Transcript CORPORATE FINANCE

Measuring & Managing
Accounting Exposure

“Foreign exchange exposure” refers to the degree
to which a company is affected by exchange rates
changes

Three basic types of forex exposure:
1.
Translation exposure
2.
Transaction exposure
3.
Operating exposure
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
Accounting exposure arises from the need
(for
purposes
of
reporting
and
consolidation)
to
convert
financial
statements of foreign operations to local
currency  i.e. from FC to HC.

If exchange rates have changed since the
last accounting period, foreign exchange
gains or losses will be reported
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Accounting
Exposure
Translation Exp.  simply the difference bet.
exposed assets and exposed liabilities.
Exposure that arises from the need to
translate FC denom. financial stats into HC
for purpose of consolidation
Transaction Exp.  the extent to which a given Δ
the value of forex denominated transactions
already entered into.
i.e.  future gains / losses on transaction
already agreed to.
Under accounting exposure  its mostly translation exposure, less
transaction exp.  the latter will be covered more under economic exposure.
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
The translation of foreign operation financial statements are
governed by rules estblished by the FASB (Financial Accounting
Standards Board).

These rules were meant to ensure consistency and standardize
reporting / translation, but (1) the diff. avail. methods and (2) the
question of which and when an asset / liability is exposed – has led to
continuing controversy.

Whatever it is, we must keep in mind that the differences in the
methods are of an accounting nature and need not necessarily mean
 in cash flows.

Just as there are diff. methods used to measure the same thing in
accounting  e.g. inventory or depreciation, there are 4 principal
methods of translation.
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1. Current/Non-current method.
2. Monetary/ Non-monetary method.
Translation Methods
3. Temporal method.
4. Current rate method.
1. Current / Non-Current Method
Balance Sheet
All current assets & liabilities.  translated at current exchange rate.
All non-current assets & liabilities.  translated at historical exchange rate. i.e. the rate at time it
was bought / sold etc.
*So translation gains/losses will arise solely due to whether it’s current asset & current liability.
if CA > CL
then  gain if LC of foreign subsidiary. appreciates; loss if LC depreciates
if CA < CL
then  loss if LC of foreign subsidiary appreciates; gain if LC depreciates
Income Statement
Translated at average exchange rate of the accounting period.
Except for items assoc. with non current assets/liab. e.g. depreciation  trans. at the same rates that
were used for fixed assets in the balance sheet. (historical exchange rate)
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(current – exch. Rate)
2. Monetary / Non Monetary Method
Differentiates between
( current exch. rate)
Monetary assets/liab.
Non monetary
assets/liab.
(historical rate)
Eg. a/c. rec;. cash
A/c pay; bank OD etc.
LT. debt
Physical assets - fixed
asset.
Ret. Earns etc.- inventory
Income Statement
Average exchange rate of period except for items related to non-monetary items
of B. Sheet  eg. depreciation. And cost of goods  at rate applied to fixed assets.
and Inventory in Balance Sheet.
 As such, under mon./ non-mon. method, COGs may be translated at
historical rate (used for inventory), while sales at the average exchange rate
of a/c period.
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TRANSLATION EXPOSURE
OPERATING EXPOSURE
Changes in income statements &
book value of assets and
liabilities (caused by an
exchange rate change)
Changes in future operating cash
flows (caused by an exchange
rate change)
Exchange gains & losses are real
Exchange gains & losses are paper
only
Impacts revenues and costs
associated with future sales
Impacts balance sheet assets and
liabilities & income statements
that already exist.
TRANSACTION EXPOSURE
Affects value of outstanding forex
denominated contracts
Contracts entered into, but to be
settled at a later date
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3.
Temporal Method
Balance Sheet

Really a variant of monetary/non-monetary method. Only diff. is that
under this method, inventory can be valued in balance sheet at
market values.

Note : In monetary/non-monetary  inventory always at historical
values
 Income statement
 again exactly same as monetary / non-monetary method ( average /
historical)
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4. Current Rate Method

All balance sheet and income statement items are
translated at current exchange rate.

Thus if FC denominated assets > FC denominated
liabilities
Then  FC appreciation  gain
 FC depreciation  loss
* The other way round, if FC-assets <FC-liabilities: loss if FC
appreciates; gain if FC depreciates
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
As can be seen from Exhibit 10.2 in the text book there is wide
variation in the reported gains/losses.

FASB 8 means that US companies had to use the temporal method 
the Board’s reason in choosing this method over others was
consistency with GAAP (Generally Accepted Accounting Principles)

FASB 8 also disallows the establishment of reserves against which
companies previously added gains or deducted losses  thereby
cushioning the impact of exch. rate Δ on reported numbers  esp.
profits.

This led to widespread dissatisfaction with FASB 8, and was replaced
by FASB 52
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Balance Sheet  firms must use current method for FC
Allowed estb. Of “cumulative translation adjustment” in bal. Sheet in which trans. gains / losses can be adjusted.  i.e. brought back reserves a/c.
1.FASB 52
Balance Sheet  firms must use current
method for DC-denomin assets/liabilities.
Income stat.  all items to be translated at
either the exchange rate on date the items are
recognized or a weighted av. Exch. Rate for the
period.
2. Allows establishment of “cumulative translation adjustment” in balance sheet
in which transaction gains / losses can be adjusted.
3. FASB 52  also differentiates bet. functional currency and reporting currency.
Currency of primary
econ. environ. of
foreign subsidiary
Parents’ HC currency
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
For a foreign subsidiary producing and selling within a foreign
country, the functional currency would be FC; for assembly
operations for exports  the functional currency could still be the
USD - i.e. parent’s HC. Eg. Motorola, Intel, etc.

Occasionally, a foreign subsidiary’s functional currency could be a
third currency. Eg. American subsidiary located in Singapore
producing telephone equipment for China, etc. (SGD as functional
currency).

FASB 52  also states that in the case of a hyperinflationary country,
defined as country with more than 100% inflation, functional currency
must be USD regardless.
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Transaction Exposure

Relates to the possibility of incurring future exchange gains or losses
on transactions already entered into and denominated in a foreign
currency.

A company’s transaction exposure is measured currency by currency,
and equals the difference between contractually fixed future cash
inflows and outflows in each currency.

Some of these unsettled transactions, such as long-term debts, etc.
would already have shown up in the Bal. Sheet, but others esp. off bal.
sheet items - like leasing agreements, agreements for future
buying/selling in FC etc. - are not included.

*Thus, while a firm could show very little translation exposure, it could
have substantial transaction exposure that may only show up later.
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Accounting Exposure in Perspective

*Recall that accounting is by nature retrospective;
 i.e. historical  tells what happened in past.

Often, accounting values may have little semblance to market values.

As a result, accounting exposure could give a misleading picture of a
firm’s true-economic exposure  which is prospective.

So, emphasizing accounting exposure, esp. translation exposure, alone
may be myopic. E.g. by translation exposure, you could get gains by 
liabilities in a depreciating currency, however, if you did that, you face
transaction exposure  since, the currency could begin to appreciate in
the subsequent year!
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
By “managing” we mean trying to anticipate and
reduce the impact of transaction exposure.

Built around the concept of “hedging” broadly
defined  i.e. not just using forward / futures
contracts, but other actions to reduce impact.

