In a corporation, there is no such thing as being perfectly hedged. Not every transaction can be matched, for international trade and production is a complex and uncertain business. As we have seen, even identifying the correct currency of exposure, the currency of determination, is tricky. Flexibility is called for, and management must necessarily give some discretion, perhaps even a lot of discretion, to the corporate treasury department or whichever unit is charged with managing foreign exchange risks. Some companies, feeling that foreign exchange is best handled by professionals, hire ex-bank dealers; other groom engineers or accountants. Yet however talented and honorable are these individuals, it has become evident that some limits must be imposed on the trading activities of the corporate treasury, for losses can get out of hand even in the best of companies.
In 1992 a Wall Street Journal reporter found that Dell Computer Corporation, a star of the retail PC industry, had been trading currency options with a face value that exceeded Dell's annual international sales, and that currency losses may have been covered up. Complex options trading was in part responsible for losses at the treasury of Allied-Lyons, the British foods group. The $150 million lost almost brought the company to its knees, and the publicity precipitated a management shake-out. In 1993 the oil giant Royal Dutch-Shell revealed that currency trading losses of as much as a billion dollars had been uncovered in its Japanese subsidiary.
Clearly, performance measurement standards, accountability and limits of some form must be part of a treasury foreign currency hedging program. Space does not permit a detailed examination of trading control methods, but some broad principles can be stated.
First, management must elucidate the goals of exchange risk management, preferably in operational terms rather than in platitudes such as "we hedge all foreign exchange risks."
Second, the risks of in-house trading (for that's often what it is) must be recognized. These include losses on open positions from exchange rate changes, counterparty credit risks, and operations risks.
Third, for all net positions taken, the firm must have an independent method of valuing, marking-to-market, the instruments traded. This marking to market need not be included in external reports, if the positions offset other exposures that are not marked to market, but is necessary to avert hiding of losses. Wherever possible, marking to market should be based on external, objective prices traded in the market.
Fourth, position limits should be made explicit rather than treated as "a problem we would rather not discuss." Instead of hamstringing treasury with a complex set of rules, limits can take the form of prohibiting positions that could incur a loss (or gain) beyond a certain amount, based on sensitivity analysis. As in all these things, any attempt to cover up losses should reap severe penalties.
Finally, counterparty risks resulting from over-the-counter forward or swap contracts should be evaluated in precisely the same manner as is done when the firm extends credit to, say, suppliers or customers.
In all this, the chief financial officer might well seek the assistance of an accounting or consulting firm, and may wish to purchase software tailored to the purposes.
CONCLUSIONS
This chapter offers the reader an introduction to the complex subject of the measurement and management of foreign exchange risk. We began by noting some problems with interpretation of the concept, and entered the debate as to whether and why companies should devote active managerial resources to something that is so difficult to define and measure.
Accountants' efforts to put an objective value on a firm involved in international business has led many to focus on the translated balance sheet as a target for hedging exposure. As was demonstrated, however, there are numerous realistic situations where the economic effects of exchange rate changes differ from those predicted by the various measures of translation exposure. In particular, we emphasized the distinctions between the currency of location, the currency of denomination, and the currency of determination of a business.
After giving some guidelines for the management of economic exposure, the chapter addressed the thorny question of how to approach currency forecasting. We suggested a market-based approach to international financial planning, and cast doubt on the ability of the corporation's treasury department to outperform the forward exchange rate.
The chapter then turned to the tools and techniques of hedging, contrasting the applications that require forwards, futures, money market hedging, and currency options.
Thursday, November 8, 2007
7 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK
In this section we consider the relative merits of several different tools for hedging exchange risk, including forwards, futures, debt, swaps and options. We will use the following criteria for contrasting the tools.
First, there are different tools that serve effectively the same purpose. Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position. Thus one can hedge a DM payment using a forward exchange contract, or debt in DM, or futures or perhaps a currency swap. In equilibrium the cost of all will be the same, according to the fundamental relationships of the international money market as illustrated in Exhibit 1. They differ in details like default risk or transactions costs, or if there is some fundamental market imperfection. indeed in an efficient market one would expect the anticipated cost of hedging to be zero. This follows from the unbiased forward rate theory.
Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows: options may be better suited to the latter.
Tools and techniques: foreign exchange forwards
Foreign exchange is, of course, the exchange of one currency for another. Trading or "dealing" in each pair of currencies consists of two parts, the spot market, where payment (delivery) is made right away (in practice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.
Forward contracts are the most common means of hedging transactions in foreign currencies, as the example in Exhibit 10 illustrates. The trouble with forward contracts, however, is that they require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. For such situations, futures may be more suitable.
Currency futures
Outside of the interbank forward market, the best-developed market for hedging exchange rate risk is the currency futures market. In principle, currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. In practice, they differ from forward contracts in important ways.
One difference between forwards and futures is standardization. Forwards are for any amount, as long as it's big enough to be worth the dealer's time, while futures are for standard amounts, each contract being far smaller that the average forward transaction. Futures are also standardized in terms of delivery date. The normal currency futures delivery dates are March, June, September and December, while forwards are private agreements that can specify any delivery date that the parties choose. Both of these features allow the futures contract to be tradable.
Another difference is that forwards are traded by phone and telex and are completely independent of location or time. Futures, on the other hand, are traded in organized exchanges such the LIFFE in London, SIMEX in Singapore and the IMM in Chicago.
