FOREIGN EXCHANGE RISK MANAGEMENT

FOREX RISK MANAGEMENT

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 firms value due to uncertain changes in the rate of exchange.

Forex Exposure
Foreign exchange exposure is a measure of the potential for a firms 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 fluctuations 2. 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.

Types of Exposures
1. Translation Exposure 2. Transaction Exposure 3. Operating Exposure 4. Tax Exposure

Economic Exposure

Translation Exposure
Translation exposure, also called Accounting Exposure, arises because financial statements of foreign subsidiaries which are stated in foreign currency must be restated in the parents reporting currency for the firm to prepare consolidated financial statements. Translation exposure is the potential for an increase or decrease in the parents 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 6 statements.

 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 subsidiarys profit exactly cancels out the domestic divisions 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 divisions loss. Now the company as a whole must report a loss. This is a simplified example of translation exposure.

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 9 contractual obligations.

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
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 firms future individual transaction exposures together with the future exposures of all the firms competitors and potential competitors worldwide.
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Operating Exposure
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
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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 companys inputs coming from? [domestic v. foreign]

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Conceptual Comparison of Translation, Transaction and Operating Foreign Exchange Exposure

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

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Types of Risk
1. Financial Risk 2. Political Risk 3. Country Risk

Economic Risk
Economic Risk Refers more generally to unexpected events in a countrys 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 countrys ideological background The countrys 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

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

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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

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.
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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: Current rate method Current/Non-current Method Monetary/Non-monetary Method Temporal Method

1. 2. 3. 4.

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/nonmonetary 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.

Managing Translation Exposure

Liabilities Assets ______________________________________________
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 firms 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.

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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 Exposure

1. 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 competition from supplier is present

but

 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

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

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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.

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 firms 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.
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HEDGING TECHNIQUES
External Techniques - also known as commercial or contractual techniques. Internal Techniques - these are within the internal management control.

Hedging Transaction Exposure

1. 2. 3. 4. 5. 6. 7. External/Contractual techniques of hedging: Forward contracts Future contracts Option contracts FRA Caps Collars Floors

1. 2. 3. 4. 5. 6. 7.

Internal/Natural techniques of hedging: It is applied when the contractual or external hedge fails to give good results Netting Leading and lagging Currency diversification Risk-sharing Pricing - Currency Invoicing Parallel loans 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 worstcase 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

Thank You!!