MF0015-SLM-Unit-09

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Unit 9 Management of Foreign

Exchange Exposure

Structure

9.1 Caselet

9.2 Introduction

Objectives

9.3 Tools of Foreign Exchange Risk Management

9.4 Distinguishing between Functional and Reporting Currency

9.5 Currency Volatility Over Time9.6 Risk Management Products

9.7 Techniques of Exposure Management

9.8 Case Study

9.9 Summary

9.10 Glossary

9.11 Terminal Questions

9.12 Answers

References/e-References

9.1 Caselet

A pr imer on corporate hedging

In the recent past, many instances relating to capital losses have surfaced

due to wrong decisions taken by companies in regard to the market

movements and erroneous hedging. Without hedging, a company is open

to the elements of the markets on which they have no control and in adverse

times the companies post losses due to poor market condition.

A case in point is with Hexaware Systems. The company booked a loss of

Rs 10.3 crore ($2.6 million). This was mainly because of dealing in foreignexchange options contracts. Another example is that of Larsen and Tuobro.

It had booked a `200-crore ($51 million) loss on commodity futures on the

London Metals Exchange. Many IT companies were also mercilessly hit by

the sharp depreciation in the dollar in 2007. The reason attributed was

inadequate hedging. These instances bring out the need and importance

of having a clear-cut and guiding policy frame-work for hedging by corporate.

However, one must not confuse these situations from losses that banks

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International Financial Management Unit 9

Sikkim Manipal University Page No. 176

(such as ICICI Bank) have incurred due to taking speculative positions in

financial markets. The basic rule behind the policy of hedging is that it is a

preventive measure taken to reduce losses in a possible adverse market

situation. The etymology of the word probably comes from the fact that

hedges protect gardens from destructive visitors like stray dogs. It is a

myth that all hedging is financial; for example, constituting a ‘bench strength’

in an IT company to ensure availability of talent when required; diversification

to reduce reliance on one market or one client and decentralization and

creation of back-ups to reduce reliance on a few key employees are all

examples of non-financial or strategic hedging. Typically, the level of financial

hedging is more in companies whose main activity is trading (such asinvestment banks and hedge funds) vis-a-vis ‘brick-and-mortar’ companies

that produce something.

Source: Adapted from http://www.thehindubusinessline.com/todays-paper/

article1620827.ece?ref=archive

Accessed on 8 October 2012

9.2 Introduction

In the previous unit, you learnt about the concept of foreign exchange exposure.

The different types of exposure had also been discussed. You also studied howto measure economic exposure and the various translation methods.

In this unit, we will take the concept forward and understand how foreign

exchange exposure is managed. You will learn about the various tools and

techniques of foreign risk management and the risk management products.

You will understand the differences between the functional and the reporting

currency and various techniques used for exposure management.

Objectives

After studying this unit, you should be able to:

• discuss the tools and techniques of foreign exchange risk management

• define the differences between functional and reporting currency

• assess risk management products and currency volatility

• discuss the techniques of exposure management

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9.3 Tools of Foreign Exchange Risk Management

Various financial instruments are used by companies in India and abroad in

order to hedge the exchange risk. Such kinds of instruments are available to

the company at varying costs. The various tools that hedge the different kinds

of risks are given below:

• Forward contracts: A forward contract is a non-standardized contract

that takes place between two parties for the purpose of selling or buying

an asset at a specified future time at a price that has already been agreed.

The party who buys the underlying position assumes a long position andthe party who sells the asset assumes a short position. Delivery price is

the price that has been agreed upon. It is one of the most common means

of hedging transactions in foreign currencies. It offers the ability to the

users to lock in a sale price or a purchase without the involvement of any

direct cost. It is also used by speculators who use forward contracts so as

to place bets on the price movements of the underlying asset. Banks and

many multinational corporations also use it to hedge the price risk by the

elimination of uncertainty about prices.

• Futures contracts: It is a standardized contract that takes place between

two parties for buying and selling a specified asset of standardized quality

and quantity for a price that has been agreed at the present date. The

payment and delivery takes place at a future specified date which is also

known as the delivery date.

• Option contracts: In this type of contract, the buyer of the option has the

right but not the obligation to fulfill the transaction while the seller has the

responsibility of fulfilling the conditions stated in the contract through the

delivery of the shares to the appropriate party.

An option can be distinguished as a call option or a put option. The option

conveying the right to buy the underlying asset at a specific price is called

a call and the option conveying the right to sell the underlying asset at a

specific price is known as the put option.

• Currency Swap: The agreement that takes place between two parties

through which they exchange a series of cash flows in one currency for a

series of cash flows in another currency is known as currency swap. It

takes place at agreed intervals and over an agreed period of time. Law

doesn’t require it to be shown on a company’s balance sheet as it is

considered to be a foreign exchange transaction.

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Act ivity 1

Select an MNC of your choice and study the hedging techniques it had

applied for foreign risk management. Make a report.

Hint:

• Browse the Internet and find out the hedging techniques that are applied

in the market.

Self-Assessment Questions

1. A ____________ is a non-standardized contract that takes place between

two parties for the purpose of selling or buying an asset at specified future

time at price that has already been agreed.

2. The option conveying the right to buy the underlying asset at a specific

price is called a ____________ .

3. ____________ is a standardized contract that takes place between two

parties for buying and selling a specified asset of standardized quality

and quantity for a price that has been agreed at the present date.

9.4 Distinguishing between Functional and Reporting Currency

In December 1981, the Financial Accounting Standards Board Statement 52

(FASB 52) was issued after which it was required of all the American MNCs to

adopt the statement for fiscal years starting on or after 15 December 1982. The

FASB 52 states that the firms must make use of the current rate method for

translating foreign currency denominated assets and liabilities into dollars. The

expense items on the income statement and all the foreign currency revenue

must be translated at either the exchange rate in effect on the date when these

items were recognized or at an appropriated weighted average exchange rate

for the period. It is also required by the FASB 52 that the translation gains and

the losses needs to be accumulated and presented in a different equity account

on the parent’s balance sheet and this account is known as the ‘cumulative

translation adjustment’ account. A foreign affiliate’s ‘functional’ and ‘reporting’

currency have also been differentiated by ASB 52.

The currency of the primary economic environment where the affiliate

operates and in which it generates cash flows is known as functional currency.

It is also the local currency in which most of the business of the entity is

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conducted. However, in some situations, it can also function as the home country

currency of the parent firm or some third country currency.

The reporting currency on the other hand is the one in which the financial

statements are prepared by the parent firm. It is also generally the currency in

which the parent is located and most of the business is conducted.

The management also needs to determine the nature and purpose of the

foreign operations in order to decide on the appropriate functional currency.

Generally the functional currency will become the local currency of the country

if the operations of the foreign affiliate are self-contained and integrated with a

particular country.


4. In December 1981, the Financial Accounting Standards Board Statement

52 (FASB 52) was issued. (True/False)

5. The currency of the primary economic environment where the affiliate

operates and in which it generates cash flows is known as reporting

currency. (True/False)

9.5 Currency Volatili ty Over Time

Currency volatility can be defined as the measure of the change in price that

takes place over a given time period. It doesn’t remain constant from one time

period to another. The currency volatility keeps on changing from time to time

and thus the assessment conducted by the MNCs of the future volatility of the

currency will not be accurate. However, it can still be beneficial for the MNCs as

they can derive information even though the MNCs may not be able to predict

accurately. Currencies such as the British pound whose value is most likely to

remain constant unlike the highly volatile currencies like the South Korean Won

or the Italian Lira can be identified.

Change in the value of a company that accompanies an unanticipated

change in exchange rates is called as economic exposure risk. This is also

related to the currency volatility over time. Of all the three exposures, economic

exposure is the most important as it has an impact on the valuation of a firm.

Suppose a Japanese company imports children toys from India. The same

product is also available from China but it is costly. If the rupee appreciates

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against the yen and the Chinese currency decreases against yen, Japan will

prefer to import the toys from China as it will get at a cheaper rate.

Since economic exposure comes from unanticipated changes, its

measurement is not as precise as those of transaction and translation exposures.

Shapiro has classified economic exposure into two components, transaction

exposure and operating exposure. The changes in the value of financial

obligations incurred before a change in exchange rates but to be settled after

the change is defined as transaction exposure. Operating exposure has an

impact on the firm’s future operating costs and cash flows. Since the firm is

valued as a going concern entity, its future revenues and costs are to be affected

by the exchange rate changes. If the firm succeeds in passing on the impact of higher input costs fully by increasing the selling price, it does not have any

operating risk exposure as its operating future cash flows are likely to remain

unaffected. In addition to supply and demand elasticity, the firm’s ability to shift

production and sourcing of inputs is another major factor affecting operating

risk exposure. High-low Position Index (HLPI) is an important tool that is used

to measure the volatility of currencies and also to describe the position of the

current exchange rate relative to its one year high and low.


6. Currency volatility can be defined as the measure of the change in price

that takes place over a given time period. (True/False)

7. Transaction exposure has an impact on the firm’s future operating costs

and cash flows. (True/False)

9.6 Risk Management Products

The most important products that the firms use to meet their exchange risk

management risks are through the forward, swap and options contracts. A survey

conducted by the Fortune 500 firms found that the most popular product is thetraditional forward contract. A currency option is the next most commonly used

instrument followed by options contract. In another survey conducted by

Jesswein, Kwok and Folks, it has been stated that the finance/insurance/real

estate industry is the one which uses the risk management products most

frequently. It also further stated that the corporate use of foreign exchange risk

management is also related to international involvement of a firm.

