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Yen against currencies of its major trading partners in 1999 (Landers 1999)

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CHAPTER 9

Managing Transaction

Exposure and Economic

Exposure

Foreign-exchange risk is the risk of loss due to changes in the international exchange value of

national currencies. For example, in 1999 Sony was the victim of a 40 percent increase in the

yen against currencies of its major trading partners in 1999 (Landers 1999). In October 1999,

Sony reported impressive accomplishments for the first half of that year: new products, product

and distribution rationalization, and increased sales and profits across the board in local-currency

terms. But the same report broke bad news in dollar terms: sales had dropped by 7.6 percent,

operating income by 45 percent, and net income by 25 percent. These results underline the

impact of the high yen on Japanese exporters such as Sony. In fact, these days many companies

are at the mercy of foreign-exchange rates.

So long as we do not have a single world currency, some degree of exchange risk will

exist, no matter what the system. Fluctuations in the value of currency had been quite frequently

pronounced even under the fixed exchange rate system. A study by DeVries (1968),

for example, shows that during the 20-year period from 1948 to 1968, 96 countries devalued

their currencies by more than 40 percent, and 24 countries devalued their currencies by

more than 75 percent. This problem has become more complicated in the past three decades,

because most countries have permitted their currencies to float since 1973. Daily currency fluctuations

and frequent currency crises have become a way of life since then. Daily currency fluctuations

and the increasing integration of the world economy are two major reasons why

multinational companies (MNCs) consider exchange rate risk as the most important among

many risks.

This chapter has four major sections. The first section describes the basic nature of foreignexchange

exposure. The second section explains how transaction exposure can be measured and

hedged. The third section explains how economic exposure can be measured and hedged. The

fourth section covers the use of exchange risk management instruments by MNCs. In addition,

this section explores the possibility that a hedge can be risky, by using the maturity mismatch in

a German firm’s oil futures hedge as an example.

9.1 The Basic Nature of Foreign-Exchange Exposures

Foreign-exchange exposure refers to the possibility that a firm will gain or lose because of

changes in exchange rates. Every company faces exposure to foreign-exchange risk as soon as it

chooses to maintain a physical presence in a foreign country. Likewise, a firm faces exposure to

exchange risk when it chooses to finance its operations in foreign currencies. Both exchange risks

are analyzed in the context of investing and financing decisions. In addition, foreign trade and

loans may involve foreign-exchange risk. An important task of the international financial manager

is to compare potential losses with the cost of avoiding these losses.

Three basic types of exchange exposure are translation exposure, transaction exposure,

and economic exposure. Translation exposure is the accounting-based changes in consolidated

financial statements caused by exchange rate changes. Transaction exposure occurs

when exchange rates change between the time when an obligation is incurred and the time

when it is settled, thereby affecting actual cash flows. Economic exposure reflects the change in

the present value of the firm’s future cash flows because of an unexpected change in exchange

rates.

222 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

9.1.1 Exposure management strategy

Most large MNCs manage their foreign-exchange risk by using a pre-established exposure management

strategy. For example, Merck uses the following five steps for currency exposure management:

(1) projecting exchange rate volatility, (2) assessing the impact of the 5-year strategic

plan, (3) deciding on hedging the exposure, (4) selecting the appropriate financial instruments,

and (5) constructing a hedging program (for details, see Case Problem 6: Merck’s Use of Currency

Options). To protect assets adequately against risks from exchange rate fluctuations, MNCs

must (1) forecast the degree of exposure, (2) develop a reporting system to monitor exposure and

exchange rate movements, (3) assign responsibility for hedging exposure, and (4) select appropriate

hedging tools.

FORECASTING THE DEGREE OF EXPOSURE To develop a viable hedging program, an MNC

must forecast the degree of exposure in each major currency in which it operates. Approaches

range from gut feelings to sophisticated economic models, each of which has had varying degrees

of success. Whatever the approach, the MNC should estimate and use ranges within which it

expects a currency to vary over the forecasting period. Some companies develop in-house capabilities

to monitor exchange rates, using economists who also try to obtain a consensus of

exchange rate movements from the banks with which they deal. Their concern is to forecast the

direction, magnitude, and timing of an exchange rate change. Other companies contract out their

forecasting needs.

DEVELOPING A REPORTING SYSTEM TO MONITOR EXPOSURE AND EXCHANGE RATE MOVEMENTS

Once the MNC has decided how to forecast the degree of exposure, it should develop

a reporting system that will assist in protecting it against risk. To achieve this goal, substantial

participation from foreign operations must be combined with effective central control. Because

exchange rates change frequently, MNCs should obtain input from those who are attuned to the

foreign country’s economy. Central control of exposure protects resources more efficiently than

letting each subsidiary monitor its own exposure. The management of the MNC should devise

a uniform reporting system for all of its subsidiaries. The report should identify the exposed

accounts that it wants to monitor, the amount of exposure by currency of each account, and the

different times under consideration.

ASSIGNING RESPONSIBILITY FOR HEDGING EXPOSURE It is important for management

to decide at what level hedging strategies will be determined and implemented. Most MNCs

today continue to centralize exchange exposure management, because it is impossible for regional

or country managers to know how their foreign-exchange exposure relates to other affiliates. A

three-country study of exchange risk management by Belk (2002) found that 66 percent of the

sample companies highly centralized their exposure management, 19 percent lowly centralized

their exposure management, and only 15 percent decentralized their exposure management.

However, a centralized policy may miss opportunities to detect the possibility of currency fluctuations

in certain regions or countries. Thus, some MNCs decentralize some exposure management

decisions so that they can react quickly to a more rapidly changing international

environment.

THE BASIC NATURE OF FOREIGN-EXCHANGE EXPOSURES 223

SELECTING APPROPRIATE HEDGING TOOLS Once an MNC has identified its level of exposure

and determined which exposure is critical, it can hedge its position by adopting operational techniques

and financial instruments (see Global Finance in Action 9.1). Operational techniques

are operational approaches to hedging exchange exposure that include diversification of a

company’s operations, the balance-sheet hedge, and exposure netting. Financial instruments are

financial contracts to hedging exchange exposure that include currency forward and futures contracts,

currency options, and swap agreements. This chapter and chapter 10 will discuss these

and other hedging devices in detail.

224 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

Global Finance in Action 9.1

Coca Cola’s Exposure Management

Coca Cola is a good example of how MNCs use operational techniques and financial

instruments for their foreign-exchange exposure management. Because Coca

Cola earns about 80 percent of its operating income from foreign operations, foreigncurrency

changes can have a major impact on reported earning. The company

manages its currency exposures on a consolidated basis, which allows it to net exposures

from different operations around the world and takes advantage of natural

offsets – for example, cases in which Japanese yen receivables offset Japanese yen

payables. It also uses financial contracts to further reduce its net exposure to currency

fluctuations. Coca Cola enters into currency forward contracts and purchases currency

options in several countries, most notably the euro and Japanese yen, to hedge

firm sales commitments. It also buys currency options to hedge certain anticipated

sales.

Source: J. D. Daniels, L. H. Radebaugh, and D. P. Sullivan, International Business: Environments

and Operations, 10th edn, Upper Saddle River, NJ: Prentice Hall, 2004, p. 620.

9.1.2 Transaction exposure

Gains or losses may result from the settlement of transactions whose payment terms are stated

in a foreign currency. Transaction exposure refers to the potential change in the value of outstanding

obligations due to changes in the exchange rate between the inception of a contract and

the settlement of the contract. Transactions that are subject to transaction exposure include credit

purchases and credit sales whose prices are stated in foreign currencies, borrowed and loaned

funds denominated in foreign currencies, and uncovered forward contracts.

Receipts and payments denominated in foreign currencies are considered to be exposed. If

exposed receipts are greater than exposed payments, foreign-currency depreciations will cause

exchange losses, and foreign-currency appreciations will cause exchange gains. On the other hand,

if exposed receipts are smaller than exposed payments, foreign-currency depreciations will create

exchange gains, and foreign-currency appreciations will create exchange losses.

9.1.3 Economic exposure

Economic exposure, also called operating exposure, competitive exposure, or revenue exposure,

measures the impact of an exchange rate change on the net present value of expected future cash

flows from a foreign investment project. Future effects of changes in exchange rates occur under

the general category of economic risk. An MNC may have established its subsidiary in a country

with price stability, readily available funds, a favorable balance of payments, and low rates of taxation.

These positive features may disappear over time if the economic situation of the country

deteriorates. Eventually, the local currency will devalue or depreciate. The subsidiary is likely to

face immediate operational problems if it has to pay for its imports in hard currencies or if it has

borrowed from abroad. Exchange rate changes may also affect economic factors such as inflationary

forces, price controls, the supply of loanable funds, and local labor availability.

Economic exposure is a broader and more subjective concept of exposure than either translation

or transaction exposure, because it involves the potential effects of exchange rate changes on

all facets of a firm’s operations. Economic exposure is difficult to measure, but may be more significant

than the others because it relates to the long-term profit performance and hence the

value of the firm.

THE BASIC NATURE OF FOREIGN-EXCHANGE EXPOSURES 225

Example 9.1

An American firm has sold machinery to a British firm through its UK subsidiary for .10,000,

with terms of 180 days. The payments must be received in pounds. The spot rate for pounds

is $1.70 and the US seller expects to exchange .10,000 for $17,000 when payment is

received.

Transaction exposure arises because of the risk that the US exporter will receive something

other than $17,000 when the British pound receipts are exchanged for dollars. If the

spot rate were to decline to $1.40 180 days from today, the US exporter would receive only

$14,000, $3,000 less than the expected $17,000. However, if the spot rate were to rise to

$1.90 during the same period, the exporter would receive $19,000, an increase of $2,000

over the amount expected. If the US exporter had invoiced in dollars, the transaction exposure

would have shifted to the British importer. Unlike translation gains and losses, transaction

gains and losses have a direct impact on actual cash flows.

Example 9.2

For the coming year, a Malaysian subsidiary of an American firm is expected to earn 35

million ringgits after taxes, and its depreciation charge is estimated at 5 million ringgits. The

exchange rate is expected to decrease from M$4 per dollar at present to M$5 per dollar

for the next year.

9.1.4 A comparison of the three exposures

The management of foreign-exchange risk based on translation exposure is basically static and

historically oriented. By definition, translation exposure does not look to the future impact of

an exchange rate change that has occurred or may occur. In addition, it does not involve actual

cash flows. In contrast, both transaction and economic exposures look to the future impact of

an exchange rate change that has occurred or may occur. These exposures also involve actual or

potential cash flow changes.

Transaction risk and economic risk are the same in kind, but they differ in degree. For example,

economic risk is essentially subjective, because it depends on estimated future cash flows for an

arbitrary time horizon. Transaction risk, on the other hand, is essentially objective, because

it depends on outstanding obligations that existed before changes in exchange rates but were

settled after changes in exchange rates. Table 9.1 illustrates the major differences among these

three exposures.

9.2 Transaction Exposure Management

An action that removes transaction risk is said to “cover” that risk. A cover involves the use of

forward contracts, a combination of spot market and money market transactions, and other techniques

to protect a foreign-exchange loss in the conversion from one currency to another. The

term “conversion” relates to transaction exposure because the transaction exposure involves the

actual conversion of exposed assets and liabilities from one currency to another. If MNCs decide

to cover their transaction exposure, they may select from a variety of financial instruments and

operational techniques. Operational techniques, such as exposure netting, leading and lagging,

and price adjustments through transfer prices, will be discussed in chapter 10. This chapter will

focus on the following four financial instruments.

226 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

The difference between the first-year cash flows with and without devaluation is computed

as follows:

Profit after taxes M$35 million

Depreciation +5 million

Cash flows from operation M$40 million

Predevaluation rate (M$4 = $1) M$40 million = $10 million

Postdevaluation rate (M$5 = $1) M$40 million = -$8 million

Potential exchange loss $2 million

The subsidiary’s economic loss is a decline in Malaysian ringgit cash flows equal to $2 million

over the next 12 months. The translation loss or the transaction loss is a one-time loss, but

the economic loss is an open-ended event. If the anticipated business activity were to stay

the same for the next 5 years, cash flows would decrease by $2 million per year for 5 years.

1 The forward market hedge.

2 The money market hedge.

3 The options market hedge.

4 Swap agreements.

9.2.1 The forward market hedge

A forward-exchange market hedge involves the exchange of one currency for another at a fixed

rate on some future date to hedge transaction exposure. The purchase of a forward contract

substitutes a known cost for the uncertain cost due to foreign-exchange risk caused by the possible

devaluation of one currency in terms of another. Although the cost of a forward contract

is usually smaller than the uncertain cost, the forward contract does not always assure the lowest

cost due to foreign-exchange rate change. The forward contract simply fixes this cost in advance,

thus eliminating the uncertainty caused by foreign-exchange rate changes. For example, an

American company may have a euro import payable in 9 months. The American company can

cover this risk by purchasing euros at a certain price for the same date forward as the payment

maturity.

9.2.2 The money market hedge

A money market hedge involves a loan contract and a source of funds to carry out that contract

in order to hedge transaction exposure. In this case, the contract represents a loan agreement.

