Tài chính doanh nghiệp - Chapter 17: Foreign exchange risk identification and management

Chapter 17Foreign Exchange RiskIdentification andManagementCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonLearning ObjectivesIdentify the different types of foreign exchange (FX) risk faced by firmsUnderstand how firms can manage their foreign exchange risk using market-based or internal hedging techniquesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation17.1 Introduction17.2 FX Risk Policy formation17.3 Measuring Transaction Exposure17.4 Risk Management: Market-based Hedging Techniques17.5 Risk Management: Internal Hedging Techniques17.6 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.1 IntroductionForeign exchange risk exposures can be classified in terms of the impact on a firm’s cash flows, balance sheet, competitive position and valueTransaction exposureTranslation or accounting exposureOperational exposureEconomic exposureCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.1 Introduction (cont.)Transaction exposureThe risk that future foreign currency denominated cash flows will vary due to exchange rate movementsE.g. a contract to import goods from the USA denominated in USDCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.1 Introduction (cont.)Translation or accounting exposureThe risk that conversion and consolidation of foreign currency assets or liabilities will adversely impact the balance sheetE.g. a firm accumulates assets and liabilities overseas and at a future date translates their value onto its consolidated balance sheetCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.1 Introduction (cont.)Operational exposureThe risk that day-to-day operating revenues and expenses will be affected by FX movementsE.g. foreign subsidiary operating expenses paid in the currency of the foreign country but sourced in another country i.e. the parent companyCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.1 Introduction (cont.)Economic exposureThe effect of exchange rate movements on the ongoing business operations of a firm (i.e. the net present value of its future cash flows)It includes both transaction exposures and operating FX exposures and extends further to recognise the impact of FX risk on the value of a firmCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation17.1 Introduction17.2 FX Risk Policy Formation17.3 Measuring Transaction Exposure17.4 Risk Management: Market-based Hedging Techniques17.5 Risk Management: Internal Hedging Techniques17.6 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.2 FX Risk Policy FormationA company’s board of directors should document and circulate specific policies on FX risk management includingFX objectivesManagement structureAuthorisationsExposure reporting systemsCommunicationsPerformance evaluationAudit and review proceduresCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.2 FX Risk Policy Formation (cont.)FX objectivesConsideration of what the company intends to achieve and how it will achieve it by specifyingThe products and services that can be used to mange FX risk exposures e.g. natural hedgesThe style of risk management e.g. active or defensiveCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.2 FX Risk Policy Formation (cont.)Management structureEnsure appropriate organisational controls and reporting systems, skilled personnel and sufficient funding are in placeAuthorisationsA description of who, in the organisation, has the authority to do what, ensuring task segregationCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.2 FX Risk Policy Formation (cont.)Exposure reporting systemsDetermine which reports are required, how frequently they are required and who is responsible to act on themCommunicationsHow communication should occur both horizontally and vertically within the Treasury division and the overall organisationCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.2 FX Risk Policy Formation (cont.)Performance evaluationEvaluation of the performance of the FX operations, given the FX objectivesAudit and review proceduresA regular and structured process of carrying out internal and external audits of FX operations, including current objectives, policies and procedures, with appropriate lines of reportingCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation17.1 Introduction17.2 FX Risk Policy Formation17.3 Measuring Transaction Exposure17.4 Risk Management: Market-based Hedging Techniques17.5 Risk Management: Internal Hedging Techniques17.6 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction ExposureThis is the risk faced by Australian firms that the AUD will change between the time an order is placed and the time of its paymentThis risk is caused by the uncertainty as to the exact value of the transactionCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure risk has two directional componentsDownside exposureAmount received (paid) in the future is less (more) than the current projected amountUpside exposureAmount received (paid) in the future is more (less) than the current projected amountCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure has two elementsNet cash flowsCollate all receivables and payables in each currency to determine net exposureRisk associated with transaction exposureCurrency variabilityCurrency correlationsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Net cash flows (cont.)It is evident from Table 17.1 that theCompany has a natural hedgei.e. matching transactions have been used to offset a potential risk exposureNet FX exposure is zeroCompany had a perfect hedge because its receivables and payables were identical in size, currency and timeCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposures: currency variabilityHaving determined the net FX exposure in each currency, the next step is to assess the extent of the risk (variability) of each exposure Currency variability relates to the probability of the spot rate changing between contract date and payment dateCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposures: currency variability (cont.)Often measured by standard deviationMay need to examine trend in currency standard deviation over time as in Table 17.2, which illustratesStandard deviations vary between currencies in the same periodStandard deviations vary over timeCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure: currency correlationsIn considering whether to hedge a FX exposure, the correlations between the currencies should be consideredCorrelation measures the degree to which two currencies move in relation to each otherCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure: currency correlations (cont.)Ranges from + 1 (perfectly