international business and finance
rishabbiyani
WEEK8LECTURESLIDE.pptWeek 8
Foreign Exchange
I. Apprehending FX risk
II. Hedging
FX volatility is a risk for MNEs
- The advent of the Euro reduced FX volatility in the EU, facilitating cross-border planning thus business
- But a world currency is very unlikely and most FX prices move
- MNEs with an imbalance between assets/liabilities in a currency that moves (‘floats’) will continue to suffer FX risk
- Managing uncertainty is costly – firms try to denominate contracts in home currency but this is not always possible
- FX position may be balanced yet market moves will create new exposure even in the absence of any new deals
Being ‘long’ or ‘short’
Applies to all assets – not just FX
- Firm with more of a currency than it needs is long: risk is that currency falls before it can be resold
- Firm with less of a currency than it needs is short: risk is that currency rises before it can be repurchased
MNEs constantly identifying origins of their longs/shorts
Sources of FX exposure
Short-term, recurring transactional exposures
- Commercial risk (= long risk)
Stems from normal transactions between firm/customers, when
trade occurs in a currency other than one in which operations
of the unit responsible for the sale are denominated.
2. Operational risk (= short risk)
Stems from purchasing costs or operational expenses that a firm
incurs through its upstream value chain operations
Sources of FX exposure (cont.)
Non-recurring, non-transactional exposures
Translation risk
Mismatch between group’s reporting currency and currencies in
which overseas units’ assets/liabilities or P/L are denominated.
Also applies to intra-firm loans or dividend payments.
2. Economic risk
Long-term fall of currencies in which MNE receives revenues/
incurs costs – or other way around for rivals
3. Speculative risk
MNE decision not to cover all FX risk. ‘To hedge or not to hedge’
Managing FX risk
Long term readjustments –
reconfiguring the global value chain
- Increasing cost base in weakening currency:
- short term via outsourcing
- longer term by relocating manufacturing
- Increasing revenues base in strengthening currency:
- targeted sales campaigns
CUTTING ASSET/LIABILITY GAP = ‘NATURAL HEDGE’
Short-term financial hedging
- Mainly used with transactional exposures - more flexible, easier to arrange
- Basic idea: new deal that benefits from worst-case scenario affecting current exposure
- Then, the profit/loss on underlying position is offset by loss/profit on hedge risk is offset
Hedging against a ‘long’ risk
Non-UK MNE sells more in STG than sum total of its STG-denominated costs, i.e. it is long STG
Risk is that STG drops
It covers this by selling STG short as part of hedge
If STG drops, profits on the hedge will offset loss on the underlying position = zero net effect
If STG rises, losses on the hedge will offset profit on the underlying position = zero net effect
How hedging offsets a long risk
| Exporter long £, Hedges by selling £ | If £ then rises | If £ then falls |
| Effect on underlying long position | Positive ( + ) | Negative (-) |
| Effect on short hedge | Negative (-) | Positive ( + ) |
| Net effect | Zero | Zero |
Hedging against a ‘short’ risk
Non-UK MNE buys more in STG than sum total of its STG-denominated revenues = it is short STG
Risk = STG rises
It covers this by buying STG as part of hedge
If STG rises, profits on the hedge will offset loss on the underlying position = zero net effect
If STG drops, losses on the hedge will offset
profit on the underlying position = zero net effect
How hedging offsets a short risk
| Importer short £, Hedges by buying £ | If £ then rises | If £ then falls |
| Effect on underlying short position | Negative (-) | Positive ( + ) |
| Effect on short hedge | Positive ( + ) | Negative (-) |
| Net effect | Zero | Zero |
Hedging and attitudes towards risk
- Hedging reduces volatility of earnings – question of corporate values/mission of MNE (financialization?)
- But prevents windfall FX profits and has a cost – in the FX market usually = bank’s bid-offer spread
- Some MNEs try to predict FX to avoid hedging costs
Technical analysis (charts, market sentiment, ‘sticky’ prices)
Fundamental analysis:
- trade balance/macroeconomic figures
- purchasing power parity
- International Fisher Effect
To hedge or not to hedge?
