You are on page 1of 52

INTERNATIONAL FINANCIAL MARKETS

Unit # 7: Exposure to Exchange Rate


Fluctuations

By
Kilugala Malimi

CURRENCY EXPOSURE
Foreign

currency exposure is the extent to


which the future cash flows of an enterprise,
arising from domestic and foreign currency
denominated transactions involving assets
and liabilities, and generating revenues and
expenses are susceptible to variations in
foreign currency exchange rates.

1/14/17

Currecy Exposure Management

CURRENCY EXPOSURE: TYPES


Transaction

Economic

exposure

exposure

Accounting/translation

1/14/17

exposure

Currecy Exposure Management

MEASURING TRANSACTION EXPOSURE TO


EXCHANGE RATE FLUCTUATIONS

Transaction Exposure

Transaction

exposure exists when the


anticipated future cash transactions of a firm
are affected by exchange rate fluctuations.
A USbased MNC importing goods from Europe
may need Euros to buy the goods and it may
know exactly how many Euros would be required
for that particular transaction, but it does know
how many US $ would be required to settle the
transaction. This uncertainty happens because
the exchange rate between Euros and US dollar
fluctuates overtime.
1/14/17

Currecy Exposure Management

CONTINUED
Again if US-based MNC will be receiving foreign
currency for the sale of goods to a customer outside
USA is exposed because, it does not know how many
US dollars it would get by exchanging the foreign
currency, though here again it may know the foreign
currency units it expects to receive. If transaction
exposure exists, the firm faces three major tasks:
It must identify its degree of transaction exposure;
It must decide whether to hedge this exposure; and
If it decides to hedge part or all of the exposure, it
must choose among the various hedging technique
available.

1/14/17

Currecy Exposure Management

TRANSACTION EXPOSURE
Source:
Arises

from the possibility of incurring exchange gains


or losses on transactions already entered into which is
denominated in a foreign currency.
That is, when a company buys or sells a good, priced in
a foreign currency, on credit.
The existence of an exposure alerts one to the fact that
any change in currency rates ,between the time the
transaction is initiated and the time it is settled, will
most likely alter the originally perceived financial result
of the transaction.
1/14/17

Currecy Exposure Management

TRANSACTION EXPOSURE
Effect:
The

financial or conversion gain or loss is the difference


between the actual cash flow in the domestic currency and
the cash flow as calculated at the time the transaction was
initiated, i.e., the date when the transaction clearly
transferred the risks and rewards of ownership.
Where financing of a transaction takes place, such as a
loan obligation, there are also gains/losses which may
result.
Transaction exposure represents only the immediate effect
on cash flow of an exchange rate change.
1/14/17

Currecy Exposure Management

SOURCES OF TRANSACTION EXPOSURE


Transaction

exposure arises from:


Purchasing or selling on credit goods or services
whose prices are stated in foreign currencies.
Borrowing or lending funds when repayment 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.
1/14/17

Currecy Exposure Management

SOURCES OF TRANSACTION EXPOSURE


Example:
Suppose

a U.S. firm, Trident, sells merchandise


on account to a Belgian buyer for:
1,800,000 payment to be made in 60 days (2
months).
Spot exchange rate, S0= $0.9000/
The U.S. seller expects to exchange the
1,800,000 for $1,620,000 when payment is
received.
1/14/17

Currecy Exposure Management

SOURCES OF TRANSACTION EXPOSURE


Transaction

exposure arises because of the


risk that the U.S. seller will receive something
other than $1,620,000.
If the euro weakens to $0.8500/, then
Trident will receive $1,530,000
If the euro strengthens to $0.9600/, then
Trident will receive $1,728,000
Thus, exposure is the chance of either a loss
or a gain
1/14/17

Currecy Exposure Management

10

SOURCES OF TRANSACTION EXPOSURE


In

1971, Great Britains Beecham Group


borrowed SF100 million (equivalent to 10.13
million).
When the loan came due five years later, the
cost of repayment of principal was 22.73
million more than double the amount
borrowed!
This is a significant amount; the amount was
more than doubled
1/14/17

