Transaction exposure

Multinational Business Finance
[email protected]
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Transaction Exposure
• Foreign exchange exposure is a measure of
how a firm’s profitability, net cash flow, and
market value will change because of a change
in exchange rates.
• An important task of the financial manager is
to measure foreign exchange exposure and to
manage it so as to maximize the profitability,
net cash flow, and market value of the firm.
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Types of Foreign
Exchange Exposure
• Transaction exposure measures changes in the
value of outstanding financial obligations
• This type of exposure deals with changes in
cash flows the result from existing contractual
obligations.
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Economic Exposure
• Operating exposure, and transaction exposure
are called economic exposure, measures the
change in the expected value of the firm
resulting from an unexpected change in
exchange rates.
• Expected changes in exchange rate can be
calculated through Parity conditions. The rest
is unexpected.
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Types of Foreign
Exchange Exposure
• Transaction exposure and operating exposure
exist because of unexpected changes in future
cash flows due to a exchange rate change.
• The difference between the two is that
transaction exposure is a contractual
obligation, while operating exposure focuses
on foreign currency cash flows generated
from operation that might change because a
change of exchange rates.
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Types of Foreign
Exchange Exposure
• Translation exposure, also called accounting
exposure, is the potential for accounting-derived
changes in owner’s equity to occur because of
the need to “translate” the owners equity to
home currency to report consolidated financial
statements.
• The exposure is not real, it is called Balance sheet
loss or gain.
• It only becomes material when the subsidiary
closes.
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Exhibit 11.1 Conceptual Comparison of Transaction, Operating, and
Translation Foreign Exchange Exposure
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Why Hedge?
• MNEs possess a multitude of cash flows that
are sensitive to changes in exchange rates,
interest rates, and commodity prices.
• These three financial price risks are the
subject of the growing field of financial risk
management.
• Many firms attempt to manage their currency
exposures through hedging.
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Why Hedge?
• Hedging is the taking of a position, i.e. a cash
flow, an asset, or a contract (including a
forward contract) that will rise (fall) in value
and offset a fall (rise) in the value of an
existing position.
• While hedging can protect the owner of an
asset from a loss, it also eliminates any gain
from an increase in the value of the asset.
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Why Hedge?
• The value of a firm, according to financial theory, is the net
present value of all expected future cash flows.
• Nothing is certain yet.
• Currency risk is defined roughly as the changes in expected cash
flows arising from unexpected exchange rate changes.
• A firm that hedges these exposures reduces some of the variance
in the value of its future expected cash flows.
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Exhibit 11.2 Impact of Hedging on the Expected Cash
Flows of the Firm
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Why Hedge?
• However, is a reduction in the variability of cash flows
sufficient reason for currency risk management? Opponents
of hedging state (among other things):
– Shareholders are much more capable of diversifying currency risk than
the management of the firm
– Currency risk management does not increase the expected cash flows
of the firm
– Management often conducts hedging activities that benefit
management at the expense of the shareholders (agency conflict)
– Managers cannot outguess the market
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Why Hedge?
• Proponents of hedging cite:
– 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 (the point of
financial distress)
– Management has a comparative advantage over the individual
shareholder in knowing the actual currency risk of the firm
– Management is in better position to take advantage of disequilibrium
conditions in the market
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Measurement
of Transaction Exposure
• Transaction exposure measures gains or losses
that arise from the settlement of existing
financial obligations whose terms are stated in
a foreign currency.
• The most common example of transaction
exposure arises when a firm has a receivable
or payable denominated in a foreign currency.
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Exhibit 11.3 The Life Span of a
Transaction Exposure
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Measurement
of Transaction Exposure
• Foreign exchange transaction exposure can be managed by
contractual, operating, and financial hedges.
• The main contractual hedges employ the forward, money,
futures, and options markets.
• Operating and financial hedges employ the use of risk-sharing
agreements, leads and lags in payment terms, swaps, and
other strategies.
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Measurement
of Transaction Exposure
• The term natural hedge refers to an off-setting
operating cash flow, a payable arising from the
conduct of business.
• A financial hedge refers to either an off-setting
debt obligation (such as a loan) or some type of
financial derivative such as an interest rate swap.
• Care should be taken to distinguish operating
hedges from financing hedges.
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Trident’s Transaction Exposure
• With reference to Trident’s Transaction Exposure,
the CFO, Maria Gonzalez, has four alternatives:
– Remain unhedged;
– hedge in the forward market;
– hedge in the money market, or
– hedge in the options market.
• These choices apply to an account receivable
and/or an account payable.
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Trident’s Transaction Exposure
• A forward hedge involves a forward (or futures) contract and
a source of funds to fulfill the contract.
• In some situations, funds to fulfill the forward exchange
contract are not already available or due to be received later,
but must be purchased in the spot market at some future
date.
• This type of hedge is “open” or “uncovered” and involves
considerable risk because the hedge must take a chance on
the uncertain future spot rate to fulfill the forward contract.
• The purchase of such funds at a later date is referred to as
covering.
