Foreign exchange exposure & risk mannagement1

Foreign exchange exposure and risk

managementUniversity Business school

COUNTRY RISK

Transfer Risk

Sovereign Risk

Contagion Risk

Currency Risk

Indirect Country Risk

Macro- economic Risk

Country Risk

COUNTRY RISK

Transfer Risk

Sovereign Risk

Contagion Risk

Currency Risk

Indirect Country Risk

Macro- economic Risk

Technical forecasting Fundamental forecasting Market based forecasting Mixed forecasting

Forecasting techniues

It involves the use of historical exchange rate data to predict future values.

Technical forecasting

It is based on fundamental relationship between economic variables and exchange rates.◦ e= f[ INF, INT, GC, EXT]◦ e=% change in the spot rate◦ INF= change in the differential between U.S.

inflation & the foreign country’s inflation◦ INT= change in the differential between U.S.

interest rate & the foreign country’s interest rates◦ INC= change in the differential between U.S.

income level & the foreign country’s income level◦ GC= change in government controls◦ EXT= change in expectations of future exchange

rates.

Fundamental forecasting

Spot rate Forward rate

◦ F= s(1+p)

Market Based forecasting

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.

Translation exposure= (exposed assets-exposed liabilities) ( change in exchange rate)

Transaction exposure This exposure refers to the extent to

which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations.

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.

Economic exposure Changes in competitive position as a

result of permanent changes in exchange rates.

Every company buying or selling abroad or even just competing with foreign companies has economic risk.

Translation Exposure

Translation methods

Single rate method

Current rate method

Multiple rate method

Current/non-current method

Monetary/non-monetary method

Temporal method

Balance sheet: All current assets and current liabilities are translated into the home currency at the current exchange rate.

Income statement/P&L a/c: translated at average exchange rate for the period cover.

AER = Total ER/Number of years Revenue and expenses related to non-

current assets and long term borrowings at the historical cost.

Current /non current method

Liabilities / Sources

Assets/ Applications

Share Capital Fixed Assets

Reserve surplus Investment

Secured Loan Current Assets

Unsecured Loan Loan & Advances

Current Liabilities & Provision

Miscellaneous Expenditure

Profit/Loss A/c

t

t

t= current rateRest of the balances are on historical cost

Net current assets= current asset- current liabilities+ve NCA: CA>CL-ve NCA: CA<CL

Monetary items: are those that represent a claim to receive or an obligation to pay a fixe amount of foreign currency unit, e.g. cash, accounts receivables, current liabilities, account payable and long term debt.

Non-monetary items: inventory, fixed assets, long term investment.

Monetary items: current rates Non-monetary items: historical rates P/L= AER except COGS, depreciation or

those related to non-monetary item.

Monetary/Non monetary method

Modified version of monetary/non monetary method.

Inventory translated at current rate if shown in the balance sheet at market value.

Temporal method

All balance sheet and income statement items are translated at current rate except equity.

Equity = historical rate. COGS and Depreciation = Actual exchange

rate/weighted average exchange rate. Dividend paid = exchange rate on payment

date. Gains/loss reported separately in

cumulative translation adjustments.

Current rate method

Accounts Functional currency

Current/non current

Monetary/non monetary

Temporal Current rate

Cash 100

Accounts receivables

150

Inventory 200

Fixed assets

250

Total 700

Current liablities

100

Long-term debt

300

Gains/loss

Accounts Functional currency

Current/non current

Monetary/non monetary

Temporal Current rate

Cash 100 100 100 100 100

Accounts receivables

150 150 150 150 150

Inventory 200 200 400 200 200

Fixed assets

250 500 500 500 250

Total 700 950 1150 950 700

Current liablities

100 100 100 100 100

Long-term debt

300 600 300 300 300

Gains/loss -350 150 -50 300

Net exposure in currency (i)- Net exposure in currency (i) New spot Rate (i/r) old spot Rate (i/r)r= reporting currency (U.S)i= Euro New spot rate = 1.1786/$1.0 Old spot rate = 1.1000/$1.0

300 - 3001.1786/1.00 1.1000/1.00 -$18.2

Balance sheet hedge: it is never entity specific. It basically arises on account mismatch of assets and liabilities denominated in same currency.

A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.

These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.

Example: Assets 7645Liabilities 5819

◦ 1826 (difference)

Managing Translation Exposure

Derivative Hedge: how much forward we need to hedge exposure of -$18.2. for this they are making forward sell.

Forward contract position in functional currency= Potential translation loss

f (r/i)-expected spot (r/i)r= reporting currency U.Si= Euro 18.2 = $1401/1.393-1/1.1786So we need to forward sell $140 to hedge

Managing Translation Exposure

Inaccurate earning forecasts Inadequate forward contracts for some

currencies Accounting distortions Increased transaction exposure

Limitations of hedging translation exposure

Reporting currency: it is currency which enterprise use to present financial statements.

Foreign currency: currency other than reporting currency.

Foreign operation: any subsidiary associate of a reporting enterprise.

India is adopting at temporal rate.

Which method is India adopting?

Transaction Risk

This exposure refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations.

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.

Determine the projected net amount of currency inflows or outflows in each foreign currency

Determine the overall exposure to those currencies.

Meaning

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

Source of transactions exposure

Suppose a U.S. firm, IBM, sells merchandise on account to a Belgian buyer for: €2,00,000 payment to be made in 60 days.

S0 = $0.9000/€

The U.S. seller expects to exchange the €2,000,000 for €1,800,000 when payment is received.

Example

Transaction exposure arises because of the risk that the U.S. seller will receive something other than $1,800,000. If the euro weakens to $0.8500/€, then

Trident will receive $1,700,000 If the euro strengthens to $0.9600/€,

then Trident will receive $1,920,000

Thus, exposure is the chance of either a loss or a gain.

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).

Hedge

Future Hedge Forward Hedge Money market hedge Currency option hedgeHedging Long-term

transaction exposure Long-term forward

contracts Currency swap Parallel loan

Techniques to eliminate transaction exposure

Alternative Hedging TechniquesLeading and laggingCross-hedgingCurrency diversification

Purchasing Currency Futures: A firm that buys a currency futures contract is entitled to receive a specified amount in a specified currency for a stated price on a specified date. E.g. for future payables.

Selling currency futures: A firm that sells a currency futures contract is entitled to Sell a specified amount in a specified currency for a stated price on a specified date. E.g. for future receivables.

Future hedge

A forward contract hedge is very similar to a future contract hedge, except that forwards contracts are commonly used for large transactions, whereas future contract tend to be used for smaller amounts.

Forward

It involves taking a money market position to cover a future payables or receivables position. ()

Money market hedge on payables Money market hedge on receivables.

Money Market Hedge

Hedging payables with currency call options- A currency call option provides the right to buy a specified amount of a particular currency at a specified price within a given period of time.

Hedging receivables with currency put options.

Currency option Hedge

Hedging techniques Hedging of

Receivables

Sell futures or forward

Money market hedge borrow foreign

currency to be received

convert to domestic currency

invest for future use Buy Put Option

Hedging of Payables

Buy futures or forward

Money market hedge borrow home

currency convert to foreign

currency invest for future

use

Buy Call Option

Long-term forward contract Currency swap () Parallel loan/back-to-back loan Alternative hedging techniques Leading& lagging() Cross- hedging Currency diversification

Hedging long-term transaction exposure

Limitations of hedging an uncertain amount Limitations of repeated short-term hedging.

Limitations of Hedging tecniques

It can be defined as the extent to which the value of the firm would be affected by unanticipated change in exchange rates.

Change in expected cash flow arising because of an unexpected change in exchange rates.

Changes in competitive position as a result of permanent changes in exchange rates.

Economic Exposure

Transaction exposure Economic exposure

Contact specific General relates to the entire investment

Cash flow losses due to an exchange rate change are easy to compute. Simple financial accounting techniques can be used to compute losses due to transaction exposure

Opportunity losses caused by an exchange rate change are difficult to compute. A good variance accounting is needed to isolate the effect of exchange rate change on sales volume, costs & profit margin

Firms generally have some policies to cope with transaction exposure

Firms generally do not have policies to cope with transaction exposure

Avoidance sometimes requires third-party cooperation

Avoidance require good strategic planning

The duration of exposure is the same as the time period of contract

The duration of exposure is the time required for the restructuring of operations through such means as changing product, markets, sources & technology

Relates to nominal contracts whose value is fixed in foreign currency terms

Relates to cash flow effects through changes in cost, price and volume relationships.

Transaction exposure: is an uncertain domestic currency value of a cash flow which is known and fixed in foreign currency terms.

Economic exposure: is an uncertain domestic currency value of a cash flow whose value is uncertain even in foreign currency terms. E.g. cash flow from a foreign subsidiary.

Exposure to currency risk can be properly measure by the Sensitivities of

1. The future home currency values of the firm’s assets/liabilities

2. The firm’s operating cash flow to random changes in exchange rates.

P= a+b*S+eA= constantE= random errorP= local currency price of assetB= sensitivity of the dollar value of asset (p)

to exchange rate. Cov( p,s)/ Var (s)

Calculation of economic exposure

Marketing initiatives◦ Market selection◦ Product strategy◦ Pricing strategy◦ Promotional strategy

Production initiatives◦ Product sourcing◦ Input mix◦ Plant location◦ Raising productivity

Managing economic exposre

Market selection: market to sell, market segmentation.

Pricing strategy: std economic proposition of setting the price that max dollar profits

Promotional strategy Product strategy: product line decisions,

product innovations.

Marketing initiatives

Input mix: outsourcing Shifting production among plants Plant location Raising productivity

Production initiatives

Fluctuations in interest rate affect a firm’s cash flow by affecting interest income on financial assets and interest expenses on liabilities. To put it another way, the market values of a firm’s portfolio of financial assets and liabilities fluctuates with interest rates.

Interest Rate Exposure

1. Net interest income: interest income on assets minus interest exposure on liabilities. Monitoring of this account will reveal the sensitivity of firm’s profitability to changes in interest rates.

2. Net equity exposure: sensitivity of the firm’ s net worth to interest rates.

Objectives

Forward rate agreements Interest rate options Interest rate caps, floors and collars Options on interest rate futures.

Management techniquies