Assume that an American company has a British pound import payable in 90 days. To

TRANSACTION EXPOSURE MANAGEMENT 227

Table 9.1 Major differences among three types of exposure

Variables Translation exposure Transaction exposure Economic exposure

Contract Specific Specific General

Duration A point in time Period of contract Project life

Gains (losses) Easy to compute Intermediate to Difficult to compute

compute

Gains (losses) Paper in nature Actual Actual

Measurement Depends on Depends on changes Depends on changes

accounting rules in actual spot rates in actual spot rates

Hedging Easy Intermediate Difficult

Extent of exposure Determined by Determined by the Determined by

accounting rules nature of the product and market

contract factors

Value Book value of assets Contract value of Market value of

and liabilities assets and assets

liabilities

Management of By the Treasury By the Treasury By all departments

exposure Department Department

hedge transaction exposure from this import payable, the American company may borrow in

dollars (loan contract), convert the proceeds into British pounds, buy a 90-day British Treasury

bill, and pay the import bill with the funds derived from the sale of the Treasury bill (source of

funds). Of course, it can buy British pounds in the foreign-exchange spot market when the import

bill becomes due, but this approach involves transaction risk.

A money market hedge is similar to a forward market hedge. The difference is that the cost

of the money market hedge is determined by differential interest rates, while the cost of the

forward market approach is determined by the forward premium or discount. If foreign-exchange

markets and money markets are in equilibrium, the forward market approach and the money

market approach incur the same cost.

9.2.3 The options market hedge

If a company has a foreign-currency receivable or a foreign-currency payable, the options market

hedge can protect the company from exchange rate fluctuations. By buying a call option on the

foreign currency, a US company can lock in a maximum dollar price for its foreign-currency

accounts payable. By purchasing a put option on the foreign currency, the company can lock in

a minimum dollar price for its foreign-currency accounts receivable.

Companies understand that hedging techniques such as the forward market hedge and the

money market hedge can backfire or may even be costly when an accounts payable currency

depreciates or an accounts receivable currency appreciates over the hedged period. Under these

circumstances, an uncovered strategy might outperform the forward market hedge or the money

market hedge. The ideal type of hedge should protect the company from adverse exchange rate

movements but allow the company to benefit from favorable exchange rate movements. The

options market hedge features these attributes.

To see how currency options provide such a flexible optional hedge against transaction exposure,

assume that Boeing exports a DC 10 to British Airways and bills .10 million in 1 year. If

Boeing purchases a put option on .10 million, this transaction provides Boeing with the right,

but not the obligation, to sell up to .10 million at a fixed exchange rate, regardless of the future

spot rate. With its pound receivable, Boeing would protect itself by exercising its put option if

the pound were to weaken, but would benefit by letting its put option expire unexercised if the

pound were to strengthen.

9.2.4 The swap market hedge

When exchange rates and interest rates fluctuate too widely, the risks of forward market and

money market positions are so great that the forward market and the money market may not

function properly. Currency options are available only for a selected number of currencies and

are inflexible. In such cases, MNCs may use swap arrangements to protect the value of export

sales, import orders, and outstanding loans denominated in foreign currencies.

The swap market hedge involves an exchange of cash flows in two different currencies

between two companies. Swaps take many forms, but one type of swap — the currency swap —

accommodates an MNC’s needs to cover its transaction risk. In a currency swap, one company

provides a certain principal in one currency to another company in exchange for an equivalent

228 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

amount in a different currency. For example, a Swiss company may be anxious to swap Swiss

francs for US dollars. Similarly, a US company may be willing to exchange US dollars for Swiss

francs. Given these needs, the two companies engage in a currency swap.

TRANSACTION EXPOSURE MANAGEMENT 229

Example 9.3

To see how forward-exchange market, money market, options market, and swap market

hedges may be utilized to protect against transaction exposure, assume that an American

firm has sold an airplane to a Swiss firm for SFr100,000, with terms of 90 days. Let us

further assume that the spot rate for francs is $0.5233, the 90-day forward rate for francs

is $0.5335, the Swiss 90-day interest rate is 10 percent, and the US 90-day interest rate is

17.8 percent. The interest rates are in equilibrium with forward-exchange quotations, and

this is confirmed by the following computation, using equation 5.8:

The US company’s bank believes that the spot rate in 90 days will rise to $0.6000, which

is higher than the implicit unbiased forecast of $0.5335 that exists in the currency forward

quotation. In addition, assume that put options with a 3-month settlement date have a

strike price of $0.5369 per franc and a premium of $0.01 per franc. Finally, a swap dealer

says that she will find a Swiss company that is willing to swap Swiss francs for US dollars

at an exchange rate of $0.5400 per franc.

Five alternatives are available to the US company: do not hedge (take the transaction

risk), hedge in the forward market, hedge in the money market, hedge in the options

market, or use swap agreements.

If the US company decides to accept the transaction risk, it would receive SFr100,000 in

90 days and sell them in the foreign-exchange market for dollars. If the bank’s forecast is

accurate, the US company would receive $60,000 ($0.6000 . SFr100,000) in 90 days.

