Transaction Exposure
Lecture 8

 

Types of Exposure

 

  • Exposure - firms are subjected to foreign currency risk

  • Changes in exchange rates impact

    • Profits

    • Net Cash Flow

    • Market Value

  • Four forms:

    1. Transaction exposure - changes in value of outstanding financial obligations

      • Impacts Cash Flow

      • Current contractual obligations such as accounts receivable and accounts payable

      • Example - Swiss Cruises, a Swiss firm, sells cruise packages to U.S. customers priced in U.S. dollars

      • Supplies are also priced in U.S. dollars

    2. Economic exposure - a firm's expected cash flows are affected by unexpected changes in exchange rates

      • Exchange rate changes future sales volume, prices, and costs

      • Also called Operating Exposure, Competitive Exposure, or Strategic Exposure

      • Example - Swiss Cruises has majority of its costs denominated in francs

      • 50% of revenues are in U.S. dollars

      • The francs are appreciating while the U.S. dollar is depreciating

      • Competitive market prevents Swiss Cruises to increase its U.S. price.

      • If Swiss Cruises raises the price, it may lose consumers

      • Cash flows will worsen over time, because revenue is in U.S. dollars and costs are in francs

    3. Translation exposure - exchange rates change a firm's consolidated financial statements

      • Also called accounting exposure

      • Example - Swiss Cruises has inventories of U.S. dollars

      • Has U.S. dollar loan of equal amount

      • Balance sheet items are translated into francs

      • Due to Swiss accounting rules, different exchange rates are used to translate U.S. dollar inventories and the U.S. dollar loan

      • Accountants could generate accounting gain/loss as they use different exchange rates

    4. Tax Exposure - changes in cash flow can change taxable income

      • Losses from transaction exposure can reduce taxable income

      • Losses from operating exposure reduce taxable income over future years

      • Translation exposures are not cash flow related and do not reduce taxable income

      • Note - companies can also gain profits from favorable changes in exchange rates

 

Measuring and Protecting Against Transaction Exposure

 

  • Measuring Transaction Exposure

    • Transaction Exposure is easy to identify and measure

    • Firms can forecast short-term exchange rates with high accuracy

Example 1 Swiss Cruises

  • Swiss Cruises sold cruise packages to a U.S. wholesaler for $2.5 million

  • Swiss Cruises bought fuel oil for $1.5 million

  • Both cash flows will occur in 30 days

    • St = 1.45 CHF / $1

The calculation is:

Profit = ( $2.5 million - $1.500,000) x 1.45 CHF/ $1= CHF 1,450,000

Swiss Cruises estimates the sensitivity of its profits to changes in the St, which is a ±10% change (ef,t = ± 0.10)

Consequently, profits fluctuate by ±145,000 CHF

Example 2

  • Trident, a U.S. company, sold equipment to a British company for 3 million pounds due in 90 days

  • Accounts receivable

    1. Spot exchange rate is $1.762 / 1 pound

    2. 90-day forward rate is $1.785 / 1 pound

    3. 90-day loan rate in pounds is 14% APR

    4. 90-day put option for pounds

      • Strike price = $1.75 / 1 pound

      • Premium = 1.5%

Strategy 1: Trident uses the spot exchange rate. This strategy has an exchange rate risk.

amount ($) = 3 million pounds ($1.762 / 1 pound) = $5.286 million

Strategy 2: Trident uses a forward contract, which has no exchange rate risk. Trident would use a forward as opposed to a futures because a forward is tailor made for the amount and has no margin call.

amount ($) = 3 million pounds ($1.785 / 1 pound) = $5.355 million

Strategy 3: Trident borrows from a British bank, and this strategy has no exchange rate risk.

Trident would borrow = 3 million pounds / (1 + 0.14 (90 / 360)) = 2.899 million pounds

Then Trident immediately transfers the funds to the United States.

loan ($) = 2.899 million pounds ($1.762 / 1 pound) = $5.107 million

Then Trident repays the loan when the British company pays its accounts receivable

Strategy 4: Buy a put options for pounds (no exchange rate risk)

premium = (0.015)(3 million pounds)($1.75 / 1 pound) = $78,750

Exercise put option if future spot falls below the strike price of $1.75 / pound

amount ($) = 3 million pounds ($1.75 / 1 pound) = $5.25 million

Example 3

  • Caterpiller (US) bought a South Korean company for 6,030 million wons due in 6 months

  • Accounts payable

    1. Spot exchange rate is won 1,200 / $1

    2. 180-day forward rate is 1,260 wons / $1

    3. 180-day Korean interest rate is 16% APR

    4. 180-day call option for wons

      • Strike price = $1 / 1,200 wons

      • Premium = 3%

Strategy 1: Calculate spot exchange rate (has exchange rate risk)

amount ($) = 6,030 million wons ($1 / 1,200 wons) = $5.025 million

Strategy 2: Forward contract (no exchange rate risk)

amount ($) = 6,030 million wons ($1 / 1,260 wons) = $4.786 million

Strategy 3: Invest money in Korea and earn interest (Has no exchange rate risk; could have country risk)

