Transcript MIM700 - Prof Dimond

International Finance
FIN45
Michael Dimond
The Balance of Payments
• The measurement of all international economic transactions
between the residents of a country and foreign residents is
called the Balance of Payments (BOP)
– The IMF is the primary source of similar statistics worldwide
– Multinational businesses use various BOP measures to gauge the
growth and health of specific types of trade or financial transactions by
country and regions of the world against the home country
Michael Dimond
School of Business Administration
The Balance of Payments
– Monetary and fiscal policy must take the BOP into account at the
national level
– Businesses need BOP data to anticipate changes in host country’s
economic policies driven by BOP events
– BOP data may be important for the following reasons
• BOP is important indicator of pressure on a country’s exchange rate, thus
potential to either gain or lose if firm is trading with that country or
currency
• Changes in a country’s BOP may signal imposition (or removal) of
controls over payments, dividends, interest, etc
• BOP helps to forecast a country’s market potential, especially in the short
run
– Rule of thumb to understand the BOP: follow the cash flow
Michael Dimond
School of Business Administration
Fundamentals of BOP Accounting
• The BOP must balance
• Elements in measuring international economic activity:
– Identifying what is/is not an international economic transaction
– Understanding how the flow of goods, services, assets, money create
debits and credits
– Understanding the bookkeeping procedures for BOP accounting
Michael Dimond
School of Business Administration
Typical BOP Transactions
• Examples of BOP transactions from US perspective
– Honda US is the distributor of cars manufactured in Japan by its parent,
Honda of Japan
– US based firm, Fluor Corp., manages the construction of a major water
treatment facility in Bangkok, Thailand
– US subsidiary of French firm, Saint Gobain, pays profits (dividends) back to
parent firm in Paris
– An American tourist purchases a small Lapponia necklace in Finland
– A Mexican lawyer purchases a US corporate bond through an investment
broker in Cleveland
Michael Dimond
School of Business Administration
Defining International Economic Transactions
• Current Account Transactions
– The export of merchandise, goods such as trucks, machinery,
computers is an international transaction
– Imports such as French wine, Japanese cameras and German
automobiles are international transactions
– The purchase of a glass figure in Venice by an American tourist is a
US merchandise import
• Financial Account Transactions
– The purchase of a US Treasury bill by a foreign resident
Michael Dimond
School of Business Administration
BOP as a Flow Statement
• Exchange of Real Assets – exchange of goods and services
for other goods and services or for monetary payment
• Exchange of Financial Assets – Exchange of financial claims
for other financial claims
Michael Dimond
School of Business Administration
The Current Account
• Goods Trade – export/import of goods.
• Services Trade – export/import of services; common services are financial
services provided by banks to foreign investors, construction services and
tourism services
• Income – predominately current income associated with investments
which were made in previous periods. Additionally the wages & salaries
paid to non-resident workers
• Current Transfers – financial settlements associated with change in
ownership of real resources or financial items. Any transfer between
countries which is one-way, a gift or a grant,is termed a current transfer
• Typically dominated by the export/import of goods, for this reason the
Balance of Trade (BOT) is widely quoted
Michael Dimond
School of Business Administration
U.S. Current Account, 2002-2009 ($ Bn)
Michael Dimond
School of Business Administration
U.S. Balances, 1985-2009 ($Bn)
U.S. Trade Balance and Balance on Services and Income
Michael Dimond
School of Business Administration
The Capital and Financial Accounts
• Capital account measures transfers of fixed assets such as
real estate and acquisitions/disposal of non-produced/nonfinancial assets
• Financial account components:
– Direct Investment: Net balance of capital which is dispersed from and
into a country for the purpose of exerting control over assets. This
category includes foreign direct investment
– Portfolio Investment: Net balance of capital which flows in and out of
the country but does not reach the 10% ownership threshold of direct
investment. The purchase and sale of debt or equity securities is
included in this category
– Other Investment Assets/Liabilities: Consists of various short and
long-term trade credits, cross-border loans, currency and bank
deposits and other accounts receivable and payable related to crossborder trade
Michael Dimond
School of Business Administration
U.S. Financial Account, 2002-2009 ($Bn)
Michael Dimond
School of Business Administration
The Other Accounts
•
Net Errors and Omissions – Account is used to account for statistical errors and/or
untraceable monies within a country
•
Official Reserves – total reserves held by official monetary authorities within a
country.
– These reserves are typically comprised of major currencies that are used in
international trade and financial transactions and reserve accounts (SDRs) held at the
IMF
– Under a fixed rate regime official reserves are more important as the government
assumes the responsibility to maintain parity among currencies by buying or selling its
currency on the open market
– Under a floating rate regime the government does not assume such a responsibility and
the importance of official reserves is reduced
Michael Dimond
School of Business Administration
Global Finance in Practice: China’s Twin Surpluses
• China’s twin surpluses aka “double surplus” in the current
and financial accounts is highly unusual
• Typically, these relationships are inverses of one another
• The reason for the twin surpluses is due to the exceptional
growth of the Chinese economy
Michael Dimond
School of Business Administration
Account Balances for the U.S., 1992-2009 ($Bn)
Michael Dimond
School of Business Administration
China’s Twin Surplus, 1998-2009
Michael Dimond
School of Business Administration
Official Foreign Exchange Reserves
• Between 2001 – 2010 China increased foreign exchange
reserves from $200 billion to $2,500 billion, more than a 10fold increase
• China is now able to manage its currency to maintain
competitiveness worldwide
• China can also maintain a relatively stable fixed exchange
rate against other major currencies
Michael Dimond
School of Business Administration
China’s Foreign Exchange Reserves
Michael Dimond
School of Business Administration
2009 Foreign Exchange Reserves ($Bn)
Michael Dimond
School of Business Administration
Balance of Payments Interactions
• A nation’s balance of payments interacts with nearly all of its
key macroeconomic variables:
–
–
–
–
Gross domestic product (GDP)
The exchange rate
Interest rates
Inflation rates
Michael Dimond
School of Business Administration
U.S. BOP, 1995-2005 ($Bn)
Michael Dimond
School of Business Administration
U.S. BOP, 1995-2005 ($Bn)
Michael Dimond
School of Business Administration
India's Current Account
Use the following India balance of payments data from the IMF (all items are for the current account) to answer questions 10 through 14.
