Managing Financial Risks in International Trading PART 1
Through the foreign exchange market, money of one country is exchanged for that of another country. The exchange rate reveals the value of one unit of a currency to be exchanged for another currency, and the rate continuously floats due to multiple reasons.
Author: Yen-Chih Lee
1. Introduction
Through the foreign exchange market, money of one country is exchanged for that of another country. The exchange rate reveals the value of one unit of a currency to be exchanged for another currency, and the rate continuously floats due to multiple reasons. Basically, the principle of demand and supply determines the foreign currency exchange rate. For instance, an increase of the U.S. interest rate tends to drive a higher demand of the U.S. dollar and a rise of the dollar exchange rate to other currencies. In general, a slow and moderate variation of the foreign currency exchange rate is expected to reflect the disparity of the purchasing power among different countries, but in reality, abrupt changes could happen over a period of time. For instance, the U.S. dollar index, which measures the value of the U.S. dollar with respect to a basket of foreign currencies, sharply rose about 88% from 1980 to 1985. A peak dollar index of 164.72 was recorded in February 1985. Then, the dollar index surprisingly dropped back to the level in 1980 from 1985 to 1988 (Trading Economics, 2017). For internationally operated MNEs, unless they could accurately project the fluctuations of the foreign currency exchange rates, they are constantly exposed in such a financial risk of losing due to changes in the exchange rates. In the following, discussions are focused on MNEs that are mainly based in the U.S. so that earnings from foreign countries are all assumed to be exchanged from the foreign currencies to the U.S. dollar.
The transaction, translation, and operating risks are what MNEs are exposed to when making international trades (Eiteman et al., 2012). First, the transaction risk is a financial loss that may occur due to changes in the currency exchange rate after entering into an outstanding financial obligation. For instance, a foreign trade is contracted to be effective three months later, but a rise in the currency exchange rate may lead to a decrease in earnings when the foreign currency is exchanged to the U.S. dollar. To mitigate such a risk, hedging is the most common management technique. Second, the translation risk is a change in value of foreign subsidiaries’ equity, asset, liability, or income after converting value from a foreign currency to the U.S. dollar. For instance, the value of a subsidiary’s asset may decrease due to an appreciation of the U.S. dollar over a time period while the asset’s value in the foreign currency remains constant. This is not a real financial loss but a decrease in value after an accounting process, and it may lead to a decrease of the net income in the parent MNE’s consolidated income statement. To minimize such an assessment risk, balance sheet hedging is a practical management approach, which is to maintain a balance between subsidiaries’ exposed assets and their exposed liabilities. Third, operating risk, which is also called the economic risk and is in principle similar to the transaction risk, deals with unexpected financial losses in the future expected but uncommitted cash flows after a sudden change in exchange rates. For instance, an MNE expects to have a periodic sale in a foreign country in the last quarter of a year but the projected earnings may decrease due to an unexpected appreciation of the U.S. dollar. Such unexpected losses could affect an MNE’s projected revenue, earnings, and the company’s planned future operations. To reduce the impact, diversifying operational and financial bases is a key strategic management method. Still, a few hedging approaches can be applied to minimize the impact.
In this article, challenges and tasks encountered by MNEs’ financial managers in dealing with the financial risks accompanied with fluctuations of the foreign currency exchange rates are studied. Suitable management strategies and illustrations are offered to facilitate the deployment by financial managers.
2. Managing Transaction Risk
In the last quarter of 2014, the U.S. dollar index appreciated from 82.78 to 90.65 (Figure 1) (Trading Economics, 2017) which led Apple to lose $3.73 billion due to currency fluctuation even though it had generated $51.18 billion revenue from its impressive iPhone sales during the same period (Udland, 2015). To minimize the currency exchange risk, Apple actually had holdings of currency-hedging contracts in the last half of 2014, but the effort was clearly not enough to avoid losses. Learning from this unpleasant experience, in 2015, the dollar index appreciated up to 98.75 by the end of the year, but, through more enhanced hedging efforts, Apple was able to save $4.1 billion in earnings (Adinolfi, 2015). Apple’s lesson illustrates the importance of hedging on turning losses to profits in international business when tackling the currency exchange risk.
Transactional exposures occur when trading involves currency exchange. Apple received foreign currencies when iPhones were delivered to foreign countries. The order usually occurred a period before the delivery. Therefore, when money was received, the amount may be lower than what it was on the day of ordering because of an appreciation of the U.S. dollar. Certainly, Apple could insist on receiving the U.S. dollar so as to let the foreign companies bear the currency exchange risk, but then Apple may lose its business competitiveness to other competitors who are willing to take foreign currencies.
