Currency Risk Management at the Firm Level Chp 3

As discussed with accounting data, a more formal test can be done with a regression. For example, a univariate regression can be used to test the EE of the average large U.S. firm, using the S&P returns as representative, as shown in Table VIII.5: TABLE VIII.5 Regression of S&P returns on changes in the USD/TWC exchange rate (1982:Jan-2022:Jan) R Square Standard Error Observations Intercept USD/TWC 0.024874 4.320756 481 Coefficients 0.737501 0.408969 Standard Error 0.197041 0.116998 t Stat 3.742879 3.495515 P-value 0.000204 0.000517 At the 5% standard significance level, changes in the value of the USD have a significant impact on the returns of the average big U.S. firm. According to the estimation, returns are quite sensitive to changes in the value of the USD: a 1% depreciation of the USD against the TWC increases returns by 0.41%. The R2 tells us that exchange rates changes explain 4.4% of the variability of S&P returns. A significant number. ¶ In Example VIII.23, we run a univariate regression, where we implicitly assumed that st – i.e., changes in St- is the only variable affecting a company’s stock returns. We know that other variables also affect a company’s stock price. We need to be careful and “control” for these other variables, to isolate the effect of st. A multivariate regression will do that and we can include other independent (“control”) variables like income growth, inflation, sales growth, assets growth, etc., not just st as determinants of the change in CFs (or stock returns). We can also borrow from the investments literature and use the three popular Fama-French factors (Market, Size (SMB), Book-to-Market (HML)) as controls. In this case, we can run a regression to check if a company faces economic exposure: Stock Returnt = α + β st + δ1 Market Returnt + δ2 SMBt + δ3 HMLt + εt A momentum can be added to accommodate the extension of Carhart (1997) of the FamaFrench model. Example VIII.24: Measuring Kellogg’s Economic Exposure We want to know if Kellogg (K) has faced economic exposure in the last 15 years. We use monthly data from January 1988 to January 2022, for a total of 409 observations. We estimate a regression using Kellogg’s stock returns against a constant and changes in the USD/TWC, sUSD/TWC,t; where TWC represents a Trade Weighted Basket of Major Currencies. We obtain the following results (absolute value of t-statistics in parenthesis): R2 = 0.01596 Observations = 409 VIII.36 Intercept (α) st (β) Coefficients Standard Error t Stat P-value 0.38592 0.27515 1.4026 0.1615 0.43775 0.17041 2.5688 0.0106 The R2 of the regression is .016, that is, changes in the USD/TWC explain 1.60% of the variability of Kellogg’s returns. At the standard 5% significance level, changes in the value of the USD have a significant impact on Kellogg’s returns (|tβ = 2.57| > 1.96). Moreover, a depreciation of the USD has a positive impact on returns, that is, Kellogg’s behaves like an exporter. But, as mentioned above, Kellogg’s returns are not only influenced by changes in exchange rates. of the changes in exchange rates is significant. We estimate a multivariate regression, including not only sUSD/TWC,t, but also the Fama-French factors: excess market returns over T-bill rates, (Rm-Rf)t, Size (SMB)t and Book-to-Market (HML)t: Krett =  + β st + δ1 Market Returnt + δ2 SMBt + δ3 HMLt + εt R2 = 0.0995 Observations = 409 Intercept Market (Rm-Rf) Size (SMB) B-M (HML) st (β) Coefficients Standard Error 0.0798 0.3893 -0.1144 0.1546 0.2601 0.2691 0.0647 0.0898 0.0851 0.1664 t Stat 0.2967 6.0204 -1.2738 1.8157 1.5633 The R2 of the regression is .0742, a higher value driven mainly by the market factor. But, looking at measuring economic exposure, we observe that the t-stat is now 1.56, that is, the significance of changes in the value of the USD drops to 12%. Thus, at the 5% significance level, we cannot reject the null hypothesis of no economic exposure. Note, also, the big drop in β.¶ The above regressions have been done repeatedly for firms around the world. (We have already done it for Kellogg.) Ivanova (2014) reports a mean β equal to 0.57 (a 1% USD depreciation increases returns by 0.57%). However, only 40% of the EE are statistically significant at the 5% level. But, for large firms (MNCs), EE is small –an average β=0.063– and not significant at the 5% level. Interestingly, 52% of the EEs come from U.S. firms that have no international transactions (a higher St can “protect” some domestic firms from foreign competition). 