FOREIGN EXCHANGE RISK MANAGEMENT

FOREX RISK MANAGEMENT

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Foreign Exchange Risk Management

• Exposure refers to the degree to which a company is affected by exchange rate changes.

• Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.

Forex Exposure

• Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates–These three components (profits, cash flow

and market value) are the key financial elements of how we view the relative success or failure of a firm

• Importance of Exchange Risk:1. Daily currency fluctuations2. Increasing integration of the world economy

• Foreign Exchange Risk Exposure:• This refers to the possibility that a firm will

gain or lose due to changes in the exchange rate. Every company faces exposure to foreign exchange risk as soon as it chooses to maintain physical presence in a foreign country.

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Types of Exposures

1. Translation Exposure

2. Transaction Exposure

3. Operating Exposure

4. Tax Exposure

Economic Exposure

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Translation exposure, also called Accounting Exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.

Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation.

The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.

Translation Exposure

• Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them.

• Every company having at least one subsidiary using a different functional currency bears translation risk.

• Assume the domestic division of a multinational company incurs a net operating loss of $3,000. But at the same time, a foreign subsidiary of the company made of profit of 3,000 units of foreign currency. At the time, the exchange rate between the dollar and the foreign currency is 1 to 1. So the foreign subsidiary’s profit exactly cancels out the domestic division’s loss.

Before the parent company consolidates its financial reports, the exchange rate between the dollar and the foreign currency changes. Now 1 unit of foreign currency is only worth $.50. Suddenly the profit of the foreign subsidiary is only worth $1,500 and it no longer cancels out the domestic division’s loss. Now the company as a whole must report a loss. This is a simplified example of translation exposure.

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Transaction Exposure Transaction exposure measures changes in the value

of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.

The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates.

Whoever makes a contract denominated in a foreign currency bears transaction risk.

Thus, this type of exposure deals with changes in present cash flows that result from existing contractual obligations.

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Sources of Transaction Exposure

Transaction exposure arises from: Purchasing or selling on credit goods or services

whose prices are stated in foreign currencies. Borrowing or lending funds when repayment is to

be made in a foreign currency. Being a party to an unperformed foreign exchange

forward contract. Otherwise acquiring assets or incurring liabilities

denominated in foreign currencies.

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Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

Operating Exposure

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Operating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure.

Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon.

Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production.

Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change

Operating Exposure

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Recognising Operating Exposure

Where is the company selling? [domestic v. foreign] Who are the key competitors? [domestic v. foreign] How sensitive is demand to price? Where is the company producing? [domestic v. foreign] Where are the company’s inputs coming from?

[domestic v. foreign]

Conceptual Comparison of Translation, Transaction and Operating Foreign Exchange Exposure

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Tax Exposure

• The tax consequence of foreign exposure varies by countries.

• As a general rule:– Only realized foreign exchange losses are tax

deductible.– Only realized foreign exchange gains create

taxable income

Types of Risk

1. Financial Risk2. Political Risk3. Country Risk

Economic Risk

• Economic Risk Refers more generally to unexpected events in a country’s financial, economic, or business life

• Examples of financial risks - currency risk, interest rate risk, Inflation risk, unexpected changes in the current account balance, unexpected changes in the balance of trade

Political Risk• The risk that a sovereign host government will

unexpectedly change the rules of the game under which businesses operate

• Examples of political risks - Expropriation risk, Disruptions in operations , Loss of intellectual property right.

• A function of: • The stability of the governments and its leadership• Attitudes of labor unions• The country’s ideological background• The country’s past history with foreign investors

Political Penetration

• Real (direct) investment is an investment over which the investor retains control– E.g., a plant in a foreign country

• Portfolio investment refers to foreign investment via the securities market– E.g., buying a number of shares of a foreign

company

• Extreme forms of country risk for portfolio investment:– Government takeover of a company– Political unrest leading to work stoppages– Physical damage to facilities– Forced renegotiation of contracts

• Modest forms of country risk for portfolio investment:– A requirement that a minimum percentage of

supervisory positions be held by locals– Changes in operating rules– Restrictions on repatriation of capital

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Macro Risk Versus Micro Risk• Macro risk refers to government actions that affect

all foreign firms in a particular industry

• Micro risk refers to politically motivated changes in the business environment directed to selected fields of business activity or to foreign enterprises with specific characteristics

