FOREIGN EXCHANGE EXPOSURE

EXPOSURE is a measure of sensitivity of the value of the financial items ( assets, liabilities or cashflows ) to change in variables like exchange rates, interest rates, inflation rates) FES can be classified into economic and translation exposure Economic exposure : refers to potential changes in all future cash flows of a firm that result from consequent anticipated changes in exchange rates Translation exposure / Accounting exposure : refers to the reinstatement of values of the items of financial statements of a MNC Economic exposure 1. Transaction exposure arises when the firms contractual obligations or monetary assets and liabilities are exposed to unanticipated changes in exchange rates 2. Operating exposure arises when the firms real assets or operating cash flows are exposed to unanticipated changes in exchange rates.

Transaction exposure
It is a common practice for many a business entity, particularly MNCs to enter into foreign currency denominated transactions. These transactions may involve future cash inflows & outflows in foreign currency Transaction exposure also arises when a firm borrows or lends in a foreign currency. For example, a firm in india that borrows US$ 1 million from a firm in newyork for 3 years. During this period if the US$ appreciates against INR , the borrower will have a greater burden in terms of INR. Conversely if the foreign currency depreciates the borrower will have a lower burden in terms of home currency.

Transaction Exposure
Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.

Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations.

Sources of Transaction Exposure

Transaction exposure arises from:
Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.

Borrowing or lending funds when repayment is to be made in a foreign currency.

Being a party to an unperformed foreign exchange forward contract. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.
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 Thus whenever a firm has foreign currency denominated contractual cash flows ( monetary assets & liabilities ) it is subjected to transaction exposure Depending on the net monetary assets position ( monetary assets less monetary liabilities ) and also on the direction of exchange rate changes the firm may experience a net gain or a net loss on transaction exposure Example : A company in india has exported goods worth USD 10 million to a US firm payable 3 months from now. At the same time , it has purchased equipment from the same US firm for USD 5 million, payable in the next 3 months. The spot rate is USD/INR 42. What is the transaction exposure of the indian company. Suppose the INR appreciates against the USD and the exchange rate becomes USD/INR 41 in the 3 month period. What is the transaction loss to the indian company.

 Solution : Net exposure in USD = Inflows- Outflows= USD 10 M USD 5 M = USD 5M Exposure in terms of INR = INR 210 M ( 5 * 42 ) Transaction loss : INR 210 x ( ( 42 41 ) / 42 ) = INR 5 million or USD 5 million X (42-41) = INR 5 million.

MANAGING TRANSACTION EXPOSURE HEDGING

TECHNIQUES
FORWA RDS & FUTUR ES

OPERATIONAL TECHNIQUES
1. Netting 2. Currency of invoicing 3.Leading & lagging

MONEY MARKET HEDGE

SWAPS

OPTIONS

Currency SWAPS A currency swap is a contract to exchange at an agreed future date principal amounts in two different currencies at a conversion rate agreed at the outset During the term of the contract the parties exchange interest , on an agreed basis, calculated on the principal amounts. In other words , currency swap is a legal agreement between two parties to exchange the principal and interest rate obligations or receipts in different currencies Currency swap is done to lower the borrowing cost of debt and to hedge exchange risk. A currency swap is an agreement to exchange fixed or floating rate payments in one currency for fixed or floating payments in a second currency plus an exchange of the principal currency amounts

Currency swap : company A borrows in dollars and company B borrows in rupees. They enter in a currency swap.

Dollar lender
Makes $ payment

Rupee Lender
Makes rupee payment Receives dollar payments from company B

Company A

Bank

Company B

Receive rupee payments from company A

STEPS IN CURRENCY SWAPS

1. once an equal but opposing need for different currencies has been identified for two counter parties, the principal amounts are exchanged 2.Interest payments are exchanged periodically throughout the lifetime of the swap 3.The principal amounts are re-exchanged at the end of the swap

BENEFITS OF CURRENCY SWAPS

CS enables corporate to exploit their comparative advantage in raising funds in one currency to obtain savings in another currencies CS permit corporate to switch their loans from a particular currency to another depending on their expectations of the future movement of the currency and interest rates It offers flexibility to corporate seeking to hedge the risk associated with a particular currency A company no longer has to live with a bad decision, if it has selected a wrong currency for its overseas funding operations a currency swap can undo the damage CS can be used to lock into exchange rates for a longer period and it do not require monitoring and reviewing The CS mode can be chosen to restructure the currency base of companies liabilities CS are used to hedge exposure to currency risk on future receipts and payments and to raise funds at a lower cost. In a CS, the exchange rates at maturity is known at the outset

CURRENCY FUTURES
A currency futures contract is a commitment to deliver a specific amount of a specified currency at a specified future date for an agreed price incorporated in the contract

Financial futures is a binding contract of a standardized nature, interlocking both buyer and seller into a particular rate.
Features of CF :
These are instruments traded in organized futures markets These contracts can be liquidated even before the contracted date These contracts are relatively inflexible and traded only in major currencies For entering into these contracts , the parties should keep margins with the exchange These contracts are cheaper than forward contracts, requiring a small commission payable Delivery dates are usually quarterly, but most contracts are closed out by buying / selling equal and opposite contracts before the delivery date.

