Techniques of transaction exposure management

CHAPTER 10 Measuring and Managing Translation and Transaction Exposure

The stream of time sweeps away errors, and leaves the truth for the inheritance of humanity.

George Brandes

LEARNING OBJECTIVES

• To define translation and transaction exposure and distinguish between the two

• To describe the four principal currency translation methods available and to calculate translation exposure using these different methods

• To describe and apply the current (FASB-52) currency translation method prescribed by the Financial Accounting Standards Board

• To identify the basic hedging strategy and techniques used by firms to manage their currency transaction and translation risks

• To explain how a forward market hedge works

• To explain how a money market hedge works

• To describe how foreign currency contract prices should be set to factor in exchange rate change expectations

• To describe how currency risk-sharing arrangements work

• To explain when foreign currency options are the preferred hedging technique

• To describe the costs associated with using the different hedging techniques

• To describe and assess the economic soundness of the various corporate hedging objectives

• To explain the advantages and disadvantages of centralizing foreign exchange risk management

KEY TERMS

accounting exposure

cross-hedge

currency call option

currency collar

currency options

currency put option

currency risk sharing

current exchange rate

current/noncurrent method

current rate method

cylinder

economic exposure

exposure netting

Financial Accounting Standards Board (FASB)

foreign exchange risk

forward market hedge

functional currency

funds adjustment

hard currency

hedging

historical exchange rate

hyperinflationary country

monetary/nonmonetary method

money market hedge

neutral zone

operating exposure

opportunity cost

price adjustment clause

range forward

reporting currency

risk shifting

soft currency

Statement of Financial Accounting Standards No. 52 (FASB 52)

Statement of Financial Accounting Standards No. 133 (FASB 133)

temporal method

transaction exposure

translation exposure

Foreign currency fluctuations are one of the key sources of risk in multinational operations. Consider the case of Dell Inc., which operates assembly plants for its computers within the United States as well as in Ireland, Malaysia, China, and Brazil; runs offices and call centers in several other countries; and markets its products in more than 100 countries. Dells currency problems are evident in the fact that it may manufacture a product in Ireland for sale in, say, Denmark and obtain payments in Danish krone. Dell would like to ensure that its foreign profits are not eroded by currency fluctuations. Also, at the end of the year, when Dell consolidates its financial statements for the year in U.S. dollars, it wants to ensure that exchange rate changes do not adversely impact its financial performance.

The pressure to monitor and manage foreign currency risks has led many companies to develop sophisticated computer-based systems to keep track of their foreign exchange exposure and aid in managing that exposure. The general concept of exposure refers to the degree to which a company is affected by exchange rate changes. This impact can be measured in several ways. As so often happens, economists tend to favor one approach to measuring foreign exchange exposure, whereas accountants favor an alternative approach. This chapter deals with the measurement and management of accounting exposure, including both translation and transaction exposure. Management of accounting exposure centers on the concept of hedging. Hedging a particular currency exposure means establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Regardless of what happens to the future exchange rate, therefore, hedging locks in a dollar (home currency) value for the currency exposure. In this way, hedging can protect a firm from foreign exchange risk, which is the risk of valuation changes resulting from unforeseen currency movements.

10.1 Alternative Measures of Foreign Exchange Exposure

The three basic types of exposure are translation exposure, transaction exposure, and operating exposure. Transaction exposure and operating exposure combine to form economic exposure. Exhibit 10.1 illustrates and contrasts translation, transaction, and operating exposure. As can be seen, these exposures cannot always be neatly separated but instead overlap to some extent.

Translation Exposure

Translation exposure, also known as accounting exposure, arises from the need, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currencies (LC) involved to the home currency (HC). If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains, and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains or losses is measured by the translation exposure figures. The rules that govern translation are devised by an accounting association such as the Financial Accounting Standards Board (FASB) in the United States, the parent firm's government, or the firm itself. Appendix 10A discusses Statement of Financial Accounting Standards No. 52 (FASB 52)—the present currency translation method prescribed by FASB.

Exhibit 10.1 Comparison of Translation, Transaction, and Operating Exposures

Transaction Exposure

Transaction exposure results from transactions that give rise to known, contractually binding future foreign-currency-denominated cash inflows or outflows. As exchange rates change between now and when these transactions settle, so does the value of their associated foreign currency cash flows, leading to currency gains and losses. Examples of transaction exposure for a U.S. company would be the account receivable associated with a sale denominated in euros or the obligation to repay a Japanese yen debt. Although transaction exposure is rightly part of economic exposure, it is usually lumped under accounting exposure. In reality, transaction exposure overlaps with both accounting and operating exposure. Some elements of transaction exposure, such as foreign-currency-denominated accounts receivable and debts, are included in a firm's accounting exposure because they already appear on the firm's balance sheet. Other elements of transaction exposure, such as foreign currency sales contracts that have been entered into but the goods have not yet been delivered (and so receivables have not yet been created), do not appear on the firm's current financial statements and instead are part of the firm's operating exposure.

Operating Exposure

Operating exposure measures the extent to which currency fluctuations can alter a company's future operating cash flows—that is, its future revenues and costs. Any company whose revenues or costs are affected by currency changes has operating exposure, even if it is a purely domestic corporation and has all its cash flows denominated in home currency.

The two cash-flow exposures—operating exposure and transaction exposure—combine to equal a company's economic exposure. In technical terms, economic exposure is the extent to which the value of the firm—as measured by the present value of its expected cash flows—will change when exchange rates change.

10.2 Alternative Currency Translation Methods

Companies with international operations will have foreign-currency-denominated assets and liabilities, revenues, and expenses. However, because home country investors and the entire financial community are interested in home currency values, the foreign currency balance sheet accounts and income statement must be assigned HC values. In particular, the financial statements of an MNC's overseas subsidiaries must be translated from local currency to home currency before consolidation with the parent's financial statements.

If currency values change, foreign exchange translation gains or losses may result. Assets and liabilities that are translated at the current (postchange) exchange rate are considered to be exposed; those translated at a historical (prechange) exchange rate will maintain their historical HC values and, hence, are regarded as not exposed. Translation exposure is simply the difference between exposed assets and exposed liabilities. The controversies among accountants center on which assets and liabilities are exposed and on when accounting-derived foreign exchange gains and losses should be recognized (reported on the income statement). A crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature—that is, no cash flows are necessarily involved.

Four principal translation methods are available: the current/noncurrent method, the monetary/nonmonetary method, the temporal method, and the current rate method. In practice, there are also variations of each method.

Current/Noncurrent Method

At one time, the current/noncurrent method, whose underlying theoretical basis is maturity, was used by almost all U.S. multinationals. With this method, all the foreign subsidiary's current assets and liabilities are translated into home currency at the current exchange rate. Each noncurrent asset or liability is translated at its historical exchange rate —that is, at the rate in efffect at the time the asset was acquired or the liability was incurred. Hence, a foreign subsidiary with positive local currency working capital will give rise to a translation loss (gain) from a devaluation (revaluation) with the current/noncurrent method, and vice versa if working capital is negative.

The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with noncurrent assets or liabilities. The latter items, such as depreciation expense, are translated at the same rates as the corresponding balance sheet items. Thus, it is possible to see different revenue and expense items with similar maturities being translated at different rates.

