Corporate Foreign Exchange Risk Management

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D R . R A K E S H K U M A R S H A R M A

CORPORATE FOREIGNEXCHANGE RISK

MANAGEMENT


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CORPORATE EXPOSURE MANAGEMENT

RISK-It is a possibility of an event to happen, whichwill negatively affect the business operations orresults.

EXPOSURE- Means being in a position where if therisk be in adverse side, it may hurt the one exposedto it. It is being open to risk.

The general concept of exposure refers to the degree

to which a company is affected by exchange ratechange


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RISK MANAGEMENT PROCESS-

It is the process, which integrates identification ofrisk, developing strategies to manage it, choosing thehedging tool and hedge the risk.


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Identification of risk-can start with the source ofproblems, or with the problem itself, i.e. know therisk facing the business

Quantification/ Assessment-Risk must beassessed as to their potential severity of loss and tothe probability occurrence. These quantities can beeither simple to measure or impossible to know for

sure in the case of probability of an unlikely eventoccurring.


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Developing Strategies include-

(a) Risk Avoidance (elimination)

(b) Risk Reduction (mitigation)

(c) Risk Retention (accepting)(d) Risk Transfer-


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Choosing the hedging Tool

Hedging means taking steps to protect the businessagainst expected loss. E.g. lagging, forwardcontracts, swaps, futures, options etc.

Hedge the Risk- apply any of the tool tohedge the position.


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OBJECTIVE OF THE HEDGING POLICY

The goal of any hedging policy should be to thecorporation achieve optimal risk profile thatbalances the benefits of protection against thecosts of hedging.

A well-designed hedging policy reduces both risksand costs. Hedging frees up resources and allowsmanagement to focus on the aspects of business inwhich it has a competitive advantage byminimizing the risks that are not central to the

basic business. Hedging increases shareholders value by reducing

the cost of capital and stabilizing earnings.


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FOREIGN EXCHANGE RISKMANAGEMENT

What is exchange risk?

Exchange risk is simple in concept: a potential gainor loss that occurs as a result of an exchange rate

change. For example, if an individual owns a share inHitachi, the Japanese company, he or she will lose ifthe value of the yen drops.


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Types of Foreign Exchange Exposure

The foreign exchange risk exposure of corporate isnormally broken down into three types:-

(a) Transaction exposure

(b) Translation (accounting) exposure(c) Economic exposure


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TRANSACTION EXPOSUREMANAGEMENT

It is the degree to which the value of future cashtransactions can be affected by exchange ratefluctuations. It relates to the gains and losses to

be made when settlement takes place at somefuture date of a foreign currency denominatedcontract that has already been entered into.These contracts may include import or exportof goods/services on credit terms, borrowing orinvesting funds denominated in a foreigncurrency, receipts of dividends from overseas or

unfulfilled foreign exchange contracts.


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It is the risk that amount to be received in localcurrency from foreign receivables may go down oramount of local currency to settle foreign payablesmay go up both due to unfavorable changes inexchange rate.


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Transaction exposure can be protected against byadopting a hedged position- that is, entering into acounterbalancing contract to offset the exposure.This is discussed in more detail in the coming parts.


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EXAMPLE-TE

Example: U.S. firm sells its product to a Germanclient for 1m, payable in 3 months, now facestransaction exposure since the CFs are fixed inEuros, and the future value of the Euro is uncertain,meaning that the dollars received are uncertain.

Example: U.S. firm borrows in U.K. pounds, owes1m in one year, faces transaction exposure since

the CFs are fixed in a foreign currency.


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MEASUREMENT OF TRANSACTIONEXPOSURE

A company has an exposure to the risk of an adversemovement in exchange rates whenever it needs tomake a payment in a foreign currency at a futuredate, and whenever it expects to receive income in aforeign currency at a future date.

The risk arises because between now and thefuture date, the exchange rate might move so

that:


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MEASUREMENT OF TRANSACTIONEXPOSURE

If payment will be made in a foreign currency, cost ofbuying the currency will be higher than it would benow, because the spot rate of the foreign currencystrengthens against the corporates domesticcurrency.

