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Foreign exchange exposure management: A portfolio approach
Book Reviews
not realize during their school years that they should really know something about what does happen in a real factory. There are ten chapters in total. The first two chapters deal with a description of the management control process, types of materials bought such as raw material to semi-finished to finished goods due to application of various make-or-buy decisions and the stages, such as stores, work in progress and finished goods, at which the material may be held in the factory at any specific time. Here and elsewhere in the book, there are no mathematical formulations or analysis. The reasons for classifying the material into categories and modifying them for proper control are given in Chapter 3. Chapter 4 details the material movement in the manufacturing and distribution processes with a good listing of all the storage. transportation costs and responsibilities of the personnel handling them. The discussion is continued in the next chapter to include functional groups and documentation to effect materials control. T h e author goes into accounting at this point from Chapters 6 to 10. Materials valuation approaches for inventory stock and cost of sales purposes, are brought out in Chapter 6. He makes a distinction between methods which focus on stock valuation, for example first-in-first-out, and methods that focus on product cost and profit, for example last-in-first-out. I, for one, do not understand. After all, product cost valuation for cost of sales implies stock valuation because of the inventory equation, beginning inventory + purchasesending inventory = cost of sales. However, the discussion is good and covers many more valuation principles, both useful and useless, in a practical sense. The chapter ends with accounting journal entries for spoilage and obsolescence with all the debits and credits. Please do not ask me why the author wanted to include them. The economic order quantity formula and its usefulness in a practical set-up is given in Chapter 7. It is nice to make the readers think about real problems due to rete,'ns to stores and returns to suppliers after delivery when they are set to feel comfortable about using EOQ levels. Chapter 8 is about standards and accounting variance, defined as the difference between the actual costs and the standard costs. The author states (p. 161), "A variance is said to be adverse or favorable according to its effects on the profits of
91
the business". Not true. Price and quantity variances may be favorable implying lesser than standard price paid for materials used and lesser than standard amount of materials used for the output. But this may result in lower overall quality with the resultant lower sales and decreased profit. In fact, positive value for actual minus standard should be defined as adverse and negative value favorable. The redeeming feature of this chapter is, however, the illustrations of various variance calculations. Chapter 9 deals with budgets and Chapter 10 with valuation of materials under inflation and their impact on profit. The book is definitely useful to undergraduate students as additional reading for courses on managerial accounting and operations management. The usefulness to managers is doubtful since the author's intention was not to bring out the theory. Kashi R. BA LA CHA NDR,4 N New York Univer'~itv New York, U.S.A.
Luc A. SOENEN
Foreign Exchange Exposure Management: A Portfolio Approach Sijthoff and Noordhoff, Alphen a/d Rijn. Netherlands and Rockville, U.S.A., 1979, x + 142 pages, Dfl.40.00 In the old days operations research concerned the optimization of physical activities only. Today the world has changed. One specific direction of development has been into the world of money management where capital is transferred and where the cost of it comes out as a deduction from the transfer itself. International cash management has a flavour of being exotic for management scientists. Not only it may concern subjects like eurodollars and japanese yens, it also has the reputation of being risky. Consequently this area might be a dream for the application of operations research. Soenen is one of the few who has taken up the challenge to discover the operations research of foreign exchange. He has tackled exchange risks
92
Rook R~vtews
for several multinational firms. He presents his experiences in this little book, which must be of interest to both those who are working on cash management models and those who have an interest in international financial management. Soenen's book concerns the optimal hedging of international capital transactions. This means to determine the optimal amount of future exchange contracts ('forward cover') that should be signed on a certain date in advance. He forms a portfolio model where the total variance of currency exposure can be minimized subject to a given level of the expected value of the currency transactions (Chapter II). With that as a reference point he analyses the problems of measuring exposure (Chapter III), of predicting exchange rates (Chapter IV) and of determining the costs of hedging (Chapter V) and the costs of taxation (Chapter VI). The final portfolio model (Chapter VII) is one of quadratic programming. One of the most interesting chapters concerns the potential application of the model seen in view of the current practice of exposure management (Chapters VIII and IX). Finally Soenen presents his conclusions (Chapter X). The classical approach to international cash management is to assume the use of two objectives - - o n e concerns maximizing the expected value of the outcome and the other the minimization of risk in terms of the variance. There has been a long line of reports about how to make the best trade-off between them. Soenen's model (pp. 58-67) allows for different alternative ways by iteratively minimizing the quadratic function of the variance subject to different levels of the expected value for the outcome. In addition to this he requires linear constraints on each hedging alternative as well as on the total amount of exposure that can be hedged. The model is applied to a U.S. multinational firm called the "Exa" Company. Over a quarter of a year as a single planning period capital will be exposed in sixteen currencies. This means a quadratic programming model with the size of fortyfive variables (exchanges between fifteen currencies and the U.S. dollar X three alternative methods of hedging) and sixty-one constraints. He solves this model by using an algorithm devised by Prof. J. Bishop of the Harvard Business School. Then he finds out that the variance of the company's foreign exchange portfolio can be substan-
