Ian H. Giddy
6.5 MANAGING ECONOMIC EXPOSURE
(a) 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.
Subsequently, the effects on the various cash flows of the firm must be netted over product lines and markets to account for diversification effects wherein gains and losses could cancel out, wholly or in part. The remaining net loss or gain is the sub- ject of economic exposure management. For a multiunit, multiproduct, multinational corporation, the net exposure may not be very large at all because of the many off- setting effects. 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.
Normally, the executives within business firms who can supply the best estimates of these effects of unanticipated currency changes in future operating cash flows 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 (see Exhibit 6.6).
(b) Financial versus Operating Strategies for Hedging. When operating (cash) in- flows 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. Copeland and Yoshi, whose study of currency hedging found transactions hedging to be of little value, assert,
“relocating plants and adjusting pricing often provide the best hedge against foreign exchange risk” (Copeland and Yoshi, 1996). 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
For practical purposes, four questions capture the extent of a company's foreign exchange ex- posure:
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, alterna- tively, how diversified are a company's factor and product markets?
3. To what extent does the firm have the ability to switch markets and sources quickly?
4. Do changes in the volume of sales, associated with unexpected exchange rate changes, have an impact on the value of assets?
Exhibit 6.6. Practical Measures of FX Exposure.
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 trans- port for taking advantage of exchange rate movements. An airplane would be more in line with the requirements of the present era.
The problem is that Philips’s 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 that have been designed to reduce or elimi- nate exposure will be undertaken only as a last resort, when less expensive options have been exhausted.
As firms face foreign exchange risk, they try to reduce this cause of cash flow volatility through either financial or operative hedging. The strengths of financial hedging are the great ease with which the hedge can be modified according to the changing exposure of the firm. However, liquid markets for financial hedging instru- ments in some currencies exist for short maturities only. Operative hedging is clearly more costly to implement and less flexible, but it provides the company with a natu- ral hedging mechanism that is very appealing: if revenues and their costs are gener- ated in the same currency and move in tandem because they are determined by the same factors, exchange risk is eliminated “automatically” (Logue, 1995). Last but not least, within the political environment of the firm’s management, conflicts of respon- sibility and blame for hedging losses between treasury and operating departments (production, purchasing, sales) are being minimized. Firms seem to be using finan- cial instruments more frequently in order to hedge exposures in the short run, whereas operative hedging is used to insure against long run exposures (Chowdhry and Howe, 1996).
It is not surprising, therefore, that risk management focuses not on the asset side, but primarily on the liability side of the firm’s balance sheet. Exhibit 6.7 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. These issues are ad- dressed in the next two sections.
6.6 GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES. Acade- mics and practitioners have sought to discover the determinants of exchange ever since there were currencies. Many students have learned about the balance of trade and that the more a country exports, the more demand there is for its currency, and the stronger is its exchange rate. In practice, the story is a lot more complex. Re-
search in the foreign exchange markets has come a long way since the days when in- ternational 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 currency values 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, probably because the worlds’ economies and financial markets are undergoing constant rapid evolution.
Corporations nevertheless avidly seek ways to predict currencies, in order to de- cide when to hedge and when not to hedge. The models typically fall into one of the following categories: political event analysis, fundamental, or technical analysis.
Academic studies in international finance, in contrast, find strong empirical sup- port for the role of arbitrage in global financial markets, and for the view that ex- change rates exhibit behavior that is characteristic of other speculative asset markets:
They react to news. Rates are far more volatile than changes in underlying economic variables; they are moved by changing expectations, and hence are difficult to fore- cast. In a broad sense they are “efficient” but tests of efficiency face inherent obsta- cles in testing the precise nature of this efficiency directly.
The simplistic “efficient market” model is the unbiased forward rate theory intro- duced 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 spec- ulative profits for those who correctly assess the future spot price relative to the cur- rent forward rate. Specifically, risk neutral players will seek to make a profit if their forecast differs from the forward rate, so if there are enough such participants, the forward rate will always be bid up and down until it equals the expected future spot.
Because expectations of future spot rates are found on the basis of presently avail- able information (historical data) and an interpretation of its implication for the fu- ture, they tend to be subject to frequent and rapid revision. The actual future spot rate STEPS IN MANAGING ECONOMIC EXPOSURE
1. Estimation of planning horizon as determined by reaction period (time dependence of ex- posure).
2. Determination of expected future spot rate (depending on state of FX market, usually for- ward 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 (exposure estimation).
5. Choice between hedging and positioning (depending on state of FX market)
6. Choice of appropriate type of hedging instrument/strategy (cash market, derivatives, arbi- trage considerations).
7. Determination of specific characteristics of hedging instrument (duration, denomination, options)
8. Estimation of amount of hedging instrument required.
9. Decision about “residual” risk: consider adjusting business strategy/operations.
Exhibit 6.7. Steps in Managing Economic Exposure.
may therefore deviate markedly from the expectation embodied in the present for- ward rate for that maturity.
As is indicated in Exhibit 6.8, 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.1
Another way of looking at these is to consider them as speculative profits or losses: what you would gain or lose if 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 ran- dom fashion, driven by unexpected events in the economic and political environ- ment.
Rigorously tested academic models have cast doubt on the pure unbiased forward rate theory of efficiency, and demonstrated the presence of speculative profit oppor- Exhibit 6.8. The Unbiased Forward Rate Theory. This theory says, in effect, that the forward rate follows a random walk; this implies that the spot rate follows a random walk with drift.
For ward Spot
Today In three
months TIME Actual
Probability distribution of actual exchange rate EXCHANGE RATE
1Note that when we say the forward rate follows a random walk, we mean the forward for a given de- livery date, not the rolling three-month forward. Since the only published measure of a forward rate for a given delivery date is the price of a futures contract, the latter serves as a proxy to test the proposition that the forward rate should fluctuate randomly.
tunities for certain currencies during specified periods (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 that exchange rate forecasting by corpora- tions, in the sense of trying to beat the market, plays a role only under very special circumstances. Indeed, few firms 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. Instead of being based on currency expectations, this advantage is based on expertise in such areas as production, marketing, the organization of people, or other technical re- sources. 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 managers of nonfinan- cial enterprises concentrate on producing and selling goods; they should find them- selves 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 6.9 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, an- ticipated exchange rate changes are a major input into virtually all decisions of en- terprises 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 at- tempting 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 in- expensive information regarding future exchange rates, using the best available data and judgment. Thus, whenever profit-seeking, well-informed traders can take posi- tions, forward rates, prices of future contracts, and interest differentials for instru- ments of similar risk (but denominated in different currencies) provide good indica- tors 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 ex- change 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. Those who tend to have the best information and track record determine market rates; incompetent market participants lose money and are eliminated.
The nature of this market-based expected exchange rate should not lead to con- fusing notions about the accuracy of prediction. In speculative markets, all decisions are made on the basis of interpretation of past data; however, new information sur- faces 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 ex- change exposure of the firm is that of a benchmark against which the economic con- sequences 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 making of this kind of forecast is completely different from trying to out- guess the foreign exchange markets.
6.7 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE