FOREIGN EXCHANGE EXPOSURE PRACTICES

Foreign exchange exposure means the ris o! "oss stemming !rom exposure to a#$erse !oreign exchange rate mo$ements% A measure of the potential change in a firms profitability, net cash flow, and market value because of a change in exchange rates & These three components 'pro!its( cash !"o) an# mar et $a"ue* are the e+ !inancia" e"ements o! ho) )e $ie) the re"ati$e success or !ai"ure o! a !irm & ,hi"e !inance theories te"" us that cash !"o)s matter an# accounting #oes not( )e no) that currenc+-re"ate# gains an# "osses can ha$e #estructi$e impacts on reporte# earnings & )hich are !un#amenta" to the mar ets opinion o! that compan+

The !oreign exchange rate exposure o! a !irm is a measure o! the sensiti$it+ o! its cash !"o)s to changes in exchange rates% Since cash !"o)s are #i!!icu"t to measure( most researchers ha$e examine# exposure .+ stu#+ing ho) the !irm/s mar et $a"ue( the present $a"ue o! its expecte# cash !"o)s( respon#s to changes in exchange rates Foreign exchange exposure is #e!ine# as the #egree to )hich a compan+ is a!!ecte# .+ exchange rate changes% The magnitu#e o! the gain or "oss that resu"ts !rom a particu"ar exchange rate change is0 FX Gain '1oss* 2 3 St4n - St 5 3 Exposure 5 Exposure is expresse# in units o! the un#er"+ing host currenc+( the exchange rate is the price o! the host currenc+ in units o! home currenc+ 'i%e% 67FC*( an# hence the exchange rate gain7"oss is in home currenc+ units%

8 An important tas o! the !inancia" manager is to measure !oreign exchange exposure an# to manage it so as to maximi9e the pro!ita.i"it+( net cash !"o)( an# mar et $a"ue o! the !irm% Transaction exposure Transaction exposure is a ris to a !irm )ith no)n !uture cash !"o)s in a !oreign currenc+ that arises !rom possi."e changes in the exchange rate% Transaction exposure is the #egree to )hich cash an# transactions #enominate# in a !oreign currenc+ an# a"rea#+ entere# into !or sett"ement at a !uture #ate are a!!ecte# .+ exchange rate changes% Transaction exposure measures net cash an# no)n cash in!"o)s against no)n cash out!"o)s% It measures changes in the $a"ue o! outstan#ing !inancia" o."igations incurre# prior to a change in exchange rates .ut not #ue to .e sett"e# unti" a!ter the exchange rate changes Transaction exposure measures gains or "osses that arise !rom the sett"ement o! existing !inancia" o."igations( name"+ & Purchasing or se""ing on cre#it goo#s or ser$ices )hen prices are state# in !oreign currencies & :orro)ing or "en#ing !un#s )hen repa+ment is to .e ma#e in a !oreign currenc+ & :eing a part+ to an unper!orme# !or)ar# contract an# & Other)ise ac;uiring assets or incurring "ia.i"ities #enominate# in !oreign currencies <% Transaction Exposure0 measures changes in the $a"ue o! outstan#ing !inancia" o."igations incurre# prior to a change in exchange rates .ut not #ue to .e sett"e# unti" a!ter the exchange rate changes

Transaction exposure measures gains or "osses that arise !rom the sett"ement o! existing !inancia" o."igations )hose terms are in a !oreign currenc+% The situations inc"u#e Purchasing or se""ing on cre#it goo#s or ser$ices )hen prices are state# in !oreign currencies

 :orro)ing or "en#ing !un#s )hen repa+ment is to .e ma#e in a !oreign currenc+ :eing a part+ to an unper!orme# !or)ar# contract Ac;uiring assets or incurring "ia.i"ities #enominate# in !oreign currencies

Examp"e 'purchasing or se""ing*0 1eo Sri$asta$a is the #irector o! !inance !or Pixe" =anu!acturing( a U%S%-.ase# manu!acturer o! han#-he"# computer s+stems !or in$entor+ management% Pixe" has comp"ete# the sa"e o! a .ar-co#e s+stem to a :ritish !irm( Gran# =etropo"itan 'U>*( !or a tota" pa+ment o! ?<(@@@(@@@% The !o""o)ing exchange rates )ere a$ai"a."e to Pixe" on the !o""o)ing #ates correspon#ing to the e$ents o! this speci!ic export sa"e% Assume each month is A@ #a+s%

'a* Assume 1eo #eci#es not to he#ge the transaction exposure% ,hat is the $a"ue o! the sa"e as .oo e#B ,hat is the !oreign exchange gain '"oss* on the sa"eB The sa"e is .oo e# at the exchange rate existing on Cune <( )hen the pro#uct is shippe# to Gran# =et( an# the shipment is categori9e# as an account recei$a."e'A7R*% Da"ue as sett"e# Da"ue as .oo e# Foreign exchange "oss 2 ?<(@@@(@@@E 6<%FGH@7? 2 ?<(@@@(@@@E 6<%FIJH7? 2 '6<(FGH(@@@ - 6<(FIJ(H@@* 2 6<(FGH(@@@ 2 6<(FIJ(H@@ 2 -6AH(H@@

'.* Assume 1eo #eci#es to he#ge the transaction exposure using a !or)ar# contract )hen the pro#uct is shippe#% ,hat is the $a"ue o! the sa"e as .oo e#B ,hat is the !oreign exchange gain '"oss* on the sa"e i! he#ge# )ith a !or)ar# contractB The sa"e is .oo e# at the exchange rate existing on Cune <( )hen the pro#uct is shippe# to Gran# =et% Da"ue as !or)ar# sett"ement 2 ?<(@@@(@@@E 6<%FI@G7? Da"ue as .oo e# Foreign exchange "oss 2 ?<(@@@(@@@E 6<%FIJH7? 2 6<(FI@(G@@ 2 6<(FIJ(H@@

2 '6<(FI@(G@@ - 6<(FIJ(H@@* 2 -6J(F@@

Examp"e 'purchasing or se""ing*0 Suppose Tri#ent Corporation se""s pro#ucts to a :e"gian .u+er !or K<(J@@(@@@ pa+a."e in I@ #a+s% The current spot rate is 6<%G@7K an# Tri#ent expects to exchange the Euros !or K<(J@@(@@@E6<%G@7K 2 6G(<I@(@@@ )hen pa+ment is recei$e#% Transaction exposure arises .ecause o! the ris that Tri#ent )i"" recei$e something other than 6G(<I@(@@@ expecte# I! the euro )ea ens to 6<%<@7K( then Tri#ent )i"" recei$e 6<(HJ@(@@@ I! the euro strengthens to 6<%A@7K( then Tri#ent )i"" recei$e 6G(AL@(@@@ Examp"e '.orro)ing an# "en#ing* PepsiCo/s "argest .ott"er outsi#e the U%S% is "ocate# in =exico 'Grupo Em.ote""a#or #e =exicoM Gemex* In mi# <G7HL( Gemex ha# US #o""ar #enominate# #e.t o! 6GIL mi""ion% The =exican peso 'Ps* )as pegge# at Ps6A%LN7US6% On <G7GG7HL( the go$ernment a""o)e# the peso to !"oat #ue to interna" pressures an# it san to Ps6N%N@7US6 in mi#-Canuar+( <HHN%

Gemex/s peso o."igation0 Oo""ar #e.t mi#-Oecem.er( <HHL Oo""ar #e.t in mi#-Canuar+( <HHN Oo""ar #e.t increase measure# in P US6GILmEPs6A%LN7US62Ps6H<@%Jm US6GILmEPs6N%N@7US6 2 Ps6<(LNGm '<LNG-H<@%J*7H<@%J 2 NH%LP

Gemex/s #o""ar o."igation increases .+ NHP #ue to transaction exposure% Note0 US6 appreciates .+ NH%LP( )hich is 'N%N@-A%LN*7A%LN%

Examp"e '!or)ar# contract*0 ,hen a !irm .u+s a !or)ar# exchange contract( it #e"i.erate"+ creates transaction exposureM this ris is incurre# to he#ge an existing exposure% A U%S% !irm )ants to o!!set transaction exposure o! Q<@@ mi""ion to pa+ !or an import !rom Capan in H@ #a+s% The !irm can purchase Q<@@ mi""ion in !or)ar# mar et to co$er pa+ment in H@ #a+s%

Examp"e 'ac;uiring !oreign assets* ,or"#)i#e Tra$e"( a <@@P pri$ate"+ o)ne# tra$e" !irm .ase# in Hono"u"u( has signe# an agreement to ac;uire a N@P o)nership share o! Taipei Tra$e"( a pri$ate"+ o)ne# tra$e" agenc+ .ase# in Tai)an specia"i9ing in ser$icing in.oun# customers !rom the Unite# States an# Cana#a% The ac;uisition price is F mi""ion Tai)an #o""ars 'NT6F(@@@(@@@* pa+a."e in cash in three months%

He#ging '<* ,hat constitutes a he#geB Ac;uiring a cash !"o)( asset( or contract that )i"" rise in $a"ue to o!!set a #ecrease in $a"ue o! an un#er"+ing 'existing* position

G% ,h+ he#geB He#ging protects the o)ner o! an asset '!uture stream o! cash !"o)s* !rom "oss% Ho)e$er( it a"so e"iminates an+ gain !rom an increase in the $a"ue o! the asset he#ge# against% Since the $a"ue o! a !irm is the net present $a"ue o! a"" expected !uture cash !"o)s( it is important to rea"i9e that $ariances in these !uture cash !"o)s )i"" a!!ect the $a"ue o! the !irm an# that at "east some components o! ris 'currenc+ ris * can .e he#ge# against% Examp"e0 Suppose there is a compan+ #ri""ing oi" an# it p"ans on se""ing G mi""ion .arre"s o! oi" in I@ #a+s% Ho) can the !irm he#ge the exposure to changes in oi" pricesB - sell a futures contract on oil deliverable in ! days

Examp"e < 'managing account recei$a."eM A7R*0 =aria Gon9a"e9( CFO o! Tri#ent( has Rust conc"u#e# a sa"e to Regenc+( a :ritish !irm( !or ?<(@@@(@@@% The sa"e is ma#e in =arch )ith pa+ment #ue in Cune 'A months*% Assumptions !or =aria/s currenc+ exposure pro."em are0 - Spot rate is 6<%FIL@7? - A-month !or)ar# rate is 6<%FNL@7? - Tri#ent/s cost o! capita" is <G%@P - U> A month .orro)ing rate is <@%@P p%a% 'per annum* - U> A month in$esting rate is J%@P p%a% - US A month .orro)ing rate is J%@P p%a% - US A month in$esting rate is I%@P p%a% - Cune put option in the OTC mar et '.an * !or ?<(@@@(@@@M stri e price 6<%FNM <%NP !or option premium - Tri#ent/s !oreign exchange a#$isor+ ser$ice !orecasts !uture spot rate in A months to .e 6<%FI7? Tri#ent operates on narro) margins an# =aria )ants to secure the most amount o! US #o""arsM her .u#get rate '"o)est accepta."e amount* is 6<%F@7?( .e"o) )hich Tri#ent actua""+ "ose mone+ on the transaction% =aria !aces !our possi.i"ities0 Remain un-he#ge# He#ge in the !or)ar# mar et He#ge in the mone+ mar et He#ge in the options mar et

'<* Un-he#ge# position =aria ma+ #eci#e to accept the transaction ris % I! she .e"ie$es that the !uture spot rate )i"" .e 6<%FI7?( then Tri#ent )i"" recei$e ?<(@@@(@@@E6<%FI7? 2 6<(FI@(@@@ in A months% Ho)e$er( i! the !uture spot rate is 6<%IN7?( Tri#ent )i"" recei$e on"+ 6<(IN@(@@@ )e"" .e"o) the .u#get rate%