CURRENCY OPTIONS Currency options is a contract giving the buyer the right but not the obligation to exchange a specified amount of one currency into another specified currency on or before a specified date at a specified rate of exchange. The buyer ( holder ) of the option pays a premium to its writer (seller)

An option is a contract that gives the holder the right , but not the obligation, to buy ( call) or sell ( put ) a specified underlying instrument
Currency options are basically rights given to the buyers of foreign currency to buy or sell a specific amount of foreign currency at a specific exchange rate ( the strike price ) till a specific date when the contract expires.

FORWARD EXCHANGE CONTRACT A forward exchange contract is a commitment to exchange ( buy or sell ) one foreign currency for another at a specified exchange rate with the exchange taking place on either a specified future date or during a specific future period The specified exchange rate is called the forward rate In a forward contract one party agrees to deliver a specified amount of one currency for another at a specified exchange rate at a designated date in future. Forward contract are usually available only for periods up to 12 months

LEADS & LAGS

a firm having exposure to pay foreign currency, can make payments in advance prior to due date called leads to take the advantage of lesser rate of foreign currency. If the firm delays the payments over the due date to take advantage of the exchange fluctuations is called lags. The technique used in this is to delay payment of weak currencies and bring forward payment of strong currencies

NETTTING
In case of MNCs, parent company and its subsidiaries periodically settling up the net amounts owned or amount as a result of trade within the firm is called Netting. The basic idea behind netting is to transfer only net amounts usually within a short period For example : instead of making each payment, incurring transaction costs, the net position between the two companies can be ascertained say, every 3 months and one payment only to be made by the company, which is in the net debtor position

TRANSFER PRICING

Under this method, the profits are transferred through an adjustment of invoice prices of transactions that take place between parent and subsidiary or between strong currency and weak currency subsidiaries This method of adjustment will not adversely affect the subsidiaries which are operating in a troubled economic environment

RE-INVOICING CENTRES
It is a widely used technique for centralization of exposures. Under this method the manufacturing subsidiaries ship directly to the sales subsidiaries, but bill to a separate entity, the re-Invoicing company The re-invoicing centers bills the sales subsidiaries in different currencies. The risk of currency exposure is now concentrated only with re-invoicing company. The manufacturing subsidiaries will receive a stream of cash flow in their own currency without exposure to foreign exchange risks

Translation Exposure
Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries which are stated in foreign currency must be restated in the parents reporting currency for the firm to prepare consolidated financial statements. Translation exposure is the potential for an increase or decrease in the parents net worth and reported net income caused by a change in exchange rates since the last translation. The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.

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Translation Methods
Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: The current rate method The temporal method
Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).

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Current Rate Method

The current rate method is the most prevalent in the world today.
Assets and liabilities are translated at the current rate of exchange. Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period. 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 account (reducing variability of reported earnings).
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Temporal Method
Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the items creation.
This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).

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Monetary / Non-monetary Method

If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/non-monetary method of translation.
Monetary assets and liabilities are translated at current exchange rates. Non-monetary assets and liabilities are translated at historical rates. Income statement items are translated at the average exchange rate for the period. Dividends (distributions) are translated at the exchange rate on the date of payment. Equity items are translated at historical rates.

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Managing Translation Exposure

The main technique to minimize translation exposure is called a balance sheet hedge.
A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firms consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.
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Working Capital Management

Working capital management in a multinational enterprise requires managing current assets (cash balances, accounts receivable and inventory) and current liabilities (accounts payable and short-term debt) when faced with political, foreign exchange, tax and liquidity constraints.
The overall goal is to reduce funds tied up in working capital while simultaneously providing sufficient funding and liquidity for the conduct of global business.

Working capital management should enhance return on assets and return on equity and should also improve efficiency ratios and other performance measures.

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International Cash Management

International cash management is the set of activities determining the levels of cash balances held throughout the MNE (cash management) and the facilitation of its movement cross-border (settlements and processing). These activities are typically handled by the international treasury of the MNE.

Cash balances, including marketable securities, are held partly to enable normal day-to-day cash disbursements and partly to protect against unanticipated variations from budgeted cash flows. These two motives are called the transaction motive and the precautionary motive.

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International Cash Management

Efficient cash management aims to reduce cash tied up unnecessarily in the system, without diminishing profit or increasing risk, so as to increase the rate of return on invested assets. Over time a number of techniques and services have evolved that simplify and reduce the costs of making cross-border payments. Four such techniques include:
Wire transfers Cash pooling Payment netting Electronic fund transfers
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Payment Netting

28

Payment Netting

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Accounts Receivable Management

Trade credit is provided to customers on the expectation that it increases overall profits by: Expanding sales volume Retaining customers Companies must keep a close eye on who they are extended, why they are doing it and in which currency. One way to better manage overseas receivables is to adjust staff sales bonuses for the interest and currency costs of credit sales.

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Inventory Management
MNCs tend to have difficulties in inventory management due to long transit times and lengthy customs procedures. Overseas production can lead to higher inventory carrying costs. Must weigh up benefits and costs of inventory stockpiling. Could adjust affiliates profit margins to reflect added stockpiling costs.

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Transfer Pricing
Pricing internally traded goods of the firm for the purpose of moving profits to a more tax-friendly location. This can reduce taxes, tariffs and circumvent exchange controls. Example: Suppose that affiliate A produces 100,000 circuit boards for $10 apiece and sells them to affiliate B. Affiliate B, in turn, sells these boards for $22 apiece to an unrelated customer. Pretax profit for the consolidated company is $1 million regardless of the price at which the goods are transferred for A to B.
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Transfer Pricing
In effect: Profits are shifted from a higher to a lower tax jurisdiction. Basic rules: If tA > tB then set the transfer price and the mark-up policy as LOW as possible.

If tA < tB then set the transfer price and the mark-up policy as HIGH as possible.
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Transfer Pricing
Methods of Determining Transfer Prices
Tax Office regulations provide three methods to establish arms length prices:
Comparable uncontrolled prices Resale prices Cost-plus calculations

In some cases, combinations of these three methods are used.

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Reinvoicing Centers
Reinvoicing centers can help coordinate transfer pricing policy. They are set up in low-tax countries. Goods travel directly from buyer to seller, but ownership passes through the reinvoicing center. Advantages:
Easier control on currency exposure Flexibility in invoicing currency

Disadvantages:
Increased costs Suspicion of tax evasion by local governments
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Internal Loans
Internal loans add value to the MNE if credit rationing, currency controls or differences in tax rates exist. Three main types:
Direct loans from parent to affiliate. Back-to-back loans deposit by parent is lent to affiliate through a bank. Parallel loans like a loan swap between two MNEs and their affiliates.

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Factoring
Definition: Factoring is defined as a continuing legal relationship between a financial institution (the factor) and a business concern (the client), selling goods or providing services to trade customers (the customers) on open account basis whereby the Factor purchases the clients book debts (accounts receivables) either with or without recourse to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers.

Benefits of factoring
The subsidiaries of the various banks have been rendering the factoring services. The factoring service is more comprehensive in nature than the book debt or receivable financing by the bankers.

Services rendered by factor

Factor evaluated creditworthiness of the customer (buyer of goods) Factor fixes limits for the client (seller) which is an aggregation of the limits fixed for each of the customer (buyer). Client sells goods/services. Client assigns the debt in favour of the factor Client notifies on the invoice a direction to the customer to pay the invoice value of the factor.

Forfaiting
Forfaiting is a specialized technique to eliminate the risk of nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit. The following exhibit illustrates a typical forfaiting transaction (involving five parties importer, exporter, forfaiter, investor and the importers bank). The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country.
Copyright 2004 Pearson Addison-Wesley. All rights reserved.

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Exhibit 23.10 Typical Forfaiting Transaction

Exporter
(private industrial firm)

Step 1

Importer
(private firm or government purchaser in emerging market)

Step 2

Step 4

FORFAITER
Step 5

(subsidiary of a European bank)

Step 3

Step 6

Investor
(institutional or individual)
Step 7

Importers Bank
(usually a private bank in the importers country

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CASH MANAGEMENT ENVIRONMENT

BANKERS PERSPECTIVE

COLLECT FUNDS

DISBURSE FUNDS

CUSTOMER ACCOUNT

TRACK TRANSACTIONS & BALANCES

MANAGE FUNDS EXCESS/ SHORTFALL

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BANK DEFINITION OF CASH MANAGEMENT

The effective planning, monitoring and management of liquid / near liquid resources including:

Provision of bank accounts Deposit / withdrawal facilities Provision of information regarding bank accounts and positions Money transfers and collection services Investment facilities Financing facilities Pooling and netting
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BENEFITS OF GOOD CASH MANAGEMENT

Control of financial risk Opportunity for profit Strengthened balance sheet Increased customer, supplier, and shareholder confidence