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Through a forward contract, a buyer or a seller can lock in a purchasing

or selling price for an asset with the arrangement that the transaction would

take place in the future. In this contract, the buyer or the seller arrives at a price

and date when they are obligated to buy or sell a given asset. Until the expiry or

the delivery date, there is no exchange of cash or assets and on the day of the

delivery it can be be settled either by physical delivery of the asset or the cash

settlement. It helps the buyer and the seller to reduce the fluctuation risks in the

currency markets through which businesses are affected.

Currency swap: A derivative in which cash flows of the financial instrument of

one party is exchanged for the cash flow of another party’s financial instrument

is known as a swap. The type of the financial instrument involved determinesthe benefits in question. The dates when the cash flows are to be paid and the

way in which they are to be calculated are defined by the swap agreement.

Various kinds of swaps are available but the most commonly used swaps are

the interest rate swaps and currency swaps. An interest rate swap can be defined

as a financial contract that takes place between two parties through which interest

payments are made on a notional amount of principal on a number of occasions

throughout a specified period. One of the parties involved in the contract make

a cash payment on each payment date during the specified period. This cash

payment depends on the differential between the fixed and the floating rates. A

currency swap on the other hand can be defined as a contract which takesplace in order to exchange interest payments in one currency for those

denominated in another currency. Back-to-back loans and parallel loans gives

way to currency swap and at present the current swap market is smaller and

less sophisticated.

Option: A derivative financial instrument through which a contract takes place

between two parties for a future transaction on a particular asset at a reference

price is known as an option. In this type of contract, the buyer gains the right but

not the obligation to engage in that transaction. There are different types of

options market. They are exchange traded option and over-the-counter option.

Exchange traded options are a class of exchange traded derivatives that are

settled through a clearing house and the fulfillment is guaranteed by the OptionsClearing Corporation (OCC). In this type of contracts, accurate pricing models

are often available as the contracts are standardized. In case of over-the-counter

options, the trade takes place between two private parties who are not listed on

an exchange. The options can also be individually tailored to meet any business

needs.

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8. Through a____________, a buyer or a seller can lock in a purchasing or

selling price for an asset with the arrangement that the transaction would

take place in the future.

9. A derivative financial instrument through which a contract takes place

between two parties for a future transaction on a particular asset at a

reference price is known as an____________.

10. ____________are a class of exchange traded derivatives that are settled

through a clearing house and the fulfillment is guaranteed by the OptionsClearing Corporation (OCC).

9.7 Techniques of Exposure Management

9.7.1 Managing Transaction Exposure

Transaction exposure calculates gains or losses which occur after the current

financial compulsions according to terms of reference are resolved. Taken that

the deal would lead to a future inflow or outflow of foreign currency cash, any

unprecedented alterations in rate of exchange amid the period in which

transaction is entered and the time taken for it to settle in cash would guide to achange in worth of net flow of cash in terms of the home currency. For example

a transaction exposure of an Indian company will be the account receivable

which is associated with a sale denominated in US dollars or the compulsion of

an account payable in Euro debt.

Presume an Indian firm sells goods with an open account to a German

buyer for €1,800,000 payment of which is to be done in 2 months. The current

exchange rate is ` 50/€, and the Indian seller expects to exchange the euros

received for ` 90,000,000 when payment is received. If euro weakens to `45/€

when payment is received, the Indian seller will receive only `81,000,000, or

some`9,000,000 less than anticipated. Opposite will be the case should eurostrengthen. Thus exposure is a chance of either gain or loss.

Alternative 1: Invoice the German buyer in rupees; but the Indian firm might

not have obtained the sale in the first place.

Alternative 2: Invoice the German buyer in dollars; both the parties are exposed

should an unanticipated change in exchange rate between dollar and the

respective home currency.

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In either case, the remedy might be worse than the disease!

(i) Forward market hedge: If you might owe foreign currency in upcoming

future, be in agreement to purchase foreign currency in present by entering

into long position in a onward contract. If you might get foreign currency

in future, consent to sell it now by entering into small time position in a

forward contract.

Let us take an example of an Indian importer of readymade garments

from Britain who has just placed the order for next year’s stock. Payment

of amount of £100 million is pending in coming year. Question: How can

you fix outflow of cash in rupees?

Another method involves putting oneself in a situation that lets one gain £

100 million a year, resulting in a long forward contract on the pound.

Suppose both the spot and one-year forward exchange rate is `80/£. If

he does not hedge the £100 million payable, in one year your gain (loss)

on the unhedged position is calculated as follows. The importer will be

better off if the pound depreciates: he still buys £100 million but at an

exchange rate of only `79/£, he saves `100 million relative to `80/£. But

he will be worse off if the pound appreciates.

