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Chapter3TheManagementofForeignExchangeRateExposureForeign exchange exposure is a Foreign exchange exposure is a measure of the measure of the potential for a firmspotential for a firms profitabilityprofitability,net cash flow,net cash flow,and market valueand market value to change because of a change to change because of a change in in exchange ratesexchange rates.Animportanttaskofthefinancialmanageristomeasureforeignexchangeexposureandtomanageitsoastomaximizetheprofitability,netcashflow,andmarketvalueofthefirm.Theeffectonafirmwhenforeignexchangerateschangecanbemeasuredinseveralways.Exhibit 8.1 Conceptual Comparison of Transaction,Operating and Accounting Foreign Exchange ExposureMoment in time whenexchange rate changesAccounting exposure(Translation)Transaction exposureOperating exposure(Economic)TimeChanges in reported owners equityin consolidated financial statementscaused by a change in exchange ratesChange in expected future cash flows arising from an unexpected change inexchange ratesImpact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange ratesTypesofForeignExchangeExposureTransaction exposure measureschangesinthevalueofoutstandingfinancialobligationsincurredpriortoachangeinexchangeratesbutnotduetobesettleduntilaftertheexchangerateschange.Thus,thistypeofexposuredealswithchangesincashflowsthatresultfromexistingcontractualobligations.TypesofForeignExchangeExposureExample:EnglishimporterMartinimportedthegoodsworthyof$1,000,000fromUSAinMarch1st2006.USdollarisstimulatedtosettlethepaymentandthepaymentdateis2-monthlater.Therateof$/is1.6000inMarch1stand1.5000inMay1st.Accordingtotherateof1.6000,Martinonlyneed625,000toconvertintoUSdollar,butafter2months,hehastopay666,700togetthesamevolumeofUSdollar.TypesofForeignExchangeExposureTransactionexposuremayappearwhenInexportationorimportation,duringtheperiodfromsigningthecontractstosettlingthepayment,thefluctuationofexchangeratemayleadtotransactionexposure.Intheinternationalloanswhicharealwaysintermsofforex,whentheloansarentcleared,rateschangemayarisethetransactionexposure.Inforwardtransactions,onthevaluedate,becausetheforexraterisesorfalls,oneparthastopaymoreonecurrencytoconvertintotheothercurrency.Accountspayableorreceivableinforeigncurrencymayalsobeinfluencedbythefluctuationofexchangerate.TypesofForeignExchangeExposureOperating exposure,alsocalledEconomic exposure,competitive exposure,orstrategic exposure,measuresthechangeinthepresentvalueofthefirmresultingfromanychangeinfutureoperatingcashflowsofthefirmcausedbyanunexpectedchangeinexchangerates.TypesofForeignExchangeExposureEconomicexposureemphasizesonthefirmssituationasawhole.Inthelateof1990s,afterthefinancialcrisisbrokeoutintheAsia,theexchangeratesofAsiacountriesfalltoagreatextent.Itledtotheexportationdifficultiesofourexporters.TypesofForeignExchangeExposureTransactionexposureandoperatingexposureexistbecauseofunexpectedchangesinfuturecashflows.The difference between the two is that transaction exposure is concerned with future cash flows already contracted for,while operating exposure focuses on expected(notyetcontractedfor)future cash flows that might change because a change in exchange rateshasalteredinternationalcompetitiveness.TypesofForeignExchangeExposureAccounting exposure,alsocalledtranslation exposure,isthepotentialforaccounting-derivedchangesinownersequitytooccurbecauseoftheneedto“translate”foreigncurrencyfinancialstatementsofforeignsubsidiariesintoasinglereportingcurrencytoprepareworldwideconsolidatedfinancialstatements.TypesofForeignExchangeExposureExample:C/AbalancebetweenAmericanoilcompanyanditsEnglishsubsidiaryis10,000,000.andtheexchangerateis1.6000$/inthebeginningoftheyear.SotheC/Abalanceequalsto$16,000,000.However,ontheendoftheyear,therateis1.5000,sotheEnglishsubsidiaryonlyhasabalanceof$15,000,000,thatis,thelossis$1,000,000.TypesofForeignExchangeExposureThetaxconsequenceofforeignexchangeexposurevariesbycountry.Asageneralrule,however,onlyrealizedforeignexchangelossesaredeductibleforpurposesofcalculatingincometaxes.Similarly,onlyrealizedgainscreatetaxableincome.