UNIT IV: RISK EXPOSURE

By:

Dr. Amit.K.Singh

FOREIGN EXCHANGE EXPOSURE

• Foreign exchange exposure is the measure of the potential of firm’s

profitability, net cash flow and market value to changes because of a change

in exchange rates.

• With the liberalization of the foreign exchange market, firm all over the

world have aware of the fact that fluctuation in exchange rates expose their

revenue, costs, operating cash flows and their market value to substantial

fluctuations. Liberalization of financial markets has enhanced corporate risk

significantly.

• An important task of the financial manager is to measure foreign exchange

exposure and to manage it so as to maximize the profitability, net cash flow

and market value of the firm.

• Firms which have exports and imports of goods and services, foreign

currency borrowings and lending’s, foreign investments are directly exposed

to currency fluctuations.

Exposure is the measure of the sensitivity of the value of the financial item (asset,

liability or cash flow) to changes in the relevant risk factor while risk is a measure of

variability of the value of the item attributed to the risk factor. Let us understand this

distinction clearly. April 1993 to about July 1995 the exchange rate between rupee

and US dollar was almost rock steady. Consider a firm whose business involved both

exports and imports from the US. During this period the firm would have readily

agreed that its operating cash flows were very sensitive to the rupee-dollar exchange

rate , i.e., it had significant exposure to this exchange rate; at the same time it would

have said that it didn’t perceive significant risk on this account because given the

stability of the rupee-dollar fluctuations would have been perceived to be minimal.

Thus, the magnitude of the risk is determined by magnitude of the exposure and the

degree of variability in the relevant risk factor.

RISK EXPOSURE

Foreign exchange exposure occurs because of unanticipated changes in the exchange rate.

Floating-rate regime, so value of currency changes frequently.

Currency rate fluctuations affect the value of revenues, costs, cash flows, assets and liabilities of a business organization.

Transactions of business firms with foreign entities could be in the form of exports, imports, borrowing, lending, portfolio investment and direct investment etc. So a firm with any one or more types of transactions is subject to exchange rate exposure.

Types of Risk exposure

RISK EXPOSURE

ACCOUNTTIONG/ TRANSLATION

ECONOMIC

TRANSACTION

Types of risk Exposure Exchange rate exposure/risk is classified into two categories:

(a) Accounting Exposure/ Translation Exposure (not involving cash flow)

(b) Economic Exposure (involves cash flow)

(c) Transaction Exposure (involves cash flows)

Accounting/Translation Exposure Translation exposure arises from the variability of the value of assets and liabilities as they appear in the balance sheet and are not to be liquidated in near future.

Translation of the balance sheet items from their value in foreign currency to that in domestic currency is done to consolidate the accounts of various subsidiaries. Therefore, translation exposure is also known as Consolidation Exposure or balance sheet exposure.

It is the mismatch between the transacted value of assets and liabilities following exchange rate change.

Ctd…..

Consolidation of financial statements is done by parent company to know the overall profitability of organisation as a whole and sometimes to evaluate the comparative performance of different subsidiaries.

Consolidation is done through translating the items of financial statements of subsidiaries denominated in different currencies into the domestic currency of the parent company.

When translation exposure will emerge?

If subsidiary maintains its accounts in the reporting currency i.e. domestic currency of the parent company , then the translation exposure does not emerge.

However normally, subsidiaries maintain their accounts in functional currency i.e. the currency of host country, there is every possibility of translation exposure to emerge in wake of exchange rate changes.

Methods of Translation Four methods are used for foreign currency translation. These are:

(i) the current/noncurrent method,

(ii) the monetary/nonmonetary method,

(iii) the temporal method,

(iv) the current rate method.

Current rate Method/ Closing Rate method

• This is the simplest method to use.

• Under this method, all items of the balance sheet are translated at the current rate except equity, which is translated at the exchange rates which existed on the dates of issuance.

• In this method, a Cumulative Translation Adjustment (CTA) account is created to make the balance sheet balance since translation gains/losses do not go through the income statement unlike in other three methods.

Current/ Non-current Method

• The basic principle behind the current/ noncurrent method is that assets and liabilities are translated on the basis of their maturity.

