International Financial Management P G Apte

1. CHAPTER - 3 The Nature and Measurement of Exposure and Risk International Financial Management P G Apte P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

2. SOME TYPICAL CURRENCY RISK SITUATIONS P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

3. It is December 1, 2009. An Indian pharmaceutical company has cleared a shipment of imported chemicals. The invoice is for $500,000 payable on March 3, 2010. The current exchange rate is Rs.46.60 per dollar. The recent history of the exchange rate shows a mixed trend with moderate volatility. During the latter half of 2007 dollar had shown considerable weakness against all currencies including the rupee. During early 2008, the rate was almost flat around Rs.40.00. Dollar was rising against the rupee in early 2009. An adverse movement in exchange rate will affect the firm’s cash flows. There is also the problem of how to value the imports for the purpose of product costing and pricing decisions. What should the firm do? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

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6. A US firm has exported some computer peripherals to a German buyer. For customer relationship reasons the sale has been invoiced in buyer’s currency viz. Euro. The invoice is for €1,000,000 to be settled 90 days from now. The current exchange rate is $1.4715 per Euro. The recent history of the dollar-euro rate shows a mixed down - up trend with some fluctuations. The firm’s bankers are fairly bullish about the Euro despite the recessionary conditions in the major European economies viz. Germany and France. However US treasury secretary has expressed concern about the weak dollar. • What should the firm do? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

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9. Caterpillar is an American firm which manufactures heavy construction equipment. At the start of the 1980’s all its manufacturing operations were located in the US while it sold its products around the world priced in local currencies. Its nearest competitor was Komatsu of Japan. Around mid-1981 the US dollar started rising against all currencies and continued rising month after month. Caterpillar found that its revenues measured in dollars were shrinking while costs kept pace with US inflation. Margins shrank. It could not compensate by raising local currency prices in export markets because Komatsu was holding the price line. How could Caterpillar cope with this? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

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12. Gems and jewelry exporters from India face stiff competition from firms in Thailand, Indonesia and Malaysia. After the East Asian currency crisis in the summer of 1997, some of these currencies crashed against the US dollar by as much as 60-80%. While rupee also fell, its fall was much smaller. Indian exporters lost market share as the East Asian exporters reduced prices in the light of falling currencies. From time to time Indian exporters and their federations like FIEO clamor for steeper fall in the rupee to maintain their competitive position. How can firms cope with this? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

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19. A Swiss pharmaceutical firm has a US subsidiary. Financial statements of the subsidiary are denominated in US dollars. • The financial year of the Swiss parent firm is September-August. On the balance sheet date it must translate the balance sheet and P-L account of its US subsidiary from dollars to Swiss francs. • During the last few months the US dollar has been weakening against the Swiss franc. On translation, the value of assets and liabilities would show a decline; if assets exceed liabilities, there would be a net loss. • Can anything be done about it? Should anything be done? How should the gains/losses be accounted for? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

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22. 3.1 The Nature of Exposure and Risk • Macroeconomic environmentalrisks • Core business risks • While core business risks are specific to a firm, macroeconomic uncertainties affect all firms in the economy • Extent and nature of impact of even macroeconomic risks crucially depend upon the nature of a firm's business P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

23. 3.1 The Nature of Exposure and Risk (contd.) • The firm is "exposed" to uncertain changes in a number of variables in its environment - Risk Factors • Long run response of the firm to these risks can involve significant changes in the firm's strategic posture • Exchange rates and interest rates are two of the key macroeconomic risk factors P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

24. 3.1 The Nature of Exposure and Risk (contd.) • Exchange rates, interest rates and inflation rates are intimately interrelated • Exposure and Risk • Exposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor • risk is a measure of the variability of the value of the performance measure attributable to the risk factor P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

25. 3.1 The Nature of Exposure and Risk (contd.) • The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g. • Exchange rate risk depends on how sensitive is the performance indicator to exchange rate fluctuations and what is the extent of likely fluctuations in the exchange rate. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

26. Risk Management and Wealth Maximization • What should be the attitude of the firm's management regarding firm-specific risks? • Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive; however they affect different firms in different ways and are therefore firm-specific or idiosyncratic. • Should the firm spend resources to manage such risks? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

27. Why Hedge? 0 • The value of a firm, according to financial theory, is the net present value of all expected future cash flows. • Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. • A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

28. Arguments against active hedging: • Removing unsystematic risks does not add value. Stockholders can diversify • M&M thesis: Shareholders can do it themselves • Firm cannot beat efficient markets • Risk removal is costly – those who take on the risk must be compensated. Will there be value addition after paying these costs? • Active risk management must alter character of cash flows in a manner beneficial to shareholders and do it cheaper than what they can do on their own. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

29. Why Hedge? Reasons not to hedge 0 • However, is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things): • Currency risk management reduces the variance of the cash flows of the firm, but also uses valuable resources. • Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

30. Arguments for Hedging: • Investment-Internal Finance linkage • Costs of being perceived as being in financial distress • Agency theoretic arguments • Convex tax schedules • Managers have better information and access to various financial markets than shareholders • For an MNC with global shareholders with different currency habitats it is not clear that hedging benefits all shareholders P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

31. Why Hedge? Reasons to hedge 0 • Proponents of hedging cite: • Reduction in risk in future cash flows improves the planning capability of the firm • Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress) • Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm • Management is in better position to take advantage of disequilibrium conditions in the market P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

32. Is Exchange Rate Risk Relevant? • Purchasing Power Parity Argument: • Exchange rate movements will be matched by price movements. • PPP does not necessarily hold. • The Investor Hedge Argument: • MNC shareholders can hedge against exchange rate fluctuations on their own. • The investors may not have complete information on corporate exposure. They may not have the capabilities to correctly insulate themselves too. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

33. Is Exchange Rate Risk Relevant? • Currency Diversification Argument: • An MNC that is well diversified should not be affected by exchange rate movements because of offsetting effects. • This is a naive presumption. • Stakeholder Diversification Argument: • Well diversified stakeholders will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. • MNCs may be affected in the same way because of exchange rate risk. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

34. The Nature of Exposure and Risk • Core business risks • Macroeconomic “Environmental” Risks • Risk Factors • Exchange rates and interest rates are two of the key macroeconomic risk factors • Long run response of the firm to these risks can involve significant changes in the firm's strategic posture • Exchange rates, interest rates and inflation rates are intimately interrelated P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

35. The Nature of Exposure and Risk • Exposure and Risk • Exposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor • Risk is a measure of the variability of the value of the performance measure attributable to the risk factor The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g. exchange rate P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

36. Exposure and Risk: A Formal Approach • Exposure of a firm to a risk factor is the sensitivity of the real value of a firm's assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in the risk factor • V : Change in the real domestic currency value of an item • S : The current value of the risk factor • Su : Unanticipated change in the value of the risk factor e.g. exchange rate Then exposure = V/ Su P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

37. An Example : A company has a US$ 500000 receivable from an American customer to be received 3 months from today. The current rupee-dollar rate is 47.50; The market is quoting a 3- month forward rate at 48.00; The forward rate can be taken as market’s expectation of what the rupee-dollar rate will be 3 months from now. Thus the expected change in exchange rate is (48.00-47.50) or +0.50. Three months later, the rupee-dollar rate falls to 46.80. Total change: (46.80-47.50) = -0.70; Expected change : +0.50 Unexpected change : -1.20 Change in the value of receivable: (46.80-48.00)(500000) Exposure : [(46.80-48.00)($500000)]/(-1.20) = $500000 P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

38. Currency Exposure: A Foreign Currency Liability P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

39. Currency Exposure: A Foreign Currency Asset P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

40. Exposure and Risk: A Formal Approach • The relation between V and Su can be represented by the following equation • V = 0 + 1(Su) • 1 is a measure of the sensitivity of V to changes in S – “Exposure” • V is in million rupees and Su is in rupees per dollar, the units of measurement for the exposure, 1, are millions of dollars P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

41. Exposure and Risk: A Formal Approach • Risk is the variance of the real domestic currency value of assets, liabilities or operating income attributable to unanticipated changes in exchange rates Vs = 0 + 1(Su) Vs is the change in value attributable to unanticipated change in the exchange rate • Foreign exchange risk is defined as the variance of Vs var(Vs) = 12[var(Su)] P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

42. TAXONOMY OF CURRENCY EXPOSURE Effect of exchange rate changes on anticipated transactions P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

43. Taxonomy of Currency Exposure P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

44. Time 0 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure Moment in time when exchange rate changes Translation exposure Operating exposure Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates Change in expected future cash flows arising from an unexpected change in exchange rates Transaction exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

45. Exchange Rates Used in Various Translation Methods Current Temporal Monetary Current NonCurrent NonMonetary Rate Cash, Current Receivables & Payables C C C C  Inventory C C or H H C  Fixed Assets H H H C Long-Term Receivables & Payables H C C C Note : "C" denotes current rate, "H" denotes historical rate. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

46. Translation Exposure: Illustration In the illustration, it is assumed that an Indian company is translating the balance sheet of a foreign entity into rupees. The "current rate", which is the rate on the balance sheet date of the parent is assumed to be LC 1 = Rs.1.50 while the "historical rate" is assumed to be LC 1 = Rs.1.00. Here "LC" stands for "Local Currency” and “HC” for parent’s home currency P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

47. LCCurrent Monetary Current Temporal Non -Non-Rate Method Current Monetary (Rs.) (Rs.) (Rs.) (Rs.) ______________________________________________________ Cash 200 300 300300 300 Inv. 300 450 300 450 450 Fixed Assets 800 800 800 1200 800 ------- ------- ------- --------- -------- 1300 1550 1400 1950 1550 Curr. Liab.200 300 300 300 300 LT Debt 300 300 450 450 450  NW 800 950 650 1200 800 P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

48. Time and Events t1 t2 t3 t4 Seller quotes a price to buyer (in verbal or written form) Buyer places firm order with seller at price offered at time t1 Seller ships product and bills buyer (becomes A/R) Buyer settles A/R with cash in amount of currency quoted at time t1 Quotation Exposure Backlog Exposure Billing Exposure Time between quoting a price and reaching a contractual sale Time it takes to get paid in cash after A/R is issued Time it takes to fill the order after contract is signed 0 The life span of a transaction exposure P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

49. Classification of Currency Exposure • An alternative but similar in spirit approach to classification of currency exposure focuses on the length of the time horizon and whether or not the exposure impacts on the end-of-the horizon financial statements • Accounting exposure is used for short-term exposures which will have an impact on the financial results • Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rate and is horizon is medium term • Strategic exposure refers to a still longer horizon and contemplates longer-term operational flexibility such as changing product-market mix, shifting location of operations and adopting new technologies P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

50. Classification of Currency Exposure • “Value-based" exposure which focuses on the impact of currency fluctuations on market value of the firm that takes into accountboth short-term accounting exposures as well as operating and strategic flexibility in responding to currency movements P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT