Foreign Exchange Risk - Financial Management

Foreign exchange risk is said to exist when a portion of the cash flows expected to be received by a firm are denominated in foreign currencies. As exchange rates change, there is uncertainty about the amount of domestic currency that will be received from a transaction denominated in a foreign currency. There are three primary categories of foreign exchange risk that multinational firms must consider:

  1. Transaction exposure (short-term)
  2. Economic (operating) exposure (long-term)
  3. Translation (accounting) exposure

Transaction Exposure

Most firms have contracts to buy and sell goods and services, with delivery and payment to occur at some time in the future. If payments under the contract involve the use of foreign currency, additional risk is involved. The potential for change in value of a foreign -currency– denominated transaction due to an exchange rate change is called transaction exposure. For example, General Electric is a major producer of locomotives. Suppose that General Electric contracts with the Brazilian government to sell 100 locomotives for delivery one year from now. General Electric wants to realize $400 million from this sale. The Brazilian government has indicated that it will only enter into the contract if the price is stated in Brazilain reals (BRL).

The 1-year forward rate is BRL3.11/$. Hence General Electric quotes a price of BRL1,244,000,000. Once the contract has been signed, General Electric faces a significant transaction exposure. Unless General Electric takes actions to guarantee its future dollar proceeds from the sale—that is, unless it hedges its position, for example, by selling BRL1,244,000,000 in the 1-year forward market—it stands to lose on the transaction if the value of the BRL weakens. Suppose that over the coming year the inflation rate in Brazil rises significantly beyond what was expected at the time the deal was signed. According to relative PPP, the value of the BRL can be expected to decline, say to BRL4/$. If this happens, General Electric will receive only $311 million (BRL1,244,000,000/BRL4/$) rather than the $400 million it was expecting.

One well-documented example of the potential consequences of transaction exposure is the case of Laker Airlines. In the late 1970s, in the face of growing demand from British tourists traveling to the United States, Laker purchased several DC-10 aircraft and financed them in U.S. dollars. This transaction ultimately led to Laker’s bankruptcy because Laker’s primary source of revenue was pounds sterling, whereas its debt costs were denominated in dollars. Over the period from the late 1970s to 1982, when Laker failed, the dollar strengthened relative to the pound sterling. This had a devastating effect because (1) the strong dollar discouraged British travel to the United tates, and (2) the pound sterling cost of principal and interest payments on the dollar-denominated debt increased.

Managing Transaction Exposure A number of alternatives are available to a firm faced with transaction exposure. First, the firm may choose to do nothing and simply accept the risk associated with the transaction. Doing nothing works well for firms with extensive international transactions that may tend to cancel each other out. For example, if General Electric has purchased goods or services from Brazilian firms that require the payment in approximately the same number of BRL as it expects to receive from the sale of the locomotives, then it is not necessary to do anything to counter the risk arising from a loss in value of the BRL relative to the dollar.

A second alternative is to invoice all transactions in dollars (for a U.S.–based firm). This avoids any transaction risk for the U.S. firm, but shifts this risk to the other party. For example, in September 1992, in a period of extreme volatility of European currencies, Dow Chemical announced that it would use the German mark as the common currency for all its European business transactions. This action shifted currency risks from Dow to its customers who did business in other currencies.When a firm is considering this alternative, it needs to determine whether this strategy is competitively possible, or whether parties on the other side of the transaction may resist or perhaps insist on a lower price if they are forced to bear all the transaction risk. In Dow’s case, analysts and competitors doubted that customers would be willing to bear all of the exchange rate risk and felt that Dow would ultimately abandon this strategy.

Two hedging techniques that are possible for a U.S. company to protect itself against transaction exposure are

  • Execute a contract in the forward exchange market or in the foreign exchange futures market.
  • Execute a money market hedge.

Consider a situation in which DuPont purchases materials from a British supplier, Commonwealth Resources, Ltd. Because the amount of the transaction (£2 million) is stated in pounds, DuPont bears the exchange risk. This example of transaction exposure is illustrated in. Assume that Commonwealth Resources extends 90-day trade credit to DuPont and that the value of the pound unexpectedly increases from $1.69/pound on the purchase date to $1.74/pound on the payment date. If DuPont takes the trade credit extended to it, the cost of the purchase effectively increases from $3.38 million to $3.48 million (that is, £2,000,000 *$1.74/pound).

Example of Transaction Exchange Rate Risk: DuPont

Example of Transaction Exchange Rate Risk: DuPont

First, DuPont could execute a contract in the forward exchange market to buy £2 million at the known 90-day forward rate, rather than at the uncertain spot rate prevailing on the payment date. This is referred to as a forward market hedge. Assume, for example, that the 90-day forward rate is $1.70/pound. Based on this rate, DuPont effectively would be able to exchange $3.4 million (that is, £2,000,000*$1.70/pound) 90 days later on the payment date when it is required to pay for the materials. Thus, DuPont would be able to take advantage of the trade credit and, at the same time, hedge against foreign exchange risk.

A second hedging technique, called a money market hedge, involves DuPont borrowing funds from its bank, exchanging them for pounds at the spot rate, and investing them in interest-bearing British securities to yield £2 million in 90 days. By investing in securities that mature on the same date the payment is due to Commonwealth Resources (that is, 90 days after the purchase date), DuPont will have the necessary amount of pounds available to pay for the materials. The net cost of this money market hedge to DuPont will depend on the interest rate on the funds it borrows from its bank relative to the interest rate on the funds it invests in securities. If the conditions of interest rate parity are satisfied, these two hedging techniques are equivalent.

Other transaction risk reduction strategies include the use of options on foreign currencies and negotiating a risk-sharing contract between the two parties to a transaction in which both parties agree in advance to share in some way the financial consequences of changes in value between the affected currencies. For large multinational companies, there will be many international transactions involving many different currencies. Attempting to hedge separately the transaction exposure for each international transaction would be time-consuming and inefficient. For example, consider Sara Lee Corporation, which has operations in both the United Kingdom and France. The British subsidiary makes purchases in France that require euros.

At the same time the French subsidiary makes purchases in the United Kingdom that require pounds sterling. To the extent that these transactions offset, no hedge is necessary. Multinational firms often make thousands of overlapping transactions using different currencies. Thus it is a complex matter to keep track of net currency exposures and avoid hedging against risks that do not really exist when one takes the consolidated corporate view, rather than the narrow subsidiary view, of exchange risk.

Economic Exposure

Economic (or operating) exposure refers to changes in a firm’s operating cash flows (and hence the firm’s value) that come about because of real rather than nominal changes in exchange rates. Real exchange rate changes occur when there are deviations from purchasing power parity (PPP). Under relative PPP, exchange rates should vary to reflect changes in the price level of goods and services in one country relative to another. For example, if the inflation rate in Mexico is 5 percent higher per year than in the United States, relative PPP says that the value of the Mexican peso can be expected to decline by about 5 percent relative to the dollar. Thus goods purchased in the United States from Mexico will cost the same as they did before the increase in Mexican inflation, after adjusting for the decline in the value of the peso.

Real exchange rate changes can affect the way competing companies in two countries do business and can impact the business conditions in the countries. For example, in April 1995, $1 equaled about ¥83. In January 2002, $1 equaled about ¥131. In relative terms, the dollar was “weak” and the yen was “strong” in April 1995, whereas in January 2002, the dollar was “strong” and the yen was “weak.” This situation reversed again by mid-2004. The weakening of the dollar and the strengthening of the yen can have a dramatic impact on firms doing business in the United States and Japan. The showcase example of these effects is the relative performance of the Japanese and American automobile industries.

In the mid-1980s, Japanese products were generally cheaper (and of better quality) than their American counterparts. The Japanese share of the U.S. auto market was growing, restrained only by voluntary import restrictions agreed to by the Japanese. By 1995, the increased value of the yen relative to the dollar had reversed the fortunes of automakers in both countries. Japanese autos were selling for several thousand dollars more in 1995 than comparable U.S. products. American firms reported significant increases in U.S. market share at the expense of the Japanese. Japanese auto firms were experiencing significant financial difficulties at a time when U.S. auto firms were reporting substantial increases in profit. U.S. firms had also begun exporting vehicles to Japan.