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Trident’s Transaction Exposure
• A money market hedge also involves a 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.
• Funds to fulfill the contract – to repay the loan – may be
generated from business operations, in which case the money
market hedge is covered.
• Alternatively, funds to repay the loan may be purchased in
the foreign exchange spot market when the loan matures
(uncovered or open money market hedge).
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Trident’s Transaction Exposure
• Hedging with options allows for
participation in any upside potential
associated with the position while limiting
downside risk.
• The choice of option strike prices is a very
important aspect of utilizing options.
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Exhibit 11.5 Trident’s Hedging Alternatives, Including an ATM
Put Option
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Risk Management in Practice
• The treasury function of most private firms, the
group typically responsible for transaction
exposure management, is usually considered a
cost center.
• The treasury function is not expected to add
profit to the firm’s bottom line.
• Currency risk managers are expected to be
conservative when managing the firm’s money.
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Risk Management in Practice
• As might be expected, transaction exposure
management programs are generally divided
along an “option-line”; those that use options
and those that do not.
• Firms that do not use currency options rely
almost exclusively on forward contracts and
money market hedges.
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Risk Management in Practice
• Many MNEs have established rather rigid transaction
exposure risk management policies that mandate
proportional hedging.
• These contracts generally require the use of forward
contract hedges on a percentage of existing
transaction exposures.
• The remaining portion of the exposure is then
selectively hedged on the basis of the firm’s risk
tolerance, view of exchange rate movements, and
confidence level.
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Exhibit 11.4 Valuation of Cash Flows by Hedging
Alternative for Trident
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Exhibit 11.6 Valuation of Hedging
Alternatives for an Account Payable
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OPERATING EXPOSURE
MANAGEMENT
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What is Operating Exposure?
Operating exposure (also called competitive
exposure, and strategic exposure)
measures the change in the firm´s present
value
resulting from the expected changes in future
operating cash flows denominated in foreign
currency (caused by an unexpected change in
exchange rates).
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How to measure Operating Exposure? Two
difficulties
• Measuring the operating exposure of a firm
requires forecasting and analyzing all the
firm’s future individual transaction exposures
together with the future exposures of all the
firm’s competitors and potential competitors
worldwide.
• To analyze the longer term exchange rate
changes that are unexpected and its impact
on the firm– is the goal of operating exposure
analysis.
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Operating cash flows and financing
cash flows
Differentiating cash flows of MNEs:
•Operating cash flows arise from business activities: that
is, from intercompany (between unrelated companies) and
intracompany (between units of the same company)
receivables and payables, rent and lease payments, royalty
and license fees and management fees.
•Financing cash flows are from financing activities, that is
payments for loans (principal and interest), equity
injections and dividends.
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Exhibit 12.1 Financial and Operating Cash Flows Between
Parent and Subsidiary
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Attributes of Operating Exposure
• Operating exposure is important for the long-run health
of a business.
• However, operating exposure is inevitably subjective
because it depends on estimates of future cash flow
changes over an arbitrary time horizon.
• Planning for operating exposure is a management
responsibility because it relates to the interaction of
strategies in finance, marketing, purchasing and
production.
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Attributes of Operating Exposure
 An expected change in foreign exchange rates
is not of concern.
 From an investor’s perspective, if the foreign
exchange market is efficient, information
about expected changes in exchange rates
should be reflected in a firm’s market value.
 Only unexpected changes in exchange rates,
or an inefficient foreign exchange market,
should cause market value to change.
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Example:
• We discuss the dilemma facing Trident as a
result of an unexpected change in the value
of the euro, €, the currency of denomination
for Trident´s German subsidiary.
• There is concern over how the subsidiary´s
revenues (price and volumes in euro terms),
costs (input costs in euro terms), and
competitive landscape will change with a fall
in the value of the euro.
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Exhibit 12.2 Trident Corporation and Its European Subsidiary: Operating
Exposure of
the Parent and Its Subsidiary
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Measuring the Impact of Operating
Exposure
• Trident Europe:
– Case 1: Euro Devaluation €, no change in any
variable.
– Case 2: Increase in sales volume; other variables
remain constant.
– Case 3: Increase in sales price; other variables
remain constant.
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The objective of the Operating
Exposure management
 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.
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Benefits of diversification
 Management team is prepositioned both to
recognize disequilibrium when it occurs and to
react competitively if the firm´s operations are
diversified internationally .
 Recognizing a temporary change in worldwide
competitive conditions permits management to
make changes in operating strategies.
 Domestic firms do not have the option to react in
the same manner as an MNE.
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Benefits of diversification
• If a firm’s financing sources are diversified, it
will be prepositioned to take advantage of
temporary deviations from the international
Fisher effect. i$ –i€ =PUS -PEU
• However, to switch financing sources from one
capital market to another, a firm must have
the ability to operate in the international
investment community.
• Again, this would not be an option for a
domestic firm.
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6 Proactive policies of Management of
Operating Exposure
• Operating and transaction exposures can be partially
managed by adopting operating or financing policies that
offset anticipated foreign exchange exposures.
