Foundations of Financial Management: An Analysis (part 83)

“The person who doesn't know where his next dollar is coming from usually doesn't know where his last dollar went.”

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International Financial Management

(Part C)

by

Charles Lamson

Managing Foreign Exchange Risk

When the parties associated with a commercial transaction are located in the same country, the transaction is denominated in a single currency. International transactions inevitably involve more than one currency (because the parties are residents of different countries). Since most foreign currency values fluctuate from time to time, the monetary value of an international transaction measured in either the seller's currency or the buyer's currency is likely to change when payment is delayed. As a result, the seller may receive less revenue than expected or the buyer may have to pay more than the expected amount for the merchandise. Thus the term foreign exchange risk refers to the possibility of a drop in revenue or an increase in cost in an international transaction due to a change in foreign exchange rates. Importers, exporters, investors, and multinational firms are all exposed to this foreign exchange risk.

The international monetary system has undergone a significant change over the last 50 years. The free trading Western nations basically went from a fixed exchange rate system to a "freely" floating rate system. For the most part, the new system has proved its agility and resilience during last four decades. The free market exchange rates have responded and adjusted well to adverse conditions. Consequently, the exchange rates fluctuated over a much wider range than before. The increased volatility of exchange markets forced many multinational firms, importers, and exporters to pay more attention to the function of foreign exchange risk management.

The foreign exchange risk of a multinational company (MNC) is divided into two types of exposure. They are: accounting or translation exposure and transaction exposure. An MNC's foreign assets and liabilities, which are denominated in foreign currency units, are exposed to losses and gains due to changing exchange rates. This is called accounting or translation exposure. The amount of loss or gain resulting from this form of exposure and the treatment of it in the parent company's books depend on the accounting rules established by the parent company's government. In the United States, the rules are spelled out in the Statement of Financial Accounting Standards (SFAS) No. 52. Under SFAS 52 all foreign currency-denominated assets and liabilities are converted at the rate of exchange in effect on the date of balance sheet preparation. An unrealized translation gain or loss is held in an equity reserve account while the realized gain or loss is incorporated in the parent's consolidated income statement for that period. Thus SFAS 52 partially reduces the impact of accounting exposure resulting from the translation of a foreign subsidiary's balance sheet on reported earnings of multinational firms.

However, foreign exchange gains and losses resulting from international transactions, which reflect transaction exposure, are shown in the income statement for the current period. As a consequence of these transactional gains and losses, the volatility of deported earnings-per-share increases. Three different strategies can be used to minimize this transaction exposure.

1. Hedging in the forward exchange market.

2.  Hedging in the monetary market.

3.  Hedging in the currency futures market.

Forward Exchange Market Hedge To see how the transaction exposure can be covered in forward markets, suppose Electricitie de France, an electric company in France, purchased a large generator from General Electric of the United States for 875,000 euros on March 21st, 2003, and GE was promised the payment in euros in 90 days. Since GE is now exposed to exchange risk by agreeing to receive the payment in euros in the future, it is up to GE to find a way to reduce this exposure. One simple method is to hedge the exposure in the forward exchange market. On March 21st, 2003, to establish the forward cover, GE sells a forward contract to deliver the 875 thousand Euros 90 days from that date in exchange for $976,412.50 on June 20th, 2003, GE receives payment from Electricitie de France and delivers the 875,000 euros to the bank that signed the contract. In return the bank delivers $976,412.50 to GE.

Thus, through this International transaction, GE receives the same dollar amount it expected three months earlier regardless of what happened to the value of euros in the interim. In contrast, if the sale had been invoiced in U.S. dollars, Electricitie de France, not GE, would have been exposed to the exchange risk.

Money Market Hedge A second way to have eliminated transaction exposure in the previous example would have been to borrow money in euros and then convert it to U.S. Dollars immediately. When the account receivable from the sale is collected 3 months later, the loan is cleared with the proceeds. In this case GE's a strategy consists of the following steps. 

The money market hedge basically calls for matching the exposed asset (account receivable) with a liability (loan payable) in the same currency. Some firms prefer this money market hedge because of the early availability of funds possible with this method.

Currency Futures Market Hedge Transaction exposure associated with a foreign currency can also be covered in the futures market with a currency futures contract. The International Monetary Market (IMM) of the Chicago Mercantile Exchange began trading in futures contracts in foreign currencies on May 16th, 1972. Trading in currency futures contracts also made a debut on the London International Financial Futures Exchange (LIFFE) in September 1982. Other markets have also developed around the world. Just as futures contracts are traded in corn, wheat, hogs, and beans, foreign currency futures contracts are traded in these markets. Although the futures market and forward market are similar in concept they differ in their operations. To illustrate the hedging process in the currency futures market, suppose that in May the Chicago-based LaSalle National Bank considers lending 500,000 pesos to a Mexican subsidiary of a U.S. parent company for 7 months. The bank purchases the pesos on the spot market, delivers them to the borrower, and simultaneously hedges it's transactions exposure by selling December contracts in pesos for the same amount. In December when the loan is cleared, the bank sells the pesos in the must spot market and buys back the December peso contracts. The contracts are illustrated for the spot and futures market in Table 3.

Table 3 Currency futures hedging

While the loan was outstanding, the peso declined in value relative to the U.S. dollar. Had the bank remained unhedged, it would have lost $1,950 in the spot market. By hedging in the futures market, the bank was able to reduce the loss to $1,300. A $650 gain in the futures market was used to cancel some of the $1,950 loss in the spot market.

These are not the only means companies have for protecting themselves against foreign exchange risk. Over the years, multinational companies have developed elaborate foreign asset management programs, which involve such strategies as switching cash and other current assets into strong currencies, while piling up debt and other liabilities in depreciating currencies. Companies also encourage the quick collection of bills in weak currencies by offering sizable discounts, while extending liberal credit and strong currencies. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 613-615*

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