However, that receipt is subject to foreign-exchange risk. If the franc were to decline to

$0.4000, the US company would receive only $40,000, which is $20,000 less than expected.

The $40,000 could in fact be insufficient to cover the manufacturing cost of the airplane.

On the other hand, if the franc should increase in value even more than the bank’s forecast,

the US company would receive substantially more than $60,000.

If the US company wishes to hedge its transaction exposure in the forward market, it

would sell SFr100,000 in the forward market for $53,350. This is known as a covered transaction,

in which the US firm no longer has foreign-exchange risk. In 90 days, the US firm

would receive SFr100,000 from the Swiss importer, deliver the proceeds to the bank against

its forward sale, and receive $53,350. It should be recognized that the certain $53,350 is

n F S

S

-day

domestic rate foreign rate

$0.5335

- . = -

- . = -

=

360

90

0 5233

0 5233

360

90

17 8 10 0

7 8 7 8

$ .

$ .

. % . %

. % . %

OPTIONS VERSUS FORWARD CONTRACTS A forward contract is often an imperfect hedging

instrument, because it is a fixed agreement to buy or sell a foreign currency at a specified price

in the future. However, in many practical situations, companies are not sure whether their hedged

foreign-currency cash flows will materialize. Consider the situations in which: (1) an overseas

deal may fall through; (2) a bid on a foreign-currency contract may be rejected; or (3) a foreign

subsidiary’s dividend payments may exceed the expected amount. In such cases, companies may

not need the obligation, but the right, to buy or sell a foreign currency at a specified price in

order to reduce their exchange rate risk. Giddy (1983) suggested that companies should use the

following rules to choose between forward contracts and currency options for hedging purposes:

1 When the quantity of a foreign-currency cash outflow is known, buy the currency forward;

when the quantity is unknown, buy a call option on the currency.

2 When the quantity of a foreign-currency cash inflow is known, sell the currency forward;

when the quantity is unknown, buy a put option on the currency.

3 When the quantity of a foreign-currency flow is partially known and partially uncertain, use

a forward contract to hedge the known portion and an option to hedge the maximum value

of the uncertain remainder.

230 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

less than the uncertain $60,000 expected from the unhedged position, because the forward

market quotation is not identical with the bank’s forecast.

In addition to the forward market approach, the US company can also cover its transaction

against foreign-exchange risk through the money market approach. The money

market approach works as follows: (1) borrow SFr97,561 from a Swiss bank at 10 percent

per annum (2.5 percent per quarter) in exchange for a promise to pay SFr100,000

(SFr97,561 . 1.025); (2) receive $51,054 (SFr97,561 . $0.5233) by exchanging the

SFr97,561 for dollars at the current spot rate of $0.5233; and (3) invest this sum in the US

money market at 17.8 percent per annum (4.45 percent per quarter) and receive $53,326

($51,054 . 1.0445) at the end of 3 months. This sum should be equal to the sum received

in the forward market hedge described earlier. The small difference between these two sums

is due to a compounding error.

The US firm can cover its franc receivables with the put option. The US firm buys put

options for a total premium of $1,000 (SFr100,000 . $0.01), exercises its options in 90

days, and sells SFr100,000 at a strike price of $0.5369 for $53,690. Thus, the US firm would

obtain a net amount of $52,690 ($53,690 — $1,000) in exchange for SFr100,000 at the

end of 3 months. If the spot rate of the Swiss franc should exceed $0.5369 in 90 days, the

US firm would let the option contract expire unexercised and convert the SFr100,000 at the

prevailing spot rate.

Finally, the US firm can cover its transaction risk with currency swaps. The US firm is

anxious to swap its SFr100,000 for US dollars. Through a swap dealer, it may be able to

find a Swiss company that may be willing to exchange US dollars for SFr100,000. Given

these needs, the two companies could arrange a currency swap that allows for an exchange

of SFr100,000 for US dollars at a predetermined exchange rate of $0.5400. In this way, the

US company could lock in the number of US dollars at $54,000 that it will receive in

exchange for SFr100,000 in 90 days.

CROSS-HEDGING A cross-hedge is a technique designed to hedge exposure in one currency by

the use of futures or other contracts on another currency that is correlated with the first currency.

Frequently, futures or forward markets are not available for some currencies. In these situations,

MNCs may be able to use a substitute or proxy for the underlying currency that is available. The

idea behind cross-hedging is this. If MNCs cannot find a forward contract on a particular currency

in which they have an exposure, they may wish to hedge their exposure through a forward

contract on a related currency.