Arguments in favour of hedging
- Firm may construe itself as a stable blue-chip, with steady albeit capped earnings growth
- Non-financial MNEs may want to avoid financial risk-taking at any cost. Question – is the treasury function seen as a profit or as a cost centre?
- Volatile earnings can disconcert actors (inc. lenders) thus raise transaction costs – fear of financial distress
- Leverage raises returns but may be inappropriate for riskier (unhedged) firm – conversely, hedged firm can borrow more
- Hedged firm may outperform rest of sector (or maybe not!)
Arguments against hedging
- Non-financial MNE may feel competent in predicting FX variations – so why outsource this function to bankers?
- Managers don’t have to reimburse bonuses: take extra risks n, if it blows up n+1 and you get fired you still keep the bonus
- Modigliani-Miller theorem: Corporate hedging does not increase value for shareholder who can hedge themselves against specific risks or diversify their equity portfolio (i.e. buy oil company to offset airliner)
- Opportunity cost of hedge – foregoing windfall profits
- Need to fund unfavourable mark-to-market (i.e. futures)
To hedge or not to hedge?(cont.)
Currency trading
Non-financial MNEs should know how banks work
- Relationship bank: FX salesperson in contact with MNE treasurer (advice – but is it disinterested?)
- Market-maker bank: offers liquidity (almost) all times. Profits from bid/offer spread = cost for market user
- Market spread depend on:
- price-maker’s current position (which it will want to offset)
- market in question (volatile? exotic?)
- prediction of customer behaviour (‘frontrunning’)
Brief intro to FX trading instruments
- ‘Arbitrage’ barely exists anymore: markets are too ‘efficient’ (info circulates too quickly)
- Most FX trading is done on ‘interbank’ basis
- Main difference is time of ‘settlement’ (payment)
- Spot FX: more or less immediate
- Forward FX: rate set today for future delivery
- Swaps: exchanging two currencies temporarily ( = lending)
- Options: right to buy/sell at given price (insurance premium)
The FX market
Does it work as it is supposed to?
- Only 2-3 %($5.3 tri daily in 2017) relates directly to physical trade ops
- Remainder = bank/other players adjusting positions
- Question of who runs the FX market:
- Commercial banks/private investors?
- Central banks?
STRUGGLE FOR POWER
Different FX regimes
- Fixed regime: central bank sets rates, no currency ‘convertibility’
- Managed float: currency allowed to move but central bank intervenes to limit variations
- Free float: private interests set FX rates, central banks intervene sporadically
TREND TOWARDS FREE FLOATS
FX and the battle for political power
- Central banks increasingly impotent in managed/free floating regimes: global privatization of wealth
- 1990s = repetition of currency crises: caused both by
speculative attacks and by government mismanagement
- FX markets are meant to provide accurate pricing and liquidity for MNEs to function. No system is perfect
Politicians have non-FX market reasons to misprice
Speculators accused of collusion/lacking democratic legitimacy, ravaging national economies
What future for the FX markets?
- Extension of free float (i.e. Chinese Yuan)?
- Re-regulation by governments?
- Financial transaction tax (ex-Robin Hood/Tobin Tax)?
Is there a disconnect between the interests of financial and industrial capital?
Exercise: Trading FX with a bank
Say £ - USD = 1.3300 (June 2018)
- What will two-way price be?
- Which side will importer/exporter trade on?
- In absence of any market movement, how might
this price change simply because
- price-giver already has a position (long? short?)
- customer announces its intention before trading
- size of trade/volatility of market
Do the international capital markets work?
- Are open K markets big factor in expansion of Int Business?
- But repeated crises – criticisms of ‘global casino’
- LDCs in 1990 (Mexico/Argentina, SE Asia, Russia)
- Dot.com bubble 2001
- Suprime crisis 2008
- European sovereign debt 2011-12 (Ireland, Portugal, Greece, Spain)
- Brexit?
- ‘Coupling’ – contagion of economic problems
- International imbalances (i.e. Asian surplus) – to be resolved by markets or redesigned financial system?