Monetary/Nonmonetary Method

The monetary/nonmonetary method differentiates between monetary assets and liabilities—that is, those items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units—and nonmonetary, or physical, assets and liabilities. Monetary items (e.g., cash, accounts payable and receivable, and long-term debt) are translated at the current rate; nonmonetary items (e.g., inventory, fixed assets, and long-term investments) are translated at historical rates.

Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to nonmonetary assets and liabilities. The latter items, primarily depreciation expense and cost of goods sold, are translated at the same rate as the corresponding balance sheet items. As a result, the cost of goods sold may be translated at a rate different from that used to translate sales.

Temporal Method

The temporal method appears to be a modified version of the monetary/nonmonetary method. The only difference is that under the monetary/nonmonetary method, inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, but it can be translated at the current rate if it is shown on the balance sheet at market values. Despite the similarities, the theoretical bases of the two methods are different. The choice of exchange rate for translation is based on the type of asset or liability in the monetary/nonmonetary method; in the temporal method, it is based on the underlying approach to evaluating cost (historical versus market). Under a historical cost-accounting system, as the United States now has, most accounting theoreticians probably would argue that the temporal method is the appropriate method for translation.

Income statement items normally are translated at an average rate for the reporting period. However, cost of goods sold and depreciation and amortization charges related to balance sheet items carried at past prices are translated at historical rates.

Current Rate Method

The current rate method is the simplest: All balance sheet and income items are translated at the current rate. This method is widely employed by British companies. With some variation, it is the method mandated by the current U.S. translation standard—FASB 52. Under the current rate method, if a firm's foreign-currency-denominated assets exceed its foreign-currency-denominated liabilities, a devaluation must result in a loss and a revaluation must result in a gain.

Exhibit 10.2 applies the four methods to a hypothetical balance sheet that is affected by both a 25% devaluation and a 37.5% revaluation. Depending on the method chosen, the translation results for the LC devaluation can range from a loss of $205,000 to a gain of $215,000; LC revaluation results can vary from a gain of $615,000 to a loss of $645,000. The assets and liabilities that are considered exposed under each method are the ones that change in dollar value. Note that the translation gains or losses for each method show up as the change in the equity account. For example, the LC devaluation combined with the current rate method results in a $205,000 reduction in the equity account ($1,025,000 − $820,000), which equals the translation loss for this method. Another way to calculate this loss is to take the net LC translation exposure, which equals exposed assets minus exposed liabilities (for the current rate method, this figure is LC 4,100,000, which, not coincidentally, equals its equity value) and multiply it by the $0.05 ($0.25 − $0.20) change in the exchange rate. This calculation yields a translation loss of $205,000 ($0.05 × 4,100,000), the same as calculated in Exhibit 10.2. Another way to calculate this loss is to multiply the net dollar translation exposure by the fractional change in the exchange rate, or $1,025,000 × 0.05/0.25 = $205,000. Either approach gives the correct answer.

10.3 Transaction Exposure

Companies often include transaction exposure as part of their accounting exposure, although as a cash-flow exposure, it is rightly part of a company's economic exposure. As we have seen, transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. For example, when IBM sells a mainframe computer to Royal Dutch Shell in England, it typically will not be paid until a later date. If that sale is priced in pounds, IBM has a pound transaction exposure.

A company's transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency. Some of these unsettled transactions, including foreign-currency-denominated debt and accounts receivable, are already listed on the firm's balance sheet. However, other obligations, such as contracts for future sales or purchases, are not.

Application Computing Transaction Exposure for Boeing

Suppose Boeing Airlines sells five 747s to Garuda, the Indonesian airline, in rupiahs. The rupiah price is Rp 140 billion. To help reduce the impact on Indonesias balance of payments, Boeing agrees to buy parts from various Indonesian companies worth Rp 55 billion.

a. If the spot rate is $0.004/Rp, what is Boeing's net rupiah transaction exposure?

Solution. Boeing's net rupiah exposure equals its projected rupiah inflows minus its projected rupiah outflows, or Rp 140 billion − Rp 55 billion = Rp 85 billion. Converted into dollars at the spot rate of $0.004/Rp, Boeing's transaction exposure equals $340 million.

b. If the rupiah depreciates to $0.0035/Rp, what is Boeing's transaction loss?

Solution. Boeing will lose an amount equal to its rupiah exposure multiplied by the change in the exchange rate, or 85 billion X (0.004 − 0.0035) = $42.5 million. This loss can also be determined by multiplying Boeing's exposure in dollar terms by the fractional change in the exchange rate, or 340 million X (0.0005/0.004) = $42.5 million.

Exhibit 10.2 Financial Statement Impact of Translation Alternatives (U.S. $ Thousands)

Although translation and transaction exposures overlap, they are not synonymous. Some items included in translation exposure, such as inventories and fixed assets, are excluded from transaction exposure, whereas other items included in transaction exposure, such as contracts for future sales or purchases, are not included in translation exposure. Thus, it is possible for transaction exposure in a currency to be positive and translation exposure in that same currency to be negative and vice versa.

10.4 DESIGNING A HEDGING STRATEGY

We now come to the problem of managing exposure by means of hedging. As mentioned earlier, hedging a particular currency exposure means establishing an offsetting currency position so as to lock in a dollar (home currency) value for the currency exposure and thereby eliminate the risk posed by currency fluctuations. A variety of hedging techniques are available for managing exposure, but before a firm uses them it must decide on which exposures to manage and how to manage them. Addressing these issues successfully requires an operational set of goals for those involved in exchange risk management. Failure to set out objectives can lead to possibly conflicting and costly actions on the part of employees. Although many firms do have objectives, their goals are often so vague and simplistic (e.g., “eliminate all exposure” or “minimize reported foreign exchange losses”) that they provide little realistic guidance to managers.1 For example, should an employee told to eliminate all exposure do so by using forward contracts and currency options or by borrowing in the local currency? And if hedging is not possible in a particular currency, should sales in that currency be forgone even if it means losing potential profits? The latter policy is likely to present a manager with the dilemma of choosing between the goals of increased profits and reduced exchange losses. Moreover, reducing translation exposure could increase transaction exposure and vice versa. What trade-offs, if any, should a manager be willing to make between these two types of exposure?

These and similar questions demonstrate the need for a coherent and effective strategy. The following elements are suggested for an effective exposure management strategy:2

1. Determine the types of exposure to be monitored.

2. Formulate corporate objectives and give guidance in resolving potential conflicts in objectives.

3. Ensure that these corporate objectives are consistent with maximizing shareholder value and can be implemented.

4. Clearly specify who is responsible for which exposures, and detail the criteria by which each manager is to be judged.

5. Make explicit any constraints on the use of exposure-management techniques, such as limitations on entering into forward contracts.

6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firm's exchange risk posture.

7. Develop a system for monitoring and evaluating exchange risk management activities.

Objectives

The usefulness of a particular hedging strategy depends on both acceptability and quality. Acceptability refers to approval by those in the organization who will implement the strategy, and quality refers to the ability to provide better decisions. To be acceptable, a hedging strategy must be consistent with top management's values and overall corporate objectives. In turn, these values and objectives are strongly motivated by management's beliefs about financial markets and how its performance will be evaluated. The quality, or value to the shareholders, of a particular hedging strategy is, therefore, related to the congruence between those perceptions and the realities of the business environment.