Assume the following four things: (1) a US company has accounts payable in Hong Kong

dollars 90 days from now; (2) the Hong Kong dollar is expected to appreciate against the US

dollar; (3) forward contracts or other hedging techniques are not available for the Hong Kong

dollar; and (4) the British pound and the Hong Kong dollar tend to move in a similar direction

against the US dollar. In this case, the US firm could effectively hedge this position by using the

pound as a proxy forward. In other words, the US firm can eliminate its exchange risk by purchasing

the British pound in the forward market.

9.2.5 Swap agreements

Swaps take many forms, but they can be divided into four general categories: currency swaps,

credit swaps, interest rate swaps, and back-to-back loans.

CURRENCY SWAPS An agreement between two parties to exchange local currency for hard currency

at a specified future date is called a currency swap. In other words, a company purchases

the specified amount of local currency in the foreign-exchange market and simultaneously buys

a forward contract to sell this amount of local currency for hard currency at a future date. The

former transaction is a spot transaction, and the latter transaction is a forward transaction. Thus,

the currency swap is a simultaneous spot and forward transaction. This arrangement allows the

company to recover the foreign exchange at a predetermined exchange rate.

To see how a currency swap works, assume that a US parent company wants to lend British

pounds to its British subsidiary and to avoid foreign-exchange risk. The parent company would

buy pounds in the spot market and lend them to the subsidiary. At the same time, the parent

firm would sell the same amount of pounds in exchange for dollars in the forward market for

the period of the loan. The parent company would receive the loan repayment in terms of pounds

from the subsidiary at maturity and exchange the pounds with the dollars to close the forward

contract. Alternatively, the US parent could enter into a swap agreement with a foreign-exchange

dealer whereby they trade dollars for pounds now and pounds for dollars at maturity.

CREDIT SWAPS This hedging device is similar to the foreign-currency swap. The credit swap

arrangement is a simultaneous spot and forward loan transaction between a private company and

a bank of a foreign country. Suppose that an American company deposits a given amount of

dollars in the New York office of a Colombian bank. In return for this deposit, the bank lends

a given amount of pesos to the company’s subsidiary in Colombia. The same contract provides

that the bank could return the initial amount of dollars to the company on a specified date, and

that the subsidiary could return the original amount of pesos to the bank on the same day. By

so doing, the American company recovers the original dollar amount of its deposit, and the

Colombian bank obtains a free hard-currency loan in the United States.

TRANSACTION EXPOSURE MANAGEMENT 231

232 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

Example 9.4

A subsidiary in Israel requires the Israel shekel equivalent of $1 million at the current

exchange rate of NIS4 per dollar, or NIS4 million. To obtain NIS4 million for the subsidiary

in Israel, the parent must open a $1 million credit in favor of an Israeli bank. The Israeli

bank charges the parent 10 percent per annum on the NIS4 million made available to the

subsidiary and pays no interest on the $1 million that the parent has deposited in favor of

the bank. The parent’s opportunity cost on the $1 million deposit is 20 percent.

The total cost of this swap consists of the parent’s opportunity cost and the interest

charge on the local currency loan. The opportunity cost at 20 percent on the $1 million is

$200,000 and the 10 percent interest on the NIS4 million (NIS400,000) is $100,000 at the

prevailing rate of NIS4 per dollar. Thus, the total swap cost is $300,000 on a loan equivalent

of $1 million, or 30 percent. This example suggests that a direct loan costs the parent

20 percent while the credit swap costs it 30 percent. The parent cannot choose between

these two alternatives solely on the basis of comparative costs, because the direct loan is

unhedged while the credit swap is hedged. The meaningful comparison of the two lending

alternatives requires the parent to explicitly consider foreign-exchange fluctuations. The

direct loan is 10 percent cheaper only if the exchange rate stays the same.

If the MNC is unable to predict future exchange rate changes with a fair degree of accuracy,

it may attempt to identify the future exchange rate that equates the cost of the credit

swap with the cost of the direct loan; that is, the exchange rate at which the MNC would

be indifferent between the two financing alternatives. Assume that this exchange rate is

denoted by y. The cost of the direct loan from the parent consists of 200,000y, which equals

the Israeli shekel cost equivalent of the direct loan ($1 million . 20 percent) plus (1,000,000y

— 4,000,000), which equals the potential foreign-exchange loss from the repayment of the

loan principal ($1 million). The cost of the credit swap consists of 200,000y, which equals

the Israeli shekel cost equivalent of the $1 million deposited in favor of the Israeli bank plus

400,000, which equals the interest paid on the NIS4 million loan extended by the Israeli

bank at 10 percent per annum. Because the cost of the direct loan and the cost of the credit

swap are the same at the exchange rate of y, we obtain:

If the MNC company believes that the foreign-exchange rate will not deteriorate to the

equilibrium exchange rate of NIS4.4 per dollar, it should choose the unhedged alternative,

which will be less costly. It should select the hedged alternative whenever its subjective

assessment indicates that there is a significant chance for the foreign-exchange rate to deteriorate

beyond NIS4.4 per dollar.

direct loan cost

200,000

credit swap cost

y y 200,000y

y

+ -

=

+

=

( , , , , ) ,

.

1 000 000 4 000 000 400 000

4 4

INTERESTYLE="RATE SWAPS This device can be used to alter the exposure of a portfolio of assets or

liabilities to interest rate movements. An interest rate swap is a technique whereby companies

exchange cash flows of a floating rate for cash flows of a fixed rate, or exchange cash flows of a

fixed rate for cash flows of a floating rate. Interest rate swaps are actively used when companies

have costs of debt that are fixed but revenues that vary with the level of interest rates.

Take the example of a French company that borrowed $100 million from the Bank of America

a year ago at 9.5 percent. The long-term interest rate in the USA has started to fall and the French

company believes that it will continue to fall. To take advantage of this drop in interest rates, the

French company decides to enter an interest rate swap in dollars. It swaps $100 million with a

fixed rate of 9.5 percent for $100 million with a floating rate equal to a 6-month SDR rate. In

effect, the French company is now protected against a downward movement in interest rates.

Conversely, a reverse swap is arranged if the French company believes that the US interest rate

will increase.

BACK-TO-BACK LOANS Back-to-back loans, or parallel loans, are arranged by two parent companies

in two different countries. Suppose that a US parent has a subsidiary in Japan and that a

Japanese parent has a subsidiary in the USA. Let us further assume that each parent wants to

lend to its subsidiary in the subsidiary’s currency. These loans can be arranged without using the

foreign-exchange market. The US parent lends the agreed amount in dollars to the American

subsidiary of the Japanese parent. In return for this loan, the Japanese parent lends the same

amount of money in yen to the Japanese subsidiary of the American parent. Parallel loan agreements

involve the same amount of loan and the same loan maturity. Of course, each loan is

repaid in the subsidiary’s currency. The parallel loan arrangement avoids foreign-exchange risk

because each loan is made and repaid in one currency.

There are a number of variations on this basic swap scheme. A variation may involve blocked

funds. Assume that General Motors (GM) and IBM have their subsidiaries in Colombia. The

Colombian subsidiary of GM has idle pesos but cannot remit to the USA because of Colombian

restrictions on the remittance of funds. On the other hand, the Colombian subsidiary of IBM

needs peso loans for expansion. In this case, in Colombia the GM subsidiary lends pesos to the

IBM subsidiary; while in the USA, IBM lends dollars to GM.

9.3 Economic Exposure Management

Companies can easily hedge translation and transaction exposures, because these risks are based

on projected foreign-currency cash flows. However, it is very difficult, if not impossible, for companies

to hedge economic exposure for several reasons. The scope of economic exposure is broad,

because it can change a company’s competitiveness across many markets and products. A

company always faces economic risks from competition. When based in foreign currencies, the

risks are long term, hard to quantify, and cannot be dealt with solely through financial hedging

techniques.

As a result, international financial managers should assess economic exposure comprehensively.

Their analysis should account for how variations in exchange rates influence: (1) a company’s

sales prospects in foreign markets (the product market); (2) the costs of labor and other inputs

to be used in overseas production (the factor market); and (3) the home-currency value of finan-

ECONOMIC EXPOSURE MANAGEMENT 233

cial assets and liabilities denominated in foreign currencies (the capital market). Consequently,

those techniques used to eliminate translation and transaction risks — forwards, money markets,

options, swaps, leads and lags of intersubsidiary accounts, and transfer pricing adjustments —

are not feasible for hedging economic exposure.

Economic exposure management is designed to neutralize the impact of unexpected exchange

rate changes on net cash flows. Diversified operations and financing can reduce economic exposure.

They permit the MNC to react to those opportunities that disequilibrium conditions in

the foreign-exchange, capital, and product markets present. Moreover, diversification strategies

do not require that management predict disequilibrium conditions. Still, they require that it recognize

them when they occur. In other words, the primary technique to minimize economic risk

is strategic management in choosing product markets, pricing policies, promotion, and investment

and financing alternatives.

When managing economic exposure, MNCs resort to maneuvers across functional areas of

operations. The functional areas of business operations for MNCs are production, marketing,

and finance. Production and marketing are clearly critical because they determine a company’s

existence – its ability to produce products and to sell them at a profit. But finance is an integral

part of total management and cuts across functional boundaries.

