International Financial Markets Prices and Policies Second Edition ©2001 Richard M Levich 16 Measuring and Managing the Risk in International Financial Positions McGraw Hill / Irwin 16 - Overview The Corporate Treasurer’s Financial Risk Management Problem The Market Value of the Firm and Channels of Risk Accounting Measures of Foreign Exchange Exposure Exposure of the Balance Sheet: Translation Exposure Exposure of the Income Statement: Transaction Exposure U.S Accounting Conventions: Reporting Accounting Gains and Losses McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - Overview Economic Measures of Foreign Exchange Exposure The Regression Approach The Scenario Approach Empirical Evidence on Firm Profits, Share Prices, and Exchange Rates Arguments for Hedging Risks at the Corporate Level McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - Overview Financial Strategies Toward Risk Management The Currency Profile and Suitable Financial Hedging Instruments Policy Issues - International Financial Managers Problems in Estimating Economic Exposure Picking an Appropriate Hedge Ratio The International Investor’s Currency Risk Management Problem The Value at Risk Approach McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - Overview Policy Issues - Public Policymakers Disclosure of Financial Exposure Financial Derivatives and Corporate Hedging Policies McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser The Corporate Treasurer’s 16 - Financial Risk Management Problem Corporate treasurers are directly responsible for managing the firm’s exposure to financial risk The risks that remain are held by the investor, who can reduce these risks through a diversified portfolio of shares, or by applying some of the same hedging techniques available to the corporate treasurer McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - The Market Value of the Firm The market value of a firm at time t (MVt) is the summation of the firm’s cash flows (CF) over time discounted back to their present value by an appropriate discount factor (i): T CFt MVt t t 0 1 it Cash flows in each currency are discounted at their own appropriate interest rate and multiplied by a spot exchange rate McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - The Market Value of the Firm The sensitivity of the market value of the firm to a change in an exchange rate measures exchange rate exposure For the $/€ exchange rate, the sensitivity measure can be expressed as: MV S$ / € McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Channels of Exposure to 16 - Foreign Exchange Risk Direct Economic Exposure Home Currency Strengthens Home Currency Weakens Unfavorable Revenue worth less in home currency terms Favorable Revenue worth more Source Abroad Favorable Inputs cheaper in home currency terms Unfavorable Inputs more expensive Profits Abroad Unfavorable Profits worth less Favorable Profits worth more Sales Abroad McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Channels of Exposure to 16 - 10 Foreign Exchange Risk Indirect Economic Exposure Competitor that sources abroad Supplier that sources abroad Customer that sells abroad Customer that sources abroad McGraw Hill / Irwin Home Currency Strengthens Home Currency Weakens Unfavorable Competitor’s margins improve Favorable Supplier’s margins improve Unfavorable Customer’s margins decrease Favorable Customer’s margins improve Favorable Competitor’s margins decrease Unfavorable Supplier’s margins decrease Favorable Customer’s margins improve Unfavorable Customer’s margins decrease 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - 22 The Scenario Approach Present Value of Cash Flows (Millions) Suppose the firm can pass along part of the exchange rate change to its Australian customers The slope of BOB* is flatter than AOA* since the firm has less exposure now $39.577 $35.222 B A $/A$ A$/$ A* B* O - 15% - 10% - 5% 5% 10% 15% $0.5435 $0.5682 $0.5952 $0.6250 $0.6563 $0.6875 $0.7188 A$1.84 A$1.76 A$1.68 A$1.60 A$1.52 A$1.45 A$1.39 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Empirical Evidence on 16 - 23 Firm Profits, Share Prices, & Exchange Rates During the Bretton Woods pegged-rate period, the general stock market index tended to move up (down) immediately after a devaluation (revaluation) of the local currency Studies also indicated that exposure coefficients vary from firm to firm within the same industry and over time, and that exchange rate changes can have a substantial impact on the overall economy McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Arguments for 16 - 24 Hedging Risks at the Corporate Level Shareholders may not favor hedging since they can select well-diversified portfolios to rid themselves of firm-specific risks McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Arguments for 16 - 25 Hedging Risks at the Corporate Level However, in view of transaction costs and taxes, hedging that reduces the volatility of cash flows may be favored If the tax credits of a firm which has incurred losses over several successive periods cannot be carried forward to reduce future tax payments, then another firm with a less volatile pattern of earnings will enjoy greater after-tax cash flows and a higher market value A firm with more volatile cash flows is also more open to the costs of financial distress McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Arguments for 16 - 26 Hedging Risks at the Corporate Level For the same reasons, banks and bondholders will prefer firms with less volatile cash flows (holding average cash flows equal) and reward them with greater borrowing capacities and higher credit ratings McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Financial Strategies 16 - 27 Toward Risk Management An important step in the process of determining the appropriate financial hedging instruments for a firm is to analyze the nature of the firm’s currency cash flows McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Financial Strategies 16 - 28 Toward Risk Management Characteristics of Currency Exposure Suitable Financial Hedging Instruments Frequency of cash flows Single period Single contract (futures/options) Multiple periods Sets (“strips”) of contracts/swaps or present value hedge Currency dimension Single currency Contracts on one currency Multiple currencies Contracts on an index (ECU, US$) or synthetic hedge McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Financial Strategies 16 - 29 Toward Risk Management Characteristics of Currency Exposure Certainty about cash flows McGraw Hill / Irwin Suitable Financial Hedging Instruments Certain, contractual cash flows Naïve hedge to match contract size of financial instrument and exposure Uncertain, estimated cash flows Option hedge or dynamic futures hedge to match probability of cash flows 2001 by The McGraw-Hill Companies, Inc All rights reser Financial Strategies 16 - 30 Toward Risk Management Note that a hedging strategy may offset certain risks, while leaving open or increasing other risks McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Policy Issues 16 - 31 International Financial Managers Problems in Estimating Economic Exposure Using market data presumes that financial markets are efficient, and that share prices respond quickly and appropriately to exchange rate changes The approach is unsuitable for newly organized or reorganized firms for which there is not a large sample of consistent observations For the exposure coefficient to be useful, the relationship between exchange rate changes and market value must remain stable in the future McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Policy Issues 16 - 32 International Financial Managers Picking an Appropriate Hedge Ratio If the exchange rate is expected to change favorably, hedging may not be desirable Complete hedging may be achieved by taking offsetting positions (-bi) Otherwise, an intermediate solution may be chosen, with hedge positions in between and bi Note that the more direct approach is to restructure the firm’s long-term financing, so as to permanently alter the firm’s financial exposure McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Policy Issues 16 - 33 International Financial Managers The International Investor’s Currency Risk Management Problem A portfolio’s exposure to foreign exchange risk can be measured using the regression approach in much the same way as the treasurer measures the firm’s exposure The investor can hedge foreign exchange risk using forward contracts, or retain the risk using a riskreturn decision criteria McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser Policy Issues 16 - 34 International Financial Managers The Value at Risk (VAR) Approach The VAR approach is a relatively new approach for measuring the exposure of financial assets It can be applied to any portfolio of assets (and liabilities) whose market values are available on a periodic basis and whose price volatilities () can be estimated Assuming normal price distributions, calculate the loss in value of the portfolio if an unlikely (say, 5% chance) adverse price movement occurs The result of this calculation is the value at risk McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - 35 Policy Issues - Public Policymakers Disclosure of Financial Exposure The possibility that individual firms may face substantial exposure to exchange rate changes, as well as the increased trading in financial derivatives in recent years, create a genuine concern among investors and regulators regarding corporate exposure to financial risks Note that a firm without a financial position may still face substantial currency and interest rate risk due to its ongoing operations McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser 16 - 36 Policy Issues - Public Policymakers Financial Derivatives and Corporate Hedging Policies The findings of various studies were consistent with the notion that firms used derivatives to lower the variability of their cash flows or earnings It was also found that the likelihood of using derivatives was positively related to foreign pretax income, foreign sales, and foreign-denominated debt McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc All rights reser ... International Financial Managers Problems in Estimating Economic Exposure Picking an Appropriate Hedge Ratio The International Investor’s Currency Risk Management Problem The Value at Risk. .. exposure to financial risk The risks that remain are held by the investor, who can reduce these risks through a diversified portfolio of shares, or by applying some of the same hedging techniques... Companies, Inc All rights reser U.S Accounting Conventions 16 - 13 Reporting Accounting Gains and Losses Under Statement 52 of the Financial Accounting Standards Board (FASB-52), translation gains and