Outline 7 7 Measuring and Managing Economic Exposure

Outline 7 7. Measuring and Managing Economic Exposure 7. 1 Value of the MC 7. 2 Types of Exposure 7. 3 Economic Exposure 7. 4 Measuring Economic Exposure 7. 5 Managing Economic Exposure 7. 6 Transactions Exposure 7. 7 Measuring Transaction Exposure 7. 8 Managing Transactions Exposure 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 1

7. 1 Value of the MC Firm V = value of MC E(CFj, t)= expected cash flow denominated in currency j to be received in period t E(ERj, t)= expected exchange rate at which currency j can be converted to $ at end of period t k = weighted average cost of capital m= number of currencies n= number of periods 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 2

7. 1 Value of the MC Firm Economic Exposure 3/19/2018 Transactions Exposure Multinational Corporate Finance Prof. R. A. Michelfelder 3

7. 2 Types of FX Exposure • • • Economic exposure – Degree to which PV of future CF’s, or, V is influenced by exchange rate fluctuations Transactions exposure – Degree to which the value of CF transactions can be affected by exchange rate fluctuations. This is a subset of economic exposure. Translation exposure – Degree to which MC’s consolidated financial statements are influenced by exchange rate fluctuations – Relevance? : Translation of financial statements for consolidated reporting does not itself affect MC’s CF’s. Some analysts argue that translation exposure is not relevant. It depends on whether foreign subsidiaries remit earnings to parent company. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 4

7. 3 Economic Exposure • Degree to which a firm’s PV of future cash flows are influenced by FX rate fluctuations – Transactions that cause transactions exposure also cause economic exposure as these CF’s can be effected by FX rate fluctuations – Other types of business that do not cause transactions exposure can cause economic exposure from FX rate fluctuations 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 5

7. 3 Economic Exposure • Economic exposure to local currency depreciation and appreciation: – Appreciation: • Causes a reduction in both cash inflows and outflows thus its difficult to generalize about the net CF impact (Inflows affected more than outflows? ) – Depreciation: • Causes opposite impact of appreciation: increase in cash inflows and outflows – net CF’s depends on whether inflows are affected more than outflows 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 6

7. 3 Economic Exposure Transactions That Influence the Firm’s Local Currency Inflows Impact of Local Currency Appreciation Impact of Local Currency Depreciation Local sales (relative to foreign competition Decrease in local markets) Firm’s exports denominated in local currency Decrease Increase Firm’s exports denominated in foreign currency Decrease Interest received from foreign investments Decrease 3/19/2018 Increase Multinational Corporate Finance Prof. R. A. Michelfelder 7

7. 3 Economic Exposure Transactions That Influence the Firm’s Local Currency Outflows Impact of Local Currency Depreciation Firm’s imported supplies denominated in local currency No change Firm’s imported supplies denominated in foreign currency Decrease Interest owed on foreign funds borrowed 3/19/2018 Impact of Local Currency Appreciation Decrease Increase Multinational Corporate Finance Prof. R. A. Michelfelder 8

7. 4 Measuring Economic Exposure • MC’s should assess the potential degree of exposure they face and then determine whether to insulate against it – Assessing economic exposure of an MC with subsidiaries around the world is difficult due to interaction of CF’s denominated in various currencies into, out of, and within the MC – The overall impact of FX fluctuations on MC is very complex 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 9

7. 4 Measuring Economic Exposure • Sensitivity of Earnings to FX rates: – Classify the CF’s into different income statement items and predict each item based on a scenario of exchange rates – Develop alternative FX rate scenarios and revise income statement items and income statement 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 10

7. 4 Measuring Economic Exposure • Sensitivity of CF’s to FX rates: Can be assessed by applying regression analysis to historical CF and FX rate data: % CFt = a 0 + a 1 % Et + t CFt = inflation-adjusted CF’s measure in home currency in time t Et = home currency price of foreign exchange in time t t = error term in time t a 0 = intercept a 1 = slope, reflects the sensitivity of CF’s to E (elasticity) Can add more E’s if the CF depends on may FX rates. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 11

7. 5 Managing Economic Exposure “The economic impact of currency exchange rates on us is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions, and other factors. These changes, if material, can cause us to adjust our financing and operating strategies. ” Pepsi. Co 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 12

7. 5 Managing Economic Exposure • Managing economic exposure in the longrun involves strategic decisions beyond short-term FX hedging to minimize CF exposure • Restructuring operations can reduce economic exposure: – Involves shifting the sources of costs or revenues to other locations to match cash inflows and outflows or foreign currencies 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 13

7. 5 Managing Economic Exposure • Restructuring operations to reduce economic exposure more difficult than hedging any foreign currency transaction – Managing economic exposure more difficult than managing transactions exposure • Long-term solution and therefore very costly to reverse or eliminate 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 14

7. 6 Transactions Exposure • Degree to which the value of future cash transactions can be affected by FX rate fluctuations – E. g. US exporters that sold products to Asian countries during the 97 -98 Asian currency crisis. Some Asian currencies depreciated by 80%. If invoiced in Asian currencies, exporters’ CF’s may have fallen 80%. If invoiced in dollars, exporters’ CF’s not affected but Asian importers would face it. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 15

7. 7 Measuring Transactions Exposure • Two steps: 1. Determine the net amount of inflows and outflows in each foreign currency 2. Determine the overall risk of exposure to those currencies 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 16

7. 7 Measuring Transactions Exposure • A MC needs to project the consolidated net amount in currency inflows or outflows for all of its subsidiaries, categorized by currency – One subsidiary may have inflows of a currency while another has outflows of the same, and the MC’s net CF’s in that currency overall may be nil. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 17

7. 7 Measuring Transactions Exposure • Transactions exposure based currency variability: – Previous e. g. FX rates were forecasted without discussing method for predicting • Measurement of currency variability: – Standard deviation of FX rates • Historical statistics indicate the potential movement in an exchange rate – some move a lot more than others. Standard deviation will provide a range for estimating the upper and lower range of a cash flow forecast in different currencies 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 18

7. 7 Measuring Transactions Exposure • Measurement of currency variability: – Currency correlations: can be used to determine the degree to which two currencies will move in relation to each other; less correlation among FX rates you deal in means less exposure due to currency diversification – Value-at-Risk: incorporates volatility and currency correlations to determine the potential maximum oneday loss on the value of positions of a MC exposed to FX rates 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 19

7. 8 Managing Transactions Exposure • Techniques to eliminate transactions exposure: – Futures hedge – Forward hedge – Currency option hedge 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 20

7. 8 Managing Transactions Exposure Hedging Method To Hedge Receivables Futures Hedge Buy a currency futures contract(s) for the amount of the payables Sell a currency futures contract(s) for the amount of the receivables Forward Hedge Negotiate a forward contract to buy the amount of currency needed to cover payables Negotiate a forward contract to sell the amount of currency from receivables Currency Option Hedge 3/19/2018 To Hedge Payables Buy a call option(s) to buy the amount of currency needed to make the payment Buy a put option(s) to sell the amount of currency from receivables Multinational Corporate Finance Prof. R. A. Michelfelder 21