Currency Risk Management: I

1. Currency Risk Management: I

2. Foreign Exchange Risk: This is the risk of loss due to change in the international exchange value of national currencies. Importance of Exchange Risk: • Daily currency fluctuations • Increasing integration of the world economy Foreign Exchange Risk Exposure: This refers to the possibility that a firm will gain or lose due to changes in the exchange rate. Every company faces exposure to foreign exchange risk as soon as it chooses to maintain physical presence in a foreign country.

3. Role of International Finance Manager: An important role of the international finance manager is to compare potential losses with the cost of avoiding these losses. Types of Exchange Exposure: • Translation (Accounting) Exposure: →Measures the effect of an exchange rate change on published financial statements of a firm. The accounting rules in many countries require the home country of the company to prepare consolidated financial statements. → Companies translate financial statement items from a foreign currency into their home country in order to prepare consolidated financial statement or compare financial results.

4. Example 3.1 A US parent company has a wholly owned subsidiary in Singapore. This subsidiary has exposed assets of SD100 million and exposed liabilities of SD50 million. The exchange rate declines from SD4 per US$ to SD5 per US$. The potential foreign exchange loss on the company’s exposed net assets of SD50 million would be US$2.5 million. Net Exposure (SD100 million – SD50 million) SD50 million Pre devaluation rate (SD4 = US$1) SD50 mill. US$12.5 million Post devaluation rate (SD5 = US$1) SD50 mill. US$10.0 million Potential exchange loss US$2.5 million

5. Transaction Exposure: → Gains or losses may result from the settlement of transactions whose payment terms are stated in a foreign currency. → Transaction exposure refers to the potential change in the value of outstanding obligations due to changes in the exchange rate between the inception of a contract and the settlement of the contract. Example 3.2 Boeing sold an airplane to Korean Airlines for 840 million won with terms of one year. Boeing will receive its payment in Korean won. The spot rate for Korean currency is 700 won per dollar and Boeing expects to exchange 840 million won for $1.2 million (840/700) when payment is received.

6. Requirements: • If the spot rate for won rises to 600 won per dollar one year from today, what is the potential transaction gain or loss? • If the spot rate for won declines to 1000 won per dollar at maturity, what is the potential transaction gain or loss? Transaction exposure: When Payment is 840,000,000 won after one year Spot rate Won 700 =1US$ Payment is US$1.2 million Spot rate Won 600 = 1US$ Payment is US$1.4 million a) Potential exchange gain (1.4 – 1.2) US$0.2 million Spot rate Won 1000 = 1US$ Payment is US$0.84 million b) Potential exchange loss (1.2 – 0.84) US$0.36 million

7. Economic Exposure: • Economic exposure, also called as operating exposure or competitive exposure or revenue exposure, 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 economic 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. Comparison of Three Exposures: • By definition, translation exposure does not look to the future impact of an exchange rate change that has occurred or may occur. In addition it does not involve actual cash flows • Both transaction and economic exposures look to the future impact of an exchange rate. They consider actual and potential cash flow changes.

8. Techniques for Hedging Foreign Exchange Risk: Foreign exchange hedging techniques can be usefully segregated into two categories: • Those internal to the company • Those that are external to the company • Internal Techniques of Exposure Management: • Netting: → This involves associated companies which trade with each other setting off inter-company debts → The mechanics of netting involves each subsidiary informing of company debts in each currency to the head office at the end of each period. Head office decides on the best netting arrangement and instructs the subsidiary accordingly

9. Leading and Lagging: → Leading and lagging adjusts the timing of payments or receipts to alter the future exposure position of a company in a particular currency. → If the price of foreign currency is expected to rise, the potential increase in cost can be reduced by speeding up (leading) the payment while conversely the importer would wish to delay payment (lag) as long as possible when the price of foreign currency is expected to fall. • Matching: →In order to mitigate translation risk, a company acquiring a foreign asset should borrow funds dominated in the currency of the country in which it is purchasing the asset. →To mitigate transaction risk, a company selling its goods in the US with prices denominated in dollars could import raw materials through a supplier that invoices in dollars.

10. Invoicing in local currency: →A company exporting goods could invoice for them in its domestic currency, rather than in the currency of the company to which it is exporting. →The transaction risk is then transferred to the foreign company buying the goods. The drawback of this method is that it may deter potential customers, as they may transfer their order to companies that invoice in their own currency.