chapter 8 Flashcards
Three types of foreign currency exposure
Transaction exposure
Economic exposure
Translation exposure
Transaction exposure
Can be defined as the sensitivity of realized domestic currency values of the firms contractual cah flows denominated in foreign currencies to unexpected exchange rate changes
Economic exposure
Can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firms value.
Translation exposure
Refers to the potential that the firms consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries financial statements from local currencies to the home currency.
Consider a U.S. multinational firm that has subsidiaries in the united kindom and japan. Each subsidiary will produce financial statements in local currency. To consolidate financial statements worldwide, the firm must translate the subsidiaries financial statements in local currencies into the US dollar, the home currency
Alternative ways of hedging transaction exposure using various financial contracts and operational techniques
Financial contracts:
Forward market hedge
Money market hedge
Option market hedge
Swap market hedge
Operational technique:
Choice of the invoice currency
Lead/lag strategy
Exposure netting
once a company enters into a forward contract
Exchange rate uncertainty becomes irrelevant
one possible shortcoming of both forward and money market hedges
These methods completely eliminate exchange risk exposure. Consequently, the firm has to forgo the opportunity to benefit from favorable exchange rate changes.
To elaborate on this point, lets assume that the spot exchange rate turns out the behigher on the maturity date of the forward contract. in this instance forward hedging would cost the firm money in terms of forgone dollar receipts. IF the company had indeed entered into a forward contract, it would regret its decision to do so.
cross hedging
cross hedging involves hedging a position in one asset by taking a position in another asset.
Suppose a US firm has an account receivable in korean won and would like to hedge its won position. IF there were a well-functioning forward market in won, the firm would simply sell the wwon receivable forward. but the firm finds it costly to do that. However, since the won/dollar exchange rate is highly correlated wtih the yen/dollar exchange rate, the US firm may sell a yen amount, which is equivalent to the won receivable, forward against the dollar thereby cross-hedging its won exposure.
contingent exposure
refers to a situation in which teh firm may or may not be subject to exchange exposure.
SUppose general electric (GE) is bidding on a hydroelectric project in quebec province canada. If the bid is acceptted, which will be known in three months, GE is going to receive C$100 million to initiate the project. Since GE may or may not face exchange exposure depending onwhether its bid will be accepted, it faces a typical contingent exposure situation
hedging via lead and lag
Technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. To lead means to pay or collect early, whereas to lag means to pay or collect late.
exposure netting
helps to centralize the firms exchange exposure management function in one location
reinvoice center
a financial subsidiary, as a mechanism for centralizing exposure management functions.
ALl the invoices airising from intrafirm transactions are sent to the reinvoice center, where exposure is netted. Once the residual exposure is determined, then foreign exchange experts at the center determine optimal heding methods and implementing them