tially reduced at a very low cost. This also means that hedging should be used much more extensively than now. I like this book. I have some critical comments on it but they are not too serious. For example, the model is limited to 'bilateral' transactions between foreign currencies and the 'home currency'. If multi-lateral hedging is introduced (i.e. from pounds to francs) the model will expand rapidly in size and the quadratic programming might become rather expensive. And there are reasons to believe that one must use such a currency-to-currency hedging, as in many countries currency exchanges are restricted to situations where there is a trade of commodities or services. Another critical comment is that very few companies will be able to estimate variances and covariances for future exchange rates even if they are as close as three months from now. In those cases the quadratic programming model will be of little help. I have not found any important printing errors in this book. However, I miss the use of brackets in some mathematical formulations (see pages 10 and 44). I also miss the definition of K (on page 67). This book presents the use of portfolio models on international financial transactions. Personally I like its financial sections more than those of mathematical modelling. I think that the field research on the current practice (Chapter VIII) as well as the practical implementation of the model (Chapter IX) are just excellent. I strongly recommend this book to management scientists working in firms which have international flow of capital.
Grran BERGENDAHL University of Gothenburg Gothenburg, Sweden Andrew C. HARVEY
The Econometric Analysis of Time Series Philip Allan, Oxford, 1981, xi + 384 pages, £17.50 The book gives a comprehensive introduction to econometric model building. It is intended for readers (students) who already are familiar with mathematical and statistical topics, such as matrix algebra, calculus and statistical inference. How-
not realize during their school years that they should really know something about what does happen in a real factory. There are ten chapters in total. The first two chapters deal with a description of the management control process, types of materials bought such as raw material to semi-finished to finished goods due to application of various make-or-buy decisions and the stages, such as stores, work in progress and finished goods, at which the material may be held in the factory at any specific time. Here and elsewhere in the book, there are no mathematical formulations or analysis. The reasons for classifying the material into categories and modifying them for proper control are given in Chapter 3. Chapter 4 details the material movement in the manufacturing and distribution processes with a good listing of all the storage. transportation costs and responsibilities of the personnel handling them. The discussion is continued in the next chapter to include functional groups and documentation to effect materials control. T h e author goes into accounting at this point from Chapters 6 to 10. Materials valuation approaches for inventory stock and cost of sales purposes, are brought out in Chapter 6. He makes a distinction between methods which focus on stock valuation, for example first-in-first-out, and methods that focus on product cost and profit, for example last-in-first-out. I, for one, do not understand. After all, product cost valuation for cost of sales implies stock valuation because of the inventory equation, beginning inventory + purchasesending inventory = cost of sales. However, the discussion is good and covers many more valuation principles, both useful and useless, in a practical sense. The chapter ends with accounting journal entries for spoilage and obsolescence with all the debits and credits. Please do not ask me why the author wanted to include them. The economic order quantity formula and its usefulness in a practical set-up is given in Chapter 7. It is nice to make the readers think about real problems due to rete,'ns to stores and returns to suppliers after delivery when they are set to feel comfortable about using EOQ levels. Chapter 8 is about standards and accounting variance, defined as the difference between the actual costs and the standard costs. The author states (p. 161), "A variance is said to be adverse or favorable according to its effects on the profits of
91
the business". Not true. Price and quantity variances may be favorable implying lesser than standard price paid for materials used and lesser than standard amount of materials used for the output. But this may result in lower overall quality with the resultant lower sales and decreased profit. In fact, positive value for actual minus standard should be defined as adverse and negative value favorable. The redeeming feature of this chapter is, however, the illustrations of various variance calculations. Chapter 9 deals with budgets and Chapter 10 with valuation of materials under inflation and their impact on profit. The book is definitely useful to undergraduate students as additional reading for courses on managerial accounting and operations management. The usefulness to managers is doubtful since the author's intention was not to bring out the theory. Kashi R. BA LA CHA NDR,4 N New York Univer'~itv New York, U.S.A.
