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learning outcomes
•Understand foreign exchange risk and how exposure is related to it
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Appreciate the value of corporate hedging
•The relation between currency exposure and firm market value
•Operating risk management
foreign exchange exposure
•Foreign exchange exposure measures the sensitivity of a firm’s profitability, net cash flow, and market value to exchange rate variation
•There are three forms of foreign exchange exposure:
–Transaction exposure: the settling of the outstanding obligations in foreign currency
–Accounting exposure: the translation of accounts denominated in foreign currencies into home currency of the reporting entity
–Operating exposure: is related to long-term future cash flows expected in the course of normal business
types of foreign exchange exposure
•Example: Nissan exports cars to the U.S.
•Transaction exposure: the strength/weakness of the US$ affects the revenue in JPY. Because Nissan incurs costs in JPY, an appreciation of US$ leads to higher income in JPY, hence higher profit in JPY
•Accounting exposure: the current JPY/$ rate is used to record the revenue. If the US$ ↑ (↓), a profit (loss) is recorded
Types of foreign exchange exposure
•Operating exposure: how Nissan competes with other car manufacturers such as General Motors (GM)
•Operating exposure can be illustrated in a chain of events: (1) A depreciationin the yen led to (2) additional gross marginfor Japanese automakers, who (3) passed along some of this benefit to consumers in the form of lower prices, and (4) as a result of lower prices the Japanese automakers gained market sharein the U.S., which (5) ate into unit sales at GM, which (6) lowered GM’s profits, which (7) reduced GM’s market value
Which exposure we manage
•Hedging is aimed at reducing exposure and therefore the associated risk
•It is generally accepted that accounting exposure does not matter if it has no impact on firm economic value
•We will find that the usual ways of managing risk are:
–Transaction exposure –Traditional risk management products and financial derivatives
–Operating exposure –Strategic and capital structure methods
who should manage this risk?
•Consider a large corporation with major exposure to certain macroeconomic factors (FX rates, interest rates, commodity prices, etc.). Who should manage this risk?
1.The managers of the corporation
2.The shareholders/bondholders of the company
advantages of hedging at the portfolio level
•Suppose that shareholders invest in both Nissan and GM. When JPY depreciates, the fall in GM’s share price will be offset by the gain from Nissan’s share price
•Hence, portfolio diversification helps eliminate firm specific or idiosyncratic risk (i.e. Currency risk)
•Portfolio managers are experts in finance, and hence risk management. Company managers are not –it is not their competitive advantage
Modigliani-Miller proposition
•The Modigliani-Miller theorem states that risk management activities (hedging) do not change the value of the firm unless they lower the firm’s taxes, affect its investment decision or can be done cheaper than individual investor’s transactions
–Total Risk = Systematic Risk + Idiosyncratic Risk
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