21.8Foreign Exchange Risk Management

Multinational corporations must pay particular attention to managing their currency

risk. Changes in currency rates affect a firm’s cash flows as well as its accounting prof-

its. Currency rate changes also affect a company’s market and book values.

Types of Foreign Exchange Risk

The various risks associated with changes in the value of currencies are generally

divided into three categories: transaction risk, translation risk, and economic risk, which

Exhibit 21.4 defines.

Transaction Risk.To summarize, transaction riskrepresents only the immediate

effect on cash flow of an exchange rate change. Exposure to transaction risk arises

when a company buys or sells a good, priced in a foreign currency, on credit. Suppose,

for example, that IBM sells computers to Nestlé, a Swiss company, for 10 million Swiss

francs. Currently, the Swiss francis worth US$0.60, with payment required in six

months. If the Swiss Franc depreciates in six months and is worth only US$0.50, IBM

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EXHIBIT21.4Categories of Currency Risk

Transaction Risk

Translation Risk

Economic Risk

Descriptions	Associated with	Arising from the	Associated with losing
	individual transactions	translation of balance	competitive advantage
	denominated in foreign	sheets and income	due to exchange rate
	currencies: imports,	statements in foreign	movements
	exports, foreign assets,	currencies to the
	and loans	currency of the parent
		company for financial
		reporting purposes

Examples	AU.S. company imports	AU.S. enterprise has a	AU.S. and a Japanese
	parts from Japan. The	German subsidiary.	company are
	U.S. company is	The U.S. enterprise is	competing in Britain.
	exposed to the risk of	exposed to the risk of	If the yen weakens
	the yen strengthening	the deutsche mark	against the pound and
	and, as a result, the	weakening, and the	the dollar-pound
	dollar price of parts	value of the	exchange rate remains
	increasing.	subsidiary’s assets,	constant, the Japanese
		liabilities, and profit	company can lower its
		contributions	prices in Britain
		decreasing in dollar	without losing yen
		terms in consolidated	income, thus obtaining
		financial statements.	a competitive
			advantage over the
			U.S. company.

will receive the equivalent of US$5 million rather than the US$6 million it had

originally expected to receive.

It is quite easy for firms to hedge against transaction risk. For example, IBM

could simply require payment in U.S. dollars, which effectively shifts the transac-

tion risk onto Nestlé. Alternatively, IBM could enter into a forward contract to sell

10 million Swiss francs at a prespecified dollar/Swiss franc exchange rate, with

delivery in six months, to lock in the revenues from its sale in U.S. dollars.

Hedges of this type are quite straightforward and are commonly observed in busi-

nesses throughout the world. However, they control only the short-term implications of

exchange rate changes. For example, IBM’s profits in Switzerland are likely to decline

if the Swiss franc weakens unless the company raises the Swiss franc price of its com-

puters to its Swiss customers. As a result, there are long-run implications of currency

changes that are not hedged when risk management is restricted to individual transac-

tions.

In the terminology described in Exhibit 21.4, the economic risk connected with

currency changes is much larger than the transaction risk because it takes into account

the long-term consequences of the change in currency value.

Translation Risk.Translation riskoccurs because a foreign subsidiary’s financial

statements must be translated into the home country’s currency as part of the consoli-

dated statements of the parent. For example, suppose IBM purchased a firm in the

United Kingdom for £100 million when the pound was worth US$1.90. The British

firm is then set up as a wholly owned subsidiary of IBM with a book value of US$190

million. Subsequently, the dollar strengthens, so that the pound is worth US$1.60. FASB

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Rule 52 requires that IBM restate its balance sheet to account for this currency change,

so that the book value of the subsidiary becomes US$160 million.¹⁵

Why is translation risk important? First, changes in value associated with exchange

rate changes often reflect real economic changes that affect the future profitability of

the firm. Translation risk may, however, be an important consideration even when the

firm’s inflation-adjusted cash flows are unaffected by a change in the exchange rate, as

long as the firm has contracts written with terms that are contingent on the firm’s book

value. For example, firms often have loan covenants that require it to keep its debt-to-

book-value ratio above a certain level. In such cases, exchange rate changes that cre-

ate a drop in the book value of a foreign subsidiary create violations of loan covenants,

even when the exchange rate changes are driven by inflation. Since covenant violations

can result in real costs, firms may find it beneficial to hedge against such possibilities.

Economic Risk.What are the determinants of economic risk? Or, what are the fac-

tors that determine how changes in exchange rates affect the fundamentals of a firm’s

business? These factors include the following:

•	Differences between the location of the production facilities and where theproduct is sold.
•	Location of competitors.
•	Determinants of input prices: Are they determined in international markets orlocal markets?