10.
11.
12.
13.
14.
What is India's balance on goods?
What is India's balance on services?
What is India's balance on goods and services?
What is India's balance on goods, services and income?
What is India's current account balance?
Assumptions (millions of US dollars)
1998
1999
2000
2001
2002
2003
2004
2005
Goods: exports
Goods: imports
Balance on goods
34,076
-44,828
-10,752
36,877
-45,556
-8,679
43,247
-53,887
-10,640
44,793
-51,212
-6,419
51,141
-54,702
-3,561
60,893
-68,081
-7,188
77,939
-95,539
-17,600
102,175
-134,692
-32,517
Services: credit
Services: debit
Balance on services
11,691
-14,540
-2,849
14,509
-17,271
-2,762
16,684
-19,187
-2,503
17,337
-20,099
-2,762
19,478
-21,039
-1,561
23,902
-24,878
-976
38,281
-35,641
2,640
52,527
-47,287
5,241
Income: credit
Income: debit
Balance on income
1,806
-5,443
-3,636
1,919
-5,629
-3,710
2,521
-7,414
-4,893
3,524
-7,666
-4,142
3,188
-7,097
-3,909
3,491
-8,386
-4,895
4,690
-8,742
-4,052
5,646
-12,296
-6,650
Current transfers: credit
Current transfers: debit
Balance on current transfers
10,402
-67
10,334
11,958
-35
11,923
13,548
-114
13,434
15,140
-407
14,733
16,789
-698
16,091
22,401
-570
21,831
20,615
-822
19,793
24,512
-869
23,643
1998
1999
2000
2001
2002
2003
2004
2005
-10,752
-8,679
-10,640
-6,419
-3,561
-7,188
-17,600
-32,517
-2,849
-2,762
-2,503
-2,762
-1,561
-976
2,640
5,241
12. What is India's balance on goods and services?
-13,601
-11,441
-13,143
-9,181
-5,122
-8,164
-14,960
-27,276
13. What is India's balance on goods, services and income?
-17,238
-15,151
-18,036
-13,323
-9,031
-13,059
-19,012
-33,926
-6,903
-3,228
-4,601
1,410
7,060
8,772
780
-10,283
Questions
10. What is India's balance on goods?
11. What is India's balance on services?
14. What is India's current account balance?
Michael Dimond
School of Business Administration
Balance of Payments Interactions
• In a static (accounting) sense, a nation’s GDP can be
represented by the following equation:
GDP = C + I + G + X – M
C
I
G
X
M
= consumption spending
= capital investment spending
= government spending
= exports of goods and services
= imports of goods and services
X–M=
Current account
balance
Michael Dimond
School of Business Administration
The Balance of Payments and Exchange Rates
• A country’s BOP can have a significant impact on the level of
its exchange rate and vice versa depending on that country’s
exchange rate regime
• The effect of an imbalance in the BOP of a country works
somewhat differently depending on whether that country has
fixed exchange rates, floating exchange rates, or a managed
exchange rate system
– Under a fixed exchange rate system the government bears the
responsibility to assure a BOP near zero
– Under a floating exchange rate system, the government of a country
has no responsibility to peg its foreign exchange rate
Michael Dimond
School of Business Administration
The Balance of Payments and Exchange Rates
• The relationship between BOP and exchange rates can
be illustrated by use of a simplified equation:
Current
Account
Balance
(X-M)
Capital
Account
Balance
+ (CI - CO)
Financial
Account
Balance
+ (FI - FO)
Reserve
Balance
+ (FXB)
=
Balance
of
Payments
BOP
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = official monetary reserves
Michael Dimond
School of Business Administration
The Balance of Payments and Interest Rates
• Apart from the use of interest rates to intervene in the foreign
exchange market, the overall level of a country’s interest
rates compared to other countries does have an impact on
the financial account of the balance of payments
• Relatively low interest rates should normally stimulate an
outflow of capital seeking higher interest rates in other
country-currencies
• In the U.S. however, the opposite has occurred as a result of
attractive growth rate prospects, high levels of productive
innovation, and perceived political stability
Michael Dimond
School of Business Administration
The Balance of Payments and Inflation Rates
• Imports have the potential to lower a country’s inflation rate
• In particular, imports of lower priced goods and services
places a limit on what domestic competitors charge for
comparable goods and services
Michael Dimond
School of Business Administration
Trade Balances and Exchange Rates
• A simple concept in principle: Changes in exchange rates
changes the relative prices of imports and exports which in
turn result in changes in quantities demanded
• In reality the process is less straight-forward
Michael Dimond
School of Business Administration
The J-Curve Adjustment Path
•
Trade balance adjustment occurs in three stages over a
varying and often lengthy period of time
1.
The currency contract period
–
2.
The pass-through period
–
3.
