Posts filed under 'Risk'
Transactional currency risk can be hedged tactically or strategically by the corporate Treasury to preserve cash flow and earnings, depending on their currency view.
Translational currency risk is usually hedged opportunistically rather than systematically, notably to try to avoid emerging market-related shocks to net assets, usually focusing on either long-term foreign investment or debt structure.
Hedging economic risk is complex, requiring the corporation to forecast its revenue and cost streams over a given period and then to analyse the potential impact on these of an exchange rate deviation from the rate used in calculating revenue and cost. For the debt structure, the currency of denomination must be chosen, the amount of debt estimated in that currency and the average interest period determined. The effect on cash flow should be netted out over product lines and across markets. What’s left from this process is the economic risk that has to be managed. For large multinationals, the net economic risk may in fact be quite small because of offsetting effects. However, economic risk can be substantial for corporations that have invested in only one or two foreign markets.
The first two steps of this process appear to have been accomplished. Firstly, we have defined very specifically the types of currency risk that a corporation is exposed to. Secondly, we have looked at broad strategy, the brushstrokes of managing that currency risk. Yet, while this currency risk may be defined, it must also be quantified. Quantifying an amount of currency may be easy for transaction risk, but for translation or economic risk it is no easy task. Just as with other types of risk management, the most popular way of doing this is to use a “VaR” model.
July 6th, 2009
The translation of foreign subsidiaries concerns the consolidated group balance sheet. However, this does not affect the real “economic” value or exposure of the subsidiary. Economic risk focuses on how exchange rate moves change the real economic value of the corporation, focusing on the present value of future operating cash flows and how this changes in line with exchange rate changes. More specifically, the economic risk of a corporation reflects the effect of exchange rate changes on items such as export and domestic sales, and the cost of domestic and imported inputs. As with translation risk, calculating economic risk is complex, but clearly necessary to be able to assess how exchange rate changes can affect the present value of foreign subsidiaries. Economic risk is usually applied to the present value of future operating cash flows of a corporation’s foreign subsidiaries. However, it can also be applied to the parent company’s operations and how the present value of those change in line with exchange rate changes. Summarizing this part, transaction risk deals with the effect of exchange rate moves on transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange rate changes to the present value of future operating cash flows, focusing on the “currency of determination” of revenues and operating expenses. Here it is important to differentiate between the currency in which cash flows are denominated and the currency that may determine the nature and size of those cash flows. The two are not necessarily the same. To complicate the issue further, there is the small matter of the parent company’s currency, which is used to consolidate the financial statements. If a parent company has foreign currency-denominated debt, this is recorded in the parent company’s currency, but the value of its legal obligation remains in the currency denomination of the debt. In sum, transaction risk is just the tip of the iceberg!
Of necessity, the reality of currency risk is very case-specific. That said, there has been an attempt by the academic and economic communities to apply the traditional exchange rate models to the corporate world for the purpose of demonstrating how exchange rates impact a corporation. More specifically, the models typically used for this purpose have been those of PPP, the international Fisher effect and the unbiased forward rate theory, which we looked at in earlier posts. To recap:
PPP (or the law of one price) suggests that price differentials of the same good in different countries require an exchange rate adjustment to offset them.
The international Fisher effect suggests that the expected change in the exchange rate is equal to the interest rate differential.
The unbiased forward rate theory suggests that the forward exchange rate is equal to the expected exchange rate.
Generally, these theories are grounded in the efficient market hypothesis and therefore flawed at best. Over the long term, these traditional “rules” of exchange rate theory suggest that competition and arbitrage should neutralize the effect of exchange rate changes on returns and on the valuation of the corporation. Equally, locking into the forward rate should, according to the unbiased forward rate theory, offer the same return as remaining exposed to currency risk, as this theory suggests that the distribution of probability should be equal on either side of the forward rate.
The unfortunate thing about such models, however worthy the attempt, is that they do not and cannot deal with the practical realities of managing currency risk. What academics regard as “temporary deviations” from where the model suggests the exchange rate should be can be sufficient and substantial enough to cause painful and intolerable deterioration to both the P&L and the balance sheet.
To conclude this part, a corporation should define and seek to quantify the types of currency risk to which it is exposed in order then to be able to go about creating a strategy for managing that currency risk.
July 5th, 2009
Translation risk is slightly more complex and is the result of the consolidation of parent company and foreign subsidiary financial statements. This consolidation means that exchange rate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to the parent company’s balance. Translation risk is thus balance sheet currency risk. While most large multinational corporations actively manage their transaction currency risk, many are less aware of the potential dangers of translation risk.