Dealing With Political Risk• Seek a foreign investment guarantee from the

Overseas Private Investment Corporation– Provides coverage against:• Loss due to expropriation

• Nonconvertibility of profits

• War or civil disorder

Dealing With Political Risk

• Avoid engaging in behavior that stirs up trouble with the host people or government:– Constructing flamboyant office buildings

– Giving the impression of natural resource exploitation

Country Risk• Macro risks - affect all firms in a host country • Micro risks - specific to an industry, firm or project in a

country Whether a particular country risk is macro or micro affects the diversifiability of the risk

• Strategies for managing country risk: 1. Negotiate the environment with the host country prior to

investment 2. Structure foreign operations to minimize country risk while

maximizing return 3. Limiting the scope of technology transfer to foreign affiliates

to include only non-essential parts of the production process 4. Limiting dependence on any single partner

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Measuring Translation Exposure

• The difference between exposed assets and exposed liabilities.– Exposed assets and liabilities are translated at the

current exchange rate.– Non-exposed assets and liabilities are translated at

the historical exchange rate.

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Currency Translation• Translation methods differ by country along

two dimensions.• Subsidiary Characterization– Integrated foreign entity– Self-sustained entity

• Functional Currency– The currency of the primary economic

environment in which the subsidiary operates and in which it generates and expends cash.

Measurement of Translation Exposure• The parent company is normally interested in

maximizing its overall profitability and for this it consolidates the items of the financial statements of its subsidiaries, during this translation, we use he various methods of translating and represent the magnitude of translation exposure.

• Methods of Translation:1. Current rate method2. Current/Non-current Method3. Monetary/Non-monetary Method4. Temporal Method

Current Rate Method• Also known as the closing rate method.• In this method, all the items of the income statement

and the balance sheet are translated at current rate.• Preferred in case of those host countries where the

local currency accounts are periodically adjusted for inflation.

• Merit of this method, the relative proportion of individual balance sheet accounts remain the same and the process of translation does not distort the various balance sheet ratios.

• Demerit, if fixed assets are translated at current rate which is against accounting principles.

The Current/Noncurrent Method • Current assets and liabilities are translated at the

current exchange rate• Non-current assets and liabilities are translated at

historical exchange rates• Most income statement items are translated at the

average exchange rate over the reporting period• Depreciation is translated at historical exchange rates• The magnitude of exposure is measured by the

difference between CA and CL .• Critics, long-term debts exposure to current

exchange rate is ignored.

The Monetary / Non-monetary

• Monetary assets and liabilities, like items that represent a claim to receive or an obligation to pay, are translated at the current exchange rate

• All other assets and liabilities like fixed assets, long term investments, are translated at historical exchange rates.

• Most income statement items are translated at the average exchange rate over the reporting period

• Depreciation and COGS are translated at historical exchange rates

Temporal Method• Items stated at the historical cost like the fixed

assets, are translated at the historical cost.• Other items like replacement cost, realizable value

items, are translated at current rate.• Income statement items are translated at the

average exchange rate over the reporting period.• This method resembles the monetary/non-

monetary method but the only difference is– Under temporal method, stock is translated at

current rate if it is shown at market value– But under monetary/non-monetary method, it is

always translated at historical rate.

Managing Translation Exposure

• The main technique to minimize translation exposure is called a balance sheet hedge.

• It rest on the belief that strong currencies normally tend to appreciate against a weak currency that are prone to depreciation.

• So the exposure cane be hedged if strong currency assets substitute the weak currency assets and if strong currency liabilities are substituted by weak currency liabilities.

• For this purpose, the weak currency assets are converted into hard currency and vice-versa.

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Managing Translation Exposure

Assets Liabilities

Hard currencies

Soft currencies

Increase

______________________________________________

Decrease

Decrease

Increase______________________________________

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Balance Sheet Hedge• It requires an equal amount of exposed foreign

currency assets and liabilities on a firm’s consolidated balance sheet– A change in exchange rates will change the value

of exposed assets but offset that with an opposite change in liabilities.

– This is termed the monetary balance.– The cost of this method depends on relative

borrowing costs in the varying currencies.

Measuring Transaction Exposure

• Transaction exposure risk has two directional components– Downside exposure• Amount received (paid) in the future is less (more) than

the current projected amount– Upside exposure• Amount received (paid) in the future is more (less) than

the current projected amount

Measuring Transaction Exposure

• Transaction exposure has two elements– Net cash flows• Collate all receivables and payables in each currency to

determine net exposure– Risk associated with transaction exposure• Currency variability• Currency correlations

Measurement of Transaction Exposure1. Export and Import on Open Account:• Under this type, changes in the cash flow is

measured as “rupee worth of accounts receivable (payable) when actual settlement is made minus rupee worth of accounts receivable (payable) when the trade transaction was initiated”.

• On account of trade, this exposure is divided into 3 parts:– Quotation exposure: created when the exporter

quotes a price in foreign currency and exist till the importer places an order at that prices.

– Backlog exposure: placement by importer and shipping by seller

– Billing exposure: billing of shipment to final settlement

2. Borrowing and lending in a Foreign currency:

• For borrowing - if the foreign currency appreciates, borrowing will be greater in terms of domestic currency and if foreign currency depreciates, the burden will be lower.

• For lending – the receipts of lender will be larger if foreign currency appreciates and lower if foreign currency depreciates.

• Not only principal but also the interest earnings changes due to changes in the exchange rate.

3. Intra-firm Flow in an International Company:• In case of international companies, when funds

flow among the different units that are located in different countries, any change in the exchange rate alters the value of cash flow.

Measuring Real Operating Exposure

• “Real” denotes the concept of real exchange rate which means nominal exchange rate adjusted for inflation.

• The word “operating” is used because we are concerned with the operating cash flow, a change in which cause change in the value of firm.

• Changes in the future value are mainly due to variations in cost and revenue.

• Impact on revenue vary if the firm produces:– For the export market– For the domestic market but competition from

import is present

• Impact on cost:– Import inputs– Procure inputs from domestic sources but

competition from supplier is present

• Impact of Inflation on Revenue:• When the firms produces only for export, it can

pass on the impact of inflation to the customers if the demand is price elastic, product is highly differentiated or the exporter has monopoly.

• If the impact can be passed on to the customers abroad, even then the revenue will increase.

But if such conditions does not exist, inflation impact cant be passed and the revenue will diminish.

• Impact of Inflation on Cost:• When a firm imports inputs, the foreign

supplier, if he has monopoly, he can charge high but if not operating at full capacity, he will not be able to raise the price.

• Locally available inputs can increase the price only if no foreign supplier is present.

• Currency Depreciation and the Cost:• Currency depreciation will make the exports cheap

for the foreigners and reduce the domestic currency earnings.

• While depreciation of currency makes imports expensive, as more of domestic currency is needed to trade for same amount of goods.

• The impact can be avoided only if the prices of the products under import and export are prices-elastic or enjoy monopoly.

• Measuring the Impact on Cash Flow:• When cash flow of different combinations

over the years is estimated, it is converted to present value and this compared with the present value of the cash flow that is expected to occur in the case of a stable real exchange rate. The difference between the two is real operating exposure

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Managing Operating Exposure

Use of Marketing Strategies Market Selection Pricing Strategy/Product Strategy Promotional Strategy

Use of Production Management Input mix Plant Location & Shifting production among plants Raising Productivity (i.e. lowering costs)

Financial Hedging techniques may also be used

Need to HEDGE

• Insuring against transaction risk to reduce or eliminate the effects of unexpected changes in exchange rates.

• You can hedge only at market rates. The effects of expected changes in exchange rates are incorporated in these market rates.

• Hedging is insurance. The purpose of hedging is to reduce or eliminate risks, not to make profits.

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To Hedge or not?

Hedging is the taking of a position, either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (fall) in value to offset a fall (rise) in value of an existing position.

Hedging, therefore, protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure).

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To Hedge or not?

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Opponents of Hedging Opponents of currency hedging commonly

make the following arguments: Stockholders are much more capable of

diversifying currency risk than the management of the firm.

Currency risk management does not add value to the firm and it incurs costs.

Hedging might benefit corporate management more than shareholders.

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Proponents of Hedging Proponents of hedging cite:

Reduction in risk in future cash flows improves the planning capability of the firm.

Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress).

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm.

Individuals and corporations do not have same access to hedging instruments or same cost.

HEDGING TECHNIQUES

• External Techniques - also known as commercial or contractual techniques.

• Internal Techniques - these are within the internal management control.

Hedging Transaction Exposure• External/Contractual techniques of hedging:1. Forward contracts2. Future contracts3. Option contracts4. FRA5. Caps6. Collars7. Floors

• Internal/Natural techniques of hedging: It is applied when the contractual or external hedge fails to give good results

1. Netting2. Leading and lagging3. Currency diversification4. Risk-sharing5. Pricing - Currency Invoicing 6. Parallel loans7. Matching and Mark ups

Netting

• Netting:• This involves associated companies which trade with

each other setting off inter-company debts• The mechanics of netting involves each subsidiary

informing of company debts in each currency to the head office at the end of each period. Head office decides on the best netting arrangement and instructs the subsidiary accordingly

• Netting is, in fact, the elimination of counter payments and finally only the net amount is paid.

Leads and Lags• Leading and lagging adjusts the timing of payments

or receipts to alter the future exposure position of a company in a particular currency.

• Lead means accelerating or advancing the time of receipt or of payment of foreign currency.

• Eg: Suppose a firm is located in a country with weak currency. There is every possibility that the hard currency appreciates against the weak currency. In such a situation, the debtor firm would like to lead the payments.

• Lag means decelerating or postponing the timing of receipt or payment of foreign currency.

• Eg - if a firm located in a hard currency country has to pay debts in weak currency, it would lag the payments.

• It can be effectively used by intra-firm settlements and even governments has regulated this technique to keep a check on the inflow and outflow of funds.

• Currency Diversification:– Limit impact of adverse exchange rate

movements by spreading transactions over a large number of currencies

– Chance of adverse movements in a large number of currencies is very small

– Greatest diversification achieved where currencies are perfectly negatively correlated

• Risk-sharing:• It is a contractual arrangement through which the

buyer and the seller agree to share the exposure.• Under this arrangement, a base rate is fixed with

mutual consent that is generally the current spot rate.

• A neutral zone is agreed upon which is few points minus and plus the base rate.\

• When the exchange rate changes within the neutral zone, the transaction takes place but if the exchange rate crosses the neutral zone, the risk is shared equally.

• Pricing – Currency Invoicing :• In the currency in which the majority of the costs

are incurred.• In the domestic currency of the main competitors,

so that comparative prices are less affected by exchange rate variations.

• Here the exporter shows the will of invoicing the bill in its own currency or in the currency in which it incurs cost.

• Inserting an exchange rate variation clause (always difficult commercially) to protect margins.

• Cases where the forward market is limited or exchange controls are strict, the exports and imports are invoiced in home currency

• Parallel loans:• It is often known as a back-to-back loan or a credit swap

loan.• It is a loan actually moving within the country but serving

the purpose of a cross-border loan.• Suppose a US parent company has a subsidiary in India.

Similarly, an Indian parent company has a subsidiary at US. Suppose both the respective subsidiaries need US$1000 at the same time for a same period. Transacting this money will hve to face the exposure. To avoid this exposure, the Indian parent company will lend the amount converted into rupees at the spot rate to US subsidiary and vice-versa. At the expiry of the specified period, the two loans will be paid to the respective lenders.

• Under such case, finding a matching and reliable counter party is difficult task.

• Matching:• Equating assets and liabilities denominated

in each currency.• In order to mitigate translation risk, a

company acquiring a foreign asset should borrow funds dominated in the currency of the country in which it is purchasing the asset.

• Pros - Avoids unnecessary hedging costs.• Cons - Appropriate matches may not be

available.

• Asset/liability management - The process whereby equal and opposite deposits or borrowings are created in a particular currency to match payments or receipts, or liabilities and assets or, alternatively, where foreign and domestic banks accounts are denominated in appropriate currencies through which settlements can be effected. This technique may be used in the Euro currency markets or in the local market where the exposure exists. An appraisal of the exchange rates and interest rates of both countries is necessary. 

• Matching/Mark-ups• To mitigate transaction risk, a company selling its

goods in the US with prices denominated in dollars could import raw materials through a supplier that invoices in dollars.

• Increasing prices on exports or imports to cover worst-case scenario changes in an exchange rate

• e.g. exporter marks-up export price of goods sold• e.g. importer marks-up the domestic price of

imported goods• Competition is a constraint to this strategy

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