• The six most commonly employed proactive policies are:
–
–
–
–
–
–
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Matching currency cash flows
Risk-sharing agreements
Back-to-back ( parallel loans), or credit swaps.
Currency swaps
Leads and lags
Reinvoicing center
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Proactive Management of Operating
Exposure
Example: a US firm has a continuing export sales to Canada.
 In order to compete effectively in Canadian markets, the firm
invoices all export sales in Canadian dollars.
 This policy results in a continuing receipt of Canadian dollars
month after month.
 This series of transaction exposures could be continually
hedged with forwards, futures or options, etc.
 Or using operating exposure management methods
described as follows:
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Matching currency cash flows
 One way to offset an anticipated continuous long
exposure to a particular company is to acquire
debt denominated in that currency (matching).
 Alternatively, the US firm could seek out potential
suppliers of raw materials or components in
Canada as a substitute for US and other foreign
firms.
 In addition, the company could engage in currency
switching, in which the company would pay
foreign suppliers with Canadian dollars.
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Exhibit 12.4 Matching:
Debt Financing as a Financial Hedge
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Proactive Management of Operating
Exposure: Risk Sharing
• Currency Risk-Sharing:
– a method to manage a long-term cash flow
exposure.
– This is a contractual arrangement in which the
buyer and seller agree to “share” or split currency
movement impacts on payments between them.
– This agreement is intended to smooth the impact
on both parties of volatile and unpredictable
exchange rate movements.
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Risk Sharing: Ford and Mazda
 Risk Sharing Agreement between Mazda and
Ford.
Ford agrees to pay all purchases in Japanese
Yen to Mazda as long as the spot exchange rate
on the day of invoice is between 115 yen/$ to
125 yen/$. If however the exchange rate falls
out of this range, Mazda and Ford will share the
difference equally.
What happens if the rate falls to 110 yen/$?
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Proactive Management
of Operating Exposure
 Back-to-Back Loans:
 A back-to-back loan, also referred to as a parallel loan
or credit swap, occurs when two business firms in
separate countries arrange to borrow foreign currency
for a specific period of time, but totally circumvent the
foreign exchange market . See the following slides.
 At an agreed terminal date they return the borrowed
currencies.
 Such a swap creates a covered hedge against
exchange loss, since each company, on its own books,
borrows the same currency it repays.
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Exhibit 12.5 Using a Back-to-Back Loan
for Currency Hedging
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Proactive Management
of Operating Exposure
• There are risks involved in the widespread use
of the back-to-back loan:
1. It is difficult for a firm to find a partner, termed a
counterparty for the currency amount and timing
desired.
2. A risk exists that one of the parties will fail to
return the borrowed funds at the designated
maturity – although each party has 100%
collateral (denominated in a different currency).
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Proactive Management
of Operating Exposure
• Currency Swaps:
– A currency swap resembles a back-to-back loan
except that it does not appear on a firm’s balance
sheet.
– In a currency swap, a firm and a swap dealer or
swap bank agree to exchange an equivalent
amount of two different currencies for a specified
amount of time.
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Exhibit 12.6 Using a Cross-Currency
Swap to Hedge Currency Exposure
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Proactive Management
of Operating Exposure
• Leads and Lags: Re-timing the transfer of funds
– Firms can reduce both operating and transaction exposure by
accelerating or decelerating the timing of payments that must be
made or received in foreign currencies.
– Intracompany leads and lags is more feasible as related companies
presumably embrace a common set of goals for the consolidated
group.
– Intercompany leads and lags requires the time preference of one
independent firm to be imposed on another.
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Proactive Management
of Operating Exposure
• Reinvoicing Centers: There are three basic
benefits arising from the creation of a
reinvoicing center:
– Managing foreign exchange exposure
– Guaranteeing the exchange rate for future orders
– Managing intrasubsidiary cash flows
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Exhibit 12.7 Use of a Reinvoicing
Center
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Proactive Management
of Operating Exposure
• Some MNEs now attempt to hedge their operating exposure
with contractual hedges.
• Merck and Eastman Kodak have undertaken long-term
currency option positions hedges designed to offset lost
earnings from adverse exchange rate changes.
• The ability to hedge the “unhedgeable” is dependent upon:
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor’s responses to exchange rate
changes
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Mini-Case Questions: Toyota’s
European Operating Exposure
• Why do you think Toyota waited so long to move much of its
manufacturing for European sales to Europe?
• If Britain were to join the European Monetary Union, would the
problem be resolved? How likely do you think it is that Britain will
join?
• If you were Mr. Shuhei, how would you categorize your problems and
solutions? What was a short-term and what was a long-term problem?
• What measures would you recommend Toyota Europe take to resolve
the continuing operating losses?
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Exhibit 12.3
Trident
Europe
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Exhibit 1 Toyota Motor’s European
Currency Operating Structure
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Exhibit 2 Daily Exchange Rates:
Japanese Yen per Euro
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Exhibit 3 Daily Exchange Rates: British
Pounds per Euro
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