Measuring and managing the risk in international financial positions

 The Corporate Treasurer’s Financial Risk Management Problem  The Market Value of the Firm and Channels of Risk  Accounting Measures of Foreign Exchange Exposure  Exposure of the Bal

Measuring and Managing the Risk in International Financial Positions

Prices and Policies

 The Corporate Treasurer’s Financial Risk

Management Problem

 The Market Value of the Firm and Channels of Risk

 Accounting Measures of Foreign Exchange

Exposure

 Exposure of the Balance Sheet: Translation Exposure

 Exposure of the Income Statement: Transaction

Exposure

 U.S Accounting Conventions: Reporting Accounting Gains and Losses

 Economic Measures of Foreign Exchange

Exposure

 The Regression Approach

 The Scenario Approach

 Empirical Evidence on Firm Profits, Share

Prices, and Exchange Rates

 Arguments for Hedging Risks at the Corporate

Level

 Financial Strategies Toward Risk Management

 The Currency Profile and Suitable Financial Hedging Instruments

 Policy Issues - International Financial Managers

 Problems in Estimating Economic Exposure

 Picking an Appropriate Hedge Ratio

 The International Investor’s Currency Risk

Management Problem

 The Value at Risk Approach

 Policy Issues - Public Policymakers

 Disclosure of Financial Exposure

 Financial Derivatives and Corporate Hedging

Policies

The Corporate Treasurer’s

Financial Risk Management Problem

 Corporate treasurers are directly responsible for managing the firm’s exposure to financial risk

 The risks that remain are held by the investor,

who can reduce these risks through a

diversified portfolio of shares, or by applying

some of the same hedging techniques available

to the corporate treasurer

The Market Value of the Firm

 The market value of a firm at time t (MV t) is the

summation of the firm’s cash flows (CF) over

time discounted back to their present value by

an appropriate discount factor (i):

i

CF MV

 Cash flows in each currency are discounted at

their own appropriate interest rate and

multiplied by a spot exchange rate

The Market Value of the Firm

 The sensitivity of the market value of the firm

to a change in an exchange rate measures

exchange rate exposure

 For the $/€ exchange rate, the sensitivity

measure can be expressed as:

Channels of Exposure to

Foreign Exchange Risk

Direct Economic

Exposure Home Currency Strengthens Home Currency Weakens

Sales Abroad Unfavorable Favorable

Revenue worth less

terms

Inputs more expensive Profits Abroad Unfavorable Favorable

Profits worth less Profits worth more

Channels of Exposure to

Foreign Exchange Risk

Indirect Economic

Exposure Home Currency Strengthens Home Currency Weakens

Competitor that Unfavorable Favorable

sources abroad Competitor’s

margins improve margins decrease Competitor’s

sources abroad Supplier’s margins

improve Supplier’s margins decrease Customer that Unfavorable Favorable

sells abroad Customer’s margins

decrease margins improve Customer’s

sources abroad Customer’s margins

improve Customer’s margins decrease

The Market Value of the Firm and

Channels of Risk

 Note that virtually any firm could be exposed to

exchange rate risk through a financial channel.

 In the long run however,

 The firm can make changes in response to an

unexpected exchange rate change.

 Other economic events that follow the exchange rate

change may lessen the impact on the firm.

 Nevertheless, the short-run exposure is critical

since the firm must survive the shock to get to the long run.

Accounting Measures of

Foreign Exchange Exposure

 Net = exposed – exposed

exposure assets liabilities

 Accounting exposure can be subdivided into

translation and transaction exposures.

 Translation exposure focuses on the book value of

assets and liabilities as measured in the firm’s

balance sheet.

 Transaction exposure focuses on the economic

value of transactions denominated in foreign

currency that are planned or forecast to occur in

the next reporting period.

U.S Accounting Conventions

Reporting Accounting Gains and Losses

 Under Statement 52 of the Financial

Accounting Standards Board (FASB-52),

translation gains and losses are accumulated in

a translation adjustment account

 FASB-52 focuses on a parent’s net investment

in a foreign operation to measure the effect of

exchange rate changes

 Transaction gains and losses represent realized

exchanges and are reported in current income

U.S Accounting Conventions

Reporting Accounting Gains and Losses

 Under FASB-133, derivatives that do not

qualify as hedges of the underlying exposures

must be marked-to-market, with the resulting

gains or losses included in either current or

deferred income

Economic Measures of

Foreign Exchange Exposure

 Economic exposure captures the entire range of effects on the future cash flows of the firm,

including the effects of exchange rate changes

on customers, suppliers, and competitors

 MV/S reflects economic exposure Two

approaches for measuring economic exposure

are the regression approach and the scenario

approach

The Regression Approach

 The regression approach directly measures the

exposure of a firm to exchange rate changes by

estimating the relationship between the firm’s

market value at time t (MV t)and the spot rate

(S t) using the equation:

MV t = a + b S t + e t

 The coefficient b measures the sensitivity of the

market value of the firm to the exchange rate

The Regression Approach

 To interpret the regression analysis, three results

The R2 of the regression.

• R2 measures the percentage of variation in the market value explained by the exchange rate.

The Regression Approach

 To measure the firm’s exposure to multiple

exchange rates, a multiple regression can be

estimated:

MV t = a + b1 S $/€,t + b2 S $/£,t + b3 S $/¥,t + e t

 If the firm has data on cash flows at the level of

a subsidiary or project, the exposure of these

smaller units can also be measured:

CF t = a + b S t + e t

The Regression Approach

 Note that exposure tends to be lower in the long run due to PPP (which tends to hold better in

the longer run) and the ability of firms to make

adjustments in response to exchange rate

changes

The Scenario Approach

 Given a scenario, we can estimate the firm’s

cash flows (and its market value) conditional on

an exchange rate path

 The scenario approach is well suited to a

spreadsheet analysis where one is encouraged

to ask a variety of “what-if” questions

The Scenario Approach

Consider the impact of a permanent 5% appreciation of the US$,

holding all other factors constant.

The slope measures the exposure of the firm at the initial exchange rate.

The Scenario Approach

Suppose the firm can pass along part of the exchange rate change

to its Australian customers.

B*

B

The slope of BOB* is flatter than AOA* since the firm has less exposure now.

Empirical Evidence on

Firm Profits, Share Prices, & Exchange Rates

 During the Bretton Woods pegged-rate period,

the general stock market index tended to move

up (down) immediately after a devaluation

(revaluation) of the local currency

 Studies also indicated that exposure coefficients vary from firm to firm within the same industry and over time, and that exchange rate changes

can have a substantial impact on the overall

economy

Arguments for

Hedging Risks at the Corporate Level

 Shareholders may not favor hedging since they

can select well-diversified portfolios to rid

themselves of firm-specific risks

Arguments for

Hedging Risks at the Corporate Level

 However, in view of transaction costs and taxes, hedging that reduces the volatility of cash flows

may be favored

 If the tax credits of a firm which has incurred losses

over several successive periods cannot be carried forward to reduce future tax payments, then another firm with a less volatile pattern of earnings will

enjoy greater after-tax cash flows and a higher market value.

 A firm with more volatile cash flows is also more

open to the costs of financial distress.

Arguments for

Hedging Risks at the Corporate Level

 For the same reasons, banks and bondholders

will prefer firms with less volatile cash flows

(holding average cash flows equal) and reward

them with greater borrowing capacities and

higher credit ratings

Financial Strategies

Toward Risk Management

 An important step in the process of determining the appropriate financial hedging instruments

for a firm is to analyze the nature of the firm’s

currency cash flows

Single contract (futures/options) Sets (“strips”) of contracts/swaps

or present value hedge

Currency

dimension Single currency

Multiple currencies

Contracts on one currency Contracts on an index (ECU, US$) or synthetic hedge

Uncertain, estimated cash flows

Nạve hedge to match contract size of financial instrument and exposure

Option hedge or dynamic futures hedge to match probability of

cash flows

Financial Strategies

Toward Risk Management

 Note that a hedging strategy may offset certain

risks, while leaving open or increasing other

risks

Policy Issues

International Financial Managers

Problems in Estimating Economic Exposure

 Using market data presumes that financial markets

are efficient, and that share prices respond quickly and appropriately to exchange rate changes.

 The approach is unsuitable for newly organized or

reorganized firms for which there is not a large sample of consistent observations.

 For the exposure coefficient to be useful, the

relationship between exchange rate changes and market value must remain stable in the future.

Policy Issues

International Financial Managers

Picking an Appropriate Hedge Ratio

 If the exchange rate is expected to change

favorably, hedging may not be desirable.

 Complete hedging may be achieved by taking

offsetting positions (-b i).

 Otherwise, an intermediate solution may be chosen,

with hedge positions in between 0 and b i.

 Note that the more direct approach is to restructure

the firm’s long-term financing, so as to permanently alter the firm’s financial exposure.

Policy Issues

International Financial Managers

The International Investor’s Currency Risk

Management Problem

 A portfolio’s exposure to foreign exchange risk can

be measured using the regression approach in much the same way as the treasurer measures the firm’s exposure.

 The investor can hedge foreign exchange risk using forward contracts, or retain the risk using a risk-

return decision criteria.

Policy Issues

International Financial Managers

The Value at Risk (VAR) Approach

 The VAR approach is a relatively new approach for

measuring the exposure of financial assets.

 It can be applied to any portfolio of assets (and

liabilities) whose market values are available on a periodic basis and whose price volatilities () can be estimated.

 Assuming normal price distributions, calculate the

loss in value of the portfolio if an unlikely (say, 5%

chance) adverse price movement occurs The result of this calculation is the value at risk.

Policy Issues - Public Policymakers

Disclosure of Financial Exposure

 The possibility that individual firms may face

substantial exposure to exchange rate changes, as well as the increased trading in financial derivatives

in recent years, create a genuine concern among investors and regulators regarding corporate

exposure to financial risks.

 Note that a firm without a financial position may

still face substantial currency and interest rate risk due to its ongoing operations.

Policy Issues - Public Policymakers

Financial Derivatives and Corporate Hedging

Policies

 The findings of various studies were consistent with the notion that firms used derivatives to lower the variability of their cash flows or earnings.

 It was also found that the likelihood of using

derivatives was positively related to foreign pretax income, foreign sales, and foreign-denominated debt.