3.D Managing Economic Exposure Managing economic exposure is about matching revenue in foreign currency and costs in foreign currency. This matching is very important for a firm. In section 3.A, we mentioned the case of Laker Airlines. Recall that Laker Airlines had unbalanced inflows and outflows denominated in USD. The majority of Laker’s revenue was in GBP, but a huge part of its outflows, loan repayments, were in USD. Thus Laker Airlines was facing economic exposure. Laker Airlines’ economic exposure was a big reason behind its 1982 bankruptcy. VIII.37 The objective of economic exposure management is to minimize the effect of changes in exchange rates on a firm's future cash flows. As we stressed in Chapter V, it is very difficult to predict exchange rate changes. Thus, a firm should be prepared in advance to face the effects of changes in exchange rates. Managing economic exposure is more difficult than managing transaction exposure. Transaction exposure involves short-term and medium-term cash flows. Economic exposure involves long-term cash flows. In general, managing economic exposure involves a restructure of a firm’s operations. Usually, by restructuring a firm’s operations, management attempts to achieve a better balance between inflows and outflows denominated in foreign currencies. This restructuring process might involve several areas of the firm. For example, in the case of Laker Airlines, management could have avoided bankruptcy by having a more balanced mixture of inflows and outflows denominated in USD. They could have achieved this by borrowing less in USD and/or generating more revenue in the U.S. Example VIII.25: The case of Toyota. By the late 1970s, Toyota, the Japanese automobile manufacturer, had established itself in the U.S. market, with a market share close to 10%. But, during those years, the JPY began to appreciate against the USD. Since the majority of Toyota’s production was done in Japan, the costs were mainly denominated in JPY and profits were seriously hurt by the JPY appreciation. Because of competition, Toyota was unable to increase the USD price of their cars in the U.S. market. Toyota’s EE was very significant. Toyota decided to restructure to reduce EE: they moved part of the production to the U.S. ¶ Another tool to reduce economic exposure is international diversification. True international diversification is probably the best way for a firm to manage economic exposure. Again, using international diversification as a risk management tool involves restructuring a firm’s organization. True international diversification means that a firm should diversify internationally the location of production, sales, input sources, and the borrowing of funds. If a firm is internationally diversified, management can respond quickly to economic shocks or disequilibrium situations. For example, management might notice a change in comparative labor costs due to changes in exchange rates. Then, management can readjust production patterns in response to this change. Even if management does not actively alter normal operations when exchange rates change, the firm should experience some beneficial portfolio effects. In general, the variability of its cash flows is reduced by international diversification, because exchange rate changes are likely to increase the firm's competitiveness in some markets while reducing it in others. In that case economic exposure would be very low.  Economic Exposure: The Case of Ericsson Ericsson is very dependent on the behavior of the SEK and on economic conditions in Sweden. Around 40% of all employees and 25% of total production is located in Sweden, but Sweden accounts for just 3% of all sales. With this substantial cost base in SEK, for example, an appreciation of the SEK against the major currencies will have a negative impact VIII.38 on Ericsson’s cash flows. As a matter of fact, during the year 2000, the depreciation of the EUR against the SEK had a negative impact on Ericsson compared to Ericsson’s competitors with costs denominated in EUR Usually, Ericsson does not hedge economic exposure. Source: Ericsson Annual Report 2000.  