financial institution and markets

UNIT :3 & 4 PROF. PARVEEN SULTANA

EXPOSURE

Foreign exchange exposure refers to the sensitivity of a firms cash flows to changes in exchange ratesforeign exchange exposure is the risk associated with activities that involve a global firm in currencies other than its home currency.firms must assess and Manage their foreign exchange exposures.

What are the specific risks to a global firm from foreign exchange exposure?

Cash inflows and outflows, as measured in home currency equivalents, associated with foreign operations can be adversely affected.• Revenues (profits) and Costs

Settlement value of foreign currency denominated contracts, in home currency equivalents, can be adversely affected.• For Example: Loans in foreign currencies.

The global competitive position of the firm can be affected by adverse changes in exchange rates.• Influence on required return.

End Result: The value (market price) of the firm can be adversely affected.

TYPES OF FOREIGN EXCHANGE EXPOSURE

There are three distinct types of foreign exchange exposures that global firms may face as a result of their international activities.These foreign exchange exposures are:

Transaction exposure• Any MNC engaged in current transactions involving foreign

currencies.Economic exposure (operating exposure)• Results for future and unknown transactions in foreign currencies

resulting from a MNC long term involvement in a particular market.

Translation exposure (sometimes called “accounting” exposure).• Important for MNCs with a physical presence in a foreign country.

Translation Exposure

• Results from the need of a global firm to consolidated its financial statements to include results from foreign operations.– Consolidation involves “translating” subsidiary financial

statements from local currencies (in the foreign markets where the firm is located) to the home currency of the firm (i.e., the parent).

– Consolidation can result in either translation gains or translation losses.

Translation exposure – the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates.

Headquarters’Consolidated

Financials

Subsidiary Financials Subsidiary Financials

Subsidiary Financials

JAPAN YEN

GERMANY €

USA $

₤

TRANSLATION RISK

Why do we Care about Translation?

managers, analysts and investors need some idea about the importance of the foreign business a translated accounting data give an approximate idea of this.performance measurement for bonus plans, hiring, firing, and promotion decisions. accounting value serves as a benchmark to evaluate valuation. for income tax purposes.legal requirement to consolidate financial statements.

MANAGING TRANSLATION EXPOSUREChoices faced by the MNC: 1. Adjusting fund flows

altering either the amounts or the currencies of the planned cash flows of the parent or its subsidiaries to reduce the firm’s local currency accounting exposure.

2. Forward contractsreducing a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency.

Exposure netting

a. Offsetting exposures in one currency with exposures in the same or another currency

b. Gains and losses on the two currency positions will offset each other.

Methods of Translation exposure

Current/Noncurrent MethodMonetary/Nonmonetary MethodTemporal MethodCurrent Rate Method

Accounting exposure = exposed assets – exposed liabilities (excluding the capital/networth)

The Mechanics of FAS52: (FINANCIAL ACCOUNTING STANDARDS BOARD STATEMENT)

FUNCTION CURRENCYThe currency that the business is conducted in.

REPORTING CURRENCYThe currency in which the MNC prepares its consolidated financial statements.

Exchange rates in various methods

1.Current/non current exchange rate methods

2.Monetary/non monetary exchange rate methods

3.temporal exchange rate methods 4.Current rate exchange rate methods

Current/Noncurrent Method

The underlying principal is that assets and liabilities should be translated based on their maturity.

current assets translated at the spot rate.noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.

generally accepted in the US from the 1930s -1975, at which time FAS8 became effective.Short-term gains/losses will be recognized long term will not be.

Balance Sheet Local Currency

Current/ Noncurrent

Cash € 2,100 $1,050 Inventory € 1,500 $750 Net fixed assets € 3,000 $1,000

Total Assets € 6,600 $2,800 Current liabilities € 1,200 $600 Long-Term debt € 1,800 $600 Common stock € 2,700 $900 Retained earnings € 900 $700CTA -------- --------Total Liabilities and

Equity€ 6,600 $2,800

Current/Noncurrent Method

Current assets /liabilities translated at the spot rate.i.e. €2=$1

Noncurrent assets /liabilities translated at the historical rate in effect when the item was first recorded on the books. i.e. €3=$

Monetary/Nonmonetary Method

The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes.All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts (owners’ equity, land) are translated at the historical exchange rate in effect when the account was first recorded.