If the importer agrees to buy £100 million in one year at forward exchange

rate of `80/£, his gain (loss) on the forward is as follows. If he agrees tobuy £100 million at a price of `80 per pound, he will make `50 million if

the price of a pound reaches `80.50. If he agrees to buy £100 million at a

price of `80 per pound, he will lose `50 million if the price of a pound is

only `79.50. This analysis is based on actual results as the future spot

rate cannot be predicted. However, the decision of going forward with the

hedge must be based on the predications. So the firm has to form an

expectation about future spot rate

(a) If E(ST)=F, the ‘expected’ gains or losses are zero. But forward

hedging eliminates exchange exposure.

(b) If E(ST)<F, the firm expects a loss from forward hedging. Thus thefirm would be less inclined to hedge under this scenario. However,

assuming that the firm is averse to risk and the firm does go ahead

with the hedge, the reduction in the predicted proceeds (in dollars)

can also be viewed as the ‘insurance premium’. In other words, it

can be used to make necessary payments in order to avoid or

minimize the risks involved with exchange rates.

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(c) If E(ST)>F, the firm expects a positive gain from forward hedging.

Thus the firm would be more inclined to hedge under this scenario.

(ii) Money market hedge: In order to hedge the payable foreign currency, a

firm can purchase a lump sum of that foreign currency and then sit on it

for a long period of time. This can be done in following ways:

• The current value of the payable foreign currency can be bought.

• The amount may be invested at the foreign rate.

• The amount can be converted back at maturity. This ensures that

the investment grows enough to cover the payable foreign currency.

The Indian importer of British readymade garments, owes in one year

£100 million to the British supplier. The spot exchange rate is `80/£. The

one-year interest rate in UK is i£ = 5 per cent. Borrow ` x million in India.

Translate ` x million into pounds at the spot rate S(`/£) = `80/£. Invest £x/

80 million in the UK at i£ = 5 per cent for one year. In one year investment

£x (1.05)/80 million will have grown to £100 million. Solving for x, we get

x=7619 (approximately), so that we have redenominated a one-year £100

million payable into a `7619 million payable due today. If the interest rate

in India is i` = 6 per cent, the Indian importer could borrow the `7619

million today and owe in one year.

`8076 million = `7619 million ×(1.06)

Let us suppose that a firm wishes to hedge £ received in the sum of £ y

along with a maturity of T:

(i) Borrow £y/(1+ i£)T at t = 0.

(ii) Exchange £y/(1+ i£)T for $x at the prevailing spot rate.

At the time of maturity, the firm will owe a $y which can be paidwith the receivable sum. This way, the firm’s exposure to theexchange rates involving dollar and pound will be reducedconsiderably.

(iii) Option hedge: One possible shortcoming of both forward and moneymarket hedges is that the firm has to forgo the opportunity to benefit from

favourable exchange rate changes. Keeping several options available

creates a flexible hedge against the downside. At the same time, it helps

in preserving the upside potential. The payable buys are called on the

foreign currency in order to hedge the currency. If there is an appreciation

in the value of the currency, then the call option allows the firm to purchase

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the currency at the exercise price of the call. In order to hedge a foreign

currency, receivable buy is put on the currency. In case of depreciation in

the value of the currency, the put option allows the firm to sell off the

currency at the exercise rate.

Suppose our importer buys a call option on £100 million with an exercise

price of `80 per pound. He pays ` 8 per pound for the call, so that the total

payment for the option is `800,000,000. This transaction provides Indian

importer with the right, but not the obligation, to buy upto £100 million for

`80/£, regardless of the future spot rate.

Assume that the spot exchange rate turns out to be `79.50 on the expiration

date. Since the importer has the right to buy each pound at `80, he will

not exercise the option. However if the rupee depreciates to `80.50 on

the expiration date, he will surely exercise the call option by buying each

pound at a much cheaper rate of `80. The foremost benefit of option

hedging is that it allows the firm to decide if it wants to exercise this option

on the basis of the realized spot exchange rate on expiry. Recall that

Indian importer has paid `800,000,000 upfront for the option. Considering

the time value of money, this upfront cost at i` = 6 per cent is equivalent

to `848,000,000 (= `800,000,000 x 0.06) as of expiration date.

Transaction

Buy a call option on £100 million for an upfront cost of `800,000,000. In one

year, decide whether to exercise the option upon observing the prevailing spot

exchange rate.

Outcome

Assurance of not having to pay more than ` 848,000,000, in case the future

spot exchange rate is found to be more than the exercise exchange rate.

Cross-hedging minor currency exposure

In today’s market, the most prominent currencies are US dollar, euro, Canadian

dollar, Swiss francs, Japanese yen and Mexican pesos. Currencies like Thaibath, Indian rupee and Korean won are minor currencies circulating in the market.

Obtaining financial contracts for hedge exposure of these minor currencies is a

difficult task and proves to be costly. For this purpose, cross-hedging is often

used. It can be understood as the hedging of a particular position in one asset

and replacing a position in some other asset. The success and effectiveness of

cross-hedging depends on the degree of interrelatedness of the assets.