But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the cash flows between parties to the transaction. In a forward contract, whether it involves full delivery of the two currencies or just compensation of the net value, the transfer of funds takes place once: at maturity. With futures, cash changes hands every day during the life of the contract, or at least every day that has seen a change in the price of the contract. This daily cash compensation feature largely eliminates default risk.
Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem.
Debt instead of forwards or futures
Debt -- borrowing in the currency to which the firm is exposed or investing in interest-bearing assets to offset a foreign currency payment -- is a widely used hedging tool that serves much the same purpose as forward contracts. Consider an example.
In Exhibit 10, Fredericks sold Canadian dollars forwards. Alternatively she could have used the Eurocurrency market to achieve the same objective. She would borrow Canadian dollars, which she would then change into francs in the spot market, and hold them in a US dollar deposit for two months. When payment in Canadian dollars was received from the customer, she would use the proceeds to pay down the Canadian dollar debt. Such a transaction is termed a money market hedge.
The cost of this money market hedge is the difference between the Canadian dollar interest rate paid and the US dollar interest rate earned. According to the interest rate parity theorem, the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge, unless the firm has some advantage in one market or the other.
The money market hedge suits many companies because they have to borrow anyway, so it simply is a matter of denominating the company's debt in the currency to which it is exposed. that is logical. but if a money market hedge is to be done for its own sake, as in the example just given, the firm ends up borrowing from one bank and lending to another, thus losing on the spread. This is costly, so the forward hedge would probably be more advantageous except where the firm had to borrow for ongoing purposes anyway.
Currency options
Many companies, banks and governments have extensive experience in the use of forward exchange contracts. With a forward contract one can lock in an exchange rate for the future. There are a number of circumstances, however, where it may be desirable to have more flexibility than a forward provides. For example a computer manufacturer in California may have sales priced in U.S. dollars as well as in German marks in Europe. Depending on the relative strength of the two currencies, revenues may be realized in either German marks or dollars. In such a situation the use of forward or futures would be inappropriate: there's no point in hedging something you might not have. What is called for is a foreign exchange option: the right, but not the obligation, to exchange currency at a predetermined rate.
A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, the strike or exercise price, but is not required to do so. The right to buy is a call; the right to sell, a put. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the instrument being delivered is the currency itself; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date; European options, only on the expiration date.
First, there are different tools that serve effectively the same purpose. Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position. Thus one can hedge a DM payment using a forward exchange contract, or debt in DM, or futures or perhaps a currency swap. In equilibrium the cost of all will be the same, according to the fundamental relationships of the international money market as illustrated in Exhibit 1. They differ in details like default risk or transactions costs, or if there is some fundamental market imperfection. indeed in an efficient market one would expect the anticipated cost of hedging to be zero. This follows from the unbiased forward rate theory.
Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows: options may be better suited to the latter.
Tools and techniques: foreign exchange forwards
Foreign exchange is, of course, the exchange of one currency for another. Trading or "dealing" in each pair of currencies consists of two parts, the spot market, where payment (delivery) is made right away (in practice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.
Forward contracts are the most common means of hedging transactions in foreign currencies, as the example in Exhibit 10 illustrates. The trouble with forward contracts, however, is that they require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. For such situations, futures may be more suitable.
Currency futures
Outside of the interbank forward market, the best-developed market for hedging exchange rate risk is the currency futures market. In principle, currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. In practice, they differ from forward contracts in important ways.
One difference between forwards and futures is standardization. Forwards are for any amount, as long as it's big enough to be worth the dealer's time, while futures are for standard amounts, each contract being far smaller that the average forward transaction. Futures are also standardized in terms of delivery date. The normal currency futures delivery dates are March, June, September and December, while forwards are private agreements that can specify any delivery date that the parties choose. Both of these features allow the futures contract to be tradable.
Another difference is that forwards are traded by phone and telex and are completely independent of location or time. Futures, on the other hand, are traded in organized exchanges such the LIFFE in London, SIMEX in Singapore and the IMM in Chicago.
But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the cash flows between parties to the transaction. In a forward contract, whether it involves full delivery of the two currencies or just compensation of the net value, the transfer of funds takes place once: at maturity. With futures, cash changes hands every day during the life of the contract, or at least every day that has seen a change in the price of the contract. This daily cash compensation feature largely eliminates default risk.
Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem.
Debt instead of forwards or futures
Debt -- borrowing in the currency to which the firm is exposed or investing in interest-bearing assets to offset a foreign currency payment -- is a widely used hedging tool that serves much the same purpose as forward contracts. Consider an example.
In Exhibit 10, Fredericks sold Canadian dollars forwards. Alternatively she could have used the Eurocurrency market to achieve the same objective. She would borrow Canadian dollars, which she would then change into francs in the spot market, and hold them in a US dollar deposit for two months. When payment in Canadian dollars was received from the customer, she would use the proceeds to pay down the Canadian dollar debt. Such a transaction is termed a money market hedge.
The cost of this money market hedge is the difference between the Canadian dollar interest rate paid and the US dollar interest rate earned. According to the interest rate parity theorem, the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge, unless the firm has some advantage in one market or the other.
The money market hedge suits many companies because they have to borrow anyway, so it simply is a matter of denominating the company's debt in the currency to which it is exposed. that is logical. but if a money market hedge is to be done for its own sake, as in the example just given, the firm ends up borrowing from one bank and lending to another, thus losing on the spread. This is costly, so the forward hedge would probably be more advantageous except where the firm had to borrow for ongoing purposes anyway.