Importers and exporters must eventually pass along the cost changes
Quantity adjustment period
–
–
Adjustment is uncertain due to existing contracts that must be fulfilled
The expected balance of trade is eventually realized
U.S. trade balance = (P$xQx) – (S$/fc PfcM QM)
Michael Dimond
School of Business Administration
The J-Curve
Trade Balance Adjustment to Exchange Rate Changes
Michael Dimond
School of Business Administration
MNCs are exposed to risk from exchange rates
Economic
Exposure
Resulting from
Accounting
Resulting from
Market Forces
Purely
Accounting
Based
Michael Dimond
School of Business Administration
Foreign Exchange Exposure
• Foreign exchange exposure is a measure of the potential
for a firm’s profitability, net cash flow, and market value to
change because of a change in exchange rates
– These three components (profits, cash flow and market value) are
the key financial elements of how we view the relative success or
failure of a firm
– While finance theories tell us that cash flows matter and
accounting does not, we know that currency-related gains and
losses can have destructive impacts on reported earnings – which
are fundamental to the markets opinion of that company
Michael Dimond
School of Business Administration
Types of Foreign Exchange Exposure
• Transaction Exposure – measures changes in the
value of outstanding financial obligations incurred prior to
a change in exchange rates but not due to be settled
until after the exchange rate changes
• Translation Exposure – the potential for accounting
derived changes in owner’s equity to occur because of
the need to “translate” financial statements of foreign
subsidiaries into a single reporting currency for
consolidated financial statements
• Operating Exposure – measures the change in the
present value of the firm resulting from any change in
expected future operating cash flows caused by an
unexpected change in exchange rates
Michael Dimond
School of Business Administration
Why Hedge?
• Hedging protects the owner of an asset (future stream of
cash flows) from loss
• However, it also eliminates any gain from an increase in
the value of the asset hedged against
• Since the value of a firm is the net present value of all
expected future cash flows, it is important to realize that
variances in these future cash flows will affect the value of
the firm and that at least some components of risk
(currency risk) can be hedged against
• Companies must first decide what they are trying to
accomplish through their hedging program.
Michael Dimond
School of Business Administration
Why Hedge - the Pros & Cons
• Proponents of hedging give the following reasons:
– 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
– Management has a comparative advantage over the individual investor
in knowing the actual currency risk of the firm
– Markets are usually in disequilibirum because of structural and
institutional imperfections
Michael Dimond
School of Business Administration
Why Hedge - the Pros & Cons
• Opponents of hedging give the following reasons:
– Shareholders are more capable of diversifying risk than the
management of a firm; if stockholders do not wish to accept the
currency risk of any specific firm, they can diversify their portfolios to
manage that risk, investors have already factored the foreign exchange
effect into a firm’s market valuation
– Currency risk management does not increase the expected cash flows
of a firm; currency risk management normally consumes resources thus
reducing cash flow
– The expected NPV of hedging is zero (Managers cannot outguess the
market; markets are in equilibrium with respect to parity conditions)
– Management’s motivation to reduce variability is sometimes driven by
accounting reasons; management may believe that it will be criticized
more severely for incurring foreign exchange losses in its statements
than for incurring similar or even higher cash cost in avoiding the foreign
exchange loss
– Management often conducts hedging activities that benefit management
at the expense of shareholders
Michael Dimond
School of Business Administration
Hedging’s Impact on Expected Cash Flows of the Firm
Michael Dimond
School of Business Administration
Measurement of Transaction Exposure
• Transaction exposure measures gains or losses that arise
from the settlement of existing financial obligations, namely
– Purchasing or selling on credit goods or services when 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 forward contract and
– Otherwise acquiring assets or incurring liabilities denominated in
foreign currencies
Michael Dimond
School of Business Administration
Purchasing or Selling on Open Account
• Suppose Caterpillar sells merchandise on open account to a
Belgian buyer for €1,800,000 payable in 60 days
• Further assume that the spot rate is $1.2000/€ and
Caterpillar expects to exchange the euros for €1,800,000 x
$1.2000/€ = $2,160,000 when payment is received
– Transaction exposure arises because of the risk that Caterpillar will
something other than $2,160,000 expected
– If the euro weakens to $1.1000/€, then Caterpillar will receive
$1,980,000
– If the euro strengthens to $1.3000/€, then Caterpillar will receive
$2,340,000
Michael Dimond
School of Business Administration
Purchasing or Selling on Open Account
• Caterpillar might have avoided transaction exposure by
invoicing the Belgian buyer in US dollars (risk shifting),
but this might have lead to Caterpillar not being able to
book the sale
• If the Belgian buyer agrees to pay in dollars, Caterpillar
has transferred the transaction exposure to the Belgian
buyer whose dollar account payable has an unknown
euro value in 60 days
Michael Dimond
School of Business Administration
The Life Span of a Transaction Exposure
Michael Dimond
School of Business Administration
Borrowing and Lending
• A second example of transaction exposure arises when funds
are loaned or borrowed
• Example: PepsiCo’s largest bottler outside the US is located
in Mexico, Grupo Embotellador de Mexico (Gemex)
– On 12/94, Gemex had US dollar denominated debt of $264 million
– The Mexican peso (Ps) was pegged at Ps$3.45/US$
– On 12/22/94, the government allowed the peso to float due to internal
pressures and it sank to Ps$4.65/US$. In January it reached Ps$5.50
Michael Dimond
School of Business Administration
Borrowing and Lending
• Gemex’s peso obligation now looked like this
– Dollar debt mid-December, 1994:
• US$264,000,000  Ps$3.45/US$ = Ps$910,800,000
– Dollar debt in mid-January, 1995:
• US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000
– Dollar debt increase measured in Ps
• Ps$541,200,000
• Gemex’s dollar obligation increased by 59% due to
transaction exposure
Michael Dimond
School of Business Administration
Other Causes of Transaction Exposure
• When a firm buys a forward exchange contract, it deliberately
creates transaction exposure; this risk is incurred to hedge
an existing exposure
– Example: US firm wants to offset transaction exposure of ¥100 million
to pay for an import from Japan in 90 days
– Firm can purchase ¥100 million in forward market to cover payment in
90 days
Michael Dimond
School of Business Administration
Contractual Hedges
• Transaction exposure can be managed by contractual, operating, or
financial hedges
• The main contractual hedges employ forward, money, futures and
options markets
• Operating and financial hedges use risk-sharing agreements, leads
and lags in payment terms, swaps, and other strategies
• A natural hedge refers to an offsetting operating cash flow, a payable
arising from the conduct of business
• A financial hedge refers to either an offsetting debt obligation or
some type of financial derivative such as a swap
Michael Dimond
School of Business Administration
Risk Management in Practice
• Which Goals?
