Part 2 International Corporate Finance - Lecture n° 5 Foreign exchange exposure

1. International Finance Part 2 International Corporate Finance - Lecture n° 5 Foreign exchange exposure DES en Gestion - Année académique 2002-2003

2. International Corporate Finance • Part 2 : International Corporate Finance (10 hrs) • Foreign Exchange Exposure (Chap. 6 & 7 - 3 hrs): • Transaction exposure + decision case • Operating exposure • Financing the Global Firm (Chap. 11 & 13 - 3 hrs): • Global cost and availability of capital • Financial structure and international debt • Foreign Investment Decision (Chap. 14 & 15 - 3 hrs): • FDI theory and strategy • Multinational capital budgeting • Adjusting for risk in foreign investment + decision case • Managing Multinational Operations (Chap. 18 & 19 -3 hrs) • Repositioning funds • Working capital management + decision case DES en Gestion - Année académique 2002-2003

3. Foreign Exchange Exposure • Type of foreign exchange exposures • The three main types of foreign exchange exposure are: transaction, operating, and translation exposure. • Transaction exposure • Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates. • Operating exposure • Change in expected future cash flows arising from an unexpected change in exchange rates. • Translation exposure • Changes in reported owner’s equity in consolidated financial statements caused by a change in exchange rates. “Accounting exposure”. DES en Gestion - Année académique 2002-2003

4. Foreign Exchange Exposure • Hedge or not hedge? • There is a debate between supporters and opponents of FX hedging. Some arguments of the two groups are: • NOT hedge, because : • Shareholders are much more capable of diversifying currency risk than the management of the firm. • Currency risk management does not increase the expected cash flows of the firm, but rather decreases the variance of the CF, and decrease them as well by the hedging costs. • Managers cannot outguess the market, if and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging is zero. • In efficient markets, investors and analysts can see across the “accounting veil” and therefore have already factored the foreign exchange effect into a firm's market valuation. DES en Gestion - Année académique 2002-2003

5. Foreign Exchange Exposure • Hedge or not hedge? • HEDGE, because : • Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flow will fall below the necessary minimum. • Management has comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. • Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks. Management is in a better position than shareholders to take advantage of the one-time opportunities theses imperfections cause, to enhance the firm value through selective hedging. DES en Gestion - Année académique 2002-2003

6. Transaction exposure • Transaction exposure • Transaction exposure arises from : • Purchasing or selling on credit goods or services when prices are stated in foreign currency. • Borrowing or lending funds when repayments is to be made in a foreign currency. • Being a party to an unperformed foreign exchange forward contract. • Otherwise acquiring assets or incurring liabilities denominated in foreign currencies. • Most common example : • Transaction exposure of a firm has a receivable denominated in a foreign currency. DES en Gestion - Année académique 2002-2003

7. Transaction exposure • Transaction exposure - example • Sale of telecom equipment from Trident (US multinational corporation) to a British company. • Payment is made in £ : 1 MM due in three months. • If the £ appreciate toward the $, Trident makes a bigger profit, but if the £ depreciates, Tridents loses part (or all) of its margin : transaction exposure. • Spot rate = $1.7640/£. The budget rate, the lowest acceptable dollar per pound exchange rate is established at $1.70/£ to maintain acceptable margin. • Four alternatives available to Trident to manage the exposure: • Remain unhedged • Hedge in the forward market • Hedge in the money market • Hedge in the options markets DES en Gestion - Année académique 2002-2003

8. Transaction exposure • Transaction exposure - example • Forward market hedge • This involves a forward (or futures) contract and a source of funds to fulfill that contract. • The forward contract is entered into at the time the transaction exposure is created. • The sequence is as follows : • Day 0 : sell £1 MM forward at $1.7540 (fwd rate 3 mths) • In 3 mths : receive £1 MM (from buyer), deliver £1 MM against forward sale, receive $1,754 MM (price of the fwd rate). • The forward contract is “covered” or “square”, the funds on hand or to be received are matched by the funds to be paid. DES en Gestion - Année académique 2002-2003

9. Transaction exposure • Transaction exposure - example • Money market hedge • Like a forward market hedge, a money market hedge also includes a contract and a source of funds. The contract is here a loan agreement. • The firm seeking the hedge borrows in one currency and exchange the proceeds for another currency. If funds to fulfill the contract are generated by business operations, the hedge is “covered”. If the funds are to buy of the spot market, the hedge is “uncovered” or “open”. • The structure is similar to the forward hedge. Here, the price is determined by the interest rate differential between the two currencies, whereas in the fwd hedge, the price is the forward premium. In efficient fwd markets, interest rate parity states that these prices are the same. DES en Gestion - Année académique 2002-2003

