The Measurement of Corporate Exposure - NYU Stern

Report
Currency Risk:
The Measurement of Corporate
Exposure
Prof. Ian Giddy
New York University
Measuring and Managing Exposure

Transactions exposure
Case study: “G.E.’s Yen Payables”
Translation exposure
 Economic exposure

Case study; “U.S. Semiconductor”
Transactions
Exposure
Translation
Exposure
Copyright ©2000 Ian H. Giddy
Economic
Exposure
Corporate Exposure 2
Transactions Exposure



Transactions exposure results from particular
transactions such as an export where a known
cash flow in a given currency will take place at a
certain date
Example: If Intel invoices a German company in
Deutsche marks for a semiconductor shipment
then the firm has German mark exposure and
can hedge this by borrowing marks.
This kind of exposure is readily hedgable using
forwards, futures or debt
Copyright ©2000 Ian H. Giddy
Corporate Exposure 3
Exchange Rate Risk: Transactions
 Transactions
exposure arises when a
company must pay or receive a foreign
currency at an unknown future
exchange rate
 It is contractual
 It affects the income statement
 It can often be hedged directly using
forwards, futures or currency options
Copyright ©2000 Ian H. Giddy
Corporate Exposure 4
Transactions Exposure: Hedging
Reeves International (CT) has a
subsidiary in Italy. It makes printing
blankets for sale in Europe.
 Reeves Italy has to pay a dividend of
approximately ITL 24 m. in December.
How should Reeves hedge this?

Forwards?
Futures?
Money
market hedge?
Do nothing?
Copyright ©2000 Ian H. Giddy
Corporate Exposure 5
Hedging Transactions Exposure
Types of exposure
 One-shot exposure
 Hedging approaches:
Open
Forward
Money
market
Futures
Options

Ongoing transactions exposure
Copyright ©2000 Ian H. Giddy
Corporate Exposure 6
International Profits



Covered under FASB No. 52 which requires
only certain transactional gains or losses to
be reflected in the income statement.
Income statement risk is dependent upon
exchange rate fluctuations.
In general, if a subsidiary has a positive
income flow, the income statement risk will be
positive.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 7
Recognition of Exchange Gains & Losses
Exchange Gain/Loss
Transaction Gain/Loss
Transaction
Date
Financial
Statement
Date
Translation Gain/Loss
Settle
ment
date
Financial
Statement
Date
Financial
Satement
date
Translation
Transaction
Copyright ©2000 Ian H. Giddy
Corporate Exposure 8
Linkages Between Interest Rates
Interest rate
differential
Covered interest
rate parity
Uncovered interest
rate parity
Expected
% change in
exchange rate
Forward
premium
Unbiased
forward rate
Copyright ©2000 Ian H. Giddy
Corporate Exposure 9
Cost of Hedging
Type of Hedge
Cost of Hedging
Forward
Forward premium
Money Market Hedge Interest rate
(Borrow to match
differential
assets)
Do nothing
Expected rate of
change of
exchange rate
Copyright ©2000 Ian H. Giddy
Corporate Exposure 10
GE’s Yen Payables
VCRs imported
Yen due in 90 days
Copyright ©2000 Ian H. Giddy
Corporate Exposure 11
GE’s Yen Payables
VCRs
Yen

Yen:
 Spot
 Forward
250
246
(6.5% premium)
 US$ Debt 15.5%, Yen interest 9.0%
Copyright ©2000 Ian H. Giddy
Corporate Exposure 12
What Happens to GE If ¥ Rises?
VCRs
Yen


If US VCR prices are fixed: GE is exposed.
Hedging is safer.
If US VCR prices are flexible, and obey PPP,
then GE is not exposed, and it would be risky
to hedge!
Copyright ©2000 Ian H. Giddy
Corporate Exposure 13
The Exposure Triangle
Transactions
Exposure
Translation
Exposure
Copyright ©2000 Ian H. Giddy
Economic
Exposure
Corporate Exposure 14
Balance Sheet Exposure


Balance sheet exposure (or translation or
accounting exposure) results from the way
accounting conventions dictate that a
company’s foreign assets and liabilities should
be booked.
Example: If Intel’s assets in Ireland are
regarded as denominated in Irish punts, then
the subsidiary’s accounting value is exposed to
the punt and the firm may wish to hedge this
exposure by financing in punts.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 15
Exchange Rate Risk: Translation

Translation exposure arises when a
company has assets and/or liabilities in
a foreign currency, which must be
translated at an unknown future
exchange rate

It affects the balance sheet
It can be hedged using forwards, futures or
currency swaps
But translation exposure can mislead!
Copyright ©2000 Ian H. Giddy
Corporate Exposure 16
Stora in Australia
Assets
 Cash
 Accounts receivable
 Inventory
 Property, plant and
equipment
Liabilities
 Accounts payable
 Bank debt
 Bonds issued
 Equity (owned by
parent company in
Sweden)
Net translation exposure = Value of foreign
currency assets - Value of foreign currency
liabilities.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 17
Translation of Individual Accounts



For US companies, governed by FASB No. 52
which specifies the current rate method
First, each entity's balance sheet and income
statement are measured in terms of their
Functional Currency, which is the currency of the
economic environment in which the entity primarily
operates and maintains records
Next, the functional-currency-denominated
financial statements are translated into the parent's
currency using the All-Current-Rate Method, which
reports balance sheet items at the closing rate and
income statement items at their average rates.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 18
Key Features of FAS 52



Objective of translation: Local subsidiary perspective
(preserve foreign currency financial results and
relationships in consolidated statements)
Functional currency: Primary currency of economic
environment in which foreign entity operates
Translation method:




If functional currency is US$: Temporal method
If functional currency is foreign currency: Current rate method
Transaction gains & losses: Recognized in current
income except those on intercompany transactions of
long-term nature
Translation gains & losses: Recognized in separate
owners' equity account.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 19
Sweden Down Under
Stora, the Swedish
pulp & paper company,
has a plant in
Melbourne, and sells in
Australian dollars
 But newsprint is a
world-wide, dollartraded commodity
 So the revenues are
effectively in dollars,
not Ozzies.

Copyright ©2000 Ian H. Giddy
Corporate Exposure 20
Stora in Australia: What’s Exposed?
Assets
 A$ Cash
 Accounts receivable
 Inventory
 Property, plant and
equipment
Liabilities
 A$ Accounts payable
 A$ Bank debt
 A$ Bonds issued
 Equity (owned by
parent company in
Sweden)
Net translation exposure = Value of foreign
currency assets - Value of foreign currency
liabilities.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 21
Criteria Favoring Local Currency As
Functional Currency
Cash flows
Sales price
Sales market
Expenses
Financing
Intercompany
transactions
Copyright ©2000 Ian H. Giddy
Mainly in local currency and do not
impact parent's cash flows
Irresponsive to exchange rate
changes and governed by local
competition
Largely in host country and
denominated in local currency
Incurred primarily in local
environment
Primarily local currency financing
Neither frequent nor extensive
Corporate Exposure 22
Purchasing Power Parity:
Theory and Evidence
S t=1-St
St
=
I-I*
1+I*
EXCHANGERATE
CHANGE

MEXICO 1994
RELATIVE
INFLATION

Copyright ©2000 Ian H. Giddy
JAPAN 1995
Corporate Exposure 23
Case Study: Arauco’s 1993 Forex Loss
1992
1st Q
1993
1st Q
Net income Price-level
($m)
restatement
37.6
9.2
(4.1)
(54.4)
ARAUCO
Copyright ©2000 Ian H. Giddy
Corporate Exposure 24
Case Study: Arauco’s 1993 Forex Loss
1992
1st Q
1993
1st Q
Net income Price-level
($m)
restatement UF
US$
37.6
9.2
2.2% -6.5%
(4.1)
(54.4)
1.0% +4.9%
ARAUCO
Copyright ©2000 Ian H. Giddy
Corporate Exposure 25
Foreign Currency Translation
All
Current
Assets
Cash
A/R
Inventory
Fixed assets
Liabilities
Short-term Debt
Long-term Debt
Equity
Copyright ©2000 Ian H. Giddy
C
C
C
C
C
C
Residual
Corporate Exposure 26
Foreign Currency Translation
Assets
Cash
A/R
Inventory
Fixed assets
Liabilities
Short-term Debt
Long-term Debt
Equity
Copyright ©2000 Ian H. Giddy
All
Current
Current/
Noncurrent
C
C
C
C
C
C
C
H
C
C
Residual
C
H
Residual
Corporate Exposure 27
Foreign Currency Translation
All
Current
Assets
C
Cash
C
A/R
C
Inventory
C
Fixed assets
Liabilities
C
Short-term Debt
C
Long-term Debt
Equity
Residual
Copyright ©2000 Ian H. Giddy
Current/
Noncurrent
Monetary/
Nonmonetary
C
C
C
H
C
C
H
H
C
H
Residual
C
C
Residual
Corporate Exposure 28
Exposed or Not Exposed?
Balance Sheet
Item
1. Fixed Assets
Exchange Net
Prices Rates
Effect
2. Inventories
3. Monetary Items
Copyright ©2000 Ian H. Giddy
Corporate Exposure 29
Exposed or Not Exposed?
Balance Sheet
Item
1. Fixed Assets
Exchange Net
Prices Rates
Effect
2. Inventories
3. Monetary Items
Copyright ©2000 Ian H. Giddy
Corporate Exposure 30
Currency Risk: Economic Exposure
Change in the economic value of the firm
resulting from unanticipated exchange
rate changes.
 Booked vs. anticipated transactions
 Expected vs. unexpected changes; the
"cost of hedging"
 Exposure and the parity assumptions:
"We are not exposed in the long run"
 Currency of denomination vs currency of
determination; compet., elasticities, etc.
Copyright ©2000 Ian H. Giddy
Corporate Exposure 31
Economic Exposure

Economic exposure is how the firm’s
revenues and costs will respond to
exchange rate changes.
 Example:
Even though Intel invoices German
customers in marks, its future revenues may be
unaffected by fluctuations in the mark if the currency
of determination of prices in the semiconductor
business is the dollar or even the yen.

The currency of determination is the
currency in which most of the competition
prices similar products.
 Example:
Copyright ©2000 Ian H. Giddy
General Electric’s Yen Payables
Corporate Exposure 32
Operational Aspects of Exchange Risk
1.VOLUME EFFECTS (compensate for
changes in profit margins)
2.PRICING FLEXIBILITY (change in
margins to offset effect of exchange rate
change)
3.DIVERSIFICATION of markets for
inputs and outputs
4.FLEXIBILITY (ability to shift markets
and sources quickly)
Copyright ©2000 Ian H. Giddy
Corporate Exposure 33
Translation vs Economic Exposure
Accounting exposure
 Exposure = "Exposed" assets - "exposed"
liabilities
Economic exposure
 Exposure = How will an unanticipated exchange
rate change affect the cash flows of the firm?
 Domestic
sales
 Exports
 Domestic
costs
 Import costs
Copyright ©2000 Ian H. Giddy
Corporate Exposure 34
A Realistic Approach



Banks versus corporations: To the extent that the
firm is like a bank, do bank-style hedging. Match
financial assets with liabilities of the same kind.
Seek to identify economic exposure using
product cost-and-market analysis, industry
competitive analysis, or statistical analysis on the
sensitivity of the company’s value to exchange
rate changes.
Hedge economic exposure using debt/swaps for
long term exposure, short term instruments for
uncertain exposure, and options for disaster
insurance
Copyright ©2000 Ian H. Giddy
Corporate Exposure 35
Case Study: US Semiconductor
CHIPS
US DOLLARS
Copyright ©2000 Ian H. Giddy
Corporate Exposure 36
Case Study: US Semiconductor
The transactions: a cost comparison
 Translation of assets and liabilities
 The economic risks

Copyright ©2000 Ian H. Giddy
Corporate Exposure 37
US Semiconductor: The Transaction
USD interest rate:
 GBP interest rate:
 Spot dollar/pound:
 5-yr forward $/pound:
Diff, % per annum:


8%
12%
2.40
1.97
-3.87%
Borrow GBP & hedge: 12%-3.6%=8.13%
Copyright ©2000 Ian H. Giddy
Corporate Exposure 38
US Semiconductor:
Translation Exposure
C U R R /N O N
CURR
M O N /N O N
M O N (F A S 8 )
TE M P O R A L
(F A S 5 2 )

$
$

$

$
$

A /R
C H IP S
YELLOW
TR U C K S
W AREHOUSE
Copyright ©2000 Ian H. Giddy
Corporate Exposure 39
US Semiconductor: Economic Exposure
SOLD IN UK
INVOICED IN GBP



LAND
WAREHOUSE
TRUCKS
Copyright ©2000 Ian H. Giddy
GBP?
CHIPS
Corporate Exposure 40
US Semiconductor: Economic Exposure



LAND
WAREHOUSE
TRUCKS
Copyright ©2000 Ian H. Giddy
CHIPS
SOLD IN UK
INVOICED IN GBP
GBP?
SOLD IN
WORLDWIDE MARKET
USD?
Corporate Exposure 41
US Semiconductor: Economic Exposure



LAND
WAREHOUSE
TRUCKS
Copyright ©2000 Ian H. Giddy
CHIPS
SOLD IN UK
INVOICED IN GBP
GBP?
SOLD IN
WORLDWIDE MARKET
USD?
DETERMINED BY
COMPETITION
JPY?
Corporate Exposure 42
Summary: Types of Exposure
Transactions
Exposure
Translation
Exposure
Copyright ©2000 Ian H. Giddy
Economic
Exposure
Corporate Exposure 43
Which Instrument?
Identifiable
Debt, swaps,
exposure
forward contracts
Uncertain exposure Instruments with
flexibility, such as
forwards and futures
Exposure that
Deep-out-of-thethreatens financial money options
distress
Copyright ©2000 Ian H. Giddy
Corporate Exposure 44
A Corporate Foreign Exchange
Roadmap
UNDERSTANDING THE EXCHANGE
RISK MANAGEMENT PROBLEM
 Value of hedging
 Goals
 Nature of the business
MEASUREMENT OF EXPOSURE
ACCOUNTING
Examples:

Sourcing flexibility

Pricing strategy

Market
diversification
Copyright ©2000 Ian H. Giddy
ECONOMIC
NATURE OF THE CASH FLOW EXPOSURE:
 One-shot?
 Linear?
 Contingent on exchange rates?
 Contingent on other events?
HEDGING METHODS
OPERATIONAL
TRANSACTION
FINANCIAL
Linear

Forwards

Futures

Debt

Currency swaps
Exchange-rate
contingent

Options

Debt with option
features
Contingent on
other events

Event options

Probability-based
hedging
Corporate Exposure 45
Local Exposure
Copyright ©2000 Ian H. Giddy
Corporate Exposure 46
Copyright ©2000 Ian H. Giddy
Corporate Exposure 47

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