So, “managing” really means first (1) identifying
which exposures need to be managed (2) then,
having identified, how do we reduce the impact.
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Which exposure
Managing
Exposure
How do we reduce the
impact?
Recall that
Accounting Exposure
Translation expo.
Transaction expo.
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How to Manage Transaction Exposure

Since transaction exposure is exposure
arising from commitments made today
that will have cash-flows in the future,
protective measures will mean entering
into FC transactions whose cash flow (CF)
will exactly offset the CF of the transaction
exposure.
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
Illustration: Managing Transaction Exposure
GE has sold turbine blades to Lufthansa. Contract awarded 1st January.
Lufthansa will pay GE: DM 25 mil. on 31st December.
e0  $0.4 0 p erDM

e  $0.3 8 2 8p erDM

Obviously, this is a typical transaction exposure.
How can GE protect itself from this exposure?
Several alternatives are available.
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
Forward Mkt. Hedge  GE can short 1 year DM forward

Currency Futures Contracts

Currency Options

Risk Shifting

Pricing Strategy

Exposure Netting

Currency Risk Sharing

Money Market Hedge

Currency Collars
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
GE could have shifted all currency exposure risk on to Lufthansa, if
Lufthansa had agreed to pay GE in USD.

Invoicing in USD does not eliminate risk, it merely shifts it to the
customer.

So, risk-shifting is a zero sum game. Yet, in international
business firms often try to invoice exports in a strong
currency and imports in weak currencies.
 *Unless, your customer is ill informed, customer will only
agree to pay in USD if it is not going to cost much more
in home currency.
 Suppose Lufthansa agrees only to pay up to $ 9.57 mil
(DM 25 mil. x 0.3828 = $9.57)
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
*Note : If GE is also well-informed $9.57 mil.
should also be acceptable to them since it is
arrived at using the expected 1-year exchange
rate (forward rate)

If GE had quoted DM25 mil, thinking it can get $10
mil. (using e0 i.e. spot rate) 1 year from now,
they’ve been ignorant.

Thus, when both parties are well informed
players, risk-shifting cannot work.
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

The idea here is to price the product in FC using the expected forward
rate and not at current spot rate (e0).
For e.g. In this case, GE should have priced the turbine :
$10,000 ,000
 DM 26 .12 mil .
0.3828
if they wanted to be paid $10 million

So, where FC expected to , charge more using the lower expected rate,
while if FC expected to , you can afford to charge the same or less.

We could use appropriate expected rates (forward rates) or take a
weighted average.

Using the pricing decision (i.e. using ê1 rather than e0) to reduce
transaction exposure is merely recognizing the fact that a DM today is
not equal to DM received at a future date.
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
Involves offsetting exposures in one currency with exposures in the
same currency or another currency where exchange rates are
expected to move in such a way that losses (gains) on the initial
position will be offset by gains (losses) on the second position.

For example, in the GE case, since they’re long DM 25 mil to be
received in a year, this could be offset by creating a liability that will
be payable in exactly 1 year for the same amount. (25 mil. DM). In this
case, a long position risk is offset by entering into a short position
counter transaction of equal size.

E.g. GE could buy the tungsten (or any other needed supply) from
German Supplier, worth DM 25 mil. repayable in one year. Since they
are receiving 25 mil. DM from Lufthansa, use it to pay the other
German supplier.
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
The basic idea is that, the asset (a/c receivable) is offset by the liability
created (a/c payable).

An alternative is to use an offsetting position in another currency.
E.g. If there’s another currency that is positively correlated with DM 
then a short position in that currency e.g. SFR. would give the same
‘hedging’/offsetting effect.

If there’s another currency that is negatively correlated, then GE could
offset is current long position in DM by taking a long position in the
negatively correlated currency.

*Note: depending on the strength of the correln. we may have to use
more of the other currency. E.g. If SFR is perfectly positively corr. (  =
1.0) then a short position of exactly [25 mil. / e0] would be sufficient.
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

Involves simultaneous borrowing & lending in 2 diff. currencies to lock-in
the dollar value of a future foreign currency Cash Flow.
Suppose German int. = 15%, US int. = 10%, e0 = 1 DM = 0.40, e1 =0.3828
(expected 1 yr from today)
Strategy
CF0
CF1
1. Borrow DM 25 mil. / 1.15 (PV of 25 mil. DM @ 15%
i.
2. Convert the DM into $ at e0 = 0.40

DM 21. 74 mil
(25 mil. DM)

-
3. Invest $ in US @ 10% int. 8.7m x 1.1

(DM 21.74) mil.
$ 8.7 mil.
($8.7 mil)
4. In one yr. repay the DM borrowed in step (1) with
Lufthansa receivable ( $9.57m/ 0.3838)
Net CF of Money Mkt. Hedge
$9.57 mil.
25 mil. DM
0
$9.57 mil
*Useful for currencies that don’t have forward contracts (note that the outcome
is same as in forward hedge).
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
Money Market Hedge Example 2: GE has 1-year EUR 10 m
receivable from Lufthansa. GE borrows EUR 10 m at 7% interest rate
= EUR 9.35 m (10/1.07). Convert this into USD 14.02 million in spot
market (1EUR = $1.5) and invest it for 1 year at 5.5%. 1 year later, GE
will receive $14.79 m (14.02 x 1.055). GE will use its EUR 10 m
proceeds from Lufthansa to pay off EUR 10 million it owes in
principal and interest
Note: exchange gain or loss on the borrowing and lending
transactions exactly offset the dollar loss or gain on GE’s euro
receivable. ($14.79 = EUR 10m @ EUR = $1.479) At old XR of 1.5, 10m
euro = $15m; at new XR it equals $14.79m
 Cross-Hedging: similar to hedging with futures; where the exact
futures contract a firm seeks is unavailable, it may cross-hedge its
exposure by using futures on another currency that is correlated with
the currency of interest
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Let’s return to the case (Money Market Hedge Example)
where GE sells turbine blades to Lufthansa: this time
valued at EUR 10 m
 Suppose current spot rate is USD 1.500/EUR and 1 year
forward rate is USD 1.479/EUR
 Forward sale of EUR 10 m for delivery 1 yr later will yield
USD 14.79 m
 Regardless of what happens to future spot rate, GE will
get US 14.79 m
 Any exchange gain or loss on forward contract will be
offset by corresponding exchange loss or gain on the
receivable

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
Cost of hedging depends on future spot rate and therefore
can’t be calculated in advance. Consider 3 scenarios:
1. If future spot rate turns out to be USD 1.500/EUR, the receivable
could have been USD 15 m and the “cost” of hedging would be USD
210,000 (15,000,000 – 14,790,000) [with no hedging $15m; with
hedging $14.79m]
2 . If future spot rate were USD 1.479 (same as forward rate); no diff in
receivable (USD 14.79 m) and thus the “cost” of hedging would be
zero [proceeds with hedging = proceeds with no hedging]
3. If future spot rate were USD 1.400, the value of the receivable would
have been USD 14 m if not hedged, and the “cost” of hedging would
be ‘negative’ USD 790,000 (14,790,000 – 14,000,000 = 790,000) [gains
$790,000, thanks to hedging]
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
In all the above 3 scenarios, total cash flow (CF) would be
USD 14,790,000 (Exhibit 10.6 in the text book)

Scenario 1: If GE did not hedge, it could have received
USD 15 m; by hedging GE “loses” $ 210,000 (15,000,000 –
210,000 = 14,790,000 CF)
Scenario 2: if GE did not hedge, it would still have received
$ 14,790,000 CF (neither loss nor gain)
Scenario 3: if GE did not hedge, it would have received
only USD 14 m. By hedging it has “gained” $ 790,000
(14,000,000 + 790,000 = 14,790,000 CF)


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
CRSA is a customized hedge contract embedded in the underlying trade
transaction.

Usually as a “price-adjustment clause”. – whereby a base price is adjusted
to reflect certain exchange rate changes.

E.g. the base price could be set at DM 25 mil. but both parties agree to
share the currency risk beyond a “neutral zone”.

E.g. Neutral Zone $0.39 – 0.41 per DM  with a base rate of $0.40 per
DM.

So, within the “neutral zone”, Lufthansa will pay $10 mil  (25 mil DM x
0.40) – Thus, Lufthansa’s cost could vary from DM24.39 mil (10/0.41) to
DM 25.64 mil (10/.039)

*But, if DM falls below or rises above the neutral zone both parties share
the risk.
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
E.g. if DM falls to $0.35  which is $0.04 lower than lowest rate of
Neutral Zone, the 4¢ is split to 2¢ for each party.

So, Lufthansa will pay $0.40 – 0.02 = $0.38 x 25 mil DM = $9.5 mil.

Note : at $ 0.35 per DM, GE should get $8.75 mil. but Lufthansa pays
$0.75 mil. more.

Likewise if DM  to $0.45 per DM  which is again 4¢ higher than upper
boundary of neutral zone, the 4¢ is again split  with Lufthansa paying
(25 DM mil x 0.42) = $10.5 mil.  which means that, in DM terms,
Lufthansa only pays 23.33 mil DM ($10.5 mil / $0.45).

So, when DM  beyond neutral zone Lufthansa gains partly (since they
could have gotten DM 25 mil. x 0.45 = $11.25 mil) GE loses partly.

When DM  beyond neutral zone Lufthansa loses partly GE gains partly.
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





Currency forwards
Currency options
Currency futures
Currency collars (Range Forward)
Collars: a contract that provides protection against currency moves
outside an agreed-upon range (e.g $1.45 to $1.55 per EUR). Company
wants protection if the rate were to move below $1.45 or rise above
$1.55 (ceiling price invoked if spot rate breaks ceiling; floor price
invoked if spot rate breaks floor)
Company agrees to sell euro proceeds at future spot rate to the bank
should the rate fall within the above range. If that rate exceeds $1.55,
it will convert euro proceeds at $1.55, in which case the bank makes
profit. If future spot rate falls below $1.45, it will convert euro
proceeds at $1.45, in which case the bank suffers a loss
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
Example


Let’s revisit GE selling turbine blades to Lufthansa
GE enters into a currency collar contract with a
bank
(a) to sell EUR 10 m @ future spot rate, if that
falls within the range of $1.45 to $1.55 per EUR;
(b) to sell EUR 10 m at $1.55 if future spot rate >
$1.55; and
(c) to sell EUR 10 m at $1.45 if future spot rate <
$1.45
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
In Scenario (a), the bank neither gains nor loses as the risk is
borne entirely by GE: if future spot rate for euro were $1.49,
GE converts EUR 10 m into USD 14.9 m at the spot market

In Scenario (b), the bank makes a profit: if the future spot
rate were $1.56, GE converts EUR 10 m at $1.55 into USD
15.5 m , while the bank gains $100,000 (15,600,000 –
15,500,000)

In Scenario (c), the bank suffers a loss: if the future spot rate
were $1.44, GE converts EUR 10 m at $1.45 into USD 14.5 m,
while the bank loses $100,000 (14,500,000 – 14,400,000)
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
The basic strategy of translation exposure
management involves increasing hard currency
assets and decreasing soft currency assets, while
simultaneously
decreasing
hard
currency
liabilities, and increasing soft-currency liabilities.

For e.g. if you expect a LC devaluation; reduce
cash levels, tighten credit terms to reduce a/c
receivable, increase local borrowing, delay a/c
payable and other such things.
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
To carry out this basic strategy, 3 methods are often
used:
1. adjusting fund flows
3 Common Methods
2. entering into forward contracts.
3. exposure netting
*Since, forward contracts, and exposure netting
have already been discussed, we’ll only cover only
(1) adjusting fund flows.
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Fund Adjustment

Involves altering either the amounts or the currencies (or both) of the
planned cash flows of the parent and / or its subsidiaries to reduce the
firm’s local currency accounting exposure.

For e.g. if an LC devaluation is anticipated, direct funds–adjustment
methods include pricing exports in hard-currencies, and replacing
hard-currency loans with local currency loans.

Other methods include (a) adjusting transfer prices on sale of goods
between affiliates, (b) speeding up the payment of dividends, fees and
royalties and (c) adjusting the leads and lags of inter-subsidiary
accounts.
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
*Note: if financial markets are efficient, firms cannot hedge expected
 in exchange rates.

Interest rates, forward rates and sales-contract prices should already
reflect anticipated s.
**So, the objective of a firm’s fund adjustment strategy should be to
protect itself only against unexpected currency changes.
*Also, many of the techniques outlined earlier  esp. funds
adjustment techniques (like transfer–prices, borrowing in devaluing
currency etc. are widely known and can often hurt business
relationships  since your suppliers / customers may not like it.
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DEPRECIATION OF LC
Sell LC forward
 Buy LC put option
 Tighten LC credit (reduce
LC receivables)
 Speed up payment of intsubs a/c payable
 Borrow locally
 Delay payment of a/c pay
 Hasten div/fee remittance
 Delay collection of FC rec
 Invoice X in FC; M in LC

APPRECIATION OF LC
Buy LC forward
• Buy LC call option
• Relax LC credit terms
(increase LC receivables)
• Delay payment of int-subs
a/c payable
• Borrow abroad
• Hasten pmt of a/c pay
• Delay div/fee remittances
• Speed up collec of FC rec
• Invoice X in LC; M in FC
•
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Accounting exposure consists of (1) translation
exposure and (2) transaction exposure (more of
the former)
 Economic exposure comprises of (1) transaction
exposure and (2) operating exposure
 Translation exposure impacts on balance sheet
assets & liabilities, and existing income
statement items
 Transaction exposure impacts on FC denominated
contracts already signed but to be settled at a
future date

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
Operating exposure impacts on revenues and
costs associated with future sales and cash flows

Translation exposure is simply the difference
between exposed assets and exposed liabilities

There are many ways to measure and manage
accounting exposure [esp. translation exposure]
using (a) current exchange rates, (b) historical
rates, and (c) average rates for the reporting
period
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
Transaction and operating exposure calls for
hedging mane0vers which include currency
forwards, currency options, currency futures,
cross-hedging, currency collars, money market
hedge, currency risk-sharing, exposure netting,
etc.

Exposure management goal is to arrange a
multinational firm’s financial affairs in such a way
as to minimize the effects of exchange rate
movements on dollar returns
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(a) What would a multinational firm do if it expects the local
currency to depreciate in the near term? Underline the
correct answers (focus on the italics) in what follows:
 *buy/sell foreign currency forward
 *go for local currency call/put option
 *reduce/increase local currency cash and marketable
securities.
 relax/tighten local currency credit terms
 hasten/delay collection of hard currency receivables
 borrow locally/abroad
 delay/speed up payment of accounts payable abroad
 delay/speed up dividend and fee remittances to parent
company and other subsidiaries
(9 marks)
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(b) An American pension fund buys euro bonds worth
EUR 10 million (upon maturity a year later) for USD
13.3 million at the current rate of USD 1.40 per EUR.
In addition, it makes a forward sale of EUR 10
million at the forward rate of USD 1.379 per EUR
(i) What is the cost of hedging if the future spot rate
turns out to be:
*EUR 1 = USD 1.40
*EUR 1 = USD 1.379
*EUR1 = USD 1.30
(6 marks)
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(ii)
Show how an exchange gain (loss) on the forward
contract is offset by a corresponding exchange
loss (gain) in the value of receivable, with a total
cash flow of USD 13.79 million in all the above
three instances, resulting in a net gain of USD
490,000 (USD 13.79 m -13.3 m).
(3 marks)
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END OF
LECTURE 7
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