Currecy Exposure Management

11

Identifying net
transaction Exposure
Before

taking any decision relating to


hedging, the MNC should identify the
individual net transaction exposure on a
currency-by-currency basis. The term
net here refers to the consolidation of all
expected inflows and outflows for a
particular time and currency which is
reported by each subsidiary to the MNC as
a whole which consolidates the expected
net position in each foreign currency.
1/14/17

Currecy Exposure Management

12

CONTINUED.
One

subsidiary may have net receivables in


dollars three months from now while other
subsidiary may have net payables in dollars. If
dollar appreciates, this will be favorable to the
first subsidiary and unfavorable to the second
subsidiary.
For the MNC as a whole however, the impact is
at least partially offset. Each subsidiary may
desire to hedge its net currency position in
order to avoid the possible adverse impact on
its performance due to fluctuations in the
currencys value.
1/14/17

Currecy Exposure Management

13

Adjusting the invoice policy to manage exposure

In

some circumstances the USA firm may


be able to modify its pricing policy to
hedge against transaction exposure. That
is the firm may be able to invoice (price)
its exports in the same currency that will
be needed to pay for imports. The
matching of inflows and outflows in foreign
currencies does have its limitations.
An MNC will normally be exposed to some
degree of exchange rate risk and
therefore, should consider the various
hedging techniques.
1/14/17

Currecy Exposure Management

14

Techniques to Eliminate
Transaction Exposure
Before

selecting a hedging technique, MNCs


normally compare the cash flows that would be
expected from each technique along with the
reduced risk associated with the hedging. Relative
advantage of the various techniques may change
overtime.
If an MNC decides to hedge part or all of its
transaction exposure, the following hedging
techniques are available:1. Futures hedge
2. Forward hedge
3. Money Market hedge
4.Currency option hedge
1/14/17

Currecy Exposure Management

15

MANAGING BY HEDGING
Hedging

is the taking of a position, either


acquiring a cash flow or an asset or a
contract (including a forward contract) that
will rise (fall) in value to offset a fall (rise) in
value of an existing position.
Hedging, therefore ,protects the owner of the
existing asset from loss (but it also eliminates
any gain resulting from changes in exchange
rates on the value of the exposure).
1/14/17

Currecy Exposure Management

16

TO HEDGE OR NOT TO HEDGE?

1/14/17

Currecy Exposure Management

17

TO HEDGE OR NOT TO HEDGE?


Is

the reduction of variability in cash flows


then sufficient reason for currency risk
management?
This question is actually a continuing debate
in multinational financial management and
corporate finance.
There are several schools of thought.

1/14/17

Currecy Exposure Management

18

MAJOR HEDGING APPROACHES


Financial

contracts:
1) Forward market hedge
2) Money market hedge
3) Option market hedge
4) Swap market hedge
Futures
Operational techniques:
1) Choice of the invoice currency
2) Lead/lag strategy
3) Exposure netting
1/14/17

Currecy Exposure Management

19

MANAGING BY HEDGING
Basic

Hedging Principle:

Hedging

risk involves engaging in a financial transaction that


offsets a long position by taking an additional short position,
or offsets a short position by taking an additional long
position.
LONG POSITION: Taking a position associated with
the purchase of an asset
SHORT POSITION: Taking a position associated with
the sale of an asset

1/14/17

Currecy Exposure Management

20

MANAGING BY HEDGING
Managing

by a hedging is often done by purchasing


derivatives.
A DERIVATIVE is a financial instrument whose
value today or at some future date is derived
entirely from the value of another asset (or group of
other assets), known as underlying asset (assets).
Examples
Futures contracts
Forward contracts
Options contracts
1/14/17

Currecy Exposure Management

21

1. Futures Hedge
Currency

futures can be used by firms that desire to


hedge transactions exposure: These are: Purchasing currency futures:- A firm that buys a
currency futures contract is entitled to receive a
specified amount in a specified currency for a stated
price on a specified date. This is done to hedge a
payment on futures payables in a foreign currency.
Selling currency futures: A firm that sells a
currency futures contract is entitled to sell a
specified amount in a specified currency for a stated
price on a specified date. This is done to hedge the
home currency value of future receivables in a
foreign currency
1/14/17

Currecy Exposure Management

22

Continued.