– The treasury function of most firms is usual considered a cost center;
it is not expected to add to the bottom line
– However, in practice some firms’ treasuries have become aggressive
in currency management and act as though they were profit centers
• Which Exposures?
– Transaction exposures exist before they are actually booked yet some
firms do not hedge this backlog exposure
– However, some firms are selectively hedging these backlog
exposures and anticipated exposures
Michael Dimond
School of Business Administration
Risk Management in Practice
• Which Contractual Hedges?
– Transaction exposure management programs are generally divided
along an “option-line;” those which use options and those that do not
– Also, these programs vary in the amount of risk covered; these
proportional hedges are policies that state which proportion and type
of exposure is to be hedged by the treasury
Michael Dimond
School of Business Administration
Translation Exposure
• Translation exposure arises because the financial statements of
foreign subsidiaries must be restated in the parent’s reporting
currency for the firm to prepare its consolidated financial
statements
• Translation exposure is the potential for an increase or decrease
in the parent’s net worth and reported income caused by a change
in exchange rates since the last transaction
• Translation methods differ by country along two dimensions
– One is a difference in the way a foreign subsidiary is
characterized depending on its independence
– The other is the definition of which currency is most important
for the subsidiary
Michael Dimond
School of Business Administration
Subsidiary Characterization
• Most countries specify the translation method to be used by a
foreign subsidiary based upon its operations
• A foreign subsidiary can be classified as
– Integrated Foreign Entity – one which operates as an extension of
the parent company, with cash flows and line items that are highly
integrated with the parent
– Self-sustaining Foreign Entity – one which operates in the local
economy independent of its parent
• The foreign subsidiary should be valued in terms of the
currency that is the basis of its economic viability
Michael Dimond
School of Business Administration
Functional Currency
• A foreign affiliate’s functional currency is the currency of
the primary economic environment in which the subsidiary
operates
• The geographic location of a subsidiary and its functional
currency can be different
– Example: US subsidiary located in Singapore may find that its
functional currency could be
• US dollars (integrated subsidiary)
• Singapore dollars (self-sustaining subsidiary)
• British pounds (self-sustaining subsidiary)
Michael Dimond
School of Business Administration
Translation Methods
• There are four principal translation methods available:
the current/noncurrent method, the
monetary/nonmonetary method, the temporal method,
and the current-rate method.
• The two most used the translation of foreign subsidiary
financial statements are
– The current rate method
– The temporal method
• Regardless of which is used, either method must
designate
– The exchange rate at which individual balance sheet and income
statement items are remeasured
– Where any imbalances are to be recorded
• This can affect either the balance sheet or the income statement
Michael Dimond
School of Business Administration
Summary of Translation Methods
•
Current Rate Method
– Everything uses the current rate
•
Current/ NonCurrent Method
– CA & CL at current rate
– All others at Historic Rate
•
Monetary/ NonMonetary Method
– Monetary assets at current rate
– NonMonetary assets at historic rate
•
Temporal Method
– Like Mon/NonMon, but Inventory is translated at Current rate
(only if inventory is at Market Cost)
Michael Dimond
School of Business Administration
Summary of Translation Methods
• A few pointers:
–
–
–
–
–
–
–
Cash & A/R: Current rate for all methods
Inventory (@ mkt): Current rate for all except Mon/NonMon
Fixed Assets: Historic rate for all except current rate method
Curr Liabilities: Current rate for all methods
LT Debt: Current rate for all except Curr/NonCurr
Equity: plug
Translation Gain (Loss): Difference in Equity (Historic vs Method)
Michael Dimond
School of Business Administration
Current Rate Method
• Under this method all financial statement items are translated at the
“current” exchange rate
• Assets & liabilities – are translated at the rate of exchange in effect on
the balance sheet date
• Income statement items – all items are translated at either the actual
exchange rate on the dates the various revenues, expenses, gains and
losses were incurred or at a weighted average exchange rate for the
period
• Distributions – dividends paid are translated at the rate in effect on the
date of payment
• Equity items – common stock and paid-in capital are translated at
historical rates; year end retained earnings consist of year-beginning
plus or minus any income or loss on the year
Michael Dimond
School of Business Administration
Current Rate Method
• Any gain or loss from re-measurement is closed to an
equity reserve account entitled the cumulative translation
adjustment, rather than through the company’s
consolidated income statement
• These cumulative gains and losses from remeasurement
are only recognized in current income under the current
rate method when the foreign subsidiary giving rise to that
gain or loss is liquidated
Michael Dimond
School of Business Administration
Temporal Method
• Under this method, specific assets and liabilities are
translated at exchange rates consistent with the timing of the
item’s creation
• The temporal method assumes that a number of line items
such as inventories and net plant and equipment are restated
to reflect market value
• If these items were not restated and carried at historical
costs, then the temporal method becomes the monetary/nonmonetary method
Michael Dimond
School of Business Administration
Temporal Method
• Line items included in this method are
– Monetary assets (primarily cash, accounts receivable, and long-term
receivables) and all monetary liabilities are translated at current
exchange rates
– Non-monetary assets (primarily inventory and plant and equipment)
are translated at historical exchange rates
– Income statement items – are translated at the average exchange rate
for the period except for depreciation and cost of goods sold which are
associated with non-monetary items, these items are translated at
their historical rate
Michael Dimond
School of Business Administration
Temporal Method
• Line items included in this method are
– Distributions – dividends paid are translated at the exchange rate in
effect the date of payment
– Equity items – common stock and paid-in capital are translated at
historical rates; year end retained earnings consist of year-beginning
plus or minus any income or loss on the year plus or minus any
imbalance from translation
• Under the temporal method, any gains or losses from
remeasurement are carried directly to current consolidated
income and not to equity reserves
Michael Dimond
School of Business Administration
US Translation Procedures
• The US differentiates foreign subsidiaries on the basis of functional
currency, not subsidiary characterization. Translation methods are
mandated in FASB-8 and FASB-52.