10. Transaction exposure • Transaction exposure - example • Money market hedge • The sequence is as follows : • Day 0 : borrow enough to repay £1 MM in 3mths; that is : £1MM / 1+0.25 = £ 975,610. • Day 0 : exchange £ 975,610 against $ at spot rate (1.7640), that is $1,720,976 • In 3 mths : receive £1 MM (from buyer), deliver £1 MM to repay the loan, that is £ 975,610 principal + £ 24,390 interests. • Depending on the relative prices of forward markets and interest rates differences, the money market hedge or the forward hedge will be preferable. DES en Gestion - Année académique 2002-2003

11. Transaction exposure • Transaction exposure - example • Option market hedge • The transaction exposure could also be covered by a £ 1 MM put option. This technique allows speculation on the upside appreciation of the pound while limiting the downside risk to a know amount (the premium of the option). • The sequence is as follows : • Day 0 : buy put option to sell pounds at $1.75/£, pay $26,460 for the option. • Option cost = (size of option)x(premium)x(spot rate) = £1,000,000 x 0.015 x $1.7640 = $ 26,460 • In 3 mths : receive £1 MM. Either deliver £1 MM against put, receiving $1,750,000 or sell £1 MM spot if current spot rate > $1.75/£ DES en Gestion - Année académique 2002-2003

12. Transaction exposure • Transaction exposure - example • Comparison of alternatives • In order to evaluate the full cost of the option hedge, one has to include the opportunity cost of the premium paid. • If one considers 12% of cost of capital ,it makes 3% a quarter. The full premium cost of the option is thus: $26,460x1.03 = $27,254. In contrast, the downside risk is limited to the premium cost incurred, in case of an option hedge. But the upside gain is unlimited. • We can calculate the trading range for the £ that defines the break-even for the option compared to others alternatives. • The upper bound of the range is determined compared to the forward rate. The £ must appreciate enough above the forward rate to cover the 0.0273$/£ to cover the cost of the option : $1.7540 + $0.0273 = $1.7813/£. • The lower bound is is determined compared to the unhedged strategy. If the spot rate falls below $1.75/£, the option is exercised. DES en Gestion - Année académique 2002-2003

13. Transaction exposure • Transaction exposure - example • Comparison of alternatives • One can thus compare the various gains or losses brought by the hedge at strike price £1.75/$, depending on the realized FX rate : • Option cost (future value) : $27.254 • Proceeds if exercises : $1,750,000 • Minimum net proceeds : $1,722,746 (proceeds at strike - cost) • Maximum net proceeds : unlimited • Break-even spot rate (upside) : $1.7813/£ • Break-even spot rate (downside) : $1.75/£ • Strategy choice and Outcome • Two selection criteria : risk tolerance & expectations of the direction and distance the exchange rate will move the period considered. DES en Gestion - Année académique 2002-2003

14. Value in US dollars of Trident’s £1,000,000 A/R Uncovered 1.84 Forward rate is $1.7540/£ 1.82 ATM put option 1.80 1.78 Money market 1.76 1.74 Forward contract 1.72 1.70 1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86 Ending spot exchange rate (US$/£) Transaction exposure DES en Gestion - Année académique 2002-2003

15. Transaction exposure • Risk Management in practice • No real consensus seems to emerge, according to international surveys. • In most firms, treasury functions are responsible for transaction exposure management and usually considered a cost function. Expected to act as conservative. • Transaction exposure generally allowed to be hedged once actually booked as receivables and payables (transaction certain). • Transaction management programs divided among those using options, and those who do not. The latter rely almost exclusively on fwd contracts and money market hedges. • Many firms establish risk mgt policy requiring proportional hedging on a % of the total exposure. The remainder is selectively hedged on the basis of expectations and views. DES en Gestion - Année académique 2002-2003

16. Transaction exposure • Risk Management in practice - Decision Case • See : Lufthansa’s purchase of Boeing 737 DES en Gestion - Année académique 2002-2003

17. Operating exposure • Definition • Operating exposure (OE) measures any change in the present value of a firm resulting from changes in future operating ash flows caused by any unexpected change in exchange rates. • Operating exposure analysis examines the consequences of changing FX rates on a firm’s own operations over the coming months and years and on its competitive position relative to other firms. • Operating exposure and transaction exposure are both related to future cash-flows. They differ in terms of which CF are considered and why they change when FX rates change. DES en Gestion - Année académique 2002-2003

