III.1 Exchange Rate Exposure & Hedging -- Introduction: III.1 Exchange Rate Exposure & Hedging -- Introduction 6F:130 International Finance Prof. David S. Bates Lecture #17


Read: Read MSE Ch. 8, “Transaction Exposure” “Analyzing Corporate Currency Dealings Isn’t Easy” (in bulk pack) Wharton/CIBC World Markets, “1998 Survey of Financial Risk Management by U.S. Non-Financial Firms.” (at http://finance.wharton.upenn.edu/weiss, or in library; slides in bulk pack)


Foreign Exchange Exposure: Foreign Exchange Exposure Transaction exposure the impact of unexpected exchange rate changes upon the cash flows from existing contractual obligations Economic exposure (a.k.a. operating, competitive or strategic exposure) the impact of unexpected exchange rate changes upon known and expected future cash flows of the firm Translation (or accounting) exposure exchange rate impacts on consolidated financial statements arising from MNC’s need to “translate” foreign affiliates’ FC financial statements


Example: Nissan’s foreign exports : Example: Nissan’s foreign exports Roughly $8 billion/year in overseas receivables Transactions exposure: yen/$ impact on yen-denominated revenues from contracted sales (e.g., for next year) ($8 bln/yr) x (S yen/$) = ??? yen


Example: Nissan’s foreign exports : Example: Nissan’s foreign exports Roughly $8 billion/year in overseas receivables Economic exposure: yen/$ impact on yen-denominated revenues from contracted and future expected sales (for indefinite future) Persistent exchange rate changes affect: future volume of U.S. sales (competitive effect), depending on Nissan’s pricing policy in U.S. yen revenues from those U.S. sales (conversion effect)


Example: Nissan’s foreign exports : Example: Nissan’s foreign exports $ $8 bln yen ? Year: 1 2 3 ... Transactions Exposure S(1) ~


Example: Nissan’s foreign exports : Example: Nissan’s foreign exports $ $8 bln $$$ $$$ $$$ yen ? ? ? ? Year: 1 2 3 ... Operating exposure S(1) ~ S(2) ~ S(3) ~


Slide8: Firm value = expected future cash flows discounted at investors’ required rate of return


Slide9: Firm value = expected future cash flows discounted at investors’ required rate of return Year 0 1 2 ... yen E[CF(1)] E[CF(2)] ... V R ~ ~


Slide10: Firm value = expected future cash flows discounted at investors’ required rate of return Operating exposure therefore measures how firm value changes with unexpected changes in exchange rates Year 0 1 2 ... yen E[CF(1)] E[CF(2)] ... V R ~ ~


Foreign Exchange Hedging: Foreign Exchange Hedging Hedging can reduce the volatility of cash flows, and reduce exchange rate exposure


Slide12: Example: pound-denominated accounts receivable (transaction exposure)


Slide13: $ value Example: pound-denominated accounts receivable (transaction exposure) F unhedged


Slide14: Example: pound-denominated accounts receivable (transaction exposure) F unhedged 50% hedged $ value


Slide15: Example: pound-denominated accounts receivable (transaction exposure) F unhedged 50% hedged 100% hedged $ value


Slide16: Should firms care about reducing (exchange rate) risk? F unhedged 50% hedged 100% hedged $ value


Should firms hedge?: Should firms hedge? If being unhedged creates a fair bet (losses as likely as gains), should a firm hedge? Arguments against Since markets are efficient, risk management does not add to firm value Active risk management wastes resources Arguments for bankruptcy risk (default costs) tax convexities relatively high cost of external financing markets are not always efficient (selective hedging)


Arguments against hedging: Arguments against hedging Market efficiency Modigliani-Miller: under ideal circumstances, the financial policies of the firm have no effect upon the value of the firm bond vs. equity financing hedging vs. not hedging


Slide19: Value of firm = expected future cash flows discounted at investors’ required rate of return Unhedged cash flows unquestionably riskier BUT: Hedging doesn’t change E[C] if markets efficient Hedging doesn’t change the required rate of return, which depends only on systematic risk -- covariance with market/variance of mkt = beta E[C ] (1+R) t t t = 1 8 V = ~ Market efficiency argument


Arguments for hedging: Arguments for hedging bankruptcy risk Example: Laker Airways debt-financed British airline 1979-82: Substantial new dollar loans to purchase aircraft: $420 mln Liabilities: mostly in dollars (interest, jet fuel) Revenues: 2/3 in pounds, 1/3 in $ Dollar soared against pound 1980-82 Laker Airways went bankrupt


Arguments for hedging: Arguments for hedging Bankruptcy risk justifies hedging BUT: most firms don’t face bankruptcy from unhedged risks. F unhedged 50% hedged 100% hedged bankrupt!! liability


Arguments for hedging: Arguments for hedging Tax convexities If corporate income taxes are significantly progressive, the Treasury will take more of your gains than they will rebate of your losses. Hedging reduces expected tax burden.


Arguments for hedging: Arguments for hedging Relatively high cost of external financing If new external financing (debt, equity) costs more than retained earnings, hedge to stabilize the cash flows that finance new investments (Froot, Scharfstein, & Stein) Can be more costly to borrow when times are bad Merck: hedge FC revenues from pharmaceuticals, so stable cash flows can cover ongoing R&D


Arguments for hedging: Arguments for hedging Selective hedging Can sometimes do better than forward rate in predicting future spot rates (maybe), so give the treasury dept. some discretion in how much they hedge: 0 - 100%. Example: pound-denominated AR If F > E[S(t+T)], hedge 100% If F < E[S(t+T)], hedge less than 100% (0%?).


Slide25: “Selective hedging” is speculation; it is not especially aimed at risk reduction. Such firms are attempting to run currency conversion operations as a profit center. Quite common: Intel Dow Chemical Kodak (pre-’92) . . .


Slide26: Tendency towards “selective hedging” reinforced by post-mortems (20-20 hindsight) Example: Wall Street Journal (2/12/96): “Hedging can protect against currency swings, but it is costly and can backfire. When the dollar rose last year to over 100 yen from around 80, many [Japanese] exporters missed out on some profits because they had hedged against the dollar.” (emphasis added)


Slide27: Risk reduction involves avoiding gambles, or reducing their impact. Sometimes (50%?) the gambles would have paid off in your favor.


Slide28: S(t+T) Risk reduction involves avoiding gambles, or reducing their impact. Sometimes (50%?) the gambles would have paid off in your favor. F = 80 yen/$ unhedged 100% hedged


Slide29: S(t+T) Risk reduction involves avoiding gambles, or reducing their impact. Sometimes (50%?) the gambles would have paid off in your favor. F = 80 yen/$ unhedged 100% hedged unhedged “pays off”


Slide30: S(t+T) Risk reduction involves avoiding gambles, or reducing their impact. Sometimes (50%?) the gambles would have paid off in your favor. F = 80 yen/$ unhedged 100% hedged unhedged “pays off” hedge “pays off”


Should firms hedge?: Should firms hedge? If being unhedged creates a fair bet (losses as likely as gains), should a firm hedge? Arguments against Since markets are efficient, risk management does not add to firm value Active risk management wastes resources Arguments for bankruptcy risk (default costs) tax convexities relatively high cost of external financing markets are not always efficient (selective hedging)


Do firms hedge? How and why?: Do firms hedge? How and why? Overall, firms’ behavior diverse. Example: gold mining firms. Can lock in the gold forward price (hedge), or sell at the (risky) future spot price. Homestake Mining: never hedges American Barrick: hedges 100% of price risk on next year’s production Others: partial hedges


Results from Wharton/CIBC World Markets, “1998 Survey of Derivatives Usage by U.S. Non-Financial Firms”: Results from Wharton/CIBC World Markets, “1998 Survey of Derivatives Usage by U.S. Non-Financial Firms”


Summary: Summary Various theoretical arguments for & against hedging. 50% of surveyed firms do use derivatives for risk management -- especially large firms (83%), and especially for FX risk. Much hedging, but some speculation. Predominantly a short-run risk focus (near-term, directly observable exposures). Those that don’t hedge: 60% feel risk isn’t big enough.


For next class: For next class Read Ch. 8, “Transaction Exposure” Look at the Lufthansa mini-case: MSE, pp.194-5(1st ed.); 225-6 (2nd ed.). We will discuss it in class.