IV. Should a Firm Hedge? So far we have analyzed different hedging tools and techniques. We have analyzed examples where firms hedge their exchange exposure. But we have not addressed a basic point: should a firm hedge? Or, in other words, does hedging add value to a firm? There are two views with respect to hedging at the firm level. The first one is based on the pioneering theoretical work of Franco Modigliani and Merton Miller, both Nobel Laureates. It states that hedging adds nothing to the value of a firm. The second view exploits some of the basic assumptions underlying the work of Modigliani and Miller. This second view analyzes specific situations where hedging might add value to a firm. 4.A Hedging is Irrelevant: The Modigliani-Miller Theorem Modigliani and Miller, in a path-breaking paper published in the Journal of Political Economy in 1958, showed that firms make money if they make good investments (investments that increase their operating cash flows). When we value a firm, the financing source of those good investments is irrelevant. Different mechanisms of financing will determine how the cash flows are divided among the different classes of investors, that is, shareholders or bondholders. This surprising and insightful result is called the ModiglianiMiller Theorem (MMT). The MMT depends on a set of assumptions about financial markets. These assumptions basically require that a firm operates in perfect markets (i.e., no transaction costs, no distortions, etc.). The MMT has implications for hedging. Clearly, if the methods of financing and the character of financial risks do not matter, managing them is not important, and therefore, should not add any value to a firm. On the contrary, since hedging is not free, hedging might reduce the value of a firm.  The Value of a Used Car When you sell your car, the price you get is independent of how you financed the purchase of it. All the financial risks you took when buying the car will not affect its value (as long as the financial risks did not affect your driving!). The MMT has similar implications for the value of a firm.  In another insight, Modigliani and Miller show that if investors want to reduce the financial risks associated to holding shares in a firm, they can diversify their portfolio of holding. VIII.39 Managers, therefore, do not need to manage financial risks of firms, since investors can do it for themselves. Example VIII.26: Suppose Ms. Sternin, a U.S. investor, holds shares of a U.S. exporting company and shares of a U.S. importing company. A depreciation (appreciation) of the USD will negatively (positively) affect the importing company and will positively (negatively) affect the exporting company. Ms. Sternin's portfolio is hedged against exchange rate movements. Hedging at the firm level -since it is expensive- will negatively affect the value of Ms. Sternin’s portfolio. ¶ 4.B Hedging Adds Value The MMT is very powerful. Many economists, however, point out that the assumptions behind the MMT are routinely violated. And, when the assumptions are violated, the MMT does not hold. Under these circumstances, at least theoretically speaking, hedging adds value to a firm. The added value of hedging to the value of the firm, however, is still open to discussion. 4.B.1 Investors might not be able to replicate an optimal hedge Several economists argue that even though investors could potentially hedge by themselves all risks, sometimes they might not be able to exactly replicate the optimal hedge structure of a firm. There are situations where firms can do a better job at hedging than individual investors. For example, investors might not be big enough to have access to optimal hedges. Or investors might not have enough information about the outflows and inflows, denominated in different currencies, of the firm. 4.B.2 Hedging as a tool to reduce the risk of bankruptcy If cash flows are very volatile, a firm might be faced with the problem of needing cash to meet its debt obligations. Therefore, a firm with little debt or with very good access to credit markets (a highly rated company) has no need to hedge, as the risk of getting into financial trouble is very small. Under this view, some of the U.S. largest corporations --which are the biggest hedgers-- may be wasting their capital. Myron Scholes, from Stanford University, disagrees with the previous argument. As a matter of fact, he proposes the opposite. Under his view, firms with little debt could reduce their riskiness by hedging, and, then, they are able to borrow more at better rates and to rely less on equity financing. Equity financing could be expensive compared to debt. Recall that equity offers no guaranteed payoff, so investors will require a higher rate of return. 4.B.3 Hedging as a tool to reduce investment uncertainty VIII.40 Kenneth Froot, David Sharfstein and Jeremy Stein, in a paper published in Harvard Business Review in 1994, argue that firms should hedge to ensure they always have sufficient cash flows to fund their planned investment plan. For example, an exporting company might have cash flow problems in a period when the USD appreciates. Example VIII.27: Merk, a U.S. pharmaceutical firm, has used derivatives to ensure that investment, especially R&D, plans can always be financed and are not subject to USD fluctuations. ¶ One problem associated with this strategy can be illustrated with an example. Suppose the USD has a long-term trend of appreciation against major currency. An exporting company will face fewer opportunities to expand and invest, and, therefore, will have a lesser need to hedge. 4.B.4 Hedging as a tool to reduce taxes For most firms, income taxes are a convex function of income. Thus, a well-known implication, using Jensen’s inequality, is that firms can reduce tax exposure from reduced income volatility. Since hedging reduces cash flow volatility, hedging can lower a firm’s tax liability. In addition, given that firms that have lower cash flow volatility can borrow more, hedging can help firms take advantage of the tax deductibility of interest. 4.C Do companies hedge? In this section, we present the results of three surveys of domestic companies about their FX hedging policies. Overall, the surveys found that companies understand FX risk. However, not all companies hedge their FX exposure. A significant proportion of companies that do hedge only hedge part of their exposure. This popular hedging practice is called selective hedging. Selective hedging carries risks, since the no-hedged part of the FX position will be subject to FX risk. It is common for companies based their FX hedging decisions on their expectations for the exchange rate. That is, speculation is not rare. Since 2004, the Bank of Canada has carried out a qualitative annual survey to assess the degree of activity in Canadian foreign exchange (FX) hedging. The survey participants comprise banks that are active in Canadian FX markets, including the eleven members of the Canadian Foreign Exchange Committee (CFEC). The 2011 survey was divided into two parts, each separately covering the FX hedging activity of the banks’ corporate and institutional accounts that have CAD hedging requirements. In 2011, the CAD continued to appreciate against the USD. The main findings in the 2011 survey were: (1) Institutional customer volume continues to account for the majority of client hedging activity, but remains largely mechanical in nature and is driven by routine hedging and rebalancing activity. Exporter FX hedging activity continues to be the largest contributor to corporate customer volume and is driven primarily by the actual level of the currency. VIII.41 (2) Across both corporate and institutional accounts, approximately half of the currency exposures are hedged. The majority of institutional accounts have a formal FX hedging policy, while fewer than half of the corporate accounts have any formal policy. (3) The majority of institutional hedges are extended (rolled) to maintain the hedge on an underlying longer-term investment, whereas most corporate hedges are used to hedge specific cash flows and are therefore not rolled forward. For both client groups, the majority of hedges are conducted for terms of less than six months. (4) Selective hedging is popular. Banks estimated that Canadian importers were affected positively by the strong CAD, increasing both their hedging volumes and the duration of the FX hedges. On the other hand, Canadian exporters have moderately reduced or delayed hedging their exposures as the CAD appreciated. If they did hedge, only shorter durations were targeted, since exporters expected some future weakness in the CAD.. (5) Domestic institutional investors increased their foreign currency investments, taking advantage of the higher CAD, but there has been no change in their overall hedging ratio for their foreign assets.  