MNC_s_Exposure_to_Exchange_Rate_Fluctuations

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MNC's Exposure to Exchange Rate Fluctuations &

Hedging Techniques Exchange rate risk can be broadly defined as the risk

that a company’s performance will be affected by exchange rate movements.

Classification of Exchange Rate Risk/Currency Exposure

1. Accounting Exposure: Transaction exposure Translation exposure

2. Economic Exposure

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Transaction Exposure

The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.

Example. If IBM sells a Mainframe computer to Royal Dutch Shell in England, it typically will not be paid until a later date. If that sale is priced in Pounds, IBM has a pound exposure.

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Measurement of Transaction Exposure

Measurement of transaction exposure involves two steps:

1. Determining the projected net amount of inflows or outflows in each foreign currency, and

2. Determine the overall risk of exposure to those currencies.

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Measurement of Transaction Exposure

Measurement of transaction exposure requires projections of the consolidated net amount in currency inflows or outflows of all subsidiaries, categorized by currency.

Subsidiary X may have net inflows of £500,000, while Subsidiary Y may have net outflows of £ 600,000. The consolidated net inflows here would be –£100,000. If the pound depreciates before the individual cash flows take place, this will have an unfavourable impact on Subsidiary X, since the pounds will be worth less when converted to desired foreign currency. However, the pound’s depreciation will have a favourable impact on Subsidiary Y.

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Consolidated Net Cash Flow Assessment of an MNC

Currency Total Total Net Inflow Current X Net Inflow or Inflow Outflow or Outflow Rate Outflow in

USD

C$ C$ 2,000,000 C$6,000,000 (C$4,000,000) $.80 ($3,200,000)

DM DM10,000,000 DM12,00,000 (DM2,000,000) $.50 ($1,000,000)

FF FF100,000,000 FF60,000,000 FF40,000,000 $.10 $4,000,000

SF SF1,000,000 SF6,000,000 (SF5,000,000 ) $.60 ($3,000,000)

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Estimating the Range of Net Inflows or Outflows for the MNC

Currency Net Inflow Range of Range of Possible or Outflow Possible X Rate Net Inflows or

at the end of pd. Outflows in USDC$ (C$4,000,000) $.79 to $.80 ($3,160,000 to $3,240,000)

DM (DM2,000,000) $.48 TO $.52 ($960,0000 to 1,040,000)

FF FF40,000,000 $.09 TO $.11 $3,600,000 to $4,400,000

SF (SF5,000,000) $.56 to $.64 ($2,800,000 to $ 3,200,000)

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Managing Transactions Exposure

Four alternatives to manage transaction/currency exposure:

1. Remain unhedged

2. Hedge in the forward market

3. Hedge in the money market

4. Hedge in the options market

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Managing Transaction Exposure

Scout Finch is the CEO of Dayton Inc., a US based manufacturing of turbine equipment. She has just concluded negotiations for the sale of a turbine generator to Crown, a British firm, for £1,000,000. Dayton has no other current foreign customers, so the the currency risk of this sale is of particular concern. Scout Finch has collected the following financial and non-financial information for the analysis of her currency exposure problem:

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Dayton Manufacturing Transaction Exposure

• Spot exchange rate: $1.7640/ £• Three month forward rate: $1.7540/ £• Dayton’s cost of capital: 12%• UK three-month borrowing interest rate:10% (or 2.5%/qtr.)• UK three-month investment interest rate: 8% (or 2%/qtr.)• US three-month borrowing interest rate: 8% (or 2%/qtr.)• US three month investment interest rate: 6% (or 1.5%/qtr.)• June put options in OTC (bank) market for £1,000,000: strike price

$1.75 (nearly at-the-money); 1.5% premium or strike price $1.71 (out-of-the-money): 1.0% premium

Dayton’s foreign exchange advisory service forecasts that the spot rate in three months will be $1.76/ £

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Unhedged Position

Scout Finch may decide to accept the transaction risk. If she believes the foreign exchange advisor, she expects to receive:

£1,000,000 X $1.76 = $1,760,000 (in three months)

However, the above amount is at risk. If the pound should fall to say, $1.65/ £, she will receive only $1,650,000

Exchange risk is not one sided, however; if the transaction is left uncovered and the pound strengthens even more than forecast by the advisor, Dayton will receive considerably more than $1,760,000.

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Forward Market Hedge

A forward hedge involves a forward (or futures) contract and a source of funds to fulfill that contract.

Should Dayton wish to hedge its transaction exposure in the forward market, it will sell 1,000,000 forward today at the three-month forward quotation of $1.7540 per pound. In three months, the firm will receive

£1,000,000 X $1.7540 = $1,754,000This certain sum is $6,000 less than the uncertain $1,760,000

expected from the unhedged position because the forward market quotation differs from the firm’s three-month forecast.

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Money Market Hedge

Like a forward market hedge, a money market hedge also involves a forward (or futures) contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement. The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. Money market hedge may be:

Covered, in which funds to fulfill the contract – that is, to repay the loan is generated from business operations; or

Uncovered or open, in which funds to repay the loan is purchased in the foreign exchange spot market.

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Money Market Hedge

To hedge in the money market, Ms. Finch will borrow pounds in London at once, immediately convert the borrowed pounds into dollars, and repay the pound loan in three months with the proceeds from the sale of the generator.

The amount to borrow now for repayment in three months is:

Scout Finch should borrow £975,610 now and in three months repay that amount plus £24,390 of interest from the sale proceeds of the account receivable. Dayton would exchange the £975,610 loan proceeds for dollars at the current spot exchange rate of $1.7640/ £, receiving $1,720,976 at once.

£1,000,000£975,610

1+.025

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Future value of the loan proceeds at the end of three months under each of the three investment assumptions

Received Invested in Rate Full value in today three months

$1,720,976 Treasury 6%/yr or 1.5%/qtr $1,746,791$1,720,976 Debt cost 8%/yr or 2.0%/qtr $1,755,396$1,720,976 Cost of capital 12%/yr or 3.0%/qtr $1,772,605Because the proceeds in three months from the forward hedge would be

$1,754,000, the money market hedge is superior to the forward hedge if scout Finch used the loan proceeds to replace a dollar loan (8%) or to conduct general business operations (12%). The forward hedge would be preferable if Dayton merely if Dayton merely invested the pound loan proceeds in dollar-denominated money market instruments at 6% annual interest.

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Money Market Hedge

A break-even investment can be calculated that would make Dayton indifferent between the forward hedge and the money market hedge. Assume that r is the unknown three-month investment rate, expressed as a decimal, that would equalize the proceeds from the forward and money market hedges. We have

(loan proceeds) (1+rate) = (forward rate)$1,720,976 (1+r) = $1,754,000

r = 0.0192Upon annualizing this three-month investment rate, we would find: 0.0192 X 360/90 X 100 = 7.68% The implications are that if Finch can invest the loan proceeds at a rate

higher than 7.68% p.a., she would prefer money market hedge, other wise forward hedge.

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Options Market Hedge

Scout Finch could purchase from her bank a three-month put option on £1,000,000 at either 1) an at-the-money (ATM) strike price of $1.75/ £ (and a premium cost of 1.50%), or 2) an out-of-the money (OTM) strike price of $1.71/ £ (and a premium cost of 1.00%) . The cost of first option with the strike price of $1.75 is:

(size of option) X (premium) X (spot rate) = cost of option

£1,000,000 X 0.015X$1.75 = $26,460Premium cost of the put option would be $26,460(1.03) = $27,254

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Options Market Hedge

Put option strike price ATM option OTM option

$1.75/£ $1.71/£

Option cost (future value) $27,254 $18,169

Proceeds if exercised $1,750,000 $1,710,000

Minimum net proceeds $1,722,746 $1,691,831

Maximum net proceeds Unlimited Unlimited

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Translation Exposure

Translation Exposure also called Balance Sheet Exposure , arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.

Illustration. Suppose an Indian company has a UK subsidiary. At the beginning of the parent’s financial year the subsidiary has real estate, inventories, and cash valued at , respectively, £1,000,000, £ 200,000 and £ 150,000. The spot rate is Rs 68 per sterling. However, during the year, there has been a drastic depreciation of the pound to Rs. 65. Due to this translated value of its assets has declined from Rs. 9.18 crore to Rs. 8.775 crore.

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Managing Translation Exposure

Firms have three available methods for managing their translation exposure:

1. Adjusting fund flows

2. Entering into forward contracts, and

3. Exposure netting

Basic strategy for Hedging Transaction Exposure

Assets Liabilities

Hard currencies (likely to appreciate) Increase Decrease

Soft currencies (likely to depreciate) Decrease Increase

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Funds Adjustment

• Sell local currency forward• Reduce levels of local-currency cash

and marketable securities• Reduce local currency receivables• Delay collection of hard-currency

receivables• Increase imports of hard-currency

goods• Borrow locally• Delay payment of accounts payable• Speed up dividend & fee remittances to

parent and other subsidiaries• Speed up payment of inter-subsidiary

accounts payable• Invoice exports in foreign currency

and imports in local currency

• Buy local currency forward• Increase levels of local-currency cash

and marketable securities• Relax local-currency credit items Speed up collection of soft-currency

receivables• Reduce imports of soft-currency

goods• Reduce local borrowing• Accelerate payment of A/P• Delay dividend and fee remittances to

parent and other subsidiaries• Delay payment of of inter-subsidiary

accounts payable• Invoice exports in local currency and

imports in foreign currency

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Managing Translation Exposure Thru Forward Contract & Exposure Netting

• Forward Contract can reduce a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency. For example, suppose that IBM U.K. has translation exposure of £40 million (that is, sterling assets exceed sterling liabilities by that amount). IBM U.K. can eliminate its entire translation exposure by selling £40 million forward. Any loss (gain) on its translation exposure will then be offset by a corresponding gain (loss) on its forward contract.

