DEFINITION • “FOREIGN CURRENCY RISK” has been defined by IFAC on “foreign currency exposure and risk management” as the net potential gain or loss which can arise from exchange rate changes to the foreign currency exposure of an organization Exchange rate risks arise because of international business being done in an environment where no uniform or universally acceptable currency is there. In results, operation are generally denominated in currencies other than the domestic one. In the absence of fixed exchange rate system, we find violent fluctuations in currency relationships. These currency relationships fluctuates not only daily but also by every hour. Management of such risk involved, in such situation is the most difficult job for a cooperate manager. On the other hand, in present scenario interest rate all around the globe are fluctuating frequently. Modern concept of finance concentrates on borrowing capital and it has become difficult to arrange borrowed finances on a fixed rate basis
What is currency risk? CURRENCY RISK It is a form of financial risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk (or foreign exchange risk). • For example, if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the U.S. dollar.
Exposure & risk*In Financial context • Each firm is “exposed” to unforeseen changes in a number of variables in its environment. These variables are called Risk Factors. E.g. Exchange rate fluctuation is a risk factor. • For example, between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady. For an Indian firm involved in exports and imports from US, this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable. It is the measure of the sensitivity of a firm’s performance to fluctuations in the relevant risk factor i.e. whether or not a certain risk factor affects a firms performance. EXPOSURE RISK It is the measure of the extent of variability of the performance attributable to the risk factor i.e. how much does a risk factor affect a firms performance.
To hedge or not to hedge? • Hedging is the taking of a position, either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position. • Hedging, therefore, protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure).
Technical forecasting • IT INVOLVES THE USE OF HISTORICAL EXCHANGE RATE DATA TO PREDICT FUTURE VALUES. • This type of forecasting is similar to the technical forecasting of share prices. Common investors use to predict the future prices of shares on the basis of examination of past movements of prices of the shares. However in case of this type of technical forecasting for exchange rate will be time consuming and costly. It will be time consuming because of monitoring currency movements in the search for any systematic pattern. From a company point of view, use of technical forecasting may be limited as it typically focuses on future, which is not helpful for developing polices of the company
Fundamental forecasting • It is based on fundamental relationship between economic variables and exchange rates. • e= f[ INF, INT, GC, EXT] • e=% change in the spot rate • INF= change in the differential between U.S. inflation & the foreign country’s inflation • INT= change in the differential between U.S. interest rate & the foreign country’s interest rates • INC= change in the differential between U.S. income level & the foreign country’s income level • GC= change in government controls • EXT= change in expectations of future exchange rates.
continue For instance the objective of Indian company is to forecast the percentage change in indianrupeewith respect to australian dollar during the last quarter of 2005. for simplicity we can assume that two factors can influence the rupee value on which indian company’s forecast is dependent. These two factors can be as under • Inflation in Australia, relative to inflation in india • Income growth in Australia relative to income growth in india Firstly historical data can be used as to determine how these variables have affected the % change in the value of rupee in past.
Market Based forecasting • Spot rate • Forward rate For instance, if US dollar is expected to increase against the rupee value in near future, that may encourage general public involved in speculation activities to buy US dollar in anticipate of its appreciation, on the other hand if US dollar is expected to devaluate against rupee value, speculators will sell their US dollar
mixed • In the absence of single appropriate and consistent forecasting technique of the multinational cooperation are using combination of different forecasting techniques. Tis is known as mixed forecasting.
Currency exposure • Transactions exposure • Translation exposure • Operating exposure • Economic exposure
Types of currency exposures ILLUSTRATIVE EXAMPLES: A Taiwanese company has the following USD exposures: • Owns a factory in Texas worth US$5 million. • Agreement to buy goods worth US$2 million. • Biggest competitor is a US company. What happens if the NT dollar appreciates? • NT$ value of US factory goes down (translation). • NT$ cost of buying goods goes down (transaction). • Global competitiveness of Taiwanese company decreases (operating). 1 US$= 32.6580NT$ → 31NT$
TRANSLATION exposure • Introduction & example • Strategies to manage translational exposure
Translation exposure TRANSLATION EXPOSURE Translation exposure, also called Accounting Exposure or Balance Sheet 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. • The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements. • It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future. • It has no direct impact on cash flows of a firm.
