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International Finance I [CFI4102]

B.Com Finance
FOREIGN EXCHANGE MARKET AND
MANAGEMENT OF FOREIGN EXCHANGE RISK
Prepared by
Edson Mbedzi

Topic Objectives
To describe the fundamental operations of the foreign exchange
market.

To explain the common methods used to determine and forecast

foreign exchange rates, and how these are used in international


finance.

To explain factors that influence the foreign exchange rate.


To identify the main international business exposures for MNCs;
To demonstrate how different international business exposures are determined
Understand and apply foreign exchange risk techniques that are commonly used
in managing international business exposures.

Foreign Exchange Market


The mechanism that permits international transacting and the pricing
of foreign exchange is the foreign exchange market.

Unlike the commodity market,


this market does not have
physical trading centres. Most
transactions are done overthe-counter (OTC), personal,
telephone
and
internet
messages.

Participants are individuals, international


firms, and nonbank financial institutions.
Transactions classified as spot and
forward.
Spot transactions are for immediate
delivery, which is OTC.
Forward transactions are at a forward
rate for delivery at a designated date more
than 2 days in the future.

Participants are local commercial


banks and large financial centre
banks.
Immediate delivery is within 2
days in interbank market.
Forward transactions also apply in
the interbank market.
Trading is in large volume
transactions of $1mln or more per
trade

Trading takes place


organised exchange.

at

an

Local banks, nonbank customers


and financial centre banks all
participate through brokers in this
market.
Transactions are for FX futures
contracts, FX Call and Put
Options.
3

Methods of Foreign Exchange


Quotations
Foreign
exchange rates (FX) can be officially quoted in two ways. Using
US$ as the home currency.
Direct Quotation: An amount of the local currency (US$) equivalent
per one unit of foreign currency (e.g. $1.5 / ).
It is also known as price quotation.
Under direct quotation, variation in FX rate is inversely related to the
value of the local currency.
Indirect Quotation: An amount of the Foreign Currency per 1 unit of
the local currency (US$) (e.g. 0.68 / $).
This is also known as quantity quotation.
Under indirect quotation, variation in FX rate is directly related to the
value of the local currency.
4

Two Types of Exchange Rates


Spot RatesS (0 ) - Buyer and Seller agree on Price (P) and Quantity (Q)
for immediate delivery.

Forward Rates (F) - Buyer and Seller agree on P and Q for delivery in
the future - 1 month, 3 month, 6 months or more in the future.
Market forces determine both spot and forward rates.
NB: When a currency is expected to appreciate, it sells at a forward
premium (%), and when it is expected to depreciate, it sells at a forward
discount (%).
Example 1
If the = 100/$ and the 1 year F = 105/$, the dollar is selling a 5%
F S0
105 100
S0
forward premium.
5%
100
Forward Premium
=S 0
=
This tells us that the dollar is expected to appreciate by 5% over the next
year.
5

Exchange Rate Determination


We shall consider two time horizons: short-run and long-run determinants of
foreign exchange rates.
1. Short-Run

Foreign Exchange Rate Determination Tools

Are the most difficult to predict and are often determined based on bandwagon
effects, overreaction to news, and speculation.
a) Trend-Following Behaviour is the tendency for the market to follow a trend. In
other words an increase in the exchange rate is more likely to be followed by
another increase.
b) Investor Sentiment is based on the consensus of the market. For example if
the market is bullish on the dollar, then the dollar is likely to strengthen versus
other currencies.
c) Order Flow - there is evidence of a positive correlation between spot exchange
rate movements and, order flows in the inter-dealer market and customer currency
order flows.
6

Exchange Rate Determination


2. Long-Run Foreign Exchange Rate Determination Tools
a)Purchasing Power Parity (PPP)

States that since the prices should be the same across countries, the
exchange rate between two countries should be the ratio of the prices
in each country. Also known as the law of equal prices.
PPP :

Price of a product in Country A


Spot rate ( S )
Price of a product in Country B

PA
where, the spot rate (S ) is B
P

Relative PPP states that the exchange rate will change to offset
differences in national inflation rates.
i.e. if Country A has higher inflation than Country B, you can expect
Country As currency to depreciate versus Country Bs currency if
parity is to be maintained.
7

Exchange Rate Determination


Derivation of Purchasing Power Parity (PPP)
Pf
Ph ( ) and that of the foreign country
Lets assume price of home country
I frates are and respectively.
Ih
( ) are equal and their inflation
Due to inflation their respective price indexes becomes:

Ph (1 I h ) Pf (1 I f )

PPP theory suggests that when inflation rates differ between countries,
the percentage change in foreign
e f currency ( ) should necessarily
vary to maintain parity in purchasing power.
If inflation occurs in the foreign country, then exchange rate of foreign
currency has to change and the foreign price index becomes as
followseto maintain parity:
Ph (1 I h ) Pf (1 I f )(1 e f )

Solving
, we obtain
P (1for
Ih )
ef h
1
Pf (1 I f )

that Ph and Pf are equal and will cancel each other.