In an attempt to offset the impact of their significant economic exposure in the United States, Japanese firms have aggressively moved to establish manufacturing and assembly operations in the United States and some European countries, so that many of their costs will be denominated in the same currency as their revenues. Also, by locating plants in many different countries, multinational firms have the flexibility to shift production from one location to another in order to offset unfavorable economic exposure.

Managing Economic Exposure Economic exposure is much more difficult and expensive to manage than the shorter-term transactions exposure already discussed. Strategies to manage the impact of real changes in exchange rates in countries where a multinational firm operates include

  1. Shift production from high -cost (exchange -rate adjusted) plants to lower-cost plants—for example, moving labor-intensive sewing operations from U.S. textile plants to plants in Mexico.
  2. Increase productivity—adopt labor-saving technologies, implement flexible manufacturing systems, reduce product cycles, make use of benchmarking, that is, copy your strongest competitors.
  3. Outsource the supply of many of the components needed to produce a product to lower-cost locations—for example, some U.S. publishing houses have outsourced typesetting to areas in the Far East with lower labor costs.
  4. Increase product differentiation to reduce the price sensitivity in the market—for example, the Japanese have moved more to the luxury car market as the yen has strengthened because of the greater price flexibility the luxury market provides relative to the economy car market.
  5. Enter markets with strong currencies and reduce involvement in competitive markets with weak currencies—U.S. firms have become increasingly aggressive in entering the Japanese market as the yen has increased in value relative to the dollar.

Translation Exposure

When a multinational firm has one or more foreign subsidiaries with assets and liabilities denominated in a foreign currency, it faces translation exposure. For example, if a U.S.–based multinational firm operates a subsidiary in Poland, the “zloty” value of the subsidiary’s assets and liabilities must be translated into the home (U.S. $) currency when the parent firm prepares its consolidated financial statements.When the translation occurs, there can be gains or losses, which must be recognized in the financial statements of the parent. Current accounting standards are set forth in Statement of Financial Accounting Standards Number 52. The major provisions of this standard are

  • Current assets, unless covered by forward exchange contracts, and fixed assets are translated into dollars at the rate of exchange prevailing on the date of the balance sheet.
  • Current and long-term liabilities payable in foreign currency are translated into dollars at the rate of exchange prevailing on the date of the balance sheet.
  • Income statement items are translated either at the rate on the date of a particular transaction or at a weighted average of the exchange rates for the period of the income statement.
  • Dividends are translated at the exchange rate on the date the dividend is paid.
  • Equity accounts, including common stock and contributed capital in excess of par value, are translated at historical rates.
  • Gains and losses to the parent from translation are not included in the parent’s calculation of net income, nor are they included in the parent’s retained earnings. Rather, they are reported in a separate equity account named “Cumulative foreign currency translation adjustments” or a similar title. Gains or losses in this account are not recognized in the income statement until the parent’s investment in the foreign subsidiary is sold or liquidated.

A decline in the value of a foreign currency relative to the U.S. dollar reduces the conversion value of the foreign subsidiary’s liabilities as well as its assets. Therefore, the parent company’s risk exposure depends on the foreign subsidiary’s net equity position (that is, assets minus liabilities). Thus, on the books of the parent company, the subsidiary’s creditors in effect bear part of the decline in the value of the subsidiary’s assets. The impact of a decrease in the exchange rate on the firm’s balance sheet can be illustrated with the following example.American Products has a subsidiary, Canadian Products, with total assets of $12 million (Canadian) and total liabilities of $8 million (Canadian).

Based on an exchange rate of $0.80 (U.S.) per dollar (Canadian), the net equity position of the Canadian subsidiary on American Products’ balance sheet as shown in Table 22.2 is $3.2 million (U.S.). Suppose now that the exchange rate declines to $0.75 (U.S.) per dollar (Canadian) and all other things remain the same. As can be seen in the table, the net equity position of the Canadian subsidiary on American Products’ balance sheet declines to $3 million (U.S.), resulting in a $200,000 currency exchange loss.

ETHICAL ISSUES
Payment of Bribes Abroada

Managers of multinational firms often must deal with the problem of making bribes or “grease” payments abroad in order to facilitate a transaction.Customs with respect to the acceptability and need for such payments vary greatly in different countries.The issue of questionable payments is especially important to managers of U.S. firms because of the Foreign Corrupt Practices Act (FCPA) of 1977 as amended in the Omnibus Trade and Competitiveness Act of 1988.The provisions of this act declare payments in the form of phony discounts, fake invoices, and inflated expense accounts illegal.

A study of 400 firms by the Securities and Exchange Commission (SEC) in the mid-1970s revealed that these firms had made over $300 million in questionable payments to officials of foreign governments, politicians, agents, and others to secure business abroad. Exxon, for example, disclosed that it had made nearly $60 million in such payments.These payments have been most common in capital -intensive industries such as aerospace, construction, and energy, which deal with large projects or contracts.

A study by the U.S. government found that bribery by competitors cost American companies $11 billion in 1995. General Electric’s general counsel estimates that the company loses several billion dollars a year to bribery.

In spite of the FCPA, U.S.–based firms have continued to make grease payments abroad. Many times these payments have been cleverly disguised. For example, in April 1980, Ashland Oil paid about $29 million to acquire a mining operation in Zimbabwe that had been controlled by an official of the Omani government. The mining operation proved to be unprofitable and was written off its books by Ashland two years later. In September 1980, the Omani government awarded Ashland a 20,000 -barrel -per-day crude oil contract at a price $3 below the regular selling price for crude oil. In 1986 the SEC brought an action against Ashland and its former chairman, charging violations of the FCPA.Ashland agreed to an SEC consent injunction barring these types of corrupt practices. Since passage of the FCPA, the U.S. government has attempted to extend the anticorruption laws to foreign companies.

Initially, these efforts were viewed as naïve by overseas companies and governments. However, more recently, the 29 countries in the Organization for Economic Cooperation and Development (OECD) have been working on a treaty to ban illegal payments to government officials. Dozens of multinational companies have supported this effort. For example, many large European companies, including Petrofina SA of Belgium, Pirelli SpA of Italy, and Robert Bosch GmbH of Germany, have pledged to abstain from bribery. Both ethical standards and U.S. law prohibit the payment of bribes to obtain business abroad. However, in many countries the receipt of bribes is not only permitted, but it is also expected. How can managers reconcile this conflict between domestic ethical standards and traditional foreign business practice?

Managing Translation Exposure In general, when a foreign subsidiary’s assets are greater than its liabilities, currency exchange losses will occur when the exchange rate decreases. The opposite effects are true for increases in the exchange rate. A company can hedge and manage its balance sheet translation exposure by financing its foreign assets with debt denominated in the same currency.

For example, in September 1993, Dow Chemical issued 4.625 percent Eurobonds. Instead of being denominated in U.S. dollars, as is usual for securities of U.S. companies, these bonds are denominated in Swiss francs. The Dow Chemical debt issue totaled 150,000,000 Swiss francs, or about $103,000,000, based on the exchange rate between the U.S. dollar and the Swiss franc at the time of issuance.

Dow Chemical’s financial managers apparently had a choice between whether to issue Swiss franc–denominated or U.S. dollar–denominated debt. One possible reason for issuing Swiss franc–denominated debt may have been to hedge the company’s Swiss assets. For example, if the value of the Swiss franc drops compared to the U.S. dollar value, presumably the U.S. dollar value of Dow Chemical’s Swiss assets also decreases. However, if this happens, the U.S. dollar amount of both the interest and principal that Dow Chemical has to pay also decreases.

Effect of a Decrease in the Exchange Rate on American

Effect of a Decrease in the Exchange Rate on American

A multinational company can also minimize its exchange rate risk, as well as the risk of expropriation or nationalization of its assets by a foreign government, by developing a portfolio of foreign investments. Rather than making all its direct investments in foreign subsidiaries that are located in one particular country, the firm can spread its foreign investments among a number of different countries, thus limiting the risk of incurring large losses within any one country.


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