Foreign Exchange Exposure

What is meant by exposure?



Simply speaking, exposure is the risk of unanticipated change in exchange rate. It is the influence the value of those firms that are involved in international transactions.

How important is study of exposure?



Some consider that exposure is IRRELEVANT. This argument is based on PPP theory which explains that the movement in exchange rate is matched by the movement in price and so the financial performance of a firm is not affected.

Example on irrelevance of exposure

  

Suppose inflation in India is more than in US. As a result, the value of rupee depreciates as regards the dollar. The Indian company importing components from US will face cost escalation on account of higher import bill and its competitive power will come down against the domestic firms producing and marketing similar products.

But since the exchange rate changes have occurred because of higher rate of inflation, the cost of domestic firms too will escalate. There will then be no change in the competitive position between the domestic firm and the importing firm even after the changes in the exchange rate. Means exchange rate exposure is irrelevant.

Exchange rate exposure is relevant

 

Because PPP is not applicable in the short run, exchange rate exposure is irrelevant. Even if it would be the long run, there are so many factors and not only the inflation rate differential that influences the exchange rate. If the exchange rate changes happen because of some other factors, the resulting exposure will then not be matched by changes in the inflation rate differential and the exchange rate exposure could really matter.

Then..


 

Unstable exchange rates lead to instability in a firms growth and may lead to bankruptcy. Hence firms have to be vigilant And apply various hedging tools to protect themselves.

You should know.



Hedging the management of exchange rate exposure by systematic and calculated methods. Speculation the trial and error method by which profits are sought to be made in foreign exchange exposure.

Type of exposure
 

Basically two types : A). Accounting or translation exposure. B). Economic exposure.

Economic exposure


 

The economic exposure is further divided into 1).transaction exposure 2). Real operating or operating exposure.

To summarise


  

3 types of foreign exchange exposures.. a). Accounting exposure b). Real operating exposure c). Transaction exposure

What are these exposures?



Accounting/ translation exposure is derived from the consolidated financial statements of the parent company and it DOES NOT influence the cash flows of the company. Economic exposure on the other hand is the result of the altered cash flow of a company.

About economic exposure.



Transaction exposure refers to the foreign exchange loss or gain on transactions already entered into and denominated in a foreign currency, as a result of changes in the exchange rate In short, it is concerned with changes in PRESENT CASH FLOWS

Real operating exposure is related to changes in future cash flows. Concerned with impact of exchange rate changes along with the changes in inflation rate on the cost and revenue structure of the firm.

TRANSACTION EXPOSURE


A Firm is faced transaction exposures when it is faces contractual cash flows that are fixed in foreign currencies. It is the sensitivity of relalized domestic currency values of the firms contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure arises from fixedprice contracting in a world where exchange rates are changing randomly.

How do firms become prone to transaction exposure?



Transaction exposure emerges mainly because of A). Export and import of goods and services on open account. B). Borrowing and lending in a foreign currency & C). Intra-firm flows in an international company.

1).Export and import on Open Account



It can cause appreciation or depreciation in the value of currency and hence on the profitability of the concern. Example : the huge appreciation in terms of rupee Vs dollar has hit badly the earnings of Infosys.

According to Eitemann, transaction exposure is divided into 3 parts.



1).quotation exposure created when the exporter quotes a price in foreign currency and exists till the importer places an order with the exporter at that price. 2). Backlog exposure exists between the placement of order by the importer and the shipping and billing by the seller. 3). Billing exposure exists between the billing of the shipment and the settlement of the trade payments.

2).Borrowing and lending in a foreign currency



Transaction exposure exists when borrowing or lending is done in a foreign currency. Lenders and borrowers can benefit or suffer, depending on the appreciation or depreciation in the foreign currency.

3). Intra-firm flow in an International Company



Happens when funds flow among the different units that are located in different countries. Can cause profit or loss to the units depending on whether there is appreciation or depreciation of the currency.

Consolidated net exposure



It considers both the inflows and outflows of funds and it is the net amount that determines the size of transaction exposure.

Find out the transaction gain/loss on the basis of the following data pertaining to Indias foreign trade :
Particular Us $ , in s million Import Export Prechange rate Postchange rate 1,250 1,150 Rs.45/$ Japanese British L, Yen, milln in million 650 800 625 Rs.0.40/ yen Rs.0.41/ yen 850 Rs.70/L

Rs.47/$

Rs.68/L

REAL OPERATING EXPOSURE



Happens when changes in exchange rate together with rates of inflation, alter the amount and risk element of a companys future revenue and cost stream.

Facts about Operating Exposure :



Addresses the issues of how to assess and manage the impact of exchange rate changes on the firms future cash flows, which are not fixed in either the home currency or the foreign currency. Neither the prices nor the quantities of outputs and inputs are fixed and all are subject to change when exchange rates change. Consequently, the firms profit margin measured in either currency is influenced by exchange rate.

Impact of Operating Exposure



Can be felt well beyond just pricing and invoicing decisions. Some output markets can become relatively more or less attractive compared to others. Input sourcing decisions may have to be reviewed. In some cases, the firm may even decide to relocate its production facilities.

Examples on Operating Exposure seriousness :



Due to the rising dollar during the first half of eighties, a number of US companies shifted their sourcing of components and materials abroad rather than buy from US suppliers, so that they could reduce costs. Also, in this period, some US corporations shifted manufacturing facilities abroad in order to retain their cost competitiveness.

Laker Airways was a British Airline which existed in the late seventies. It offered simple flights to British tourists visiting US. The companies business grew rapidly so that it expanded its fleet and financied the purchase with US $ borrowing.

