Foreign exchange risk and exposure

Kanchan KandelBBA 8th

Risk and exposure Business firms, whether operating domestically or

internationally, are exposed to risks of adverse movements in their profits resulting from unexpected movements in exchange rates.

Movement of exchange rates gives rise to foreign exchange exposure and foreign exchange risk.

Though these two terms are often used interchangeably, in reality they represent two different, yet closely related, concepts. Let us first understand these two terms. 2

Foreign Exchange Risk Management

Exposure refers to the degree(sensitivity) to which a company is affected by exchange rate changes.

It is calculated by regression.

Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.

It is calculated by variance or standard deviation.

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Cont… Thus as the foreign exchange exposure is the sensitivity of values of

assets, liabilities and operating income to the unexpected change in the exchange rate, we can relate this relationship to a regression equation which is as mentioned below:

ΔV($) = β ΔS($/£) + µ ------ Eq.(I) Here, β (exposure) =regression coefficient which explains the

systematic relation between ΔV and ΔS($/£). ΔV=change in value of foreign assets denominated in domestic

currency ΔS=change in exchange rate (Direct quote) µ = random error (regression error). If we assume there is no random error then

exposure (β) = ΔV($) / ΔS($/£)

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Types of Exposures

Transaction Exposure

Translation Exposure (Accounting Exposure)

Operating Exposure (Economic Exposure)

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Transaction Exposure Transaction Exposure: Results from a firm taking on “fixed”

cash flow foreign currency denominated contractual agreements. Examples of transation exposure:

An Account Receivable denominate in a foreign currency. A maturing financial asset (e.g., a bond) denominated in a foreign

currency. An Account Payable denominate in a foreign currency. A maturing financial liability (e.g., a loan) denominated in a foreign

currency.

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Cont…

For instance, if a firm has entered into a contact to sell computers to a foreign customer at a fixed price denominated in foreign currency, then the firm would be exposed to exchange rate movements till it receives the payment and converts the receipts into the domestic currency.

Cont… In contractual assets, the exposure value is equal to euro deposits

(Face value).

Exposure is positive magnitude i.e. change in exchange rate and dollar value of the investment move same direction.

If investor gain when the spot value of foreign currency increase and loss when it decrease is known as long position in foreign currency

In contractual liabilities exposure is negative magnitude i.e. change in exchange rate and dollar value of the investment move opposite direction.

If investor gain when the spot value of foreign currency decrease, loss when it increase is known as short position in foreign currency

Translation exposure Translation exposure, (also called accounting exposure),

results from the need to restate foreign subsidiaries’ financial statements, usually stated in foreign currency, into the parent’s reporting currency when preparing the consolidated financial statements.

While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price

Restating financial statements may lead to changes in the parent’s net worth or net income.

If exchange rates have changed since the previous reporting period, translation/restatement of those assets/liabilities, revenues/expenses that are denominated in foreign currencies will result in foreign exchange gains or losses

Cont… When converting financial statement items (transactions)

denominated in currencies other than the parent currency, two choices of exchange rate are possible:

The historical rate, the exchange rate prevailing at the time of the transaction.

²The current rate, the exchange rate prevailing at the balance sheet date or during the income statement period.

There are two method of adjusting Translation exposure:

Temporal Method

Current Rate method

Management of transaction exposure

Forward contract hedge

Option hedge

Money market hedge (borrowing or investing in local market)

Overview of Options Contracts

Important advantage: Options provide the investor which the potential to take

advantage of a favorable change in the spot exchange rate. Recall that this is not possible with a forward contract.

Important disadvantage: Options can be costly:

Firm must pay an upfront non-refundable option premium which it loses if it does not exercise the option. Recall there are no upfront fees with a forward contract.

This fee must be considered in calculating the home currency equivalent of the foreign currency.

This cost can be especially relevant for smaller firms and/or those firms with liquidity issues.

Leading and lagging To “lead” means to pay or collect early, whereas to

“lag” means to pay or collect late.

If there is payable and you expect that foreign currency will appreciate in near future but before credit period, it may attempts to expedite the payment to exporter before the foreign currency appreciation. As we know if foreign currency appreciate you have to pay more. This is the leading strategy.

As second scenario, assume that you expect the foreign currency will depreciate in near future but before credit period, it may attempts to stall its payment until the after the foreign currency depreciate. Deprecation of pound gives lower payments. This is the lagging strategy

Manager hedge vs. Shareholder hedge

There is always question of who should hedge corporate risk? It should hedge by corporate manager or individual shareholder. Following are some of the strong reason to hedge corporate risk by manager not by shareholder.

Progressive tax rate: Volatile EBT

Cost of hedging: Economic of scale

Operating cost: Volatile income

Debt repayment: If organization loan mature when their income is low

Strategic planning: Difficult to collect information

Instrument availability: Specialization

Exposure and purchase power parity

Relative theory of PPP suggests that the exchange between two countries should change as difference of inflation rate of these two countries

If relative purchasing power is hold then there will be no exposure. Exposure arise due to change in exchange rate and when change in exchange rate is offset by inflation change there is no question about arising exposure.

Suppose euro depreciate from 1.500/€ to 1.3500/€ during the year. American MNC has building worth €1,000,000 in Europe. In same year America experience 0% inflation and Europe 11.1111% inflation. new price of building after inflation will be €1000,000*1.111111=€1,111,111.