Chapter 13 Managing Foreign Exchange Exposure Outright

Chapter 13 Managing Foreign Exchange Exposure

Outright Forward Market l l l Forward contract is a contract between a foreign currency trader and a client for future sale or purchase of foreign currency Forward contract is a derivative because its future value is based on the current spot exchange rate During a period of stability, little difference may exist between the current spot and forward rates International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Outright Forward Market Example from The Wall Street Journal 90 -day forward Spot Points British Pounds $1. 8983 $1. 9077 -94 Spread is -. 0094 or 94 points (discount) International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Outright Forward Market Premium (discount) = Fo – So x 12 x 100 So N If forward rate < spot rate, DISCOUNT If forward rate > spot rate, PREMIUM Fo = forward rate on the day that the contract is entered into So = spot rate on that day N = number of months forward 100 is used to convert the decimal to a % International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Outright Forward Market Example from The Wall Street Journal Premium = 1. 8983 – 1. 9077 x 12 x 100 = -1. 97% Pound is selling at a 1. 97% discount below the dollar spot rate International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Swaps l l l A swap is a simultaneous spot and forward transaction Variation of this is a foreign exchange swap based on interest rate differentials The swap exchange rate is the rate at which two companies agree to exchange one currency for the other International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Futures l l l l Specifies an exchange rate sometime in advance of the actual exchange of currency Traded on an exchange, not OTC Futures contract is for a specific amount and a specific maturity date Less valuable to a company than a forward contract May be useful to speculators and small companies Contract months are March, June, Sept. , Dec. Less flexible than forward contracts International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Options l l l The right but not the obligation to trade foreign currency at a given exchange rate on or before a given date in the future Can be traded on an exchange or with a financial intermediary Two parties to an option l l l Writer – sells the option Holder – buys the option, pays a premium to the writer Holder determines whether or not the option will be exercised International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Foreign Exchange Markets l l l Central Bank survey by the Bank of International Settlement in Basel, Switzerland l Global net turnover of foreign exchange is estimated to be $1. 9 trillion per business day Interbank market is the most important market in trading foreign exchange Banks also deal indirectly with each other through foreign exchange brokers Movement toward computer-based trades Foreign exchange is traded on l Specialized market – International Monetary Fund of the Chicago Mercantile Exchange l OTC revolves around investment banks like Goldman Sachs International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Foreign Exchange Markets l Most widely traded instrument is swaps, followed by spot transactions and outright forwards International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The International Monetary System l l International Monetary Fund (IMF) created in 1944 to promote exchange stability Exchange Rate Arrangements l l IMF permits countries to select and maintain an arrangement of their choosing as long as they communicate the arrangement to the fund Some countries lock their currencies onto another currency – Ecuador and the U. S. dollar Other countries adopt a free float or a managed float Importance lies in the relation of the home office currency to the currencies in countries where the company has operations l Example – U. S. dollar was stable against the Chinese yuan, but weak against the euro, pound, and yen in 2004 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The Determination of Exchange Rates l l Fisher Effect – the nominal interest rate equals the real rate of interest worldwide plus the expected inflation rate International Fisher Effect l l The country with the higher nominal interest rate should have a higher rate of inflation The country with the higher nominal interest rate should expect its currency to weaken against a low-interest-rate (low-inflation) country International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The Determination of Exchange Rates l Important factors affecting exchange rates l l l Purchasing power parity (PPP) or inflation differentials Relative interest rates The forward exchange rate According to PPP, a change in relative inflation must result in a change in exchange rates to keep the prices of goods in two countries similar, taking into consideration transportation costs. PPP is a good long-run indicator of exchange rate differences International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The Determination of Exchange Rates Higher inflation = weakening currency Lower inflation = stronger currency International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The Determination of Exchange Rates l l The forward rate differs from the spot rate by a percentage equal to the projected exchange rate Political issues can change exchange rate differentials l Example – 2002 Presidential election in Brazil l Brazilian real fell against the U. S. dollar because of a perceived leftist president l When the president turned out to be conservative, the real strengthened against the dollar International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Unbiased Forward Rate Theory International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Transaction Exposure l When a company engages in foreign currency transactions, a foreign exchange risk is incurred Example l l If a U. S. exporter receives payment in U. S. dollars from a British importer, there is no immediate impact on the exporter if the exchange rate changes The British importer has a cash flow gain/loss from the change in exchange rates because their accounts payable would change in value as the exchange rate changes International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Translation or Accounting Exposure l l l Accounting exposure arises when a company translates its financial statements from one currency to another for consolidation purposes If current rate method is used, all accounts except owners’ equity change in value with the exchange rate If the temporal method is used, only