Balance Sheet Hedge free essay sample

The rapid growth of risk management services suggests that management can increase firm value by controlling financial risks. 5 Moreover, investors and other stakeholders increasingly expect financial managers to identify and actively manage market risk exposures. If the value of the firm equals the present value of its future cash flows, active exposure management is justified on several grounds. †¢ First, exposure management helps stabilize a firm’s expected cash flows. Amore stable cash flow stream helps minimize earnings surprises, thereby increasing the present value of expected cash flows. Stable earnings also reduce the likelihood of default and bankruptcy risk, or the risk that earnings may not cover contractual debt service payments. †¢ Second, active exposure management enables firms to concentrate on their primary business risks. Thus, a manufacturer can hedge its interest rate and currency risks and concentrate on production and marketing. †¢ Third, debt holders, employees, and customers also gain from exposure management. As debt holders generally have a lower risk tolerance than shareholders, limiting the firm’s risk exposure helps align the interests of shareholders and bondholders. †¢ Fourth, derivative products allow employer-administered pension funds to enjoy higher returns by permitting them to invest in certain instruments without having to actually buy or sell the underlying instruments. †¢ Fifth, because losses caused by certain price and rate risks are passed on to customers in the form of higher prices, exposure management limits customers’ exposure to these risks. 6 In a world of floating exchange rates, risk management includes (1) anticipating exchange rate movements, (2) measuring a firm’s exposure to exchange risk, (3) designing appropriate protection strategies, and (4) establishing internal risk management controls. Information frequently used in making exchange rate forecasts (e. g. , currency depreciation) relates to changes in the following factors: Inflation differentials. Evidence suggests that a higher rate of inflation in a given country tends, over time, to be offset by an equal and opposite movement in the value of its currency. Monetary policy. An increase in a country’s money supply that exceeds the real growth rate of national output fosters inflation, which affects exchange rates. Balance of trade. Governments often use currency devaluations to cure an unfavorable trade balance (i. e. , when exports lt; imports). Balance of payments. A country that spends (imports) and invests more abroad than it earns (exports) or receives in investments from abroad experiences downward pressure on its currency’s value. International monetary reserves and debt capacity. Acountry with a persistent balance of payments deficit can forestall a currency devaluation by drawing down its savings (i. . , level of international monetary reserves) or drawing on its foreign borrowing capacity. As these resources decrease, the probability of devaluation increases. National budget. Deficits caused by excessive government spending also worsen inflation. Forward exchange quotations. Aforeign currency that can be acquired for future delive ry at a significant discount signals reduced confidence in that currency. Unofficial rates. Increases in the spread between official and unofficial or black market exchange rates suggest increased pressure on governments to align their official rates with more realistic market rates. Structuring a company’s affairs to minimize the adverse effects of exchange rate changes requires information on its exposure to FX rate risk. FX exposure exists whenever a change in FX rates changes the value of a firm’s net assets, earnings, and cash flows. 3 Traditional accounting measures of FX exposure center on two major types of exposure: translation and transaction. Translation Exposure A foreign currency asset or liability is exposed to exchange rate risk if a change in the exchange rate causes its parent currency equivalent to change. Based on this definition, foreign currency balance sheet items exposed to exchange rate risks are those items that are translated at current (as opposed to historical) exchange rates. Accordingly, translation exposure is measured by taking the difference between a firm’s exposed foreign currency assets and liabilities. This process is depicted in Exhibit 11-4. An excess of exposed assets over exposed liabilities (i. e. , those foreign currency items translated at current exchange rates) causes a net exposed asset position. This is sometimes referred to as a positive exposure. Devaluation of the foreign currency relative to the reporting currency produces a translation loss. Revaluation of the foreign currency produces a translation gain. Conversely, a firm has a net exposed liability position or negative exposure whenever exposed liabilities exceed exposed assets. In this instance, devaluation of the foreign currency causes a translation gain. Revaluation of the foreign currency causes a translation loss Transaction Exposure Transaction exposure concerns exchange gains and losses that arise from the settlement of transactions denominated in foreign currencies See pg 401- A transaction exposure report also has a different perspective than a translation exposure report. A translation exposure report takes the perspective of the parent company. A transaction exposure report takes the perspective of the foreign operation. Exhibit 11-9 focuses on what happens on the books of the Philippine affiliate if the peso changes value relative to the Australian dollar, the Indonesian rupiah, and the U. S. dollar. The peso column is of no concern, as peso transactions are recorded and settled in pesos. Adevaluation of the peso relative to the Australian and U. S. dollars will produce transaction gains owing to positive exposures in both currencies. A devaluation of the peso relative to the rupiah would produce a transaction loss, as more pesos would be required to settle the Philippine subsidiary’s foreign currency obligations. These transaction gains or losses (net of tax effects) directly impact U. S. dollar earnings upon consolidation Economic Exposure- The notion of economic exposure recognizes that exchange rate changes affect the competitive position of firms by altering the prices of their inputs and outputs relative to those of their foreign competitors. For example, assume that our hypothetical Philippine subsidiary obtains its labor and material locally. Devaluation of the Philippine peso relative to all other foreign currencies could improve rather than worsen the subsidiary’s position. It could increase its exports to Australia and the United States as the devalued peso would make its goods cheaper in terms of the Australian and U. S. dollar. Domestic sales could also rise, because the peso devaluation would make imported goods more expensive in local currency. The devaluation would have no appreciable effect on the cost of local-source inputs. Thus, the future profitability of the Philippine subsidiary might increase because of the currency depreciation Alternatively, a German manufacturing affiliate of a U. K. parent, organized to serve the German market, may have a positive translation exposure. Appreciation of the euro relative to the pound would produce a translation gain upon consolidation. If the German affiliate were to source all of its inputs in Germany, its economic exposure would appear to be shielded from exchange risk. Yet, if a major German competitor obtained some of its manufacturing components from Russia, this competitor may enjoy a cost advantage if the rouble were undervalued relative to the deutsche mark. These examples suggest that economic or operating exposure bears little or no relation to translation and transaction exposure.