• Exposure Netting involves offsetting exposure in one currency with exposure in the same or another currency such that gains or losses on the two currency positions will offset each other. It is easy to see, for example, that a DM 1 million receivable and DM I million payable cancel each other out with no net (before-tax) exposure.

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Economic Exposure

Economic Exposure, also called operating exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates.

Economic exposure and transaction exposure are related in that they both deal with future cash flows. They differ in that the latter stems from exchange gains or losses on foreign-currency-denominated contractual obligations whereas the former attempts to assess and manage the impact of exchange rate movements on the firm’s future cash flows, which are not fixed in either the home currency or the foreign currency.

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Economic Exposure & Real Exchange Rate

Operating exposure arises mainly on account of changes in real exchange rates. Consider an example to reinforce this point:

An Indian firm exports carpets to the UK. At the beginning of the year, the X rate is Rs. 68.00/£. Competitive considerations suggest that the exporter should invoice in sterling and price the carpet at £200. At this price it is able to sell 100 carpets per month. The firm’s operating cost is Rs. 8,000 per carpet. Thus its operating margin is Rs. 5,600 per unit. Over the year, UK & Indian prices increase by 5% and 15%. It can raise the UK price to £210 without affecting sales. Its operating costs increase to Rs. 9200. To maintain operating margin in real terms that is, Rs. 6440 per unit, it must get Rs. 15640 from each unit. If the exchange rate appreciates to Rs. 74.4762, the firm is unaffected. But this means that real X rate must remain unchanged at 74.4762 = 68 (1.15/1.05).

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Economic Exposure & Real Exchange Rate

The previous example makes it clear that operating exposure depends upon:

• Change in nominal exchanges rate

• Change in selling price (output price).

• Change in the quantity of output sold.

• Change in operating costs, that is, quantities and prices of inputs.

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Economic Exposure & Real Exchange RateBalance Sheet of Aquarius Garments (Current exchange rate is Rs. 45/USD)

AssetsCash 5,00,000

A/C Receivable 25,000,000

Inventory 12,500,000

Net Fixed Assets 100,000,000

142,500,000

LiabilitiesA/C Payable 6,000,000

L.T. Debt 60,000,000

Equity 76,500,000

142,500,000

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Aquarius Garments P/L Statement Before Change in X Rate

Units Rs. Per Unit TotalHome sales 100,000 900 90,000,000Export Sales 50,000 900 45,000,000Labour @ 150Domestic Raw Materials @ 200Imported Raw Materials @100Total operating cost @450 per unit 67,500,000Operating income 67,500,000Fixed cash operating cost 8,000,000Depreciation 10,000,000Interest 10,000,000Pre-tax profit 39,500,000Tax @40% 15,800,000Profit after Tax 23,700,000Add Depreciation 10,000,000Operating Cash Flow 33,700,000

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Economic Exposure

Scenario I: The rupee will depreciate to Rs. 47. Price for home sales will be raised by 10% while the foreign currency price for US buyers will be raised by 5%. There will be a loss of sales at home of 3% while US sales will remain unchanged. Labour costs will increase by 10%, domestic material costs by 15% and cost of imported materials by 5%.

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Aquarius Garments P/L Statement: Scenario I


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Economic Exposure

Scenario II: We now anticipate that the rupee depreciates to Rs. 50. The firm lowers its dollar price for US sales by 5% (from $20 to $19). The price for home sales is raised to Rs. 950, equivalent to the foreign price at the new exchange rate. Export sales volume increases by 6% while home sales volume by 5%. Assumptions regarding costs are same as in Scenario I except he cost of imported materials, which is projected to increase by 10%. The projected P/L statement is given below. Now a small real deprecation of the rupee has caused the operating cash flow to increase marginally due to the increase in physical sales volume.

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Aquarius Garments P/L Statement: Scenario II


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Economic Exposure

Scenario III: finally we consider the case where the rupee actually appreciates in nominal terms to Rs 42. This could happen if there is a surge in capital inflows and the central bank does not prevent the dollar from falling. The firm raises dollar prices for US sales by 8% and loses 10% of sales volume. At home, rupee prices are left unchanged from the base case scenario but still there is a loss of 2% in domestic sales. There is no change in the rupee cost of imported materials, domestic material costs increase by 15

%. While labour cost goes up by 8%. The projected P/L statement shows a deterioration in the firm’s cash flow as a result of this substantial real appreciation of the rupee.

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Aquarius Garments P/L Statement: Scenario III

Units Rs. Per Unit TotalHome sales 98,000 900 88,200,000Export Sales 45,000 907.20 40,824,000Labour @ 162Domestic Raw Materials @ 230Imported Raw Materials @100Total operating cost @492 per unit 70,356,000Operating income 58,668,000Fixed cash operating cost 8,000,000Depreciation 10,000,000Interest 10,000,000Pre-tax profit 30,668,000Tax @40% 12,267,200Profit after Tax 18,400,800Add Depreciation 10,000,000Operating Cash Flow 28,400,800

MNC_s_Exposure_to_Exchange_Rate_Fluctuations

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