18. Operating exposure • Attributes of Operating exposure • Measuring the OE of a firm requires forecasting and analyzing all the firm’s future exposures of all the firm’s competitors and potential competitors worldwide. OE is far more important for the long-run health of a business than transaction exposure or translation exposure. • The CF can be divided in operating cash-flows and financial cash-flows. • Operating cash flows arise from intercompany and intracompany receivables and payables, rent and lease payments of facilities, royalties and license fees, etc. • Financial cash flows are payments for the use of intercompany and intracompany loans and stockholders equity. • Each of these CF can occur in different time intervals, amounts, currencies and denomination, and each has a different predictability of occurrence. DES en Gestion - Année académique 2002-2003

19. Operating exposure • Attributes of Operating exposure • Financial and Operating Cash Flows between a Parent and Affiliate DES en Gestion - Année académique 2002-2003

20. Operating exposure • Attributes of Operating exposure • An expected change in FX rates is not included in the definition of OE, because it has already been included in the firm’s valuation parameters. Only unexpected changes in FX rate, or inefficient foreign exchange market should cause market value to change. • OE is not just the sensitivity of a firm’s future CF to unexpected change in FX rates, but also its sensitivity to other key macroeconomic variables. • Illustrating of Operating Exposure : Trident • Suppose an MNE US Corp. Deriving much of its profits from its German subsidiary. If the euro unexpectedly falls in value : • How will Trident Europe’s revenue change (prices in euro terms and volumes) ? • How will its costs change (input costs in euro) ? • How will its competitors react ? DES en Gestion - Année académique 2002-2003

21. Operating exposure • Illustrating of Operating Exposure : Trident • Imagine that input are bought in Europe, labeled in Euro. Half of the production is sold in Europe, half is exported to non-European countries. All sales are invoiced in Euros, and the average collection of period account receivables is 90 days. • Following a Euro depreciation, Trident might choose to : • maintain its domestic price constant in euro terms • try to raise domestic prices because competing imports are now priced higher in Europe • keep exports prices constant in terms of foreign currencies, in terms of euro, or some where in between (partial pass-through) DES en Gestion - Année académique 2002-2003

22. Operating exposure • Illustrating of Operating Exposure : Trident • The strategy undertaken depends largely on management's opinion about the price elasticity of demand. • On the cost side, Trident Europe might raise price because of more expensive imported raw material or components. • Trident’s domestic sales and costs might also be partly determined by the effect of the euro devaluation on demand. DES en Gestion - Année académique 2002-2003

23. Operating exposure • Strategic Management of Operating Exposure • The objective of both transaction and operating exposure management is to anticipate and to influence the effect of the changes in FX rates on a firm’s future cash-flows. • To this end, management can : • Diversify operations : sales, location of production facilities, and raw material sources. Flexibility can allow firms to change its operating structure according to international changes (ex. Goodyear and the Mexican Peso devaluation) • Diversify financing : raise funds in more than one capital market and in more than one currency. • A diversification strategy permits the firm to react either actively or passively, depending on management’s risk preferences, and to opportunities presented by disequilibirum conditions in the FX, capital, or products markets. DES en Gestion - Année académique 2002-2003

24. Operating exposure • Proactive Management of Operating Exposure • Operating and transaction exposures can be partially managed by adopting policies that partially offset the effect of FX changes. The four most common used techniques are the following : • 1. Matching currency cash-flow : Ex : exporting US firm in Canada : match the in flows of CAD from its sales by the outflows of part of its debt labeled in CAD. • 2. Risk sharing agreements : contractual arrangements in which the buyer and the seller agree to split currency movements impacts on payments between them. DES en Gestion - Année académique 2002-2003

25. Operating exposure • Proactive Management of Operating Exposure • 3. Back-to-back or parallel loans, or credit swaps : two business firms in separate countries agree to borrow each other’s currency from a limited period of time. At an agreed terminal date, they return to their borrowed currencies. The transaction takes place outside of the FX markets, although the spot quotation can be used as a reference point. • 4. Currency swaps : similar to a back-to-back loan but off balance sheet. Agreement between two parties to exchange a given amount of one currency for another and, after a period of time, to give back the original amounts swapped. Currency swaps can be negotiated for a wide range of maturities and currencies. The swap dealer or swap bank acts as a middleman in setting up the swap agreement. DES en Gestion - Année académique 2002-2003

26. Japanese Corporation United States Corporation Assets Liabilities & Equity Assets Liabilities & Equity Inflow of US$ Inflow of yen Sales to US Sales to Japan Debt in yen Debt in US$ Receive yen Pay yen Receive dollars Pay dollars Swap Dealer Wishes to enter into a swap to “pay dollars” and “receive yen” Wishes to enter into a swap to “pay yen” and “receive dollars” Operating exposure • Proactive Management of Operating Exposure • 4. Currency swaps : DES en Gestion - Année académique 2002-2003