Investment (won) = 6,030 million wons / (1 + 0.16 (180 / 360)) = 5,583.3 million wons

Then immediately transfer funds to South Korea

Investment ($) = 5,583.3 million wons ($1 / 1,200 wons) = $4.65 million

Earn interest and then pay accounts payable

Strategy 4: Buy a call options for wons (no exchange rate risk)

premium = (0.03)(6,030 million wons)($1 / 1,200 wons) = $150,750

Exercise call option if future spot rises above the strike price of $1 / 1,200 wons

amount ($) = 6,030 million wons ($1 / 1,200 wons) = $5.025 million

Example 4

  • Seattle Scientific sold 12.5 million yen in scientific equipment to a Japanese firm that is due in 30 days

  • Accounts receivable

    1. The spot exchange rate is 111.4 yen / $1

    2. Japanese firm will pay today in cash if given 4.5% discount

    3. 30-day forward rate is 111.0 yen / $1

    4. 90-day forward rate is 110.4 yen / $1

Strategy 1: Seattle Scientific uses the spot exchange rate. This strategy has exchange rate risk.

amount ($) = 12.5 million yen ($1 / 111.4 yen) = $112,208.26

Strategy 2: Seattle Scientific grants the discount. It has no exchange rate risk because it transfers the funds to the U.S. today.

amount ($) = 12.5 million yen (0.955)($1 / 111.4 yen) = $107,158.89

Strategy 3: Seattle Scientific enters a 30-Forward contract. This strategy has no exchange rate risk.

amount ($) = 12.5 million yen ($1 / 111.0 yen) = $112,612.61

Strategy 4: Seattle Scientific buys a 90-Forward contract. This strategy has no exchange rate risk.

amount ($) = 12.5 million yen ($1 / 110.4 yen) = $113,224.64

This 90 days is odd. This would imply the company keeps the money in Japan for an extra 60 days. Thus, it would deposit funds in a Japanese bank to earn interest for 60 days.

Example 5

  • Farah Jeans constructed a new factory in Guatemala and 8.4 million quetzals are due in six months

  • Accounts payable

    1. Spot exchange rate is 7.0 quetzals / $1

      • Forecast

      • Devaluation 8.0 quetzals / $1

      • Strengthen 6.4 quetzals / $1

    2. 180-day forward rate is 7.1 quetzals / $1

    3. 180-day Guatemala interest rate 14% APR

    4. 180-day U.S. interest rate is 6% APR

Strategy 1: Farah Jeans will use the forecasted spot rate, which has exchange rate risk. The forecast may be wrong.

amount ($) = 8.4 million quetzals ($1 / 8 quetzals) = $1,050,000

amount ($) = 8.4 million quetzals ($1 / 6.4 quetzals) = $1,312,500

Strategy 2: Farah Jeans protects its account payable with a 180-day forward contract. This strategy has no exchange rate risk.

amount ($) = 8.4 million quetzals ($1 / 7.1 quetzals) = $1,183,098.59

Strategy 3: Farah Jeans invests money in Guatemala and earn interest. Although it has no exchange rate risk, this could have a country risk. We work backwards to determine how much funds to transfer today in Guatemala.

Investment (Q) = 8.4 million quetzals / (1 + 0.14 (180 / 360)) = 7,850,467.29 quetzals

Then immediately transfer funds to Guatemala

Investment ($) = 7,850,467.29 quetzals ($1 / 7.0 quetzals) = $1,121,495.33

Earn interest and then pay accounts payable

Strategy 4: Farah Jeans invests money in the United States and then use a forward to transfer money. This strategy has no exchange rate risk.

From Strategy 2

amount ($) = 8.4 million quetzals ($1 / 7.1 quetzals) = $1,183,098.59

Then invest money in U.S.

