Foreign ExchangeRisk Management

Foreign Exchange Risks

• Transaction Risk

• Translation Risk

• Economic Risk

Transaction Risk• The risk of changes in the expected value of a contract

between its signing and its execution as a result of unexpected changes in foreign exchange rates.

• Whoever makes a contract denominated in a foreign currency bears transaction risk.

• Ocean Drilling has transaction risk if it borrows money in French francs or Japanese yen, and Hintz-Kessels-Kohl has transaction risk if it agrees to accept future payments for its vehicles in U.S. dollars.

Translation Risk• Gains or losses from exchange rate changes that

occur as a result of converting financial statements from one currency to another in order to consolidate them.

• Every company having at least one subsidiary using a different functional currency bears translation risk.

• MSDI has translation risk from having a subsidiary, MSDI Alcala de Henares, whose financial statements are kept in Spanish pesetas and not in U.S. dollars.

Economic Risk

• Changes in competitive position as a result of permanent changes in exchange rates.

• Every company buying or selling abroad or even just competing with foreign companies has economic risk.

• Maybach has economic risk from manufacturing its automobiles in Germany for export to the United States, where it competes with Rolls Royces manufactured in England.

Transaction Risk

Passive Transaction Risk Management

• Denominate all contracts in domestic currency. This is a possible strategy for companies with market power.

• Do nothing about transaction risk. This is a possible strategy for companies with a large number of small contracts in a large number of currencies.

Natural Transaction Risk Hedging

• Centralize cash management to net all offsetting transactions, transactions which are long and short the same currency.

• Time, lead and lag, offsetting business transactions in the same currency.

• Create offsetting business transactions in the same currency.

Market Transaction Risk Hedging

• Forward Markets

• Futures Markets

• Money Markets

• Swaps Markets

• Options Markets

Hedging

• Insuring against transaction risk to reduce or eliminate the effects of unexpected changes in exchange rates.

• You can hedge only at market rates. The effects of expected changes in exchange rates are incorporated in these market rates.

• Hedging is insurance. The purpose of hedging is to reduce or eliminate risks, not to make profits.

Reasons Not To Hedge

• Since no one can out-guess the market, the expected value of hedging, not including the direct costs, is zero. With the direct costs, hedging is expected to lose money. But are there offsetting benefits?

• Hedging affects the appearance of a company but not the economic reality. Investors can see through the accounting statements to the underlying economics. But do investors really have enough information to do this?

• Hedging stabilizes financial performance, which benefits the managers of a company but not the owners. The owners can diversify away the risk in their investment portfolios. But is such diversification always possible?

Reasons To Hedge

• Hedging reduces the risk of the extraordinary costs of extreme financial distress.

• Hedging facilitates the execution of complex operational and financial plans.

• Hedging prevents changing economic conditions from destroying the effectiveness of performance evaluation systems.

Translation Risk

Example of Translation Risk

• Narodno Pivo intends to set up a marketing subsidiary in the United States.

• It loans this subsidiary 125,000,000 SIT when the exchange rate is 250 SIT/USD.

• The 500,000 USD (125,000,000/250) is deposited in an account at a U.S. bank.

• Narodno Pivo credits cash and debits a new asset, loan to subsidiary, for 125,000,000 SIT.

• The subsidiary debits cash and credits a new liability, loan from parent, for 500,000 USD.

Financial Statement Consolidation

• No other transactions have occurred, and the cash remains in the account at the U.S. bank.

• The tolar has strengthened, and the exchange rate is now 200 SIT/USD.

• The financial statements of Narodno Pivo and its subsidiary must be consolidated for financial reporting at the end of the fiscal year.

Convert at Current Rate

• The cash is worth 100,000,000 SIT (500,000 x 200).

• On the subsidiary statements, the loan from parent is also worth 100,000,000 SIT (500,000 x 200).

• The subsidiary balance sheet balances.• But on the Narodno Pivo statements, the loan to

subsidiary is still 125,000,000 SIT.• The loan to subsidiary and the loan from parent

no longer offset each other.

Convert at Historical Rates

• The cash is worth 100,000,000 SIT (500,000 x 200).• On the subsidiary statements, the loan from parent is still

worth 125,000,000 SIT (500,000 x 250).• On the Narodno Pivo statements, the loan to subsidiary is

still 125,000,000 SIT.• The loan to subsidiary and the loan from parent still offset

each other.• But the subsidiary balance sheet does not balance in SIT.

The asset is 100,000,000 SIT and the liability is 125,000,000 SIT.

Solutions

• If current rates were used for consolidation, the value of the loan to subsidiary on Narodno Pivo’s balance sheet must be written down by 25,000,000 SIT (125,000,000 - 100,000,000).

• If historical rates were used for consolidation, a 25,000,000 SIT loss (125,000,000 - 100,000,000) must be recognized in order to make the Narodno Pivo consolidated balance sheet balance.

Is the Loss Real?

• Yes. Narodno Pivo has lost 25,000,000 SIT in tolar value as a result of transaction risk; that is, making a loan denominated in a foreign currency. Had they kept that money in Slovenia, they could be doing more with it now.

• No. Narodno Pivo has lost nothing in dollar value. The ability of the subsidiary to perform its economic function has not changed as a result of the exchange rate change. Had the subsidiary belonged to a U.S. company, the exchange rate change would have been completely irrelevant. Narodno intended the subsidiary to be successful and did not intend to get the cash back. It cannot lose what it never intended to have.

Hedging Translation Risk

• Translation risk is hedged in the same ways as transaction risk.

• Does it make sense to create a real risk (a natural or market hedge) to offset a translation risk that may or may not be real?

• It appears as if investors are indifferent to foreign currency translation gains and losses.

Market Transaction Risk Hedging

• Forward Markets

• Futures Markets

• Money Markets

Forward and Futures Markets

• Any currency, any amount, any maturity

• Illiquid• Self-regulated OTC market• Contract with dealer• Requires credit-worthiness• Cash flow only at maturity• Settled by executing contract• Hedge by buying forward the

short currency or selling forward the long currency

• Selected currencies, standard contracts, standard maturities

• Liquid• Government-regulated exchange-

based market• Contract with exchange• Requires margin account• Marked to market daily• Settled by offsetting trade• Hedge by making a transaction

whose gains or losses offset those of the underlying position

Forward and Money Markets

• Money markets can always be used to synthesize forward markets.

• Money market rates are used to set forward market rates.

• Money market transactions are likely to be more costly than forward market transactions, since three transactions having their own bid-ask spreads are required to duplicate one forward market transaction with one bid-ask spread.

• Money market transactions appear on the balance sheet; forward market transactions do not.