TYPES OF FOREIGN EXCHANGE RISK One problem we encounter when trying to evaluate the effect of

TYPES OF FOREIGN EXCHANGE RISK One problem we encounter when trying to evaluate the effect of

exchange rate changes on a business firm arises in determining the appro- priate concept of exposure to foreign exchange risk.

We can identify three principal concepts of exchange risk exposure:

1. Translation exposure. This is also known as accounting exposure. It is the difference between foreign-currency-denominated assets and foreign-currency-denominated liabilities.

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concerned with the sensitivity of the real domestic currency value of long-term cash flows to exchange rate changes. Economic exposure is the most important to the firm. Rather than

worry about how accountants will report the value of our international operations (translation exposure), it is far more important to the firm (and to rational investors) to focus on the purchasing power of long-run cash flows insofar as these determine the real value of the firm.

Let us consider an example of a hypothetical firm’s situation to illustrate the differences among the alternative exposure concepts. Suppose we have the balance sheet of XYZ-France, a foreign subsidiary of the parent U.S. firm XYZ, Inc. The balance sheet in Table 8.1 initially shows the position of XYZ-France in terms of euros. A balance sheet is simply a recording of the firm’s assets (listed on the left side) and liabilities (listed on the right side). A balance sheet must balance. In other words, the value of assets must equal the value of liabilities so that the sums of the two columns are equal. Equity is the owners’ claims on the firm and is a sort of residual value in that equity will change to keep liabilities equal to assets.

Although the balance sheet at the top of Table 8.1 is stated in terms of euros, the parent company, XYZ, Inc., consolidates the financial statements of all foreign subsidiaries into its own statements. Thus, the euro-denominated balance sheet items must be translated into dollars to

Table 8.1 Balance Sheet of XYZ-France, May 31 Cash

Debt h5,000,000 Accounts receivable

h1,000,000

Equity 6,000,000 Plant & equipment

h11,000,000 Dollar translation on May 31 $1 h1

Cash

Debt $5,000,000 Accounts receivable

Equity 6,000,000 Plant & equipment

Inventory

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be included in the parent company’s balance sheet. Translation is the pro- cess of expressing financial statements measured in one unit of currency in terms of another unit of currency.

Assume that initially the exchange rate equals h15$1. The balance sheet in the middle of Table 8.1 uses this exchange rate to translate the balance sheet items into dollars. Current U.S. accounting standards, introduced in 1981, require all foreign-denominated assets and liabilities to be translated at current exchange rates. In the United States, accounting standards are set by the Financial Accounting Standards Board (FASB). On December 7, 1981, the FASB issued Financial Accounting Standard No. 52, commonly referred to as FAS 52. FAS 52 essentially requires that balance sheet accounts be translated at the exchange rate prevailing at the date of the balance sheet. The issue in translation exposure is the sensitivity of the equity account of the balance sheet to exchange rate changes. The equity account equals assets minus liabilities and measures the accounting or book value of the firm. As the domestic currency value of the foreign-currency-denominated assets and liabilities of the foreign subsidiary changes, the domestic currency book value of the subsidiary will also change.

The top two balance sheets in Table 8.1 give us the euro and dollar position of the firm on May 31. However, suppose there is a devaluation of the euro on June 1 from $15h1 to $.905h1. The balance sheet in terms of dollars will change as illustrated by the new translation at the bottom of the table. Now the owners’ claim on the firm in terms of dollars, or in terms of the book value measured by equity, has fallen from $6 million to $5.4 million. Given the current method of translating exchange rate changes, when the currency used to denominate the for- eign subsidiaries’ statements is depreciating relative to the dollar, then the owners’ equity will fall. We must realize that this drop in equity does not necessarily represent any real loss to the firm or real drop in the value of the firm. The euro position of the firm is unchanged; only the dollar value to the U.S. parent is altered by the exchange rate change.

Since the balance sheet translation of foreign assets and liabilities does not by itself indicate anything about the real economic exposure of the

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before payment is received. Furthermore, suppose that at the time the contract was made, the exchange rate was 100 yen per euro (f100 5 h1). Suppose also that the contract called for payment in yen of exactly f100,000 in 30 days. At the current exchange rate the value of f100,000 is h1,000. But if the exchange rate changes in the next 30 days, the value of f100,000 would also change. Should the yen depreciate unexpectedly, then in 30 days XYZ-France will receive f100,000; however, this will be worth less than h1,000, so that the transaction is not as profitable as originally planned. This is transaction exposure. XYZ has committed itself to this future transaction, thereby exposing itself to exchange risk. Had the contract been written to specify payment in euros, then the transaction exposure to XYZ-France would have been eliminated; the Japanese importer would now have the transaction exposure. Firms can, of course, hedge against future exchange rate uncertainty in the forward- looking markets discussed in Chapter 4. The Japanese firm could buy yen in the forward market to be delivered in 30 days and thus eliminate the transaction exposure.

The example of transaction exposure, just analyzed, illustrates how exchange rate uncertainty can affect the future profitability of the firm. The possibility that exchange rate changes can affect future profitability, and therefore the current value of the firm, is indicative of economic exposure. Managing foreign exchange risks involves the sorts of operations considered in Chapter 4. There we covered the use of forward markets, swaps, options, futures, and borrowing and lending in international currencies, and so will not review that information here. Note, however, that firms should manage cash flows carefully, with an eye toward expected exchange rate changes, and should not always try to avoid all risks since risk taking can be profitable. Firms practice risk mini- mization subject to cost constraints and eliminate foreign exchange risk only when the expected benefits from it exceed the costs.

Although forward exchange contracts may be an important part of any corporate hedging strategy, there exist other alternatives that are frequently used. For example, suppose a firm has assets and liabilities

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repayment at a cheaper rate in the future. Insofar as is possible, the firm will try to reinforce these practices on payables and receivables by invoic- ing its sales in currency Y and its purchases in X. Although institutional constraints may exist on the ability of the firm to specify the invoicing currency, it would certainly be desirable to implement such policies.

We see, then, that corporate hedging strategies involve more than simply minimizing holdings of currency X and currency-X-denominated bank deposits. Managing cash flows, receivables, and payables will be the daily activity of the financial officers of a multinational firm. In instances when it is not possible for the firm successfully to hedge a foreign cur- rency position internally, there is always the forward or futures market. If the firm has a currency-Y-denominated debt and it wishes to avoid the foreign exchange risk associated with the debt, it can always buy Y cur- rency in the forward market and thereby eliminate the risk.

In summary, foreign exchange risk may be hedged or eliminated by the following strategies:

1. Trading in forward, futures, or options markets

2. Invoicing in the domestic currency

3. Speeding (slowing) payments of currencies expected to appreciate (depreciate)

4. Speeding (slowing) collection of currencies expected to depreciate (appreciate)