'G* For)ar# mar et he#ge - A !or)ar# he#ge in$o"$es a currenc+ !or)ar# or !utures contract an# a source o! !un#s to !u"!i"" the contract - The !or)ar# contract is entere# at the time )hen the A7R 'account recei$a."e* is create#( in this case in =arch% - ,hen this sa"e is .oo e#( it is recor#e# at the spot rate% - In this case the A7R is recor#e# at a spot rate o! 6<%FIL@7?( thus 6<(FIL(@@@ is recor#e# as a sa"e !or Tri#ent% - I! Tri#ent #oes not ha$e an o!!setting A7P 'account pa+a."e* in the same amount( then the !irm is consi#ere# unco$ere#%

- I! =aria )ants to co$er this exposure )ith a !or)ar# contract( then she )i"" se"" ?<(@@@(@@@ !or)ar# to#a+ at the A-month !or)ar# rate o! 6<%FNL@7? - She is no) Sco$ere#T an# Tri#ent no "onger has an+ transaction exposure - In A months( Tri#ent )i"" recei$e ?<(@@@(@@@ an# exchange those poun#s at 6<%FNL@7? recei$ing 6<(FNL(@@@% - This )ou"# .e recor#e# in Tri#ent/s .oo s as a !oreign exchange "oss o! 6<@(@@@ '6<(FIL(@@@ as .oo e#( 6<(FNL(@@@ as sett"e#*

'A* =one+ mar et he#ge - A mone+ mar et he#ge a"so inc"u#es a contract an# a source o! !un#s( simi"ar to a !or)ar# contract - In this case( the contract is a "oan agreement - The !irm .orro)s in one currenc+ an# exchanges the procee#s !or another currenc+ - He#ges can .e "e!t SopenT 'i%e%( no in$estment* or Sc"ose#T 'i%e%( in$estment*%

- To he#ge in the mone+ mar et( =aria )i"" .orro) poun#s in 1on#on( con$ert the poun#s to #o""ars an# repa+ the poun# "oan )ith the procee#s !rom the sa"e - To ca"cu"ate ho) much to .orro)( =aria nee#s to #iscount the PD o! the ?<(@@@(@@@ to to#a+ ?<(@@@(@@@7'<4<@PE<7L* 2 ?HFN(I<@ - =aria shou"# .orro) ?HFN(I<@ to#a+ an# in A months repa+ this amount p"us ?GL(AH@ in interest !rom the procee#s o! the sa"e '?<(@@@(@@@*% - Tri#ent )ou"# exchange the ?HFN(I<@ at the spot rate o! 6<%FIL@7? an# recei$e 6<(FG@(HFI imme#iate"+% - This he#ge creates a poun# #enominate# "ia.i"it+ '.an "oan* that is o!!set )ith a poun# #enominate# asset 'the sa"e o! goo#sM A7R* thus creating a .a"ance sheet he#ge In or#er to compare the !or)ar# he#ge )ith the mone+ mar et he#ge( =aria must ana"+9e the use o! the "oan procee#s - Remem.er that the "oan procee#s ma+ .e use# to#a+( .ut the !un#s !or the !or)ar# contract ma+ not - Three "ogica" choices exist !or an assume# in$estment rate !or the next A months - First( i! Tri#ent is cash rich( the "oan procee#s might .e in$este# at the US rate o! I%@P p%a% - Secon#( =aria cou"# use the "oan procee#s to su.stitute an e;ua" #o""ar "oan that Tri#ent )ou"# ha$e other)ise ta en !or )or ing capita" nee#s at a rate o! J%@P p%a% - Thir#( =aria might in$est the "oan procee#s in the !irm itse"! in )hich case the cost o! capita" is <G%@P p%a%

- :ecause the procee#s in A months !rom the !or)ar# he#ge )i"" .e 6<(FNL(@@@( the mone+ mar et he#ge is superior to the !or)ar# he#ge i! =aria use# the procee#s to rep"ace a #o""ar "oan 'JP* or con#uct genera" .usiness operations '<GP* - The !or)ar# he#ge )ou"# .e pre!era."e i! =aria )ere to Rust in$est the "oan procee#s 'IP* - ,e assume that she uses the cost o! capita" as the rein$estment rate - A .rea e$en in$estment rate can .e ca"cu"ate# an# he"p =aria in her #ecision

