FOREIGN EXCHANGE RISK MANAGEMENT AND EXPOSURE

INTERNATIONAL FINANCE

By:-

Group 5

April 11, 2023 1

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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