Do U.S. Firms Hedge? A survey of the largest 250 U.S. MNCs, by Kasibhatla, Rivera-Solis and Malindretos (2001), studies the behavior of those firms with respect to translation, transactions, and economic exposures. They find the following results: (1) Most of the MNCs in the survey understood translation, transactions, and economic exposure completely or substantially. (2) A large percentage (32%-44%) hedged themselves substantially or partially. However, a larger percentage did not cover themselves at all against transactions and economic exposure. (3) A significant percentage of the firms' hedging decisions depended on future exchange rate fluctuations. A significant percentage of them did not cover themselves against translation and transaction exposures, transactions and economic exposures, and translation and economic exposures. (4) With respect to hedging, a majority of the firms indicated not applicable or they did not hedge. However, over a quarter of the firms surveyed indicated that they utilized the forward hedge. (5) The majority of the firms surveyed do have a better understanding of transactions and translation exposure than of economic exposure.  The National Bank of Australia also conducts an annual survey, since 2000, of superannuation (retirement program) funds. In the past years, the AUD has also seen a steady appreciation. The 2009 survey found the following results: VIII.42 (1) The average hedge benchmark for international equities has remained stable at around 45%. But there was a big dispersion in hedge ratios for participants. (2) Government funds have decreased their average hedging from 61% to 57% but this was offset by industry funds that have increased their hedge ratio from 40% to 43%. (3) When tracking the 18 participants who have participated in every survey since 2000, there was a significant decline in the weighted average hedge benchmark, resulting primarily because government and industry funds have reduced their hedging. (4) Some 22 % of funds now have a ‘portfolio approach’ compared to only 5% in 2007. (5) Illiquid assets continue to have a very high hedge ratio of around 70% to 80%, depending on the asset class. (6) 85% of super funds believe currency issues are important or very important. This compares to 74% in 2007. (7) Use of specialist for either passive or active currency management stands at 76%. Some super funds have moved currency management in-house and smaller funds increasingly use their custodian for this service. (8) Active currency management remains low at 24%, and reaching an all-time low of 18% when we look at the same sample set since 2000. Interesting readings Parts of Chapter VIII were based on the following books: International Financial Markets, by J. Orlin Grabbe, published by McGraw-Hill. International Financial Management, by Jeff Madura, published by West. International Financial Markets and The Firm, by Piet Sercu and Raman Uppal, published by South Western. International Investments, by Bruno Solnik, published by Addison Wesley. Financial Accounting Standards Board, Original Pronouncements, 1999/90 edition, Homewood Illinois: Irwin, 1989. Kasibhatla, K. M., Rivera-Solis, L. E. and Malindretos, J. (2001), “MNC foreign exchange exposure under FASB no.8 and FASB no.52: A survey,” American Business Review. VIII.43 Norton and J. Malindretos, "FAS 52 and Exchange Rate Exposure: Hedging Strategies", American Business Review, June 1991, pp. 31-34. Pringle, J. J. (1990), “Managing Foreign Exchange Exposure,” Journal of Applied Corporate Finance, pp. 73-82. VIII.44 Exercises: 1. Reconsider Example VIII.10. Suppose Burgos Corporation anticipates no payables in CHF, but will receive CHF 200,000 in 180 days. The same information on the spot, forward, and options prices are used to compare techniques and an unhedged strategy. Which strategy would you recommend to Burgos Corporation? 2. GZK wants to measure its economic exposure to changes in the USD/ZAR. They have available 80 quarterly observations from the past 20 years. They run the following regression (standard errors in parenthesis): CFt = .207 + .552 St + .354 St-I + .199 St-II + .103 St-III. (.14) (.191) (.12) (0.09) (0.09) R2= .248. Determine GZK's ZAR cash flow sensitivity to changes in exchange rates. Interpret your sensitivity estimate. Based on your estimate and the R2, do you think that GZK should manage its currency exposure? 