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Managing Foreign Exchange Risk The nature of foreign exchange risk was discussed in Chapter 9. There we described how changes in exchange rates alter the profitability of trade and investment deals, how forward exchange rates and currency swaps enable firms to insure themselves to some degree against foreign exchange risk, and how relative inflation rates determine exchange rate movements. In this section, we focus on the various strategies international businesses use to manage their foreign exchange risk. Buying forward, the strategy most discussed in Chapter 9, is just one of these. We will examine the types of foreign exchange exposure, the tactics and strategies firms adopt in attempting to minimize their exposure to foreign exchange risk, and things firms can do to develop policies for managing foreign exchange risk. Types Of Foreign Exchange Exposre When we speak of foreign exchange exposure, we are referring to the risk that future changes in a country's exchange rate will hurt the firm. As we saw in Chapter 9, changes in foreign exchange values often affect the profitability of international trade and investment deals. Foreign exchange exposure is normally broken into three categories: transaction exposure, translation exposure, and economic exposure. Each is explained here. Transaction Exposure Transaction exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. Suppose a US company has just contracted to import laptop computers from Japan. When the shipment arrives in 30 days, the company must pay the Japanese supplier ¥200,000 for each computer. The dollar/yen spot exchange rate today is $1 = ¥120. At this rate, each laptop computer would cost the importer $1,667 (i.e., 200,000/120 = 1,667). The importer knows it can sell each computer for $2,000 on the day the shipment arrives, so as the exchange rate stands, the US company expects to make a gross profit of $333 on every computer it sells (2,000 - 1,667). If the dollar depreciates against the yen over the next 30 days, say to $1 = ¥95, the U.S. company will still have to pay the Japanese company ¥200,000 per computer, but in dollar terms that would be $2,105 per laptop computer--more than the computers could be sold for. A depreciation in the value of the dollar against the yen from $1 = ¥120 to $1 = ¥95 would transform this profitable transaction into an unprofitable one. Translation Exposure Translation exposure is the impact of currency exchange rate changes on the reported consolidated results and balance sheet of a company. This issue was discussed in Chapter 19 when we looked at currency translation practices. Translation exposure is basically concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized--they are "paper" gains and losses--but they are still important. Consider a US firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar, as it did during the early 1990s, this would substantially reduce the dollar value of the Mexican subsidiary's equity. In turn, this would reduce the total dollar value of the firm's equity reported in its consolidated balance sheet. This would raise the apparent leverage of the firm (its debt ratio), which could increase the firm's cost of borrowing and restrict its access to the capital market. Thus, translation exposure can have a very negative impact on a firm. Economic Exposure Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. Consider the effect of the wide swings in the value of the dollar on many US firms' international competitiveness during the 1980s. The rapid rise in the value of the dollar on the foreign exchange market in the early 1980s hurt the price competitiveness of many US producers in world markets. US manufacturers that relied heavily on exports (such as Caterpillar) saw their export volume and world market share plunge. The reverse phenomenon has occurred since the mid1980s, when the dollar has declined against most major currencies. The fall in the value of the dollar between 1985 and 1995 increased the price competitiveness of US manufacturers in world markets and helped produce an export boom in the United States. Tactics and Strategies for Reducing Foreign exchange Risk, A number of strategies and tactics can help firms reduce their foreign exchange exposure. The tactics, which include buying forward and the use of leading and lagging, are best suited to alleviating transaction exposure and translation exposure. The strategies addressing the configuration of a firm's assets across countries are best suited to reducing economic exposure. Reducing Transaction and Translation Exposure A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We discussed two of these tactics in Chapter 9, buying forward and using currency swaps. They are important sources of insurance against the short-term effects of foreign exchange exposure. (For details, return to Chapter 9.) In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivables--that is, collecting and paying early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involves accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries. Lead and lag strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for exports or making payments for imports. Several other tactics that can reduce transaction and translation exposure have already been discussed in this chapter. We have explained that:
Reducing Economic Exposure Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm's productive assets to various locations so the firm's long-term financial well- being is not severely affected by adverse changes in exchange rates. The post1985 trend by Japanese automakers to establish productive capacity in North America and Western Europe can partly be seen as a strategy for reducing economic exposure (it is also a strategy for reducing trade tensions). Before 1985, most Japanese automobile companies concentrated their productive assets in Japan. However, the rise in the value of the yen on the foreign exchange market has transformed Japan from a lowcost to a high-cost manufacturing location over the past 10 years. In response, Japanese auto firms have moved many of their productive assets overseas to ensure their car prices will not be unduly affected by further rises in the value of the yen. In general, reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce. An example of how Black & Decker has pursued strategies for reducing its economic exposure is given in the accompanying Management Focus. Developing Policies for Managing Foreign Exchange Exposure The firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out.16 First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals--particularly in large, complex multinationals where myriad transactions may be pursued simultaneously--they should at least set guidelines for the firm's subsidiaries to follow. Second, firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications.17 Firms need to develop strategies for dealing with economic exposure (see the Management Focus about Black & Decker). Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw in Chapter 9, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide reasonable predictions of exchange rate movements, and in the long run, fundamental economic factors--particularly relative inflation rates--should be watched because they influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict the future. Fourth, firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm's exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered. Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates. The reports can then be used by management as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks. Unfortunately, some of the largest and most sophisticated firms don't take such precautionary steps, exposing themselves to very large foreign exchange risks. In 1990, the treasury department of the British food company Allied-Lyons apparently entered the forward foreign exchange market, not so much to hedge against future currency movements as to profit from placing large speculative bets that currencies would move one way or another. Unfortunately for Allied-Lyons, the treasury department made the incorrect speculative bets and it incurred losses of $240 million. Similarly, Showa Shell Sekiyu, the Royal Dutch/Shell group's Japanese affiliate, revealed in February 1993 that its treasury department had incurred some $1 billion in unrealized foreign exchange losses.18 |
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