PPP is the low of one price, which means that in theory all commodities and goods should have the same price in all markets, as people otherwise could gain from arbitrage which means that the purchase of goods on one market for immediate resale on another country in order to profit from a price discrepancy. The problem with PPP is that there are time lags between the changes of price levels and the changes in exchange rates which could leave importing companies exposed in the short term. An exporter will remain exposed even if exchange rates more in line with general inflation, if the price of this expecting product does not increase by as much as inflation.
In a neoclassical, Modigliani-Miller type of world, management could not increase firm value by engaging into risk management activities. In such a perfect world without any information asymetrics, transaction costs or taxes, all hedging activities by the firm could be done or undone in the same way by investors. The reason for this is that the firm does not have any. On the other hand, having looked at the more theoritical arguments mainly taking the view that hedging at the best doesn’t influence company value at the worst reduces shareholder value, we will now look at the pros on why a company should involve itself in hedging activities and the benefits for shareholders. The primary purpose of foriegn exchange hedging is to reduce the cashflow volatility caused by precisely these kinds of foreign exchange movements.
In turn according to Thomas Copeland & Yash Joshi, the reduction in foreign exchange induced volatility is expected to dampen the volatility of a company’s total cashflow and can increase maximise market value of the firm: By reducing the probability of business disruption costs. Large swings in cashflows can lead to liquidity crises when cashflows turn negative unexpectedly. The cost of doing business will the rise because because suppliers are slow to deliver when dealing with a customer in distress, customers shy away from its products need servicing, and workers depart as demand extra pay from an employer that may be gone tommorrow.
By creating new business opportunities. Firms with smoother cashflows can gain competitive advantage over other companies in their industry and could increase Research and Development in order to keep up the supply of new products. By reducing taxes. Since tax rates are progressive, that is, a higher income attracts a higher percentage tax. Smoothing cashflows across tax years reduces the tax percentage and thus the tax liability. By increasing debt capacity. Lenders are more willing to deal with companies that have stable cashflows. If a company reduces the probability of a cash crunch it improves its ability to borrow
Academic theory suggests that some companies facing large exposures to interest rates, exchange rates, interest rates or commodity prices can use derivatives in order to reduce the variability of cash flows and in so doing reduces various costs associated with financial distress if total risk matters. For instance the cost of purchasing, as suppliers should be willing to give better credit terms due to the better past performance of the company and the knowledge of the company hedging its exposures.
Mangement will also be more efficient, as they will not have to spend a lot of time concentrating on short term survival strategies but can concentrate on improving the long term competitiveness of the firm. An increase in cash flow stability should also give the company a better credit rating from financial agencies S&P Moodys which will reduce its cost of debt and thus the discount rate by which cashflows are discounted increase the value of the firm. (Derivatives & corporate risk management, 1995).
However, even a diversified investor, does not gain from a company getting engaged in hedging activities, in practice especially for small investors who are not well diversified due to the fact that they have a minimum stock broking commissions, which probably only make diversification efficient for a big portfolio as the big institutions have better to hedge it. After reviewed all the general issues when deciding whether or not to hedge, shell should take action to reduce the potential impact of exchange volatility on future cashflows. Reduction of such volatility removes an important element of uncertainity confronting the strategic management of the company consequently, a hedging programme will be useful if it allows the company to maximise its own value by having the ability to monetize investment and growth oppurtunities.
2. Specify the particular exposures your firm has and suggest an appropriate method to hedge that exposure. Exchange rate exposure is usually divided (e.g. Shapiro (1996)) into three different types: transaction, translation and operating exposure. The combined effect of transaction exposure and operating exposure is usually referred to as economic exposure (Sercu and Uppal, 1995). Transaction exposure arises from the possibility that future incomes (or costs) from a contract denominated in foreign currency change between the date when a firm commits to a transaction and the actual transaction date. It is clear that many companies see transaction exposure as a problem (e.g see the survey by Bodnar and Marston (1996)). However since this kind of exposure usually is well defined and short term, it can be (if the firm so desires) hedged quite easily using derivatives.
Translation exposure is the difference between assets and liabilities that are exposed to currency fluctuations. Consider an U.S. multinational firm that operates in several different countries and has subsidiaries operating in local currency. Even if the subsidiary faces no exchange rate risk at all in local currency the shareholders of the multinational firm might be interested in U.S. dollars. Therefore the remittance from the foreign unit of the firm are exposed to exchange rate fluctuations when it is translated back to U.S. dollars.
A more complex and more interesting measure of exchange rate exposure is economic exposure. If we define the value of a firm as the present value of expected future cash flows, economic exposure measures the degree to which movements in exchange rates affect the firm’s value. This could be through existing contracts (transaction exposure) or by changing the value of future revenues and costs, so called operating exposure.
Hence economic exposure depends on the operations of the firm (locations of factories, competitive structure etc.) and is in theory the type of currency exposure companies want to deal with, but in practice very complicated to identify and hedge. Using economic exposure as the measure it is quite clear that few firms stay unaffected by currency fluctuations. It is also obvious that currency exposure will vary substantially across firms. Rolls Royce a uk based manufacturer of aero engine producer, has just concluded negotiations for the sale of its engine with American airline for the sum of $1,000,000.