Currency options
Many companies, banks and governments have extensive experience in the use of forward exchange contracts. With a forward contract one can lock in an exchange rate for the future. There are a number of circumstances, however, where it may be desirable to have more flexibility than a forward provides. For example a computer manufacturer in California may have sales priced in U.S. dollars as well as in German marks in Europe. Depending on the relative strength of the two currencies, revenues may be realized in either German marks or dollars. In such a situation the use of forward or futures would be inappropriate: there's no point in hedging something you might not have. What is called for is a foreign exchange option: the right, but not the obligation, to exchange currency at a predetermined rate.
A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, the strike or exercise price, but is not required to do so. The right to buy is a call; the right to sell, a put. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the instrument being delivered is the currency itself; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date; European options, only on the expiration date.
GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES
Academics and practitioners have sought the determinants of exchange rate changes ever since there were currencies. Many students have learned about the balance of trade and how the more a country exports, the more demand there is for its currency, and so the stronger is its exchange rate. In practice, the story is a lot more complex. Research in the foreign exchange markets have come a long way since the days when international trade was thought to be the dominant factor determining the level of the exchange rate. Monetary variables, capital flows, rational expectations and portfolio balance are all now understood to factor into the determination of currencies in a floating exchange rate system. Many models have been developed to explain and to forecast exchange rates. No model has yet proved to be the definitive one, perhaps because the structure of the worlds economies and financial markets are undergoing such rapid evolution.
Corporations nevertheless avidly seek ways to predict currencies, in order to decide when and when not to hedge. The models they use are typically one or more of the following kinds: political event analysis, or fundamental, or technical.
Academic students of international finance, in contrast, find strong empirical support for the role of arbitrage in global financial markets, and for the view that exchange rates exhibit behavior that is characteristic of other speculative asset markets. Exchange rates react quickly to news. Rates are far more volatile than changes in underlying economic variables; they are moved by changing expectations, and hence are difficult to forecast. In a broad sense they are "efficient," but tests of efficiency face inherent obstacles in testing the precise nature of this efficiency directly.
The central "efficient market" model is the unbiased forward rate theory introduced earlier. It says that the forward rate equals the expected future level of the spot rate. Because the forward rate is a contractual price, it offers opportunities for speculative profits for those who correctly assess the future spot price relative to the current forward rate. Specifically, risk neutral players will seek to make a profit their forecast differs from the forward rate, so if there are enough such participants the forward rate will always be bid up or down until it equals the expected future spot. Because expectations of future spot rates are formed on the basis of presently available information (historical data) and an interpretation of its implication for the future, they tend to be subject to frequent and rapid revision. The actual future spot rate may therefore deviate markedly from the expectation embodied in the present forward rate for that maturity. The actual exchange rate may deviate from the expected by some random error.
As is indicated in Exhibit 8, in an efficient market the forecasting error will be distributed randomly, according to some probability distribution, with a mean equal to zero. An implication of this is that today's forecast, as represented by the forward rate, is equal to yesterday's forward plus some random amount. In other words, the forward rate itself follows a random walk. Another way of looking at these errors to consider them as speculative profits or losses: what you would gain or lose of you consistently bet against the forward rate. Can they be consistently positive or negative? A priori reasoning suggests that this should not be the case. Otherwise one would have to explain why consistent losers do not quit the market, or why consistent winners are not imitated by others or do not increase their volume of activity, thus causing adjustment of the forward rate in the direction of their expectation. Barring such explanation, one would expect that the forecast error is sometimes positive, sometimes negative, alternating in a random fashion, driven by unexpected events in the economic and political environment.
Rigorously tested academic models have cast doubt on the pure unbiased forward rate theory of efficiency, and demonstrated the presence of speculative profit opportunities (for example, by the use of "filter rules"). However it is also logical to suppose that speculators will bear foreign exchange risk only if they are compensated with a risk premium. Are the above-zero expected returns excessive in a risk-adjusted sense? Given the small size of the bias in the forward exchange market, and the magnitude of daily currency fluctuations, the answer is "probably not."
As a result of their finding that the foreign exchange markets are among the world's most efficient, academics argue the exchange rate forecasting by corporations, in the sense of trying to beat the market, plays a role only under very special circumstances. Indeed few firms are actively decide to commit real assets in order to take currency positions. Rather, they get involved with foreign currencies in the course of pursuing profits from the exploitation of a competitive advantage; rather than being based on currency expectations, this advantage is based on expertise in such areas as production, marketing, the organization of people, or other technical resources. If someone does have special expertise in forecasting foreign exchange rates, such skills can usually be put to use without incurring the risks and costs of committing funds to other than purely financial assets. Most finance managers of nonfinancial enterprises concentrate on producing and selling goods; they should find themselves acting as speculative foreign exchange traders only because of an occasional opportunity encountered in the course of their normal operations. Only when foreign exchange markets are systematically distorted by government controls on financial institutions do the operations of trading and manufacturing firms provide an opportunity to move funds and gain from purely financial transactions. Exhibit 9 offers a flowchart of criteria for forecasting and hedging decisions.
Forecasting exchange rate changes, however, is important for planning purposes. To the extent that all significant managerial tasks are concerned with the future, anticipated exchange rate changes are a major input into virtually all decisions of enterprises involved in and affected by international transactions. However, the task of forecasting foreign exchange rates for planning and decision-making purposes, with the purpose of determining the most likely exchange rate, is quite different from attempting to beat the market in order to derive speculative profits.