• Current assets and liabilities are translated at the current exchange rate.

• Noncurrent (long-term) assets and liabilities are translated at the historical exchange rate which prevailed at the time when they were recorded for the first time in the balance sheet.

Monetary/ Non-Monetary Method

• As per this method, all monetary items of balance sheet of a foreign subsidiary are translated at the current exchange rate. These terms include cash, marketable securities, accounts receivables and accounts/notes payable etc.

• All the nonmonetary items in the balance sheet, including equity, are translated at the historical exchange rate.

Temporal Method

Under this method, monetary accounts such as cash, receivables and payables, irrespective of their maturity (whether short-term or long-term) are translated at the current rate.

Other items are translated at the current rate if their value is written in the balance sheet at current rather than historical valuation.

On the other hand, if these items are carried at historical costs, they are translated at the historical rate. For example, inventory and fixed assets will have the same translated value under temporal as well as monetary/ nonmonetary method if they are recorded in the balance sheet at historical value.

Translation Example • Zepata Auto Parts, the Mexican affiliate of American diversified, Inc., had the

following balance sheet on January 1, 2010:

Assets Liabilities & Equity

Cash 1,000 Accts Payable 47,000

Accts Rec. 50,000 Long Term Debt 12,000

Inventory 32,000 Total Liabilities: 59,000

Net fixed Asset 111,0000 Equity 135,000

Total Asset 194,000 Liab. & Equity 194,000

At the beginning of the year, what is the Zapata’s translation exposure to the Peso?..... It depends on the translation method which determines which accounts are

revaluated at the new rate and which are not !

1. Current rate method: all assets and liabilities translated at current exchange rate each reporting period. Exposure is net quality.

Zapata Exposure 194,000- 59,000 = 135,000

2. Current/ Noncurrent Method: only current accounts are translated at current exchange rate .Noncurrent accounts remain at the historical exchange rate used to record the account. Exposure is CA-CL.

Zapata Exposure 1,000+ 50,000+32,000-47,000= 36,000

3. Monetary/ Nonmonetary Method: only monetary accounts are translated at current exchange rate. Non-monetary accounts remain at the historical exchange rate used to record the account. (Monetary accounts include cash, receivables, Payables, debt). Exposure is MA-ML.

Zapta Exposure 1,000+ 50,000 - 12,000-47,000= -8,000

4. Temporal method: same as monetary method except inventory is included. Exposure is

MA- ML+ Inventory

Zapta Exposure: -8000M+32,000 M= 24,000

Translation Methods

Summary: Translation Methods

Methods Current rate Current/ Non-current method

Monetary/ Non-Monetary method

Temporal Method

Current Rate All items CA & CL All liabilities All CAs except inventory

All liabilities All CAs if inventory at market price

Historical Rate FA & Long term Liabilities

Inventory & FAs FA & inventory only if they are at market price

Average Rate Income statement items except those related to fixed assets

Income statement items except those related to fixed assets

Income statement items except those related to fixed assets

Managing Translation Exposure

Hedging of translation exposure is not necessary as it does not affect cash flow but firms try to hedge in view of its potential impact on the reported consolidated earnings.

Technique- Balance sheet hedge supplemented by contractual and natural hedge.

Ctd…..

• Balance-sheet hedge removes mismatch between liabilities and assets through creating liabilities/ assets.

• Translation exposure if arises on account of lower amount of liabilities than assets and its impact on net worth, then fresh borrowings are made to eliminate this mismatch and if amount is lower than of liabilities, assets need to be matched with liabilities through making investment.

• Note: Investments should be made in strong currency and borrowings should be made in weaker currency. But when borrowings/ investments are made , there is a possibility of emergence of transaction exposure in case exchange rate changes, then contractual and natural hedges can be used.

Transaction Exposure

• Impact of changes in exchange rate on present cash flows.

• Transaction exposure emerges because:

Export & import of items (Trade)

Borrowing & lending in foreign currency

Intra firm flows in an international company

Ctd….. This exposure arises when a company has assets

and liabilities the value of which is contractually fixed in foreign currency and these items are to be liquidated in the near future.

