October 4, 2022

Risk is an inevitable part of financial management especially when exchanging money with international economies. In order to reduce risk, financial managers use hedging strategies to off

Risk is an inevitable part of financial management especially when exchanging money with international economies. In order to reduce risk, financial managers use hedging strategies to offset exposure to price risk. Think about the various hedging strategies that are employed in the foreign exchange markets including the forward market hedge, the money market hedge, and the options market hedge.

With these thoughts in mind, address the following:

Summarize how businesses and investors can use hedging to manage exposure.
Is it cost effective for most multinational corporations to hedge their foreign currency risk? Why or why not? Support your response with this week’s Learning Resources.

By Day 4

Post a brief statement.

Read a selection of your colleagues' postings.

Management of Economic Exposure

Chapter Nine

This chapter provides a way to measure economic exposure, discusses its determinants, and presents methods for managing and hedging economic exposure.

Chapter Outline

How to Measure Economic Exposure

Operating Exposure: Definition

Illustration of Operating Exposure

Determinants of Operating Exposure

Managing Operating Exposure

Summary

9-2

Economic Exposure

Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms.

Furthermore, changes in exchange rates may affect not only the operating cash flows of a firm by altering its competitive position but also dollar (home currency) values of the firm’s assets and liabilities

Exchange rate changes can systematically affect the value of the firm by influencing its operating cash flows as well as the domestic currency values of its assets and liabilities

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Exchange Rate Exposure of U.S. Industry Portfolios

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This exhibit provides an estimate of the U.S. industries’ market betas as well as the “forex” betas during the period of 2000-2018.

How to Measure Economic Exposure

Currency risk (or uncertainty) represents random changes in exchange rates, while currency exposure measures “what is at risk”

Exposure to currency risk can be properly measured by the following:

Sensitivity of the future home currency values of the firm’s assets and liabilities to random changes in exchange rates

Sensitivity of the firm’s operating cash flows to random changes in exchange rates

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Channels of Economic Exposure

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Measuring Asset Exposure

From the perspective of a U.S. firm that owns an asset in Britain, the exposure can be measured by the coefficient (b) in regressing the dollar value (P) of the British asset on the dollar/pound exchange rate (S)

P = a + b×S + e

Where

a is the regression constant

e is the random error term with mean zero

the regression coefficient b measures the sensitivity of the dollar value of the asset (P) to the exchange rate (S)

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Measuring Asset Exposure (Continued)

The exposure coefficient, b, is defined as follows:

Where

Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate

Var(S) is the variance of the exchange rate

Cov(P,S)

Var(S)

b =

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Example

Suppose a U.S. firm has an asset in Britain whose local currency price is random.

For simplicity, suppose there are only three states of the world and each state is equally likely to occur.

The future local currency price of this British asset (P*) as well as the future exchange rate (S) will be determined, depending on the realized state of the world.

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Measurement of Currency Exposure

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First, consider Case 1, described in Panel A. Case 1 indicates that the local currency price of the asset (P*) and the dollar price of the pound (S) are positively correlated, so that depreciation (appreciation) of the pound against the dollar is associated with a declining (rising) local currency price of the asset. The dollar price of the asset on the future (liquidation) date can be $1,372, or $1,500 or $1,712, depending on the realized state of the world. (For illustration, the computations of the parameter values for Case 1 are shown in the next slide.)

Next, consider Case 2. This case indicates that the local currency value of the asset is clearly negatively correlated with the dollar price of the British pound. In fact, the effect of exchange rate changes is exactly offset by movements of the local currency price of the asset, rendering the dollar price of the asset totally insensitive to exchange rate changes. The future dollar price of the asset will be uniformly $1,400 across the three states of the world. One thus can say that the British asset is effectively denominated in terms of the dollar. Although this case may be unrealistic, it shows that uncertain exchange rates or exchange risk does not necessarily constitute exchange exposure.

We now turn to Case 3, where the local currency price of the asset is fixed at £1,000. In this case, the U.S. firm faces a “contractual” cash flow that is denominated in pounds. This case, in fact, represents an example of the special case of economic exposure, transaction exposure. Intuitively, what is at risk is £1,000, that is, the exposure coefficient, b, is £1,000.

Computations of Regression Parameters: Case 1

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Hedging Asset Exposure

Once the magnitude of the exposure is known, the firm can hedge the exposure by simply selling the exposure forward

We can decompose the variability of the dollar value of the asset, Var(P), into two separate components: exchange rate-related and residual

Consequences of hedging the exposure by forward contracts are illustrated in the next slide

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The first term in the right-hand side of the equation, b2Var(S), represents the part of the variability of the dollar value of the asset that is related to random changes in the exchange rate, whereas the second term, Var(e), captures the residual part of the dollar value variability that is independent of exchange rate movements.

Consequences of Hedging Currency Exposure

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Operating Exposure: Definition

Many managers do not fully understand the effect of volatile exchange rates on operating cash flows

Operating exposure is the extent to which the firm’s operating cash flows will be affected by random changes in the exchange rates

In many cases, operating exposure may account for a larger portion of the firm’s total exposure than contractual exposure

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Illustration of Operating Exposure

“Suppose a U.S. computer company has a wholly owned British subsidiary, Albion Computers PLC, that manufactures and sells PCs in the U.K. market. Albion Computers imports microprocessors from Intel, which sells them for $512 per unit. At the current exchange rate of $1.60 per pound, each Intel microprocessor costs £320. Albion Computers hires British workers and sources all the other inputs locally. Albion faces a 50 percent income tax rate in the U.K.”

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Projected Operations for Albion Computers PLC: Benchmark Case ($1.60/)

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Illustration of Operating Exposure (Continued)

Consider the possible effect of a depreciation of the pound on the projected dollar operating cash flow of Albion Computers.

Assume the pound may depreciate from $1.60 to $1.40 per pound

The dollar operating cash flow may change following a pound depreciation due to:

Competitive effect

Conversion effect

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Illustration of Operating Exposure (Concluded)

Consider the following cases with varying degree of realism:

Case 1: No variables change, except the price of the imported input.

Case 2: The selling price as well as the price of the imported input changes, with no other changes.

Case 3: All the variables change.

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Projected Operations for Albion Computers PLC: Case 1 ($1.40/£)

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Projected Operations for Albion Computers PLC: Case 2 ($1.40/£)

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Projected Operations for Albion Computers PLC: Case 3 ($1.40/£)

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Summary of Operating Exposure Effect of Pound Depreciation on Albion Computers

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Determinants of Operating Exposure

Operating exposure cannot be readily determined from the firm’s accounting statements, unlike transaction exposure

A firm’s operating exposure is determined by:

The structure of the markets in which the firm sources its inputs, such as labor and materials, and selling its products

The firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing

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Determinants of Operating Exposure (Continued)

A firm is usually subject to high degrees of operating exposure when either its cost or its price is sensitive to exchange rate changes

When both the cost and the price are sensitive or insensitive to exchange rate changes, the firm has no major operating exposure

The extent to which a firm is subject to operating exposure depends on the firm’s ability to stabilize cash flows in the face of exchange rate changes

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Managing Operating Exposure

Objective of managing operating exposure is to stabilize cash flows in the fact of fluctuating exchange rates

Firms may use the following strategies for managing operating exposure:

Selecting low-cost production sites

Flexible sourcing policy

Diversification of the market

Product differentiation and R&D efforts

Financial hedging

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Selecting Low Cost Production Sites

When the domestic currency is strong or expected to become strong, a firm may choose to locate production facilities in a foreign country where costs are low

Low costs may be due to either the undervalued currency or underpriced factors of production

The firm may choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes

Example: Nissan has manufacturing facilities in the U.S., U.K., and Mexico, as well as Japan

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Flexible Sourcing Policy

Even if a firm has manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes by sourcing from where input costs are low

Example: In the early 1980s when the dollar was very strong against most major currencies, U.S. multinational firms often purchased materials and components from low-cost foreign suppliers

Flexible sourcing policy is a strategy for managing operating exposure that involves sourcing from areas where input costs are low

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Diversification of the Market

Diversifying the market for the firm’s products is another way to managing exchange exposure

Example: If GE is selling power generators in Mexico and Germany, reduced sales in Mexico (due to the dollar appreciation against the peso) could be compensated by increased sales in Germany (due to the dollar depreciation against the euro)

Note that expansion into a new business should be justified on is own right, not solely as a solution to currency exposure

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R&D Efforts and Product Differentiation

Investment in research and development (R&D) can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements

Successful R&D allows the firm to do the following:

Cut costs and enhance productivity

Introduce new and unique products for which competitors offer no close substitutes

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Financial Hedging

Financial hedging can be used to stabilize the firm’s cash flows

Financial hedging refers to hedging exchange risk exposure using financial contracts such as currency forward and options contracts

If operational hedges, which involve redeployment of resources, are costly or impractical, financial contracts can provide the firm with a flexible and economical way of dealing with exchange exposure

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Management of Translation Exposure

Chapter Ten

Chapter Outline

Translation Methods

FASB Statement 8

FASB Statement 52

International Accounting Standards

Management of Translation Exposure

Empirical Analysis of the Change from FASB 8 to FASB 52

10-2

Translation Exposure

Translation exposure, frequently referred to as accounting exposure, refers to the effect that an unanticipated change in exchange rates will have on the consolidated financial reports of a MNC

When exchange rates change, the value of a foreign subsidiary’s assets and liabilities denominated in a foreign currency change when they are viewed from the perspective of the parent firm

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Translation Methods

Four methods of foreign currency translation have been used in recent years:

Current/noncurrent method

Monetary/nonmonetary method

Temporal method

Current rate method

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Current/Noncurrent Method

The idea that current assets and liabilities are converted at the current exchange rate while noncurrent assets and liabilities are translated at the historical exchange rates is the current/noncurrent method

Under this method, a foreign subsidiary with current assets in excess of current liabilities will cause a translation gain (loss) if the local currency appreciates (depreciates)

This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective

10-5

Monetary/Nonmonetary Method

The idea that monetary balance sheet accounts (e.g., accounts receivable) are translated at the current exchange rate while nonmonetary balance sheet accounts (e.g., stockholder’s equity) are converted at the historical exchange rate is the monetary/nonmonetary method

Compared to current/noncurrent method, this approach differs substantially with respect to accounts like inventory, long-term receivables, and long-term debt

Classifies accounts based on similarity of attributes rather than similarly of maturities

10-6

Temporal Method

The idea that current and noncurrent monetary accounts as well as accounts that are carried on the books at current value are converted at the current exchange rate is the temporal method

Accounts carried on the books at historical costs are translated at the historical exchange rate

Fixed assets and inventory are usually carried at historical costs, and as a result, the temporal method and the monetary/nonmonetary method will typically provide the same translation

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Current Rate Method

The idea that all balance sheet accounts are translated at the current exchange rate except stockholder’s equity, which is translated at the exchange rate on the date of issuance, is the current rate method

Simplest of all translation methods to apply

A “plug” equity account named cumulative translation adjustment (CTA) is used to make the balance sheet balance, since translation gains or losses do not go through the income statement according to this method

10-8

FASB Statement 8

FASB 8 became effective on January 1, 1976

Objective was to measure in dollars an enterprise’s assets, liabilities, revenues, or expenses that are denominated in a foreign currency according to GAAP

Essentially the temporal method of translation, with few subtleties

Temporal method requires taking foreign exchange gains or losses through the income statement.

Therefore reported earnings could (and did) fluctuate substantially from year to year, irritating executives

10-9

FASB Statement 52

Due to controversary surrounding FASB 8, FASB 52 was issued in December 1981

Stated objectives of FASB 52:

Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity

Reflect in consolidated statements the financial results and relationship of the individual consolidated entities as measured in their functional currencies in conformity with U.S. GAAP

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Functional Currency versus Reporting Currency

The method of translation prescribed by FASB 52 depends upon the functional currency used by the foreign subsidiary whose statements are to be translated

Functional currency is the currency of the primary economic environment in which the entity operates

Reporting currency is the currency in which the MNC prepares its consolidated financial statements

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The Mechanics of FASB 52 Translation Process

Two-stage process:

First, determine in which currency the foreign entity keeps its books

If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required

Temporal method used to accomplish remeasurement

Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method

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FASB 52 Two-Stage Process

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Highly Inflationary Economies

In highly inflationary economies, FASB 52 requires foreign entities to remeasure financial statements using the temporal method “as if the functional currency were the reporting currency”

Highly inflationary economy is defined as, “one that has cumulative inflation of approximately 100 percent or more over a 3-year period”

10-14

International Accounting Standards

Since January 2005, all companies doing business in the European Union must use the acc

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