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9.7.2 Managing Operating Exposure

Operating exposure is alternatively known as economic exposure. It evaluates

the changes that occur in the current value of the firm. The change in the current

value may be a result of the change that takes place in predicted operating

cash flows on account of fluctuations in exchange rates.

They are similar in that they both deal with future cash flows. They differ

in terms of which cash flows management considers. Transaction exposure

deals with the predicted cash flows for future that have already been contracted

and hence accounted for. At the same time, the operating exposure focuses on

the predicted-but not yet contracted-cash flows in future. These future cashflows may undergo changes in case of a major fluctuation in the exchange rate,

resulting in changes in the overall competitiveness at international level.

Suppose an Indian MNC, such as Videocon, has sales in India, United

States, China and Europe and therefore, posts a continuing series of foreign

currency receivables (and payables). Sales and expenses that are already

contracted for are traditional transaction exposures. Sales that are highly

probable based on the Videocon’s historical business line and market share but

have no legal basis yet are anticipated transaction exposures. Let us extend

the analysis of the firm’s exposure to exchange rate changes even further into

the future. The analysis of this longer term – where exchange rate changes are

unpredictable and, therefore, unexpected – is the goal of operating exposure

analysis. Broadly speaking, operating exposure and its implications are not limited

to the sensitivity and dependability of the future cash flows of a firm upon the

unpredictable fluctuations in foreign exchange rates. It is also directly affected

by other chaif macroeconomic variables. This phenomenon is often known as

macroeconomic uncertainty.

Some firms face operating exposure without even dealing in foreign

exchange. Consider an Indian perfume manufacturer who sources and sells

only in the domestic market. Since the firm’s product competes against imported

perfumes (say from Paris) it is subject to foreign exchange exposure. It faces

severe competition when rupee gains against other currencies (here, euro),lowering the prices of imported perfumes.

Suppose that an Indian manufacturer has contracted to sell 100 pairs of

jeans per year to Britain at `1200 per pair and to buy 200 yards of denim from

Britain in this same period for £2 per yard. Suppose that 2 yards of denim are

required per pair and that the labour cost for each pair is `400. Suppose that at

the time of contracting the exchange rate is S(`/£) = 80 and the rupee is then

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devalued to S(`/£) = 81. Suppose also that the elasticity of demand for Indian

jeans in Britain is -2 and that after the contract expires the Indian manufacturer

raises the price of jeans to `1205 per pair. What are the gains/losses from the

devaluation on the jeans sold and on the denim bought at the pre-contracted

prices? (i.e., what are the gains/losses from transaction exposure on payables

and receivables?) What are the gains/losses from the extra competitiveness of

Indian jeans, that is, from operating exposure?

Solution: Effect of transaction exposure

Before the devaluation

Expected total revenue/year =100 pairs x `1200/pair =`1,20,000. Expected totalcost /year =100 pairs x 2yd/pair × £2/yd x `80/£ + 100 pairs x `400/pair =

`72,000. Expected profit = `120,000 – `72,200 = `48,000.

After the devaluation

Expected total revenue/year =100 pairs x `1200/pair =`1,20,000. Expected total

cost /year =100 pairs x 2yd/pair x £2/yd x `81/£ + 100 pairs x `400/pair = `72,400.

Expected profit = `120,000 – ̀ 72,400 = `47,600. Exporter’s profit on contracted

quantities and prices of jeans supplied and denim purchased is reduced by

`400 per year because of the transaction exposure.

Solution: Effect of operating exposure

Before the devaluation

Expected profit = ` 48,000

After the contract expires

When the rupee price of jeans rises from `1200/pair to `1205/pair, the pound

price falls from £15 to £14.88, i.e., a 0.8 per cent reduction. With a demand

elasticity of -2, it will result in sales increasing by 1.6 per cent to 101 pairs per

year. Expected total revenue/year =101 pairs x `1205/pair =`121,705. Expected

total cost /year =101 pairs x 2yd/pair x £2/yd x `81/£ + 101 pairs x `400/pair =

`73,124. Expected profit = `121,705 – `73,124 = `48,581. We find that theexporter’s profit is increased by `581 per year from the devaluation because of

operating exposure.

The operating exposure of a firm is dependent upon the following:

1. The overall market structure in terms of inputs and products

2. The level of competitiveness and monopoly existing in the market

that the firm is looking to face

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3. The capability of the firm to align its marketing strategies, product

mix, and sourcing in relation to the exchange rates and the

accompanying changes

In case, the cost or the price of a firm is directly affected by the changes

in the exchange rates, then the firm is understood to be subjected to increased

levels of operating exposure. As an extension of this, when the cost as well as

the price of the firm is being affected by the changes in exchange rates, then

firm can be said to have little or no operating exposure.

Consider a hypothetical company, Ford Indiana, a subsidiary of Ford,

which imports cars from US and distributes in India. If dollar is expected to

appreciate against the rupee, Ford Indiana’s expected cost goes up in rupee

terms. Whether this creates operating exposure for Ford critically depends on

the structure of the car market in India. If Ford Indiana faces competition from

India (or other foreign) car makers for whom rupee costs did not arise, raising

the rupee price of imported car is not a feasible option. In contrast, if Ford

Indiana faces competition only from other US car makers (like General Motors)

for whom rupee costs would have similarly been affected by dollar appreciation,

competitive position of Ford Indiana would not be adversely affected, leading to

a higher rupee price of imported cars.

Even if Ford Indiana faces competition from local car makers in India, it

can reduce exposure by starting to source Indian parts and materials, whichwould be cheaper in dollar terms after the dollar appreciation. Ford can even

start to produce cars in India by hiring local workers and sourcing local inputs,

thereby making its costs less sensitive to changes in the dollar/rupee exchange

rate. The firm’s flexibility regarding production locations, sourcing, and financial

hedging strategy is an important determinant of its operating exposure to

exchange risk.

Suppose the annual inflation rate in US is 2 per cent and in India, it is 6

per cent. Recollect the relative PPP condition: the exchange rate change during

a period should equal the inflation differential for that same time period, to avoid

possibility of any arbitrage.Case 1: dollar appreciates about 4 per cent against the rupee. Since the

rupee prices of both Ford and locally produced cars rise by the same 6 per cent

(for Ford it includes a 2 per cent increase in the dollar price of cars + a 4 per

cent appreciation of dollar against rupee), the 4 per cent appreciation of the

dollar will not affect the competitive position of Ford vis-à-vis local car makers.

Ford is thus not exposed to exchange risk

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Case 2: Suppose dollar appreciates by more than 4 per cent against

rupee. Ford cars will become relatively more expensive than locally produced

cars, adversely affecting Ford’s competitive position. Ford is thus exposed to

exchange risk.

Managing operating exposure

(i) Selecting low cost production sites: A firm may wish to diversify the

location of their production sites to mitigate the effect of exchange rate

movements. The adverse repercussions of the fluctuations in exchangerates can be avoided, if the location of the production sites is shifted to

other countries with currencies that have depreciated in real terms. Onecondition to this is that the production costs in these countries should

involve plenty of local and topical content. The Japanese car maker Nissanhas manufacturing facilities in US other than Japan. During the January-

May, 1993 yen appreciated against the dollar by more than 13 per cent,thereby affecting the competitive position of Nissan in US car market.

Nissan choose to shift production from Japan to US manufacturing facilitiesin order to mitigate the negative effect of the strong yen on US sales.

Another example is of Honda Group, which constructed factories in North America in the view of the strong position of yen in the market. However,

later when the yen began to weaken, the company decided to import

more cars from Japan than to build them in North American factories.(ii) Flexible sourcing policy: It is found that if the inputs and raw materials

are bought in foreign markets where the local content in the production

costs is considerably high, then the fluctuations in excshange rates resultin a corresponding change in the relative cost of sourcing from alternative

sources.

Example: Facing strong yen, Japanese manufacturers in the car andconsumer electronics industries, depend heavily on parts and intermediate

products from such low-cost countries as Thailand, Malaysia and China.Sourcing is not limited to components used in production but also extend

to hiring ‘guest workers’. For instance, Japan Airlines recruited peoplefrom foreign countries for its crew in order to retain its competitive edge in

the wake of strong yen. Later, however, it reversed its strategy when theyen began to weaken and there was a rise in the rate unemployment in

the local market.

(iii) Diversification of market: this can be understood in terms of sale of

products in a number of markets in order to maximize advantage on

account of diversification of the exchange rate risk. Suppose Infosys is

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outsourcing its services in US as well as in Germany. Reduced outsourcing/

sales in US, following rupee appreciation against dollar can be

compensated by increased sales in Germany due to rupee depreciation

against the euro. As a result Infosys overall cash flows will be much more

stable, than would be the case if it were to outsource in only one country.

(iv) R&D and product differentiation: This entails an effective R&D in order

to facilitate the following:

• Cost reduction

• Increase in productivity

• Product differentiation

An effect ive product differentiation results in a decrease in demand

elasticity, which in turn, translates into reduced risks involving exchange

rate fluctuations.

(v) Financial hedging: Transaction exposure to currency risk is mostly short-

term in nature. In contrast operating exposure has a very long time horizon.

The four most commonly employed financial hedging policies are:

• Matching currency cash flows

• Risk-sharing agreements

• Back-to-back or parallel loans• Currency swaps

(a) Matching currency cash flows: Let us suppose, that an Indian

company is involved in continuous export sales in the US market. In

order to gain a competitive advantage, the firm invoices all its sales

in American dollars. This strategy leads to a continuous receipt of

dollars every month. This continuous string of transactions results in

a continuous hedging with forwards and contractual agreements.

Alternatively, the firm can match its continual inflow of American

dollars, with an equivalent outflow by acquiring debt denominated in

dollars.Exposure:The sale of manufactured products in the US markets

results in the creation of a foreign currency exposure out of inflow of

American dollars.

Hedge: The payment of debts in American dollars serves as a

financial hedge. It requires debt service, which is an outflow of

American dollars.

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Situation 1: A predicted and constant exposure to a company can

be counterbalanced by acquiring debt dominated in the currency, by

the method of matching.

Situation 2: Alternatively, the method of currency switching can be

adopted, according to which, the company can pay the foreign

supplier/ dealers in American dollars.

(b) Risk-sharing agreements: Long-term cash flow exposure between

firms can also be managed by using the method of risk sharing. The

risk-sharing method involves a contractual agreement between the

buyer firm and the seller firm, to ‘share’ or divide the impact, if any,

of the currency movements on the transaction being done between

them. This agreement serves as an ideal and co-operative way of

functioning between firms that look forward to building a long-term

relationship based on the product quality and mutual reliability. It

facilitates building a relationship that does not depend on the whims

of the unpredictable currency markets. It helps in smoothening the

impact of the changes and movements of exchange rates by dividing

the burden of the impact on the involved parties (firms).

For example, Ford’s operations in America involve importing the

automotive parts from Mazda in Japan every year. Major fluctuations

in the exchange rates tend to profit one firm at the expense of theother.

The Agreement

• All purchases by Ford will be made in Japanese yen at the

current exchange rate, as long as the spot exchange rate on

the date of invoice is between ¥ 115/$ and ¥ 125/$; so that

whatever transaction exposure exists is borne by Ford.

• If however, the exchange rate falls outside this range on the

payment date, Ford and Mazda will share the difference equally.

Suppose Ford has an account payable of ¥ 25,000,000 for the monthof March and the spot rate on the date of invoice is ¥110/$, i.e., the

Japanese yen would have appreciated versus dollar increasing Ford’s

costs from $217,391.30 to $227,272.73. However, since the rate

falls outside the stipulated range, the difference of ¥5/$ would be

shared between Ford and Mazda; so that Ford’s total payment in

Japanese yen would be calculated using an effective exchange rate

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of ¥112.5/$, and saves Ford $5,050.51. This ‘savings’ is a reduction

in an increased cost, not a true cost reduction.

(c) Back-to-Back loans: When two companies from two different

countries borrow each other’s currencies for a particular time period,

the arrangement is termed as back-to-back loan (parallel loan or

credit swap). The borrowed currencies are returned on a terminal

decided with retural consent. Suppose a British parent firm discuss

of make funds investment to invest funds in its Dutch subsidiary

locates a Dutch parent firm that wants to invest funds in the UK. The

British parent lends pounds to the Dutch subsidiary in UK, while the

Dutch parent lends euros to the British subsidiary in the Netherlands.The two loans would be for equal values at the current spot rate and

for a specified maturity. At maturity the two separate loans would

each be repaid to the original lender, without the need to use the FX

markets.

Two primary obstacles to the extensive usage of the back-to-back

loan exist which are as follows:

• It is not easy for a firm to find a partner, termed a counterparty

for the currency amount and timing desired.

• One risk is that one of the parties will fail to return the borrowed

funds at the designated maturity—although each party has 100

per cent collateral (denominated in a different currency).

These disadvantages have resulted in the rapid development and

wide use of the currency swap, where a firm and a swap dealer or

swap bank agree to exchange an equivalent amount of two different

currencies for a specified amount of time.

(d) Currency Swaps: This is already discussed in earlier subsection.

Act ivity 2

Find out the various alternatives that are available to the Indian corporatefor hedging risk. Put it down on a chart.

Hint:

• Some of the alternatives are forward market hedge, money market

hedge, futures market hedge and options market hedge.

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11. In order to ____the payable foreign currency, a firm can purchase a lump

sum of that foreign currency and then sit on it for a long period of time.

12. Cross-hedging is the hedging of a particular position in one asset and

replacing a position in some other asset. (True/False)

9.8 Case Study

Reserve Bank of India eases hedging rules to aid volumes

For the purpose of boosting trading volumes in the over-the-counter market,

the Reserve Bank of India has liberalized the norms related to hedging. It

has imposed these restrictions for restricting speculation in the foreign

exchange market after the weakening of the rupee by over 18 per cent

between August and December 2011.

This has enabled the exporters to credit 100 percent of their foreign

exchange earnings to the EEFC (exchange earners’ foreign currency

account) without the need of converting 50 per cent of it in rupee terms.

EEFC is an account that is maintained in foreign currency with a bank or an

authorized dealer. The foreign exchange earners are provided this facilityto credit 100 per cent of their foreign exchange earnings to the account.