Monetary/ Nonmonetary

Cash € 2,100 $1,050 Inventory € 1,500 $500 Net fixed assets € 3,000 $1,000


Equity€ 6,600 $2,400

All monetary balance sheet accounts are translated at the current exchange rate. i.e. €2=$1All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. i.e.€3=$1

Monetary/Nonmonetary Method

Temporal Method

Same as monetary and non monetary methodFAS no.8Monetary assets into current exchange ratesNon monetary assets into historical ratesInventory at market value is on current ERMost income statements are translated at average ERDepreciation and cogs are non monetary at historical rates.


Temporal

Cash € 2,100 $1,050 Inventory € 1,500 $900Net fixed assets € 3,000 $1,000


Equity€ 6,600 $2,400

Items carried on the books at their current value are translated at the spot exchange rate. i.e. €2=$1Items that are carried on the books at historical costs are translated at the historical exchange rates. i.e. €3=$1

Temporal Method

Current Rate Method

All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate.Very simple method in application.A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance.


Current Rate

Cash €2,100.00 $1,050 Inventory €1,500.00 $750 Net fixed assets €3,000.00 $1,500

Total Assets €6,600.00 $3,300 Current liabilities €1,200.00 $600 Long-Term debt €1,800.00 $900 Common stock €2,700.00 $900 Retained earnings €900.00 $360 CTA -------- $540

Total Liabilities and Equity

€6,600.00 $3,300

All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. i.e. €2=$1A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance

Current Rate Method

How Various Translation Methods Deal with a Change from €3 to €2 = $1


Current/ Noncurrent

Monetary/ Nonmonetary

Temporal Current Rate

Cash €2,100 $1,050 $1,050 $1,050 $1,050 Inventory €1,500 $750 $500 $900 $750 Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500

Total Assets €6,600 $2,800 $2,550 $2,950 $3,300 Current liabilities €1,200 $600 $600 $600 $600 Long-Term debt €1,800 $600 $900 $900 $900 Common stock €2,700 $900 $900 $900 $900 Retained earnings €900 $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and Equity

€6,600 $2,800 $2,550 $2,950 $3,300

Spot rate

Book value of inventory at spot

exchange rate

Current value of

inventory at spot

exchange rate

Historical data

Spot rate

Income statement

Under the current rate method, a “plug” equity account named cumulative translation adjustment makes the balance sheet balance.

Translation

A US company establishes a subsidiary in the year 2006 in Europe. The below balance sheet is translated at the prevailing exchange rate of $1.00/Euro If the dollar were to depreciate 25%, prepare the balance sheet under the 4 translation methods.

Translation

AV Ltd is an Indian subsidiary of a US manufacturer. AV's balance sheet in 1000's of Rupees is as follows as on March 31: Calculate accounting gain or loss by the current rate and monetary/non-monetary methods. Explain the accounting translation via changes in the value of exposed accounts.

Transaction Exposure

Transaction Exposure: Results from a firm taking on “fixed” cash flow foreign currency denominated contractual agreements.

Examples of transaction exposure:• An Account Receivable denominate in a foreign currency.• A maturing financial asset (e.g., a bond) denominated in a

foreign currency.• An Account Payable denominate in a foreign currency.• A maturing financial liability (e.g., a loan) denominated in a

foreign currency.

Transaction Exposure

Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations.When transaction exposure exists, the firm faces three major tasks: Identify its degree of transaction exposure, Decide whether to hedge its exposure, and Choose among the available hedging techniques if it

decides on hedging.

MANAGING TRANSACTION EXPOSURE

I. METHODS OF HEDGING

Forward market hedgeMoney market hedgeRisk shiftingPricing decisionExposure nettingCross-hedgingForeign currency options

A.FORWARD MARKET HEDGE1. consists of offsettinga. a receivable or payable in a foreign currency

b. using a forward contract:

- to sell or buy that currency

- at a set delivery date

- which coincides with receipt of the foreign currency.

B.MONEY MARKET HEDGE 1.Definition: simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow C.RISK SHIFTING

1. home currency invoicing2. zero sum game3. common in global business

4. firm will invoice exports in strong currency, import in weak currency.

5. Drawback: it is not possible with informed customers or suppliers.

PRICING DECISIONS

1. General rules: on credit sales convert foreign price to home price using forward rate, but not spot rate.2. If the home price is high (low) enough the exporter (importer) should follow through with the sale (sign the contract).

E. EXPOSURE NETTING1. Protection can be gained by selecting currencies that minimize exposure.2. Netting: MNC chooses currencies that are not perfectly positively correlated.3. Exposure in one currency can be offset by the exposure in another currency.

CURRENCY RISK SHARING

1. Developing a customized hedge contract

2. The contract typically takes the form of a Price Adjustment Clause, whereby a base price is adjusted to reflect certain exchange rate changes.

G. CROSS-HEDGING

1. Often forward contracts not available in a certain currency.

2. Solution: a cross-hedge - a forward contract in a related currency.

3. Correlation between 2 currencies is critical to success of this hedge.

H. FOREIGN CURRENCY OPTIONS When transaction is uncertain, currency options are a good hedging tool in situations in which the quantity of foreign exchange to be received or paid out is uncertain.

A call option : is valuable when a firm has offered to buy a foreign asset at a fixed foreign currency price but is uncertain whether its bid will be accepted.

A put option: allows the company to insure its profit margin against adverse movements in the foreign currency while guaranteeing fixed prices to foreign customer.

TECHNIQUES TO ELIMINATE TRANSACTION EXPOSURE

Hedging Payables Hedging Receivables

Futures Purchase currency Sell currencyhedge futures contract(s). futures contract(s).

Forward Negotiate forward Negotiate forwardhedge contract to buy contract to sell

foreign currency. foreign currency.

Money Borrow local Borrow foreignmarket currency. Convert currency. Converthedge to and then invest to and then invest in foreign currency. in local currency.

Currency Purchase currency Purchase currencyoption call option(s). put option(s).

ECONOMIC EXPOSURE

Economic Exposure: Results from the “physical” entry (and on-going presence) of a global firm into a foreign market.This is a long term foreign exchange exposure resulting from a previous FDI location decision.Over time, the firm will acquire foreign currency denominated assets and liabilities in the foreign country.

The firm will also have operating income and operating costs in the foreign country.

Economic exposure impacts the firm through contracts and transactions which have yet to occur, but will, in the future, because of the firm’s location.These are really “future” transaction exposures which are unknown today.

Economic exposure can have profound impacts on a global firm’s competitive position and on the market value of that firm.

ECONOMIC EXPOSURE

Economic Exposure

= Transaction Exposure +Operating Exposure

Operating Exposure arises because exchange rate changes alter the value of future revenues and costs.

OPERATING EXPOSUREDEFINITION:

Operating exposure measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

OE analysis assesses the longer term impact of changing exchange rates on a firm’s operating and on its competitive position.

The goal of the OE analysis is to identify strategic moves and policies to deal with effectively unexpected exchange rate changes.

OPERATING EXPOSURE

Analyze change in PV of firm resulting from changes in future operating cash flows & competitive position caused by any unexpected change in exchange rates.

Operating cash flows arise from inter-company and intra-company receivables & payables, rent & lease payments, royalty & licensing fees.

Financing cash flows are payments for use of inter- and intra- company loans & stockholder equity.

Financial Cash Flows

Dividend paid to parentParent invested equity capitalInterest on intrafirm lendingIntrafirm principal payments

Operational Cash Flows

Payment for goods & servicesRent and lease paymentsRoyalties and license fees

Management fees & distributed overhead

Parent Subsidiary

Operating & Financing Cash Flows

ATTRIBUTES OF OPERATING EXPOSURE Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

From a broader perspective, operating exposure is not just the sensitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also to its sensitivity to other key macroeconomic variables.