• Regardless of the translation method selected, measuring
accounting exposure is conceptually the same. It involves
determining which foreign currency-denominated assets and
liabilities will be translated at the current (postchange) exchange
rate and which will be translated at the historical (prechange)
exchange rate. The former items are considered to be exposed,
while the latter items are regarded as not exposed. Translation
exposure is just the difference between exposed assets and
exposed liabilities.
• By far the most important feature of the accounting definition of
exposure is the exclusive focus on the balance sheet effects of
currency changes. This focus is misplaced since it has led firms to
ignore the more important effect that these changes may have on
future cash flows.
Michael Dimond
School of Business Administration
Managing Translation Exposure
• Balance Sheet Hedge – this requires an equal amount of
exposed foreign currency assets and liabilities on a firm’s
consolidated balance sheet
– A change in exchange rates will change the value of exposed assets
but offset that with an opposite change in liabilities
– This is termed monetary balance
– The cost of this method depends on relative borrowing costs in the
varying currencies
Michael Dimond
School of Business Administration
Managing Translation Exposure
• When is a balance sheet hedge justified?
– The foreign subsidiary is about to be liquidated so that the value of its
CTA would be realized
– The firm has debt covenants or bank agreements that state the firm’s
debt/equity ratios will be maintained within specific limits
– Management is evaluated on the basis of certain income statement
and balance sheet measures that are affected by translation losses or
gains
– The foreign subsidiary is operating in a hyperinflationary environment
Michael Dimond
School of Business Administration
Choosing Which Exposure to Minimize
• As a general matter, firms seeking to reduce both types of
exposures typically reduce transaction exposure first
• They then recalculate translation exposure and then decide if
any residual translation exposure can be reduced without
creating more transaction exposure
Michael Dimond
School of Business Administration
Operating Exposure
• The change in company value resulting from changes in future
operating cash flows caused by an unexpected change in exchange
rates.
• Because the value of a firm is equal to the present value of future cash
flows, accounting measures of exposure that are based on changes in
the book values of foreign currency assets and liabilities need bear no
relationship to reality.
• Because currency changes are usually preceded by or accompanied
by changes in relative price levels between two countries, it is
impossible to determine exposure to a given currency change without
considering simultaneously the offsetting effects of these price
changes.
Michael Dimond
School of Business Administration
Operating Exposure
•
•
The primary exposure management objective of financial executives should
be to arrange their firm's finances in such a way as to minimize the real
effects of exchange rate changes.
The major burden of coping with exchange risk must be borne by the
marketing and production people
– They deal in imperfect product and factor markets where their specialized
knowledge provides a real advantage.
– Their role is to design marketing and production strategies to deal with exchange
risks.
– The appropriate marketing and production strategies are similar to those that
would be suitable for any firm confronted with shifting relative output or input
prices caused by any economic, political, or social factors.
•
•
Measuring the operating of a firm requires forecasting and analyzing all the
firm’s future individual transaction exposures together with the future
exposure of all the firm’s competitors and potential competitors
This long term view is the objective of operating exposure analysis
Michael Dimond
School of Business Administration
Operating Exposure
• Exchange rate changes do not always increase the riskiness of
multinational corporations.
– Purchasing Power Parity tells us devaluations (or revaluations) are usually
preceded by higher (or lower) rates of inflation, therefore we should not evaluate
only the devaluation phase of an inflation-devaluation cycle.
– Nominal currency changes smooth out the profit peaks and valleys caused by
differing rates of inflation. Devaluations or revaluations should actually reduce
earnings variability for MNCs. Only if currency changes involve real exchange
rate changes does risk increase.
• Domestic firms are also subject to exchange rate risk, not just MNCs
– Domestic facilities that supply foreign markets normally entail much greater
exchange risk than foreign facilities supplying local markets (because material
and labor used in a domestic plant are paid for in the home currency while the
products are sold in a foreign currency).
– A purely domestic company selling locally but facing import competition may be
seriously hurt (helped) by the devaluation (revaluation) of a competitor's home
currency.
Michael Dimond
School of Business Administration
Managing Exchange Risk
•
•
•
•
•
Since currency risk affects all facets of a firm's operations, it should not be the
concern of financial managers alone.
Operating managers should develop marketing & production initiatives that help to
ensure profitability over the long run. They should also devise anticipatory strategic
alternatives in order to gain competitive leverage internationally.
The key to effective exposure management is to integrate currency considerations
into the general management process.
Managers trying to cope with actual or anticipated exchange rate changes must first
determine whether the exchange rate change is real or nominal. Nominal changes
can be ignored. Real changes must be responded to.
If real, the manager must first assess the permanence of the change. In general, real
exchange rate movements that narrow the gap between the current rate and the
equilibrium rate are likely to be longer lasting than are those that widen the gap.
Neither, however, will be permanent. Rather, there will be a sequence of equilibrium
rates, each of which has its own implications for the firm's marketing and production
strategies.
Michael Dimond
School of Business Administration
Integrated Exchange Risk Program
• The role of the financial executive in an integrated exchange
risk program is fourfold
• to provide local operating management with forecasts of inflation and
exchange rates
• to identify and highlight the risks of competitive exposure
• to structure evaluation criteria such that operating managers are not
rewarded or penalized for the effects of unanticipated real currency
changes
• to estimate and hedge whatever real operating exposure remains after
the appropriate marketing and production strategies have been put in
place.