However, it is needed that the exporters convert the total accrual into rupee

terms by the end of the month.

Experts state that this measure will help the exporters in hedging their

exposures with banks in turn giving a boost to the rupee which has become

weak by 9 per cent against the dollar in the first quarter of the financial year

2013. Anil Bhansali, the vice-president of Mecklai Financial said that though

exporters might sell, it will stand to have a limited impact as the demand for

dollars is high and one-off inflows have not helped the rupee correct much

in the recent pastThe exporters have also been permitted by the RBI to book and cancel

forward contracts to about 25% of their total contracts that have been booked

for hedging exposures. RBI has already stated in a circular that was issued

in July that the forward contracts that have been booked once will not be

cancelled. While getting into a forward contract, the exporters and the

importers comes to an agreement to buy or sell a currency at a pre-

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determined exchange rate at a given time. Subir Gokarn, the deputy

governor of SBI had said that the steps that have been taken by the RBI

seem to be helping in the reduction of volatility.

“And having reached that situation, we felt that there was some room to

give our participants a little more flexibility in their management of their

exposures, their genuine hedging requirements and that has motivated the

actions that we took today.”

RBI has also freed the net overnight open positions (NOOP) of overseas

branches of banks from the limits imposed earlier. Net open positions are

transactions which have not been squared off on an overnight basis.

“This liberalizes the NOOP a bit more,” said the ED, trading, UBS. “These

moves are directed towards undoing the restrictions the RBI had put in

place in December. Trading volumes in the OTC market will certainly

increase,” he added.

Questions

1. Do you think that the steps taken by the RBI will help in easing hedging?

2. What are the opinions of the experts in this matter?

Source: Adapted from http://articles.economictimes.indiatimes.com/2012-

08-01/news/32981521_1_eefc-foreign-currency-exporters-and-importers

Accessed on 5 August 2012

9.9 Summary

Let us recapitulate the important concepts discussed in this unit:

• The different tools that hedge the different kinds of risks are forward

contracts, futures contracts, Option contracts and currency swap.

• An option can be distinguished as a call option or a put option.

• In December 1981, the Financial Accounting Standards Board Statement

52 (FASB 52) was issued after which it was required of all the AmericanMNCs to adopt the statement for fiscal years starting on or after 15

December 1982.

• The FASB 52 states that the firms must make use of the current rate

method for translating foreign currency denominated assets and liabilities

into dollars.

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• The hedge involves a money market position to cover a future payable or

receivables position.

• A natural hedge is applied when the contractual hedge fails to give good

results. It may be mentioned that the contractual hedge provides only

temporary protection against exchange rate movement.

• Risk-sharing is a contractual arrangement through which the buyer and

the seller agree to share the exposure.

9.10 Glossary

• Hedge: To make an investment for the reduction of the risk of adverse

price movements in an asset

• Underlying asset: The security or property or loan agreement through

which the option holder receives the right to buy or to sell

• Cumulative: A preferred stock where the publicly-traded company must

pay all dividends

• Aff ili ate: A corporation that is related to another corporation by one

owning shares of the other

• Transaction exposure: Transaction exposure measures gains or loses

that arises from the settlement of existing financial obligations the terms

of which are stated in a foreign currency

• Translation exposure: Accounting exposure, also called translation

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

9.11 Terminal Questions

1. Define the tools of foreign exchange risk management.

2. Discuss functional currency.

3. What is the function of a forward contract? Discuss.

4. Define reporting currency.

5. Explain the types of contractual hedges.

6. What is transaction exposure?

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9.12 Answers

Answers to Self -Assessment Questions

1. Forward contract

2. Call option

3. Futures contracts

4. True

5. False6. True

7. False

8. Forward contract

9. Option

10. Exchange traded options

11. hedge

12. True

Answers to Terminal Questions

1. The different tools of Foreign risk management are:

• Forward contracts

• Future contracts

• Options contract

• Currency swap

For further details, refer to Section 9.3.

2. The currency of the primary economic environment where the affiliateoperates and in which it generates cash flows is known as functional

currency.


3. The reporting currency on the other hand is the one in which the financial

statements are prepared by the parent firm.


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4. Currency volatility can be defined as the measure of the change in price

that takes place over a given time period. It doesn’t remain constant from

one time period to another.


5. Through a forward contract, a buyer or a seller can lock in a purchasing

or selling price for an asset with the arrangement that the transaction

would take place in the future. In this contract, the buyer or the seller

arrives at a price and date when they are obligated to buy or sell a given

asset.

For further details, refer to Section 9.6.6. Transaction exposure calculates gains or losses which occur after the

current financial compulsions according to terms of reference are resolved.

For further details, refer to Section 9.7.1.

References/ e-References

• Kaur, Dr. Harmeet. International Financial Management. Delhi: Vikas

Publishing.

• Kuntluru, Dr. Sudarshan. International Financial Management. Delhi: Vikas

Publishing.

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