FOREIGN EXCHANGE RISK

MANAGEMENT AND EXPOSURE

INTERNATIONAL FINANCE

By:-
Group 5

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BRUSH UP YOUR BASICS
 Exchange Rate .
 Spot exchange Rate .
 Forward Exchange Rate .
 Example of Currency Quote
 USD/EUR exchange rate is 1.2290.
 Quote Currency(Price/Payment) is USD and the Base Currency(Unit/Transaction) is
EUR.
 I EUR = 1.2290 USD.
 Direct and Indirect Quote.

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RISK
 Macro Economic Environmental Risk.
Uncertainties due to change in exchange rates , interest rates , inflation
rates , relative prices and so forth .

 Core Business Risk.

Uncertainties related to operating business such as interruptions in raw
material supply , laborer supply etc.

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EXPOSURE AND RISK
 EXPOSURE is the extent to which the future cash flows of an
enterprise, arising from domestic and foreign currency denominated
transactions are susceptible to variations in foreign currency exchange
rates.

 RISK is a measure of variability of the value of the item attributable to

the risk factor.

 EXAMPLE: During 1993 to 1995 a business involved export and

import from US. The exchange rate was quiet steady during that period.
Thus we say that the company had significant EXPOSURE to this
exchange rate , but it did not perceive significant risk on that account .

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TYPES OF FOREIGN EXCHANGE EXPOSURE

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EXAMPLE
 An Indian Company has following exposures in United States of
America:-
 Owns a factory in California worth US$50 million.
 A purchase order worth US $ 3 million.
 A US firm is the biggest competitor .

 Now if INR appreciates, then following are the implications:-

 Value of factory goes down.(TRANSLATION)
 Cost of purchasing goods goes down.
 Global Competitiveness of Indian firm increases.

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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 parent’s reporting currency
for the firm to prepare consolidated financial statements.

 Translation exposure is the potential for an increase or decrease in the

parent’s net worth and reported net income caused by a change in
exchange rates since the last translation.

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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.

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EXAMPLE
 In 1971, Great Britain’s Beecham Group borrowed
SF100 million (equivalent to £10.13 million).

 When the loan came due five years later, the cost of
repayment of principal was £22.73 million – more
than double the amount borrowed!

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OPERATING EXPOSURE
 OPERATING EXPOSURE, also called economic exposure, competitive
exposure, and even strategic exposure on occasions . It measures any
change in the present value of a firm resulting from changes in future
operating cash flows caused by an unexpected change in exchange rates.

 Measuring the operating exposure of a firm requires forecasting and

analyzing all the firm’s future individual transaction exposures together
with the future exposures of all the firm’s competitors and potential
competitors worldwide.

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 An expected change in foreign exchange rates is not included in the
definition of operating exposure, because both management and
investors should have factored this information into their evaluation of
anticipated operating results and market value.

 From an investor’s perspective, if the foreign exchange market is

efficient, information about expected changes in exchange rates should
be reflected in a firm’s market value.

 Only unexpected changes in exchange rates, or an inefficient foreign

exchange market, should cause market value to change.

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RECOGNISING OPERATING EXPOSURE

 Aspen Skiing Company owns and operates ski resorts in

Colorado
 Uses only American labor and materials
 Nonetheless, hurt by a strong dollar that made American skiers opt for the
French Alps or the Canadian Rockies, and foreign skiers stay at home.

 So, even a domestic firm with zero transaction exposure to

exchange rates can be vulnerable to exchange rate risk.

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 If EUR/USD exchange rate is 1.0 ad a Washington state
apple costs USD1 in US and eur1 in France. A EUR
depreciation to EUR 1.2/USD will increase the apple cost to
EUR 1.2 if US exporter does not adjust the USD prices .
French may find the apple to be costly which will affect the
demand of US apples in France . Alternatively if EUR price
is kept unchanged at EUR1 the balance between the French
supply and demand is not affected, but the exporter now
only receives 1/1.2 = USD 0.83 for the apple

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ECONOMIC EXPOSURE
 Economic exposure or operational exposure moves outside of the
accounting context and has to do with the strategic evaluation of foreign
transactions and relationships.

 Its determination requires an understanding of the structure of the

markets in which an enterprise and its competitors obtain capital, labour,
materials, services and customers.

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OBJECTIVES OF RISK
MANAGEMENT
 The maintenance of the reporting enterprise's book value of
global investments in terms of accounting communication in the
reporting currency. This is synonymous with managing
translation exposure.
 The maintenance of exchange values on contractual receipts and
payments which are denominated in foreign currencies. This is
synonymous with managing transaction exposure.
 The maintenance of future foreign currency cash flows in terms
of the reporting currency. This is synonymous with managing
economic exposure.

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INTEREST RATE EXPOSURE AND
RISK
 A firm wants to undertake a fixed investment Project . For this it
requires a foreign currency financing and is forced to borrow on floating
interest rate. Since cost of capital is uncertain, an additional element of
risk is introduced in project appraisal.

 Thus an adverse movement in interest rate hurts the businesses

positively or negatively.

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HEDGING STRATEGIES
 A hedge is a position established in one market in an attempt to offset
exposure to price fluctuations in some opposite position in another
market with the goal of minimizing one's exposure to unwanted risk.

 Few Hedging instruments:

 Forwards.
 Futures.
 Options.
 Swaps.

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FACTORS AFFECTING HEDGING DECISIONS

 Firm size
 Leverage
 Liquidity and profitability
 Sales growth

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THANK YOU

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