Expected exchange rate changes are revealed by market prices when rates are free to reach their competitive levels. Organized futures or forward markets provide inexpensive information regarding future exchange rates, using the best available data and judgment. Thus, whenever profit-seeking, well-informed traders can take positions, forward rates, prices of future contracts, and interest differentials for instruments of similar riskiness (but denominated in different currencies), provide good indicators of expected exchange rates. In this fashion, an input for corporate planning and decision-making is readily available in all currencies where there are no effective exchange controls. The advantage of such market-based rates over "in-house" forecasts is that they are both less expensive and more likely to be accurate. Market rates are determined by those who tend to have the best information and track-record; incompetent market participants lose money and are eliminated.
The nature of this market-based expected exchange rate should not lead to confusing notions about the accuracy of prediction. In speculative markets, all decisions are made on the basis of interpretation of past data; however, new information surfaces constantly. Therefore, market-based forecasts rarely will come true. The actual price of a currency will either be below or above the rate expected by the market. If the market knew which would be more likely, any predictive bias quickly would be corrected. Any predictable, economically meaningful bias would be corrected by the transactions of profit-seeking transactors.
The importance of market-based forecasts for a determination of the foreign exchange exposure of the firm is that of a benchmark against which the economic consequences of deviations must be measured. This can be put in the form of a concrete question: How will the expected net cash flow of the firm behave if the future spot exchange rate is not equal to the rate predicted by the market when commitments are made? The nature of this kind of forecast is completely different from trying to outguess the foreign exchange markets
Corporations nevertheless avidly seek ways to predict currencies, in order to decide when and when not to hedge. The models they use are typically one or more of the following kinds: political event analysis, or fundamental, or technical.
Academic students of international finance, in contrast, find strong empirical support for the role of arbitrage in global financial markets, and for the view that exchange rates exhibit behavior that is characteristic of other speculative asset markets. Exchange rates react quickly to news. Rates are far more volatile than changes in underlying economic variables; they are moved by changing expectations, and hence are difficult to forecast. In a broad sense they are "efficient," but tests of efficiency face inherent obstacles in testing the precise nature of this efficiency directly.
The central "efficient market" model is the unbiased forward rate theory introduced earlier. It says that the forward rate equals the expected future level of the spot rate. Because the forward rate is a contractual price, it offers opportunities for speculative profits for those who correctly assess the future spot price relative to the current forward rate. Specifically, risk neutral players will seek to make a profit their forecast differs from the forward rate, so if there are enough such participants the forward rate will always be bid up or down until it equals the expected future spot. Because expectations of future spot rates are formed on the basis of presently available information (historical data) and an interpretation of its implication for the future, they tend to be subject to frequent and rapid revision. The actual future spot rate may therefore deviate markedly from the expectation embodied in the present forward rate for that maturity. The actual exchange rate may deviate from the expected by some random error.
As is indicated in Exhibit 8, in an efficient market the forecasting error will be distributed randomly, according to some probability distribution, with a mean equal to zero. An implication of this is that today's forecast, as represented by the forward rate, is equal to yesterday's forward plus some random amount. In other words, the forward rate itself follows a random walk. Another way of looking at these errors to consider them as speculative profits or losses: what you would gain or lose of you consistently bet against the forward rate. Can they be consistently positive or negative? A priori reasoning suggests that this should not be the case. Otherwise one would have to explain why consistent losers do not quit the market, or why consistent winners are not imitated by others or do not increase their volume of activity, thus causing adjustment of the forward rate in the direction of their expectation. Barring such explanation, one would expect that the forecast error is sometimes positive, sometimes negative, alternating in a random fashion, driven by unexpected events in the economic and political environment.
Rigorously tested academic models have cast doubt on the pure unbiased forward rate theory of efficiency, and demonstrated the presence of speculative profit opportunities (for example, by the use of "filter rules"). However it is also logical to suppose that speculators will bear foreign exchange risk only if they are compensated with a risk premium. Are the above-zero expected returns excessive in a risk-adjusted sense? Given the small size of the bias in the forward exchange market, and the magnitude of daily currency fluctuations, the answer is "probably not."
As a result of their finding that the foreign exchange markets are among the world's most efficient, academics argue the exchange rate forecasting by corporations, in the sense of trying to beat the market, plays a role only under very special circumstances. Indeed few firms are actively decide to commit real assets in order to take currency positions. Rather, they get involved with foreign currencies in the course of pursuing profits from the exploitation of a competitive advantage; rather than being based on currency expectations, this advantage is based on expertise in such areas as production, marketing, the organization of people, or other technical resources. If someone does have special expertise in forecasting foreign exchange rates, such skills can usually be put to use without incurring the risks and costs of committing funds to other than purely financial assets. Most finance managers of nonfinancial enterprises concentrate on producing and selling goods; they should find themselves acting as speculative foreign exchange traders only because of an occasional opportunity encountered in the course of their normal operations. Only when foreign exchange markets are systematically distorted by government controls on financial institutions do the operations of trading and manufacturing firms provide an opportunity to move funds and gain from purely financial transactions. Exhibit 9 offers a flowchart of criteria for forecasting and hedging decisions.
Forecasting exchange rate changes, however, is important for planning purposes. To the extent that all significant managerial tasks are concerned with the future, anticipated exchange rate changes are a major input into virtually all decisions of enterprises involved in and affected by international transactions. However, the task of forecasting foreign exchange rates for planning and decision-making purposes, with the purpose of determining the most likely exchange rate, is quite different from attempting to beat the market in order to derive speculative profits.
