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Risk Management Strategy. Joy McAlister November 4, 2003. Overview. Short-run transaction management Diversification Routing cash balances Payments netting Leading and Lagging Re-invoicing Intermediate-run operations management Marketing and Production management
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Risk Management Strategy Joy McAlister November 4, 2003
Overview Short-run transaction management • Diversification • Routing cash balances • Payments netting • Leading and Lagging • Re-invoicing Intermediate-run operations management • Marketing and Production management • Managing net worth exposure
Short-Run Transaction Management Management Decision: To centralize or decentralize management of foreign exchange risk and international cash balances.
Diversification Centralization • Reduces the number of hedge transactions overall • Economies of scale • Reduces risk through diversification Decentralization • Potential for excessive hedging • Does not lead to portfolio effect
Routing Cash Balances In a centralized organization, the cash depository serves as a pooling center for international currency. • Protects from borrowing at high interest rates and saving at low interest rates • Facilitates currency conversion • Lower transaction costs
Payments Netting A goal of centralized transaction management is to reduce the number of intra-company payments. • Payments netting can reduce the amount of currency transferred between departments/subsidiaries • Multilateral payments netting • Reduces transactions • Facilitates currency conversion
Leading and Lagging “A method of routing cash balances by using the payments netting system, which accelerates payments to a subsidiary that needs cash and delay payments from the same subsidiary that are due all other subsidiaries.” • Increased asset liquidity for subsidiaries
Re-invoicing Process of import and export transactions in favor of each subsidiaries home currency. • Under centralization model, management accepts transaction exposure and foreign exchange risk • Subsidiary is left to operate exclusively in home currency
Intermediate-Run Operations Management Managing Cash Flow Exposure Objectives: • Manage revenue through marketing • Manage costs through production • Pre-planned flexibility • Active response to exchange rate signals
Marketing Management Increase sales in countries where currency is overvalued and decrease sales in countries where currency is undervalues – in respect to PPP. • Marketing impact on marginal revenue vs. cost • Product design as a component of marketing strategy • Pricing strategy
Production Management Focus on countries where the currency is undervalued. • Production should be in a country that is a low-cost producer • Sourcing from low-cost producers
Managing Net Worth Exposure Management concern is the underlying currency denominations of the firms assets and liabilities. Balance sheet hedge is a way to manage economic exposure through structuring the balance sheet exposure to offset a firm’s income statement exposure.
Current Risk Management Examples • www.garp.com • www.contingencyanalysis.com