Economic exposure to exchange risk refers to the possibility of unforeseen variations in exchange rates affecting a company’s cash flows and market value. It can be gauged by analyzing how sensitive the firm’s future cash flows and market value are to random fluctuations in exchange rates.
The sensitivity can be estimated through the regression coefficient, indicating that exposure is equivalent to the regression coefficient.
Regarding the effects of exchange rate changes on a firm’s operating cash flow, there are two aspects. The competitive effect refers to how these changes affect operating cash flows by altering the firm’s competitive position. On the other hand, the conversion effect involves converting a specific operating cash flow in foreign currency into higher or lower amounts in US dollars (home currency) as the exchange rate fluctuates.
The determinants of a firm’s operating exposure primarily consist of two factors. Firstly, it is influenced by the extent of market presence in terms of sourcing inputs (such as labor and materials) and selling products. Secondly, it depends on the firm’s ability to mitigate the impact of exchange rate changes by adjusting markets, product mix, and sourcing strategies.
Purchasing power parity has implications for operating exposure.
Answer: If the exchange rate changes and the inflation rate differential between countries are proportional, firms’ competitive positions will remain unaffected by exchange rate changes. Therefore, firms do not experience operating exposure.
In the Spanish market, General Motors exports cars despite the strong alular against the Euro, which negatively impacts GM car sales in Spain. However, GM faces competition from Italian and French car makers like Fiat and Renault, whose operating currencies are the Euro.
To help GM maintain its market share in Spain, I would suggest implementing certain measures.
To address the situation, GM has several measures they can take. One option is to expand car sales not only in Spain and other European countries but also Asian markets. Another possibility is establishing production facilities in Spain and sourcing inputs locally, which would support the local economy while reducing costs. Alternatively, they could set up production facilities in a country with low production costs like Morocco and export cars to Spain. Additionally, it is crucial for GM to evaluate the advantages and disadvantages of hedging their operating exposure financially. This may involve operational hedges such as relocating the manufacturing site.
Financial hedging is a cost-effective and quick method to implement, but it may not effectively hedge long-term, real exposure. Conversely, operational hedges are expensive, time-consuming, and hard to reverse. When evaluating the pros and cons of maintaining multiple manufacturing sites as a hedge against exchange rate exposure, it can be an effective risk management measure. However, this approach might be costly if the company cannot take advantage of economies of scale.
Tutorial: 8 MANAGEMENT OF TRANSACTION EXPOSURE
1. Definition of transaction exposure and its difference from economic exposure.
Answer: Transaction exposure is the sensitivity of a firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. It differs from economic exposure as it is well-defined and short-term.
Discussing and comparing hedging transaction exposure using forward contracts vs. Money market instruments, and identifying when both approaches yield the same result.
The act of hedging transaction exposure can be accomplished through the utilization of a forward contract to either pre-purchase or pre-sell foreign currency receivTABLE or payTABLE. Alternatively, a money market hedge entails either borrowing or lending the present value of foreign currency receivTABLE or payTABLE, which results in opposing positions in foreign currency. If interest rate parity is maintained, these two methods of hedging are viewed as being equivalent.
When considering whether a firm should partake in hedging and examining the reasons for and against it, within an ideal capital market, firms may not have a necessity to hedge against exchange risk. However, if markets are imperfectly functioning, firms can enhance their value by implementing hedging strategies.
The text emphasizes the importance of firms hedging their risks for multiple reasons. To start, if the firm’s management possesses superior knowledge regarding the firm’s exposure in comparison to the shareholders, it should be the responsibility of the firm itself to hedge its risks. Additionally, firms may have an opportunity to hedge at a lower cost. Furthermore, hedging can decrease the likelihood of default and justify its costs, especially if they are substantial. Lastly, for firms that are subject to progressive taxes, hedging can reduce tax obligations and offer stability to corporate earnings. An example that illustrates these advantages is observed in the case of Cray Research from the United States selling a supercomputer on credit to Germany’s Max Planck Institute for €15 million with a payment deadline of six months.
The current six-month forward exchange rate is $1.10 per unit, and the foreign exchange advisor for Cray Research predicts that the spot rate will be $0.06 per unit in six months. The expected gain/loss from the forward hedging is calculated as follows: Expected gain(S) = $600,000 – ($1.10 – $0.06). If I were the financial manager of Cray Research, I would recommend hedging this Euro receivable because it allows us to increase our expected dollar receipt by $600,000 and eliminate any exchange risk.
Tutorial: 9 MANAGEMENT OF TRANSLATION EXPOSURE
1. Explain the difference in the translation process between the monetary/monetary method and the temporal method.
Answer: In the monetary/monetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate.
When other balance sheet accounts are kept at their current value, they are translated at the current rate. However, if they are maintained at their historical value, they are translated using the rate applicable on the date of entry. This is because fixed assets and inventory are usually recorded at historical costs, which makes both the temporal method and the monetary/monetary method produce similar translations. Nonetheless, it is typically not possible to completely eliminate both translation exposure and transaction exposure.
In certain situations, one exposure being eliminated can also eliminate the other. However, in other cases, the removal of one exposure can actually create the other. Let’s discuss which exposure should be considered more important for effective management if a conflict arises in controlling both exposures. Additionally, let’s analyze and evaluate the typical methods used to control translation exposure. Response: As it is generally impossible to completely eliminate both transaction and translation exposure, we suggest prioritizing transaction exposure since it involves actual cash flows.
The translation process has no direct impact on reporting currency cash flows, but it can affect net investment when assets are sold or liquidated. There are two ways to manage translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves matching the amount of exposed assets in an exposure currency with the exposed liabilities in the same currency, resulting in a net exposure of zero. Therefore, when the exchange rate of an exposure currency fluctuates relative to the reporting currency, the change in assets will offset the change in liabilities.
Creating a balance sheet hedge can sometimes involve creating new transaction exposure, which can lead to real cash flow losses. A derivatives hedge is more like a speculative position, as it is based on the expected future spot rate of exchange. If the actual spot rate differs from the expected rate, the “hedge” can result in the loss of real cash flows.