The actual translation process in consolidating financial statements is done either at the average exchange rate of the period or at the exchange rate at the period end, depending on the specific accounting regulations affecting the parent company. As a direct result, the consolidated results will vary as either the average or the end-of-period exchange rate varies. Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on the parent company’s balance sheet, and that value will vary accordingly. Translation risk for a foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to potential exchange rate moves.
Problems can occur with regard to translation risk if a corporation has subsidiaries whose accounting books are local currency-denominated. For consolidation purposes, these books must of course be translated into the currency of the parent company, but at what exchange rate? Income statements are usually translated at the average exchange rate over the period. However, deciding at what exchange rate to translate the balance sheet is slightly more tricky. There are generally three methods used by major multinational corporations for translating balance sheet risk, varying in how they separate assets and liabilities between those that need to be translated at the “current” exchange rate at the time of consolidation and those that are translated at the historical exchange rate:
The all current (closing rate) method
The monetary/non-monetary method
The temporal method
As the name might suggest, the all current (closing rate) method translates all foreign currency exposures at the closing exchange rate of the period concerned. Under this method, translation risk relates to net assets or shareholder funds. This has become the most popular method of translating balance exposure of foreign subsidiaries, both in the US and worldwide. On the other hand, the monetary/non-monetary method translates monetary items such as assets, liabilities and capital at the closing rate and non-monetary items at the historical rate. Finally, the temporal method breaks balance sheet items down in terms of whether they are firstly stated at replacement cost, realizable value, market value or expected future value, or secondly stated at historic cost. For the first group, these are translated at the closing exchange rate of the period concerned, for the second, at the historical exchange rate.
The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under FAS 52, the translation of foreign currency revenues and costs is made at the average exchange rate of the period. FAS 52 generally uses the all current method for translation purposes, though it does have several important provisions, notably regarding the treatment of currency hedging contracts. Under SSAP 20, the corporation can use either the current or average rate. Generally, there has been a shift among multinational corporations towards using the average rather than the closing rate because this is seen as a truer reflection of the translation risk faced by the corporation during the period.
Translation risk is a crucial issue for corporations. Later in this blog, we will look at methods of hedging it. For now, it is important to get an idea of how it can affect the company’s overall value.
July 4th, 2009
So, what precisely is currency risk? There is no point in focusing on an issue if one cannot first define it. Although definitions vary within the academic community, a practical description of currency risk would be:
The impact that unexpected exchange rate changes have on the value of the corporation
Currency risk is very important to a corporation as it can have a major impact on its cash flows, assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation has accepted that currency risk needs to be managed specifically and separately, it has three initial priorities:
1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose
Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible gain or loss resulting from an exchange rate move. It can affect the value of a corporation directly as a result of an unhedged exposure or more indirectly.
Different types of currency risk can also offset each other. For instance, take a US citizen who owns stock in a German auto manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the face of it the individual sees the US dollar value of their holding decline. However, the German auto exporter should in fact benefit from a weaker Euro as this makes the company’s exports to the US cheaper, allowing them the choice of either maintaining US prices to maintain margin or cutting them further to boost market share. Sooner or later, the stock market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the currency translation, but gain on the higher stock price.
This is of course a very simple example and life unfortunately is rarely that simple. For just as a weaker Euro makes exports from the Euro-zone cheaper, so it makes imports more expensive. Thus, an exporter may not in fact feel the benefit of the currency translation through to market share because higher import prices force it to raise export prices from where they would otherwise would be according to the exchange rate.
The first step in successfully managing currency risk is to acknowledge that such risk actually
exists and that it has to be managed in the general interest of the corporation and the corporation’s shareholders. For some, this is of itself a difficult hurdle as there is still major reluctance within corporate management to undertake what they see as straying from their core, underlying business into the speculative world of currency markets. The truth however is that the corporation is a participant in the currency market whether it likes it or not; if it has foreign currency-denominated exposure, that exposure should be managed. To do anything else is irresponsible. The general trend within the corporate world has however been in favour of recognizing the existence of and the need to manage currency risk. That recognition does not of itself entail speculation. Indeed, at its best, prudent currency hedging can be defined as the elimination of speculation:
The real speculation is in fact not managing currency risk
The next step, however, is slightly more complex and that is to identify the nature and extent of the currency risk or exposure. It should be noted that the emphasis here is for the most part on non-financial corporations, on manufacturers and service providers rather than on banks or other types of financial institutions. Non-financial corporations generally have only a small amount of their total assets in the form of receivables and other types of transaction. Most of their assets are made up of inventory, buildings, equipment and other forms of tangible “real” assets. In order to measure the effect of exchange rate moves on a corporation, one first has to define the type and then the amount of risk involved, or the “value at risk” (VaR). There are three main types of currency risk that a multinational corporation is exposed to and has to manage.
July 1st, 2009