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DIFFERENCE BETWEEN FACTORING AND FORFAITING

1.Suitable for ongoing open account sales, not backed by LC or accepted bills or exchange. 2. Usually provides financing for short-term credit period of upto 180 days. 1. Oriented towards single transactions backed by LC or bank guarantee. 2. Financing is usually for medium to long-term credit periods from 180 days upto 7 years though shorterm credit of 30180 days is also available for large transactions.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

3.Requires a continuous arrangements between factor and client, whereby all sales are routed through the factor. 4. Factor assumes responsibility for collection, helps client to reduce his own overheads. 3. Seller need not route or commit other business to the forfaiter. Deals are concluded transaction-wise. 4. Forfaiters responsibility extends to collection of forfeited debt only. Existing financing lines remains unaffected.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

5. Separate charges are applied for financing collection administration credit protection and provision of information. 5. Single discount charges is applied which depend on guaranteeing bank and country risk, credit period involved and currency of debt. Only additional charges is commitment fee, if firm commitment is required prior to draw down during delivery period.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

6. Service is available for 6. Usually available for domestic and export export receivables only receivables. denominated in any freely convertible 7. Financing can be with currency. or without recourse; the credit protection 7. It is always without collection and recourse and administration services essentially a financing may also be provided product. without financing.

DIFFERENCE BETWEEN FACTORING AND FORFAITING

8. Usually no restriction on minimum size of transactions that can be covered by factoring . 9. Factor can assist with completing import formalities in the buyers country and provide ongoing contract with buyers. 8. Transactions should be of a minimum value of USD 250,000. 9. Forfaiting will accept only clean documentation in conformity with all regulations in the exporting/importing countries

Float
Any delay in the process of converting materials and labour to receipt of payment involves cost, float cost. Similarly, any delay in making payments will also give rise to float but this time to our advantage What is float?

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FLOAT

Definition of bank float

The time lost between a payor making a payment and a beneficiary receiving value

Cost of Float

principle amount due x no of days x cost of funds 360 or 365

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WHY DOES FLOAT OCCUR?

Deliberately Inefficiency Logistical situations Compensation mechanism

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STAGES OF FLOAT
Function 1. Order received 2. Goods dispatched Float Production float System float Responsibility Supplier Supplier Supplier Buyer Buyer/ postal service Supplier Banks Banks Banks

3. Invoice issued
4. Payment due 5. Payment made 6. Payment received 7. Payment banked 8. Funds available 9. Funds to correct account 10. Advice of availability

Credit period
Customer float Postal float System float Bank float Concentration float Information float

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Controlling Float
We need to look at controlling / influencing float in three areas * Ourselves * Our Customers * Our Banks

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HOW TO REDUCE/CONTROL FLOAT

Your Own Actions

Change own systems Educate customers

Include costs in prices

Negotiate with bank

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RECEIVABLES AND PAYABLES MANAGEMENT

Good receivables and payables management aids in:

Cash flow forecasting Long-term funding and investment decisions Reduced risk of bad debts Stronger liquidity

Stronger balance sheet ratios

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RECEIVABLES IMPACT
Important because of costs arising from Float Bad debts Management time Legal fees And Impact on analysts and creditors
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RECEIVABLES MANAGEMENT 1
Clear instructions Method of payment

Documentation
Account structures Terms of Trade
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Controlling Float
Payment Methods Payment methods are important because of - Cost - Risk - Value Dating - Finality

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INTERNATIONAL TRADE PAYMENTS

Terms of trade

Settlement
Open account Clean collection Documentary collection Against payment Against acceptance Revocable documentary letter of credit Irrevocable documentary letter of credit Unconfirmed Confirmed Advance payment
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RECEIVABLES MANAGEMENT 2
Penalties Post dated cheques Legal process Internal process Stop supply
But do not forget Relationship
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The Capital Budgeting Decision

Capital Budgeting is the process of identifying, evaluating, and implementing a firms investment opportunities. It seeks to identify investments that will enhance a firms competitive advantage and increase shareholder wealth. The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. Poor capital budgeting decisions can ultimately result in company bankruptcy.
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Motives for Capital Expenditures

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Steps in the Process

1. Proposal Generation
2. Review and Analysis
Our Focus

3. Decision Making 4. Implementation 5. Follow-up

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Basic Terminology: Independent versus Mutually Exclusive Projects

Independent Projects, on the other hand, do not compete with the firms resources. A company can select one, or the other, or bothso long as they meet minimum profitability thresholds. Mutually Exclusive Projects are investments that compete in some way for a companys resourcesa firm can select one or another but not both.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
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Basic Terminology: Unlimited Funds versus Capital Rationing

If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented.

However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time.

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Basic Terminology: Accept-Reject versus Ranking Approaches

The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firms minimum acceptance criteria. The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.
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