If foreign currency income will be received andexchange for the companys domestic currency, the

value of the receipt will be less than it would benow, because the spot rate of the currency is

weakens against the companys domestic currency.

h i f i (h d i )


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Techniques of managing (hedging)transaction exposure

The following are the methods/techniques of hedginga currency transaction exposure.

1. Internal Techniques

Invoicing in home currency Leading and lagging

Multilateral netting and matching

h i f i (h d i )


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Techniques of managing (hedging)transaction exposure

2. External Techniques

Forward contracts

Money market hedges

Currency futures Currency options

Currency swaps

( ) i i i h h


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(1) Invoicing in home currency: Thecurrency of invoice decision

A company exporting goods or services has to decidewhether to invoice in its own currency, the buyerscurrency or another acceptable currency. For,example, a Tanzanian company exporting goods toKenya can decide to invoice it customers in Tshs. Indoing so, it avoids an exposure to a risk of fall in the

value of the Kshs (which it would have if it invoiced

in Kshs). The currency risk is shifted to the Kenyancustomers.


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Drawback to invoicing in domestic currency

foreign customers might go to a different supplierwho is willing to invoice them in their domesticcurrency.

the company is unlikely to compare well with acompetitor who invoices in the buyers currency. It isalso necessary to revise prices frequently in responseto currency movements, to ensure that the prices

remain competitive.


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Drawback to invoicing in domestic currency

Invoicing in the buyers currency should promotesales and speed up payment and currencymovements can be hedged using forward cover. However, this is only available for the worldsmajortraded currencies


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(2) Leading and lagging

Leading and Lagging are terms relating to the speedof settlement of debts.

(a) Leading refers to an immediate payment or the

granting of very short-term credit. This I beneficialto a payer whose currency (used to settle) isweakening against the payees currency

(b) Lagging refers to granting (or taking) of long-

term credit.


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(3) Multilateral netting and matching

Matching -involves the use of receipts inparticular currency to meet payment obligationsin the same currency.

For example, suppose that a company expects to make

payments of USS$470,000 in two months time, and alsoexpects to receive income of USS$250,000 in twomonths. The company can use its income of $250,000 tomeet some of the payments of $470,000.

This reduces to $220,000 (i.e. 470,000-250,000) itsexposure to a rise in the value of the dollar over the nexttwo months.


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Matching

Matching receipts and expenditures is very useful way ofpartially hedging currency exposures. It can be organizedat group level by the treasury team, so that currencyincome for one subsidiary can be matched with

expenditures in the same currency by another subsidiary.This is most easily managed when all subsidiaries arerequired to pay their income into a group bank accountand all payments are made out of this central account.

Successful matching, however, depends onreliable forecasts of amounts and timing offuture inflow and outflows of currencies.


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Netting

Netting- involves offsetting the groupsdebtors and creditors in the same currencyand onlycovering the net position. This reduces theamount to be hedged by the group. For example,there is no point in one subsidiary hedging a $1million debt receivable at same time as anothersubsidiary is hedging a $ 1 million debt payable.


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Example of netting -

Assume a multinational company Y with subsidiariesA,B and C. netting of the Y inter-group debts payableand receivable can be arranged as follows:


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Netting


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Netting


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Before netting (if not for netting) the firm wasexposed/had to cover a total amount of 2,900/=payables and receivables where each subsidiary

would consider to cover its own payables andreceivables independently. But after netting only320/= remain for the group to cover by otherhedging tools.


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Advantages of Netting

Advantages.

Fewer transactions hence less administration andlower transaction costs

Regular settlement hence less inter subsidiarydisagreement and less exposure risk


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Disadvantages

Subsidiary loses flexibility over timing of paymentsand receipts i.e. affect its ability to chooseadvantageous exchange rates.

Central treasury may not operate as efficiently asexpected

Inter subsidiary transactions will be affected bychanges in the exchange rate of the base currency

Taxation may adversely affect the subsidiary


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* Note: How ever some of the internaltechniques explained above are restricted bysome central banks, hence the need toconsult the countrys central bank beforeusing them for their legality in the respectivecountry.

TRANSLATION EXPOSURE


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TRANSLATION EXPOSUREMANAGEMENT

Translation (accounting) exposure arisesfrom the need to, for purposes of reportingand consolidation, to convert the financialstatements of foreign operations from the

local currency (LC) involved to the homecurrency (HC). If exchange rates have changedsince the previous reporting period, this translation,or restatement, of those assets, liabilities, revenues,

expenses, gains and losses that are denominated inforeign currencies will result in foreign exchangegains or losses.