the monetary accounts are translated into dollars at the current rate method and exposed to exchange gains and losses International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Translation or Accounting Exposure l l l Current rate method is likely to have an exposed asset position Temporal method is likely to have an exposed liability position Firms are positively exposed with income earned in a strong currency country Income earned in a weak currency country will be reduced by the weak exchange rate Dividend flows follow the same pattern as income Results under the temporal method will be mixed International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Economic (Operating) Exposure l l Economic exposure is the potential for change in expected cash flows Economic exposure arises from l l l Pricing of products Sourcing and cost of inputs Location of investments International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Economic (Operating) Exposure l Example by Aeppel, 2005 l Superior Products Inc. , a U. S. company, found that prices for valves it was sourcing from Germany were continuing to rise. As a result, Superior’s management decided to begin producing the valves itself and selling them to U. S. customers. When the Germans realized what was happening, they lowered their prices, but it was too late. International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Economic (Operating) Exposure l l l Future events have more economic exposure than transactions exposure because of the different ways to account for and hedge them Currency of a country could affect its competitiveness as a production location Example (Aeppel, 2005) l Bison Gear and Engineering Corp. closed down its facility in Holland when the dollar was weak, manufactured its products in the U. S. , and sold them back into Europe. International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Hedging Strategies l Duffey’s Six Reasons Why Management Does Nothing (2003) l Managers do not take time to understand the issue l Managers claim that exposure cannot be measured l Managers say that the firm is hedged through hedging of transactions, without understanding the broader economic exposure l Managers say that the firm does not have any exchange risk because it does all of its transactions in the reporting currency. Management ignores economic risk l Management argues that doing business is risky and the firm gets rewarded for bearing both business and financial risks l The balance sheet is hedged on an accounting basis, especially when the functional currency is the reporting currency International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Financial Strategies l l l Hedge exposure by use of derivatives Enter into foreign currency debt Use derivatives to hedge income statement or balance sheet exposure If a company is in a net monetary asset position, it will enter a contract to sell foreign currency. If a company is in a net liability position, it will enter a contract to buy foreign currency International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Operating Strategies l Operating hedges are usually l l l More complicated and costly than financial hedges Involved in betting on the exposure of the entire firm rather than just specific financial transactions Companies can balance costs with revenues l Examples l A company that sells to a European customer might consider manufacturing in Europe so expenses are in euros and can offset euro revenues. l A company might also incur costs in euros so that it can use euro revenues to pay its euro costs. International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Foreign Exchange Risk Management Strategies l Four steps to protect against exchange rate exposure l l Define and measure exposure Organize and implement a reporting system that monitors exposure and exchange-rate movements Adopt a policy assigning responsibility for minimizing – or hedging – exposure Formulate strategies for hedging exposure International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Define and Measure Exposure l l Differentiate between transactions, translation, and economic exposure Each type of exposure may require a different hedging response International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Organize and Implement a Reporting System l l l System must monitor exposure and exchange-rate movements System must forecast exposure to establish a good hedging strategy Management should set up a uniform reporting system for all subs that identifies l l l Exposed accounts that the company wants to monitor Amount of exposure by currency of each account Different time periods in consideration International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Adopt a Policy Assigning Responsibility l l l Determine who is ultimately responsible for protecting the company from exchange rate movements Multidomestic companies usually delegate hedging strategies to national organizations Global companies are more likely to centralize hedging strategies Corporate should determine overall policy Corporate should provide forecasts on exchange rate movements to help local management International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Formulate Hedging Strategies l Choice of exposures to be hedged depends l l l On risk aversion of the company On management’s confidence in predicting exposures Dell Example l l Dell hedges everything Dell’s Brazilian operations hedge about 80% of forecasted revenues International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Adopt a Policy Assigning Responsibility l l l Local management must develop good capabilities in foreign exchange risk management Local banking relationships can help local management develop forecasts of exchange rate movements Local management must establish strategies that fit within corporate guidelines The more centralized the strategy, the more corporate will take responsibility for hedging strategies Local management will then be free to focus on operations International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Hedging Standards l l IAS 39 and SFAS 133 are very similar A derivative is defined by three characteristics l l l Has one or more underlyings (foreign exchange) and one or more notional amounts (units of foreign currency traded) or payment provisions or both Requires no initial net investment or one that is smaller that would be required for other contracts that would have a similar response to changes in market factors Terms require or permit net settlement, it can be readily net by a means outside the contract, or provides for delivery of an asset that puts the recipient in a position close to net settlement International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Hedging Standards l IAS 39 and SFAS 133 require l l l Three kinds of hedges l l All derivatives be recognized as assets or liabilities on the balance sheet at fair value Changes in FV are recorded in comprehensive income Fair-value hedge Cash flow hedge Foreign-currency hedge Hedge accounting matches the recognition of the gain or loss of the derivative with the gain or loss on the underlying transaction International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The Use of a Forward Contract to Hedge a Transaction International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign Currency Transaction Redex Imports, a U. S. company, bought inventory from a British supplier on May 1, incurring a liability of £ 50, 000 that must be paid on June 30. $1. 