Translation exposure • No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent company's stock. Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company, unless the foreign operations are an integral part of the parent business for e.g. a branch. • However, major stock exchanges require it as one of their listing requirements. • As more and more Indian firms are going multinational, they are increasingly considering translation and consolidation of foreign subsidiaries, and hence are becoming vulnerable to translational exposure.
Translation exposure: An ExampleAn Indian Company with a U.k. subsidiary Financial details of U.K. Subsidiary
TRANSLATION exposure • Introduction & example • Methods • Strategies to manage translational exposure
Current /non current method • Current assets (like Cash) and current liablitiestranslated at the spot rate (current exchange rate) • Revenue and expenses related to non-current assets and long term borrowings at the historical cost.
t t t= current rate Rest of the balances are on historical cost
Monetary/Non monetary method • Monetary items: e.g. cash, accounts receivables, current liabilities, account payable and long term debt. • Non-monetary items: inventory, fixed assets, long term investment. • Monetary items: current rates • Non-monetary items: historical rates • P/L= AER except COGS, depreciation or those related to non-monetary item.
Temporal method • The underlying principle is that assets and liabilities should be translated based on how they are carried on the firm’s books. • Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value. • Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books. • Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).
Current rate method • All balance sheet and income statement items are translated at current rate except equity. • Equity = historical rate. • COGS and Depreciation = Actual exchange rate/weighted average exchange rate. • Dividend paid = exchange rate on payment date. • Gains/loss reported separately in cumulative translation adjustments.
TRANSLATION exposure • Introduction & example • methods • Strategies to manage translational exposure
Managing Translation exposure:Balance sheet hedge • Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge. • To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. Hence this is not always a very wise option. Making an investment to reduce or control risk. Investors use this strategy when they are unsure of what the market will do. HEDGE • In simple language, a hedge is used to reduce any substantial losses/gains. A hedge can be constructed from many types of financial instruments, including stocks, derivative products, futures contracts etc. BALANCE SHEET HEDGE It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency, so that the net exposure is zero.
Managing Translation exposure:derivatives hedge DERIVATIVES A derivative is a financial contract which derives its value from the performance of another entity such as an asset, index, or interest rate, called the "underlying". • Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. • For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. • Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat.
Transaction exposure • Introduction & example • Strategies to manage transaction exposure
Transaction exposure TRANSACTION EXPOSURE The risk, faced by companies involved in international trade, that currency exchange rates will change after the companies have already entered into financial obligations. • It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency. • Transaction exposure is short term in nature. • It has a direct impact on cash flows of a firm.
Transaction exposure:Examples • A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future; • A currency has to be converted to repay a loan or make an interest payment on a particular date in future; • A currency has to converted to make a dividend payment, royalty payment etc. whose foreign currency amount is fixed. For e.g. suppose a firm receives an export order. It fixes a price, manufactures the product, makes the shipment and gives 90 days credit to the buyer who will pay in his currency. Then, the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency.
Transaction exposure:Examples Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for€1,800,000 payment to be made in 60 days. (S0 = $0.90/€) The U.S. seller expects to exchange the €1,800,000 for $1,620,000 when payment is received. • Transaction exposure arises because of the risk that the U.S. seller will receive something other than $1,620,000. • If the euro weakens to $0.8500/€, then Trident will receive $1,530,000 • If the euro strengthens to $0.9600/€, then Trident will receive $1,728,000 • Thus, exposure is the chance of either a loss or a gain.
Transaction exposure • Introduction & example • Strategies to manage transaction exposure
Managing Transaction Exposure:Forward market hedge An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Contracts entered into in the forward market are binding on the parties involved. FORWARD MARKET • If you are going to owe a foreign currency on future, agree to buy the foreign currency now by entering into long position in a forward contract. • If you are going to receive a foreign currency on future, agree to sell the foreign currency now by entering into short position in a forward contract. The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value is called long position. The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value is called short position.
Managing Transaction Exposure:money market hedge • To hedge a foreign currency payable, buy the foreign currency today &hold it. • Buy the present value of the foreign currency payable today • Invest that amount at the foreign rate • At maturity your investment will have grown enough to cover for your foreign currency payable. • A US based importer of Italian bicycles. What can he do in this situation? • In one year owes €100,000 to an Italian supplier • The spot exchange rate is $1.25 = €1.00 • The one year interest rate in Italy is 4% Can hedge this payable by buying €96,153.85 = €100,000/(1.04) today and investing it at 4% in Italy for one year. At maturity he will have €100,000 = €96,153.85*(1.04)
Managing Transaction Exposure:money market hedge • A US based importer of Italian bicycles. What can he do in this situation? • In one year owes €100,000 to an Italian supplier • The spot exchange rate is $1.25 = €1.00 • The one year interest rate in Italy is 4% Dollar cost today = $120,192.31 = €96,153.85 * With this money market hedge, we have redenominated a one-year €100,000 payable into a $120,192.31 payable due today. If the US interest rate is 3%, we could borrow$120,192.31 today and owe it in one year. $123,798.08 = $120,192.31 * (1.03)
Managing Transaction Exposure:Options market hedge An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. OPTIONS • To hedge a foreign currency payable buy calls on the currency. • If the call currency appreciates, your call option lets you buy the currency at the exercise price of the call. • To hedge a foreign currency receivable buy puts on the currency • If the currency depreciates, your put options lets you sell the currency for the exercise price. • Two types of options are: • A call gives the holder the right to buy an asset at a certain price within a specific period of time. • A put gives the holder the right to sell an asset at a certain price within a specific period of time.
OPERATING exposure • Introduction & example • Strategies to manage operating exposure
OPERATING exposure OPERATING EXPOSURE Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, 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. • Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure.
ATTRIBUTES OF OPERATING exposure • The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows. • Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments, royalty and license fees and assorted management fees. • Financing cash flows are payments for loans (principal and interest), equity injections and dividends of an inter and intracompany nature.
Measuring the impact of OPERATING exposure • In the short run, it is difficult to change the exposure due to implied obligations, such as purchase or sales commitments, because the currency of denomination cannot be changed. • It is also difficult to change sales prices or to renegotiate factor costs SHORT RUN IMPACT
Measuring the impact of OPERATING exposure • The second level impact is on expected medium-term cash flows. • If parity conditions hold, the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows • The country of cash flow origination and its monetary, fiscal, and balance of payments policies will determine whether firms can adjust prices and costs. • Example: If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises, Volvo will be protected if it can raise its DM prices, so that the Krona price is maintained. MEDIUM RUN – PARITY CONDITIONS HOLD
Measuring the impact of OPERATING exposure • Long-run cash flows beyond five years could be affected. Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes. • In principle, all firms subject to international competition, domestic or multinational, are subject to foreign exchange operating exposure in the long run, whenever real variables are affected. LONG RUN
Management of Operating Exposure • Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. • The four most commonly employed proactive policies are: • Matching currency cash flows • Risk-sharing agreements • Back-to-back or parallel loans • Currency swaps
Management of Operating Exposure:Matching currency cash-flows • EXAMPLE: • A US firm has continuing export sales to Canada. • In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars. • This policy results in a continuing receipt of Canadian dollars month after month. • This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements.
Management of Operating Exposure:Matching currency cash-flows Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars
Management of Operating Exposure:Matching currency cash-flows • One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). • Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms. • In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.
Management of Operating Exposure:Risk sharing agreements • Currency Clauses: Risk-Sharing • An alternate method for managing a long-term cash flow exposure between firms is risk sharing. • This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them. • This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements.