FOREIGN EXCHANGE RISK

MANAGEMENT

• CORE BUSINESS RISKS

• 1) Raw Material Shortage
• 2) Labour problem
• 3) Failure of new product / technology etc.

• These risks are specific to firm and going to

have an impact on firm’s performance.
• MACRO ECONOMIC
ENVIRONMENTAL RISK
• 1) Exchange rate variation
• 2) Interest rate variation
• 3) Inflation
• 4) Increase in prices of key
commodities like oil, steel, etc.
• These are risks affects all firms in the
economy but the nature of impact varies.
 FOREIGN
EXCHANGE/CURRENCY
EXPOSURE / RISK

Foreign currency risk is the net potential gain

or loss which arises from exchange rate
changes, to a foreign currency exposure of
an enterprise.
• Currency risk is the risk that he domestic
currency value of cash flows, denominated
in foreign currency may change because of
the variation in the foreign exchange rate.
• Currency exposure is a measure of the
sensitivity of real value of enterprises
assets, liabilities and incomes express in its
functional currency (operating currency) to
unanticipated changes in exchange rate.
• A project / firm has a currency exposure
when the currencies for its expenditure and
revenues are not the same’.
• Foreign currency risk management is the proper
management of foreign currency assets, liabilities
income and expenditure with a view to optimising
rupee earnings and minimizing rupee cost. It
involves selection of right currency for invoicing
imports and exports, and for denominating loans
where such choice exists, prepayment or delayed
payment of payables, postponements of
receivables, judicious matching of imports and
exports and, finally, proper usage of hedging
instruments and facilities available for the
purpose.
 Currency risk management has become
necessary for Indian business due to
• Increased cross border transaction: India’s
cross border trade has increased tremendously in
post liberalisation era. Now India accounts for 1%
of world trade in respect of visibles and 2% of
world trade in respect of invisibles.
• Increased volatility in currency:
• Increased domestic and overseas competition:
• Greater flexibility in hedging due to
liberalisation:
• OBJECTIVES OF FOREX RISK
MANAGEMENT
• Hedge against the risk of currency
exchange loss.
• Speculative gains
• Smoothing earnings
• EXPOSURE AND RISK
• Exposure refers to foreign currency assets,
liabilities, income and expenditure whose
values will change in terms of home
currency in response to exchange rate
fluctuations.
• Risk is the likely or probable loss from such
forex exposure due to adverse exchange
rate fluctuations.
• HEDGING V/S SPECULATION
• Hedging is a transaction undertaken to
offset the forex risk.
• Speculation involves or taking or creating a
forex exposure deliberately for gaining
from favorable exchange rate movement.
• “ not hedging a risk amounts to
speculation”
• Currency exposure can be divided into
• 1) Transaction exposure
• 2) Economic / operating
exposure
• 3) Translation exposure
 Transaction exposure
Deals with current cash flows. It arises
whenever firm’s receivables or payables are
denominated in foreign currencies. This
exposure will have an effect on the
networking capital position and
profitability.
• This is the most common form of currency
exposure that arises when a firm has receivables or
payables denominated in foreign currency.
• This is a measure of the sensitivity of the
domestic currency value of assets and liabilities,
which are denominated in a foreign currency to
unanticipated changes in exchange rates, when the
said assets or liabilities are liquidated.
• The foreign-currency values of these items are
contractually fixed, i.e., they do not vary with the
exchange rate. It is also known as contractual
exposure.
MEASUREMENT OF TRANSACTION
EXPOSURE
 MANAGING TRANSACTION
EXPOSURE