positively correlated) to – 1 (perfectly negatively correlated)Figure 17.2 indicatesCurrencies A and B are highly positively correlatedCurrency C is highly negatively correlated with both currencies A and BCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure: currency correlations (cont.)Table 17.3 is used to demonstrate the use of correlation coefficients in assessing whether a FX exposure requires hedgingDate t+6A change in the AUD will result in a similar change in both inflows and outflows which offset each otherA natural hedge existsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure: currency correlations (cont.)Date t+8A change in the AUD will result in either a gain or a loss on both flowsThe exposure should be hedgedDate t+9A change in the AUD will result in either a gain or loss on both flowsThe exposure should be hedgedCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.3 Measuring Transaction Exposure (cont.)Transaction exposure: currency correlations (cont.)Date t+11A change in the AUD will result in a similar change in both inflows and outflows which offset each otherA natural hedge existsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation17.1 Introduction17.2 FX Risk Policy Formation17.3 Measuring Transaction Exposure17.4 Risk Management: Market-based Hedging Techniques17.5 Risk Management: Internal Hedging Techniques17.6 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.4 Risk Management: Market-based Hedging TechniquesA firm may attempt to minimise FX risk (particularly downside exposure) through the use of hedging techniques/instrumentsHedging instruments includeForward exchange contractsMoney market hedgeFutures, options and swaps (discussed in Chapters 18, 19 and 20 respectively)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.4 Risk Management: Market-based Hedging Techniques (cont.)Forward exchange contractsLock in an exchange rate today for delivery or receipt of a foreign currency at a specified future dateTable 17.4 provides an example of the use of a forward exchange contract to hedge a US$1 million receivable in 6-months’ timeCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.4 Risk Management: Market-based Hedging Techniques (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.4 Risk Management: Market-based Hedging Techniques (cont.)Money market hedging to cover FX riskAlso called BSI hedgeExampleA company has US$1 million receivable in 6-months’ timeMoney market hedging involvesSTEP I: Borrow USD today STEP II: Spot convert USD to AUDSTEP III: Invest the AUD todayCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.4 Risk Management: Market-based Hedging Techniques (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation17.1 Introduction17.2 FX Risk Policy Formation17.3 Measuring Transaction Exposure17.4 Risk Management: Market-based Hedging Techniques17.5 Risk Management: Internal Hedging Techniques17.6 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.5 Risk management: Internal Hedging TechniquesInternal hedging minimises FX exposures and the need to use market-based hedging techniquesMain internal hedging techniquesInvoicing in the home currencyCreating a natural hedgeCurrency diversificationLeading and lagging FX transactionsMark-upsCounter-trades and currency offsetsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonMain internal hedging techniquesInvoicing in the home currencyAvoids FX exposureEffectively transfers all FX risk to the other party in the business transactionThe other party may charge a higher price to compensate for the extra riskCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonMain internal hedging techniques (cont.)Creating a natural hedgeMatch foreign currency receivables and payables in terms of currency, timing and magnitudeUnlikely that an exact hedge can be achievedCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonMain internal hedging techniques (cont.)Currency diversificationLimit impact of adverse exchange rate movements by spreading transactions over a large number of currenciesChance of adverse movements in a large number of currencies is very smallGreatest diversification achieved where currencies are perfectly negatively correlatedCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonMain internal hedging techniques (cont.)Leading and lagging FX transactionsLeading: changing the timing of a cash flow so that it takes place prior to the originally agreed date E.g. pay a USD payable before an expected AUD depreciationLagging: delaying the timing of an existing FX cash flowE.g. delaying a USD payable to coincide with a USD receivableNeed to assess costs/impact of strategiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonMain internal hedging techniques (cont.)Mark-upsIncreasing prices on exports or imports to cover worst-case scenario changes in an exchange rateE.g. exporter marks-up export price of goods soldE.g. importer marks-up the domestic price of imported goodsCompetition is a constraint to this strategyCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonMain internal hedging techniques (cont.)Counter-trade and currency offsetsThe exchange of product for product, rather then currency-based buy or sell contractsLimited to companies wishing to exchange products of equal value and at the same timeApplicable to both internal cash flows of a firm and FX cash flows between firmsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation17.1 Introduction17.2 FX Risk Policy Formation17.3 Measuring Transaction Exposure17.4 Risk Management: Market-based Hedging Techniques17.5 Risk Management: Internal Hedging Techniques17.6 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.6 SummaryForeign exchange risk exposures can be classified asTransaction exposureTranslation or accounting exposureOperational exposureEconomic exposureCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.6 Summary (cont.)FX risk policy formulation involves a number of aspects necessary to measure and manage FX risk includingFX objectives, authorisations, exposure reporting systems, communications, performance evaluation, audit and review proceduresCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.6 Summary (cont.)Transaction exposures can be measured byNet cash flowsCurrency variabilityCurrency correlationsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson17.6 Summary (cont.)Risk management techniques includeMarket-based hedging: forward exchange contracts and money market hedgingInternal hedging: invoicing in home currency, natural hedge, currency diversification, leading and lagging FX transactions, mark-ups, counter-trade and currency offsetsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson