CH 8, 9, 10, EXCHANGE RATE RISK EXPOSURES AND MANAGEMENTCH 8, 9, 10, EXCHANGE RATE RISK EXPOSURES AND MANAGEMENT* Exchange Rate Risk Relevant? If the world markets were “perfect” (notransactions costs, all information available to everyone, etc) and “efficient”(prices adjust rapidly to reflect true values), the exchange rate risks mightnot be relevant to the extent that 1) other prices (prices of goods andservices, interest rates, etc) may adjust rapidly to undo any impacts fromexchange rate changes (recall all the parity conditions), 2) individuals andcorporations can use available hedging tools or diversify their portfolios tominimize the impact. However, to the extent that the world markets may notbe perfect, exchange rate risk is real and relevant. * 3 Types of Exchange Rate Risk Exposures 1) Transactions Exposure – HC value of a contractual cash flow (A/R, A/P, etc)denominated in a FC may vary - “Net” cash flows 2) Economic (Operational) – the value of the firm may be affected as thebusiness (buying, selling, and business operation) may be affected. We needto know firm’s operation, market conditions, competition, etc to be able toassess this risk. - Economic exposure of a purely domestic firm may also be affected. How?The business may not be affected directly, but its business partners orcompetitors can be affected. In other words, the business may be affectedindirectly. - Measuring Economic Exposure – difficult! 3) Translation (Accounting) – arises when the MNC consolidates financialstatements of all of its operations (HQs, subsidiaries, and affiliates) – historicalvs. current exchange rates - Does it matter? Cosmetic? - Determinants of Translation Exposure - Accounting Methods by International Accounting Standards Board, a. Current/non-current, b. Monetary/non-monetary, c. Temporal, d. Currentrate- FASB 8 vs FASB 52 (2 sets of financial statements, one in HC and the otherin a functional currency)* MANAGING TRANSACTION EXPOSURE* A US firm has a SF 25 million receivable in two months. So = $.63/SF, E(S1)= $.64/SF, F=$.64/SF, US interest rate is 5% APR, Swiss interest rate is 4% APR, option premium (cents per unit) = 0.15 for K=$.63/SF and 0.30 for K=$.64/SF(Hint: 5%=>.83%, 4%=>.67%, op pm=$.0015 and $0.003)1. UH: $16m - FV, Uncertain2. FH: $16m – FV, Certain 3. MMH: SF 24.83m, PV=$15.64m, FV=$15.77m Note: If CIRP holds, MMH and FH are equivalent. If MMH and FH results are different, it indicates that CIRP does not hold.4. Currency Option Hedge: 400 put contracts, $75k option premium for K=$.63 and $37.5k for K=$.63,Guaranteed $ receipt = $15.75m vs $16m, with net (in FV) $15,712,188 vs $15,924,377.50 - Option value determinants: So, volatility, time to maturity, interest rate, exercise price5. Futures ~ basically, very similar to the forward contract* Other Hedging Techniques6. Risk Shifting and Pricing Decision – Price sales in home currency (e.g., $ invoicing)7. Hedging via lead or lag – pay or collect early or late.8. Exposure Netting – Portfolio approach, “Net” offsetting exposure in one currency with exposures in the same or other currency. Lufthansa example. - This includes Cross-Hedging and Currency Diversification 9. Currency Risk Sharing based on a formula10. Currency Swap and Parallel Loan* Limitations of Hedging 1. Contingent Exposure (Potential) Exposure – FC denominated transaction is not certain and contingent on a future event. Example: comparing alternative hedging techniques for GE bidding on a hydroelectric project in Canada. If accepted, GE gets an A/R of CD$ 100m.2. Over-hedging – example 3. Limitation of Repeated Short-Term Exposure * Hedging Long-Term Transaction Exposure 1. Long-Term Forward Contract2. Currency Swap 3. Parallel Loan* Examples of transaction exposure and management1. Your brewery produces Lusty Lite, a very-low-calorie, almost tasteless beer that has not yet developed a following. In mid-March you receive an order for 10,000 cartons from Munich, Germany, for next fall's Oktoberfest, with payment of 384,000 euro due in mid-September. In your opinion the euro will rise from its present rate of e 1.006/$ to e 1.005/$ by September. You can borrow euros for six months at 6% per annum. What should you do? Discuss issues as necessary.2. Whitfield Corporation is completing a new factory building in Yorkshire, England, and must make a final construction payment of £8,000,000 in six months. Foreign exchange and interest rate quotations are as follows. Present spot rate $1.80/£ Six-month forward rate $1.79/£ British six-month interest rate 8.00% per annumU.S. six-month interest rate 7.00% per annumThe financial manager's own analysis suggests that in six months the following spot rates can be expected. Highest expected rate $1.80/£ Most likely rate $1.78/£ Lowest expected rate $1.77/£What alternatives are available for making payment, and what are the advantages or disadvantages of each?3. Ithaca Tool Company has received an order from a Malaysian manufacturing company for machinery worth M$480,000. (M$ stands for Malaysian ringgits.) The export sale would be denominated in Malaysian ringgits on a one-year open account basis. The current spot rate is M$2.00/US$, and the forward ringgit sells at a discount of 10% per annum. The finance staff of Ithaca Tool Company forecasts that the ringgit will drop 8% in value over the next year. Ithaca Tool Company faces the following alternatives.a. Wait one year to receive M$480,000 and then sell the ringgits received for dollars in the spot market.b. Sell the ringgit proceeds of the sale forward today.c. Borrow ringgits from Public Bank in Kuala Lumpur at 15% per annum against the expected future receipts of ringgits. What do you recommend and why?4. You have just purchased a deluxe Lamborghini sports car to be delivered to you in Italy three months from today. The purchase price is 90,000 euro tobe paid in cash at that time. You have enough dollars in the bank in the United States to pay cash for the car. These dollars are