Foreign Exchange Risk

Management
 Exchange Risk
Foreign exchange risk is the possibility of a gain or
loss to a firm that occurs due to unanticipated
changes in exchange rate.
The risks arise because multinational corporations
operate in multiple currencies.
But firms who have a diversified portfolio find
that the negative effect of exchange rate
changes on one currency are offset by gains in
others i.e. exchange risk is diversifiable.
 Foreign Exposure Management
It is the measure of the sensitivity of changes in the real
domestic currency value of assets, liabilities, or
operating incomes to unanticipated changes in
exchange rates
Foreign Exchange exposure may broadly be classified into:
• Translation exposure
• Transaction exposure
• Operating exposure
• Economic exposure
 Translation Exposure
It is also known as accounting exposure. It arises
when items of financial statements that are
stated in foreign currencies are restated in the
home currency of an MNCs.
The magnitude of translation exposure is
determined by the extent of changes in the
exchange rates between the home currency of
the parent unit and the local currencies in which
the accounts are prepared by the subsidiaries.
 Methods of Translation methods
• Current/Noncurrent method:
– The values of all the current assets and liabilities
of a foreign subsidiary are translated into the
home currency of the parent company at the
current spot exchange rate.
– Noncurrent assets and liabilities are translated at
the historical exchange rate, that is the acquisition
rate of asset or a liability item incurred.
• Monetary/non monetary method: where assets
and liabilities are classified as monetary and non-
monetary items.
– Monetary assets represents a claim to receive and
monetary liabilities involve an obligation to pay.
– Nonmonetary assets and liabilities are those that do
not have contractual payoffs.
Monetary items are translated at the current spot
exchange rate and nonmonetary items are translated
at historical rates.
• Temporal method: the choice of the exchange
rate is based on whether the balance sheet
item is evaluated at historical cost or market
value.
– if an item is originally stated at historical cost, its
translation is carried out at the historical spot rate
of exchange.
– If the item is stated at market value, translation is
carried out at the current spot rate of exchange.
• Current rate method: all the items of the
balance sheet and income statement are
translated at the current spot rate of
exchange. Therefore different items of
accounts will remain the same.
 Transaction Exposure
It refers to the effect of exchange rate movement associated
with the time-gap between the date of the transaction and
the date on which the consideration is settled.
Transaction exposure arises from:
• Purchasing or selling on credit goods and services when
prices are stated in foreign currencies.
• Borrowings or Lending's funds when repayment is to be
made in a foreign currency.
• Acquiring assets or incurring liabilities denominated in
foreign currencies.
 Economic Exposure
It measures the impact of an exchange rate
change on the net present value of expected
future cash flows from a foreign investment
projects.
It is an unanticipated change in exchange
rate, which has an impact on the potential of an
organization to perform.
 Operating exposure
It is the sensitivity of future operating cash flows
to unexpected changes in the foreign
exchange rate.
It involves decision making with respect to plant
location, sourcing of raw materials,
production, technology, pricing of products,
product development and selection of
markets.
Operating exposure depends on..

• Change in nominal exchange rate

• Change in selling price
• Change in output quantity
• Change in operating cost
 Hedging Instruments
There are four instruments multinational
companies predominantly use for hedging their
foreign exchange exposure (Transaction
exposure).
• Forwards
• Futures
• Options
• Swaps
Steps in exposure management strategy
It involves four steps:
• Forecasting the degree of exposure in each major currency in
which the MNC operates.
• Developing a reporting system to monitor exposure and
exchange rate movement to assist in protecting the MNC from
risk.
• Assigning responsibility for hedging exposure and determining
whether to centralize or decentralize exposure management.
• Selecting appropriate hedging tools including diversification of
the MNC’s operations, a balance sheet hedge, and exposure
netting.
 Strategies for Exposure Management
• Low Risk: Low Reward
It is the simplest way of approach or manage
exposure but may not be considered the best strategy.
All exposure are hedged in the forward market as
soon as they occur without considering whether it is
the best choice. Under this strategy the company
knows its cash flow receipts with certainty and the
cost associated with it.
• Low Risk: Reasonable Reward
The company can opt this strategy only when it feels
that it can spend more time and effort and also
hedging is adopted if it feels that it can avoid more loss
with hedging.
The rewards on the other hand are more as company
puts lot of serious efforts to quantify the future
expectations and then decides to hedge. More over the
rewards depends upon the accuracy of the prediction.
• High Risk: Low Reward
when the company leaves movement of
foreign currencies open and decides not to
hedge any exposure, it obviously takes very high
risk. Since the exposure are always kept open,
rewards are uncertain, cash flows are not stable,
but the advantage is management need not
spend any time to manage their exposure.
• High Risk: High Reward
This strategy involves active trading in the currency
market through continuous cancellations and re-
bookings of forward contracts. It is the most
aggressive method of managing exposure.
Frequent booking and cancellations to get the best
rate for the exposures increases transaction costs
and generally adopted by large companies.
Exposure Management Techniques
EMT
Internal External
Netting Forward contracts
Matching Short-term borrowings
Leading & Lagging Discounting
Pricing policies Factoring
Asset & Liability Mgt. Govt. exchange risk
guarantees
 Internal Techniques
• Netting: it is a technique of optimizing cash flow
movements with the joint efforts of subsidiaries and is
typically used by companies with a number of affiliates in
different countries.
A netting agreement is a contract where by each party agrees to
set off amount it owes against amount owed to it.
The process involves the reduction of administration and
transaction costs that result from currency conversion.
Overall exposure netting is a portfolio approach to hedging,
according to which a firm may manage its trade transaction in such
a way that exposures in one currency will be offset by exposures in
the same or other currencies.
• Matching: the terms netting and matching are
often used interchangeably. But the netting
used only for inter company flows.
Matching can be applied to both third party as well
as inter-company cash flows, and it can be used by
the exporters/importers as well as multinational
company.
• Leading and Lagging: it refers to the adjustment of
intercompany “Credit Term”.
– Leading: Prepayment of a trade obligation
– Lagging: a delayed payment.
Leading and Lagging can be used as part of either a risk-
minimizing strategy to facilitate matching or an aggressive
strategy to maximize expected exchange gains.
Overall shifting the timing of receipt or payment of
foreign currency in accordance with expectations of
future exchange rate movements.
• Asset and Liability Management: this
technique can be used to manage balance
sheet, income statement or cash flow
exposure.
They can be used aggressively or defensively.
 External Techniques
• Forward Exchange: forwards exchange contracts
are derivatives which can be used for exchange
rate risk management. It helps to lock the price
and give definite amount of cash flows exposure
• Short term borrowings: an alternative to hedging
on the forward market is the short term borrowing
technique. A company can borrow either dollar or
some other foreign currency or the local currency
to manage exposed difficulty and exchange rate.
• Discounting: discounting can be used to cover
only export receivables. It cannot be used to
cover foreign currency payables or to hedge a
translation exposure.
Where an export receivables is to be settled by bill
of exchange the exporter can discount the bill and
thereby receive payment before the receivable
settlement date.
• Factoring: it means the receivables can be assigned as
collateral for selected bank financing under which
circumstance such as service will give protection against
exchange rate changes.
• Government exchange risk guarantees: to encourage
exports, government agencies in many countries offer
their exporters insurance against export credit risk and
special export financing schemes like
– Risk insurance to their exporters
– Export credit guarantees
– Exchange risk guarantee schemes
Working Capital Management
 Meaning
It is the process of planning and controlling the
level and mix of current assets of the firm as
well as financing of these assets.
Both MNCs and domestic firms are essentially
concerned with selecting that combination of
inventory, accounts receivable and cash that
will maximize the value of the firm.
Basic difference between domestic and
international working capital management is
the impact of currency fluctuations, differing
rate of inflation, potential exchange controls
and multiple tax jurisdiction on these
decisions.
 International Cash Management
Cross-border movements of funds, from and to
other companies as well as within the
company.
It is related to two things:
the movement of money and
the movement of information relating to the
movement of money
 Objectives of an Effective International Cash
Management System
• Minimize the currency exposure risk
• Minimize the country and political risk
• Minimize the overall cash requirements of the
company as a whole without disturbing the
smooth operations of the subsidiary or its
affiliate.
• Minimize the transactions costs.
• Full benefits of economies of scale as well as the
benefit of superior knowledge.
Techniques to optimize Cash Flow (Generate
Working Capital)
• Accelerating cash inflows
• Managing blocked funds
• Leading and lagging strategy
• Using netting to reduce overall transaction
costs by eliminating a number of unnecessary
conversations and transfer of currencies
• Minimising the tax on cash flow through
international transfer pricing
• Centralized Cash Management: the cash
management of the entire MNC is vested in a
centralized cash depository, which may be a
special corporate entity. It acts as a netting
centre as well as the depository of all surplus
funds of a subsidiary unit.
• Decentralized Cash Management: when the
cash management is left to the affiliates, each
subsidiary has to take on the entire
responsibility of cash management, including
short-term investment.
 Receivables Management
They are also known as accounts receivables, trade
receivables or customer receivables.
But the major costs that are associated with credit sales.
• The cost for the use of the funds to carry accounts
receivables (financing costs)
• Administrative expenses (costs for credit investigation
and supervision).
• Credit collection costs
• Bad-debt losses.
Factoring: It is another way to minimize
accounts receivables risks from changes in
exchange rates between the sale date and the
collection date.
Multinational accounts receivables are created
by two separate types of transaction:
Sales to outside the corporate group and
Intra-company sales
 Inventory Management
Firms hold inventory for different purposes,
which may be broadly categorized as
transaction, precautionary and speculative
purposes. A firm may hold inventory to meet
its day to day business requirements.
While deciding on the level of inventory, the
management of the firm should consider the
costs of holding inventory as well as the
benefits derived from it.
Inventory is broadly classified as raw materials,
work-in-process, supplies and finished goods.
Supplies inventory which includes office
materials, plant maintenance materials and
those items that do not directly enter
production, but are necessary for production
and maintenance.
 Economic Order Quantity
It is used to determine the optimal level of inventory. The total
costs of inventory broadly consists of order costs and
carrying costs.
The order costs increase with the number of orders placed.
The higher the frequency of orders placed for the inventory,
the higher the order costs.
A high order quantity leads to higher carrying costs but lower
order costs
A low order quantity leads to lower carrying costs but higher
order costs.
EOQ model balances order costs against carrying costs.
Management of Cash and near cash assets

It includes four steps:

1. Assessment of cash requirement
2. Optimization of cash needs through
restructuring of cash flows
3. Selection of the source of funds
4. Investment of surplus cash into near cash
assets.
If investment of cash surplus is done then, the
effective rate of return can be expressed as
r = (1+if) (1+ef) – 1
Where,
if = interest rate on foreign currency investment
ef = changes in the exchange rate
Problem:
If an US company invests its cash in the Canadian market
where the interest rate is 6% as compared to the
interest rate of 4% in the US. If the Canadian dollar
depreciates during the period by say 5%, the effective
return will be:
r = (1+0.06) (1+(-0.05) – 1
= 0.7%
Which is very less return, hence US company will not
invest in Canadian market.