Expected exchange rate changes are revealed by market prices when rates are free to reach their competitive levels. Organized futures or forward markets provide inexpensive information regarding future exchange rates, using the best available data and judgment. Thus, whenever profit-seeking, well-informed traders can take positions, forward rates, prices of future contracts, and interest differentials for instruments of similar riskiness (but denominated in different currencies), provide good indicators of expected exchange rates. In this fashion, an input for corporate planning and decision-making is readily available in all currencies where there are no effective exchange controls. The advantage of such market-based rates over "in-house" forecasts is that they are both less expensive and more likely to be accurate. Market rates are determined by those who tend to have the best information and track-record; incompetent market participants lose money and are eliminated.
The nature of this market-based expected exchange rate should not lead to confusing notions about the accuracy of prediction. In speculative markets, all decisions are made on the basis of interpretation of past data; however, new information surfaces constantly. Therefore, market-based forecasts rarely will come true. The actual price of a currency will either be below or above the rate expected by the market. If the market knew which would be more likely, any predictive bias quickly would be corrected. Any predictable, economically meaningful bias would be corrected by the transactions of profit-seeking transactors.
The importance of market-based forecasts for a determination of the foreign exchange exposure of the firm is that of a benchmark against which the economic consequences of deviations must be measured. This can be put in the form of a concrete question: How will the expected net cash flow of the firm behave if the future spot exchange rate is not equal to the rate predicted by the market when commitments are made? The nature of this kind of forecast is completely different from trying to outguess the foreign exchange markets
Financial versus operating strategies for hedging.
When operating (cash) inflows and (contractual) outflows from liabilities are affected by exchange rate changes, the general principle of prudent exchange risk management is: any effect on cash inflows and outflows should cancel out as much as possible. This can be achieved by maneuvering assets, liabilities or both. When should operations -- the asset side -- be used?
We have demonstrated that exchange rate changes can have tremendous effects on operating cash flows. Does it not therefore make sense to adjust operations to hedge against these effects? Many companies, such as Japanese auto producers, are now seeking flexibility in production location, in part to be able to respond to large and persistent exchange rate changes that make production much cheaper in one location than another. Among the operating policies are the shifting of markets for output, sources of supply, product-lines, and production facilities as a defensive reaction to adverse exchange rate changes. Put differently, deviations from purchasing power parity provide profit opportunities for the operations-flexible firm. This philosophy is epitomized in the following quotation.
It has often been joked at Philips that in order to take advantage of currency movements, it would be a good idea to put our factories aboard a supertanker, which could put down anchor wherever exchange rates enable the company to function most efficiently...In the present currency markets...[this] would certainly not be a suitable means of transport for taking advantage of exchange rate movements. An aeroplane would be more in line with the requirements of the present era.
The problem is that Philips' production could not fit into either craft. It is obvious that such measures will be very costly, especially if undertaken over a short span of time. it follows that operating policies are not the tools of choice for exchange risk management. Hence operating policies which have been designed to reduce or eliminate exposure will only be undertaken as a last resort, when less expensive options have been exhausted.
It is not surprising, therefore, that exposure management focuses not on the asset side, but primarily on the liability side of the firm's balance sheet. Exhibit 7 provides a summary of the steps involved in managing economic exposure. Whether and how these steps should be implemented depends first, on the extent to which the firm wishes to rely on currency forecasting to make hedging decisions, and second, on the range of hedging tools available and their suitability to the task.
We have demonstrated that exchange rate changes can have tremendous effects on operating cash flows. Does it not therefore make sense to adjust operations to hedge against these effects? Many companies, such as Japanese auto producers, are now seeking flexibility in production location, in part to be able to respond to large and persistent exchange rate changes that make production much cheaper in one location than another. Among the operating policies are the shifting of markets for output, sources of supply, product-lines, and production facilities as a defensive reaction to adverse exchange rate changes. Put differently, deviations from purchasing power parity provide profit opportunities for the operations-flexible firm. This philosophy is epitomized in the following quotation.
It has often been joked at Philips that in order to take advantage of currency movements, it would be a good idea to put our factories aboard a supertanker, which could put down anchor wherever exchange rates enable the company to function most efficiently...In the present currency markets...[this] would certainly not be a suitable means of transport for taking advantage of exchange rate movements. An aeroplane would be more in line with the requirements of the present era.
The problem is that Philips' production could not fit into either craft. It is obvious that such measures will be very costly, especially if undertaken over a short span of time. it follows that operating policies are not the tools of choice for exchange risk management. Hence operating policies which have been designed to reduce or eliminate exposure will only be undertaken as a last resort, when less expensive options have been exhausted.
It is not surprising, therefore, that exposure management focuses not on the asset side, but primarily on the liability side of the firm's balance sheet. Exhibit 7 provides a summary of the steps involved in managing economic exposure. Whether and how these steps should be implemented depends first, on the extent to which the firm wishes to rely on currency forecasting to make hedging decisions, and second, on the range of hedging tools available and their suitability to the task.
MANAGING ECONOMIC EXPOSURE
Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows .
From this analytical framework, some practical implications emerge for the assessment of economic exposure. First of all, the firm must project its cost and revenue streams over a planning horizon that represents the period of time during which the firm is "locked-in," or constrained from reacting to (unexpected) exchange rate changes. It must then assess the impact of a deviation of the actual exchange rate from the rate used in the projection of costs and revenues.
STEPS IN MANAGING ECONOMIC EXPOSURE
1. Estimation of planning horizon as determined by reaction period.
2. Determination of expected future spot rate.
3. Estimation of expected revenue and cost streams, given the expected spot rate.
4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes.
5. Choice of appropriate currency for debt denomination.
6. Estimation of necessary amount of foreign currency debt.
7. Determination of average interest period of debt.
8. Selection between direct or indirect debt denomination.
9. Decision on trade-off between arbitrage gains vs. exchange risk stemming from exposure in markets where rates are distorted by controls.
10. Decision about "residual" risk: consider adjusting business strategy.
Subsequently, the effects on the various cash flows of the firm must be netted over product lines and markets to account for diversification effects where gains and losses could cancel out, wholly or in part. The remaining net loss or gain is the subject of economic exposure management. For a multiunit, multiproduct, multinational corporation the net exposure may not be very large at all because of the many offsetting effects.7 By contrast, enterprises that have invested in the development of one or two major foreign markets are typically subject to considerable fluctuations of their net cash flows, regardless of whether they invoice in their own or in the foreign currency.
For practical purposes, three questions capture the extent of a company's foreign exchange exposure.
1. How quickly can the firm adjust prices to offset the impact of an unexpected exchange
rate change on profit margins?
2. How quickly can the firm change sources for inputs and markets for outputs? Or,
alternatively, how diversified are a company's factor and product markets?
3. To what extent do volume changes, associated with unexpected exchange rate
changes, have an impact on the value of assets?
Normally, the executives within business firms who can supply the best estimates on these issues tend to be those directly involved with purchasing, marketing, and production. Finance managers who focus exclusively on credit and foreign exchange markets may easily miss the essence of corporate foreign exchange risk.
From this analytical framework, some practical implications emerge for the assessment of economic exposure. First of all, the firm must project its cost and revenue streams over a planning horizon that represents the period of time during which the firm is "locked-in," or constrained from reacting to (unexpected) exchange rate changes. It must then assess the impact of a deviation of the actual exchange rate from the rate used in the projection of costs and revenues.
STEPS IN MANAGING ECONOMIC EXPOSURE
1. Estimation of planning horizon as determined by reaction period.
2. Determination of expected future spot rate.
3. Estimation of expected revenue and cost streams, given the expected spot rate.
4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes.
5. Choice of appropriate currency for debt denomination.
6. Estimation of necessary amount of foreign currency debt.
7. Determination of average interest period of debt.
8. Selection between direct or indirect debt denomination.
9. Decision on trade-off between arbitrage gains vs. exchange risk stemming from exposure in markets where rates are distorted by controls.
10. Decision about "residual" risk: consider adjusting business strategy.
Subsequently, the effects on the various cash flows of the firm must be netted over product lines and markets to account for diversification effects where gains and losses could cancel out, wholly or in part. The remaining net loss or gain is the subject of economic exposure management. For a multiunit, multiproduct, multinational corporation the net exposure may not be very large at all because of the many offsetting effects.7 By contrast, enterprises that have invested in the development of one or two major foreign markets are typically subject to considerable fluctuations of their net cash flows, regardless of whether they invoice in their own or in the foreign currency.
For practical purposes, three questions capture the extent of a company's foreign exchange exposure.
1. How quickly can the firm adjust prices to offset the impact of an unexpected exchange
rate change on profit margins?
2. How quickly can the firm change sources for inputs and markets for outputs? Or,
alternatively, how diversified are a company's factor and product markets?
3. To what extent do volume changes, associated with unexpected exchange rate
changes, have an impact on the value of assets?
Normally, the executives within business firms who can supply the best estimates on these issues tend to be those directly involved with purchasing, marketing, and production. Finance managers who focus exclusively on credit and foreign exchange markets may easily miss the essence of corporate foreign exchange risk.
Currency of denomination versus currency of determination
One of the central concepts of modern international corporate finance is the distinction between the currency in which cash flows are denominated and the currency that determines the size of the cash flows. In the example in the previous section, it does not matter whether, as a matter of business practice, the firm may contract, be invoiced in, and pay for each individual shipment in its own local currency. If foreign exporters do not provide price concessions, the cash outflow of the importer behaves just like a foreign currency cash flow; even though payments are made in local currency, they occur in greater amounts. As a result, the cash flow, even while denominated in local currency, is determined by the relative value of the foreign currency. The functional currency concept introduced in FAS 52 is similar to the "currency of determination" -- but not exactly. The currency of determination refers to revenue and operating expense flows, respectively; the functional currency concept pertains to an entity as a whole, and is, therefore, less precise.
To complicate things further, the currency of recording, that is, the currency in which the accounting records are kept, is yet another matter. For example, any debt contracted by the firm in foreign currency will always be recorded in the currency of the country where the corporate entity is located. However, the value of its legal obligation is established in the currency in which the contract is denominated. An example of the importance of these distinctions may be found in Exhibit 5.
It is possible, therefore, that a firm selling in export markets may record assets and liabilities in its local currency and invoice periodic shipments in a foreign currency and yet, if prices in the market are dominated by transactions in a third country, the cash flows received may behave as if they were in that third currency. To illustrate: a Brazilian firm selling coffee to West Germany may keep its records in cruzeiros, invoice in German marks, and have DM-denominated receivables, and physically collect DM cash flow, only to find that its revenue stream behaves as if it were in U.S. dollars! This occurs because DM-prices for each consecutive shipment are adjusted to reflect world market prices which, in turn, tend to be determined in U.S. dollars. The significance of this distinction is that the currency of denomination is (relatively) readily subject to management discretion, through the choice of invoicing currency. Prices and cash flows, however, are determined by competitive conditions which are beyond the immediate control of the firm.
Yet an additional dimension of exchange risk involves the element of time. In the very short run, virtually all local currency prices for real goods and services (although not necessarily for financial assets) remain unchanged after an unexpected exchange rate change. However, over a longer period of time, prices and costs move inversely to spot rate changes; the tendency is for Purchasing Power Parity and the Law of One Price to hold.
In reality, this price adjustment process takes place over a great variety of time patterns. These patterns depend not only on the products involved, but also on market structure, the nature of competition, general business conditions, government policies such as price controls, and a number of other factors. Considerable work has been done on the phenomenon of "pass-through" of price changes caused by (unexpected) exchange rate changes. And yet, because all the factors that determine the extent and speed of pass-through are very firm-specific and can be analyzed only on a case-by-case basis at the level of the operating entity of the firm (or strategic business unit), generalizations remain difficult to make. Exhibit 6 summarizes the firm-specific effects of exchange rate changes on operating cash flows.
Conceptually, though, it is important to determine the time frame within which the firm cannot react to (unexpected) rate changes by (1) raising prices; (2) changing markets for inputs and outputs; and/or (3) adjusting production and sales volumes. Sometimes, at least one of these reactions is possible within a relatively short time; at other times the firm is "locked-in" through contractual or strategic commitments extending considerably into the future. Indeed, those firms which are free to react instantaneously and fully to adverse (unexpected) rate changes are not subject to exchange risk.
A further implication of the time-frame element is that exchange risk stems from the firm's position when its cash flows are, for a significant period, exposed to (unexpected) exchange rate changes, rather than the risk resulting from any specific international involvement. Thus, companies engaged purely in domestic transactions but who have dominant foreign competitors may feel the effect of exchange rate changes in their cash flows as much or even more than some firms that are actively engaged in exports, imports, or foreign direct investment.
To complicate things further, the currency of recording, that is, the currency in which the accounting records are kept, is yet another matter. For example, any debt contracted by the firm in foreign currency will always be recorded in the currency of the country where the corporate entity is located. However, the value of its legal obligation is established in the currency in which the contract is denominated. An example of the importance of these distinctions may be found in Exhibit 5.
It is possible, therefore, that a firm selling in export markets may record assets and liabilities in its local currency and invoice periodic shipments in a foreign currency and yet, if prices in the market are dominated by transactions in a third country, the cash flows received may behave as if they were in that third currency. To illustrate: a Brazilian firm selling coffee to West Germany may keep its records in cruzeiros, invoice in German marks, and have DM-denominated receivables, and physically collect DM cash flow, only to find that its revenue stream behaves as if it were in U.S. dollars! This occurs because DM-prices for each consecutive shipment are adjusted to reflect world market prices which, in turn, tend to be determined in U.S. dollars. The significance of this distinction is that the currency of denomination is (relatively) readily subject to management discretion, through the choice of invoicing currency. Prices and cash flows, however, are determined by competitive conditions which are beyond the immediate control of the firm.
Yet an additional dimension of exchange risk involves the element of time. In the very short run, virtually all local currency prices for real goods and services (although not necessarily for financial assets) remain unchanged after an unexpected exchange rate change. However, over a longer period of time, prices and costs move inversely to spot rate changes; the tendency is for Purchasing Power Parity and the Law of One Price to hold.
In reality, this price adjustment process takes place over a great variety of time patterns. These patterns depend not only on the products involved, but also on market structure, the nature of competition, general business conditions, government policies such as price controls, and a number of other factors. Considerable work has been done on the phenomenon of "pass-through" of price changes caused by (unexpected) exchange rate changes. And yet, because all the factors that determine the extent and speed of pass-through are very firm-specific and can be analyzed only on a case-by-case basis at the level of the operating entity of the firm (or strategic business unit), generalizations remain difficult to make. Exhibit 6 summarizes the firm-specific effects of exchange rate changes on operating cash flows.
Conceptually, though, it is important to determine the time frame within which the firm cannot react to (unexpected) rate changes by (1) raising prices; (2) changing markets for inputs and outputs; and/or (3) adjusting production and sales volumes. Sometimes, at least one of these reactions is possible within a relatively short time; at other times the firm is "locked-in" through contractual or strategic commitments extending considerably into the future. Indeed, those firms which are free to react instantaneously and fully to adverse (unexpected) rate changes are not subject to exchange risk.
A further implication of the time-frame element is that exchange risk stems from the firm's position when its cash flows are, for a significant period, exposed to (unexpected) exchange rate changes, rather than the risk resulting from any specific international involvement. Thus, companies engaged purely in domestic transactions but who have dominant foreign competitors may feel the effect of exchange rate changes in their cash flows as much or even more than some firms that are actively engaged in exports, imports, or foreign direct investment.
WHAT IS ECONOMIC EXPOSURE?
PDVSA, the Venezuelan state-owned oil company, recently set up an oil refinery near Rotterdam, The Netherlands for shipment to Germany and other continental European countries. The firm planned to invoice its clients in ECU, the official currency unit of the European Community. The treasurer is considering sources of long term financing. In the past all long term finance has been provided by the parent company, but working capital required to pay local salaries and expenses has been financed in Dutch guilders. The treasurer is not sure whether the short term debt should be hedged, or what currency to issue long term debt in.
