An Introduction to Foreign Exchange (FX) Risk Management

By Germán L. Villar

Introduction

For companies that sell their goods and services internationally (export) and get paid
in a foreign currency, foreign exchange risk is the likelihood that a change in exchange
rates will result in the company receiving a lower amount of domestic currency than
originally anticipated. For companies that import and pay foreign suppliers in foreign
currency, foreign exchange risk is the likelihood that a change in exchange rates will
result in the company paying a higher amount of domestic currency than originally
anticipated. This form of foreign exchange exposure, which impacts the cash flow of
the company, is commonly referred to as transaction exposure.

Other forms of exposure also exist, such as accounting exposure and economic
exposure.

Accounting exposure applies when assets and liabilities denominated in a foreign

currency need to be converted into the domestic currency for accounting purposes.
The conversion normally results in foreign exchange gains or losses. This is of
particular concern to companies that have foreign subsidiaries, but can also impact
companies that export and import.

Economic exposure relates to the overall impact that exchange rate fluctuations can
have on a company’s value. Companies that only sell domestically can also face
economic exposure when, for example, the domestic currency strengthens and
improves the competitive position of foreign producers.

For most firms, managing foreign exchange risk centers on how to mitigate transaction
exposure. This paper focuses on this type of exposure.

Impact of movements in foreign exchange rates on businesses

Effects of Domestic currency losing value (depreciation) against Foreign currency:

• it can increase costs for importers, thus potentially reducing their profitability. This
can lead to decreased dividends, which in turn can lead to a fall in the market
value of the business
• domestically produced products can become more competitive against imported
products
• it can increase the cost of capital expenditure where such expenditure requires, for
example, the import of capital equipment
• the cost of servicing foreign currency debt increases
• exporters may become more competitive in terms of costs, potentially increasing
their market share and profitability
• the business could become a more attractive investment proposition for foreign
investors
• for the business, the cost of investing overseas could increase

Effects of Domestic currency gaining value (appreciation) against Foreign currency:

• exports can be less competitive, thus reducing the profitability of exporters. This
can lead to decreased dividends, which in turn can lead to a fall in the market
value of the business
• it can decrease the value of investment in foreign subsidiaries and monetary assets
(when translating the value of such assets into the domestic currency)
• foreign currency income from investments, such as foreign currency dividends,
when translated into the domestic currency may decrease
• the cost of foreign inputs may decrease, thus giving importers a competitive
advantage over domestic producers
• the value of foreign currency liabilities will fall. Hence the cost of servicing these
liabilities decreases
• the cost of capital expenditure will decrease if it is for the importation of capital
equipment, for example
• the business potentially becomes a less attractive investment proposition for
foreign investors
• the cost of investing overseas may decrease

Managing Foreign Exchange Risk

Transactional exposure will refer basically to cash flow risk and how to deal with the
effect of exchange rate movements related to receivables (exports) and payables
(imports) and other operations linked to foreign currency.
In order to develop an strategy that effectively helps to protect the operations of the
company from FX risk, its needed first to identify and measure FX exposure.

Identify and measure FX exposure

The net Foreign Currency (FC) position of the firms has to be established. This can be
calculated by forecasting the Cash Flow of the firm. From there it will be possible to get
the net FX exposure for each time in the future that needs to be hedged.
Exports are FC inflows and Imports and debts in FC are FC outflows. Also has to be
taken into account if the company has FC deposits, this can be taken as one time
inflow.
To measure the risk of the FX exposure it´s relevant to calculate the impact of the FX
rate change into the company profit margin. This can be determined by a Sensitive
Analysis by changing the value of the Foreign Exchange rate (FX rate).

Sensitive analysis for company located in Argentina with net FC exposure to USD
Selling price ARS 65,94
Cost ARS 46,16
Profit margin ARS 19,78
% Profit Margin 30,00%
USD Cost of imports (unit) 2,25
SPOT Exchange rate 10 ARS/USD
ARS Cost of imports (unit) 22,50

ARS/USD Cost of Profit Profit

Exchange imports Margin Margin
rate ARS ARS %
7 15,75 26,53 40%
8 18 24,28 37%
9 20,25 22,03 33%
10 22,5 19,78 30%
11 24,75 17,53 27%
12 27 15,28 23%
13 29,25 13,03 20%
As shown in the example a depreciation of the ARS impacts in a negative way in the
profits of the company. To maintain the profit margin the company has to increase the
selling price or reduce other costs, both actions most of the time are not so easy or
fast to put into action. By doing this the FX risk will be translated by price or cost.
But many times is not possible to translate the FX cost so the company has to absorb
the impact by losing profits.

It is extremely important to analyze the Operating Cycle of the company in order to

identify when and where the transactional risk arises.
Every company has an operating cycle made up of recurring operations that are
specific to its type of business. During this cycle, the company produces and markets
its goods or services, generates cash flows and earns a profit.
Analyzing the operating cycle can help to understand the exact nature of the
company’s operations and the unique characteristics related to the marketing, sale,
production and delivery.

Below its shown the structure of the operating cycle and the FX risk for an exporting
process.

As shown above, if the FX risk can be identified and the FX exposure calculated, so
then the company can proceed to hedge the FX risk using different techniques.

Techniques for managing foreign exchange exposure

There are mainly two types of possible hedges that a company use to manage the FX
risk, natural hedging and financial hedging. Many companies uses both of them.
Natural Hedging
The objective of natural hedging is to reduce the difference between receipts and
payments in a given foreign currency. By doing this the transactional exposure is
reduced. For example for an importer the natural hedge will be to buy locally the
products that its importing. Unfortunately this type of hedge it's not always possible to
implement.

Financial Hedging

In the case of a financial hedge, operations with spot and derivatives products are
used to create a hedge against FC risk.

1. Money Market Operations

By using operations in the spot market an FX hedge can be created by simply

borrowing in domestic (foreign) currency and investing in foreign (domestic) currency,
depending on the position to cover. So the company can be Long or Short in foreign
currency to cover the FX risk in a given period of time.
This is also known as a synthetic forward, this method utilizes the fact from the
covered interest rate parity, that the currency price in the future must be equal to the
current spot exchange rate times the ratio of the two currencies´ riskless return.

2. Derivatives

Forwards and Futures

Forwards an Futures are agreements to buy or sell an asset at a given period of time.
The type of asset, price, the maturity and other conditions of the agreement are set at
the present time. At the maturity date the agreement is settled (the buyer pays and
the seller delivers the asset)
The main difference between Forwards and Futures is the existence or not of a clearing
house in the operation. Futures markets operate with clearing houses and forwards
not.

By taking a position in a Forward or a Future agreement it is possible to fix a selling or

buying price for an asset for a future date (maturity date). The Currency Forwards or
the Currency Futures are the agreements where the assets to buy or sell are
"Exchange Rates".

So in the case of an importer with foreign currency deficit in its cash flow in a given
future date, a hedge can be established by buying a Currency Forward or Currency
Future agreement. The price to acquire the foreign currency is fixed at the time of
buying the contract and the payment and delivery of the Foreign Currency it´s
performed at the maturity date.

Following the importer case, for example an importer located in Brazil with commercial
debts of EUR 1 million with maturity in 6 months, will face an FX risk up to the time
the debts are paid. The obvious risk for the importer is the depreciation of the BRL
(Brazilian REAL) in relation to the EUR.
The market shows the following information,

SPOT MARKET
BID OFFER
EUR/BRL 3,3115 3,3225

6 MONTHS FUTURE MARKET

BID OFFER
EUR/BRL 3,4108 3,4221

The situation for the Brazilian importer it´s as follows,

Without the Hedge, the position will be settled at the spot rate in 6 month from now.
The amount of BRL that will be paid in 6 months is unknown.

T=0 T= 6 months

EUR -1.000.000

Spot rates are known- FX RISK

EUR/BRL The spot rate for the EUR/BRL in
BID OFFER 6 months is unknown
3,3115 3,3225

On the other hand a hedge can be created by buying a futures contract with 6-month
maturity. The price to pay for each EUR in 6 months will be equal to the futures offer
rate, EUR/BRL 3.4221.-
As the FX rate is fixed using the future contract the amount of BRL to be paid
in 6 months is fixed, BRL 3.422.100- The company is not exposed any more to FX
fluctuations, the price to buy each EUR was fixed at a price of 3,4221 BRL for each
EUR.

T=0 T= 6 months

EUR -1.000.000
Fut. FX rate 3,4221
BRL -3.422.100
6 - months Future contract
EUR/BRL
BID OFFER FX RISK is HEDGED
3,4108 3,4221
Position: LONG
Options

An option is contract that gives the owner (the buyer) the "right" but not the
"obligation" to BUY (CALL option) or to SELL (PUT option) an specific asset (underlying
asset) at an specific price (strike price) in a date or during a period of time (up to the
maturity date). The price of the "right" is called "premium" and its paid by the buyer of
the option at the moment that the option is acquired.

Following the example of the Brazilian importer, next is a market quote for a Call
option for EUR/BRL,

Maturity Strike Price Bid Ask

EUR/BRL
6-months 3,315 0,0960 0,1080

The company can create a hedge by paying today the premium of the option contract,
0.1080 BRL/EUR. As the company needs to buy in 6 months EUR 1 million the total
premium to be paid will be BRL 108.000 (0.1080 x 1 million).- By doing this the
company has the right to buy EUR 1 million at a fixed price of 3,315 BRL/EUR. So to
use the right to buy the EUR 1 Million the company has to pay at maturity BRL
3.315.000 (3.315 x 1 million).-

The cost of acquiring the EUR 1 million using the option contract is:

Cost of the Premium 108.000 BRL

Strike price (excersise the option) 3.315.000 BRL
TOTAL 3.423.000 BRL

FIXED FX RATE EUR/BRL 3,423

As shown above the FX rate for 6-months is FIXED at EUR/BRL 3,423. The
company is not exposed any more to FX fluctuations