The most frequently occurring objectives, explicit and implicit, in management behavior include the following:3

1. Minimize translation exposure. This common goal necessitates a complete focus on protecting foreign-currency-denominated assets and liabilities from changes in value resulting from exchange rate fluctuations. Given that translation and transaction exposures are not synonymous, reducing the former could cause an increase in the latter (and vice versa).

2. Minimize quarter-to-quarter (or year-to-year) earnings fluctuations owing to exchange rate changes. This goal requires a firm to consider both its translation exposure and its transaction exposure.

3. Minimize transaction exposure. This objective involves managing a subset of the firm's true cash-flow exposure.

4. Minimize economic exposure. To achieve this goal, a firm must ignore accounting earnings and concentrate on reducing cash-flow fluctuations stemming from currency fluctuations.

5. Minimize foreign exchange risk management costs. This goal requires a firm to balance off the benefits of hedging with its costs. It also assumes risk neutrality.

6. Avoid surprises. This objective involves preventing large foreign exchange losses.

The most appropriate way to rank these objectives is on their consistency with the overarching goal of maximizing shareholder value. To establish what hedging can do to further this goal, we return to our discussion of total risk in Chapter 1. In that discussion, we saw that total risk tends to adversely affect a firm's value by leading to lower sales and higher costs. Consequently, actions taken by a firm that decrease its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows.

Reducing total risk can also ensure that a firm will not run out of cash to fund its planned investment program. Otherwise, potentially profitable investment opportunities may be passed up because of corporate reluctance to tap the financial markets when internally generated cash is insufficient.4

This and other explanations for hedging all relate to the idea that there is likely to be an inverse relation between total risk and shareholder value.5 Given these considerations, the view taken here is that the basic purpose of hedging is to reduce exchange risk, where exchange risk is defined as that element of cash-flow variability attributable to currency fluctuations. This is Objective 4.

To the extent that earnings fluctuations or large losses can adversely affect the company's perceptions in the minds of potential investors, customers, employees, and so on, there may be reason to also pay attention to Objectives 2 and 6.6 However, despite these potential benefits, there are likely to be few, if any, advantages to devoting substantial resources to managing earnings fluctuations or accounting exposure more generally (Objectives 1 and 3). To begin, trying to manage accounting exposure is inconsistent with a large body of empirical evidence that investors have the uncanny ability to peer beyond the ephemeral and concentrate on the firm's true cash-flow-generating ability. In addition, whereas balance sheet gains and losses can be dampened by hedging, operating earnings will also fluctuate in line with the combined and offsetting effects of currency changes and inflation. Moreover, hedging costs themselves will vary unpredictably from one period to the next, leading to unpredictable earnings changes. Thus, it is impossible for firms to protect themselves from earnings fluctuations resulting from exchange rate changes except in the very short run.

Given the questionable benefits of managing accounting exposure, the emphasis in this text is on managing economic exposure. However, this chapter describes the techniques used to manage transaction and translation exposure because many of these techniques are equally applicable to hedging cash flows.

In operational terms, hedging to reduce the variance of cash flows translates into the following exposure management goal: to arrange a firm's financial affairs in such a way that however the exchange rate may move in the future, the effects on dollar returns are minimized. This objective is not universally subscribed to, however. Instead, many firms follow a selective hedging policy designed to protect against anticipated currency movements. A selective hedging policy is especially prevalent among those firms that organize their treasury departments as profit centers. In such firms, the desire to reduce the expected costs of hedging (Objective 5)—and thereby increase profits—often leads to taking higher risks by hedging only when a currency change is expected and going unhedged otherwise.

If financial markets are efficient, however, firms cannot hedge against expected exchange rate changes. Interest rates, forward rates, and sales-contract prices should already reflect currency changes that are anticipated, thereby offsetting the loss-reducing benefits of hedging with higher costs. In the case of Mexico, for instance, the one-year forward discount in the futures market was close to 100% just before the peso was floated in 1982. The unavoidable conclusion is that a firm can protect itself only against unexpected currency changes.

Moreover, there is always the possibility of bad timing. For example, big Japanese exporters such as Toyota and Honda have incurred billions of dollars in foreign exchange losses. One reason for these losses is that Japanese companies often try to predict where the dollar is going and hedge (or not hedge) accordingly. At the beginning of 1994, many thought that the dollar would continue to strengthen, and thus they failed to hedge their exposure. When the dollar plummeted instead, they lost billions. The lesson is that firms that try simultaneously to use hedging both to reduce risk and to beat the market may end up with more risk, not less.

Application Malaysia Gets Mauled by the Currency Markets

In January 1994, Bank Negara, Malaysias central bank, declared war on “currency speculators” who were trying to profit from an anticipated rise in the Malaysian dollar. The timing of this declaration struck a nerve among currency traders because Bank Negara had itself long been a major speculator in the currency markets—a speculator whose boldness was matched only by its incompetence. During the two-year period from 1992 to 1993, Bank Negara had foreign exchange losses of M$14.7 billion (US$5.42 billion). It seems that even central banks are not immune to the consequences of market efficiency—and stupidity.

1 Dow Chemical stated in its 2007 Form 10-K (p. 54) that “The primary objective of the Company's foreign exchange risk management is to optimize the U.S. dollar value of net assets and cash flows, keeping the adverse impact of currency movements to a minimum.” Although a laudable objective, it is difficult to determine what specific actions a manager should take to accomplish it.

2 Most of these elements are suggested in Thomas G. Evans and William R. Folks, Jr., “Defining Objectives for Exposure Management,” Business International Money Report, February 2, 1979, pp. 37-39.

3 See, for example, David B. Zenoff, “Applying Management Principles to Foreign Exchange Exposure,” Euromoney, September 1978, pp. 123-130.

4 This explanation appears in Kenneth Froot, David Scharfstein, and Jeremy Stein, “A Framework for Risk Management,” Harvard Business Review, November 1994, pp. 91-102. The reluctance to raise additional external capital may stem from the problem of information asymmetry—this problem arises when one party to a transaction knows something relevant to the transaction that the other party does not know—which could lead investors to impose higher costs on the company seeking capital.

5 For a good summary of these other rationales for corporate hedging, see Matthew Bishop, “A Survey of Corporate Risk Management,” The Economist, February 10, 1996, special section.

6 Fluctuating earnings could also boost a company's taxes by causing it to alternate between high and low tax brackets (see Rene Stulz, “Rethinking Risk Management,” working paper, Ohio State University).

Costs and Benefits of Standard Hedging Techniques

Standard techniques for responding to anticipated currency changes are summarized in Exhibit 10.3. Such techniques, however, are vastly overrated in terms of their ability to minimize hedging costs.

Costs of Hedging.

If a devaluation is unlikely, hedging may be a costly and inefficient way of doing business. If a devaluation is expected, the cost of using the techniques (like the cost of local borrowing) rises to reflect the anticipated devaluation. Just before the August 1982 peso devaluation, for example, every company in Mexico was trying to delay peso payments. Of course, this technique cannot produce a net gain because one company's payable is another company's receivable. As another example, if one company wants peso trade credit, another must offer it. Assuming that both the borrower and the lender are rational, a deal will not be struck until the interest cost rises to reflect the expected decline in the peso.

Even shifting funds from one country to another is not a costless means of hedging. The net effect of speeding up remittances while delaying receipt of intercompany receivables is to force a subsidiary in a devaluation-prone country to increase its local currency borrowings to finance the additional working capital requirements. The net cost of shifting funds, therefore, is the cost of the LC loan minus the profit generated from use of the funds—for example, prepaying a hard currency loan—with both adjusted for expected exchange rate changes. As mentioned previously, loans in local currencies subject to devaluation fears carry higher interest rates that are likely to offset any gains from LC devaluation.

Exhibit 10.3 Basic Hedging Techniques

Reducing the level of cash holdings to lower exposure can adversely affect a subsidiary's operations, whereas selling LC-denominated marketable securities can entail an opportunity cost (the lower interest rate on hard currency securities). A firm with excess cash or marketable securities should reduce its holdings regardless of whether a devaluation is anticipated. After cash balances are at the minimum level, however, any further reductions will involve real costs that must be weighed against the expected benefits.

Invoicing exports in the foreign currency and imports in the local currency may cause the loss of valuable sales or may reduce a firm's ability to extract concessions on import prices. Similarly, tightening credit may reduce profits more than costs.

In summary, hedging exchange risk costs money and should be scrutinized like any other purchase of insurance. The costs of these hedging techniques are summarized in Exhibit 10.4.

Benefits of Hedging.

A company can benefit from the preceding techniques only to the extent that it can forecast future exchange rates more accurately than the general market. For example, if the company has a foreign currency cash inflow, it would hedge only if the forward rate exceeds its estimate of the future spot rate. Conversely, with a foreign currency cash outflow, it would hedge only if the forward rate was below its estimated future spot rate. In this way, it would apparently be following the profit-guaranteeing dictum of buy low-sell high. The key word, however, is apparently because attempting to profit from foreign exchange forecasting is speculating rather than hedging. The hedger is well advised to assume that the market knows as much as she does. Those who feel that they have superior information may choose to speculate, but this activity should not be confused with hedging.

Exhibit 10.4 Cost of the Basic Hedging Techniques

Application Selective Hedging

In March, Multinational Industries, Inc. (MII) assessed the September spot rate for sterling at the following rates:

$1.80/£ with probability 0.15

$1.85/£ with probability 0.20

$1.90/£ with probability 0.25

$1.95/£ with probability 0.20

$2.00/£ with probability 0.20

a. What is the expected spot rate for September?

Solution. The expected future spot rate is 1.80(0.15) + 1.85(0.2) + 1.90(0.25) + 1.95(0.20) + 2.00(0.20) = $1.905.

b. If the six-month forward rate is $1.90, should the firm sell forward its £500,000 pound receivables due in September?

Solution. If MII sells its pound proceeds forward, it will lock in a value of $950,000 (1.90 × 500,000). Alternatively, if it decides to wait until September and sell its pound proceeds in the spot market, it expects to receive $952,500 (1.905 × 500,000). Based on these figures, if MII wants to maximize expected profits, it should retain its pound receivables and sell the proceeds in the spot market upon receipt.

c. What factors are likely to affect Multinational Industries’ hedging decision?

Solution. Risk aversion could lead MII to sell its receivables forward to hedge their dollar value. However, if MII has pound liabilities, they could provide a natural hedge and reduce (or eliminate) the amount necessary to hedge. The existence of a cheaper hedging alternative, such as borrowing pounds and converting them to dollars for the duration of the receivables, would also make undesirable the use of a forward contract. This latter situation assumes that interest rate parity is violated. The tax treatment of foreign exchange gains and losses on forward contracts could also affect the hedging decision.

Under some circumstances, a company may benefit at the expense of the local government without speculating. Such a circumstance would involve the judicious use of market imperfections or existing tax asymmetries, or both. In the case of an overvalued currency, such as the Mexican peso in 1982, if exchange controls are not imposed to prevent capital outflows and if hard currency can be acquired at the official exchange rate, then money can be moved out of the country via intercompany payments. For instance, a subsidiary can speed payments of intercompany accounts payable, make immediate purchases from other subsidiaries, or speed remittances to the parent. Unfortunately, governments are not unaware of these tactics. During a currency crisis, when hard currency is scarce, the local government can be expected to block such transfers or at least make them more expensive.

Another often-cited reason for market imperfection is that individual investors may not have equal access to capital markets. For example, because forward exchange markets exist only for the major currencies, hedging often requires local borrowing in heavily regulated capital markets. As a legal citizen of many nations, the MNC normally has greater access to these markets.

Similarly, if forward contract losses are treated as a cost of doing business, whereas gains are taxed at a lower capital gains rate, the firm can engage in tax arbitrage. In the absence of financial market imperfections or tax asymmetries, however, the net expected value of hedging over time should be zero. Despite the questionable value to shareholders of hedging balance sheet exposure or even transaction exposure, however, managers often try to reduce these exposures because they are evaluated, at least in part, on translation or transaction gains or losses.

In one area, at least, companies can reduce their exchange risk at no cost. This costless hedging technique is known as exposure netting.

Exposure Netting.

Exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in a way such that losses (gains) on the first exposed position will be offset by gains (losses) on the second currency exposure. This portfolio approach to hedging recognizes that the total variability or risk of a currency exposure portfolio will be less than the sum of the individual variabilities of each currency exposure considered in isolation. The assumption underlying exposure netting is that the net gain or loss on the entire currency exposure portfolio is what matters, rather than the gain or loss on any individual monetary unit.

Centralization versus Decentralization

In the area of foreign exchange risk management, there are good arguments both for and against centralization. Favoring centralization is the reasonable assumption that local treasurers want to optimize their own financial and exposure positions, regardless of the overall corporate situation. An example is a multibillion-dollar U.S. consumer-goods firm that gives its affiliates a free hand in deciding on their hedging policies. The firm's local treasurers ignore the possibilities available to the corporation to trade off positive and negative currency exposure positions by consolidating exposure worldwide. If subsidiary A sells to subsidiary B in sterling, then from the corporate perspective, these sterling exposures net out on a consolidated translation basis (but only before tax). If A or B or both hedge their sterling positions, however, unnecessary hedging takes place, or a zero sterling exposure turns into a positive or negative position. Furthermore, in their dealings with external customers, some affiliates may wind up with a positive exposure and others with a negative exposure in the same currency. Through lack of knowledge or incentive, individual subsidiaries may undertake hedging actions that increase rather than decrease overall corporate exposure in a given currency.

A further benefit of centralized exposure management is the ability to take advantage, through exposure netting, of the portfolio effect discussed previously. Thus, centralization of exchange risk management should reduce the amount of hedging required to achieve a given level of safety.

After the company has decided on the maximum currency exposure it is willing to tolerate, it can then select the cheapest option(s) worldwide to hedge its remaining exposure. Tax effects can be crucial at this stage, in computing both the amounts to hedge and the costs involved, but only headquarters will have the required global perspective. Centralized management also is needed to take advantage of the before-tax hedging cost variations that are likely to exist among subsidiaries because of market imperfections.

All these arguments for centralization of currency risk management are powerful. Against the benefits must be weighed the loss of local knowledge and the lack of incentive for local managers to take advantage of particular situations that only they may be familiar with. Companies that decentralize the hedging decision may allow local units to manage their own exposures by engaging in forward contracts with a central unit at negotiated rates. The central unit, in turn, may or may not lay off these contracts in the marketplace.

Managing Risk Management

A number of highly publicized cases of derivatives-related losses have highlighted the potential dangers in the use of derivatives such as futures and options. Although not all these losses involved the use of currency derivatives, several lessons for risk management can be drawn from these cases, which include the bankruptcies of Orange County and Barings PLC and the huge losses taken at AIG, Merrill Lynch, Kidder Peabody, Sumitomo, Daiwa, Allied Irish Banks, Union Bank of Switzerland, and Citic Pacific. The most important lesson to be learned is that risk management failures have their origins in inadequate systems and controls rather than from any risk inherent in the use of derivatives themselves.7 In every case of large losses, senior management did not fully understand the activities of those taking positions in derivatives and failed to monitor and supervise their activities adequately. Some specific lessons learned include the following.

First, segregate the duties of those trading derivatives from those supposed to monitor them. For example, Nicholas Leeson, the rogue trader who sank Barings, was in charge of trading and also kept his own books. When he took losses, he covered them up and doubled his bets. Similarly, the manager responsible for the profits generated by trading derivatives at UBS also oversaw the risks of his position. No one else at the bank was allowed to examine the risks his department was taking. And a rogue trader at Sumitomo, who lost $1.8 billion, oversaw the accounts that kept track of his dealings. These conflicts of interest are a recipe for disaster.

Second, derivatives positions should be limited to prevent the possibility of catastrophic losses, and they should be marked to market every day to avoid the possibility of losses going unrecognized and being allowed to accumulate. As in the cases of Barings and Sumitomo, traders who can roll over their positions at nonmarket prices tend to make bigger and riskier bets to recoup their losses.

Third, compensation arrangements should be designed to shift more of the risk onto the shoulders of those taking the risks. For example, deferring part of traders’ salaries until their derivatives positions actually pay off would make them more cognizant of the risks they are taking. Fourth, one should pay attention to warning signs. For example, Barings was slow to respond to an audit showing significant discrepancies in Leeson's accounts. Similarly, Kidder Peabody's executives ignored a trader who was generating record profits while supposedly engaging in risk-free arbitrage. A related lesson is that there's no free lunch. Traders and others delivering high profits deserve special scrutiny by independent auditors. The auditors must pay particular attention to the valuation of exotic derivatives—specialized contracts not actively traded. Given the lack of ready market prices for exotics, it is easy for traders to overvalue their positions in exotics without independent oversight. Finally, those who value reward above risk will likely wind up with risk at the expense of reward.

Application The Luck of the Irish Eludes Allied Irish Banks

In February 2002, Allied Irish Banks announced that a rogue trader at its U.S. unit lost $750 million through unauthorized foreign exchange trades. Allied said John Rusnak, a foreign exchange dealer at its U.S. unit Allfirst tried to disguise huge losses through fictitious foreign exchange trades over the past year. Traders in the foreign exchange market believe that Rusnak bet on the wrong direction of the Japanese yen, which was the only currency that moved enough during that period to have enabled a trader to pile up such colossal losses. The foreign exchange trades at issue were believed by the bank to have been hedged with currency options to reduce their risk. As it turned out, however, the options that Rusnak claimed to have bought were fictitious, leaving the bank with enormous “naked” (unhedged) foreign exchange positions. As his losses piled up, he placed even larger foreign currency bets, which turned sour as well. Bank analysts said the episode raised serious issues about the risk management controls in place at Allied and throughout the entire banking industry that are supposed to prevent the kinds of events that apparently hit Allied.

7 According to Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia, some bank managers have little knowledge of controls on their trading activities. For example, when he visited a major financial institution in New York, the CEO assured him that the bank had a highly sophisticated risk-management system already in place, the CFO said they had just implemented it, the head of trading said they were about to implement it, and the traders had never heard of it. See Anthony M. Santomero, “Processes and Progress in Risk Management,” Business Review, Federal Reserve Bank of Philadelphia, Q1 2003, p. 3.

Accounting for Hedging and FASB 133

Companies have a greater incentive for systematizing their hedging practices since FASB issued its Statement of Financial Accounting Standards No. 133 (FASB 133) to establish accounting and reporting standards for derivative instruments and for hedging activities. Under FASB 133, a foreign currency derivative that qualifies as a foreign currency hedge gets special hedge accounting treatment that essentially matches gains or losses resulting from the changes in the value of the derivative with losses or gains in the value of the underlying transaction or asset, thereby removing these hedging gains and losses from current income. However, any change in the value of the derivative not offset by a change in the value of the hedged item is recorded to earnings in the current period. Foreign currency hedges include hedges of net investments in foreign operations, of forecasted foreign currency transactions, and of foreign-currency-denominated assets or liabilities.

Under FASB, an entity that elects to apply hedge accounting is required to formally document each hedging transaction from the outset, explain its risk management objective and strategy for undertaking the hedge and the nature of the risk being hedged, and establish the method it will use for assessing the effectiveness of the hedging derivative and its measurement approach for determining the ineffective aspect of the hedge.

Three points are worth noting.

Hedge designations are critical. Each hedging relationship should fit into the company's risk management objectives and strategy, which must be documented.

Hedging must be effective. To qualify for hedge accounting, an entity must demonstrate a hedging relationship to be highly effective in achieving offsetting changes in fair value or cash flows for the risk being hedged. “Highly effective” has been interpreted to mean a correlation ratio between 80% to 125% (this is the change in value of the derivative divided by the change in value of the hedged item).

Hedge ineffectiveness can lead to earnings volatility. A foreign currency derivative that cannot be shown to be effective in hedging a specific foreign currency risk must be marked to market and any gain or loss on it included in current earnings, making reported earnings more volatile.

10.5 Managing Translation Exposure

Firms have three available methods for managing their translation exposure: (1) adjusting fund flows, (2) entering into forward contracts, and (3) exposure netting. The basic hedging strategy for reducing translation exposure shown in Exhibit 10.5 uses these methods. Essentially, the strategy involves increasing hard currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets, while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities. For example, if a devaluation appears likely, the basic hedging strategy will be executed as follows: Reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward. An expected currency appreciation would trigger the opposite tactics.

Despite their prevalence among firms, these hedging activities are not automatically valuable. As discussed in the previous section, if the market already recognizes the likelihood of currency appreciation or depreciation, this recognition will be reflected in the costs of the various hedging techniques. Only if the firm's anticipations differ from the markets and are also superior to the markets can hedging lead to reduced costs. Otherwise, the principal value of hedging would be to protect a firm from unforeseen currency fluctuations.

Funds Adjustment

Most techniques for hedging an impending LC devaluation reduce LC assets or increase LC liabilities, thereby generating LC cash. If accounting exposure is to be reduced, these funds must be converted into hard currency assets. For example, a company will reduce its translation loss if, before an LC devaluation, it converts some of its LC cash holdings to the home currency. This conversion can be accomplished, either directly or indirectly, by means of funds adjustment techniques.

Exhibit 10.5 Basic Strategy for Hedging Translation Exposure

Funds adjustment involves altering either the amounts or the currencies (or both) of the planned cash flows of the parent or its subsidiaries to reduce the firm's local currency accounting exposure. If an LC devaluation is anticipated, direct funds adjustment methods include pricing exports in hard currencies and imports in the local currency, investing in hard currency securities, and replacing hard currency borrowings with local currency loans. The indirect methods, which are elaborated upon in Chapter 20, include adjusting transfer prices on the sale of goods between affiliates; speeding up the payment of dividends, fees, and royalties; and adjusting the leads and lags of intersubsidiary accounts. The last method, which is the one most frequently used by multinationals, involves speeding up the payment of intersubsidiary accounts payable and delaying the collection of intersubsidiary accounts receivable. These hedging procedures for devaluations would be reversed for revaluations (see Exhibit 10.3, p. 366).

