International BusinessForeign exchange risk

Professor: Marc Arza marc@futura.cat

1. Foreign exchange risk

Foreign exchange exposure is one of the most important risks of international business practice. Business operations in between two countries with a different currency will always represent a risk for one or both of the players as the operation will necessarily be in a different currency than the one they usually operate with. Any exchange rate fluctuation during their business operations will change the money/value relation and obviously impact results.

Sellers are favoured by a lower exchange rate as buyers will prefer a higher exchange rate. Financial operations, on the other hand, require lower interest rates, linked with a currency lower value (higher interest rates attract savings and investments and so will tend to increase a currency exchange rate).

2. Foreign exchange reference (strong) currencies

Most international business transactions are conducted in a limited set of reference currencies: dollars (USD - $), euros (EUR - €), brittish pounds (GBP - £) and japanese yens (JPY - ¥). These strong currencies are convertible into almost any other world currency and being used as a reference are reliable and more stable than other currencies.

After the gold standard was abandoned in the seventies the exchange rate of world currencies is fixed by the exchange market (supply/demand) and influenced by the following criteria:

- Supply & demand (Central bank's role)- Higher inflation = Lower value- Higher interest rate = Higher value- Economic performance

3. Foreign exchange restrictions

Although most global currencies are freely floating presently (subject to free market exchange rate setting) some countries still use restrictions to control the value of their exchange rate limitting the currency conversion. The reason for this may be to prevent capital flight or to keep an artifficial value because of political/economic interests.

Some of this weak currencies echange policies include:

- Exchange restrictions (forbidding exchange or limitting it to certain transactions)- Dual exchange rate (using different exchange rates depending on the final use)- Advanced import deposit (requiring a deposiit to exchange currency to control the use)

4. Foreign exchange exposure

Foreign exchange exposure is normally broken into: transaction exposure, translation exposure, and economic exposure.

Transaction exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.Translation exposure is the impact of currency exchange rate changes on the reported consolidated results and balance sheet of a company. Translation exposure is basically concerned with the present measurement of past events. (Example: A US firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar this would substantially reduce the dollar value of the Mexican subsidiary's equity. This would reduce the total dollar value of the firm's equity reported in its consolidated balance sheet raising the apparent leverage of the firm (its debt ratio), which could increase the firm's cost of borrowing).Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure.

5. Reducing foreign exchange exposure

Reducing Transaction and Translation Exposure: A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates.

Firms can minimize their foreign exchange exposure through leading and lagging payables and receivables--that is, collecting and paying early or late depending on expected exchange rate movements.

A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involves accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.

5. Reducing foreign exchange exposure

Several other tactics can reduce transaction and translation exposure:

. Financial solutions: forwards, options and SWAP's

� Local debt financing can provide a hedge against foreign exchange risk. As will any policy directed to link income and expenses currencies (being paid in the same

currency in which expenses are denominated).

� Transfer prices can be manipulated to move funds out of a country whose currency is expected to depreciate.

� It may make sense to accelerate dividend payments from subsidiaries based in countries with weak currencies.

5. Reducing exposure (financial tools)

Spot rate: The current exchange rate at the moment of a transaction.

Forward contract: A forward exchange contract is a non-standardized contract between two parties to buy or sell currency at a specified future time at a price agreed today. A tool to fix the value of a future exchange rate. The forward price of such a contract is commonly contrasted with the spot price. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Option contract: Is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

SWAP: Using a spot & a forward contract at the same time (or two forwards for different currencies) to cover against possible exchange rate variations.

5. Reducing foreign exchange exposure

Reducing Economic Exposure: Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm's productive assets to various locations so the firm's long-term financial well- being is not severely affected by adverse changes in exchange rates.

The post1985 trend by Japanese automakers to establish productive capacity in North America and Western Europe can partly be seen as a strategy for reducing economic exposure (it is also a strategy for reducing trade tensions). Before 1985, most Japanese automobile companies concentrated their productive assets in Japan. However, the rise in the value of the yen on the foreign exchange market has transformed Japan from a lowcost to a high-cost manufacturing location over the past 10 years. In response, Japanese auto firms have moved many of their productive assets overseas to ensure their car prices will not be unduly affected by further rises in the value of the yen. In general, reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce.

5. Reducign foreign exchange exposure

The firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure.

- Central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers to set guidelines for subsidiaries to follow. - Firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. - The need to forecast future exchange rate movements cannot be overstated, though. The best that can be said is that in the short run, forward exchange rates provide reasonable predictions of exchange rate movements, and in the long run, fundamental economic factors--particularly relative inflation rates--should be watched because they influence exchange rate movements. - Firms need to establish good reporting systems so the central finance function (or in- house foreign exchange center) can regularly monitor the firm's exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered.Tthe firm should produce monthly foreign exchange exposure reports.

6. FOREX case: The small Irish company Lily O'Briens

A wooden spoon and a saucepan were Mary Ann O'Brien's start-up tools 12 years agowhen, with a recipe for honeycomb crisp hearts, she launched a small venture makingIrish handcrafted chocolates for local shops. Today as managing director of Lily O'Briens -which is named after her daughter - she has a factory in Newbridge, Co Kildare, employs100 people and makes 500 tons of luxury chocolates a year.

The company is heavily reliant on Britain as an export market and British Airways is oneof her biggest customers. So Gordon Brown's decision to keep sterling out of theeurozone means the accountants at Lily O'Briens must remain busy watching exchangerate fluctuations with Ireland's nearest neighbour for some time to come."I'm a chocolatemanufacturer, not a currency trader," Mrs O'Brien says. "But I have to study the ratesevery day, and I have been preparing for the day when we have parity.

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FOREX case: The small Irish company Lily O'Briens

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The euro weakness against sterling has been great for our profits for the past few yearsbut the euro has strengthened so we have to factor that in now. And ultimately, for a smallor medium-sized company, exchange rate volatility could wipe you out."

Since Ireland abandoned the punt in 1999 with the launch of the euro, Mrs O'Brien hasensured the company sources all its ingredients, and its boxes, ribbons and packaging, inthe eurozone. "We have to try not to buy in sterling." Despite yesterday's decision, Britainwill remain a crucial export market for cultural and gastronomic reasons,although thecompany now exports to the United States, Australia and New Zealand. "The euro area isflooded with chocolate, and tastes are different. The British tend not to eat as much darkchocolate as the French, Belgians or Swiss."

Mrs O'Brien would rather concentrate on innovation by designing new centres and fillings so that she can compete with her Belgian rivals than check the foreign exchange rates. But the Chancellor's announcement came as little surprise. "The currency risk has been part of the business since we started. So we just manage it, and we're used to it."