Investment ($) = 1,183,098.59 / (1 + 0.06 (180 / 360)) = $1,148,639.41

Earn interest and then pay accounts payable

  • Some firms may have a natural hedge

  • Hedge 1: A firm has both an accounts payable and accounts receivable in the same country

    • If the maturity and amount is roughly equal, then a firm uses the accounts payable to payoff the accounts payable

  • Hedge 2: A U.S. firm requires payment in U.S. dollars while firms in the Eurozone require payments in euros

    • Exchange rate risk is forced upon the other party

    • A firm could require payment in Special Drawing Rights

    • The IMF sets the value of the SDRs in a currency basket of British pounds, euros, U.S. dollars, and Japanese yen

Measuring and Protecting Against Economic Exposure

1. Economic exposure can be difficult to estimate

  • Economists must know how future exchange rate changes
  • If an exchange rate has a trend, then analysts can measure the economic exposure accurately
  • Example - PEMEX, Mexico's National Petroleum Company could have an unfavorable economic exposure
  • Operating costs are denominated in Mexico pesos
  • Receives U.S. dollars for selling petroleum
  • If U.S. dollar depreciates against the peso, then revenues fall while costs rise over time, squeezing profits

2. Analysts estimate a regression equation

  • Foreign price asset, P
  • Spot exchange rate, S
  • Random error term, e
  • a and b are parameters
    • We call b the Forex Beta or Exposure Coefficient

Forex Beta

  • We calculate beta by
    • Covariance - measures the variation between the asset price and the spot exchange rate
    • Variance - measure the variability of the spot exchange rate

Calculating the Forex Beta

  • Case 1 - You made an investment in Europe
    • You receive euros and convert it into U.S. dollars
    • You have an equal chance of receiving the payouts: 1,000, 1,500, or 2,000 euros
    • We refer to each state as a possible outcome
    • We calculate a Forex Beta = 1,666.67
      • A positive Beta indicates economic exposure
      • Did you notice your dollar payout varies positively with the exchange rate?
      • You could buy a forward contract for 1,666.67 at the exchange rate of $1.50 per euro
      • Example works out nicely because exchange rate is evenly spaced out
      • We can show 1,666.67 is the correct hedge in the textbook
Case 1
State Probability P S S×P
1 1/3 1,000 $1.20/€ 1,200
2 1/3 1,500 $1.50/€ 2,250
3 1/3 2,000 $1.80/€ 3,600
  • Case 2 - You made an investment in Europe
    • You receive euros and convert it into U.S. dollars
    • You have an equal chance of receiving the payouts: 1,666.67, 1,333.33, or 1,111.11 euros
    • We calculate a Forex Beta = -925.93
      • A negative Beta no economic exposure
      • Did you notice you receive the same dollar payout regardless of the exchange rate?
      • As the euro appreciates, your investment value falls
      • You would not buy a forward contract in this case
Case 2
State Probability P S S×P
1 1/3 1,666.67 € $1.20/€ 2,000
2 1/3 1,333.33 € $1.50/€ 2,000
3 1/3 1,111.11 € $1.80/€ 2,000
  • Case 3 - You made an investment in Europe
    • You receive euros and convert it into U.S. dollars
    • You receive the same investment 1,500 euros regardless of state and exchange rate
    • We calculate a Forex Beta = 0
      • You can hedge your investment by buying a forward contract for 1,500 euros at a price of $1.50 per euro
Case 3
State Probability P S S×P
1 1/3 1,500 $1.20/€ 1,800
2 1/3 1,500 $1.50/€ 2,250
3 1/3 1,500 $1.80/€ 2,700

3. Difficult to do in practice. Companies use the following techniques to reduce economic exposure

  • Reduce costs by shifting production to low-cost countries.
    • Honda Motor Company produces high-quality cars, trucks, and motorcycles
    • Factories are located in Brazil, Canada, China, India, Indonesia, Japan, Pakistan, Thailand, United States, and other countries.
    • If the Japanese yen appreciates relative to the other currencies and raises Honda's production costs
    • Honda can shift production to other facilities outside of Japan
  • Outsources production or uses low-cost labor.
    • Example 1
      • Many hotels and restaurants are competitive
      • Compete in prices to attract consumers.
      • Hotels and restaurants rely on immigrants or even undocumented workers to reduce both its costs and prices
    • Example 2
      • Taiwanese company, Foxconn, is the largest electronics company in the world
      • Produces the Ipad, Iphone, Ipod, Kindle, PlayStation 3, and X-box
  • Diversify its products and services by selling to consumers around the world
    • U.S. corporations produce and market fast food, snack food, and sodas in many around the world
    • Weakening U.S. dollar reduces the companies' profits inside the United States
    • Foreign operations offset the depreciating dollar and sustain profits
  • Invests in research and development.
    • Offers innovative products that consumers want
    • Apple Inc. set the standard for high-quality smart phones and tablet computers.
    • Apple sells to U.S. consumers with a depreciating dollar
    • Has some monopoly power to raise its products' prices without reducing its sales
  • Can use derivatives and hedge against exchange rate changes.
    • Porsche manufactures cars within the European Union
    • Sells between 40 to 45% of cars to the United States
    • U.S. dollar was depreciating against the euro until 2008.
      • Depreciating U.S. dollar reduced U.S. sales while boost costs
      • Managers hedged or shorted against the U.S. dollar
      • 50% of Porsche's profits came from its hedging activities.

 

 

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