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Chapter 13 - Foreign exchange risk management. The objectives of this chapter are: To explain why there is concern about foreign exchange risk; to illustrate how to manage short-term transaction exposure using forward hedging, futures hedging, money market hedging and option hedging; to illustrate other techniques of managing short-term and longterm transaction exposure;…
Chapter 13 Foreign Exchange Risk Management Objectives • To explain why there is concern about FX risk • To illustrate how to manage transaction, economic and translation exposure Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-2 Hedging • Hedging, which is the core risk management operation, is a process whereby a firm can protect itself from unanticipated changes in exchange rates and other sources of risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa (cont ) 13-3 Hedging (cont.) • The decision to hedge or not to hedge an uncovered or open foreign currency position is basically a speculative decision • It all depends on the expected exchange rate or the movement of the exchange rate between the point in time when the decision is taken and when its effect materialises Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-4 Why is there no need to worry about FX risk? • If international parity conditions hold, FX risk will not arise • If it is possible to forecast exchange rates accurately, FX risk can be controlled • Shareholders are naturally hedged though diversification Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-5 Why worry about FX risk? • International parity conditions not hold • Forecasting exchange rates is rather difficult • Hedging produces a more stable income stream Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-6 Benefits of hedging • Hedging has a positive effect on the value of the firm • It produces a more stable corporate income stream Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-7 Managing short-term transaction exposure (financial hedging) • • • • Forward hedging Money market hedging Futures hedging Option hedging Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-8 Financial hedging • By taking an affecting position on a hedging instrument (forward, etc), the profit/loss on the unhedged position is offset by the loss/profit on the hedging instrument Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-9 Forward hedging • Forward hedging entails locking in the exchange rate at which payables and receivables are converted from the domestic currency into a foreign currency, and vice versa Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa (cont ) 13-10 Currency diversification • Depending on correlation of the exchange rates against the base currency, currency diversification reduces risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-38 Exposure netting • A natural hedge would arise when the firm has payables and receivables in the same currency, in which case only net exposure should be covered Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-39 Price variation and currency of invoicing • The foreign currency price of a product can be adjusted by varying its domestic currency price • Exposure to FX risk can be eliminated completely by using the domestic currency as the currency of invoicing Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-40 Risk sharing and currency collars • Risk-sharing arrangements and currency collars involve the use of various values of the exchange rate to convert cash flows Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-41 AUD value of receivables with and without risk-sharing arrangement 60000 50000 Hedge 40000 30000 20000 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 0.28 0.30 13-42 AUD value of receivables with and without currency collar 60000 50000 Hedge 40000 30000 20000 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 0.28 0.30 13-43 Economic exposure • Economic exposure arises because revenues and costs vary with changes in the real exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-44 The effects of real appreciation • Assuming elastic demand, real appreciation of the foreign currency leads to: an increase in domestic sales revenue an increase in foreign sales revenue an increase in the costs of imported raw materials and foreign borrowing Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-45 The effects of real depreciation • Assuming elastic demand, real depreciation of the foreign currency leads to: a decrease in domestic sales revenue a decrease in foreign sales revenue a decrease in the costs of imported raw materials and foreign borrowing Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-46 Hedging economic exposure • Reducing economic exposure requires: changing sales in new or existing foreign markets changing dependence on foreign supply of raw materials establishing or eliminating production facilities abroad changing the level of foreign debt Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-47 Why worry about translation exposure? • Translation exposure does not affect the economic value of the firm • Different translation methods affect reported earnings per share and other financial indicators Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-48 Hedging translation exposure • Fund adjustment • Forward contracts • Exposure netting and balance sheet hedging Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-49 Fund adjustment • Fund adjustment involves altering the amounts and/or currencies of the planned cash flows of the firm or its subsidiaries to reduce exposure to the currency of the subsidiary (the local currency) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-50 Forward contracts • If the base currency of a foreign subsidiary is expected to depreciate against the parent firm’s base currency, then translation exposure exists Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-51 Exposure netting and balance sheet hedging • Exposure netting can be used by multinational firms with offsetting positions in more than one foreign currency • A balance sheet hedge eliminates the mismatch between assets and liabilities in the same currency Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 13-52 ... McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 3- 7 Managing short-term transaction exposure (financial... Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 3- 30 Managing long-term transaction exposure... 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 3- 14 Introducing the bid-offer spread Hedge No-Hedge Payables