To illustrate, let us consider that a company buys raw material from abroad the contractual price of which is $100. The payment will be settled after a credit period of six months within the current financial year. Till the date of settlement, this company has a transaction exposure of $100..

Ctd…..

If dollar appreciates during six months period, the company will have to pay more in rupees than what it would have paid on the date of contract. Conversely, depreciation of dollar will result in a smaller rupee outflow. Either way, the company remains under an uncertainty as to what rupee outflow will take place on the settlement date. This uncertainty of cash flows is what constitutes the exposure/risk.

Ctd….. From the above description, it becomes clear that transaction exposures affect operating cash flows during the current financial year and they have short time frame. As they arise from contractually fixed items, they are also called contractual exposures. Some examples of transaction exposure could be as follows: i) a foreign currency receivable or payable arising out of sales or

purchases of goods and services is to be liquidated in near future;

ii) a foreign currency loan or interest due thereon is to be paid or received shortly; iii) payment of dividend or royalty etc. is to be made or received in foreign currency.

Consolidated Net exposure Changes in net cash flows from all the sources.

Q: Find out the transaction gain or loss on the basis of following data pertaining to India’s foreign trade

US $ Miliion Japanese Yen, million

British pound million

Import 1250 650 800

Export 1150 625 850

Pre-change Rate

Rs 45/$ Rs 0.40/yen Rs. 70/ pound

Post-change Rate

Rs 47/$ Rs 0.41/ yen Rs.68/ pound

Ctd…..

Net inflow Pre change value (Rs million)

Post change value (Rs million)

Size of exposure (Rs million)

$ -100 -4500 -4700 -200

Yen -25 -10 -10.25 -00.25

Pound 50 Net Transaction

+3500 Exposure =

+3400 Rs. 300.25 million

-100

Management of Transaction Exposure

HEDGING TECHNIQUES For Transaction Exposure

CONTRACTUAL/ External Currency Future Currency Option Forward Market Money Market

NATURAL/ INTERNAL Leads & LAGS Cross Hedging Risk Sharing Parallel Loans Currency Swaps Currency Diversification Matching of cash flows Pricing of Transactions

ECONOMIC EXPOSURE • Economic exposure results from those items which have an

affect on cash flows but the value of which is not contractually defined, as is the case of transaction exposure.

• Some examples of operating exposure are given below; • a) Tender submitted for a contract remains an item of

operating exposure until the award of contract. Once the contract is awarded, it becomes transaction exposure.

• b) A deal for buying or selling of goods is under negotiation. The price of goods being negotiated may be affected by fluctuations in the exchange rate.

• e) Domestic inflation will increase in home currency. • d) Interest cost on working capital put costs of the firm even if

there is no change in the exchange rate. This will adversely affect its competitiveness vis-a-vis the firms of other countries.

Management of Economic Exposure Methods of managing economic exposure a) Selecting low-cost production location To set up its production facilities in a foreign country whose costs are lower. b)Adopting flexible sourcing policy Another way of reducing the economic exposure is to buy inputs from where they have lower cost. Sourcing from low cost countries is not limited to raw material or accessories but, also, the firms can hire low cost manpower from abroad c)Diversifying the market Diversification of the market of the firm's product will reduce its economic exposure.

Real Operating Exposure

• Real operating exposure manifests in changes in inflation-adjusted future cash flow of a firm following exchange rate changes.

• Real– Nominal exchange rate adjusted for inflation

• Operating– we are concerned with operating cash flow a change in which causes a change in the value of firm

Real operating exposure-Example

Q: A company expects cashflow from its new project to the extent of $5300, $6500 and $6000 respectively during the first three years of its operation. However due to changes in exchange rate/ inflation rate, the cash flow is affected and it will change to $4000, $5800 and $5200. Find the magnitude of the possible real operating exposure during the initial year of operation assuming a discount rate of 10%.

Ctd….

Answer:

Original expectation of cash flow= $5000/1.10+ 6500/1.21 + 6000/1.331 = $14425.23

Cash flow expectation after inflation rate/ exchange rate changes = 4000/1.10+ 5800/1.21+ 5200/1.331 = $12336.59

Size of real operating exposure= $14425.23 -12336.59 = $2088.64