- Conc"usion0 I! =aria can in$est the "oan procee#s at a rate e;ua" to or greater than F%IJP p%a%( then the mone+ mar et he#ge )i"" .e superior to the !or)ar# he#ge%

'L* Options mar et he#ge0 - =aria cou"# a"so co$er the ?<(@@@(@@@ exposure .+ purchasing a put option 'insurance*% This a""o)s her to specu"ate on the upsi#e potentia" !or appreciation o! the poun# )hi"e "imiting her #o)nsi#e ris % - Gi$en the ;uote ear"ier( =aria cou"# purchase A-month put option at an AT= 'atthe-mone+* stri e price o! 6<%FN7? an# a premium o! <%NP The cost o! this option 2 'si9e o! option*E'premium*E'spot rate*

2 ?<(@@@(@@@E@%@<NE6<%FIL@7? 2 6GI(LI@ - :ecause )e are using !uture $a"ue to compare the $arious he#ging a"ternati$es( it is necessar+ to proRect the cost o! the option in A months% Using a cost o! capita" o! <GP p%a% or A%@P per ;uarter( the premium o! the option as o! Cune 6GI(LI@E<%@A 2 6GF(GNL - Since the upsi#e potentia" is un"imite#( Tri#ent )ou"# not exercise its option at an+ rate a.o$e 6<%FN7? an# )ou"# se"" poun#s on the spot mar et )))%unm%e#u7Uchenh7LFLV<<VTransactionPG@Exposure%#oc

Economic exposure Economic exposure is an exposure to !"uctuating exchange rates( )hich a!!ects a compan+Ws earnings( cash !"o) an# !oreign in$estments% The extent to )hich a compan+ is a!!ecte# .+ economic exposure #epen#s on the speci!ic characteristics o! the compan+ an# its in#ustr+% The ris s !ace# .+ a countr+ that #oes .usiness or ho"#s in$estments a.roa#% Economic exposure can inc"u#e changes in !oreign exchange rates or the chance o! !oreign countries #e!au"ting on their #e.t% Companies o!ten he#ge against this t+pe o! ris through the !oreign exchange mar et%
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Why real exchange rate changes? "elative price changes ultimately determine a firms long#run exposure to currency change$ Currenc+ changes - particu"ar"+ those o! high-in!"ation currencies - are usua""+ prece#e# .+ or accompanie# .+ changes in re"ati$e price "e$e"s .et)een t)o countries% Hence( it is impossi."e to #etermine exposure to a gi$en currenc+ )ithout consi#ering simu"taneous"+ the o!!setting e!!ects o! these price changes% A"ternati$e"+( exchange rates o!ten a!!ect !irms most se$ere"+ )hen the nomina" exchange rate #oes not mo$e at a"" - )hen re"ati$e price changes are not .eing o!!set .+ exchange rate a#Rustments% Measuring economic exposure A statistica" measure o! economic exposure can .e o.taine# .+ app"+ing "inear regression ana"+sis to cash !"o)s or rea" net asset $a"ues% For cash !"o) exposure( a regression o! the !o""o)ing t+pe can .e estimate#0 CFt 2 a 4 . st 4 ut( )here CFt #enotes cash !"o)s in home currenc+ units in perio# t an# st is the spot exchange rate in terms o! home currenc+ units per !oreign currenc+ unit%

The estimate# coe!!icient .( )i"" .e0 . 2 Co$'CFt st* 7 Dar'st* . 2 Co$'CFt st* 7 Dar'st* Hence( . )i"" measure the sensiti$it+ o! cash !"o)s to the "e$e" o! the exchange rate - )hich is precise"+ exposure #enominate# in the !oreign currenc+ units% Examp"e% The RG statistic !rom the regression )i"" measure the !raction o! cash !"o) $aria.i"it+ that can .e exp"aine# .+ changes in the exchange rate% The regression shou"# .e run in rea" terms% The cash !"o)s shou"# .e #e!"ate# .+ the home currenc+ in!"ation 'i%e% con$erte# into constant <HJ@ #o""ars*% The exchange rate shou"# .e the rea" exchange rate