Some of these techniques or tools may require considerable lead time, and—as is the case with a transfer price—once they are introduced, they cannot easily be changed. In addition, techniques such as transfer price, fee and royalty, and dividend flow adjustments fall into the realm of corporate policy and are not usually under the treasurer's control, although this situation may be changing. It is, therefore, incumbent on the treasurer to educate other decision makers about the impact of these tools on the costs and management of corporate exposure.

Although entering forward contracts is the most popular coverage technique, the leading and lagging of payables and receivables is almost as important. For those countries in which a formal market in LC forward contracts does not exist, leading and lagging and LC borrowing are the most important techniques. The bulk of international business, however, is conducted in those few currencies for which forward markets do exist.

Forward contracts can reduce a firm's translation exposure by creating an offsetting asset or liability in the foreign currency. For example, suppose that IBM U.K. has translation exposure of £40 million (i.e., sterling assets exceed sterling liabilities by that amount). IBM U.K. can eliminate its entire translation exposure by selling £40 million forward. Any loss (gain) on its translation exposure will then be offset by a corresponding gain (loss) on its forward contract. Note, however, that the gain (or loss) on the forward contract is of a cash-flow nature and is netted against an unrealized translation loss (or gain).

Selecting convenient (less risky) currencies for invoicing exports and imports and adjusting transfer prices are two techniques that are less frequently used, perhaps because of constraints on their use. It is often difficult, for instance, to make a customer or supplier accept billing in a particular currency.

Exposure netting is an additional exchange-management technique that is available to multinational firms with positions in more than one foreign currency or with offsetting positions in the same currency. As defined earlier, this technique involves offsetting exposures in one currency with exposures in the same or another currency such that gains and losses on the two currency positions will offset each other.

Evaluating Alternative Hedging Mechanisms

Ordinarily, the selection of a funds adjustment strategy cannot proceed by evaluating each possible technique separately without risking suboptimization; for example, whether a firm chooses to borrow locally is not independent of its decision to use or not use those funds to import additional hard currency inventory. However, when the level of forward contracts that the financial manager can enter into is unrestricted, the following two-stage methodology allows the optimal level of forward transactions to be determined apart from the selection of what funds adjustment techniques to use.8 Moreover, this methodology is valid regardless of the manager's (or firm's) attitude toward risk.

Stage 1: Compute the profit associated with each funds adjustment technique on a covered after-tax basis. Transactions that are profitable on a covered basis ought to be undertaken regardless of whether they increase or decrease the firm's accounting exposure. However, such activities should not be termed hedging; rather, they involve the use of arbitrage to exploit market distortions.

Stage 2: Any unwanted exposure resulting from the first stage can be corrected in the forward market. Stage 2 is the selection of an optimal level of forward transactions based on the firm's initial exposure, adjusted for the impact on exposure of decisions made in Stage 1. When the forward market is nonexistent, or when access to it is limited, the firm must determine both the techniques to use and their appropriate levels. In the latter case, a comparison of the net cost of a funds adjustment technique with the anticipated currency depreciation will indicate whether the hedging transaction is profitable on an expected-value basis.

8 This methodology is presented in William R. Folks, Jr., “Decision Analysis for Exchange Risk Management,” Financial Management, Winter 1972, pp. 101-112.

10.6 Managing Transaction Exposure

As we saw in Section 10.1, transaction exposure arises whenever a company is committed to a foreign-currency-denominated transaction. Since the transaction will result in a future foreign currency cash inflow or outflow, any change in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change in the dollar (HC) amount of the cash inflow or outflow. Protective measures to guard against transaction exposure involve entering into foreign currency transactions whose cash flows exactly offset the cash flows of the transaction exposure.

These protective measures include using forward contracts, price adjustment clauses, currency options, and borrowing or lending in the foreign currency. For example, General Electric explained its hedging activities in its 2007 Annual Report (p. 52) as follows:

Financial results of our global activities reported in U.S. dollars are affected by currency exchange. We use a number of techniques to manage the effects of currency exchange, including selective borrowings in local currencies and selective hedging of significant cross-currency transactions. Such principal currencies are the pound sterling, the euro, the Japanese yen and the Canadian dollar.

Alternatively, the company could try to invoice all transactions in dollars and to avoid transaction exposure entirely. However, eliminating transaction exposure does not eliminate all foreign exchange risk. The firm still is subject to exchange risk on its future revenues and costs—its operating cash flows. In its 2007 Annual Report (p. 49), IBM explained that its hedging program may not completely eliminate all the risks:

The company earned approximately 47 percent of its pre-tax income from continuing operations in currencies other than the U.S. dollar. The company also maintains hedging programs to limit the volatility of currency impacts on the company's financial results. These hedging programs limit the impact of currency changes on the company's financial results but do not eliminate them. In addition to the translation of earnings and the company's hedging programs, the impact of currency changes also will affect the company's pricing and sourcing actions. For example, the company may procure components and supplies in multiple functional currencies and sell products and services in other currencies. Therefore, it is impractical to quantify the impact of currency on these transactions and on consolidated Net income.

We will now look at the various techniques for managing transaction exposure by examining the case of General Electric's euro exposure. Suppose that on January 1, GE is awarded a contract to supply turbine blades to Lufthansa, the German airline. On December 31, GE will receive payment of €10 million for these blades. The most direct way for GE to hedge this receivable is to sell a €10 million forward contract for delivery in one year. Alternatively, it can use a money market hedge, which would involve borrowing €10 million for one year, converting it into dollars, and investing the proceeds in a security that matures on December 31. As we will see, if interest rate parity holds, the two methods will yield the same results. GE can also manage its transaction exposure through risk shifting, risk sharing, exposure netting, and currency options.

Forward Market Hedge

In a forward market hedge, a company that is long a foreign currency will sell the foreign currency forward, whereas a company that is short a foreign currency will buy the currency forward. In this way, the company can fix the dollar value of future foreign currency cash flow. For example, by selling forward the proceeds from its sale of turbine blades, GE can effectively transform the currency denomination of its €10 million receivable from euros to dollars, thereby eliminating all currency risk on the sale. For example, suppose the current spot price for the euro is $1.500/€, and the one-year forward rate is $1.479/€. Then, a forward sale of €10 million for delivery in one year will yield GE $14.79 million on December 31. Exhibit 10.6 shows the cash-flow consequences of combining the forward sale with the euro receivable, given three possible exchange rate scenarios.

Regardless of what happens to the future spot rate, Exhibit 10.6 demonstrates that GE still gets to collect $14.79 million on its turbine sale. Any exchange gain or loss on the forward contract will be offset by a corresponding exchange loss or gain on the receivable. The effects of this transaction also can be seen with the following simple T-account describing GE's position as of December 31:

Exhibit 10.6 Possible Outcomes of Forward Market Hedge as of December 31

December 31: GE T-Account (Millions)

Account receivable

€10.00

Forward contract payment

€10.00

Forward contract receipt

$14.79

Without hedging, GE will have a €10 million asset whose value will fluctuate with the exchange rate. The forward contract creates an equal euro liability, offset by an asset worth $14.79 million dollars. The euro asset and liability cancel each other out, and GE is left with a $14.79 million asset.

This example illustrates another point as well: Hedging with forward contracts eliminates the downside risk at the expense of forgoing the upside potential.

The True Cost of Hedging.

Exhibit 10.6 also shows that the true cost of hedging cannot be calculated in advance because it depends on the future spot rate, which is unknown at the time the forward contract is entered into. In the GE example, the actual cost of hedging can vary from +$210,000 to −$790,000; a plus (+) represents a cost, and a minus (—) represents a negative cost or a gain. In percentage terms, the cost varies from −5.3% to +1.4%.

This example points out the distinction between the traditional method of calculating the cost of a forward contract and the correct method, which measures its opportunity cost. Specifically, the cost of a forward contract is usually measured as its forward discount or premium:

where e0 is the current spot rate (dollar price) of the foreign currency and f1 is the forward rate. In GE's case, this cost would equal 1.4%.

However, this approach is wrong because the relevant comparison must be between the dollars per unit of foreign currency received with hedging, f1, and the dollars received in the absence of hedging, e1, where e1 is the future (unknown) spot rate on the date of settlement. That is, the real cost of hedging is an opportunity cost. In particular, if the forward contract had not been entered into, the future value of each unit of foreign currency would have been e1 dollars. Thus, the true dollar cost of the forward contract per dollar's worth of foreign currency sold forward equals

The expected cost (value) of a forward contract depends on whether a risk premium or other source of bias exists. Absent such bias, the expected cost of hedging via a forward contract will be zero. Otherwise, there would be an arbitrage opportunity. Suppose, for example, that management at General Electric believes that despite a one-year forward rate of $1.479, the euro will actually be worth about $1.491 on December 31. Then GE could profit by buying (rather than selling) euros forward for one year at $1.479 and, on December 31, completing the contract by selling euros in the spot market at $1.491. If GE is correct, it will earn $0.012 (1.491 − 1.479) per euro sold forward. On a €10 million forward contract, this profit would amount to $120,000—a substantial reward for a few minutes of work.

The prospect of such rewards would not go unrecognized for long, which explains why, on average, the forward rate appears to be unbiased. Therefore, unless GE or any other company has some special information about the future spot rate that it has good reason to believe is not adequately reflected in the forward rate, it should accept the forward rate's predictive validity as a working hypothesis and avoid speculative activities. After the fact, of course, the actual cost of a forward contract will turn out to be positive or negative (unless the future spot rate equals the forward rate), but the sign cannot be predicted in advance.

On the other hand, the evidence presented in Chapter 4 points to the possibility of bias in the forward rate at any point in time. The nature of this apparent bias suggests that the selective use of forward contracts in hedging may reduce expected hedging costs, but beware of the peso problem—the possibility that historical returns may be unrepresentative of future returns. The specific cost-minimizing selective hedging policy to take advantage of this bias would depend on whether you are trying to hedge a long or a short position in a currency. The policy is as follows:

• If you are long a currency, hedge (by selling forward) if the currency is at a forward premium; if the currency is at a forward discount, do not hedge.

• If you are short a currency, hedge (by buying forward) if the currency is selling at a forward discount; if the currency is at a forward premium, do not hedge.

As discussed in Section 10.4, however, this selective hedging policy does not come free; it may reduce expected costs but at the expense of higher risk. Absent other considerations, therefore, the impact on shareholder wealth of selective hedging via forward contracts should be minimal, with any expected gains likely to be offset by higher risk.

Money Market Hedge

An alternative to a forward market hedge is to use a money market hedge. A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow. For example, suppose euro and U.S. dollar interest rates are 7% and 5.5%, respectively. Using a money market hedge, General Electric will borrow €(10/1.07) million = €9.35 million for one year, convert it into $14.02 million in the spot market, and invest the $14.02 million for one year at 5.5%. On December 31, GE will receive 1.055 X $14.02 million = $14.79 million from its dollar investment. GE will then use the proceeds of its euro receivable, collectible on that date, to repay the 1.07 X €9.35 million = €10 million it owes in principal and interest. As Exhibit 10.7 shows, the exchange gain or loss on the borrowing and lending transactions exactly offsets the dollar loss or gain on GE's euro receivable.

The gain or loss on the money market hedge can be calculated simply by subtracting the cost of repaying the euro debt from the dollar value of the investment. For example, in the case of an end-of-year spot rate of $1.50, the €10 million in principal and interest will cost $15 million to repay. The return on the dollar investment is only $14.79 million, leaving a loss on the money market hedge of $210,000.

We can also view the effects of this transaction with the simple T-account used earlier:

December 31: GE T-Account (Millions)

Account receivable

€10.00

Loan repayment (including interest)

€10.00

Investment return (including interest)

$14.79

As with the forward contract, the euro asset and liability (the loan repayment) cancel each other out, and GE is left with a $14.79 million asset (its investment).

The equality of the net cash flows from the forward market and money market hedges is not coincidental. The interest rates and forward and spot rates were selected so that interest rate parity would hold. In effect, the simultaneous borrowing and lending transactions associated with a money market hedge enable GE to create a “homemade” forward contract. The effective rate on this forward contract will equal the actual forward rate if interest rate parity holds. Otherwise, a covered interest arbitrage opportunity would exist.

In reality, there are transaction costs associated with hedging: the bid-ask spread on the forward contract and the difference between borrowing and lending rates. These transaction costs must be factored in when comparing a forward contract hedge with a money market hedge. The key to making these comparisons, as shown in Chapter 7, is to ensure that the correct bid and ask and borrowing and lending rates are used.

Exhibit 10.7 Possible Outcomes of Money Market Hedge as of December 31

Application Comparing Hedging Alternatives When There Are Transaction Costs

PespsiCo would like to hedge its C$40 million payable to Alcan, a Canadian aluminum producer, which is due in 90 days. Suppose it faces the following exchange and interest rates:

Spot rate:

$0.9422-31/C$

Forward rate (90 days):

$0.9440-61/C$

Canadian dollar 90-day interest rate (annualized):

4.71%—4.64%

U.S. dollar 90-day interest rate (annualized):

5.50%-5.35%

Which hedging alternative would you recommend? Note that the first interest rate is the borrowing rate and the second one is the lending rate.

Solution. The hedged cost of the payable using the forward market is U.S. $37,844,000 (0.9461 × 40,000,000), remembermg that PepsiCo must buy forward Canadian dollars at the ask rate. Alternatively, PepsiCo could use a money market hedge. This hedge would entail the following steps:

1. Borrow U.S. dollars at 5.50% annualized for 90 days (the borrowing rate). The actual interest rate for 90 days will be 1.375% (5.50% X 90/360).

2. Convert the U.S. dollars into Canadian dollars at $0.9431 (the ask rate).

3. Invest the Canadian dollars for 90 days at 4.64% annualized for 90 days (the lending rate) and use the loan proceeds to pay Alcan. The actual interest rate for 90 days will be 1.16% (4.64% X 90/360).

Since PepsiCo needs C$40 million in 90 days and will earn interest equal to 1.16%, it must invest the present value of this sum or C$39,541,321 (40,000,000/1.0116). This sum is equivalent to U.S.$37,291,420 converted at the spot ask rate (39,541,321 × 0.9431). At a 90-day borrowing rate of 1.375%, PepsiCo must pay back principal plus interest in 90 days of U.S.$37,804,177 (37,291,420 × 1.01375). Thus, the hedged cost of the payable using the money market hedge is $37,804,177.

