Finance 450 Final

Every individual firm in the end decides whether or not to hedge, for what purpose, and how

. But this often results in more questions and even more doubts

What are the four main contractual instruments used to hedge transaction exposure?

Remain Un-hedged o subject to the exchange rate changes • Hedge in the forward market o Involves a forward (or futures) contract and a source of funds to fulfill that contract. • Hedge in the money market o Similar to a hedge in the forward market in that involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement. • Hedge in the options market o This allows speculation on the upside potential for appreciation of the currency while limiting downside risk to a known amount.

• Transaction Exposure

o Measures change in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, it deals with changes in cash flows that result from existing contractual obligations.

• Operating exposure (economic exposure, competitive exposure, or strategic exposure)

o Measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices, and costs.

• Translation Exposure

o The potential for accounting-derived changes in owner's equity to occur because of the need to "translate" foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.

. How does a money market hedge differ for an account receivable versus that of an account payable? Is it really a meaningful difference?

• A money market hedge involves a contract - a loan agreement - and a source of funds to fulfill that contract. The firm seeking to construct a money market hedge borrows in one currency and exchanges the proceeds for another currency. Funds to fulfill the contract are generated from business operations. Yes, money market hedges are certainly meaningfully different for accounts payable vs. accounts receivables. The difference lies in which country's currency you choose to exchange the funds up front and where you choose to invest them before repaying the loan.

What - according to financial theory - is the value of a firm?

• According to financial theory, the value of a firm is the net present value of all expected future cash flows. The fact that they are expected emphasizes that nothing about the future is certain.

What are the major differences in translating assets between the current rate method and the temporal method

• Current o Assets • All are translated at the current rate of exchange; that is, at the rate of exchange in effect on the balance sheet date. • Temporal o Assets • Monetary assets (primarily cash, marketable securities, accounts receivable, and long-term receivables) and monetary liabilities are translated at current exchange rates. Non-monetary assets (primarily inventory and fixed assets) are translated at historical cost.

What are the two basic methods for translation used globally

• Current rate o All financial statement line items are translated at the "current" exchange rate with few exceptions. • Temporal o Specific assets and liabilities are translated at exchange rates consistent with the timing of the item's creation. It assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value.

What activity gives rise to translation exposure?

• Financial statements of foreign subsidiaries - which are stated in foreign currency - must be restated in the parent's reporting currency so that the firm can prepare consolidated financial statements.

Why is translation exposure called an accounting exposure?

• It is an accounting exposure because it affects the accounting side of the business. They must restate foreign currency-denominated financial statements into the currency used so that they can be added to the parent company's income statement and balance sheet. It is the potential for an increase or decrease in the parent's net worth and reported net income that is caused by a change in the exchange rates since the last translation.

What is a hedge?

• Many firms attempt to manage their currency exposure through this. Hedging requires a firm to take a position - an asset, a contract, or a derivative -- the value of which will rise or fall in a manner that counters the fall or rise in value of an existing position - the exposure. Hedging protects the owner of the existing asset from loss. However, it also eliminates any gain from an increase in the value of the asset hedged.

. What are the four main types of transactions from which transaction exposure arises?

• Purchasing or selling on credit - on open account -- goods or services when prices are stated in foreign currencies. • Borrowing or lending funds when repayment is to be made in a foreign currency • Being a party to an unperformed foreign exchange forward contract • Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

Transaction, translation, and operating

What are the three types of foreign exchange exposure?

Describe four arguments in favor of a firm pursuing an active currency risk management program

• Reduction in risk of future cash flows improves the planning capability of the firm. If the firm can more accurately predict future cash flows, it may be able to undertake specific investments or activities that it might not otherwise consider.• Reduction of risk in future cash flows reduces the likelihood that the firm's cash flows will fall below a level sufficient to make debt service payments required for continued operation. Hedging reduces the likelihood that the firm's cash flows will fall to the point of financial distress. This point is to the left of the center of the distribution of expected cash flows. • Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Regardless of the level of disclosure provided by the firm to the public, management always possesses an advantage in the depth and breadth of knowledge concerning the real risks. • Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks (such as an oil crisis or war). Management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of single opportunities to enhance firm's value through selective hedging - hedging only exceptional exposures or the occasional use of hedging when management has a definite expectation of the direction of exchange rates.

What is the difference between a self-sustaining foreign subsidiary and an integrated foreign subsidiary

• Self-sustaining: one that operates in the local economic environment independent of the parent company. • Integrated: one that operates as an extension of the parent company, with cash flows and general business lines that are highly interrelated with those of the parent.

Describe six arguments against a firm pursuing an active currency risk management program

• Shareholders are more capable of diversifying currency risk than is the management of the firm. If stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage the risk in a way that satisfies their individual preferences and risk tolerance. • Currency hedging does not increase the expected cash flows of the firm. Currency risk management does, however, consume firm resources and so reduces cash flow. The impact on value is a combination of the reduction of the cash flow (which lowers value) and the reduction in variance (which increases value). • Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally more risk-averse than are shareholders. • Managers cannot outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be zero. • Management's motivation to reduce variability is sometimes for accounting reasons. Management may believe that it will be criticized more severely for incurring foreign exchange losses than for incurring even higher cash costs by hedging. Foreign exchange losses appear in the income statement as a highly visible separate line item or as a footnote, but the higher cost of protection through hedging are buried in the operating or interest expenses. • Efficient market theorists believe that investors can see through the "accounting veil" and therefore have already factored the foreign exchange effect into a firm's market valuation. Hedging would only add cost.

What is a functional currency? What do you think a "non-functional currency" would be?

• The currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations.

Theoretically, shouldn't forward contract hedges and money market hedges have the same identical outcome? Don't they both use the same three specific inputs - the initial spot rate, the domestic cost of funds, and the foreign cost of funds?

• The difference between a money market hedge and a forward hedge is that the cost of the money market hedge is determined by different interest rates than the interest rates used in the formation of the forward rate.

Which of the three currency exposures relate to cash flows already contracted for, and which of the exposures do not?

• Transaction exposure and operating exposure both exist because of unexpected changes in future cash flows. However, while transaction exposure is concerned with future cash flows already contracted for, operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.

What does the word translation mean?

• Translation means to prepare consolidated financial statements and also assess the performance of foreign subsidiaries.