Michael Dimond
School of Business Administration
Expected Versus Unexpected Changes in Cash Flows
• Operating exposure is far more important for the long-run
health of a business than changes caused by transaction or
translation exposure
– Planning for operating exposure is total management responsibility
since it depends on the interaction of strategies in finance, marketing,
purchasing, and production
– An expected change in exchange rates is not included in the definition
of operating exposure because management and investors should
have factored this into their analysis of anticipated operating results
and market value
Michael Dimond
School of Business Administration
Measuring Operating Exposure
• Short Run - The first-level impact is on expected cash flows in the 1-year
operating budget. The gain or loss depends on the currency of
denomination of expected cash flows. These are both existing transaction
exposures and anticipated exposures. The currency of denomination
cannot be changed for existing obligations
• Medium Run Equilibrium - The second-level impact is on expected
medium-run cash flows, such as those expressed in 2- to 5-year budgets
• Medium Run: Disequilibrium. The third-level impact is on expected
medium-run cash flows assuming disequilibrium conditions. In this case,
the firm may not be able to adjust prices and costs to reflect the new
competitive realities caused by a change in exchange rates
• Long Run. The fourth-level impact is on expected long-run cash flows,
meaning those beyond five years. At this strategic level, a firm’s cash
flows will be influenced by the reactions of both existing and potential
competitors, possible new entrants, to exchange rate changes under
disequilibrium conditions
Michael Dimond
School of Business Administration
Strategic Management of Operating Exposure
• The objective of both operating and transaction exposure
management is to anticipate and influence the effect of
unexpected changes in exchange rates on a firm’s future
cash flows
• To meet this objective, management can diversify the
firm’s operating and financing base
• Management can also change the firm’s operating and
financing policies
Michael Dimond
School of Business Administration
Diversifying Operations
• Diversifying operations means diversifying the firm’s
sales, location of production facilities, and raw material
sources
• If a firm is diversified, management is prepositioned to
both recognize disequilibrium when it occurs and react
competitively
• Recognizing a temporary change in worldwide
competitive conditions permits management to make
changes in operating strategies
Michael Dimond
School of Business Administration
Diversifying Financing
• Diversifying the financing base means raising funds in more
than one capital market and in more than one currency
• If a firm is diversified, management is prepositioned to take
advantage of temporary deviations from the International
Fisher effect
Michael Dimond
School of Business Administration
Proactive Management of Operating Exposure
• Operating and transaction exposures can be partially
managed by adopting operating or financing policies that
offset anticipated currency exposures
• Six of the most commonly employed proactive policies are
–
–
–
–
–
–
Matching currency cash flows
Risk-sharing agreements
Back-to-back or parallel loans
Currency swaps
Leads and lags
Reinvoicing centers
Michael Dimond
School of Business Administration
Matching Currency Cash Flows
• One way to offset an anticipated continuous long exposure to
a particular currency is to acquire debt denominated in that
currency
• This policy results in a continuous receipt of payment and a
continuous outflow in the same currency
• This can sometimes occur through the conduct of regular
operations and is referred to as a natural hedge
Michael Dimond
School of Business Administration
Debt Financing as a Financial Hedge
Michael Dimond
School of Business Administration
Currency Clauses: Risk-sharing
• Risk-sharing is a contractual arrangement in which the buyer
and seller agree to “share” or split currency movement
impacts on payments
– Example: Ford purchases from Mazda in Japanese yen at the current
spot rate as long as the spot rate is between ¥115/$ and ¥125/$.
– If the spot rate falls outside of this range, Ford and Mazda will share
the difference equally
– If on the date of invoice, the spot rate is ¥110/$, then Mazda would
agree to accept a total payment which would result from the difference
of ¥115/$- ¥110/$
(i.e. ¥5)
Michael Dimond
School of Business Administration
Currency Clauses: Risk-sharing
• Ford’s payment to Mazda would therefore be



 ¥25,000,00
¥25,000,00
0
0

 $222,222.22


¥5.00/$
¥112.50/$
 ¥115.00/$
2


• Note that this movement is in Ford’s favor, however if the yen
depreciated to ¥130/$ Mazda would be the beneficiary of the
risk-sharing agreement
Michael Dimond
School of Business Administration
Back-to-Back Loans
• A back-to-back loan, also referred to as a parallel loan or
credit swap, occurs when two firms in different countries
arrange to borrow each other’s currency for a specific period
of time
– The operation is conducted outside the FOREX markets, although
spot quotes may be used
– This swap creates a covered hedge against exchange loss, since
each company, on its own books, borrows the same currency it repays
Michael Dimond
School of Business Administration
Cross-Currency Swaps
• Cross-Currency swaps resemble back-to-back loans except
that it does not appear on a firm’s balance sheet
• In a currency swap, a dealer and a firm agree to exchange an
equivalent amount of two different currencies for a specified
period of time
– Currency swaps can be negotiated for a wide range of maturities
• A typical currency swap requires two firms to borrow funds in
the markets and currencies in which they are best known or
get the best rates
Michael Dimond
School of Business Administration
Cross-Currency Swaps
• For example, a Japanese firm exporting to the US wanted to
construct a matching cash flow swap, it would need US dollar
denominated debt
• But if the costs were too great, then it could seek out a US firm
who exports to Japan and wanted to construct the same swap
• The US firm would borrow in dollars and the Japanese firm would
borrow in yen
• The swap-dealer would then construct the swap so that the US
firm would end up “paying yen” and “receiving dollars” be
“paying dollars” and “receiving yen”
• This is also called a cross-currency swap
Michael Dimond
School of Business Administration
Using Cross Currency Swaps
Michael Dimond
School of Business Administration
Contractual Approaches
• Some MNEs now attempt to hedge their operating exposure with
contractual strategies
• These firms have undertaken long-term currency option positions
hedges designed to offset lost earnings from adverse changes in
exchange rates
• The ability to hedge the “unhedgeable” is dependent upon
predictability
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor responses to exchange rate
changes
• Few in practice feel capable of accurately predicting competitor
response, yet some firms employ this strategy
Michael Dimond
School of Business Administration
Capital Mobility
• The degree to which capital moves freely cross-border is critically
important to a country’s balance of payments
• Historical patterns of capital mobility
– 1860-1914 – period characterized by continuously increasing capital
openness as more countries adopted the gold standard and
expanded international trade relations
– 1914-1945 – period of global economic destruction due to two world
wars and a global depression
– 1945-1971 – Bretton Woods era, saw great expansion of international
trade in goods and services
– 1971-2002 – period characterized by floating exchange rates,
economic volatility, but rapidly expanding cross-border capital flows
Michael Dimond
School of Business Administration
The Evolution of Capital Mobility
Michael Dimond
School of Business Administration
Capital Flight
“International flows of direct and portfolio investments under
ordinary circumstances are rarely associated with the capital
flight phenomenon. Rather, it is when capital transfers by
residents conflict with political objectives that the term “flight”
comes into general usage.”
