Ways to Neutralize Foreign Exchange Risk

Note, however, that currency swings work both ways. A weak dollar would boost foreign returns of U.S. investors. Exhibit 33 is a quick reference to judge how currency swings affect your foreign returns.

CURRENCY RISK MANAGEMENT

Foreign exchange rate risk exists when the contract is written in terms of the foreign currency or denominated in the foreign currency. The exchange rate fluctuations increase the riskiness of the investment and incur cash losses. The financial manager must not only seek the highest return on temporary investments but must also be concerned about changing values of the currencies invested. You do not necessarily eliminate foreign exchange risk. You may only try to contain it. In countries where currency values are likely to drop, financial managers of the subsidiaries should:

• Avoid paying advances on purchase orders unless the seller pays interest on the advances sufﬁcient to cover the loss of purchasing power.

• Not have excess idle cash. Excess cash can be used to buy inventory or other real assets.

• Buy materials and supplies on credit in the country in which the foreign subsidiary is operating, extending the ﬁnal payment date as long as possible.

• Avoid giving excessive trade credit. If accounts receivable balances are outstanding for an extended time period, interest should be charged to absorb the loss in purchasing power.

• Borrow local currency funds when the interest rate charged does not exceed U.S.

rates after taking into account expected devaluation in the foreign country.

A.1. Entering a Money-Market Hedge

Here the exposed position in a foreign currency is offset by borrowing or lending in the money market.

EXAMPLE 40

XYZ, an American importer enters into a contract with a British supplier to buy merchandise for 4,000 pounds. The amount is payable on the delivery of the good, 30 days from today. The company knows the exact amount of its pound liability in 30 days. However, it does not know the payable in dollars. Assume that the 30-day money-market rates for both lending and borrowing in the U.S. and U.K. are .5% and 1%, respectively. Assume further that today’s foreign exchange rate is $1.735 per pound.

In a money-market hedge, XYZ can take the following steps:

Step 1. Buy a one-month U.K. money-market security, worth 4,000/(1 + .005) = 3,980 pounds.

This investment will compound to exactly 4,000 pounds in one month.

Step 2. Exchange dollars on today’s spot (cash) market to obtain the 3,980 pounds. The dollar amount needed today is 3,980 pounds × $1.7350 per pound = $6,905.30.

Step 3. If XYZ does not have this amount, it can borrow it from the U.S. money market at the going rate of 1%. In 30 days XYZ will need to repay $6,905.30 × (1 + .1) = $7,595.83.

Note: XYZ need not wait for the future exchange rate to be available. On today’s date, the future dollar amount of the contract is known with certainty. The British supplier will receive 4,000 pounds, and the cost of XYZ to make the payment is $7,595.83.

A.2. Hedging by Purchasing Forward (or Futures) Exchange Contracts

A forward exchange contract is a commitment to buy or sell, at a specified future date, one currency for a specified amount of another currency (at a specified exchange rate). This can be a hedge against changes in exchange rates during a period of contract or exposure to risk from such changes. More specifically, do the following: (1) Buy foreign exchange forward contracts to cover payables denominated in a foreign currency and (2) sell foreign exchange forward contracts to cover receivables denominated in a foreign currency. This way, any gain or loss on the foreign receivables or payables due to changes in exchange rates is offset by the gain or loss on the forward exchange contract.

EXAMPLE 41

In the previous example, assume that the 30-day forward exchange rate is $1.6153. XYZ may take the following steps to cover its payable.

Step 1. Buy a forward contract today to purchase 4,000 pounds in 30 days.

Step 2. On the 30th day pay the foreign exchange dealer 4,000 pounds × $1.6153 per pound = $6,461.20 and collect 4,000 pounds. Pay this amount to the British supplier.

Note: Using the forward contract XYZ knows the exact worth of the future payment in dollars ($6,461.20).

Note: The basic difference between futures contracts and forward contracts is that futures contracts are for speciﬁed amounts and maturities, whereas forward contracts are for any size and maturity.

A.3. Hedging by Foreign Currency Options

Foreign currency options can be purchased or sold in three different types of markets:

(1) options on the physical currency, purchased on the over-the counter (interbank) market;

CURRENCY RISK MANAGEMENT

(2) options on the physical currency, purchased on organized exchanges such as the Phila- delphia Stock Exchange and the Chicago Mercantile Exchange; and (3) options on futures contracts, purchased on the International Monetary Market (IMM) of the Chicago Mercantile Exchange.

A.4. Using Currency Swaps

Currency swaps are temporary exchanges of funds between two parties—central banks or the central bank and MNC—that do not go through the foreign exchange market. Suppose a U.S. MNC wants to inject capital into its Ghanan subsidiary. The U.S. company signs a swap contract with the central Ghanan bank, then deposits dollars at the bank. The bank then makes a loan in Ghanan currency to the subsidiary ﬁrm. At the end of the loan period, the subsidiary pays off the loan to the bank, which returns the original dollar deposit to the U.S.

MNC. Usually, the central bank does not pay interest on the foreign currency deposit it receives but does charge interest on the loan it makes. Therefore, the cost of the swap includes two interest components: the interest on the loan and the foregone interest on the deposit.

In recent years, MNCs have made direct swaps with each other. In the late l970s some British and U.S. companies were swapping currency, typically for about 10 years. Because British interest rates were higher, the U.S. ﬁrm paid a 2% fee to the British ﬁrm. To protect against movements in U.S.–U.K. exchange rates, many swap contracts often had a top-off provision, calling for renegotiation at settlement time if the exchange rate moved over 10%.

A.5. Repositioning Cash by Leading and Lagging the Time at Which an MNC Makes Operational or Financial Payments

Often, money- and forward-market hedges are not available to eliminate exchange risk. Under such circumstances, leading (accelerating) and lagging (decelerating) may be used to reduce risk.

A.6. Maintaining Balance between Receivables and Payables Denominated in a Foreign Currency

MNCs typically set up multilateral netting centers as a special department to settle the outstanding balances of affiliates of an MNC with each other on a net basis. These act as a clearing house for payments by the firm’s affiliates. If there are amounts due among affiliates they are offset insofar as possible. The net amount would then be paid in the currency of the transaction; thus, a much lower quantity of the currency must be acquired.

A.7. Maintaining Monetary Balance

Monetary balance refers to minimizing accounting exposure. If a company has net positive exposure (more monetary assets than liabilities), it can use more ﬁnancing from foreign monetary sources to balance things. MNCs with assets and liabilities in more than one foreign currency may try to reduce risk by balancing off exposure in the different countries. Often, the monetary balance is practiced across several countries simultaneously.

A.8. Positioning of Funds through Transfer Pricing

A transfer price is the price at which an MNC sells goods and services to its foreign affiliates or, alternatively, the price at which an affiliate sells to the parent. For example, a parent that wishes to transfer funds from an affiliate in a depreciating-currency country may charge a higher price on the goods and services sold to this affiliate by the parent or by affiliates from strong-currency countries. Transfer pricing affects not only transfer of funds from one entity to another but also the income taxes paid by both entities.

CURRENCY RISK MANAGEMENT

CURRENCY SPREAD

A currency spread involves buying an option at one strike price and selling a similar option at a different strike price. Thus, the currency spread limits the option holder’s downside risk on the currency bet but at the cost of limiting the position’s upside potential as well. There are two types of currency spreads:

• A bull spread, which is designed to bet on a currency’s appreciation, involves buying a call at one strike price and selling another call at a higher strike price.

• A bear spread, which is designed to bet on a currency’s decline, involves buying a put at one strike price and selling another put at a lower strike price.

CURRENCY SWAP

Currency swaps are temporary exchanges of monies between two parties that do not go through the foreign exchange market. In official swaps, the two parties are central banks. Private swaps are between central banks and MNCs. Currency swaps are often used to minimize currency risk.

See CURRENCY RISK MANAGEMENT; SWAPS.

CURRENCY TRANSLATION METHODS

Accountants are concerned with the appropriate way to translate foreign currency-denominated items on ﬁnancial statements into their home currency values. If currency values change, translation gains or losses may result. A foreign currency asset or liability is said to be exposed if it must be translated at the current exchange rate. Regardless of the translation method selected, measuring accounting exposure is conceptually the same. It involves determining which foreign currency-denominated assets and liabilities will be translated at the current (postchange) exchange rate and which will be translated at the historical (prechange) exchange rate. The former items are considered to be exposed, while the latter items are regarded as not exposed.

Translation exposure is the difference between exposed assets and exposed liabilities.

There are various alternatives available to measure translation (accounting) exposure. The basic translation methods are the current-rate method, current/noncurrent method, monetary/

nonmonetary method, and temporal method. The current-rate method treats all assets and liabilities as exposed. The current/noncurrent method treats only current assets and liabilities as being exposed. The monetary/nonmonetary method treats only monetary assets and liabilities as being exposed. The temporal method translates ﬁnancial assets and all liabilities valued at current cost as exposed and historical cost assets and liabilities as unexposed.

Exhibit 33 summarizes these four currency translation methods.