Economic exposure management depends on the assumption that disequilibrium conditions

exist in national markets for factors of production, products, and financial assets. For example,

consider the cases in which there are temporary deviations from purchasing power parity and the

international Fisher effect. Companies could observe changes in comparative costs, profit

margins, and sales volume in one country compared to another.

9.3.1 Diversified production

Several production strategies can deal with economic exposure when disequilibrium conditions

exist: (1) plant location, (2) input mix, (3) product sourcing, and (4) productivity increase.

First, companies with manufacturing facilities in many countries can quickly lengthen their

production runs in one country and shorten them in another in line with the changing currency

costs of production. Second, well-managed companies can substitute their input mix between

domestic and imported inputs, depending on the relative prices of inputs and the degree of possible

substitution. Third, well-diversified companies can make shifts in sourcing raw materials,

components, and products in accordance with currency value fluctuations. Fourth, companies

assaulted by wide swings in currency values can improve productivity by closing inefficient plants,

automating production processes, and negotiating concessions from unions.

9.3.2 Diversified marketing

Marketing programs are normally adjusted only after changes in exchange rates. Yet marketing

initiatives under conditions of exchange rate changes can obtain competitive leverage by means

of: (1) product strategy, (2) pricing strategy, (3) promotional options, and (4) market selection.

First, product differentiation, diversification, and deletions reduce the impact of exchange rate

fluctuations on worldwide corporate earnings. Second, prices may be adjusted to cope with the

consequences of currency-value changes. A pricing strategy is affected by a variety of factors such

234 MANAGING TRANSACTION EXPOSURE AND ECONOMIC EXPOSURE

as market share, profit margin, competition, and price elasticity. Third, the size of promotional

budgets for advertising, personal selling, and merchandising could be adjusted to reflect changes

in currency values. For example, a devaluation of the Japanese yen may well be the time to increase

a US company’s advertising budget in Japan. Fourth, a worldwide distribution system enables

companies to neutralize the impact of unexpected exchange rate changes on overall company

revenues.

9.3.3 Diversified financing

On the financial side, additional tools to protect against economic risk are the currency denomination

of long-term debt, the place of issue, the maturity structure, the capital structure, and

leasing versus buying. For example, LSI Logic, a manufacturer of custom-made microchips based

in California, uses four financial instruments: (1) equity markets in London and other European

markets; (2) Japanese equity through institutional investors such as Nomura Securities; (3) local

Japanese credit markets through its joint venture partners; and (4) Eurobond issues through Swiss

and US securities firms.

Diversified financing sources allow a company to improve its overall financial performance

because interest rate differentials do not always equal expected changes in exchange rates. In addition

to taking advantage of unexpected differentials in diversified markets, companies reduce economic

risk by matching the mix of currencies in loan portfolios or operating expenses to the mix

of currencies in expected revenues.

9.3.4 A summary of economic exposure management

Purely domestic companies do not have as many options for reacting to international disequilibrium

conditions as MNCs. International diversification neutralizes the impact of unexpected

exchange rate changes on corporate cash flows. Exchange rate changes under conditions of disequilibrium

are likely to increase competitiveness in some markets and to reduce it in others.

However, at least one serious constraint may limit the feasibility of a diversification strategy: companies

with worldwide production systems may have to relinquish large economies of scale.

However, these companies could still diversify sales functions and financing sources.

9.4 Currency Exposure Management Practices

9.4.1 The relative importance of different exchange exposures

Table 9.2 shows the relative importance of different exchange exposures from two perspectives:

the amount of attention given to each exposure and hedging preference for each exposure. A

survey of 125 US MNCs by Malindretos and Tsanacas (1995) revealed that transaction exposure

was the overwhelming choice of chief financial officers (CFOs) in terms of the attention

that it must receive, with 64 percent ranking it as the most important one. Twenty-six percent

of these CFOs picked economic exposure as their number one choice, while only 13 percent

considered translation exposure as their most important exposure. A survey of large US MNCs

CURRENCY EXPOSURE MANAGEMENT PRACTICES 235

by Business International and Arthur Andersen & Co. found that 65 percent of the sample companies

hedged their transaction exposure, while only 26 percent hedged their translation exposure.

Apparently, not many executives of MNCs think that they should hedge paper gains and

losses for translation exposure and potential exchange gains and losses from future operations

(economic exposure). In addition, these executives do not pay too much attention to these two

types of exposure, because they believe that these exposures are not as important as transaction

exposure.

9.4.2 The use of hedging techniques by MNCs



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