Managing FX exposure Flashcards
What are the arguments against corporate hedging?
- Forward contracts have the zero-initial value property, options even cost money.
- -> How would adding a forward contract to a firm’s portfolio increase shareholder value? - Investors and stakeholders can hedge themselves.
- -> Why don’t we let individuals decide on their own if and which portion to hedge? - Lost upside potential and associated communication challenges.
- Costs for staff and technology
Why should corporate hedging increase the value of the firm?
- Hedging can affect other cash flows of the firm in a positive way. If this is the case, hedging can add value.
- In other words, a potential added value of hedging stems from a useful interaction between the hedge’s cash flow and other cash flows of the firm.
- Reduction of financial-distress costs and the underinvestment problem
- Reduction of taxes
- Communicating information to stakeholders
- Protect company reputation
- Reduce agency costs and improve decision making
Explain how hedging can reduce the financial-distress costs
- Most obvious route for hedging to add value is by decreasing the risk of financial distress and bankruptcy
- In practice, outright bankruptcy and financial distress is costly:
- Costs associated with liquidation (e.g., legal advisors, courts)
- Loss of customers and reputation
- Higher refinancing costs, canceled credit lines, loan covenants trigger early repayment
- Avoid underinvestment problems by protecting internal funds.
Explain how hedging can reduce the expected taxes
- Hedging can reduce the tax burden if taxes are progressive (convexity in tax scheme) or due to the treatment of negative profits (carry-back, carry-forward).
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Explain how hedging can reduce the agency costs and improve decision making
- Agency costs arise from conflict of interest between shareholders, bondholders, and managers.
- For example, in the absence of corporate hedging, managers might refuse to undertake risky but positive NPV projects because their salary depends on the performance of the firm and they cannot easily hedge on their own.
- Hedging can improve decision making throughout the firm
- Focus on fundamental forces and underlying profitability instead of swings in exchange rates.
- Knowledge of risks involved leaving money on the table and giving away free options to customers (compare the import decision mini-case).
What are the generic strategies for dealing with currency exposure?
- As we have seen earlier, the general way to (partly) eliminate exposure** is to create an **off-setting position. This can be done in different ways:
- Natural hedges (or “real hedges”).
- For example, shift production to countries with substantial cash inflow to generate costs in this currency.
- Buy inputs from countries/firms invoicing in this currency.
- Financing policy
- Finance the company partly in those currencies in which there are substantial cash inflows to generate costs in this currency.
- Conversely, try to generate revenue countries with substantial cash outflows (e.g. by investing in these countries).
- Financial instruments targeted at specific situations.
- Insurance policies, forwards, options, swaps, …
- Diversify across a broad spectrum of countries & risks.
- This does not avoid exposure but just results in a more balanced portfolio of activities.
- Natural hedges (or “real hedges”).
What are the different types of exposure?
- Contractual exposure (Transaction exposure)
- Operating exposure (Economic exposure)
- Translation exposure (Accounting exposure)
If not clear picture, look at slide 135 in the slide show
Explain transaction exposure
(plus, what else is it called?)
- We know already that “standard” contractual exposure hedging is straightforward and can be done by means of forwards, swaps, or options.
- In fact, nowadays these risks are usually managed very eciently by MNCs (e.g. “netting centers” in the airline industry).
- However, there are some limits and limitations to contractual exposure hedging:
- Hedging with, e.g., forwards does not insure a firm against long-run swings in exchange rates.
- Counterparty risk might turn a hedge into an open position.
- (also called Contractual exposure)
Explain operating exposure - and what is a good example?
- Operating exposure focuses on the impact of future exchange rates on noncontractual future cash flows or asset values due to changes in the economic environment.
- Exporters and importers (regardless if invoicing practice)
- “Domestic firms” with (potential) foreign competitors
- All firms: via general economic activity
- Typical issues:
- Dicult to identify the relationship between VT and ST
- Conclusions often surprising or counterintuitive
- Nonlinearities and noise
Define really briefly country and political risk?
- Political risk
- Risk that a government action will negatively affect a company’s cash flows
- Country risk
- Broader concept that encompasses a country’s political, economic, and financial environment
- –> Political and country risk matter a great deal for capital budgeting and for managing operations!
What are the political risk factors?
- Expropriation or nationalization
- Host country takes over a multinational’s subsidiary (with or without compensation)
- Contract repudiation, taxes, and regulations
- Foreign government revokes contracts or licenses, introduces laws or regulations that interfere with existing contracts, sudden increases in taxes, restrictions on firing local workers, forced sales of equity stakes, …
- Exchange controls
- Government prevents conversion of local currency to foreign currency
- Corruption and other legal ineciency
- Foreign government increases red tape when, demands bribes to keep operations going
- Home-country restrictions
- Example: U.S. embargo in 1979 on Iran forced Coca-Cola to shut down its operations
What is the most extreme form of political risks?
Most extreme form: Expropriation or nationalization
Why is country risk a broader concept than political risks?
Country risk is a broader concept than political risk because it includes adverse economic and financial shocks not caused by government action.
- Recession in a foreign country reduces demand and, hence, exports to that country.
- Labor strikes disrupt production and distribution.
–>One particularly important aspect of country risk: Debt defaults
What is important to note about debt in developing countries?
Most debt from developing countries is denominated in the currency of developed-country currencies.
Hence, the capacity to repay foreign debt depends on a country’s ability to generate foreign exchange.
What are some common variables to discriminate between sound and troubled debtor countries?
- Ratio of external debt to GDP
- Current account deficit
- Terms of trade (export to import prices)
- Ratio of country’s debt service payments to its exports
