Hedging as a Strategic Option at the Firm Level - Coursework Example

International Finance What is meant by exposure to exchange rate risk, and identifies how such exposure(s) can be measured? Which type of exposure is likely to be most important in the long run? Executive summary Bonds and stocks can both be exposed to changes in real exchange rates and the subsequent risk factor has a dichotomous outcome for the two investment vehicles. Bonds have an assured constant return over its life time till the time of maturity. Thus they experience only a limited impact by way of interest rate changes. On the other hand stocks are exposed to risks associated with changes in exchange rates in two ways, i.e. they are influenced by interest rates and cash flow at the same time. Thus this paper has adequately accounted for the aftermath of outcomes related to changes in real exchange rates with special focus on the long term and short term analyses separately. It has conclusively proved that all three exchange rate exposures have a degree of strategic solution through the inherent dynamics of interest rate and cash flow changes across a broader time period. Introduction In the process of considering exchange rate risk exposure there are three basic categories of exposure that need analysis here. They are economic exposure, translation exposure and transaction exposure. (a). Economic exposure This is the most important of the three. For example when a certain unexpected or unanticipated change in real exchange rates takes place that will change the value of the company or its stock (Graham, 2001, p.115). There is a clear cut strategy by the management to define the distinction between an anticipated change and an unanticipated change in exchange rates. In the first place, an anticipated change in exchange rates is taken into consideration well in advance by the management and expressed through the valuation process of the company based on demand for and supply of its shares (Shim and Contas, 2001, p.87). On the other hand an unanticipated negative change in exchange rates involves a greater risk if it proves to be too big. (b). Translation exposure Translation exposure refers to those changes that take place due to changes in accounting income and assets and liabilities in the company balance sheet that are brought about by changes in exchange rates (Homaifar, 2003, 219). In other words it’s the risk of loss resulting from negative foreign exchange movements such as those associated with the Sterling Pound. These changes are reflected in assets and liabilities of company balance sheets in foreign countries and also those previous transactions in foreign currencies. In the US the rules and regulations under the Financial Accounting Standards Board (FASB), require companies with foreign subsidiaries which have vertical or horizontal links with the parent company in the US, to maintain a functional currency for such conversion of values between two currencies. The functional currency serves the purpose of converting values and establishing value parameters for each currency. It specifically affects a company’s balance sheet (Shamah, 2003. P.37). (c). Transaction exposure When a company is involved in a transaction with a foreign company or individual there can either be a gain or a loss arising from such a transaction. Since such a transaction exposes a deal between two parties – the company and a customer/creditor/supplier – the resulting outcome can either be a gain or a loss to the company. Businesses have a way of reducing the impact of transaction exposure related risk in part or whole by using hedging techniques though (Clark, Tamirisa, Wei, Sadiko and Zend, 2004, p.3). 1. Analysis Exchange rate volatility is a common denominator of a country’s exposure to international risk through international trade. The higher the degree of exposure the higher the degree of risk associated with such exposure. For instance companies that are located in developing countries that depend on commodity exports to a greater extent are more likely to face a greater degree of risk due to the fact that commodity prices in international markets are subject to huge fluctuations (Desai, 2006, p.3). As a result their currencies against those of advanced industrialized economies are weaker. Even the well developed countries are faced with this reality but their ability to manipulate exchange rates in international markets is considerably higher when compared to those developing countries. All these developments are expressed through the company balance sheet, cash flow, profit and loss account and the accounting statements. Risk control managers are compelled to take hasty decisions to avoid such risk and make good the outcomes related to company balance sheets (Chung and Eichengreen, 2007, p.5).Their response constitutes a complex and diverse set of alternative strategies as outlined below. 1.1. Purchasing Power Parity Strategy Purchasing Power Parity Argument is based on the fact that real exchange rates, which measure the rate at which goods and services of two countries exchange, would ideally exist in highly efficient markets where similar goods would have the same price. Translation exposure related risk comes under this strategy. The price levels in each country though tend to vary there is a common measure to be adopted to reconcile these differences. It’s the PPP. Two economies can be taken for example such as the British economy and the American economy. Thus the general price level in the UK can be expressed as P(UK) and the general price level in the US can be expressed as P(US). Britain is the home country of the business organization while the US is the foreign country with which the company has trade relations. By extension PPP is the quantity of a given basket of basic