3. Mr. Poppie is the owner of a big and trendy New York French restaurant. He obviously sells all its production in the U.S. His monthly revenue is USD 750,000. More than 60% of his purchases are imports from France. The monthly total cost of the French imports is Europe EUR 250,000. Mr. Poppie wants to set up a USD/EUR hedge that would ensure his ability to make affordable purchases should the USD collapse. In particular, he is very worried about a potential appreciation of the EUR against the dollar in December. Mr. Poppie broker charges a flat fee of USD 20 and the exchange charges USD 1.50 per contract. Using the information given in Example VII.2, construct: i) at the money Dec hedge. ii) out-of-the money Dec hedge. iii) a collar. (Specify type and number of contracts, strike prices, and costs.) Briefly discuss the advantages and disadvantages of each strategy. Which one would you recommend to Mr. Poppie? (Why?) 4. Swiss Cruises believes that changes in the CHF/USD exchange rate follow a normal distribution with mean 0% and standard deviation of 4%. That is, st~N(0,.0.0016). Assume that St=1.45 CHF/USD. The USD net transaction exposure is USD 1 million. Calculate a 95% range for the USD net transaction exposure. 5. You work for a Vandelay Industries, U.S. MNC. Vandelay gives you the following projections for next year: Currency Total inflows Total outflows Exchange rate GBP GBP 65,000 GBP 50,000 1.60 USD/GBP EUR EUR 80,000 EUR 95,000 0.95 USD/EUR a.- What is Vandelay's net transaction exposure (NTE)? VIII.45 b.- Suppose the GBP and the EUR are perfectly and positively correlated. The USD/GBP exchange rate increases to 1.76. What is the change in net transaction exposure for Vandelay Industries? c.- Go back to part (a). The GBP's standard deviation is .10, while the EUR's standard deviation is .05. Construct a range -i.e., a 95% confidence interval- for the transaction exposure of each currency. 6. Cami SDP, a Mexican subsidiary of the California based Cami MVP, has the following balance sheet. All items are in MXP. The current exchange rate of St=.14 USD/MXP. Cami SDP Balance Sheet in millions of MXP Balance Sheet Accounts Assets Cash Accounts receivable Inventory Net fixed plant and equip. Total assets 200 860 120 900 2,080 Liabilities and Capital Accounts payable Notes payable Long-term debt Shareholder's equity Total liabilities and capital 150 400 510 1,020 2,080 i. Calculate the exposure in USD of Cami SDP under the current method and the monetary/nonmonetary method. ii. Management believes that the MXP will depreciate against the USD within one year. Cami MVP wants to avoid translation exposure in MXP. Suggest a translation hedge. iii. Suppose in a year the company has the same balance sheet but St=.1900 USD/MXP. Calculate the translation gain under FASB #52. Is this translation loss/gain increase, decrease or leave unchanged earnings? 7. From 1999 to 2001, the euro showed a depreciating trend against the dollar and the yen. Did the increase in the USD affect the net transaction exposure of a European exporting firm? And what about economic exposure? 8. Kramerica Company does business in the U.S. and Canada. In attempting to assess its economic exposure, it compiled the following information:  Its U.S. sales are somewhat affect by the Canadian dollar's value because it faces competition from Canadian exporters. It forecasts the U.S. sales based on the following exchange rate scenarios: St (USD/CAD) Revenue from U.S. (in million) .70 USD 90 .80 USD 110 VIII.46  Its CAD revenues on sales to Canadians invoiced in CAD are expected to be CAD 200,000,000. • Its anticipated cost of goods sold is estimated at USD 50 million from the purchase of U.S. material and CAD 80 million from the purchase of Canadian materials.  Fixed operating expenses are USD 30 million.  Variable operating expenses are estimated at 20 percent of total sales (including Canadian sales, translated to a USD amount).  Interest expense is estimated at USD 10 million on existing U.S. loans, and the company has no CAD loans.  Income tax is paid at the U.S. tax rate of 30%. A. Create a forecasted income statement for Kramerica under each of the two exchange rate scenarios. B. Does Kramerica face economic exposure? Explain how Kramerica's projected earnings before taxes are affected by possible exchange rate movements. C. Explain how Kramerica can restructure its operations to reduce the sensitivity of its earnings to exchange rate movements, without reducing its volume of business in Canada. VIII.47 0.0738252 0.0446002 0.0153751 -0.013849 -0.043074 -0.072300 40 30 20 10 0 -0.101525 Frequency USD/CHF