2. Forward Hedge
Forward

contracts can be used to lock


in the future exchange rate at which
an MNC can buy or sell a currency.
A forward contract is very similar to a
futures contract hedge, except that
forward contracts are commonly used
for large transactions whereas futures
contracts tend to be used for smaller
amounts.
1/14/17

Currecy Exposure Management

23

Continued.

3. Money Market Hedge


A

money market hedge involves taking a


money market position to cover a future
payables or receivables position. Money
market hedge may be on payables or
receivables. If a firm has a payment
(payable) required in a foreign currency in
six months time, it can buy the required
amount of foreign currency now and
deposit it in a bank account denominated
in that currency. In six months time the
money can be used to make the payment.
1/14/17

Currecy Exposure Management

24

Continued.
If

in six months time, a firm expects


receivables in a foreign currency, it
can
hedge
this
position
by
borrowing the present value of the
receivables now in that currency
and converting the amount into the
home
currency.
The
foreign
receivables can then be left to repay
the foreign borrowing and will
therefore not be converted again.
1/14/17

Currecy Exposure Management

25

Continued..

4. Currency Option Hedge


Firms

recognize that hedging techniques


such as the forward hedge and money
market hedge can backfire when payables
are made in a currency that depreciates or a
receivable earned in a currency that
appreciates over a hedge period.
In these situation an un-hedged strategy is
like to outperform the forward hedge or
money market hedge.
continued
1/14/17

Currecy Exposure Management

26

Currency

options provide the right to purchase or sell


currencies at specified prices.
Currency option can either be call option or put option
Currency Call Options
A currency call option grants the right to buy a specific
currency at a designated price within a specific period
of time.
The price at which the owner is allowed to buy that
currency is known as the exercise price or strike price,
and there are monthly expiration dates for each option.
1/14/17

Currecy Exposure Management

27

Call

options are desirable when one wishes to lock in


a maximum price to be paid for a currency in the
future. If the spot rate of the currency rises above the
strike price, owners of call options can exercise their
options by purchasing the currency at the strike price,
which will be cheaper than the prevailing spot rate.
The owner can choose to let the option expire on the
expiration date without ever exercising it. Owners of
expired call options will have lost the premium they
initially paid, but that is the most they can lose.
1/14/17

Currecy Exposure Management

28

currency call option is said to be in the money


when the present exchange rate exceeds the
strike price, at the money when the present
exchange rate equals the strike price, and out of
the money when the present exchange rate is
less than the strike price.
For a given currency and expiration date, an inthe-money call option will require a higher
premium than options that are at the money or
out of the money.
1/14/17

Currecy Exposure Management

29

Factors Affecting Currency Call Option


Premiums
The

premium on a call option represents the


cost of having the right to buy the underlying
currency at a specified price. For MNCs that
use currency call options to hedge, the
premium reflects a cost of insurance or
protection to the MNCs.
The call option premium (referred to as C) is
primarily influenced by three factors;

1/14/17

Currecy Exposure Management

30

CONTINUED
Three

factors
influence
the
option premium:The difference between the spot
exchange rate and the strike price;
The time to maturity; and
The volatility of the currency as
measured by the standard deviation
of the movements in the currency
1/14/17

Currecy Exposure Management

31


where

S - X represents the difference between the spot


exchange rate (S) and the strike or exercise price (X), T
represents the time to maturity, and represents the
volatility of the currency, as measured by the standard
deviation of the movements in the currency.
Level of existing spot price relative to strike price.
The higher the spot rate relative to the strike price, the
higher the option price will be.
This is due to the higher probability of buying the
currency at a substantially lower rate than what you
could sell it for.
1/14/17

Currecy Exposure Management

32

Length

of time before the expiration date


It is generally expected that the spot rate has a greater
chance of rising high above the strike price if it has a longer
period of time to do so.
A settlement date in June allows two additional months
beyond April for the spot rate to move above the strike price.
Potential variability (Volatility)of currency as measured by
standard deviation
The greater the variability of the currency, the higher the
probability that the spot rate can rise above the strike price.
Thus, less volatile currencies have lower call option prices
1/14/17