commodities such as food, clothing, energy, transport and so on that a consumer can purchase by using the currency of that particular country. Thus £P ($/£) = $P. This identity establishes the relationship ($/£ = $P/£P) which refers to a hypothetical exchange rate that is equal to the PPP rate of exchange. According to this argument if the exchange rate between the US $ and the British Pound is greater from the view point of British companies, then it’s possible that the Sterling is overvalued against the US $. The opposite holds if the exchange rate is lower. Assuming that the common basket of goods in the US costs $300 and in the UK £200, then PPP is equal to $3.00/£. Further assuming the actual spot exchange rate to be $3.75/£, then it’s clear that the Sterling is overvalued by 25%. The above example is based on a simple argument. If the argument that the real spot rate assumption is misleading and therefore cannot be accepted holds true, of course the whole PPP-based foreign exchange exposure risk reduction theory becomes irrelevant. Whatever the outcome of such calculations, PPP is not altogether a very reliable measure of exchange rates and a yardstick to reduce disparities so that risk involved in foreign exchange exposure can be minimized (Mark, 2001, p.144). In the first instance PPP is basically determined by a basket of commonly purchased goods whose quality might vary from one country to the other. Under such circumstances any sustained effort to equalize the two baskets of goods in value terms and PPP is highly misleading. When a currency is overvalued or undervalued, as the current situation between the US and China trade relations illustrate, then PPP has no real meaning. The US government accuses China of undervaluing it currency substantially in order to benefit from lower exchange rates. At present roughly 7 to 8 Chinese Yuan exchange for one US dollar. The US Trade Department has consistently argued that it should be somewhere around 2 to 3 Yuan per Dollar. Next, there is the argument of inflation. In two countries at a given time the rates of inflation might not be the same. This has a direct bearing on the real interest rate and the exchange rate. When inflationary tendencies in an economy persist, importers abroad hesitate to buy that country’s goods. As a result there is little demand for that country’s currency in overseas markets. This would bring down the exchange rate to a realistic level but nevertheless it’s the price elasticity of demand for the country’s goods that matters much more than absolute prices (Levi, 2005, p.5). 1.2. The Investors’ Hedging Strategy It’s a common belief that shareholders of Multinational Companies (MNCs) have the capacity and knowledge to hedge their investment against exchange rate fluctuations. However to what extent such hedging is possible depends on the extent to which they have access to corporate exposure of the company to foreign exchange markets (Dawson and Rodney, 1994, Vol.5 (4), pp.56-67). While foreign exchange markets might behave in unpredictable ways there is much less information available to individual investors about corporate exposure to risk. Therefore it’s less likely that individual investors would be in a position to carry out effective hedging against such risk. Investors themselves have no special knowledge about the different outcomes related to equally different modes of investment such as buying shares, bonds or other securities. Thus the only commonly available comparative measure is the prevailing interest rate (Gandolfo, 2002, p.43). Assuming that the interest rate is higher and therefore borrowing costs are higher, the tendency on the part of shareholders to sell their shares would be greater. However higher interest rates are not a guarantee against a higher level of exposure to risk. The risk-averse investor would not hesitate to juggle his investment portfolio in a manner to achieve the least amount of exposure to risk by way of exchange rate exposure (Sarno and Taylor, 2003, p.4). A business organization would adopt hedging by taking a particular market position so that its value would rise in order to cancel out a value loss in a previously taken position. For example it might be in the form of a new cash flow, a contract or an asset. MNCs adopt such hedging on the principle that the current value of the firm is the Net Present Value (NPV) of the all expected future cash flows. However the degree of uncertainty associated with such future cash flows is disregarded. In other words future cash flows of the firm would be subject to fluctuations in value, i.e. exchange rate fluctuations. Hedging is a classical tool used by MNCs to overcome this problem but its real impact is determined by a series of market-based outcomes that the company has little or no control over. The following figure illustrates how hedging and expected cash flows are related (Copeland, 2008, p.290). The figure was little changed by this writer to represent real highs of cash flows and the hedged area represents the degree of relative safety available to the firm from exposure to risk. Figure 1: Hedging and expected cash flows Source: www.som.yale.edu While the unhedged position is likely to lead to a situation of bankruptcy, there are some not so significant advantages to be derived from this strategy. For instance if future cash flows were improved as a result of hedging the management would have less trouble in corporate governance (Isard, 2008, p.19). Most of the rest are generalizations associated with probable outcomes. Financial markets often move in and out of disequilibria and therefore it is possible the management would have less trouble in times of wider negative fluctuations. Managers are better equipped than shareholders to focus on the hedging activity (Dunn Jr. and Mutti, 2003, p.7). However risk control managers are more interested in managing risk through hedging as a measure of saving their own skin. In other words there is very little benefit to shareholders because the latter do not have an idea about what hedging is except that they themselves adopt such as interest rate related measures. 