This factor has been labeled macroeconomic uncertainty.

ATTRIBUTES OF OPERATING EXPOSURE The cash flows of the MNE can be divided into operating cash flows and financing cash flows.

Operating cash flows arise from receivables and payables, rent and lease payments, royalty and license fees and assorted management fees.

Financing cash flows are payments for loans (principal and interest), equity injections and dividends.

Operating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure.

Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon.

Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production.

An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value.

From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firm’s market value.

Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

MEASURING THE IMPACT OF OE An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels: Short run

Medium run: Equilibrium case

Medium run: Disequilibrium case

Long run

STRATEGIC MANAGEMENT OF OE The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than merely hoping for the best.

To meet this objective, management can diversify the firm’s operating and financing base.

Management can also change the firm’s operating and financing policies.

A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs.

STRATEGIC MANAGEMENT OF OE if a firm’s operations are diversified internationally, management is prepositioned both to recognize disequilibrium when it occurs and to react competitively.

Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies.

Diversification also reduces the variability of the firm’s cash flows.

Domestic firms may be subject to the full impact of foreign exchange operating exposure (even without any cash flows) and do not have the option to react in the same manner as an MNE.

STRATEGIC MANAGEMENT OF OE If a firm’s financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect.

However, to switch financing sources a firm must already be well-known in the international investment community.

Again, this would not be an option for a domestic firm (if it has limited its financing to one capital market).

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures.

The six most commonly employed proactive policies are:Matching currency cash flowsRisk-sharing agreementsBack-to-back or parallel loansCurrency swapsLeads and lagsReinvoicing center

MATCHING CURRENCY CASH FLOWS. One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching).

A second alternative: the US firm seeks out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms.

A third alternative: the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.

RISK-SHARING:

An alternate method for managing a long-term cash flow exposure between firms is risk sharing.

This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them.

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements.

BACK-TO-BACK LOANS:

A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time.

At an agreed terminal date they return the borrowed currencies.

Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays.

CURRENCY SWAP

A currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet.

In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time.

LEADS AND LAGS

Retiming the transfer of fundsFirms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies.

Intra-company leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group.

Inter-company leads and lags requires the time preference of one independent firm to be imposed on another.

RE-INVOICING CENTERS

There are three basic benefits arising from the creation of a reinvoicing center: Managing foreign exchange exposure Guaranteeing the exchange rate for future orders Managing intra-subsidiary cash flows Disadvantage: cost of setting up, and running the center.

ECONOMIC EXPOSURE:

1. A forward looking concept: it focuses on future cash flows.

2. Involves real cash flows, not just accounting figures.

3. Relates to changes in the economic value (or, in an efficient market, the market value) of the firm.

4. Contractual exposure depends on the firm’s portfolio of FC engagements undertaken in the past. Operating exposure depends on the environment (especially the market structure and the input-output mix) and on the firm's strategic response (e.g., relocation of production, changes in the marketing mix or financial structure, etc.).

5. Also exists for firms without foreign subsidiaries, such as exporting firms, import-competing firms, and notably potential import-competing firms.

ACCOUNTING EXPOSURE:

1. A backward-looking concept: it reflects past decisions as reflected in the subsidiary's assets and liabilities.

2. A change in an accounting value due to translation is not a "realized" gain or loss; no change in the cash situation is involved —except possibly through taxation effects.

3. Changes the firm's accounting value, but not necessarily its market value.

4. Depends on the accounting rules chosen. This is because the subsidiary's own internal rules affect its accounting values (e.g., type of depreciation, or inventory valuation methods) and also because the translation process itself can be done in different ways (see below).

5. Accounting exposure only exists in the case of foreign direct investment, since pure exporting or import-substituting firms have no foreign subsidiaries.

THE END

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financial institution and markets