MNFM Lecture 4 Slides - Exchange Rate Fluctuation and Managing Forex Exposure

International Financial Management
Lecture 4
Exchange Rate Fluctuation &

Managing Forex Exposure
Dr. Said El Salmy

September 2018
Exchange Rate Fluctuations Affect Everyone
 An exchange rate is an expression of the price of a

currency against another currency.
 Like any commodity, a currency price may fluctuate

and can go up and down.
 Fluctuations in currencies prices affect everyone,

directly or indirectly.
 Direct effects of exchange rates fluctuations are

evident in:
a. Foreign trade cash flows due to:

1. Increase or decrease in payments by importers for
goods and services sourced from other countries.
2. Increase or decrease in receipts by exporters for

goods and services sold to other countries.
b) Investments cash flows due to:

1. Increase or decrease in values of investments in
equities, bonds bank deposits, real estate and
other assets and properties.
2. Increase or decrease in values of investments

income from dividends on equities, interest on
bonds and bank deposits, rents from real estate
and other properties.
 Indirect effects of exchange rates fluctuations are

evident in:
1. Higher or lower prices paid to buy foreign goods

and services due to change in local currency
exchange rate.
2. Increase or decrease of inflation and in cost of

living due to higher or lower prices of foreign
goods and services.
Exchange Rate Fluctuations
Impact Financial Results
 Exchange rates fluctuations could bring gains to

some and losses to others but they pose a risk to all.
 All businesses regardless of their nature, location or

size are exposed to the risk of currencies exchange
rate fluctuations even though in varying degrees.
 Similarly, investors who deal or invest in foreign

currencies are exposed to the risk of currencies
exchange rate fluctuations in varying degrees.
 Importers and exporters of goods and services paid for

in foreign currencies are exposed to changes in the
exchange rates of the foreign currencies they pay or
receive. They may gain and they may lose.
 Similarly, investors in transactions in foreign currencies

are exposed to changes in the exchange rates of the
foreign currencies they pay or receive. They may gain
and they may lose.
 A simple example is a company who had $100,000 in its

Egyptian bank account.
 On November 16, 2016 US$/EGP rate was 8 pounds and

the equivalent of $100,000 was EGP 800,000.
 On November 17, 2016 the pound was floated and the

US$/EGP rate became 16 pounds and $100,000 would
yield EGP 1,600,000. The local currency value of the
company’s dollars in the bank doubled due to change of
the exchange rate.
 Another example is a company who had EGP 800,000 in

its bank account.
 On November 16, 2016 US$/EGP rate was 8 pounds and

the dollar equivalent of EGP 800,000 was $100,000.

US$/EGP rate became 16 pounds and EGP 800,000
would yield $50,000. The dollar value of the company’s
EGP balance in the bank was halved due to change of
the exchange rate.
 Domestic companies exposure to foreign currencies

fluctuations is usually limited and indirect.
 Domestic companies are usually involved in no or

limited foreign currency transactions.
 Domestic companies balance sheets usually show

assets and liabilities denominated in local currency
only.
 International companies are engaged in extensive

foreign currencies transactions.
 Therefore, international companies financial statements

are mainly foreign currency denominated, as:
1. The balance sheet shows assets and liabilities in a
mix of currencies.
2. The income statement shows revenues and costs
in a mix of currencies.
3. The cash flow statement shows cash flows in a mix
of currencies.
 The components of foreign currency denominated

financial statements will all be impacted with changes
in the relationship between:
a. The foreign currencies in which the transactions

took place and were recorded,
b. The company’s home currency in which activities

are reported and financial statements are published.
 Unmanaged foreign exchange rate fluctuations will

impact and distort firms core business results and
expose investors value to risk.
 With proper management, foreign exchange risks

can be minimized and mitigated, and the impact on
business results can be reduced.
 If not managed properly, foreign exchange risks will

lead to:
a. Distortion of business results
b. Wrong evaluation of business components
c. Wrong decisions on direction, location of
activities and projects
d. Losses in shareholders and investors value
e. Loss of the entire business in worst case
scenarios
Income Statement for Year Ending 31/12/2015
International International
Company X Company Y
Domestic operations net $18,000,000 ($20,000,000)

income
Foreign operations net ($14,000,000) $24,000,000

income
Combined net income $4,000,000 $4,000,000

Foreign Operations NI for Year Ending 31/12/2015
Analysis
International International
Company X Company Y
Foreign operations core income $30,000,000 ($16,000,000)
Foreign operations exchange ($44,000,000) $40,000,000

rate gains/(losses)
Foreign operations net income ($14,000,000) $24,000,000

Impact Financial Results – The Examples
 Exchange loss in Company X foreign operations

masked the strength of the core foreign business
and gave a misleading net loss.
 Exchange gain in Company Y foreign operations

masked the weakness of the core business and gave
a misleading net profit.
 In both cases, the misleading results could influence

wrong decisions to the detriment of the company
and the shareholders.
Exchange Rate and
Dual Currency Reporting
 Management, investors and other stakeholders are

interested in a company’s results in the company’s
home currency rather than in the local currencies it
does business in.
 For example, an investor in Pfizer (USA) is interested

in Pfizer’s results in Egypt or in China or Japan as
measured in US dollars rather than in Egyptian
pound, Chinese yuan or Japanese yen.
Exchange Rate and
 Foreign branches and subsidiaries of MNCs transmit

business results to parent in periodical (monthly,
quarterly, yearly) reports.
 Parent combines domestic and foreign business

results in consolidated statements for the entire
company in home office currency.
 For consolidation purposes, foreign currency

