Economic Exposure Management

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1583754

Economic Exposure management

There are two types of exposure: Accounting exposure and economic exposure.

Operating exposure and transaction exposure belong to economic exposure, which may have real economic consequences.

When discussing economic exposure, one should distinguish the exchange rate changes that is justified by inflation and the part that is in excess of it. That is, the unexpected exchange rate changes which result in real economic gains and losses of the firm’s future cash flow.

∆S%=∆P D, F +e

Currency exchange rate changes that are of concern are real exchange rate appreciation or depreciation. Since nominal changes generated by price level (inflation) changes are justified relative changes, it satisfies the law of one price, thus has no economic consequences.

Operating exposure

Operating exposure is the economic exposure created when operations of a firm generates foreign currency denominated cash flows.

Ex: For a foreign subsidiary that has its whole operation and market in the same country, the only exposure is the profit repatriation.

For a subsidiary that has production in foreign country and sales in the home country, the exposure is the cost of the production.

Transaction Exposure

Transaction exposure is the economic exposure created when contractual obligations are denominated in foreign currencies.

Operating exposure example:

An US based company ETRADE sells E system to UK. ETRADE has invested 300000 US dollars in the exporting business in US dollars. In 2006, it sold 100 units of the E system to the UK company. Each unit cost 480 dollars to build, and was sold at 520 British Pounds. The exchange rate was 0,65 £/$. The dollar revenue was 800 $ per unit.

Now suppose the inflation in UK is 8% and in US is 3% over the next year, what effect will this be on the ETRADE? What will be the expected exchange rate changes due to the inflation difference?

We have learned the PPP parity conditions that predicts exchange rate changes would offset the inflation difference.

S1 /S0 =(1+Pd )/(1+Pf)

Where S is exchange rate expressed in domestic currency per unit of foreign currency. (cross check: if domestic inflation is higher, S1 should be higher, which points to domestic currency amount per unit of foreign currency)

S1= 0,65 (1+0,08)/(1+0,03)= 0,6812 $/£

Exchange rate that deviates from 0,6812 $/£ is unexpected, thus is exposed to risks. One can hedge this risk by options or forward contracts depending on your type of risk.

The firm’s operating exposure is determined by:

1.  The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

2.  The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are. (BMW exchange rate pass through case)

Managing Operating Exposure

1.  Selecting Low Cost Production Sites

2.  Flexible Sourcing Policy, both components and workers.

3.  Diversification of the Market

4.  R&D and Product Differentiation, increase competitive advantage, less currency risk

5.  Financial Hedging

Selecting Low Cost Production Sites

A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements.

e.g. Honda built North American factories in response to a strong yen, but later found itself importing more cars from Japan due to a weak yen.

Diversification of the Market

Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.

Financial Hedging

The goal is to stabilize the firm’s cash flows in the near term.

Financial Hedging is distinct from operational hedging.

Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others.

Managing Transaction Exposure

·  Forward Market Hedge

·  Money Market Hedge

·  Options Market Hedge

·  Hedging Contingent Exposure

·  Hedging Recurrent Exposure with Swap Contracts

·  Hedging Through Invoice Currency

·  Hedging via Lead and Lag

·  Exposure Netting

·  Should the Firm Hedge?

·  What Risk Management Products do Firms Use?

Recall forward contract is a derivative contract that agrees to buy or sell a specific amount of currency with a pre specified exchange rate in a predetermined time in the future.

Forward Market Hedge

ü  If you are going to pay foreign currency in the future (payables), agree to buy the foreign currency now by entering into long position in a forward contract.

ü  If you are going to receive foreign currency in the future (receivables), agree to sell the foreign currency now by entering into short position in a forward contract.

Forward Market Hedge: an Example

You are a U.S. importer of British wool and have just ordered next year’s inventory.

Payment of £100M is due in one year.

Question: How can you fix the cash outflow in dollars?

Answer: One way is to put yourself in a forward position that delivers £100M in one year—a long forward contract on the pound.

Money Market Hedge

This is the same as covered interest arbitrage (CIA)

Hedging Contingent Exposure

If only certain contingencies give rise to exposure, then options can be effective insurance.

For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options. You should buy Call on Canadian dollars to protect against strengthening of it suppose your bid is in Canadian dollars.

Hedging through Invoice Currency

The firm can shift, share, or diversify:

ü  shift exchange rate risk by invoicing foreign sales in home currency

ü  share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies

ü  diversify exchange rate risk by using a market basket index

Hedging via Lead and Lag

If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency.

If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

Exposure Netting

A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.

Many multinational firms use a reinvoice center.

Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging.

As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen

with won.

Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.

Should the Firm Hedge?

Not everyone agrees that a firm should hedge:

Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves.

Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

Reasons for hedge: In the presence of market imperfections, the firm

should hedge.

Default Costs: Hedging may reduce the firms cost of capital if it reduces the probability of default (bankruptcy). Thus hedging corresponds to higher firm value.

Information Asymmetry: The managers may have better information than the

shareholders.

Differential Transactions Costs: The firm may be able to hedge at better prices than the

shareholders.

Taxes can be a reason for hedging.

_Corporations that face progressive tax rates may find hat they pay less in taxes if they can manage earnings by hedging than if they have volatile earnings.
Other definitions of Economic exposure:

Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates.

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