Measuring and Managing Foreign Exchange Risk - Dissertation Example

ACADEMIA RESEARCH Order 158986 7080 INTERNATIONAL FINANCIAL MANAGEMENT Measuring and Managing Foreign Exchange Risk. The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2003). Foreign Exchange exposure can be divided into two main types-Accounting exposure and Economic exposure. Transaction reflects the firm's risk to exchange rate movements regarding its balance sheet assets and liabilities... The terms of these transactions are established and settled at a given time period and their exposure can easily be measured by accounting systems (Mullem & Verschoor, 2005). The implicit or explicit contractual agreements have to be taken into account as well as when measuring the overall exchange rate exposure. (Mullem & Verschoor, 2005). The last component of a company's exposure to currency fluctuations is called competitive or economic exposure. As exchange rate variations affect the relative prices of goods sold in different countries, they affect a firm's competitive position and indirectly influence its economic environment and future growth possibilities (Mullem & Verschoor, 2005). Although a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. Economic exposure arises because future profits from operating as importer or exporter depend on exchange rates, and due to its nature, this type of exposure is difficult to mute. (Faff & Iorio 2001, Mullem & Verschoor). (Mullem & Verschoor, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and hence hedging it efficiently (Mullem & Verschoor, 2005). Firms that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt & Lee, 2001). Transaction exposure reflects the risk that exchange rates change between the time a transaction is recorded and the time actual receipt of cash or payment of cash is made. (Solt & Lee, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Lee, 2001). Economic exposure on the other hand is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Lee, 2001). The table below summarises the different types of exchange rate risk faced by firms: Comparison of translation, transaction and operating Exposure Translation exposure Operating exposure Fluctuations in income statements items and book values of balance sheet assets and liabilities that are caused by exchange rate fluctuations. Subsequent exchange rate gains and losses are determined by accounting rules and reflect nominal gains and losses only. The measurement of accounting exposure is retrospective that is it is applied to prior period accounts. Its only impact is on liability and assets that already exist. Movements in the amount of future operating cash flows occurring as a result of fluctuations in exchange rates. Subsequent exchange translation gains and losses are determined by changes in the firm's future competitive position and are real. The measurement of operating exposure is prospective That is it is based on future periods unlike the retrospective measurement applied to translation exposure. The impacts of operating exposure are more serious than those of translation exposure as it affects revenues and costs associated with future sales. Taken from Shapiro (2003). N.B: Transaction exposure is common to both translation and operating exposure. That is why I have not mentioned it in the table. Measuring Foreign Exchange Exposure Shapiro identifies four methods of measuring currency translation gains and losses or translation exposure. They include: the current/concurrent method, the monetary/nonmonetary method the temporal method and the current rate method. The current/non-current Method The current method translates all the foreign subsidiary's assets and liabilities in the home country currency at the current exchange rate. Non-current assets and liabilities are translated at their historical exchange rates, that is, the rates prevailing at the period the assets were purchased or the period the liabilities were incurred. The translation in the income statement is done by applying the average exchange rate of the period except for those revenue and expense items associated with non current assets and liabilities. (Shapiro, 2003) Depreciation expenses are translated at the at the historical exchange rate of the corresponding asset in the balance sheet, thereby making it possible for different income statement items with same expiration dates to be translated at varying exchange rates (Shapiro, 2003). The Non-Monetary/Monetary Method Under this method, monetary assets and liabilities are separated from non-monetary assets and liabilities. Monetary assets include assets such as cash and accounts receivable whereas monetary liabilities include accounts payable and long-term debt. (Shapiro, 2003). Non-monetary items include trading stock, long-term investments and fixed assets such as land property, plant and equipment (PPE). After separating the assets and liabilities into monetary and non-monetary assets, the current rate is then applied to translate the monetary assets whereas the non-monetary assets are translated by applying the historical rates. The translation of income statement items is done by applying the average exchange rate except for revenue and expense items related to monetary assets and liabilities. The monetary items are translated using the current rate as earlier stated above. (Shapiro, 2003). The Temporal Method Under this method, the same procedures applied for the translation of the balance sheet and income statement items using the monetary/non-monetary method apply. However, the only difference is that inventory which is normally translated at the historical cost can be translated at the current rate if the inventory is shown on the balance sheet at the market values. (Shapiro, 2003). Current Rate Method The current rate method translates all income statement and balance sheet items using the current rate and if the firm's foreign-currency-denominated assets exceed its foreign-currency-denominated liabilities, then depreciation in the home currency value will result in a loss while an appreciation in the home currency value will result in a gain. Managing transaction and Economic Exposure. Transaction exposure can be managed through well-structured hedging strategies. Hedging refers to the process of establishing an offsetting currency position so as to lock in a home currency value for the currency exposure thus, eliminating risk associated with movements in the currency. Locking in a home currency value means that the strategy is established in such a way that the value of the foreign currency in terms of the home currency to be received or paid at a future date is known with certainty. For example, if we assume that a US citizen is expecting to receive 10million pounds in 3months. The current exchange rate is 2 US dollars per pound. Therefore the current home currency (US Dollar) value of the future receivable will be 20million dollars. However, because the US citizen is unaware of what the exchange rate will be in three months, he is facing foreign exchange risk. If the pound goes below 2 US dollars per pound, he/she will make a foreign exchange loss equal to 10million times the amount of decrease. If the pound goes above 2US dollars per pound he will make a gain. Let's assume that there is a forward contract on the exchange rate with a forward price of 1.9US dollars per pound. This US citizen can decide to sell his pound receivables forward at the price of 1.9US dollars per pound. By so doing he is locking in a minimum value of 19million US dollars (Home currency value) to be received in 3 months. Anything that happens to the exchange rate in three months will not affect his future receivable. Economic Exposure is difficult to manage. However, it can be managed by using Marketing management, pricing strategy and production management. (Shapiro, 2003). 2 Arcelor Mittal. a) Forecasted Income Statements for Arcelor Mittal Under Different Scenarios Scenario 1 Forecasted Income Statement for Arcelor Mittal (NZ$=US$0.48) US$ NZ$ US$ NZ$ Domestic Sales 600,000,000.00 US Revenue 100,000,000.00 208,333,333.33 Total Revenue (NZ$) 808,333,333.33 Cost of sales (NZ Materials) 100,000,000.00 Cost of sales (US Materials) 200,000,000.00 416,666,666.67 Total Cost of Sales 516,666,666.67 Variable operating expenses 161,666,666.67 Fixed operating expenses 30,000,000.00 62,500,000.00 Interest Expense 20,000,000.00 41,666,666.67 Income before tax 25,833,333.33 Scenario 2 Forecasted Income Statement for Arcelor Mittal (NZ$=US$0.50) US$ NZ$ US$ NZ$ Domestic Sales 600,000,000.00 US Revenue 105,000,000.00 210,000,000.00 Total Revenue (NZ$) 810,000,000.00 Cost of sales (N Z Materials) 100,000,000.00 Cost of sales (US Materials) 200,000,000.00 400,000,000.00* Total cost of sales 500,000,000.00 Variable operating expenses 162,000,000.00 Fixed operating expenses 30,000,000.00 60,000,000.00 Interest Expense 20,000,000.00 40,000,000.00 Income before tax 48,000,000.00 Scenario 3 Forecasted Income Statement for Arcelor Mittal (NZ$=US$0.54) US$ NZ$ US$ NZ$ Domestic Sales 600,000,000.00 US Revenue 110,000,000.00 203,703,703.70 Total Revenue (NZ$) 803,703,703.70 Cost of sales (N Z Materials) 100,000,000.00 Cost of sales (US Materials) 200,000,000.00 370,370,370.37 Total cost of sales 470,370,370.37 Variable operating expenses 160,740,740.74 Fixed operating expenses 30,000,000.00 55,555,555.56 Interest Expense 20,000,000.00 37,037,037.04 Income before tax 80,000,000.00 b) As the exchange rates change from 0,48 to 0,50 to 0,54 US dollars per New Zealand dollar, income before tax also increases. As can be seen above the incomes before taxes are N$ N$25,833,333.33, N$48,000,000.00, and N$80,000,000.00 for scenario 1, 2 and 3 respectively. The increase in profit is accounted for by the fact that Arcelor Mittal has liabilities US-dollar-denominated expenses. For example, its anticipated cost of goods sold is anticipated at $200million, its fixed operating expenses are estimated at $30million and interest expense is estimated at $20million on existing US loans and it has no New Zealand loans. This total to a figure of $250million, which by far exceeds its dollar, receipts under the three scenarios of $100million, $105million and $110million for scenarios 1, 2 and 3 respectively. As the New Zealand dollar appreciates against the US dollar, the amount of New Zealand dollars necessary to settle the US-dollar liabilities also reduces thus leading to an increase in profit. Also considering that the revenue from US Business increases with the dollar depreciation it also offsets some of the profit that could have been lost as a result of foreign currency receipts. c) Arcelor Mittal can restructure its operations by increasing its dollar-denominated expenses such as invoicing purchases from the United States in US dollars, increasing its US-dollar denominated loans. It can also restructure by reducing its US-dollar-denominated receipts by invoicing its exports to the United States in New Zealand dollars so as to benefit from the depreciation of the US dollar. Also Arcelor Mittal can transfer some of its operations to the United States where it can benefit from cheaper labour and raw materials resulting from the depreciation of the US dollar. In a nutshell Arcelor Mittal should increase in US-dollar-denominated liabilities and reduce its US-dollar-denominated assets. According to Shapiro (2003) a firm can manage its operating exposure by using either production management, marketing management or financial management, the firm may consider its input mix, shifting production among plants, plant location, raising productivity and planning for exchange rate changes. Shapiro (2003) stipulates that the company can arrive at a more flexible solution by changing the input mix, that is, purchasing more components from abroad. The company can also achieve a solution by shifting production among plants. This can be done by increasing production in a country whose currency has devalued and reducing production in a country whose currency has appreciated. (Shapiro, 2003). Thus Arcelor Mittal can achieve a solution by increasing production in the United States of America. Under marketing Management Shapiro (2003) emphasizes pricing strategy and market selection. Arcelor Mittal can restructure her operations by increasing her purchase of inputs from the United States, which are invoiced in US dollars and arrange for its sales to the United States to be invoiced in New Zealand dollars. Also, it should increase its US-dollar denominated liabilities such as accounts payable and long-term debt. d) Currency fluctuations remain a major source of macro-economic uncertainty with significant impacts on the profitability of multinational companies. (Muller et al, 2006). Changes in exchange rate can also have an impact on the cash flows of a multinational firms and thus on the multinational firm's value (Fraser and Pantzalis, 2004). Considering the fact that multinational firms have operations in a number of countries, they are bound to interact with a series of currencies and as such are subject to foreign exchange exposure. These exposures which can either be translation or economic have different impacts on the firm. Translation exposure, however measures changes in balance sheet items that already exist and does not really have a significant impact on the firm as it affects only balance sheet items that have already been booked. Economic exposure on its part can have significant impacts on both the cash flows and profit of a multinational company. Economic exposure will affect both the competitive position of the multinational corporation as well as its profitability. Take Toyota for example, one of the global leading automakers, its functional currency is the Japanese yen and Toyota sources inputs from the United States of America, United Kingdom, Europe, Australia, and other parts of the world. It also makes sales to the United States of America, Europe and the rest of the world. Toyota's consolidated financial statements are therefore subject to exchange rate movements. In particular, it is exposed to the US dollar, the British pound, the Euro, the Australian dollar and other currencies such as the Swedish krona, the Danish krona and the Norwegian krona. (Toyota Annual Report, 2006). Given all these movements in these currencies will affect pricing of its products as well as its inputs. An appreciating yen for example, against the US dollar will have a significant impact on Toyota's operating results. (Toyota Annual Report, 2006). 3. Arcelor Mittal's Hedging Strategies a. One yen call option costs 0.015cents Therefore 125,000,000 yen will cost US$0.00015 x 125,000,000 = $US18,750 If the yen settles at the minimum price (that is, out-of-the-money), Arcelor Mittal will not exercise the option. On the other hand if the yen settles at the maximum price (in-the-money), then Arcelor Mittal will exercise the option. In that case he will earn (0.0084-0.00800) x 125,000,000 = US$50,000. Therefore his net profit from exercising the option will be given by: Net profit = US$50,000-US$18,750 = US$31,250. Assuming that Arcelor Mittal uses a futures contract to lock in a price of $0.00794/ at a total cost of 0.007940 x 125,000,000 = US$992,500 If the yen ends at its minimum value of US$0.007500, she will lose an amount equal to US$0.007500-US$0.007940 = (US$0.000440/). Therefore she will lose a total sum of 0.000440 X 125,000,000 = US$55,000 on the 125,000,000 purchase. However, assuming the yen settles at the maximum value, then Arcelor Mittal will make a profit given by: Net Profit/Yen = US$0.008400- US$0.007940 = US$0.000460/ Its total profit on 125,000,000 will be US$0.000460/ x 125,000,000 = US$57,500. The table below shows the cash outflows and inflows of the futures and options positions as well as the profit/loss positions of the futures and options positions. The graphs that follow represent Arcelor Mittal's profit/loss on both the options and futures positions. Table showing the profit/loss for Acerlor Mittal's Option and Futures Position Yen price 0.007500 0.007940 0.008150 0.008400 Option inflow 1,018,750 1,050,000 Option premium -18,750 -18,750 -18,750 -18,750 Exercise cost 1000,000 1,000,000 