Luc A. SOENEN
Foreign Exchange Exposure Management: A Portfolio Approach Sijthoff and Noordhoff, Alphen a/d Rijn. Netherlands and Rockville, U.S.A., 1979, x + 142 pages, Dfl.40.00 In the old days operations research concerned the optimization of physical activities only. Today the world has changed. One specific direction of development has been into the world of money management where capital is transferred and where the cost of it comes out as a deduction from the transfer itself. International cash management has a flavour of being exotic for management scientists. Not only it may concern subjects like eurodollars and japanese yens, it also has the reputation of being risky. Consequently this area might be a dream for the application of operations research. Soenen is one of the few who has taken up the challenge to discover the operations research of foreign exchange. He has tackled exchange risks
92
Rook R~vtews
for several multinational firms. He presents his experiences in this little book, which must be of interest to both those who are working on cash management models and those who have an interest in international financial management. Soenen's book concerns the optimal hedging of international capital transactions. This means to determine the optimal amount of future exchange contracts ('forward cover') that should be signed on a certain date in advance. He forms a portfolio model where the total variance of currency exposure can be minimized subject to a given level of the expected value of the currency transactions (Chapter II). With that as a reference point he analyses the problems of measuring exposure (Chapter III), of predicting exchange rates (Chapter IV) and of determining the costs of hedging (Chapter V) and the costs of taxation (Chapter VI). The final portfolio model (Chapter VII) is one of quadratic programming. One of the most interesting chapters concerns the potential application of the model seen in view of the current practice of exposure management (Chapters VIII and IX). Finally Soenen presents his conclusions (Chapter X). The classical approach to international cash management is to assume the use of two objectives - - o n e concerns maximizing the expected value of the outcome and the other the minimization of risk in terms of the variance. There has been a long line of reports about how to make the best trade-off between them. Soenen's model (pp. 58-67) allows for different alternative ways by iteratively minimizing the quadratic function of the variance subject to different levels of the expected value for the outcome. In addition to this he requires linear constraints on each hedging alternative as well as on the total amount of exposure that can be hedged. The model is applied to a U.S. multinational firm called the "Exa" Company. Over a quarter of a year as a single planning period capital will be exposed in sixteen currencies. This means a quadratic programming model with the size of fortyfive variables (exchanges between fifteen currencies and the U.S. dollar X three alternative methods of hedging) and sixty-one constraints. He solves this model by using an algorithm devised by Prof. J. Bishop of the Harvard Business School. Then he finds out that the variance of the company's foreign exchange portfolio can be substan-
tially reduced at a very low cost. This also means that hedging should be used much more extensively than now. I like this book. I have some critical comments on it but they are not too serious. For example, the model is limited to 'bilateral' transactions between foreign currencies and the 'home currency'. If multi-lateral hedging is introduced (i.e. from pounds to francs) the model will expand rapidly in size and the quadratic programming might become rather expensive. And there are reasons to believe that one must use such a currency-to-currency hedging, as in many countries currency exchanges are restricted to situations where there is a trade of commodities or services. Another critical comment is that very few companies will be able to estimate variances and covariances for future exchange rates even if they are as close as three months from now. In those cases the quadratic programming model will be of little help. I have not found any important printing errors in this book. However, I miss the use of brackets in some mathematical formulations (see pages 10 and 44). I also miss the definition of K (on page 67). This book presents the use of portfolio models on international financial transactions. Personally I like its financial sections more than those of mathematical modelling. I think that the field research on the current practice (Chapter VIII) as well as the practical implementation of the model (Chapter IX) are just excellent. I strongly recommend this book to management scientists working in firms which have international flow of capital.
Grran BERGENDAHL University of Gothenburg Gothenburg, Sweden Andrew C. HARVEY
The Econometric Analysis of Time Series Philip Allan, Oxford, 1981, xi + 384 pages, £17.50 The book gives a comprehensive introduction to econometric model building. It is intended for readers (students) who already are familiar with mathematical and statistical topics, such as matrix algebra, calculus and statistical inference. How-