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BALANCE SHEET HEDGE

The most common means of protecting againsttranslation exposure is balance sheet hedging.This involves attempting equalize exposed assetsand liabilities. For example, a company may try to

reduce its foreign currency denominated assets if it fearsa devaluation of the overseas currency, by running downcash balances, chasing debtors and reducing stock levels.

At the same time it might increase its liabilities byborrowing in the local currency and slowing down

payment to creditors. If it can equate its foreigncurrency assets and liabilities then it will have nonet exposure to changes in exchange rates.


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BALANCE SHEET HEDGE

Asset-Liability Management- involveschoosing the different currencies in whichthe assets and liabilities of a company aredenominated. Essentially assets should be instrong currencies and liabilities in weakcurrencies. This is an example of balancesheet hedge.


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MEASURING TRANSLATION EXPOSURE

The translation of subsidiaries financial statementsfrom their functional currencies into reportingcurrency give rise to translation gain or loss if therehas been exchange rate changes within the periodcovered by the translated financial statements. Sucha gain or loss is the quantity of risk/ exposure to

which such a group is/ was exposed.


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How ever, home-country and the entirefinancial community are interested in home-currency values, the foreign currencybalance-sheet accounts and incomestatement must be assigned home currencyvalues. In particular, the financial statementsof an MNCs overseas subsidiaries must betranslated from local currency to homecurrency prior to consolidation with theparents financial statements.


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Translation exposure is simply the differencebetween exposed assets and exposedLiabilities. The controversies to amongaccountants center on which assets and liabilities areexposed and on when accounting driven foreignexchange gains and losses should be recognized(reported on income statement).


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METHODS

Four principal translation methods areavailable: - the current/non-current method,the monetary/non-monetary method and thecurrent rate method


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Current/Non-current method

With this, all the foreign subsidiarys currentassets and liabilities are translated into homecurrency at the current exchange rate. Eachnon-current asset or liability is translated at

its historical exchange rate, that is, at the ratein effect at the time the asset was acquired orliability incurred. Hence, a foreign subsidiary

with positive local-currency working capital will give

rise to a translation loss (gain) from devaluation(revaluation) with the current/non-current method,and vice versa if working capital is negative.


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Current/Non-current method

The income statement is translated at theaverage exchange rate of the period, exceptfor those revenues and expense itemsassociated with non-current assets orliabilities. The latter items, such as depreciationexpense, are translated at the same rates as thecorresponding balance-sheet items. Thus, it ispossible to see different revenue and expense items

with similar maturities being translated at differentrates.


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Monetary/Non-monetary method

The monetary/non-monetary method differentiatesbetween monetary assets and liabilities-that is, thoseitems that represent a claim to receive, or an obligationto pay, a fixed amount of foreign currency units-and non-

monetary, or physical, assets and liabilities. Monetary items (for example, cash, accounts

payable and receivable, and long-term debt) aretranslated at the current rate; non-monetary

items (for example,. Inventory, fixed assets, andlong-term investments) are translated athistorical rates.


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Income statement items are translated at theaverage exchange rate during the period,except for revenue and expense items relatedto non-monetary assets and liabilities.


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Current rate method

The current rate method is the simplest; all balancesheet and income items are translated at the currentrate. Under this method, if a firms foreign-currency denominated assets exceeds itsforeign-currency denominated liabilities,devaluation must result in a loss and arevaluation, in a gain. One variation is totranslate all assets and liabilities except net fixedassets at the current rate.


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ECONOMIC/OPERATING EXPOSUREMANAGEMENT

Economic Exposure relates to the possibilitythat the value of the company (the PresentValue of all future cash flows) will changedue to unexpected changes in futureexchange rates.


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ECONOMIC/OPERATING EXPOSUREMANAGEMENT

Economic exposure is also known as operating,competitive and strategic exposure. The reason isbecause operating exposure reflects theeconomic consequences that changes inexchange rate may have on the operatingincome of the firm and must deal with bothstrategic and competitive responses to theseunexpected changes.

Documents

Corporate Foreign Exchange Risk Management