This is an example of a situation where the definition of exposure has a direct impact on the firm's hedging decisions.
Translation exposure has to do with the location of the assets, which in this case would be a totally misleading measure of the effect of exchange rate changes on the value of the unit. After all, the oil comes from Venezuela and is shipped to Germany: its temporary resting place, be it a refinery in Rotterdam or a tanker en route to Germany, has no import. Both provide value added, but neither determine the currency of revenues. So financing should definitely not be done in Dutch guilders.
Transactions exposure has to do with the currency of denomination of assets like accounts receivable or payable. Once sales to Germany have been made and invoicing in ECU has taken place, PDVSA-Netherlands has contractual, ECU-denominated assets that should be financed or hedged with ECU. For future sales, however, PDVSA-Netherlands does not have exposure to the ECU. This is because the currency of determination is the U.S. dollar.
Economic exposure is tied to the currency of determination of revenues and costs. Since the world market price of oil is dollars, this is the effective currency in which PDVSA's future sales to Germany are made. If the ECU rises against the dollar, PDVSA must adjust its ECU price down to match those of competitors like Aramco. If the dollar rises against the ECU, PDVSA can and should raise prices to keep the dollar price the same, since competitors would do likewise. Clearly the currency of determination is influenced by the currency in which competitors denominate prices.
This is an example of a situation where the definition of exposure has a direct impact on the firm's hedging decisions.
Translation exposure has to do with the location of the assets, which in this case would be a totally misleading measure of the effect of exchange rate changes on the value of the unit. After all, the oil comes from Venezuela and is shipped to Germany: its temporary resting place, be it a refinery in Rotterdam or a tanker en route to Germany, has no import. Both provide value added, but neither determine the currency of revenues. So financing should definitely not be done in Dutch guilders.
Transactions exposure has to do with the currency of denomination of assets like accounts receivable or payable. Once sales to Germany have been made and invoicing in ECU has taken place, PDVSA-Netherlands has contractual, ECU-denominated assets that should be financed or hedged with ECU. For future sales, however, PDVSA-Netherlands does not have exposure to the ECU. This is because the currency of determination is the U.S. dollar.
Economic exposure is tied to the currency of determination of revenues and costs. Since the world market price of oil is dollars, this is the effective currency in which PDVSA's future sales to Germany are made. If the ECU rises against the dollar, PDVSA must adjust its ECU price down to match those of competitors like Aramco. If the dollar rises against the ECU, PDVSA can and should raise prices to keep the dollar price the same, since competitors would do likewise. Clearly the currency of determination is influenced by the currency in which competitors denominate prices.
WHAT DOES THE EFFECT OF EXCHANGE RATE CHANGES ON OPERATIONAL CASH FLOWS DEPEND ON?
1. VOLUME EFFECTS (compensate for changes in profit margins)
2. PRICING FLEXIBILITY (change in margins to offset effect of exchange rate change)
3. DIVERSIFICATION of markets for inputs and outputs
4. PRODUCTION AND SALES FLEXIBILITY (ability to shift markets and sources quickly)
Inventories may serve as a good illustration of this proposition. The value of an inventory in a foreign subsidiary is determined not only by changes in the exchange rate, but also by a subsequent price change of the product--to the extent that the underlying cause of this price change is the exchange rate change. Thus, the dollar value of an inventory destined for export may increase when the currency of the destination country appreciates, provided its local currency prices do not decrease by the full percentage of the appreciation. Exhibit 4 provides a numerical illustration.
The effect on the local currency price depends, in part, on competition in the market. The behavior of foreign and local competitors, in turn, depends on capacity utilization, market share objectives, likelihood of cost adjustments and a host of other factors. Of course, firms are not only interested in the value change or the behavior of cash flows of a single asset, but rather in the behavior of all cash flows. Again, price and cost adjustments need to be analyzed. For example, a firm that requires raw materials from abroad for production will usually find its stream of cash outlays going up when its local currency depreciates against foreign currencies. Yet the depreciation may cause foreign suppliers to lower prices in terms of foreign currencies for the purpose of maintaining market share.
2. PRICING FLEXIBILITY (change in margins to offset effect of exchange rate change)
3. DIVERSIFICATION of markets for inputs and outputs
4. PRODUCTION AND SALES FLEXIBILITY (ability to shift markets and sources quickly)
Inventories may serve as a good illustration of this proposition. The value of an inventory in a foreign subsidiary is determined not only by changes in the exchange rate, but also by a subsequent price change of the product--to the extent that the underlying cause of this price change is the exchange rate change. Thus, the dollar value of an inventory destined for export may increase when the currency of the destination country appreciates, provided its local currency prices do not decrease by the full percentage of the appreciation. Exhibit 4 provides a numerical illustration.
The effect on the local currency price depends, in part, on competition in the market. The behavior of foreign and local competitors, in turn, depends on capacity utilization, market share objectives, likelihood of cost adjustments and a host of other factors. Of course, firms are not only interested in the value change or the behavior of cash flows of a single asset, but rather in the behavior of all cash flows. Again, price and cost adjustments need to be analyzed. For example, a firm that requires raw materials from abroad for production will usually find its stream of cash outlays going up when its local currency depreciates against foreign currencies. Yet the depreciation may cause foreign suppliers to lower prices in terms of foreign currencies for the purpose of maintaining market share.
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