During the first half of eighties, as the dollar rose steeply against the pound sterling, tourist traffic from UK to US shrank. This coupled with the transactions exposure on its debt service, created enormous difficulties for the firm eventually leading to bankruptcy.

After, the east asian currency crisis, in which some of those currencies dropped by as much as 50% against the US $, Indian exports of gems and jewellery to the Western markets suffered a competitive disadvantage vis-vis exporters from East Asia.

The recent outcry over the rising Rupee against the $, has infact drastically reduced the earnings potential of several big indian software firms. Even their market capitalisation has suffered a reduction.

To summarise:


Unanticipated changes in exchange rates can have a serious and sustained impact on a firms revenue and costs. This may threaten its very survival in its existing markets and viability of its existing lines of business. This may force the company to restructure the companys operations.

But the most important about operating exposure is..



A company is subject to operating exposure even when it has LITTLE OR NO DIRECT INVOLVEMENT in international markets.

How can this happen???????????



Let us consider a domestic firm whichProduces exclusively for the domestic market. Sources all its inputs from domestic suppliers Then

Changes in exchange rates for such firms can affect in the following ways:


The firms competitors may be importing a competing product. Changes in the home currency exchange rate affect their costs and hence their competitive posture. Example: if the home currency appreciates, they may reduce their prices as compared to domestic firms.

Even though the firm sources all its inputs from domestic suppliers, they in turn and their suppliers in turn, may have imported inputs or competition from imports. Changes in exchange rate affect their costs and hence the prices they offer to our domestic firms. This is called as INDIRECT OPERATING EXPOSURE.

Consumers of the firms output may have direct exposure to exchange rates. A change in their fortunes has an impact on our domestic firms. Example : a manufacturer of chemicals used in leather industry, faces indirect exposure because many of its customers are exporters of finished leather goods.

Changes in exchange rate may lead to changes in wages due to their impact on the cost of living index which affects all the firms in the economy. They may also lead to macroeconomic policy shifts like monetary tightening in the face of depreciation home currency or changes in trade policies which again impacts all the firms in the country.

To conclude..


The analysis and the management of operating exposure are at the same time more important and considerably more difficult than contractual transactions exposure. Because operating exposure can have significant long-term impact on future business of the firm and its strategic posture.

It is more difficult because it involves too many questions and assumptions And no simple hedges like forward contracts are available. This makes operating exposure hedging highly IMPRACTICABLE if not IMPOSSIBLE !!!!!

What are the factors on which operating exposure depends?



1).Changes in nominal exchange rate. 2). Changes in selling price or output price. 3). Changes in the quantity of the output sold. 4).change in operating costs, i.e quantities and prices of inputs.

Consider this example.

 

   

An indian co exports carpets to UK. Beginning of the year, the rate is Rs.68/L Price is 200L Sales at this price is 100unit/month Domestic S.P is Rs.8000/unit. Thus, its operating margin is Rs.5600 per unit.

Over the year, the following have happened------    

 

Uk prices up by 5% Indian prices up by 15% It can raise UK price to 210L without affecting sales. Operating costs increases to Rs.9200 If its operating margin in real terms is to be maintained, ie Rs.6440, it must get R.s15640 from each unit. If exchange rate increases to rs.74.47, the firm is unaffected. But this means that real exchange rate must remain unchanged as 74.47=68*1.15/1.05

How to manage operating exposure?



Operating exposure covers a much longer horizon than contractual transactions exposures. Long-maturity forward contracts are not easily available even in major currencies of the world.

The only ways then are..



   

Altering the firms operations consisting of pricing. Choice of markets. Sourcing of materials Location of production etc. However, these are not easily alterable, everyone knows !!!!

Strong rupee set to hurt companys' earnings

Translation Exposure
 

Also known as accounting exposure. Emerges on account of consolidation of financial statements of different units of a multinational firm. To ascertain overall profitability and evaluate comparitive performance of different subsidiaries, they are consolidated.

How is this objective achieved?



By translating and transforming the items of the financial statements of subsidiaries denominated in different currencies into the domestic currency of the parent company.

What happens in this process?



When the currency of any of the host countries changes its value its translated value in the domestic currency of the parent company changes and also the picture of the consolidated statement. The extent of this change represents the TRANSALATION EXPOSURE.

Relevancy of accounting exposure



Accounting exposure irrelevant because it does not influence the cash flow nor the subsidiarys earning actually converted into the parents currency. Accounting exposure relevant because the change in the value of the currency of the host countries has an impact on the net worth of the firm as a whole.

Methods of translation
 

1). Current rate method 2). Current/non-current method. 3). Monetary/non-monetary method. 4). Temporal method.

1). Current rate method :



Also known as the closing rate method. In this method, all items of the balance sheet and the P&L A/c are translated at current rate or the post change rate.

Demerits of current rate method



Fixed assets are also translated at current rate and that goes against the principles of accounting.

Current/non-current method :


Current assets & current liabilities translated at current rate or the post change rate. The fixed assets and long term liabilites are translated at the historical or pre-change rate or a rate at which they were acquired. Income statement items are translated at the average of exchange rate- the prechange and the post-change rate. Few income statement items which by virtue of being closely related to the non-current assets and long-term liabilities are translated at pre-change or historical rate.

Monetary/non-monetary method :


     

Under this method, the assets and liabilities are classified as monetary and nonmonetary. Cash, AR, AP are monetary. FA,Stock,Investments are non-monetary. Monetary- at current rate. Non-monetary- at historical rate. Income statements items average rate. Income statements items closely related ot non-monetary assets and liabilities are translated at historical rate.

Temporal method


Uses historical rate for the items that are stated at historical cost. Items stated at replacement cost, realisable value, market value or expected future value are translated at current rate. For income statement items, the same norm as applicable for monetary/non-monetary method.