Comparing the two hedged costs, we see that by using the money market hedge instead of the forward market hedge, PepsiCo will save $39,823 (37,844,000 − 37,804,177). Other things being equal, therefore, this is the recommended hedge for PepsiCo.

Application Plantronics Hedges Its Exposure

Plantronics owes SKr 50 million, due in one year, for electrical equipment it recently bought from ABB Asea Brown Boveri. At the current spot rate of $0.1480/SKr, this payable is $7.4 million. It wishes to hedge this payable but is undecided how to do it. The one-year forward rate is currently $0.1436. Plantronics’ treasurer notes that the company has $10 million in a marketable U.S. dollar CD yielding 7% per annum. At the same time, SE Banken in Stockholm is offering a one-year time deposit rate of 10.5%.

a. What is the low-cost hedging alternative for Plantronics? What is the cost?

Solution. Plantronics can use the forward market to lock in a cost for its payable of $7.18 million. Alternatively, Plantronics can use a money market hedge to lock in a lower dollar cost of $7,165,611 for its payable. Thus, the money market hedge is the low-cost hedge. To compute this cost, note that Plantronics must invest SKr 45,248,869 today at 10.5% to have SKr 50 million in one year (45,248,869 × 0.105 = 50 million). This amount is equivalent to $6,696,833 at the current spot of SKr $0.1480/SKr. The opportunity cost to Plantronics of taking this amount from its CD today and converting it into SKr is $7,165,611, which is the future value of $6,696,833 invested at 7%.

b. Suppose interest rate parity held. What would the one-year forward rate be?

Solution. Interest rate parity holds when the dollar return on investing dollars equals the dollar return on investing SKr, or 1.07 = (1/0.1480) X 1.105 X f1, where f1 is the equilibrium one-year forward rate. The solution to this equation is f1 = $0.1433/SKr. Because the actual one-year forward rate exceeds this number, interest rate parity does not hold and a forward hedge is more expensive than a money market hedge.

Risk Shifting

To return to our previous example, General Electric can avoid its transaction exposure altogether if Lufthansa allows it to price the sale of turbine blades in dollars. Dollar invoicing, however, does not eliminate currency risk; it simply shifts that risk from GE to Lufthansa, which now has dollar exposure. Lufthansa may or may not be better able, or more willing, to bear it. Despite the fact that this form of risk shifting is a zero-sum game, it is common in international business. Firms typically attempt to invoice exports in strong currencies and imports in weak currencies.

Is it possible to gain from risk shifting? Not if one is dealing with informed customers or suppliers. To see why, consider the GE-Lufthansa deal. If Lufthansa is willing to be invoiced in dollars for the turbine blades, that must be because Lufthansa calculates that its euro equivalent cost will be no higher than the €10 million price it was originally prepared to pay. Since Lufthansa does not have to pay for the turbine blades until December 31, its cost will be based on the spot price of the dollars as of that date. By buying dollars forward at the one-year forward rate of $1.479/€, Lufthansa can convert a dollar price of P into a euro cost of P/1.479. Thus, the maximum dollar price PM that Lufthansa should be willing to pay for the turbine blades is the solution to

or

Considering that GE can guarantee itself $14.79 million by pricing in euros and selling the resulting €10 million forward, it will not accept a lower dollar price. The bottom line is that both Lufthansa and General Electric will be indifferent between a U.S. dollar price and a euro price only if the two prices are equal at the forward exchange rate. Therefore, because the euro price arrived at through arm's-length negotiations is €10 million, the dollar price that is equally acceptable to Lufthansa and GE can only be $14.79 million. Otherwise, one or both of the parties involved in the negotiations has ignored the possibility of currency changes. Such naiveté is unlikely to exist for long in the highly competitive world of international business.

Pricing Decisions

Notwithstanding the view just expressed, top management sometimes has failed to take anticipated exchange rate changes into account when making operating decisions, leaving financial management with the essentially impossible task, through purely financial operations, of recovering a loss already incurred at the time of the initial transaction. To illustrate this type of error, suppose that GE has priced Lufthansa's order of turbine blades at $15 million and then, because Lufthansa demands to be quoted a price in euro, converts the dollar price to a euro quote of €10 million, using the spot rate of $1.50/€.

In reality, the quote is worth only $14.79 million—even though it is booked at $15 million—because that is the risk-free price that GE can guarantee for itself by using the forward market. If GE management wanted to sell the blades for $15 million, it should have set a euro price equal to €15,000,000/1.479 = €10.14 million. Thus, GE lost $210,000 the moment it signed the contract (assuming that Lufthansa would have agreed to the higher price rather than turn to another supplier). This loss is not an exchange loss; it is a loss due to management inattentiveness.

The general rule on credit sales overseas is to convert between the foreign currency price and the dollar price by using the forward rate, not the spot rate. If the dollar price is high enough, the exporter should follow through with the sale. Similarly, if the dollar price on a foreign-currency-denominated import is low enough, the importer should follow through on the purchase. All this rule does is recognize that a euro (or any other foreign currency) tomorrow is not the same as a euro today. This rule is the international analogue to the insight that a dollar tomorrow is not the same as a dollar today. In the case of a sequence of payments to be received at several points in time, the foreign currency price should be a weighted average of the forward rates for delivery on those dates.

Application Weyerhaeuser Quotes a Euro Price for Its Lumber

Weyerhaeuser is asked to quote a price in euros for lumber sales to a French company. The lumber will be shipped and paid for in four equal quarterly installments. Weyerhaeuser requires a minimum price of $1 million to accept this contract. If PF is the euro price contracted for, then Weyerhaeuser will receive 0.25PF every three months, beginning 90 days from now. Suppose the spot and forward rates for the euro are as follows:

Spot

90-Day

180-Day

270-Day

360-Day

$1.4772

$1.4767

$1.4761

$1.4758

$1.4751

On the basis of these forward rates, the certainty-equivalent dollar value of this euro revenue is 0.25PF(1.4767 + 1.4761 + 1.4758 + 1.4751), or 0.25PF(5.9037) = $1.4759PF. In order for Weyerhaeuser to realize $1 million from this sale, the minimum euro price must be the solution to

or

At any lower euro price, Weyerhaeuser cannot be assured of receiving the $1 million it demands for this sale. Note that the spot rate did not enter into any of these calculations.

Exposure Netting

As defined in Section 10.4, exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, when exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. Although simple conceptually, implementation of exposure netting can be more involved. It is easy to see, for example, that a €1 million receivable and €1 million payable cancel each other out, with no net (before-tax) exposure. Dow Chemical explained this basic form of exposure netting in its 2007 Form 10-K (p. 81) when it stated that “Assets and liabilities denominated in the same foreign currency are netted, and only the net exposure is hedged.” It may be less obvious that such exposure netting can also be accomplished by using positions in different currencies. However, multinationals commonly engage in multicurrency exposure netting. In practice, exposure netting involves one of three possibilities:

1. A firm can offset a long position in a currency with a short position in that same currency.

2. If the exchange rate movements of two currencies are positively correlated (e.g., the Swiss franc and euro), then the firm can offset a long position in one currency with a short position in the other.