Foreign exchange exposure & risk mannagement1
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Foreign exchange exposure and risk
managementUniversity Business school
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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
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Technical forecasting Fundamental forecasting Market based forecasting Mixed forecasting
Forecasting techniues
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It involves the use of historical exchange rate data to predict future values.
Technical forecasting
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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
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Spot rate Forward rate
◦ F= s(1+p)
Market Based forecasting
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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)
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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.
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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.
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Translation Exposure
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Translation methods
Single rate method
Current rate method
Multiple rate method
Current/non-current method
Monetary/non-monetary method
Temporal method
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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
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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
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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
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Modified version of monetary/non monetary method.
Inventory translated at current rate if shown in the balance sheet at market value.
Temporal method
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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
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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
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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
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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
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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
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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
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Inaccurate earning forecasts Inadequate forward contracts for some
currencies Accounting distortions Increased transaction exposure
Limitations of hedging translation exposure
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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?
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Transaction Risk
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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
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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Limitations of hedging an uncertain amount Limitations of repeated short-term hedging.
Limitations of Hedging tecniques
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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
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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.
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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.
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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
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Marketing initiatives◦ Market selection◦ Product strategy◦ Pricing strategy◦ Promotional strategy
Production initiatives◦ Product sourcing◦ Input mix◦ Plant location◦ Raising productivity
Managing economic exposre
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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
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Input mix: outsourcing Shifting production among plants Plant location Raising productivity
Production initiatives
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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
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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
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Forward rate agreements Interest rate options Interest rate caps, floors and collars Options on interest rate futures.
Management techniquies