What happens if the regression is run in nominal terms? As an examp"e( consi#er the case )here the Poun#-Oo""ar rea" exchange rateis constant% I! in!"ation is <@P in the U%S% per +ear an# 9ero in the U%>%( the #o""ar must .e #epreciating .+ <@P per +ear to maintain the constant rea" exchange rate% I! a nomina" regression is run( ho)e$er( #o""ar cash !"o)s )i"" .e increasing at <@P per +ear an# the spot exchange rate )i"" .e rising at <@P per +ear re!"ecting the nomina" #epreciation o! the #o""ar% . )i"" pic up the !act that each si#e o! the regression is increasing at <@P per +ear - )hich )i"" .e misattri.ute# to exposure% Run in rea" terms( the regression correct"+ #e"i$ers . 2 @%

This measurement technique can be applied in many different ways: - Regressing net asset $a"ue on exchange rate to #etermine net )orth exposure% - Regressing tota" mar et $a"ue( reco$ere# !rom the stoc price( onto exchange rate changes%

- inc"u#ing "agge# $a"ues o! the exchange rate in the regression i! an a#Rustment "ag in cash !"o)s might exist%

Accounting Exposure <% A .ac )ar#-"oo ing concept0 it re!"ects past #ecisions as re!"ecte# in the su.si#iar+Ws assets an# "ia.i"ities% G% A change in an accounting $a"ue #ue to trans"ation is not a Xrea"i9e#X gain or "ossM no change in the cash situation is in$o"$e# Yexcept possi."+ through taxation e!!ects% A% Changes the !irmWs accounting $a"ue( .ut not necessari"+ its mar et $a"ue% L% Oepen#s on the accounting ru"es chosen% This is .ecause the su.si#iar+Ws o)n interna" ru"es a!!ect its accounting $a"ues 'e%g%( t+pe o! #epreciation( or in$entor+ $a"uation metho#s* an# a"so .ecause the trans"ation process itse"! can .e #one in #i!!erent )a+s 'see .e"o)*% N% Accounting exposure on"+ exists in the case o! !oreign #irect in$estment( since pure exporting or import-su.stituting !irms ha$e no !oreign su.si#iaries% Trans"ation exposure is re"e$ant to the preparation o! the parent compan+/s !inancia" statements( )here a !irm/s !oreign currenc+-#enominate# accounts on the .a"ance sheet are a!!ecte# .+ exchange rate changes% A !irm )hich has su.si#iaries an# assets in another countr+ is su.Rect to trans"ation exposure% Trans"ation exposure resu"ts as a conse;uence o! the !act that a parent compan+ must conso"i#ate a"" o! the operations o! its su.si#iaries into its o)n !inancia" statements% Since a !oreign su.si#iar+/s assets are carrie# on its .oo s in a !oreign currenc+( it is necessar+ to con$ert the !oreign $a"ues into #omestic currenc+ !or com.ining )ith the parent/s assets% F"uctuating exchange rates resu"ts in gains an# "osses occurring #uring the trans"ation process% Since this t+pe o! exposure is re"ate# to .a"ance sheet assets an# "ia.i"ities( it is o!ten re!erre# to as accounting exposure%

The primar+ issue re"ate# to the trans"ation o! !oreign asset $a"ues has to #o )ith )hether the proper exchange rate to use is the current rate o! exchange or the historic rate o! exchange that existe# at the time that an asset )as ac;uire# ,hen con$erting !inancia" statement items 'transactions* #enominate# in currencies other than the parent currenc+( t)o choices o! exchange rate are possi."e0 The historica" rate( the exchange rate pre$ai"ing at the time o! the transaction The current rate( the exchange rate pre$ai"ing at the .a"ance sheet #ate or #uring the income statement perio#