4 types of exposure

1. 4 types of exposure • Exposure (to FX risk): firm is affected by a change in the exchange rate • Transactions Exposure: firm’s cash flow • Operating Exposure: firm’s cash flow • Accounting Exposure: firm’s financial statements • Translation Exposure: firm’s financial statements

2. Transactions Exposure • Contractual: contract exists that specifies a certain amount of FX will be received/paid e.g. export/import, debt denominated in FX. • Change in the FX rate results in gain/loss. • FX receipt worry: FX depreciation • FX payment worry: FX appreciation • Transactions exposure is reflected in the firm’s financial statements, i.e. firm with transactions also has accounting exposure.

3. Hedging a future FX receipt • Worry: FX depreciation • Sell the FX forward: sign contract now with bank committing to sell the FX at the future date at a rate set now • Will receive Y10 million at year end • Hedge by selling Y10 million one-year forward at one-year forward rate • The C$-value of the Y10 million is now set, i.e. now know the C$-value

4. Hedging a future FX payment • Worry: FX appreciation • Buy the FX forward: sign contract now with bank committing to buy the FX at the future date at a rate set now • E.g. will pay Y10 million at year end • Hedge by buying Y10 million one-year forward at one-year forward rate. • The C$-value of the Y10 million is now set, i.e. now know the C$-value of the FX payment

5. Operating Exposure • Non-contractual: no contract exists, yet firm is exposed • Change in the exchange rate results in gain or loss of competitive advantage • Explored in 3 vignettes document • Effects of operating exposure do not appear on the firm’s financial statements • Explored in Canuck Ltd.’s accounting exposure

6. 3 operating exposure vignettes • 1. Aspen Skiing (US firm): Revenues exhibited positive operating exposure to French franc, C$, Italian lira, etc. • 2. Laker Airways (UK firm): Ditto, but negative operating exposure to U$. • 3. Canuck Ltd. (Canadian firm): Positive operating exposure to UK pound sterling.

7. Aspen Skiing • Colorado resort: all balance sheet items and cash flows in greenbacks. • Yet exposed to C$, FFr, etc. • In 1983, U$ appreciated, I.e. C$, FFr depreciated. • Domestic and foreign clientele shifted holidays to Banff, Chamonix, Chicopee.

8. Aspen Skiing Y-axis: Cash flows in U$; X-axis: S(U$/C$)

9. Aspen Skiing: Lesson Gleaned Although you operate exclusively domestically, if your clientele has the option of purchasing in a foreign market, you exhibit positive exposure to that foreign market’s currency. A U.S. firm with Aspen Skiing as client likewise possesses the same type of exposure.

10. Aspen Skiing: Two Hedges • Hedge positive operating exposure of cash flows to C$, FFr, etc. • Denominate some debt in C$, FFr, etc.Result: negative transactions exposure of debt offsets positive operating exposure of revenues. • Buy resorts in Canada, France, etc. Result: some revenue streams rise, other fall with rise in C$, FFr, etc.

11. Laker Airways • Early exploiter of air transport deregulation in late 70’s. Target market: Price conscious Brit tourists vacationing in Florida. • Cost structure: jet fuel U$-denominated. • Financed jets with cheap U$-debt provided by US Ex-Im Bank. • Steep U$ appreciated in early 80’s spelled doom for Laker Airways.

12. Laker Airways’ Exposures • Jet fuel: both transactions and operating exposure to U$. • Debt: transactions exposure to U$. • Revenues: negative operating exposure to U$. When U$ appreciated target clientele shifted holidays from Florida to Palma de Mallorca, Islas Canarias, Marbella, etc.

13. Laker Airways: Lessons Gleaned • If your business involves assisting a domestic clientele purchase goods/services in a foreign country, you have negative operating exposure to that foreign country’s currency. • Dollar denomination of debt aggravated the firm’s negative exposure to the greenback.

14. Sir Freddie’s Egregious Error • Error: Denominated debt in U$’s. • Appreciation of U$ resulted in: Sterling value of costs and debt service increasing; Sterling value of revenues decreasing. • Sir Freddie got squeezed! • Hedges: debt denominated in Sterling; cater to Yank clientele vacationing in UK.

15. Canuck Ltd. • Canadian firm operating exclusively in Canada with no FX denominated assets/contracts. • Major competitor in Canada sources product in the UK. • Canuck Ltd. has positive exposure to the Pound Sterling, PS. If PS appreciates, Canuck gains competitive advantage. • Hedge with PS denominated debt.

16. Accounting Exposure • Effects of FX rate changes that are reflected in the firm’s financial statements. • Transactions exposure is reflected. • Translation exposure is reflected. • Operating exposure is not reflected. • Accounting Exp. comprised of Transactions Exp. & Translation Exp

17. Translation Exposure • Parent company has a foreign subsidiary • Foreign subsidiary’s financial statements must be consolidated (combined) with those of parent • E.g. Canadian parent (C$) vs. Chinese subsidiary (RMB) currency • Subsidiary’s statements are FX denominated • If FX (RMB) rate changes, consolidated statements are impacted: translation exposure!

18. Subsidiary’s Functional Currency • Primary currency of the subsidiary’s activities, i.e. in which cash flows are generated • 2 possibilities: parent’s currency (C$) versus subsidiary’s currency (RMB) • Distinction: subsidiary’s currency versus subsidiary’s functional currency

19. Subsidiary is self-sustaining • Most foreign subsidiary’s sales in the foreign country. It is a freestanding entity with self-contained operations • Functional currency is foreign (RMB) • Translation via current rate method • All assets / liabilities translated at the rate prevailing on the balance sheet date

20. Subsidiary is integrated with parent • Most foreign subsidiary’s sales in the parent country; a mere extension of parent, i.e. not freestanding • Subsidiary’s functional currency is parent’s currency (C$) • Translation via temporal method • Only monetary assets / liabilities translated at the rate that prevails on the balance sheet date.

21. Subsidiary’s Monetary • Assets: cash, marketable securities, accounts receivable • Liabilities: current liabilities, all debt (short term and long term) • Monetary means promises a fixed amount of currency • Nonmonetary: inventory, fixed assets, equity

22. Hedging Translation Exposure • Net Translation Exposure (NTE) in FX • Sell the amount of NTE forward: write contract now with bank committing to sell the amount of NTE at year-end • E.g. NTE=Y10 million; Hedge by selling Y10 million one-year forward • If NTE=-Y4 million, buy Y4 million forward; selling a negative quantity means buying