1.3. Currency Diversification Strategy Currency diversification strategy is put forward by some risk control mangers as a more effective strategy in reducing risk associated with foreign exchange exposure. Thus the argument holds that any MNC with a well diversified portfolio of currencies is less likely to be affected by negative exchange rate movements (Yadav, 2008, p.48). This is because of the fact that there is an offsetting effect. There are some correlations to be worked out. In the first place when currency diversification is adopted there is a positive correlation where total exposure to risk is equal to the nearest sum of two exposures. Then there is a negative correlation. Risk and the degree of exposure would not be added. There are both advantages and disadvantages associated with currency diversification. In the first place a portfolio of well diversified currencies would reduce risk by offsetting the impact of negative foreign exchange movements (McKinnon, 1979, p.203). Secondly it would allow the manager to identify and isolate constantly weaker currencies. On the other hand disadvantages include the risk of total collapse if many currencies are denominated in one dominant currency such as the US Dollar. Many countries hold their reserves in US denominated assets. When the US Dollar depreciates constantly, assets of these countries also depreciate in value. Thus even if a firm diversifies its currency holdings, when those affected countries respond in a hurry by selling dollar-denominated assets, not only the dollar that would be affected but even those currencies for which there is a greater demand because an expensive currency means less demand for that country’s exports abroad. As a result there can be a reverse effect in the long run. If the scramble continues many currencies can be affected (Helliar, Dhanani, Fifield and Stevenson, 2005, p.15). 1.4. Shareholder Diversification Strategy Finally a well diversified portfolio of investments by shareholders would bring them considerable immunity against the risk of foreign exchange exposure but nevertheless the argument runs counter to the predictable behavior of the average investor (Doherty, 2000, 155). If a particular shareholder has a more diversified portfolio of shareholdings in different companies that trade in different currencies, this in itself would insulate the total portfolio against collapse in value in case one or two currencies happen to experience wild fluctuations. In the same manner an MNC would be insulated if it happens to trade in many currencies. Conclusion Economic, transaction and translation exposures have all been investigated along with their respective solutions to minimize risk associated with foreign exchange exposure (Neal, 1993, p.191). The identification of relevant strategies has been done in conformity with the outcomes of those solutions or strategies. For example PPP strategy is directly connected with Translation Exposure and firms selling their final products in foreign countries might as well adopt it to overcome risk associated with depreciating purchasing power of foreign currencies they earn. However it’s less feasible in other two areas, viz. Transaction Exposure and Economic Exposure. For instance Chinese producers can benefit from an undervalued currency while the US importers lose as a result of an overvalued dollar (Driver, Sinclair and Thoenissen, 2004, p.270). These two positions cannot be reconciled unless PPP of both the currencies is established through a realistic process of valuation. The Chinese government has failed to do so or has willy-nilly tolerated it for unfair trade gains. The investors’ hedging strategy is perhaps the best and is associated with both Economic and Transaction Exposures. Both MNCs and individual investors can benefit from this because even if the related benefits do not amount to substantial gains losses could be minimized. After all hedging undertaken by a firm is not intended to increase value of its assets. It’s just an off-setting exercise (Clark, 2002, p.29). However for an individual investor it’s a strategic option either to remain indifferent to international currency movements and their impact on his investment or act quickly. Currency diversification strategy and shareholder diversification strategy along with MNCs’ response to risk do not have any practical importance except that they have some theoretical underpinnings (Mussa, Masson, Swoboda, Jadresic, Mauro and Berg, 2000, p.3). Recommendations The firm should choose a more strategically efficient variant of the Hedging Strategy in order to achieve long term organizational goals such as proper corporate governance, positive returns and share price growth. There must be a clearer enunciation of the strategic option and their execution plans thus incorporating into them all the essential elements of follow-up action. PPP is less likely to benefit the organization either in the long term or the short term. Therefore less resources must be devoted to its design and planning process if any (Shapiro, 2006, p.48). Finally hedging as a strategic option at the firm level would be more feasible even if it does not bring in returns by way of enhancing the company’s asset value. This is perhaps not only a guarantee against foreign exchange exposure risk in international markets but also a highly desirable survival tactic in a competitive environment. REFERENCES 1. Chung, D. and Eichengreen, B.J. 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