Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 12: Measuring and managing transaction exposure

Topic #12: Measuring and managing transaction exposureL. GattisThe Pennsylvania State University1Finance 407: Multinational Financial ManagementPoll2Caterpillar’s Japanese subsidiary has yen receivables of ¥100M, payables of ¥200M, and debt of ¥300M. The USD is designated the functional currency. The accounts are recorded on the balance sheet at a spot rate of ¥83.33. What is the translation gain or loss if the exchange rate is ¥85 at the end of the reporting period.A. -$94,310 B. +$94,310 C. -$668M D. +$668MPoll3Caterpillar’s Japanese subsidiary has yen receivables of ¥100M, payables of ¥200M, and debt of ¥300M due in 45 business days. The USD is designated the functional currency. What is Caterpillars 95%, 45 day, EaR if the annualized volatility of the $/Yen daily returns is 10% and the spot price is $.012/¥ (¥83.33/$)? (Assume 260 business days in a year to compute daily standard deviation)A. $.033M B. $.33M C. $3.3M D. $33M E. $330MLearning Objectives4Students understand and can recallmethods for measuring and managing transaction exposurethe definitions, implementation, and use of CaR to measure exchange rate riskStudents can calculatetransaction exposure/lossStudents can calculate CaR given cashflow information and exchange rate volatilityForex Exposure5I. Translation “Accounting” Exposure arises when reporting and consolidating financial statements require conversion from foreign currency to home currency. It is a possible accounting gain/loss on foreign assets and liabilities which are reported as losses in income or adjustments to equity (Translation exposures often lead to cashflow losses when accounts are liquidated)II. Cashflow ExposuresTransaction Exposure: potential gains or losses on foreign transactions such as bond payments and receivables paid in the foreign currency. (Up until a payment is made, these are only translation exposures)Competitive Exposure: long-term exposure to currency change on future business.Translation and Transaction Risk6Translation gains and losses may or may not lead to actual cash losses (Transaction Losses)Example 1: Book value of Mexico City storage facility fluctuates with the exchange rate causing translation gains and losses, but the gains and losses are never realized because property is never sold.Example 2: Book value of peso inventory fluctuates with the exchange rate causing translation gain and losses, and is realized as inventory is sold and proceeds converted into dollars.Translation losses become transaction losses when the asset is sold (inventory, property, cash) or comes due (receivables, payables, loans).Transaction exposure is the net position (assets – liabilities) in foreign denominated accounts that are expected to come due. (not just reported – translation exposure)Transaction gains and losses are the difference between the expected domestic currency value (book value in some cases) and the actual domestic currency value of the position.Transaction ExposurePractice ProblemRolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts from U.S. companies. Suppose it has accounts receivable of $1.5 billion and accounts payable of $740 million. It also borrowed $600 million. The current spot rate is $1.5128/£. What is Rolls-Royce's dollar transaction exposure in dollar terms? Suppose the pound appreciates to $1.7642/£. What is Rolls-Royce's gain or loss, in pound terms, on its dollar transaction exposure? A. -£40M B. -£15M C. £15M D. £40M77Cashflow at Risk (CaR)“Measuring Transaction Exposure”CaR measures the risk that actual cashflows are different than what is expected (or planned)More technically, CaR is the level of cashflow loss that has a x% probability of being exceeded over the next n periods. Example: Manager may have a 1-year €80 receivable and asks how much can the cashflows be different from the expected value with 95% confidence?Expected € CF: Receivable is €80, and the euro is expected to be $1.25 in one year (forward exchange rate). The annualized volatility of the exchange rate estimate is $.225.Expected $ CF: €80 x $1.25/€ = $10088Cashflow at Risk (CaR) The CaR formula is the same as EaR But V is the expected foreign cashflow (not balance sheet items that are subject to translation)Example: €80M, 1-year, 95%, σ(annual)=$.225 CaR = 80*1.65*.225=$29.7 I could have divided .225 by the sqrt(260) to get daily volatility, then multiplied by sqrt(260) to get annual, but why bother.The manager could then say that he expects $100, but $29.70 is at risk (with 95% certainty)He could also state that there is a 95% probability that the cash flow will be at least $70.30 (i.e., 5% chance less than $70.30; $100 expected – $29.7 at risk)99Cashflow at Risk (CaR)Example: XYZ Corp has a 1-month, €80 net receivable, the forward exchange rate is 1.25$/€, and ask how much can the cashflows be different from the expected value with 99% confidence? Daily exchange rate standard deviation was $.014 for the past year.What is the expected US$ value of the receivable?$100$64What is the 99%, 1-month CaR? (assume 22 days/mo)$8.67$12.24What is the 99%, one month, minimum US$ proceeds? How would the answers change if it were a net payable?1010MANAGING TRANSLATION AND TRANSACTION EXPOSURE11Exposure Netting: Example 1: offset fx assets with liabilities by issuing foreign denominated debt.Example 2: offset fx liabilities with assets by holding fx cash or cash equivalentsIncrease hard currency assetsIncrease soft currency liabilitiesPrice Adjustment Clauses (Foreign customers pay more or less based on exchange rates)Use Derivatives (Forwards, Futures, Swaps, Options)Choosing EaR or CaR as the corporation’s primary risk measure12Depends on what triggers financial distress in your business--- Cashflows or Earnings disruptionsAccess to contingent funding (like a line of credit) or liquid assets reduce the need for cashflow management.Adoption of FASB 52 allows firms to have exchange rate adjustments bypass the income statement effectively eliminating earnings exposureAdvantages of CaR and EaR as a Risk Measure13Can summarize the total risk of a corporation’s exposure to currency revaluationsUse exposure nettingAccounts for expected variability of exchange ratesMore volatile exchange rates create larger exposure measuresCan be used to make probabilistic statementsCan be scaled across time by using the sqrt(t)Criticisms of VaR and CaR14Reliance on historical standard deviationsAssumes Normal DistributionsCaR and EaR do not provide information about how big losses can getCan make risk managers complacent by simply focusing on the control of a single number.EaR and CaR and Risk Management15EaR and CaR measures can help management choose whether to hedge or accept risksHedging Exposure Netting and funds adjustments Derivatives DiversificationGM has a policy of hedging 50% of exchange rate volatilityiClicker: Class Evaluation16How would you rate today’s class? Highest LowestAssigned Problems171.=250-85=165*2.33*.02*sqrt(40)=55*2.33*.02*sqrt(22)=250-85-10-100Assigned Problems18Suppose Google expects that in 20 days the following yen accounts will come due: ¥175 million in receivable, ¥50 million in payable, and a debt coupon payment of ¥25 million. What is Google’s 20-day, 95% probability (Hint: 1.65 Standard deviation) CaR if the daily standard deviation of the Yen is .005?3,689,512=100*(sqrt(20)*1.65*.005)Microsoft has a net position of 100M Swedish Kronor and it expects the exchange rate to be SKr8.5/$. What is the transaction gain or loss if the final rate is SKr7.5?Skr100*(1/7.5-1/8.5)=$1.5686MIBM has a net position of -100M (net payable) Norwegian Krone and it expects the exchange rate to be NKr7.5/$. What is the transaction gain or loss if the final rate is NKr6.5? -Nkr100*(1/6.5-1/7.5)=-$2.05M Textbook19Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 8 covers translation and transaction exposure