reports are translated to home office currency.
Exchange Rate and
 To enable consolidation, subsidiaries in foreign

countries use a dual currency accounting system:
a. One is the functional currency,

b. The second is the reporting currency.
 Dual currency accounting system enables production

of financial reports in home office currency for further
consolidation.
Functional Currency Vs.
Reporting Currency
 Functional currency is the currency of the country in

which the affiliate or the subsidiary operates.
 Therefore, functional currency of an affiliate of a US

corporation in Japan is the Japanese yen, and of an
affiliate of the same corporation operating in China
is the yuan, and so on..
 Reporting currency is parent’s home currency, in

this case the US dollar.
Functional Currency Vs.
Reporting Currency
 Dual currency accounting system works in the

following sequence:
1. Branches and subsidiaries in foreign locations

record their transactions in functional currency,
which is the foreign location currency.
2. Statements are translated to reporting currency.
3. Translated statements are sent to home office.

Current & Historical Exchange Rates
 Translation from functional currency to reporting

currency is done using two methods:
1. Current exchange rate method

2. Historical exchange rate method
 Company’s policy determines the translation method

used which becomes constant and doesn’t change
without management approval and auditors consent
and for good reasons.
 Income and expense items are translated from

functional currency to reporting currency at current
month exchange rate.
 New balance sheet items (assets & liabilities) are

translated at the exchange rate for the month they
are created.
 Carried forward balance sheet items need to be re-

translated to be carried forward to the following
period.
 For re-translation of carried forward balance sheet

items, one of two exchange rates is used:
1. Current exchange rate

2. Historical exchange rate
 Company policy determines which of the two

translation methods is applied.
1. Current Exchange Rate Method
 Under current exchange rate method, balance sheet

items carried forward are re-translated from the local
currency value to home currency value at the current
exchange rate for the reporting month.
 As a result, re-translated values in home currency will

change up or down depending on the exchange rate
movement between the reporting dates.
1. Current Exchange Rate Method
 Effects of changes in re-translated values are:
1. Translation gains or losses will be realized, which

lead to increase or decrease in accounting net profit.
2. Cash flow is not affected directly by translation gains

or losses as they are of accounting nature.
3. Cash flow will be affected with higher or lower tax and

dividends payments on higher or lower profits due to
translation gains or losses.
Current Exchange Rate Method - Example
 On October 31, 2016 the balance sheet of the Egyptian

branch of a US company showed cash balance in the
bank in the amount of EGP 800,000. Exchange rate was
EGP 8/$1.
 For October reports, EGP 800,000 cash balance was

translated to $100,000.

exchange rate became EGP 16/$1.
Current Exchange Rate Method - Example
 For November reports, the cash balance carried forward

from October was the same EGP 800,000 but translated
at the then current exchange rate of EGP 16/$1.
 The re-translated dollar value of the cash balance at the

end of November is reduced to $50,000 from $100,000 in
the previous month’s reports.
 Result is a translation loss of $50,000 between the two

reporting dates.
2. Historical Exchange Rate Method
 Under historical exchange rate method, carried

forward balance sheet accounts are maintained at
the same historic values, regardless of changes in
exchange rate between reporting dates.
 At historical rates, carried forward balance sheet

accounts are not affected by exchange rate
fluctuations until the asset is disposed of.
 In historical rates method, exchange gains or losses

are recognized when the asset is disposed of.
Historical Exchange Rate Method –
Example
 Egypt branch of a US company purchased a building

in January 2000 for EGP 5 million and exchange rate
was EGP 5/$1.
 In March 2017 the company sold the building for

EGP 9 million and exchange rate was EGP 18/$1.
 The company translates asset accounts at historical

exchange rate.
 Illustrate the company’s gain or loss from the asset.

Historical Exchange Rate Method – Solution
1. The asset will be maintained at the same book value

recorded in Jan. 2000 being EGP 5MM and $1MM
2. At sale time, the cost being EGP 5MM translated at 18/1

rate equals $277,778. Result is exchange loss of $722,222
3. Sales price of EGP 9 million is $500,000 at 18/1 rate
4. Gain in selling price is EGP 4 million equal to $222,222 at

18/1
5. Net exchange gain/loss in dollars is a loss of $500,000

(loss $722,222 less gain $222,222).
Historical Exchange Rate Case
In January 2000 In March 2017
Exchange rate EGP 5/$1 Exchange rate EGP 18/$1

$
Building EGP US$ Building EGP US$ Gain/(Loss)
Revaluation
of book
Book value 5,000,000 1,000,000 value 5,000,000 277,778 (722,222)
Selling price 9,000,000 500,000
Selling Gain 4,000,000 222,222 222,222
Net gain/
(loss) (500,000)
Foreign Currency Exposures
 As explained, foreign currency exposures lead to

gains or losses from exchange rate fluctuations.
 Foreign currency gains distort the business results

and disguise operating weaknesses.
 On the other hand, foreign currency losses could

wipe out core business profits and destroy firm and
shareholders value.
 Foreign currency exposure must be managed.

Managing Foreign Currency Exposures
 Managing foreign currency exposures requires

regular review of business activities and of related
current and future conditions to:
a) Ensure the availability of adequate resources

and means to deal with these exposures.
b) Mitigate or minimize the effects of such

exposures.
Types of Foreign Currency Exposures
 Foreign currency exposures are classified in the

following two types:
1. Translation exposure
2. Transaction exposure
Forex Fluctuation Risks
Translation Transaction
exposure exposure
1. Translation Exposure
 As explained, translation exposure involves balance

sheet accounts carried forward from one period to
another.
 Translation exposure is specific and can be calculated

accurately.
 Translation exposure results in accounting gain or

loss with no direct impact on cash flows.
 Translation gain or loss lead to higher or lower tax and

dividends payments, which affect cash flows indirectly
Case on Translation Gains & Losses
 Mad Max Corporation of USA has a branch in Egypt.

 Functional currency of the branch is the EGP and
reporting currency is the US dollar.
 For translation purposes, company applies:
 Historical exchange rate in translating fixed assets
and equity.
 Current exchange rate in translating all other
balance sheet accounts.
(continued)
Case on Translation Gains & Losses
 On Oct. 31, 2016 the exchange rate was EGP 8/1$.

 In November 2017 the pound was floated and the
exchange rate on Nov. 30, 2016 became 16/1.
 By reference to the branch’s balance sheet at Oct.
31, 2016 do the following:
1. Calculate the translation gain or loss resulting
from the change of the exchange rate between the
two reporting dates.
2. Explain the impact of the translation gain or loss
on the company’s cash flows.
Mad Max Egypt Branch
Balance Sheet as at October 31, 2016
(A Gain Situation)
Assets: Amount L.E. Liabilities: Amount L.E.
Land 2,500,000 Bank loans 10,000,000
Equipment 10,500,000 Bonds 4,000,000
Other fixed assets 3,500,000 Net equity 10,500,000
Cash in banks 500,000 Bank overdraft 1,100,000
Receivables 5,000,000 Payables 700,000
Inventory 4,500,000 Accruals 200,000
Total assets 26,500,000 Total liabilities 26,500,000
Mad Max Egypt Branch Balance Sheet
As At Oct. 31, 2016 Historic (H)/ As At Nov. 30, 2016 Exchange
Exchange Rate Current (C) Exchange Rate Gain/
EGP 8/US$ Translation EGP 16/US$ (Loss)
Assets
Fixed Assets EGP US$ Translation EGP US$ US$
Land 2,500,000 312,500 H 2,500,000 312,500 0
Equipment 10,500,000 1,312,500 H 10,500,000 1,312,500 0
Other F. Assets 3,500,000 437,500 H 3,500,000 437,500 0
Current Assets 0
Cash in Banks 500,000 62,500 C 500,000 31,250 (31,250)
Receivables 5,000,000 625,000 C 5,000,000 312,500 (312,500)
Inventory 4,500,000 562,500 C 4,500,000 281,250 (281,250)
Total Assets 26,500,000 3,312,500 26,500,000 2,687,500 (625,000)
Liabilities
Bank loans 10,000,000 1,250,000 C 10,000,000 625,000 625,000
Bonds 4,000,000 500,000 C 4,000,000 250,000 250,000
Net Equity 10,500,000 1,312,500 H 10,500,000 1,312,500 0
Bank
overdrafts 1,100,000 137,500 C 1,100,000 68,750 68,750
Payables 700,000 87,500 C 700,000 43,750 43,750
Accruals 200,000 25,000 C 200,000 12,500 12,500
Total Liabilities 26,500,000 3,312,500 26,500,000 2,312,500 1,000,000
Net Forex Gain/
(Loss) 375,000
Equity increase
with Forex gain 375,000
Total Liabilities
w/forex gain 2,687,500
Mad Max Egypt Branch
Balance Sheet as at October 31, 2016
(A Loss Situation)
Assets: Amount L.E. Liabilities: Amount L.E.
Land 2,500,000 Bank loans 5,000,000
Equipment 10,500,000 Bonds 1,000,000
Other fixed assets 3,500,000 Net equity 18,500,000
Cash in banks 500,000 Bank overdraft 1,100,000
Receivables 5,000,000 Payables 700,000
Inventory 4,500,000 Accruals 200,000
Mad Max Egypt Branch Balance Sheet
Assets
Land 2,500,000 312,500 H 2,500,000 312,500 0
Equipment 10,500,000 1,312,500 H 10,500,000 1,312,500 0
Other F. Assets 3,500,000 437,500 H 3,500,000 437,500 0
Current Assets 0 0
Cash in Banks 500,000 62,500 C 500,000 31,250 (31,250)
Receivables 5,000,000 625,000 C 5,000,000 312,500 (312,500)
Inventory 4,500,000 562,500 C 4,500,000 281,250 (281,250)
Total Assets 26,500,000 3,312,500 26,500,000 2,687,500 (625,000)
Liabilities
Bank loans 5,000,000 625,000 C 5,000,000 312,500 312,500
Bonds 1,000,000 125,000 C 1,000,000 62,500 62,500
Net Equity 18,500,000 2,312,500 H 18,500,000 2,312,500 0
Bank overdrafts 1,100,000 137,500 C 1,100,000 68,750 68,750
Payables 700,000 87,500 C 700,000 43,750 43,750
Accruals 200,000 25,000 C 200,000 12,500 12,500
Total Liabilities 26,500,000 3,312,500 26,500,000 2,812,500 500,000
Net Forex Gain/
(Loss) (125,000)
Equity increase
with Forex gain (125,000)
Total Liabilities
w/forex gain 2,687,500
Solution Explained
 The gain situation is primarily due to:
1. The saving in the dollar equivalent of the large bank

loan liability following translation at current
exchange rate.
2. The smaller equity which is maintained at historical

rate.
Solution Explained
 The loss situation is primarily due to:
1. The smaller bank loan which resulted in a smaller

saving in the dollar liability following translation at
current exchange rate.
2. The larger equity which is maintained at historical

rate.
Solution Explained
 No direct cash flows result from translation gains or

losses. Accounting results only.
 Translation loss reduces taxable income which leads

to indirect positive cash flow from lower tax but
leaves more after tax dividends for payment.
 Translation gain raises taxable income which leads to

indirect negative cash flow from higher tax but leaves
less after tax dividends for payment.
Composite Case on Translation Gain or Loss
Functional currency of Egypt branch of an American company is

the Egyptian pound. The branch provides monthly reports to
home office in US dollars. Below is the branch balance sheet as
at October 31, 2016 when exchange rate was EGP8/$1:
Assets Amount EGP Liabilities Amount EGP

Machinery 2,500,000 Net equity 10,500,000
Office building 3,500,000 Long term loan 4,000,000
Factory building 10,500,000 Bank overdraft 10,000,000
Cash in banks 500,000 Other payables 1,800,000
Receivables 5,000,000 Accruals 200,000
Inventory 4,500,000
 In November 2016 the Egyptian pound was floated and the

exchange rate became EGP16/$1.
 In March 2017 the company sold the office building for
EGP 9 million and moved to a rented office.
 At the time of selling the office building the exchange rate
was EGP 16/$1 against EGP 8/$1 in 2010 when the building
was acquired.
 In August 2017 the company settled the long term loan. At
the date of settlement the exchange rate was EGP 16/$1
against EGP 8/$1 in 2010 when the loan was obtained.
 For translation purposes, the company applies current
exchange rate to all balance sheet accounts except fixed
assets, equity and long term loans which are maintained at
historical exchange rates.
 You are the CFO of the branch and you are required to
provide the home office with a report containing the
following information:
a. Calculation of translation gain or loss recognized in
the branch’s November 30, 2016 reports following the
floatation of the EGP.
b. Calculation of the gain or loss realized from selling the
office building.
c. Calculation of the gain or loss realized from settlement
of the loan.
d. Explanation of the impact of exchange gain or loss on
company’s cash flow.
Solution: A- Translation Gain/(Loss)
Broken Chair Company - Egypt Branch
Assets
Machinery & equipment 2,500,000 312,500 H 2,500,000 312,500 0
Office building 3,500,000 437,500 H 3,500,000 437,500 0
Factory building 10,500,000 1,312,500 H 10,500,000 1,312,500 0
Cash in Banks 500,000 62,500 C 500,000 31,250 (31,250)
Receivables 5,000,000 625,000 C 5,000,000 312,500 (312,500)
Inventory 4,500,000 562,500 C 4,500,000 281,250 (281,250)
Total Assets 26,500,000 3,312,500 26,500,000 2,687,500 (625,000)
Liabilities
Net Equity 10,500,000 1,312,500 H 10,500,000 1,312,500 0
Long term bank loan 4,000,000 500,000 H 4,000,000 500,000 0
Bank overdrafts 10,000,000 1,250,000 C 10,000,000 625,000 625,000
Other payables 1,800,000 225,000 C 1,800,000 112,500 112,500
Accruals 200,000 25,000 C 200,000 12,500 12,500
Total Liabilities 26,500,000 3,312,500 26,500,000 2,562,500 750,000
Net Forex Gain/(Loss) 125,000
Equity increase w/
Forex gain 125,000
Total Liabilities w/forex
gain 2,687,500
Solution: B-
1. Office Building
Acquisition in 2010 (EGP8/$1) Revaluation in 2017 (EGP16/$1)
Book Translation
value EGP $ Book value EGP Translation $ Gain/(Loss) $
Office
building 3,500,000 437,500 3,500,000 218,750 (218,750)
Sale in 2017 (EGP16/$1)
Sale
Book Sale Price Gain/(loss) Sale Gain/(loss) Translation Gain/Loss $
value EGP EGP EGP $ $ Net Gain/(Loss) $
Office
building 3,500,000 9,000,000 5,500,000 343,750 (218,750) 125,000
2. Bank Loan
Loan in 2010 (EGP8/$1) Revaluation in 2017 (EGP16/$1)
Book Translation
value EGP $ Book value EGP Translation $ Gain/(Loss) $
Bank
loan 4,000,000 500,000 4,000,000 250,000 250,000
Settlement in 2017 (EGP16/$1)
Acquisition in 2010 (EGP8/$1) Revaluation in 2017 (EGP16/$1)
Settlement
Book Settlement Gain/(loss) Settlement
value EGP EGP EGP Gain/(loss) $ Translation Gain/Loss $ Net Gain/(Loss) $
Bank
loan 4,000,000 4,000,000 0 0 250,000 250,000
C- Impact on cash flow:

 Translation gain or loss has no impact on cash flow.
 In Egypt, cash flow impact will be:
• Tax will be paid on EGP 5,500,000 gain from office building
sale. This is a cash flow burden.
 In USA, cash flow impact will be:

• Tax will be paid on $125,000 net gain from the building and
on $250,000 gain from the bank loan settlement. This is a
cash flow burden.
• Increased tax will result in lower after tax profits and less
dividends for payment. This is a cash flow saving.
2. Transaction Exposure
 Exists when a company is involved in transactions

yielding future foreign currency cash in or out flows.
 Results from changes in the exchange rates of the

currencies in which a company conducts its buying,
selling, investing or financing transactions.
 Relates to future events which cannot be predicted

precisely.
 Due to future uncertainty, transaction exposure can

only be estimated, correctly or wrongly.
Transaction Exposure
 Examples of transactions exposure:
1. Receiving sales revenues in foreign currencies
2. Paying for purchases in foreign currencies
3. Servicing foreign currencies debt
4. Redemption of outstanding debt

 In spot transactions such as spot sales and spot

purchasing there is no time gap between:
1. Entering the deal, and
2. Settling the value in cash.
 In spot foreign currencies transactions the buyer

and the seller are saved the risk of fluctuation in
exchange rates.
 Spot settlement eliminates transaction exposure.

 In a deferred payment transaction there is a time gap

between entering the deal and making the settlement
in cash.
 If the transaction is in foreign currency, the buyer

and the seller are exposed to the risk of fluctuations
in exchange rate. One gains and the other loses.
 The risk involves a change in the amount in home

currency of the receivable (cash inflow) or of the
payable (cash outflow) between the date of entering
the deal and the date of settlement.
Managing Transaction Exposure
 Transaction exposure need to be managed to avoid

or minimize the risk of exchange rate fluctuations.
 Managing risk, however, is done for a price, which

requires balancing between the risk and the cost of
avoiding it.
 Derivatives are popular tools in managing risks

relating to forex fluctuations and to supply/demand
exposures. Hedging is the derivative of choice to
manage most of these exposures.
What Are Derivatives?
 Derivatives are contracts that “derive” their

value from a material reference that could be:
1. An underlying asset (a stock, bond, or currency)
2. A reference rate (such as a 90-day Treasury Bill

rate)
3. Index (such as S&P 500 stock index)
4. A commodity (crude oil, gold, platinum...)

 Derivatives are examples of new breed of financial

instruments that differ from traditional instruments
and part with conventional rules of investing.
 Derivatives include various types of futures and

options applications.
 Hedging is a derivatives popular application.

 Derivatives go against the norms of traditional

investing.
 Derivatives are more like gambling as they center on

investors betting on future events to happen or not.
 Derivatives are like medicines that cure diseases if

used properly, but kill the patient if used in wrong
conditions or without experience.
What Derivatives Are Used For?
 Derivatives can be used by investors and companies

to manage risk exposures related to availability or
price movements of foreign exchange, securities or
commodities.
 This is a “defensive” and benign use of derivatives

meant to avoid or minimize risk exposures.
What Derivatives Are Used For?
 Derivatives can also be used by speculators to make

profit on price movements of currencies, securities
or commodities.
 This is an “aggressive” and malignant use of

derivatives to make profits from exposure to risk.
What Are Futures Contracts?
 Futures are available for key currencies including the

US dollar, the pound sterling, euro, Swiss franc, yen.
 Futures are also available for securities and for

commodities such as crude oil, copper, cocoa etc..
 Futures contracts are traded in exchanges (regulated

markets) for specific quantities of the underlying
assets (currency, security or commodity).
Short and Long Positions
In Futures Contracts
 Futures contracts involve two parties:
1. A buyer who is taking a “long position”

2. A seller who is taking a “short position”
 The trading exchange is the other party in the

contract and the investor is either buyer or seller.
 Shorting is when:
a. An investor believes that the price of an asset (a

currency, stock or commodity) will go down in the
future.
b. The investor doesn’t have the asset.
c. The investor enters a contract to sell the asset at

current price hoping that he can buy it later (cover
his position) at a lower price.
 If price goes down, the seller gains the difference

between the price at which he short sold the asset and
the lower spot price at which he buys the same asset
sometime in the future.
 If price goes up, the investor incurs a loss.

 By going long, the investor enters a contract to buy an

asset as he believes that price will go up in the future.
 If price goes up, the buyer gains the difference

between the price at which he bought the asset and
the higher spot price at which he covers his position
sometime in the future.
 If price goes down, the investor incurs a loss.

 The farmer is taking a short position when he sells

the crop before harvesting subject to future delivery
of the contracted quantity at agreed time against
payment by the buyer of the agreed price.
 The farmer locks in the price against the risk of a

lower spot price at harvest time.
 The farmer gains if the price at harvest time is lower

and loses if the price at harvest time is higher.
 The buyer in this transaction is taking a long position

subject to future receipt of the crop and payment of
the price.
 The buyer locked in the price against the risk of crop

spot price going up at harvest time.
 If price goes down, the buyer incurs a loss which is

seller’s gain.
 If price goes up, the buyer gains what is seller’s loss.

Future Contract Example
Case
A
Market/Spot Price
Long $10 Case A $9
Short $10 Case B $14
Long Loss $1 Case C $11
Case Case
B Short gain $1 C
Long $10 Long $10

Short $10 Short $10
Long Gain $4 Long Gain $1
Short Loss $4 Short Loss $1
 By shorting a security or a currency, the investor

(speculator) sells units of an asset he does not have.
 The transaction is done through a broker who acts as

a market maker. The asset is “borrowed” by the
investor from the broker and delivered to the buyer.
 The investor deposits a “ margin” with the broker

and pays commission on the transaction.
 Subsequently, investor must buy and return to the

broker the same units of the asset he borrowed.
 Investor pays commission on the buying transaction.
 Investor’s margin account is settled and closed with

realized gain or loss.
 In “naked shorting” the transaction is done without

“borrowing” the underlying asset.
Customer Shorting Account on A Stock
Gain Case
Action Debit $ Credit $
1- Jan. 1 customer borrows 10 shares of XYZ stock 0 0
2- Jan. 1 customer charged borrowing commission 200
3- Jan. 1 customer short sells the 10 shares for $100/share 1000
4- Jan. 1 customer charged selling commission 50
5- Feb. 8 customer buys the 10 shares for $40/share 400
6- Feb. 8 customer charged buying commission 50
Total 700 1000
7- Feb. 8 customer receives $300 gain from transaction 300

Customer Shorting Account on A Stock
Loss Case
Action Debit $ Credit $
1- Jan. 1 customer borrows 10 shares of XYZ stock 0 0
2- Jan. 1 customer charged borrowing commission 200
3- Jan. 1 customer sells the 10 shares for $100/share 1000
4- Jan. 1 customer charged selling commission 50
5- Feb. 8 customer buys the 10 shares for $120/share 1200
6- Feb. 8 customer charged buying commission 50
Total 1500 1000
7- Feb. 8 customer pays $500 loss from transaction 500

Hedging Forex Exposure
 Managing foreign currency exposure centers around

the concept of hedging.
 By hedging a foreign currency exposure, a company

transforms a probable undefined risk (exchange rate
fluctuation) into a definite and known cost (the cost
of the hedge).
 Technically, when you hedge you are engaging in

two transactions with opposite correlations.
 Hedging occurs almost everywhere, and we see it

everyday, probably without recognizing it.
 Hedging doesn't prevent a negative event from

happening, but if the event happens and you're
properly hedged, the impact of the event is reduced.
 The best way to understand hedging is to think of it

as an insurance.
 If you buy insurance for your house or car, you are

hedging yourself against fire, theft, or other probable
dangers or risks your property is exposed to.
 If the insured (hedged) risk doesn’t occur, the cost of

the insurance (hedge) would be seen, in retrospect,
as unwarranted. You still have the peace of mind.
 Hedging is the most popular utilization of forward

contracts.
 A forward contract is a contract between a bank and a

customer (which could be another bank).
 A forward contract calls for delivery by the bank at a

fixed future date of a specified amount of one currency
against simultaneous payment in another currency by
the customer.
Hedging and the Forward Market
 Hedging is done under forward contracts between

two parties. Both parties must perform the agreed
action.
 The other party could be a bank or a buyer/seller of a

commodity.
 If the hedge is done with a bank, the bank must

deliver the specified volume of the currency, and the
customer must buy them at the prefixed price.
Hedging Techniques
 Hedging techniques include:

1. Forward market hedge
2. Money market hedge (borrowing locally)
3. Risk shifting by selling and invoicing in home
currency (currency risk is shifted to customer)
4. Risk shifting by buying and paying in home
currency (currency risk is shifted to seller)
5. Using “Currency Collar” contracts for protection
against currency fluctuation outside an agreed-
upon range. Risk is shared by both parties.
1- Forward Market Hedge
 In a forward market hedge, a company that is long a

foreign currency (example is receivables) will sell
the foreign currency forward.
 Whereas a company that is short a foreign currency

(example is payables) will buy the currency forward.
 In this way the company can fix the home currency

value of future foreign currency cash flows and not
worry about exchange rate fluctuations.
Forward Market Hedge –
A Payable Example
 A U.S. importer buys textiles from England for £1

million due in 90 days. Spot price of the £ is $1.71.
 The £ exchange rate might rise against the $ during

the next 90 days, raising the $ cost of the textiles. It
may also go down but the importer can never tell.
 The importer decides to hedge this exchange risk by

negotiating a 90-day forward contract with a bank at
a price of, say, £1 = $1.72.
A Payable Example
 On the 90th day the following activity takes place:

a. The bank gives the importer £1 million.
b. The importer pays the £1 million for his textile order
c. The importer pays the bank $1.72 million, which is
the $ equivalent of £ 1 million at the forward rate of
$1.72.
 By entering the forward contract to buy £ for future

delivery, the importer has offset a “short” position in £
by going “long” in the forward market for the currency.
A Receivable Example
 On January 1, US Boeing sells airplane to BA.

 Sale amount is £100 million receivable in 90 days.
 Boeing is not interested in sterling pounds, it wants
dollars.
 The sterling is rallying against the dollar but Boeing
wants to protect the receivable dollar cash flow
against adverse fluctuation that could take place in
the dollar/pound exchange rate till March 31.
 Boeing decided to enter a forward market hedge for
the pounds receivable for dollars. The hedge party is
a bank.
A Receivable Example
 Current spot price for the pound is $1.30/ £1, and the
hedge agreed 90 days forward rate is $1.3828/ £1.
 The forward sale of £100 million for delivery in 90

days will yield Boeing $138,280,000 on March 31 no
matter what happens to the exchange rate.
 Illustration of the transaction with possible gains or

losses to Boeing based on actual movement of the
dollar/pound exchange rate is as follows:
Receivable Forward Market Hedge Gain or Loss
Based on Exchange Rate Scenarios
Scenarios for Scenario’s for Guaranteed Gain (Loss)
Spot Spot Value of Forward on Forward
Exchange £100 million Contract Cash Contract at
Rate on Receivable (1) flow (2) $1.3828
March 31 exchange
rate (2-1)
£ 1 = $1.40 $140,000,000 $138,280,000 ($1,720,000)
£ 1 = $1.3828 $138,280,000 $138,280,000 0
£ 1 = $1.36 $136,000,000 $138,280,000 $2,280,000
£ 1 = $1.42 $142,000,000 $138,280,000 ($3,720,000)

2- Money Market Hedge
 Money market hedge is an alternative to forward

market hedge and involves exchange rates and
interest rates on the currencies involved.
 Money market hedge is done at spot market rate rather

than a forward market rate.
 Money market hedge requires simultaneous borrowing

and investing transactions in two different currencies
to lock in the home currency value of a future foreign
currency cash flow.
Money Market Hedge Example -
Hedging a Receivable
 GE sells engines to Air France on January 1 and will

receive €10 million on December 31.
 The euro was in a downward spiral and GE decides

to hedge the receivable using a money market hedge
 Prevailing market conditions as follows:

1. Euro interest rate 15%
2. US dollar interest rate 10%
3. Spot exchange rate is $1/euro.
 Following is the sequence of the hedge:

1. GE is due €10 million after one year
2. GE borrows the discounted present value of €10
million at 15% for one year which is €8.70 million.
3. The borrowed €8.70 million will become €10 million
after one year at 15% interest rate.
4. GE sells the borrowed €8.70 million in the spot
market at €1 to $1 rate, yielding $8.7 million.
5. GE invests the $8.7 million for one year at 10% yield
6. On Dec. 31 GE receives from its dollar investment
$9.57 million ($8.7 million plus 10% interest).
7. On Dec. 31 GE receives the €10 million receivable

and pays it to settle the €8.7 million loan plus 15%
interest.
 Result is that a €10 million receivable due Dec. 31

was converted on January 1 into $9.57 million cash
flow to be received December 31 at a guaranteed
exchange rate of €0.957.
 The risk of exchange rate fluctuation was eliminated.

Receivable Money Market Hedging Gain or Loss
Based on Exchange Rate Scenarios
Scenarios for Scenario’s Money Gain (Loss)
Spot Exchange Spot Value of market on Contract
Rate December 10 million euro Contract at $0.957
31 Receivable Cashflow exchange
(1) (2) rate (2-1)
€1 = $1.00 $10,000,000 $9,570,000 ($430,000)
€1 = $0.957 $9,570,000 $9,570,000 0
€1 = $0.90 $9,000,000 $9,570,000 $570,000
€1 = $1.10 $10,100,000 $9,570,000 ($530,000)

Solution Explained
 The following factors drove GE’s decision to use a

money market hedge for the euro receivable:
1. A 15% interest on the euro lowers the amount to be

borrowed in euros. This is a wash out, however,
against the 15% interest on the euro loan.
2. A 10% interest on the dollar provides a good yield

on the dollars investment.
3. A spot rate of $1/€1 is attractive to GE considering

the expectation of lower rates when the receivable
is on hand at year end.
Solution Explained
4. If the euro/dollar rate slips to less than €1/$1 by

Dec. 31st , the dollar cash flow could become lower
than the $9,570,000 secured under the hedge.
5. For example, if the euro fell to, say, $0.85/euro by

year end, an unhedged €10 million receivable would
bring $8.5 million against $9.570 million realized
from a money market hedge based on 1/1 spot rate.
6. The potential loss to GE will be higher if the euro

slides to even lower rates.
Solution Explained
7. In a weak euro situation, a forward market hedge

with a bank is sure to give GE a significantly lower
rate than the 1/1 spot rate.
8. GE captured the moment and locked in the 1/1 spot

rate which may not be attainable in other options.
Composite Case On Hedging
On March 1, 2016 US Ford sold trucks to an Italian customer

for €10 million due to Ford after 12 months. To hedge the €
receivable Ford was considering two options:
a. A forward market hedge at a future rate of €1/$0.9.
b. A money market hedge based on the following factors:
 €/$ spot market rate is 1/1
 € interest rate is 15%
 $ interest rate is 10%
Using the above information:
1. Illustrate the sequence of each of the two hedges
2. Calculate the dollar cash flow from each of the hedges
3. Recommend the hedge GE should select
Composite Case On Hedging - Solution
 Sequence of the forward market hedge:

1. Ford is due €10 million after one year. Ford negotiates a
forward market hedge with several banks to determine
the highest future dollar rate available.
2. Given information is that available rate is $0.90/€1. Ford
enters a contract with the bank at a fixed $0.90/€1 rate.
3. On due date Ford receives €10 million from the customer
and delivers to the bank who gives GE $9 million.
4. The deal is closed.
 The dollar cash flow from the forward market hedge is

€10 million X 0.9 = $9,000,000.
 Sequence of the money market hedge:

1. Ford is due €10 million after one year. Ford borrows the
discounted present value of €10 million at 15% for one
year which is €8.70 million.
2. The borrowed €8.70 million will become €10 million after
one year at 15% interest rate.
3. Ford converts the €8.70 million in the spot market at the
exchange rate of €1 to $1, yielding $8.7 million.
4. Ford invests $8.7 million at 10% interest for one year,
yielding $9.57 million at maturity.
5. At the end of the year Ford receives €10 million from the
customer which settles the €8.7 million loan plus 15%.
6. At the end of the year Ford receives $9.57 million from
its dollar investment, being $8.7 million plus 10%.
7. The deal is closed.
 The €10 million receivable due after one year was

converted at a guaranteed exchange rate of €0.957,
yielding $9,570,000 to be received one year later.
 Therefore, the dollar cash flow from the money market

hedge is $9,570,000.
 Based on the above results, Ford should select the

money market hedge as it yields a higher dollar cash flow
than the forward market hedge.
Forward Market vs Money Market Hedges-
Summary
 The choice between forward market hedge and

money market hedge depends on the spot market
exchange rate compared to future rate expected at
the time the hedged currency is received (hedging a
receivable) or paid (hedging a payable).
 The cash flow to result from each of the two hedging

techniques will first be calculated by the hedger to
decide the method to select.
Hedging A Receivable
 In hedging a receivable, forward market is hedger’s

preferred option if the hedged currency’s exchange
rate at the time of receipt is expected to be higher
than its spot market rate at the time of entering the
hedge.
 Money market is hedger’s preferred option if the

hedged currency’s exchange rate at the time of
receipt is expected to be lower than its spot market
rate at the time of entering the hedge. Borrow the
foreign currency, invest in local currency
Hedging A Payable
 In hedging a payable, forward market is hedger’s

preferred option if the hedged currency’s exchange
rate at the time of payment is expected to be lower
than its spot market rate at the time of entering the
hedge.
 Money market is hedger’s preferred option if the

hedged currency’s exchange rate at the time of
payment is expected to be higher than its spot
market rate at the time of entering the hedge. Borrow
local currency, invest in the foreign currency.
Currency Arbitrage and Hedging
 Currency arbitrage is another form of hedging.
 Currency arbitrage involves buying a currency in

one market and selling it simultaneously in another.
 Such transactions tend to keep exchange rates

uniform in the various markets.
Currency Arbitrage - Example
 Example involves the instantaneous exchange rates

of three currencies:
1. The US dollar
2. The sterling pound
3. The Euro.
 Assumptions as follows:
1. The £ can be sold at $1.903 in New York
2. The € can be purchased at $1.300 in Frankfurt.
3. At the same time, the £ can be purchased in London
at €1.4615.
Currency Arbitrage - Example
 Arbitrage transaction by a clever trader would be to:
1. Sell $ for € in Frankfurt,
2. Use the € to acquire £ in London, and
3. Sell the £ in New York for $.

Currency Arbitrage – Example
 Therefore, and assuming that the transaction is made

by a smart trader in N. Y. who starts with $1,000,000,
the numbers will be as follows:
1. Sell $1,000,000 for € in Frankfurt @ €1 = $1.3

= €769,230.76
2. Sell €769,230.76 for £ in London @ £1 = €1.4615

= £ 526, 329.59
3. Sell £ 526, 329.59 for $ in New York @ £ 1 = $1.903

= $1,001,605.20
TRIANGULAR CURRENCY ARBITRAGE
4. Net Profit Equals $ 1,605,20
NEW YORK
Finish Start
$ 1,001,605.20 $ 1,000,000
1. Sell $ 1,000,000
In FRANKFURT
at € 1 = $ 1.300 for
€769,230.76
Multiplied by Divided by
$ 1.903 / £ $ 1.300 / €
3. Resell the pounds
Sterling in NEW YORK
at £ 1 = $ 1.903 for
$ 1,001,605. 20
£ 526,329.59 € 769,230.76
London Frankfurt
Divided by
€ 1.4615 / £
2. Sell these Euros
In LONDON
at £ 1 = € 1.4615
for £ 526,329. 59
Currency Arbitrage – Example
 So, the trader started in N. Y. with $1,000,000 and

ended also in New York seconds later but with
$1,001,605.20.
 Transaction three actions were done in only a few

seconds and ended with net profit of $1,605.20.
 However, transaction could end with loss had

information or timing been different or incorrect.

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International Financial Management

Exchange Rate Fluctuation &

Dr. Said El Salmy

 An exchange rate is an expression of the price of a

 Like any commodity, a currency price may fluctuate

 Fluctuations in currencies prices affect everyone,

 Direct effects of exchange rates fluctuations are

a. Foreign trade cash flows due to:

2. Increase or decrease in receipts by exporters for

b) Investments cash flows due to:

2. Increase or decrease in values of investments

 Indirect effects of exchange rates fluctuations are

1. Higher or lower prices paid to buy foreign goods

2. Increase or decrease of inflation and in cost of

 Exchange rates fluctuations could bring gains to

 All businesses regardless of their nature, location or

 Similarly, investors who deal or invest in foreign

 Importers and exporters of goods and services paid for

 Similarly, investors in transactions in foreign currencies

 A simple example is a company who had $100,000 in its

 On November 16, 2016 US$/EGP rate was 8 pounds and

 On November 17, 2016 the pound was floated and the

 Another example is a company who had EGP 800,000 in

 On November 16, 2016 US$/EGP rate was 8 pounds and

 On November 17, 2016 the pound was floated and the

 Domestic companies exposure to foreign currencies

 Domestic companies are usually involved in no or

 Domestic companies balance sheets usually show

 International companies are engaged in extensive

 Therefore, international companies financial statements

 The components of foreign currency denominated

a. The foreign currencies in which the transactions

b. The company’s home currency in which activities

 Unmanaged foreign exchange rate fluctuations will

 With proper management, foreign exchange risks

 If not managed properly, foreign exchange risks will

Domestic operations net $18,000,000 ($20,000,000)

Foreign operations net ($14,000,000) $24,000,000

Combined net income $4,000,000 $4,000,000

Foreign operations exchange ($44,000,000) $40,000,000

Foreign operations net income ($14,000,000) $24,000,000

 Exchange loss in Company X foreign operations

 Exchange gain in Company Y foreign operations

 In both cases, the misleading results could influence

 Management, investors and other stakeholders are

 For example, an investor in Pfizer (USA) is interested

 Foreign branches and subsidiaries of MNCs transmit

 Parent combines domestic and foreign business

 For consolidation purposes, foreign currency

 To enable consolidation, subsidiaries in foreign

a. One is the functional currency,

 Dual currency accounting system enables production

 Functional currency is the currency of the country in

 Therefore, functional currency of an affiliate of a US

 Reporting currency is parent’s home currency, in

 Dual currency accounting system works in the

1. Branches and subsidiaries in foreign locations

2. Statements are translated to reporting currency.

3. Translated statements are sent to home office.

 Translation from functional currency to reporting

1. Current exchange rate method

 Company’s policy determines the translation method

 Income and expense items are translated from