—Ingo Walter, Capital Flight and Third World Debt
Michael Dimond
School of Business Administration
Capital Flight
• Five primary mechanisms exist by which capital may be
moved from one country to another:
– Transfers via the usual international payments mechanisms, regular
bank transfers are easiest, cheapest and legal
– Transfer of physical currency by bearer (smuggling) is more costly,
and for many countries illegal
– Transfer of cash into collectibles or precious metals, which are then
transferred across borders
– Money laundering, the cross-border purchase of assets which are
then managed in a way that hide the movement of money and its
owners
– False invoicing on international trade transactions
Michael Dimond
School of Business Administration
Currency Market Intervention
• Foreign currency intervention, the active management, manipulation, or
intervention in the market’s valuation of a country’s currency, is a
component of currency valuation and forecast that cannot be overlooked.
• Central bank’s driving consideration – inflation or unemployment?
• “beggar-thy-neighbor,” policy to keep currency values low to aid in
exports, may prove inflationary if some goods MUST be imported … e.g.
oil
Michael Dimond
School of Business Administration
Currency Market Intervention
• Direct Intervention - This is the active buying and selling of the domestic
currency against foreign currencies. This traditionally required a central
bank to act like any other trader in the currency market
• Coordinated Intervention - in which several major countries, or a collective
such as the G8 of industrialized countries, agree that a specific currency’s
value is out of alignment with their collective interests
• Indirect Intervention - This is the alteration of economic or financial
fundamentals which are thought to be drivers of capital to flow in and out
of specific currencies
Michael Dimond
School of Business Administration
Currency Market Intervention
• Capital Controls - This is the restriction of access to foreign
currency by government. This involves limiting the ability to
exchange domestic currency for foreign currency
– The Chinese regulation of access and trading of the Chinese yuan is a
prime example over the use of capital controls over currency value.
Michael Dimond
School of Business Administration
Disequilibria: Exchange Rates in Emerging Markets
• Although the three different schools of thought on exchange rate
determination make understanding exchange rates appear to be
straightforward, that is rarely the case
• The problem lies not in the theories but in the relevance of the
assumptions underlying each theory
• After several years of relative global economic tranquility, the
second half of the 1990s was racked by a series of currency crises
which shook all emerging markets
– The Asian crisis of July 1997
– The Argentine crisis (1998 – 2002)
Michael Dimond
School of Business Administration
The Asian Crisis – July 1997
• The roots of the Asian crisis extended from a fundamental
change in the economies of the region, the transition of many
Asian countries from being net exporters to net importers
• Starting in 1990 in Thailand, the rapidly expanding
economies of the Far East began importing more than they
were exporting, requiring major net capital inflows to support
their currencies
– As long as capital kept flowing in, the currencies were stable, but if
this inflow stopped then the governments would not be able to support
their fixed currencies
Michael Dimond
School of Business Administration
The Asian Crisis – July 1997
• The most visible roots of the crisis were in the excesses of
capital inflows into Thailand in 1996 and 1997
• Thai banks, firms and finance companies had ready access
to capital and found US dollar denominated debt at cheap
rates
• Banks continued to extend credits and as long as the capital
inflows were still coming, the banks, firms, and government
was able to support these credit extensions abroad
Michael Dimond
School of Business Administration
The Asian Crisis – July 1997
• After some time, the Thai Baht came under attack due to the country’s
rising debt
• The Thai government intervened in the foreign exchange markets
directly to try to defend the Baht by selling foreign reserves and
indirectly by raising interest rates
• This caused the Thai markets to come to a halt along with massive
currency losses and bank failures
• On July 2, 1997 the Thai central bank allowed the Baht to float and it
fell over 17% against the dollar and 12% against the Japanese Yen
– By November 1997, the baht fell 38% against the US dollar
Michael Dimond
School of Business Administration
The Asian Crisis – July 1997
• Within days, other Asian countries suffered from the contagion effect
from Thailand’s devaluation
• Speculators and capital markets turned towards countries with similar
economic traits as Thailand and their currencies fell under attack
• In late October, Taiwan caught the markets off-guard with a 15%
devaluation and this only added to the momentum
– The Korean Won fell from WON900/$ to WON1100/$ (18.2%)
– The Malaysian ringgit fell 28.6% and the Filipino peso fell 20.6%
against the dollar
• The only currencies that were not severely affected were the Hong
Kong dollar and the Chinese renminbi
Michael Dimond
School of Business Administration
The Thai Baht and the Asian Crisis
Michael Dimond
School of Business Administration
The Asian Crisis – July 1997
• The Asian currency crisis was more than just a currency
collapse
• Although the varying countries were different they did have
similar characteristics which allow comparison
– Corporate socialism – Post WWII Asian companies believed that
their governments would not allow them to fail, thus they engaged in
practices, such as lifetime employment, that were no longer
sustainable
Michael Dimond
School of Business Administration
The Asian Crisis – July 1997
– Corporate governance – Most companies in the Far East were often
largely controlled by either families or groups related to the governing
body or party of that country
• This was labeled cronyism and allowed the management to ignore the
bottom line at times when this was deteriorating
– Banking liquidity and management – Although bank regulatory
structures and markets have been deregulated across the globe, their
central role in the conduct of business has been ignored
• As firms collapsed, government coffers were emptied and investments
made by banks failed
• The banks became illiquid and they could no longer support companies’
need for capital
Michael Dimond
School of Business Administration
The Russian Crisis of 1998
• 1995 – 1998 Russian govt and nongovt borrowing very high, servicing the
debt becomes difficult
• Russian exports are mostly commodity-based and world commodity
prices drop as a result of the Asian crisis of 1997 – thus, Russian exports
values decline
• The Ruble was under a managed float with a band of 1.5% and most
days the Russian Central Bank is forced to enter the market to buy rubles
• The August Collapse – Currency reserves had fallen, Russia announces
it will raise an extra $1 billion in foreign bonds to help pay for rising debt
Michael Dimond
School of Business Administration
The Russian Crisis of 1998
• The August Collapse – Russian stocks drop by 5% on August 10 on
fears that China would cut its currency value – Russia claims they will not
devalue the Ruble then at RUB6.3/USD
• August 17, the ruble is devalued by 34% by the 26th the Ruble is down to
RUB13/USD
• Exhibit 9.3 traces the fall of the Russian Ruble
Michael Dimond
School of Business Administration
The Fall of the Russian ruble
Michael Dimond
School of Business Administration
The Argentine Crisis - 2002
• In 1991 the Argentine peso had been fixed to the U.S. dollar
at a one-to-one rate of exchange
• This policy was a radical departure from traditional methods
of fixing the rate of a currency’s value
• Argentina adopted a currency board, which was a structure
rather than just a commitment, to limiting the growth of
money in the economy
• Under a currency board, the central bank of a country may
increase the money supply in the banking system only with
increases in its holdings of hard currency reserves
Michael Dimond
School of Business Administration
The Argentine Crisis - 2002
• By removing the ability of government to expand the rate of
growth of the money supply, Argentina believed it was
eliminating the source of inflation which had devastated its
standard of living
• The idea was to limit the rate of growth in the country’s
money supply to the rate at which the country receives net
inflows of U.S. dollars as a result of trade growth and general
surplus
Michael Dimond
School of Business Administration
The Collapse of the Argentine peso
Michael Dimond
School of Business Administration
The Argentine Crisis - 2002
• A recession that began in 1998, as a result of a restrictive
monetary policy, continued to worsen by 2001 and revealed
three very important problems with Argentina’s economy:
– The Argentine peso was overvalued
– The currency board regime had eliminated monetary policy
alternatives for macroeconomic policy
– The Argentine government budget deficit – and deficit spending – was
out of control
Michael Dimond
School of Business Administration
The Argentine Crisis - 2002
• While the value of the peso had been stabilized, inflation had
not been eliminated
• The inability of the peso’s value to change with market forces
led many to believe increasingly that it was overvalued
• Argentine exports became some of the most expensive in all
of South America as other countries saw their currencies
slide marginally against the dollar over the past decade while
the peso did not
Michael Dimond
School of Business Administration
The Argentine Crisis - 2002
• Because the currency board eliminated expansionary
monetary policy as a means to stimulate economic growth in
Argentina, the Argentine government was left with only fiscal
policy as a means to this end
• The Argentine government continued to spend as a means to
quell increasing social and political tensions and unrest, but
without the benefit of increasing (or even stable) tax receipts
• Continued government spending and the injection of foreign
capital into the country steadily increased the debt burden
Michael Dimond
School of Business Administration
The Argentine Crisis - 2002
• Many began to fear an impending devaluation, removing their peso
denominated funds (as well as U.S. dollar funds) from Argentine
banks
• Capital flight as well as rampant conversion of peso holdings into U.S.
dollar deposits put additional pressure on the value of the peso
• On Sunday January 6, 2002, in the first act of his presidency (the fifth
president in two weeks), President Eduardo Duhalde devalued the
peso from Ps 1.00/$ to Ps 1.40/$
• On February 3, 2002, the government announced that the peso would
be floated, beginning a slow but gradual depreciation
Michael Dimond
School of Business Administration
The Greek Crisis – 201X?
•
•
•
•
In early 2000s, Greece was managing to a large budget deficit and relying on a
healthy global economy to feed two main industries: Shipping and Tourism. In
2001, Greece transitioned away from its sovereign currency to the Euro.
By 2010, concerns about Greece’s national debt suggested emergency bailouts
might be necessary. Germany refused to endorse the loan until a series of
austerity measures were announced.
In May 2010, Eurozone countries and the IMF agreed to a three year €110 billion
loan at 5.5% interest, conditional on the implementation of austerity measures.
Changes to the ruling government of Greece and rioting protestors showed
evidence at the dissatisfaction of the Greek people with the circumstances.
Michael Dimond
School of Business Administration
The Greek Crisis – 201X?
•
•
•
In 2011, Eurozone leaders changed the terms of the Greek loan package to
extend the payback period and reduce the interest rate to 3.5%. Also, eurozone
leaders and the IMF also came to an agreement with banks to accept a write-off
of €100 billion of Greek debt, reducing the country's debt level from €340bn to
€240bn or 120% of GDP by 2020.
In 2012, the second bailout package from July 2011 was extended from €109
billion to €130 billion
One current opinion is the best option for Greece (and the rest of the EU), would
be to create an “orderly default” on Greece’s public debt. In this case, Greece
would withdraw simultaneously from the eurozone and reintroduce its national
currency the drachma at a debased rate. This might lead to a 60% devaluation of
the new drachma. Critics also point to political and financial instability leading to
hyperinflation, civil unrest and possibly a forcible overthrow of the current
government.
Michael Dimond
School of Business Administration