Currecy Exposure Management

33

Continued..
Hedging

payables with currency call options


A currency call option provides the right to buy a
specified amount of a particular currency at a
specified price within a given period of time, yet
unlike a futures or forward contract, the currency
call option does not oblige its owner to buy the
currency at that price.
If the spot rate of the currency remains lower than
the specified price throughout the life of the
option, the firm can let the option expire and
simply purchase the currency at the existing spot
rate. Like currency call options, currency put
options can be a valuable hedging device.
1/14/17

Currecy Exposure Management

34

Speculating with Currency Call Options


Individuals

may speculate in the currency options


market based on their expectation of the future
movements in a particular currency. Speculators
who expect that a foreign currency will
appreciate can purchase call options on that
currency.
Once the spot rate of that currency appreciates,
the speculators can exercise their options by
purchasing that currency at the strike price and
then sell the currency at the prevailing spot rate.
1/14/17

Currecy Exposure Management

35

Speculators

may sometimes want to sell a


currency call option on a currency that they
expect will depreciate in the future.
The only way a currency call option will be
exercised is if the spot rate is higher than the
strike price.
Thus, a seller of a currency call option will
receive the premium when the option is
purchased and can keep the entire amount if the
option is not exercised.
1/14/17

Currecy Exposure Management

36

The

net profit to a speculator who trades call


options on a currency is based on a
comparison of the selling price of the
currency versus the exercise price paid for
the currency and the premium paid for the
call option.

1/14/17

Currecy Exposure Management

37

Currency Put Options


The

owner of a currency put option receives


the right to sell a currency at a specified price
(the strike price) within a specified period of
time.
As with currency call options, the owner of a
put option is not obligated to exercise the
option.
Therefore, the maximum potential loss to the
owner of the put option is the price (or
premium) paid for the option contract.
1/14/17

Currecy Exposure Management

38

currency put option is said to be in the money


when the present exchange rate is less than the
strike price, at the money when the present
exchange rate equals the strike price, and out of
the money when the present exchange rate
exceeds the strike price.
For a given currency and expiration date, an inthe-money put option will require a higher
premium than options that are at the money or
out of the money.
1/14/17

Currecy Exposure Management

39

Factors Affecting Currency Put Option


Premiums
The

put option premium (referred to as P) is


primarily influenced by three factors:

where

S - X represents the difference


between the spot exchange rate (S) and the
strike or exercise price (X), T represents the
time to maturity, and s represents the
volatility of the currency, as measured by the
standard deviation of the movements in the
currency.
1/14/17

Currecy Exposure Management

40

Factors Affecting Currency Put Option


Premiums
First,

the spot rate of a currency relative to the strike price is


important.
The lower the spot rate relative to the strike price, the more
valuable the put option will be, because there is a higher
probability that the option will be exercised.
Recall that just the opposite relationship held for call options.
A second factor influencing the put option premium is the length of
time until the expiration date.
As with currency call options, the longer the time to expiration, the
greater the put option premium will be.
A longer period creates a higher probability that the currency will
move into a range where it will be feasible to exercise the option
(whether it is a put or a call).
1/14/17

Currecy Exposure Management

41

third factor that influences the put option


premium is the variability of a currency.
As with currency call options, the greater the
variability, the greater the put option
premium will be, again reflecting a higher
probability that the option may be exercised.

1/14/17

Currecy Exposure Management

42

Hedging

receivables with currency put

options
A currency call option provides the right to
buy a specified amount of a particular
currency at a specified price within a given
period of time, yet unlike a futures or forward
contract, the currency call option does not
oblige its owner to buy the currency at that
price.
1/14/17

Currecy Exposure Management

43

Speculating with Currency Put Options


Individuals

may speculate with currency put options


based on their expectations of the future movements
in a particular currency. For example, speculators
who expect that the British pound will depreciate can
purchase British pound put options, which will entitle
them to sell British pounds at a specified strike price.
If the pounds spot rate depreciates as expected, the
speculators can then purchase pounds at the spot
rate and exercise their put options by selling these
pounds at the strike price.
1/14/17

Currecy Exposure Management

44

Speculators

can also attempt to profit from selling currency

put options.
The seller of such options is obligated to purchase the
specified currency at the strike price from the owner who
exercises the put option.
Speculators who believe the currency will appreciate (or at
least will not depreciate) may sell a currency put option.
If the currency appreciates over the entire period, the
option will not be exercised. This is an ideal situation for
put option sellers since they keep the premiums received
when selling the options and bear no cost
1/14/17

Currecy Exposure Management

45

TRANSLATION EXPOSURE
MNCs

effectively hedge its given level of


translation exposure
Translation exposure occurs when an MNC
translates each subsidiary financial data to its
home currency for consolidated financial
statements.
Evan if translation exposure does not affect cash
flows; it is a concern of many MNCs because not
hedging translation exposure can reduce an
MNCs consolidated earnings and risks causing a
decline in its share price. Thus
MNCs may
consider hedging their translation exposure.
1/14/17

Currecy Exposure Management

46

Continued

Very

often annual reports of


many
MNCs
make
such
statement that while the Group
uses short term hedging for
trading activities, the company
does not believe that it is
appropriate or practicable to
hedge long term translation
exposure and in addition to this
the MNCs state that the group
1/14/17

Currecy Exposure Management

47

Continued.
Hedging

a translation exposure does not


further the wealth of the shareholders and
therefore is not appropriate as expenditure.
MNCs can use forward contracts or futures
contracts to hedge translation exposure.
Specifically, they can hedge the currency
using forward contract that their foreign
subsidiaries to receive as earnings. In this
way, they create a cash outflow in the
currency to offset the earnings received in
that currency.
1/14/17

Currecy Exposure Management

48

Continued..

Whether more established or less established


MNCs can better predict its level of foreign
earnings, the given question is intended to
stimulate class discussion.
There is no perfect answer. One answer is that a
more established MNC can better predict its level
of foreign earnings because its foreign business
is stabilized. Therefore, it is more able to hedge
the appropriate amount of foreign earnings.
Less established MNC is still in a process of
stabilizing its operations; it may not be in a
position to effectively hedge its given level of
translation exposure.
1/14/17

Currecy Exposure Management

49

Limitations of Hedging Translation


Exposure

Suppose Oakville Company is a US-based


multinational corporation that has European
subsidiaries and wants to hedge its
translation exposure to fluctuation in the
euros value. Following are the limitations
when Oakville Company a US based MNC
hedges its translation exposure: Oakville
Company needs to forecast its
foreign subsidiary earnings and may forecast
inaccurately. Thus it will hedge against a level
of foreign earnings that differs from actual
foreign earnings.
1/14/17

Currecy Exposure Management

50

Continued
Forward

contracts are not available for all currencies,


although Oakville Company will not be affected by this
limitation since forward contracts in Euros are available.
Translation losses are not taxdeductible, while gains on
forward contract used to hedge transaction exposure
are taxed.
Transaction exposure may be increased as a result of
hedging strategy on translation exposure.
Forward rate gain or loss reflects the differences
between the forward rate and the future spot rate,
whereas the translation gain or loss reflects the
differences between the average exchange rate over
the period of concern and the future spot rate.
A translation loss is not a real loss as it does not affect
the value of a multinational company in an efficient
market.
1/14/17

Currecy Exposure Management

51

ECONOMIC EXPOSURE
The degree to which a firms present value of future
cash flows can be influenced by exchange rate
fluctuations is referred to as economic exposure to
exchange rates.
The types of anticipated future transactions that cause
transaction exposure also cause economic exposure
because these transactions represent cash flows that
can be influenced by exchange rate fluctuations.
Thus economic exposure can be defined as the extent
to which the value of the firm would be affected by
unanticipated changes in exchange rates. Any
anticipated changes in exchange rates would have
already been discounted and reflected in the firms
value.
1/14/17

Currecy Exposure Management

52