(1, given
Ih )
ef
1
(1 I f )

This formula shows the relationship between relative inflation rates of 8

Exchange Rate Determination


Using PPP to Determine Exchange Rates
Assume exchange rate is in equilibrium initially. Then the home country experience
a 5% inflation rate and foreign country experiences 3%, with current spot rate at
$1.50/. According to PPP, the foreign exchange rate will adjust as follows:
ef

(1 0.05)
(1 I h )
1
1 e f
(1 0.03)
(1 I f )

= 0.0194 or 1.94%

Thus the foreign currency should appreciate by 1.94% in response to the higher
inflation rate of the home country relative to that of the foreign country.
The estimated future spot rate becomes:
E ( S t 1 ) S t (1 e f )

E ( S t 1 ) $1.50(1 0.0194)

E ( S t 1 ) $1.53

As a results of the exchange rate effect, price indexes of both countries rise by 5%
from the home country perspective, thus the purchasing power is the same for
foreign and home goods.

Exchange Rate Determination


b) International Fisher Effect (IFE)
i ( ) differential rather
The theory uses nominal interest rate
than inflation rate differentials to explain changes in
exchange rate over time.

It is closely related to PPP because interest rates are often


highly correlated with inflation rates.
It can be derived like the PPP equilibrium equation above to
(1 r )
give.
e
1
(1 r )

rh
rf
h

Where
and
respectively.

represent the home and foreign interest rate


10

Exchange Rate Determination


Using IFE to determine FX Rate
Assume that the interest rate on a one year insured home country bank
deposit is 11% and on a foreign country is 12%. For the actual returns of
these two investments to be similar from the perspective of investors in
the home country, the foreign exchange rate would have to change over
the investment horizon based on the IFE theory:
e (1 rh ) 1
f

ef

(1 r f )

(1 0.11)
1
(1 0.12)

= -0.0089 or -0.89%
Thus the foreign currency should depreciate by 0.89% to make the
actual return of 12% on the foreign deposit equal the 11% from the
perspective of the investors in the home country. This would make the
return on the foreign country equal to the return on a domestic
investment.
11

Exchange Rate Determination


c) Interest Rate Parity (IRP)
States that an exchange rate quoted today for settlement at a future date (forward
rate premium or discount) should be linked to interest rate differentials.

Fdays

days

i
x

f 360


S0

days

1 id x 360

Where, S 0 is the spot rate and are the annual foreign and domestic interest rates
respectively.
Forward rates are unbiased predictors of future exchange rates.
An unbiased predictor means that on average the estimation will be wrong on
the up side or the downside with equal frequency and degree. In other words, the
errors are normally distributed

12

Exchange Rate Determination


Determination of the Forward Rate using IRP
Assume the Mexican peso exhibits a six months interest rate of 6% and the US
dollar of 5% while the current spot rate is $0.10. According to IRP, the forward rate
of the peso with respect to US dollar is given by:

Forward Rate is given by:

Fdays

Forward Rate 0.10

days

1 i f x

360


S0

days

1 id x 360

{1 0.05

{1 0.06

180

360
180

360

Forward rate is: F= $0.0995

13

Exchange Rate Determination


Use of IRP to arbitrage in International Finance
There are two ways to it:

a) Covered Interest-Rate Parity the idea that an imbalance in parity


conditions can create a risk less opportunity for a foreign exchange trader, in this
case a corporate arbitrager.
Example
Assume the home country interest rate is 8% p.a. in US and 4% p.a. in Japan.
Given that the spot rate is 106/$ and the 180 days forward rate is 103.50/$.
Discuss how an arbitrager can use covered Interest rate parity to earn risk-free
profits.
First, check that an imbalance in parity conditions exist and to be certainty that the
foreign currency should indeed depreciate.
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Exchange Rate Determination


Using Covered Interest Rate Parity in International Finance

{1 0.04

Forward premium / discount

{1 0.08

180
}
360
1
180
}
360

= -0.019.

This means the should depreciate by 0.019 to 103.96/$. This means the 180
days forward rate of 103.50 in the FX market is slightly undervalued and therefore
there exist an arbitrage opportunity.
Figure 1: Covered Interest Arbitrage diagrammatical illustration

$4,638.
00

15

Exchange Rate Determination


Using Uncovered Interest Rate Parity in International Finance

b) Uncovered Interest-Rate Parity - Uncovered interest arbitrage is great


when you are dealing with fixed exchange currencies, because the profit at the end
of the period is dependant on the prevailing exchange rate (and since this is
uncovered it is a very risky investment and therefore in free rate system, your
estimate of the forward rate must be very accurate).

$83,333.
33

$87,500.
00
16

Factors influencing Exchange Rate


The equilibrium exchange rate will change over time as supply and demand
schedules change.
The factors that cause currency supply and demand to change are discussed
below based on a hypothetical initial equilibrium of the British pound exchange rate
of $1.55/ to US dollar, shown in figure 3 below
Figure 3: Equilibrium Exchange Rate Determination
Value
of
S

$1.6
0
$1.5
5
$1.5
0

Quantity
of

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Factors influencing Exchange Rate


a) Relative Inflation Rates
Relative inflation rates can affect international trade activity, which influences
the SS and DD of currencies and therefore influences exchange rates.

Example
Imagine D and S schedule in figure 4 below and if US inflation suddenly increased
while the British inflation remains the same. The sudden jump in US inflation
causes an increase in US DD for British goods and therefore an increase in US DD
for British . In addition, increase in US inflation reduces the British DD for US
goods and thus reduce SS of for sale in the international market. The increased
US DD for and reduced SS of for sale place pressure on value of shifting the
equilibrium to $1.57 as shown on figure 4 below.
Figure 4: Impact of rising US inflation on Equilibrium value of British
Value
of

$1.60

S1
S

$1.57
$1.5
5

D1
D

$1.50

Quantity

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Factors influencing Exchange Rate

b) Relative Interest Rates

Relative interest rates affect investment in foreign securities, which influences


the supply and demand of currencies and therefore influences exchange rates.

Example
Assume US interest rates rise while the British interest rates remain the same. US
investors will reduce their DD for British since US interest rates are now more
attractive, and therefore less desire for British bank deposits. In addition, US
rates are more attractive to British investors with excess cash, the supply of for
sale by British investors increases as they establish more deposits in US. Due to
inward DD for and an outward SS of , the equilibrium exchange rate should
decrease to; say $1.53 as shown on figure 5 below.
Figure 5: Impact of rising US interest on Equilibrium value of British
S
$1.60
Value
S
of
1
$1.55
$1.5
3
$1.50
D

D1

Quantity

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Factors influencing Exchange Rate


c) Relative Income Rates

Relative income levels affect the amount of imports demanded, it also influences
exchange rates.

Example
Assume US income levels rise substantially while the British income rates remain
unchanged. First, the DD for will shift outward, reflecting the US increase in
income and therefore increased demand for British goods through the MPM
effect. Second, the SS schedule of pounds is not expected to change as there is
no corresponding change in income in Britain. Therefore, equilibrium exchange
rate of the pound is expected to rise to; say $1.56 as shown on figure 6 below.
Figure 6: Impact of rising US income levels on Equilibrium Value of British
Value
of
S
$1.6
0
$1.57
$1.55
D1
D

$1.5
0

Quantity

20

Forecasting Foreign Exchange Rate


Why International Firms forecast exchange rates
The following are some of the corporate functions for which
exchange rates forecasts are essential:

Financing Decisions

Investment Decisions

Hedging Decisions

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Forecasting Techniques

a)

Technical Forecasting

It involves use of historical exchange rate data to predict future values in


the short-run period.
It has very limited use because it estimates exchange rates for the near
future which is rarely used for developing corporate policies.
Uses factors for short-term exchange rate determinants such as;
trend-following behaviour,
investor sentiment and,
orderflow by traders in the foreign exchange market.
It is a perfect fusion of professional knowledge and the different methods
of research.

22

Forecasting Techniques
Fundamental Forecasting

b)

It is based on fundamental relationships between economic variables (relative


interest, inflation, and national income) and the exchange rate.

1) Use of Sensitivity Analysis for Fundamental Forecasting


When regression model is used for forecasting, values of influential factors have to
be generated (Recall your Financial Engineering or Advanced Asset Pricing and
Theory for the generation of regression coefficients).
The forecasted future exchange rate can be computed as:

et b0 b1 INTt b2 INFt 1 b3 INC t 1 t


et = percentage change in the reference currencys exchange rate over period t.

= real interest rate differential over period t


INF = inflation differential in the previous period
INC
= national income level differential in the previous period.
t = error term
b0 = regression constant,
b1 = coefficient that measures the sensitivity of to changes in interest rate,
b2 = coefficient that measures the sensitivity of to changes in inflation rate
b3 = coefficient that measures the sensitivity of to changes in national income
23
levels
INTt

t 1

t 1

Forecasting Techniques
2)

Use of PPP for Fundamental Forecasting

Recall the theory of PPP specifies the fundamental relationship between inflation
differential and exchange rate, meaning this theory can be used to forecast
future exchange rates.
Example
Assume US inflation is expected to be 1% while the Australian one is 6% in the
next year. According to PPP, the Australian dollar (A$) exchange rate will adjust
as follows:
ef

(1 I h )
1
(1 I f )

ef

(1 0.01)
1
(1 0.06)

= -0.047 or - 4.7%
St

S t 1
This forecast of the percentage change
in the A$ can be applied to its existing spot rate to
forecast
future spot rate
end of one period. If the existing spot rate ( ) of the A$
E ( S t 1 ) Sthe
E (at
S t the
t (1 e f )
1 ) $0.20[1 ( 0.047 )]
E ( S t 1 ) $0.1906
is $0.20, the expected spot rate E ( ) at the end of one period will be:

This is the forecasted exchange rate at the end of period t. NB the same principle can be
applied on other international parity conditions such as the IFE and the IRP theories
24 to

Forecasting Techniques
3.

Market-Based Forecasting

The process of developing forecasts from market indicators and usually uses either the spot
rate or the forward rate as its basis.
Example
The US annualised five-year interest rate is currently 10% p.a. while the British one is 13%
p.a. and the current British spot rate is $0.856. Based on these current rates, the five-year
compounded returns on investments in each of these countries are compounded as follows:
Country

Five-Year Compounded Return

1 0.10 5 1 61%
1 0.13 5 1 84%

United States
United Kingdom

Thus the five-year forward rate premium or discount of the British pound will be:
(1.61)
(1 i F )
e P 5 0.125 or 12.5%
eP5
1
eP5
1
(1 i H )

(1.84)

The spot rate is expected to depreciate by 12.5% in 5 years period to give the expected
forward rate of:

E ( S t 5 ) S t (1 e f )

E ( S t 5 ) $0.856[1 (0.125)]

E ( S t 5 ) $0.749
25

Forecasting Techniques
4.

Mixed Forecasting

Since no single forecasting technique can be 100% accurate and


consistently superior to others, many MNCs prefer to use various
techniques.
Techniques used are assigned weights totalling 100%, with techniques
considered more reliable over the period under consideration given more
weights.
The actual forecast produced becomes the weighted average of the
various forecast techniques used by the institution.

26

Forecasting Techniques
Evaluation of Forecast Performance of an MNC
MNCs that forecast exchange rates need to monitor their performance over time
to ascertain that the forecasting procedures are satisfactory.
This leads us to the calculation of the forecast error given by:
Absolute Forecast Error as % of Re alised Value

Forecast Value Re alised Value


Re alised Value

Example
Consider the following forecasted and realised values by an MNC during one period.
Forecast value

Realised Value

British Pound

$1.35

$1.50

Mexican Peso

$0.12

$0.10

The difference between the forecasted value and realised value is $0.15 for the pound and
$0.02 for the peso. This does not mean that the peso was forecasted more accurately
because when the size of what was forecasted is considered; the pound has been predicted
with more accuracy
27

Forecasting Techniques
With data given, forecast error for the pound is:
Absolute Forecast Error as % of Re alised Value

$1.35 $1.50

$1.50
$0.15
$1.50
0.10 or 10%

The forecast error for the Mexican peso is:


Absolute Forecast Error as % of Re alised Value

$0.12 $0.10
$0.10
$0.02

$0.10
0.20 or 20%

Thus, over the period under study, the peso had been forecasted with less accuracy. By
tracking its forecasting error over time, the MNC can evaluate its forecast performance over
several periods and understand whether it has good precision for short period or over long
periods.
NB: Due to the increasing corporate need to forecast currency values, there are now several
independent consulting companies which provide these services, including Business
International and Wharton Econometric Forecasting Associates among others.

28

Exchange Rate Systems


Fixed exchange rate system - Rate fixed by government as constant
or forced to stay within defined narrow limits.
Freely floating exchange rate system - Exchange rates determined
purely by market forces. Incidental imbalances efficiently resolved by
market forces.
Managed float exchange rate system - Blend of the above that can
be termed a not perfectly free floating rate system.
Pegged exchange rate system - The currency of one country is set
equal to or as a fixed percentage of another country's currency
(generally a major stable currency like the US dollar)

29

Government Intervention in the Exchange Rate Market


Each country has a government agency (the central bank) that may
intervene in the foreign exchange market to control the value of the
countrys currency.
In the United States, the Federal Reserve System (Fed) is the central
bank and in Zimbabwe is RBZ.
Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate boundaries, and/or
to respond to temporary disturbances.
Often, intervention is overwhelmed by market forces, intervention
efforts may have little impact.
However, currency movements may be even more volatile in the
absence of intervention.
30

Government Intervention in the Exchange Rate


Market

Direct intervention
Refers to the direct involvement by the countrys central bank in the
foreign exchange market to push the price of the local currency to
desired levels.
Purchase and sell of foreign reserves
Buying and selling government securities e.g. Governments bonds,
OMO etc
Indirect intervention
This involves central bank influencing fundamental
determine the value of the currency to optimal levels.
Interest rate
Inflation
Income levels

factors

that

31

32

Foreign Exchange Exposure


Measurement and Management

33

Foreign Exchange Exposure

Concept of exposure refers to the extent to which the business of an MNC is


affected by foreign exchange rate.

Types of Exposures
Exposures take three forms, namely translation (accounting) exposure,
transaction exposure and economic exposure.

a) Translation (Accounting) Exposure

Translation/accounting exposure arises when MNC coverts local currencies (LC)


of subsidiaries to the parents home currencies (HC), for the purposes of
financial reporting and producing consolidated financial statements.
Reasons:
(i) Taxes in the parents home country on income earned by the foreign
subsidiary are payable in home currency.
(ii) Most countries require consolidation of the parents and subsidiarys
financial statements for financial reporting purposes.
(iii) A firm needs to consolidate data in order to make investment and financial
decisions.
(iv) In order to make performance measures comparable. Decisions to
promote or fire managers are also based on performance.
(v) To value the entire firm.
34

Methods of Translation Exposure


1. Current/Non-current Method
Under this method, all foreign subsidiary current assets and liabilities are translated
into the home currency at the current exchange rate, while noncurrent assets and
liabilities are translated at historical exchange rate (rate applying when acquired or
incurred).
2. Monetary/Nonmonetary Method
This method separates monetary assets and liabilities; those items representing cash
claim to receive or obligation to pay, such as cash, accounts payables and
receivables, and long-term debt are all translated at current rate, where as
nonmonetary items like inventory, fixed assets and long-term investments are
translated at historical rates.
3. Temporal Method
Same as the monetary/nonmonetary method except for the treatment of inventory.
Under this methods it is translated at current whenever it appears in the balance
sheet at current market value.
4. Current Rate Method
In this method, all balance sheet and income items are translated at the current rate.

35

Financial Statements Impact of Translation Methods (US000) following a 25% depreciation of local currency
LC

US$
before Monetary/
change of FX
Nonmonetary
LC4 =$1
LC5 =$1

Temporal

Current/
Noncurrent
LC5 =$1

LC4 =$1

Current
LC5 =$1

Assets
Current Assets
Cash
Inventory (at Market)

2,600
3,600

650
900

520
900

520
720

520
720

520
720

200

50

50

50

40

40

6,400

1,600

1,470

1,290

1,280

1,280

Fixed assets
Goodwill
TOTAL ASSETS

3,600
1,000
11,000

900
250
2,750

900
250
2,620

900
250
2,440

900
250
2,430

720
200
2,200

Liabilities
Current Liabilities

3,400

850

680

680

680

680

Long-term debt

3,000

750

600

600

750

600

500

125

100

100

125

100

Total Liabilities

6,900

1,725

1,380

1,380

1,555

1,380

Capital
Retained earnings

1,500
2,600

375
650

375
865

375
685

375
500

375
445

4,100
11,000

1,025
2,750

1,240
2,620

1,060
2,440

875
2,430

820
2,200

215

35

(150)

(205)
36

Prepaid expenses
Total Current Assets

Deferred income taxes

Total Equity
TOTAL LIABILITIES
Translation Gain/loss

Transaction Exposure

The degree to which the value of future cash transactions (cash inflows to be
received or cash outflows to be paid) can vary due to exchange rate fluctuations
of underlying currencies is transaction exposure.
It arises when an MNC is committed to a foreign currency denominated
transaction.

Measuring Transaction Exposure


There are various steps involved:

a)Transaction exposure based on Net Cash Flows


To measure its transaction exposure, MNC first needs to project its consolidated
net currency by currency inflows and outflows for all its subsidiaries.

Currency

Total Inflows

Total outflows

Net cash flow

Expected
Net Exposure of
Exchange rate at cash flow in US$
end of period

British

17,000,000

7,000,000

10,000,000

$1.50

$15,000,000

Canadian $

C$12,000,000

C$2,000,000

C$10,000,000

$0.80

$8,000,000

Swedish
Kronor

SK20,000,000

SK120,000,000

(SK100,000,000)

$0.15

($15,000,000)

Mexican Peso

MXP90,000,000

MXP10,000,000

MXP80,000,000

$0.10

$8,000,000
37

Measuring Transaction Exposure


From a glance, the MNC can tell that it has more exposure in the Swedish and
British currencies.
However a scenario analysis gives more insights:
Currency

British

Net cash flows

Range
of
expected Range of possible net cash flows
exchange rate at end of in US$
period

10,000,000

$1.40 to $1.60

$14,000,000 to $16,000,000

C$10,000,000

$0.79 to $0.81

$7,900,000 to $8,100,000

Swedish
Kronor

(SK100,000,000)

$0.14 to $0.16

($14,000,000) to ($16,000,000)

Mexican
Peso

MXP80,000,000

$0.06 to $0.11

$4,800,000 to $8,800,00

Canadian $

38

Measuring Transaction Exposure


b) Measuring Transaction Exposure based on Currency Variability

Variability of currency is measured using the standard deviation statistic derived


from historical data, which measures the degree of movement of each currency
Time Period
Currency

1981-1993

1994-2006

British

0.0109

0.0148

Canadian $

0.0100

0.0110

Swedish Kronor

0.0287

0.0195

Mexican Peso

0.0330

0.0246

For each period, some currencies fluctuated more than others.

For example, standard deviations for the British and Canadian $ are much lower
than those of the Swedish and Mexican currencies.

This information is important to the MNC to identify which currencies are likely to
be stable or highly variable in future.

In practice currencies which exhibit lower levels of variability tend to also exhibit
lower forecast error.
39

Measuring Transaction Exposure


c) Measuring Transaction exposure based on currency
correlations
This analyses how each currency changes relate to that of another; in which the
correlation can be either positive or negative.
The correlations among currencies movements can be measured by their
correlation coefficients; i.e. the degree to which two currencies
move relative to
Assume MNC needs $30 million to
each other.
+5.
Currency
purchase currencies X and Y at a
%
0
change
of
currency +2.5
against
US$
0

Currency
Y
Currency
Z

-2.5

-5.0

ratio of 1:2 and another $30 of


currency Z.
Given the correlation among
currencies any changes in value of
currencies X and Y are offset by
changes in currency Z.
What happens if currencies X and Y
appreciate by 20%?

Time

40

Forms of managing Transaction


Exposure
the following example
for all methods of managing

We will use
transaction
exposure. Assume a USs General Electrical (GE)s Deutsche Mark (DM)
exposure. On 1 January, GE is awarded a contract to supply turbine blades to
Lufthansa, the Germany Airline and GE will receive DM25 million on 31
December the same year. The current spot rate for deutsche mark is
DM1=$0.40 and the one-year forward rate is DM1=$0.3828. The following are
potential exchange rate exposure management options.
a) Forward Market Hedge
In forward market hedge a company that expect to receive a foreign currency sells foreign
currency forward and one that expect to pay (short position) a foreign currency buys the
currency forward. In our case, GE sell the proceeds of the sale forward and transforms the
currency denomination of its expected DM25 million into dollars, thereby eliminating all
currency risk on the sale.
Spot Exchange rate

DM1=$0.40

Value of original Gain/Loss


on Total
Cash
receivable(1)
forward contract(2)
(1+2=3)

Flow

$10,000,000

($430,000)

$9,570,000

DM1=$0.3828

$9,570,000

$9,570,000

DM1=$0.36

$9,000,000

570,000

$9,570,000
41

Forms of managing Transaction


Exposure
c) Money market Hedge
A money market hedge involves simultaneous borrowing and lending activities
in two different markets.
Suppose deutsche mark and dollar interest rates are 15% and 10% respectively.
Using money market hedge, GE will borrow DM21.74 million (DM25/1.15) for one
year, covert it into $8.7 million (21.74x$0.40) in the spot market and invest it for
one year in the US$ market.
On 31 December, GE receives $9.57 million ($8.7x1.10) from its local
investment and at the same GE receives DM25 million from Lufthansa which it
uses to pay back the loan (21.74x1.15=DM25).
d) Risk Shifting
GE can avoid the transaction exposure by pricing the turbine blades in dollars.
Dollar invoicing however does not eliminate the currency risk, but merely shifts
the risk from the buyer to the seller.
For this reason, it is common in international business to invoice exports in
strong currencies and imports in weak currencies.
42

Forms of managing Transaction


Exposure
e) Exposure Netting
It involves offsetting exposures in one currency with exposures in the same or
other currencies.
In practice, there are three exposure netting strategies:
offset a long position in a currency with a short position in the same currency.
offset a long position in one currency with a short position in another
currency if the two currencies are positively correlated.
offset a long (short) position in one currency with another long (short)
position in another currency if the two currencies are negatively correlated.

43

Forms of managing Transaction


Exposure
f) Currency Risk Sharing

It is a trade transaction with a price clause whereby base price is adjusted for
certain foreign rate changes beyond the neutral zone.

The neutral zone is the currency range within which risk is not shared,
supposedly incurred by one party.

Suppose we specify our neutral zone as $0.39-$0.41: DM1, with the base rate
of spot rate $0.40. Therefore, for any future rate within the neutral zone, GE
receives DM25 million at the base rate of $0.40 or $10 million. Thus
Lufthansas cost in this case varies from DM24.39 million to DM25.64 million
(10,000,000/0.41 to 10,000,000/0.39).

Should the DM depreciates from $0.40, to say $0.35, the actual rate would
have moved $0.04 from the lower limit of the neutral zone, and this change is
shared equally. Thus the applied rate in settling the transaction is $0.38
($0.40-$0.04/2) and GE receives $9.5 million (DM25, 000,000x$0.38) but
Lufthansas cost rises to DM27.14 ($9,500,000x$0.35).

In the absence of risk sharing agreement, GE would have received only $8.75
million (DM25, 000,000x$0.35).
44

Forms of managing Transaction


The diagram below compares theExposure
currency risk sharing contract to a forward
hedge contract. 12
Transacti
on Value
($million
s)

No Risk
Sharing

11

Neutra
l
Zone

10

Risk Sharing
Contract

9.5
7
9

Forward
Contract

7
0.3
4

0.36

0.3
8

0.4

0.42

0.44

0.46

Exchange rate of DM1


to $

At any point below the lower boundary of neutral zone, say at rate of $0.35, GEs
loss is reduced from $8.75 million dollars to $9.5 million due to risk sharing.
Also, beyond the upper boundary, say at $0.45 exchange rate, GEs transaction
gain is also reduced from $11.25 million to $10.5 million as the full potential
45
gain is shared

Measuring Economic Exposure

The extent to which a firms present value of future cash flows (firm value)
can be influenced by exchange rate movements.

NB, all transactions that cause transaction exposure also cause economic
exposure.

Transactions that influence the Impact


of
local
currency Impact
of
local
currency
firms local currency inflows
appreciation on transactions
depreciation on transactions
Local sales

Decrease

Increase

Firms exports denominated in local


currency
Firms exports denominated in foreign
currency
Interest
received
from
foreign
investments
Transactions that influence the
firms local currency outflows
Firms imported supplies denominated
in local currency
Firms imported supplies denominated
in foreign currency
Interest owed on foreign loans

Decrease

Increase

Decrease

Increase

Decrease

Increase

No change

No change

Decrease

Increase

Decrease

Increase

46

Measuring Economic Exposure


Economic Exposure of MNCs

Economic exposure of the MNC results in two ways, which ultimately affect
firm value:

1. Directly due to transaction losses as the exchange rate moves.


2. Indirectly due to loss of sales depending on the reaction to the exchange rate
by international competitors.
Measuring Economic Exposure

MNCs must assess the level of economic exposure that exist and try to
minimise it.

It involves assessing overall impact of fluctuations of currencies on all


subsidiaries.

Sensitivity of earnings to exchange rate is one method commonly used to


measure economic exposure based on a forecast of exchange rate.
47

Measuring Economic Exposure


Example

Madison, a US based MNC has businesses in the US and Canada both sales
denominated in local currencies, i.e. US$ and C$ respectively. The business
income statements are as follows.
Revenue and Cost of Madison (Millions of US$ and C$)
Item

US Business

Canadian Business

Sales

$304.00

C$4.00

50.00

C$200.00

$254.00

-C$196.00

fixed

30.00

Variable (10% of US Sales)

30.30

Total

60.30

$193.70

-C$196.00

3.00

10.00

$190.70

-C$206.00

Cost of goods sold


Gross profit
Operating Expenses

Earnings before interest and tax (EBIT)

Interest expenses
Earnings before tax (EBT)

48

Measuring Economic Exposure


Madison wants to assess it economic exposure over three possible exchange
rate scenarios; $0.75, $0.80 and $0.85 for the C$ in which US sales become
300, 304 and 307 in response to imports substitution effect.
Exchange rate scenario

Sales
US
Canadian

C$=$0.75

C$=$0.80

C$=$0.85

$300.00
3.0

$304.00
$3.20

$307.00
$3.40

Total
Cost of goods sold

$303.00

$307.20

$310.40

US
Canadian

$50.00
$150.00

$50.00
$160.00

$50.00
$170.00

$200.00
$103.00

$210.00
$97.20

$220.00
$90.40

US Fixed

$30.00

$30.00

$30.00

US variable (10% of total sales)

$30.30

$30.72

$31.04

Total
EBIT
Interest Expenses

$60.30
$42.70

$60.72
$36.48

$61.04
$29.36

$3.00
$7.50

$3.00
$8.00

$3.00
$8.50

$10.50
$32.20

$11.00
$25.48

$11.50
$17.86

C$4=

C$200=

Total
Gross profit
Operating expenses

US
Canadian
Total
EBT

C$10=

49

Measuring Economic Exposure


Therefore, based on this sensitivity analysis of cash flow income items
to exchange rate, the value of the firm may vary from the lowest of
$17.86 million to the highest of $32.20 million.
The economic exposure gives us a range of $14.34 million (32.2017.86), which is quite a big exposure, worthy managing.
While in this case all scenarios give a positive EBT, the worst case is a
situation where some exchange rate scenarios actually give a
negative EBT.

50

Managing Economic Exposure

MNC may restructure their operations to reduce economic exposure.

This may involve shifting the sources of revenues or costs to other locations
in order to match cash inflows with outflows in foreign currencies.

In the above case, Madison has more cash outflows than cash inflows in
Canada and therefore can balance by increasing Canadian sales and reducing
Canadian Costs.

This may involve:


1. Suppose Madison increases sales in Canada to C$20 million.
2. To increase sales in Canada, US parent incurs $2 million more to establish
distribution channels in Canada.
3. Again increase in sales will require an additional $10 million on materials
from US suppliers.
4. It wants to reduce reliance on Canadian suppliers by C$100 million
compensated by increase in US suppliers by $80 million.
5. Further it plans to borrow additional funds in the US and retire some loans in
Canada, which increases interest expenses to US banks by $4 million and
reduce that of Canadian banks by C$5 million.
51
51

Managing Economic Exposure

Sales
US
Canadian
Total
Cost of goods sold

Exchange Rate Scenario


C$=$0.75
C$=$0.80
Old Structure New Structure
Old
New
Structure
Structure

C$=$0.85
Old
New
Structure
Structure

$300
C$4 = 3
$303

300
C$20=15
$315

$304
$3.2
$307.2

$304
C$20=16
$320

$307
$3.40
$310.40

$307
C$20=17
$324

$50

$140
C$100=$75

$50
$160

$140
C$100=80

$50
$170

$140
C$100=85

$200
$103

$215
$100

$210
$97.2

$220
$100

$220
$90.40

$225
$99.00

US Fixed
variable (10% sales)

$30
$30.3

$32
31.50

$30
$30.72

$32
32

$30
$31.04

$32
32.40

Total
EBIT
Interest Expenses

$60.30
$42.70

63.50
36.50

$60.72
$36.48

64.00
36.00

$61.04
$29.36

64.40
34.60

$3
C$10=$7.5

7
C$5=$3.75

$3
$8

C$5=$4

$3
$8.5

C$5=$4.25

$10.5
$32.20

10.75
$25.75

$11
$25.48

11
$25.00

$11.5
$17.86

11.25
$23.35

US
Canadian
Total
Gross profit

C$200=$150

Operating expenses

US
Canadian
Total
EBT

52

Measuring Economic Exposure


With the restructuring, the economic exposure on the value of the MNC is
reduced from a wide range of $14.34 million dollars to a narrow variation of only
$2.4 million (25.75 million-23.35 million)
This risk exposure can be illustrated diagrammatically as shown below.
Economic exposure based on original and proposed operating exposure

Earning
s before
Taxes
(in
Millions)

$3
0
$2
5

Proposed Operating
Structure

$2
0

Original Operating
Structure

$1
5
C$=$0.7
5

C$=$0.8
0

C$=$0.8
5

Exchange Rate
Scenario
53

Managing Economic Exposure


Issues that matter in Restructuring Decisions
To reduce economic exposure; must carefully analyse the impact of the following on firms
value:
1.Impact on firms value if the firm attempt to increases or reduces sales in new or existing
foreign markets.
2.Evaluate firms value if firm increases or reduces its dependency on foreign suppliers.
3.Impact on value when a firm establishes or eliminates production facilities in foreign
markets.
4.Impact when firm increases or reduces its level of debt denominated in foreign currencies
for local and foreign affiliates.
Each of these elements affects the firms income statement items. The first one affects
foreign cash inflows and the rest relate to foreign cash outflows.
Economic exposure is highly reduced when sources of revenues and costs are closely
matched in each subsidiary

54

How to restructure operations to balance the impact of currency movements


on cash inflows and outflows
Type of Operations

Recommended Action when a Recommended Action when a


foreign currency has a greater foreign currency has a greater
impact on cash inflows
impact on cash outflows

Sales in foreign currency units

Reduce foreign sales

Increase foreign sales

Reliance on foreign supplies

Increase foreign supply orders

Reduce foreign supply orders

Proportion of debt structure Restructure debt to increase Restructure debt to reduce debt
representing foreign debts
debt payments in foreign payments in foreign currency
currency

55

END

56

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