EXHIBIT 34

Four Currency Translation Methods

Items Translated at

Current Rate Historical Rate Current rate All assets and all liabilities and

common stock

— Current/noncurrent Current assets and current

liabilities

Fixed assets and long-term liabilities Common stock

Monetary/nonmonetary Monetary assets and all liabilities Physical assets Common stock Temporal Financial assets and all liabilities

and physical assets valued at current price

Physical assets valued at historical cost

Common stock CURRENCY TRANSLATION METHODS

EXAMPLE 42

G&G France, the French subsidiary of a U.S. company, G&G, Inc., has the following balance sheet expressed in French francs:

(1) Suppose the current spot rate is $0.21/FFr. G&G’s translation exposure would be calculated as follows:

Under the current rate method, G&G France’s exposure is its equity of FFr 52 million, or

$10.92 million (0.21 × 52 million). Under the current/noncurrent method, G&G France’s accounting exposure is FFr 34 million (7 + 18 + 31 − 14 − 8, in millions), or $7.14 million (0.21 × 34 million). Its monetary/nonmonetary method accounting exposure is −FFr 42 million (7 + 18 − 14 − 8 − 45, in millions), or −$8.82 million (0.21 ×−42 million). G&G’s temporal method exposure is the same as its current/noncurrent method exposure. The calculations assume that all assets and liabilities are denominated in francs.

(2) Suppose the French Franc depreciates to $0.17. The balance sheets for G&G France at the new exchange rate are shown below.

Assets (FFr thousands) Liabilities (FFr thousands) Cash, marketable securities 7,000 Accounts payable 14,000

Accounts receivable 18,000 Short-term debt 8,000

Inventory 31,000 Long-term debt 45,000

Net ﬁxed assets 63,000 Equity 52,000

FFr 119,000 FFr 119,000

Current Rate Method

Assets (U.S. $ thousands) Liabilities (U.S. $ thousands) Cash, marketable securities 1,190 Accounts payable 2,380

Accounts receivable 3,060 Short-term debt 1,360

Inventory 5,270 Long-term debt 7,650

Net ﬁxed assets 10,710 Equity 8,840

$20,230 $20,230

Current/noncurrent Method

Assets (U.S. $ thousands) Liabilities (U.S. $ thousands) Cash, marketable securities 1,190 Accounts payable 2,380

Accounts receivable 3,060 Short-term debt 1,360

Inventory 5,270 Long-term debt 9,450

Net ﬁxed assets 13,230 Equity 9,560

$22,750 $22,750

Monetary/nonmonetary Method

Assets (U.S. $ thousands) Liabilities (U.S. $ thousands) Cash, marketable securities 1,190 Accounts payable 2,380

Accounts receivable 3,060 Short-term debt 1,360

Inventory 6,510 Long-term debt 7,650

Net ﬁxed assets 13,230 Equity 12,600

$23,990 $23,990

CURRENCY TRANSLATION METHODS

The translation gain (loss) equals the franc exposure multiplied by the −$0.04 change in the exchange rate. These translation gains (losses) are as follows: current rate method—loss of $2.08 million (−0.04 × 52 million); current/noncurrent method—loss of $1.36 million (−0.04 × 34 million);

monetary/nonmonetary method—gain of $1.68 million (−0.04 ×−42 million); temporal method—

loss of $1.36 million (−0.04 × 34 million). These gains (losses) show up on the equity account and equal the difference in equity values calculated at the new exchange rate of $0.17/FFr and the old exchange rate of $0.21/FFr.

CURRENT ACCOUNT

The current account in the balance of payments, analogous to the revenues and expenses of a business, is the sum of the merchandise, services, investment income, and unilateral transfer accounts. When combined, they provide important insights into a country’s international economic performance, just as a ﬁrm’s proﬁt and loss statement conveys vital information about its performance.

See also BALANCE OF PAYMENTS; OFFICIAL SETTLEMENTS BALANCE.

CURRENT ACCOUNT BALANCE

A balance of payments that measures a nation’s merchandise trade balance plus its net receipts of unilateral transfers during a speciﬁed time period.

D

DEBENTURE

A long-term debt instrument that is not collateralized. Because it is unsecured debt, it is issued usually by large, financially strong companies with excellent bond ratings.

DEBT SWAP

Also called a debt-equity swap, a debt swap is a set of transactions in which an MNC buys a country’s dollar bank debt at a discount and swaps this debt with the central bank for local currency that it can use to acquire local equity.

DEFAULT RISK

Default risk is the risk that a borrower will be unable to make interest payments or principal repayments on debt. For example, there is a great amount of default risk inherent in the bonds of a company experiencing financial difficulty. Exhibit 35 presents the degree of default risk for some investment instruments.