“Realized”meansthatthelossorgaininvolvescashflows.MeasurementofTransactionExposureToforecastthetendencyofexchangerateaccuratelyisthecorepremisetoavoidtherisks.Underthefloatsystem,theexchangerateisdecidedbasicallybythesupplyanddemandoftheforeigncurrency.Butmanyfactorshavecomplexinfluenceonthesupplyanddemand.MeasurementofTransactionExposureTransactionexposuremeasuresgainsorlossesthatarisefromthesettlementofexistingfinancialobligationswhosetermsarestatedinaforeigncurrency.Themostcommonexampleoftransactionexposureariseswhenafirmhasareceivableorpayabledenominatedinaforeigncurrency.Exhibit The Life Span of a Transaction Exposuret1t2t3t4Seller quotesa price to buyer(in verbal or written form)Buyer placesfirm order withseller at priceoffered at time t1Seller shipsproduct andbills buyerBuyer settles billswith cash inamount of currencyquoted at time t1QuotationExposureBacklogExposureBillingExposureTime between quotinga price and reaching acontractual saleTime it takes tofill the order aftercontract is signedTime it takes toget paid in cash afterBills are issuedTime and EventsMeasurementofTransactionExposureIntheinternationaltrade,tradersalwaysmakeuseoftradecreditstoavoidtheforexrisks.MainmeasurementscontainExportcreditsExportExportGovernmentbanksexporterimporterMeasurementofTransactionExposureInwarddocumentarybillItisprovidedbythebankswhoissuetheL/Ctotheimporters.Whentheissuingbanksreceivethebills,theyhavetoclearthepaymentandgivethebillstotheimporters.After1or3months,theimporterspayofftheloans.OutwarddocumentarybillAftershippingthegoods,theexportersconvertthebillsintothepaymentwiththenegotiatedbanks.Thenthenegotiatedbankssendthebillstotheissuingbanksforthepayments.FactoringAftershipment,theexporterstransferthebillstothespecialfactoringformstogainmostofthepaymentinadvance.Forfaitingtheexportersdiscountthelong-termwithoutrecourseperiodbillstothefinancialinstitutions.MeasurementofTransactionExposureTradersalsocanadjustthetimeandaggregateofreceivableorpayabledenominatedinaforeigncurrency.LeadsandLagsItmeanstochangethepaymentdateorthereceivabledate.Whentheanticipationisappreciation,theexportersdelaythepaymentdate,iftheanticipationisdepreciation,theexportersspeedupthepayments.Matchingthetradersmatchtheforeignassetsandforeignliabilities.PairingNestingMeasurementofTransactionExposureForeignexchangetransactionexposurecanbemanagedbycontractual,operating,andfinancial hedges.Themaincontractualhedgesemploytheforward,money,futures,andoptionsmarkets.Operatingandfinancialhedgesemploytheuseofrisk-sharingagreements,leadsandlagsinpaymentterms,swaps,andotherstrategies.RiskManagementinPracticeThetreasuryfunctionofmostprivatefirms,thegrouptypicallyisresponsiblefortransactionexposuremanagement.Thetreasuryfunctionisnotexpectedtoaddprofittothefirmsbottomline.Currencyriskmanagersareexpectedtobeontheconservativesidewhenmanagingthefirmsmoney.RiskManagementinPracticeFirmsmustdecidewhichexposurestohedge:ManyfirmsdonotallowthehedgingofquotationexposureorbacklogexposureasamatterofpolicyManyfirmsfeelthatuntilthetransactionexistsontheaccountingbooksofthefirm,theprobabilityoftheexposureactuallyoccurringisconsideredtobelessthan100%Anincreasingnumberoffirms,however,areactivelyhedgingnotonlybacklogexposures,butalsoselectivelyhedgingquotationandanticipatedexposures.AnticipatedexposuresaretransactionsforwhichthereareatpresentnocontractsoragreementsbetweenpartiesRiskManagementinPracticeAsmightbeexpected,transactionexposuremanagementprogramsaregenerallydividedalongan“option-line”;thosethatusecurrencyoptionsandthosethatdonot.Firmsthatdonotusecurrencyoptionsrelyalmostexclusivelyonforwardcontractsandmoneymarkethedges.RiskManagementinPracticeManyMNEshaveestablishedratherrigidtransactionexposureriskmanagementpoliciesthatmandateproportionalhedging.Thesecontractsgenerallyrequiretheuseofforwardcontracthedgesonapercentageofexistingtransactionexposures.Theremainingportionoftheexposureisthenselectivelyhedgedonthebasisofthefirmsrisktolerance,viewofexchangeratemovements,andconfidencelevel.questionsIfyouareaCFOoftheHAIER,whatdoyouthinktocontroltheforexexposure?
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