Figure 1: The U.S. Dollar Index (Trading Economics, 2017).
Transaction exposures are often managed through hedging which is to acquire a currency contract that will rise/fall in value and offset losses in the future expected cash flows caused by the fall/rise in the currency exchange rate. This includes forward contracts, option contracts, and money market contracts (Eiteman, et al, 2012).
Foreign currency forward contracts are offered by market maker banks operated in the foreign exchange market to sell/buy foreign currency forward. For instance, an American MNE will receive/pay €100,000 in three months. The firm can go to a market maker bank and seek a three-month forward quote on the euro. The quote may be EUR/USD 1.1800/1.1900 as the bid/ask price of the current day, which means that the bank will buy euros in three months for $1.1800 and sell euros in three months for $1.1900. By selling/purchasing these forward contracts, the MNE can lock in the receivables/payables in the U.S. dollar after three months and offset any losses caused by changes in foreign currency exchange rates during the three-month period. In this case, after three months, the company will receive/pay €100,000 with the fixed EUR/USD 1.1800/1.1900 quote without losing/earning due to appreciation/depreciation of the U.S. dollar. Certainly, the company must hold a forward contract of €100,000 and pay for the service of the forward contract to ensure a satisfactory hedge. Here, the contract size could be a problem to MNEs. For instance, Apple did not keep the size of its hedge contracts close to its sales in the last half of 2014 and suffered from losses (Udland, 2015).
Foreign currency exchange option contracts offer MNEs the right, but not the obligation, to buy, which is a “call” option, or sell, which is a “put” option, a given quantity of foreign currency at a specified exchange rate at some date in the future. A put/call option is used to offset a company’s foreign currency long position and provides the firm with a lower limited price for the foreign currency that the company will receive/pay in the future. For instance, a U.S.-based MNE will receive/pay €100,000 in three months. The company can buy a put/call option of €100,000 at a fixed exchange rate (i.e. the exercise rate). After three months, if the spot exchange rate is higher/lower than the exercise rate, the company can allow the option to expire and receive/pay €100,000 with an exchange to/from the U.S. dollar based on the spot exchange rate. This is the upside condition with unlimited potential of gains. The company only pays the cost of options while it gains from the change of the exchange rate. However, if after three months the spot exchange rate is lower/higher than the exercise rate, the company will exercise the option and sell/buy €100,000 with the exercise rate. This is the downside condition with limited cost. In this case, besides paying for the premium of options, the company will not lose from the change of exchange rate.
Money market hedge contracts are similar to the forward hedge contract except that this is a loan agreement. An MNE will borrow the money in one currency, exchange it to another currency, and then use the future earned income to pay back the loan. For instance, an American MNE will receive €100,000 in three months. The company can borrow the money first and pay annual 10% interest, which is 2.5% per quarter. Therefore, the company ought to borrow €97,561 (= €100,000 / (1+2.5%)). Then, after three months when the company receives €100,000, it can directly pay back the loan. In the meantime, the company can exchange the borrowed €97,561 to the U.S. dollar and receive the money immediately without worrying about any exchange rate changes in the coming three months. In addition, the company can further deposit the money in the bank or purchase Treasury bills to earn extra interests during that three months. In the money market, highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and commercial paper can all be mixed with the money market hedge to generate the highest outcomes. In general, the advantages embedded in the money market hedge create a favorable condition for a retail investor or a small business that tends to deal with a small-scale foreign exchange currency, but the complexity of the operation indicates that it is not the most cost-effective or convenient approach for large corporations and institutions (Eiteman, et al, 2012).
Finally, currency hedge is not for profit earning but for reducing the variance of the future expected cash flows. In the process, an MNE needs to evaluate its risk tolerance before deciding its hedging strategy because there are costs in hedging that the MNE must bear (Wilkinson, 2013). For instance, a financial management department is needed to manage the complex hedge options of the accounts receivable and accounts payable in foreign currencies (Desai, 2008), while the size of the total hedging contracts will directly affect the effectiveness of hedging (Adinolfi, 2015).
3. Managing Translation Risk
Besides the transaction risk, an MNE is also exposed in the translation risk which is caused by consolidating financial information of overseas subsidiaries to the parent MNE’s financial statements in the parent MNE’s reporting currency (Eiteman, et al, 2012). In the process, increases or decreases in the parent MNE’s net income and net worth may occur so as to cause the MNE to gain or lose due to changes in the currency exchange rates between periods of reporting. The level of net exposed overseas assets will affect the level of gains or losses.
Information that must be translated from foreign subsidiaries to the parent MNE include subsidiaries’ assets and liabilities, income statement items, dividend distributions, and equity items (Eiteman, et al, 2012). There are a few different translation methods that can be applied to translate those selected items at a specific spot exchange rate. The most prevalent current rate method used in translation adopts the current spot rate, which is the rate of exchange in effect on the balance sheet date, to translate the assets and liabilities. As to the income statement items, they are translated at the actual rate of the exchange on the dates of incurrence or the weighted average exchange rate for a certain period. In the meantime, dividend distributions are translated at the exchange rate in effect on the date of payment while equity items including common stocks and paid-in capital accounts are translated at historical rates. Year-end retained earnings are estimated by adding gains or deducting losses from the year-beginning retained earnings with each item translated at the year-beginning or the year-end exchange rate. In the process of translation, gains or losses may occur due to translation adjustments and they are reported separately and accumulated in a separate equity reserve account on the consolidated balance sheet with a title of cumulative translation adjustment (CTA) (Eiteman, et al, 2012). In parallel to the current rate method, there are the temporal method, which uses exchange rates at the time of creation to translate specific assets and liabilities, and the monetary/non-monetary method, which applies current exchange rates to translate monetary assets and liabilities and adopts historical rates to translate non-monetary assets and liabilities. Gains or losses generated through these two methods are directly merged into the consolidated income statement instead of adding them into a separate equity reserve account.
The translation risk happens because the fluctuation of foreign currency exchange rates affects the translated values of financial items on the consolidated financial statements. For instance, an MNE has a net operating loss of $3,000 and it can be offset by a gain of $3,000 by one of its subsidiaries. However, on the date of consolidating financial statements, a change of exchange rate may reduce subsidiary’s gain of $3,000 to $1,500 which would result in a failure of the MNE’s original plan of offseting parent company’s loss by the subsidairy’s gain. The company now loses $1,500. Clearly, certain management technique is needed to minimize the impact of the translation exposure.
A balance sheet hedging technique has been widely applied to maintain an equal amount of the exposed assets and liabilities in the foreign currency of each subsidiary so as to keep a zero translation exposure (Eiteman, et al, 2012). The goal is to ensure that a decrease of the value of exposed assets caused by a change of exchange rate will be offset by an increase of the value of exposed liabilities. If an MNE applies the temporal method to translate assets and liabilities, a zero net exposed position could happen and it is called a monetary balance. However, when the current rate method is applied, a complete monetary balance will not be achieved because on the balance sheet the total assets must be balanced by the total equity and liability but the equity items are translated at the historical rates while the exposed assets and liabilities are translated at the current exchange rate. Most of all, adjusting liability is the major approach to balance the exposed assets which then links the borrowing costs to the cost of the balance sheet hedging approach. If the foreign currency borrowing cost is higher than the parent currency borrowing cost, the approach would be quite costly. Still, in comparison with an uncertain level of the exposed assets and liabilities due to the exposed translation risk, the cost of the balance sheet hedging may be negligible.
Additionally, the complexity of the task increases with the number of subsidiaries and the level of exposed amount. Still, translation exposure hedge is needed for maintaining a satisfactory credit rating and for meeting shareholders’ expectation (Wilkinson, 2013). Without such an effort, an MNE will not be able to stabilize its consolidated financial statements and offer attractive outcomes to its shareholders. Ignorance of the translation risk may also cost the company to get a downgraded credit rating due to unexpected changes in the exchange rates.
Finally, to a U.S.-based MNE, minimizing an MNE’s tax burden is also one of its many financial tasks because the U.S. corporate tax rate of 38.9% is the highest among OECD (Organization for Economic Cooperation and Development) countries (Kurtzleben, 2017). Therefore, many MNEs create tax-haven subsidiaries, also named International Offshore Financial Centers, in countries like Bermuda, the Cayman Islands, Panama, Luxembourg, and others, and keep their overseas profit away from the reach of the Internal Revenue Service (IRS). Furthermore, some American companies have moved their headquarters overseas to avoid direct taxation by the U.S. government (Wilber, 2016). In other words, keeping profits overseas has been another attractive alternative for an American MNE to deal with the translation risk because those overseas assets will not be translated back to the parent MNE’s currency and will not be included in MNE’s consolidated financial statements.
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