• INTERNAL HEDGING STRATEGIES

/TECHNIQUES
• EXTERNAL HEDGING STRATEGIES
/TECHNIQUES
• INTERNAL HEDGING STRATEGIES
/TECHNIQUES
• a) Natural hedge
• b) Invoicing in own currency
• C) Split currency invoicing
• D) Netting
• D) Leading and lagging
• e) Price adjustments
• f) Risk sharing agreements
• g) Review of market – product
combination
• EXTERNAL HEDGING STRATEGIES
/TECHNIQUES
• a) Currency forward contracts
• b) Currency future contracts
• c) Currency options
• e) Money market hedge
 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
• Translation exposure is the potential for an
increase or decrease in the parent’s net
worth and reported net income caused by a
change in exchange rates since the last
translation. Translated statements are used
by management to assess the performance
of foreign subsidiaries, amongst other
things. Restatement of all subsidiary
statements into the single ‘common
denominator’ of one currency facilitates
management comparison.
• The difference between exposed assets and
exposed liability is called translation
exposure.
• Eg; US subsidiary at France has monetary
assets of 200 mn FFr and monetary liability
of 100 mn FFr. The exchange rate declines
from FFr 4/$ to FFr 5/$
• The potential foreign exchange loss on
company's exposed net monetary assets of
100 mn FFr would be 5mn FFr.
• Translation principles in many countries are
often a complex compromise between
historical and current market valuation.
Historical exchange rates can be used for
certain equity accounts, fixed assets and
inventory items while current exchange
rates can be used for current assets, current
liabilities, income and expense items.
• Current Rate Method
• The current rate method is the most
prevalent in the world today. Under this
method, all financial statement line items
are translated at the current exchange rate
with few exceptions.
• Assets and liabilities: All assets and
liabilities are translated at the current rate of
exchange; that is, at the rate of exchange in
effect on the balance sheet date
• Income statement items: All items,
including depreciation and cost of goods
sold are translated at either the actual
exchange rate on the dates the various
revenues, expenses, gains and losses were
incurred or at an appropriately weighted
average exchange rate for the period.
• Distributions: Dividends paid are translated
at the exchange rate in effect on the date of
payment
• Equity items: Common stock and paid in
capital accounts are translated at historical
rates. Year-end retained earnings consist of
the original year-beginning retained
earnings plus or minus any income or loss
for the year.
• Gains or losses caused by translation
adjustments are not included in the
calculation of consolidated net income.
Rather, translation gains or losses are
reported separately and accumulated in a
separate equity reserve account (on the
consolidated balance sheet) with a title such
as cumulative translation adjustment (CTA).
• The biggest advantage of the current rate
method is that the gain or loss on translation
does not pass through the income statement
but goes directly to a reserve a/c. This
eliminates the variability of reported
earnings due to foreign exchange translation
gains or losses. A second advantage of the
current rate method is that the relative
proportions of individual balance sheet
accounts remain the same.
• Monetary and Non-monetary method.
• Monetary assets (these are primarily cash,
marketable securities, accounts receivable and
long-term receivables) and monetary liabilities
(primarily current liabilities and long-term debt)
are translated at current exchange rates
• Non-monetary assets and liabilities (primarily
inventory and fixed assets) are translated at
historical rates
• Income statement items: Average exchange
rate for the period except for depreciation
and cost of goods sold ( which are directly
associated with non monetary assets or
liability). These are translated at historical
rate.
• Temporal Method
• This method is same as monetary and non
monetary method. Only difference is that
inventory is translated at current rate if
inventory is shown in the balance sheet at
market value. ( in the above method it is
translated at historical value)
 Operating exposure
• Operating exposure also known as
economic exposure. This exposure refers to
the degree to which a firms present value of
future cash flows can be influenced by
exchange rate fluctuations.
• Deals with impact of exchange rate on the
firms future cash flows from operations
which are not fixed in either home currency
or foreign currency.
• Neither the prices nor quantities of outputs
or inputs are fixed and all are subject to
change when exchange rate changes.
• Economic exposure is a more managerial
concept that an accounting concept . a
company can have an economic exposure to
say pound/rupee rates even if it does not
have any transaction or translation exposure
in the british imports. If the pound weakens,
the company loses its competitiveness.
• The economic exposure to an exchange rate
is the risk that a variation in the rate will
affect the companies competitive position in
the market and hence its profits .
• It affects the profitability of the company
over a larger time span than transaction or
translation exposure .
• . under the Indian exchange control ,
economic exposure cannot be hedged while
both transaction and translation can be
hedged.
• operating exposure to currency risk depends
on the effect of unexpected
• changes in the exchange rate on the firm’s
output prices (e.g., product prices) and input
costs (e.g., raw materials, labor costs, etc.).
 Diff bet transaction and economic
exposure
• Contract specific • General, relates to
entire investment.
• Cash flow loss can be • V difficult to compute
easily computed opportunity losses.
• Co’s do have policies • Do not have any
to cope up with it policies to cope up.
• Duration is same as • Relatively longer
time period of contract duration
• MANAGING ECONOMIC EXPOSURE
1 Marketing Initiatives
A Market selection;
B Product strategy
C Promotional strategy
D Pricing strategy
• 2 Production initiatives
• A Input mix
• B shifting production among plants
• C Plant location
• D Raising productivity