It is easy to see how a firm with a large percentage of its sales overseas is exposed to

currency fluctuations. However, even firms that sell only in the United States are sub-

ject to currency risk if they import some of their supplies or have foreign competitors.

Why Do Exchange Rates Change?

To understand foreign exchange hedging in greater detail, it is important to think about

why exchange rates change over time. Perhaps the most important contributor to

exchange rate changes is the difference in the inflation rates of two countries. For exam-

ple, suppose the British pound is initially worth US$1.50. If the inflation rate in the

United Kingdom is 10 percent over the next year while the inflation rate in the United

States is zero—and nothing else changes during this time period—then the British

pound is likely to fall in value by 10 percent to US$1.35. In this case, thenominal

exchange rate,which measures the U.S. dollar price of British pounds, changes by

10percent, but the real exchange rate,which measures the relative price of British

and U.S. goods, remains unchanged. An American tourist in the United Kingdom will

find British goods and services selling at the same price in terms of U.S. dollars as

they were selling for in the previous year.

The Case of No Real Effects.If you believe that differential inflation rates are the

primary cause of exchange rate movements, would you need to hedge against unex-

pected changes? If your main concern is economic risk or transaction risk, there would

¹⁵The gain or loss on the translation of foreign currency in a firm’s financial statements is not

recognized in current net income, but is reported as a separate component of stockholders’equity. The

amounts accumulated in this separate component of stockholders’equity are realized on the sale or

liquidation of the investment in the foreign entity.

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764Part VIRisk Management

be no need for your firm to hedge. The firm is subject to neither risk. This point is

illustrated in Example 21.6.

Example 21.6:Currency Risk and Inflation

Textronics will buy three million circuit boards from a small firm in Taiwan in about one year.

Each circuit board is currently priced at NT$100, which is equivalent to about US$4 at current

exchange rates.Suppose Taiwan has an uncertain monetary policy and could experience

either inflation or deflation, which can cause currency movements of as much as 10 percent.

Is Textronics exposed to currency risk?

Answer:If inflation is the only cause of exchange rate changes, then Textronics is not

exposed to currency risk.A 10 percent increase in the Taiwan price level will result in a price

increase of circuit boards to NT$110.However, the inflation will simultaneously result in a

drop in the value of the Taiwan dollar to US$.0364.The U.S.dollar price that Textronics pays

for the circuit boards is thus unchanged.

In Example 21.6, Textronics was simply purchasing an item from a foreign com-

pany. Suppose now that Textronics sets up a plant in Taiwan to produce the circuit

boards. In this case, an exchange rate change driven purely by inflation can have real

effects because it can affect how the firm’s Taiwanese assets are represented on its bal-

ance sheets which could, in turn, affect bond covenants and other contracts.

Inflation Differences Tend to Generate Real Effects.Of course, it is rare when dif-

ferent inflation rates in two countries are not also generating real effects in the two coun-

tries. For example, when oil was discovered in the North Sea off Britain’s coast, the

British pound strengthened because, at the prevailing exchange rate, the United King-

dom was expected to have an excess of exports (especially oil) over imports. In this

case, the strengthening of the pound did affect relative prices. AU.S. tourist in the United

Kingdom after the oil discovery would find that prices calculated in U.S. dollars had

increased. Since the real, or inflation-adjusted, exchange rate changed, a U.S. firm that

imported materials from the United Kingdom would see its costs increase. If the pro-

duction costs of the British firm in British pounds stayed the same, the firm’s price in

pounds also would stay the same, which implies that U.S. dollar prices would increase

if the pound strengthened. AU.S. firm would be exposed to currency risk in this case.

Result 21.13

Exchange rate movements can be decomposed into those caused by differences in the infla-tion rates in the home country and the foreign country, and those caused by changes in realexchange rates. In most cases, the incentive is to hedge against real exchange rate changesrather than the component of exchange rate changes that is driven by inflation differencesbetween the two countries.

Exhibit 21.5 documents both real and nominal exchange rate movements from 1990

to 2000 for five countries: Indonesia, Japan, Spain, Thailand, and Turkey. Note that nom-

inal exchange rates changed dramatically over this time period for countries experienc-

ing high levels of inflation. However, the real exchange rates, which are more important

for multinational firms, are somewhat less volatile over longer periods of time.

The exchange rates shown in Exhibit 21.5 represent the number of units of the

local currency that can be exchanged for each U.S. dollar. For example, the 1990

exchange rate for Turkey was 2,930, which means that 2,930 Turkish liras could have

been exchanged for US$1.00 on the spot market at the end of 1990. The consumer

price index (CPI) for each year relates the price levels of each country to the price lev-

els for 1995. An index value of 100 means that the price level is identical to the prices

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EXHIBIT21.5Real and Nominal Exchange Rates in Five Countries*