Profit from option -18,750 -18,750 0 31,250 Futures inflow 937,500 992,500 1,000,000 1,050,000 Futures outflow -992,500 -992,500 -992,500 -992,500 Profit -55,000 0 7,500 57,500 If the yen settles at its most likely value of US$0.007900, Acerlor Mittal will not exercise her call option and will lose the call premium of US$18,750. On the other hand if Acerlor Mittal establishes a hedge position using futures, she will have to buy yen at a price of US$0.007940 when the spot price is US$0.0079. Therefore, Acerlor Mittal will lose (0.007900-0.007940) x 125,000,000 = US$5,000. b. The break-even future spot price on the option contract is given by exercise price plus the call premium, which is as follows: Exercise price = US$0.0080 Option premium = US$0.00015 The break-even point for the futures contract is 0.007940 since it is the point at which Arcelor neither makes a loss nor a gain. Therefore break-even future price = US$0.0080 + US$0.00015 = US$0.00815 c. The profit/loss position and break-even prices of the sellers on the futures and options contracts will be the mirror images of Arcelor Mittal's position. The futures sellers will break-even at a price of 0.007940 while the options sellers will break-even at a price of $0.008150., similarly if the yen settles at its minimum value, the options sellers will earn a profit of $18,750 while the futures sellers will earn a profit of $55,000. However, if the yen settles at its maximum value, the options sellers will lose $31,250 while the futures sellers will lose $57,500. See diagrams below. 4. a. According to interest rate parity theorem, the currency of the country with the lower interest rate should be at a forward premium in terms of the currency with the higher interest rate. (Shapiro, 2003). For example consider the UK pound and the UK dollar if we call E0 the current exchange rate between two countries implying E0 dollars are needed to buy 1pound. F0, is the forward price, that is the number of dollars agreed upon today to buy one pound at time T in the future. Lets call the risk-free rate in the US and in the United Kingdom . Then interest rate parity theorem states that the proper relationship between F0 and E0 is given as: (Bodie et al, 2002) Therefore if =$1.13 = $1.10 If IRP holds then the dollar should sell and a forward premium while the euro should sell at a distance. Substituting in equation 1 and considering a one-year period we get: $1.10 = = $1.10 Therefore IRP holds. b. According to purchasing power parity (PPP), price levels should be equal worldwide, that is, a unit of home currency (HC) should have the same purchasing power parity around the world. (Shapiro, 2003). If and are the inflation rates in the home and foreign currency respectively; is the dollar value of the euro at the beginning of the period; and is the spot exchange rate in period t, then (Shapiro, 2003). If (2) holds true then Therefore for , c. The International Fisher Effect states that currencies with low interest rates are expected to appreciate relative to currencies with high interest rates. (Shapiro, 2003). Mathematically: Substituting for the interest rates and we get -3.39 = = -$2.26. d. The difference can be reconciled by the fact that IFE is not an accurate predictor of the forward rate over short periods of time. IFE is likely to fail in this case considering that we are predicting just for one year ahead. Prediction error for shorter periods is usually very high and thus IFE does not hold true for shorter periods, whereas prediction error for longer periods cancels out as we predict over time. (Shapiro, 2003). 5 East Asian Crises a) Investors regarded the high interest rates as a compensation for the high risk associated in these countries. They were therefore risk-averse. A risk-averse investor is an investor who will consider risky investments only when these investments provide compensation for risk through a risk premium. (Bodie et al, 2002). According to the capital asset pricing model, investors expect a compensation for the time value of money and a risk premium for bearing risk. (Bodie et al, 2002). Therefore, investors will take on high risk provided they are compensated for bearing such risk. Under such circumstances, the international fisher effect is sometimes violated as investors regard the provision of a risk premium as enough for them to take the risk. Thus, the investors in the Southeast Asian case simply became risk-averse and were willing to take the risk despite the fact that the level of interest rates reflected the level of inflation. The reason for failure of the International Fisher Effect to hold may also be as a result of the fact that there were time varying exchange risk premiums. (Shapiro, 2003). Time varying exchange risk premiums are exchange risk premiums that compensate for risk resulting from changes in exchange rates as time changes. b) According to the International Fisher Effect, the rising interest rates reflected expectations of inflation and as such depreciating currencies for the Southeast Asian countries. It is obvious therefore that no investor would have been willing to hold bonds, stocks or other securities denominated in a currency that is expected to depreciate in value in the future if he/she was aware of this fact. Therefore despite the high interest rates no investors would have invested in Southeast Asian countries provided he/she was aware that the interest rates reflected levels of inflation and thus future devaluation or depreciation of their currencies. a. The determinants of the exchange rate in theory include the following: Relative inflation rates Relative interest rates Relative economic growth rates Political risk and Economic Risk Relative inflation Rates Inflation occurs when the supply of money is more than the demand for money. During this period, relative prices of goods and services also increase. (Shapiro, 2003). To illustrate suppose that the supply of dollars is in excess relative to its demand in the United States, implying that US prices will start rising relative to prices of say European goods and services. European consumers are likely to buy fewer US products and thus will start shifting to European substitutes. This will lead to a decrease in the amount of euros supplied at every exchange rate between the euro and the dollar. The result will be a leftward shift in the euro supply curve from S to S as shown in the figure below. Also US consumers will begin substituting European imports with US products, this will lead to an increase in the demand for euros as shown by D'. to sum up both Europeans and Americans are searching for the best deals worldwide and will switch their purchases to reflect this. (Shapiro, 2003). Therefore when inflation is high in the United States that in Europe, the resulting effect will be an increase in European exports to the United States and a decrease in US exports to Europe. This will lead to a depreciation of the US dollar relative to the euro. (Shapiro, 2003). Equally if inflation is higher in Europe than in the United States, the demand for US goods in Europe will increase and the demand for European goods in the US will decrease thus leading to depreciation in the euro relative to the dollar. (Shapiro, 2003). In general a country that runs a relatively high rate of inflation will witness a declining home currency value relative to currencies of countries with relatively lower levels of inflation. Relative Interest Rates. The equilibrium exchange rate between two countries' currencies is also affected by differences in interests. If US interest rates rise relative to European interest rates, investors in both nations will begin shifting their portfolios from euro-denominated assets to dollar-denominated ones to take advantage of the rising interest rates, thus leading to a decrease in the value of the euro as opposed to the dollar. (Shapiro, 2003). It should be noted that the interest rates here are real interest rates, that is, the nominal interest rate minus the inflation rate. If the difference in interest rates reflects nominal interest rates then the net result would be a weaker dollar. (Shapiro, 2003). Relative Economic Growth A country with a higher economic growth has the potential to attract foreign direct investment and therefore increase demand for its currency as opposed to a country experiencing economic stagnation as measured by growth in per capita GDP (Shapiro, 2003). Countries facing economic stagnation will suffer from capital flights and this will result to depreciation in their currency. Political And Economic Risk Political and economic risk can also influence the equilibrium exchange rates between currencies of different countries. Investors will be attracted to low-risk currencies than to high-risk currencies. Thus currencies that are associated with high risk are likely to witness depreciations, as investors will not be willing to hold assets denominated in such currencies whereas currencies with lower risk will witness an appreciation, as investors will be willing to shift their portfolios into assets denominated in such currencies. In practice exchange rates are determined by government action. For example if the government of a particular country restricts investors in that country to purchase only securities (bonds) issued in the country, then interest rate parity will not hold. Thus the exchange rate in practice is dependent on the regime put in place by the government, is it a free floating exchange rate regime or is it a fixed exchange rate regime Exchange rates under a fixed exchange rate regime are highly dependent on the actions of the government while market forces determine exchange rates in a free-floating regime. (Economic Report of the President) REFERENCES Bodie Z., Kane A., Markus A. J. (1999). Investments. Fifth International Edition. McGraw-Hill Irwin. Fraser S . P., Pantzalis C. (2004). Foreign exchange rate exposure of US multinational corporations: a firm-specific approach Journal of Multinational Financial Management Vol. 14, pp 261-281. Mullem A., Willem F.C., Verschoor (2005). Asymmetric foreign exchange risk exposure: Evidence from U.S. multinational firms. Journal of Empirical Finance. Vol. 13, pp 495-518. Economic Report of the President. Currency Markets and Exchange Rates downloaded from: http://www.whitehouse.gov/cea/ch7-erp07.pdf Faff R., Iorio A. (2001). A test of stability of exchange rate risk. Evidence from the Australian equities market. Global Finance Journal. Vol 12, Pp 179-203. Shapiro A.C.(2003). Multinational Financial Management. Seventh Edition Wiley and Sons Inc. Solt M. E., Lee W. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 Toyota Annual Report. (2006). Risk Factors. Taken from the following Link: http://www.toyota.co.jp/en/ir/library/annual/pdf/2006/p44_45.pdf Read More