with Operational Hedges A discussion of the various operational arrangements which global firms and global investors can use when managing open foreign exchange positions

2. Hedging Known Future Cash Flows • In the previous lecture, the hedging techniques we discussed (forwards and options) are most appropriate for covering transaction exposure. • Transaction exposures have known foreign currency cash flows and thus they are easy to hedge with financial contracts. • The majority of transaction exposure risk results from receivables (payables) from exports (imports) contracts and repatriation of dividends. • Usually, the time frame for these committed transactions (the time between contracting and payment) is relatively short. However, it can in some cases reach several years, where deliveries are committed a long time in advance (forward sales of airplanes or building contracts).

3. Quick Review: Identifying Sources of Transaction Exposure • Transaction exposure arises from: • (1) Purchasing or selling, on credit, goods or services denominated in foreign currencies. • (2) Borrowing or lending denominated in foreign currencies. • (3) Acquiring financial assets or incurring liabilities denominated in foreign currencies.

4. Dealing with Transaction Exposure Through Operational Hedges • While global companies can manage their transaction exposures with financial hedges, they can also utilize operational hedges. • Operational hedges refers to “internal” organizational strategies that firms use to deal with their currency exposures. • With respect to transaction exposure, potential operational techniques include: • Risk Shifting: Invoicing overseas purchases and sales in home currency. • Netting: Hedged net amounts of transaction exposures. • Leading (speeding up) and Lagging (slowing down) payments in response to changes in exchange rates.

5. Operational Hedging of Transaction Exposures: Risk Shifting, Home Currency Invoicing, 2003-2007 Data

6. Operational Hedging: Netting • Given that large and globally diverse multinational firms may need to manage exchange rate risk associated with several different currencies these generally consider their net exposure to currency risk instead of just looking at each currency separately. • Global firms will achieve netting through a centralized approach because a non-centralized, whereby each subsidiary assesses and manages its individual exposure to exchange rate riskwill result in redundancy and added costs in hedging.

7. Transaction Exposure Using "Net" Cash Flows • Centralized exposure management requires headquarters to consolidate the net amount of currency inflows and outflows for all subsidiaries categorized by currency. • Consider two subsidiaries X & Y of a U.S. MNC: • Subsidiary X has net inflow (long position) of £500,000 • Subsidiary Y has net outflows (short position) of £600,000 • Then, the consolidated "net" outflow for this multinational corporation is £100,000 which is the amount to be hedged. • Additionally, if the pound weakens it will be unfavorable to X but favorable to Y. If hedging is limited to net exposure, transaction cost savings are realized.

8. Operational Hedging: Leading and Lagging Payments • Refers to the timing of when a firm with an FX exposed position will initiate foreign currency payments (or specifically when the firm has an open short position). • Leading (“speeding-up) Payments. • Lead payments when home currency is weakening (i.e., foreign currency is strengthening). • Lagging (“slowing down/delaying”) Payments • Lag payments when home currency is strengthening (i.e., foreign currency is weakening).

9. Hedging Unknown Cash Flows • In the previous examples we were dealing with known foreign currency cash flows (resulting from current “transactions”). • However, economic exposures do not provide the firm with this “known” cash flow information. • Economic exposure refers to the impact of exchange rate movements on the home currency value of uncertain future cash flows. • Global firm: Uncertain future cash flows relate to the firm’s costs (e.g., raw materials, labor costs, etc.) and output prices and sales (e.g., product prices). • Global investor: Uncertain future cash flows relate to the future dividends and changes in market prices.

10. Channels of Economic Exposure for Firms • (1) Direct effects of FX changes result from a company’s actual involvement in foreign markets. • Impact on the home currency equivalents of cost and revenue streams in overseas markets. • (2) Indirect effects refer to FX induced changes in foreign company competition in a company’s domestic market. • Foreign competitors exporting into company’s home country (FX induced change in competitive position of foreign exporters). • Foreign companies setting up FDI activities in company’s home country. • Both (1) and (2) driven by globalization.

11. The Globalization of Business Firms: 2010 Data for S&P 500 Firms

12. Data for Selected S&P 500 Companies, Sorted by Percentage Point Increase

13. The Global Reach of Selected U.S. Companies, 2010 Data • Wal-Mart. Total revenue: $420 billion, 26% from overseas; nearly 5,000 stores in 14 foreign countries, including China, India, the U.K., and Latin America. • Bank of America. Total revenue: $134 billion, 20% from overseas. Europe is biggest market. • Ford. Total revenue: $129 billion, 51% from overseas; Canada and Europe. • Boeing. Total revenue: $64 billion in revenue, 41% from overseas; Europe, Asia, and the Middle East. • Intel. Total revenue: $44 billion, 85% from overseas. Taiwan, followed by China. • Amazon. Total revenue: $34 billion, 45% from overseas; Canada, several European countries, Japan, and China. • McDonald's. Total revenue: $24 billion, 66% from overseas; Europe and Asia. • Nike. Total revenue: $21 billion, 50% from overseas; North America, Europe and China.

14. McDonald’s, 2010 Annual Report

15. Impact of FX Changes on SalesNote: Excluding F/X estimates sales based on the previous year’s exchange rate

16. 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.

17. Global Diversification of Sales • Subway: • 35,561 restaurants in 98 countries • Visit: http://www.subway.com/subwayroot/exploreourworld.aspx • McDonald’s (2010): • 32,737 restaurants in 117 countries. • Revenues by segment

18. 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 in specific countries (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)?

19. 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

20. 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

21. 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 (against the USD) and the revenue currencies weaken (against the USD)? • Negative impact on USD profits • Possible solution: Adjust prices in revenue countries. • What if the cost currencies weaken and the revenue currencies strengthen? • Positive impact on USD profits • How could Nike balance its overseas activities?

22. A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure • Step 1: Determining Specific Foreign Exchange Exposures • What type of exposure are you dealing with? • By currency and net amounts (i.e., long minus short positions) • Are the net amounts worth hedging? If they are go to Step 2; if not, no need to hedge. • Step 2: Forecasting Exchange Rates • Determining the potential for and possible range of currency movements. • Important to select the appropriate forecasting model. • A “range” of forecasts is probably appropriate here (i.e., forecasts under various assumptions) • How comfortable are you with your forecast? If comfortable, go to Step 3. If not, hedge.

23. A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure • Step 3: Assessing the Impact of Forecasted Exchange Rates on Company’s Home Currency Equivalents (What is the Measured Risk?). • Impact on earnings, cash flow, liabilities (positive or negative?) • Go to Step 4 • Step 4: Deciding Whether to Hedge or Not • Determine whether the anticipated impact of the forecasted exchange rate change merits the need to hedge. • Perhaps the estimated negative impact on home currency equivalent is so small as not to be of a concern. • But, if impact is unacceptable, go to Step 5 • Or, perhaps the firm feels it can benefit from its exposure. • If this is the case, go to Step 6

24. A Comprehensive Approach or Assessing and Managing Foreign Exchange Exposure • Step 5: Selecting the Appropriate Hedging Instruments if Risk is Unacceptable. • Consider: • Which hedge is appropriate for the type of exposure? • Financial and/or operational • Firm’s familiarity and comfort level with types of hedging strategies. • Review the cost involved with different financial contracts. • Step 6: Selecting the Appropriate Strategy to Position the Firm to Take Advantage of a Favorable Exchange Rate Change. • Consider: • Partial “open” position versus complete “open” position. • Which financial contract will achieve your objective?

25. Appendix 1 The following slides illustrate how companies deal with and report translation exposures

26. 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

27. 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