8500 spot rate on May 1 $1. 8700 forward rate quoted on May 1 for delivery on July 30 $1. 8800 spot rate on June 30 $1. 8900 forward rate quoted on June 30 for delivery on July 30 $1. 9000 spot rate on July 30 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign Currency Transaction May 1 Purchases 92, 500 A/P 92, 500 to record the purchase at the spot rate of $1. 8500 A memorandum entry is made to record Redex’s commitment to deliver dollars to the bank and receive £ 50, 000 at the rate of $1. 87 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign Currency Transaction June 30 Foreign Exchange Loss 1, 500 A/P 1, 500 £ 50, 000 x (1. 88 -1. 85) Forward contract 1, 000 Foreign exchange gain 1, 000 £ 50, 000 x (1. 89 -1. 87) International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign Currency Transaction July 30 A/P Loss 94, 000 1, 000 Cash Forward Contract Gain £ 50, 000 x (1. 90 -1. 89) Cash 95, 000 500 1, 500 Forward contract 1, 500 Assuming a 6% discount rate, PV for one month (June 30 – July 30) is $1. 8900 -1. 8700 =. 02 x 50, 000 = $1, 000/(1 +. 06/12) = $995 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

The Use of a Forward Contract to Hedge a Commitment International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Firm Commitment Redex Imports enters into a commitment to purchase capital equipment for £ 1, 000 from a British manufacturer with delivery to take place on April 30 and payment to be made on May 31. Spot rates Forward rates $1. 4900 March 1 $1. 5700 March 1 $1. 5200 March 31 $1. 5850 March 31 $1. 5500 April 30 $1. 5950 May 31 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Firm Commitment PV of forward contract for March 31 – May 31 1. 5850 – 1. 5700 =. 015 x 1, 000 = $15, 000/(1 +. 06/6) = $14, 851 March 31 Forward Contract 14, 851 Gain on forward contract 14, 851 Loss on firm commitment Firm commitment 14, 851 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Firm Commitment PV of the contract for March 31 – April 30 $1. 59 -1. 57 =. 02 x 1, 000 = $20, 000/(1+. 06/12) = $19, 900 April 30 Forward contract Gain on forward contract 5, 049 Loss on firm commitment Firm commitment 5, 049 Equipment Purchase commitment A/P 5, 049 1, 530, 100 19, 900 1, 550, 000 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Firm Commitment Value of the forward contract on May 31 $1. 5950 - $1. 5700 =. 025 x 1, 000 = $25, 000 May 31 Forward contract Gain on forward contract Foreign exchange loss A/P Forward contract Cash 5, 100 45, 000 1, 595, 000 25, 000 1, 570, 000 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale On March 1, XYZ company estimates it will sell £ 1, 000 of inventory to British customers effective April 30. XYZ enters into a forward contract to hedge the British pounds receivable Spot Rate March 1 $1. 4772 March 31 $1. 4950 Date of sale $1. 5100 Forward Rate for April 30 $1. 4900 $1. 5050 $1. 5100 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale Nominal Value FV Mar 1 0 0 Mar 31 ($15, 000) ($14, 925) Apr 30 ($20, 000) Gain/Loss 0 ($14, 925) ($5, 075) Fair Value adjustment on March 31 15, 000/[1 + (. 06/12)] = 14, 925 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale March 1 No entry March 31 Other comprehensive income 14, 925 Forward contract 14, 925 April 30 Other comprehensive income 5, 075 Forward contract 5, 075 Foreign currency Sales 1, 510, 000 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: A Forward Contract to Hedge a Foreign-Currency Forecasted Sale April 30 Forward contract 20, 000 Cash 1, 490, 000 Foreign currency 1, 510, 000 Sales 20, 000 Other comp. income 20, 000 International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Illustration: An Option Contract to Hedge Foreign-Currency Forecasted Sale XYZ enters into a put option for £ 1, 000 on March 1 at a strike price of $1. 4900 and a premium of $20, 000. The sale is expected to take place on June 30, the same time the option contract expires. March 1 Foreign-currency options 20, 000 Cash 20, 000 The option will be adjusted to FV and the adjustment will go to comprehensive income. When the sale is recorded, this adjustment will be taken from other comp. income and used to adjust the amount of sales. Sales revenue and cash received will be at least $1, 490, 000. International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Use of Derivatives to Hedge a Net Investment l l l SFAS 133 allows hedge accounting for the hedge of a net investment Gains and losses are taken to a separate component of stockholders’ equity The gain or loss may be included in the cumulative translation adjustment to the extent the changes represent an effective hedge of the net investment International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Disclosure of Derivative Financial Instruments l Derivatives are subject to the following l l Market risk – the risk of loss due to unexpected changes in interest and exchange rates Credit risk – the potential loss from counterparty nonperformance Liquidity risk – related to market liquidity of instruments held; closely related to market risk Operating risk – linked to inadequate controls that ensure following a properly defined corporate policy International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black

Disclosure of Derivative Financial Instruments l l l Must disclose the extent of the risk to users Must provide qualitative and quantitative information about derivatives Must disclose l l Objectives for holding derivatives Context needed to understand objectives Strategies for achieving the objectives Separate information should be provided for l l l Fair-value hedges Cash-flow hedges Foreign currency hedges International Accounting & Multinational Enterprises – Chapter 13 – Radebaugh, Gray, Black