Theory and Practice of

International Financial
Management

Foreign Exchange Risk

Management
Foreign exchange risk: meaning
• Value of a currency changes frequently
• Affects firms engaged in international
transactions
• Assets, liabilities and cash flows are
affected through changes in exchange
rates
• Possibility of unfavourable changes - Risk
 Types of risk/ exposure
• Accounting/ translation exposure: financial
statements
• Economic exposure: cash flows
– Transaction exposure: present cash flows
– Real operating exposure: future cash flows
 Translation exposure
• Occurs on consolidation of financial statements
of different units of MNCs
• When the value of currency of a subsidiary
changes, its translated value in the domestic
currency of the parent company changes
• This change represents translation exposure
• It is only an accounting exposure
 Transaction exposure
• Impact of exchange rate fluctuations on
present cash flows
• From transactions already entered into
– Export and imort
– Borrowing and lending in foreign currency
– Intra firm fund flow in an international
company
 Real operating exposure
• Changes in exchange rates alter future
operating revenues and cost streams of a
company
• Changes in future cash flows from
changes in exchange rates
- real operating exposure
 Foreign exchange risk:
techniques of management
• Transaction risk (short term):
– Hedging using currency forwards or futures
• Real operating risk (long term):
– Adaptation in production and marketing
strategy (plant location, input mixing, input
sourcing, market selection, product planning,
pricing, etc )
• Translation risk: accounting risk
 The Nature of Hedging
We have:
1. Developed a number of measures of exposure
2. Constructed measures of the risks associated with
these exposures
3. Determined how to identify the appropriate exposure to
hedge among a portfolio of exposures.
4. Reviewed the advantages and disadvantages of a
number of financial instruments that can aid us in
hedging these exposures.
 The Nature of Hedging
At this point, we want to address some broader concerns
in foreign exchange risk management:
1. Why hedge?
2. What kinds of risks should we focus on to hedge?
3. At what horizon should the hedging take place?
4. What can be done from the operational side to manage
foreign exchange risks?
5. What is an appropriate overall approach for managing
foreign exchange risk at a multinational?
 Why Hedge?
As we have seen, exposure alone does not justify hedging.
However, the risk associated with a particular exposure
may be sufficient to justify hedging.
But this assumes that companies are risk-averse.
When are companies risk-averse?
This question must be addressed before a firm undertakes the
costs associated with hedging foreign exchange risks.
Why do corporations prefer a known home currency amount
rather than a gamble with the same expected value involving
potential gains or losses?
What is the ultimate objective of the firm?
To maximize shareholder value…and minimize systematic
risks.
 Why Hedge?
Relative to the amount of hedging that takes place, the
arguments for firm risk-aversion are somewhat scarce.
When will risk management improve shareholder wealth
and/or reduce their systematic risk?
1. Tax gain/loss treatment asymmetry.
2. High financial distress costs.
3. Internal vs. external capital markets.
4. Executive compensation / monitoring / transparency.
5. Firms can hedge more efficiently than their shareholders.
The point is that unless a firm can identify one of the above
concerns as relevant to a particular exposure, the costs
associated with hedging may not be worthwhile.
 What instruments you can use
to hedge?
• Structural adjustment/counterpoising
Leads & lags
Forwards
Swaps
Options
Financial futures
Parallel lending/ Back-to-back loan
Currency baskets
Leasing
Foreign Exchange Debt Restructuring
Subsidiaries'‘ payments in growing currencies
• Self-insurance

and any other ones you can design

SMALL COFFEE BREAKE
 What instruments you can use
to hedge?
• Structural adjustment/counterpoising
• Leads & lags
• Forwards
• Financial futures
• Swaps
• Options
• Parallel lending/ Back-to-back loan
• Currency baskets
 Structural
adjustment/counterpoising
• Assets
• Liabilities
- Cash in Euro
- Short-term obligation
- Cash in USD – in USD
- Sell Contract in UKP - Mid-term obligation in
UKP
- Purchase Contract in
UKP
Leads & lags
 Forwards
A company expected payment in $87 mln in 27 days
and have to pay in three months Є 60 mln for taxation

Є60.1
XR $/Є $ 98

Forward 1.6 3

Spot 1.55 Є 

1.50 1.70 Є 
Є 66.7
 Financial futures

Є61.3
XR $/Є $ 100

Forward 1.51 1.6 3 1. 75

mnt 3 mnt 6 mnt

 Financial futures
Sold Futures Purchased Futures

Adverse movement
of exchange rate
Reimbursement

+ +
Rate of Rate of
contract contract
0 0
1,500 1,600 1,700 Rate 1,500 1,600 1,700 Rate

- -

Loss of
additional
windfall profit
 Future Contract Pricing
Formula for forward rate calculation:

(% Rate EURO BID - % Rate USD OFFER) x Days

BID = Spot BID x 1+
100 х 360

(% Rate EURO OFFER - % Rate USD BID) x Days

OFFER = Spot OFFER x 1 +
100 х 360

Interest Rate Spread may be either positive or negative. By this reason

forwards are traded either with premium or with SPOT Rate Discount (to
show interest rate spread between two currencies).
 Swap
Swap – combination of two opposite exchange
contracts with different dates: purchase/sale in the spot
market for a simultaneous purchase/sale in the forward
foreign exchange market.
 Swap
Bank

1Y Euro

Euro TOM USD TOM

1Y USD

Current Euro TOM USD TOM

Capital
Activity Company Market
1Y Euro 1Y USD

A company needs  funds make borrow expensive in  or cheaper in USD but face XR risk.
It can : sale USD for  by 1.4 for tomorrow (spot) and
purchase USD for  by 1.39 for 1 year (forward)
 Option
• Option – the right to choose, to buy (call option) or
to sell (put option) in any moment between two
given dates.
• For this right to buy/sell, the buyer/seller will
pay the other party called the writer a fee
(premium) which will be forfeited if the option is
not exercised before the day of maturity.
 Back-to-back loan
• Such loan involve two companies in
different countries funding the other
parties’ operations.

Inc.

Inc.
Currency Basket
 Currency Basket

Price Fixing in:

Є -Tailor Designed Basket
-SDR
-ECU

RUR UAH
SMALL COFFEE BREAKE
 What Risks Should be Hedged?
If firms should only concern themselves with risks that
have real economic costs associated with them, upon
which of our measures of exposure should we focus?
1. Translation exposure
Across-the-board changes in the balance sheet will
generally have little effect on the ongoing operations of the
firm. Cash flows are ignored and balance sheet entries are
measured in terms of book values.
The only possibility here is the tax gain/loss asymmetry. If
the firm operates in a high inflationary environment, it may
find the translation adjustment reported to the income
statement taxed more when positive than credited when
negative.
 What Risks Should be Hedged?
Likewise, a firm may find changes in foreign borrowing
subject to asymmetric treatment of capital gains/losses.
But this is really part of a larger point.
In general, if firms need to worry about the balance sheet,
it will be due to an anticipated sale or discontinuation of
the firm’s operations or due to changes in the firm’s
capital structure - when firm value is no longer in NPV of
cash flows.
If this is the case, the appropriate measure of exposure will
generally be net worth exposure - with assets and
liabilities recorded at market values.
Any balance sheet exposure hedging activities must focus
on net worth exposure and be justified from this
standpoint.
 What Risks Should be Hedged?
2. Transaction exposure
Transaction exposure is similarly limited as it focuses
solely on known, contractual cash flows.
Nonetheless, because these cash flows are almost always
denominated in pre-determined nominal amounts, hedging
them will perfectly insulate the firm against exchange rate
changes - nominal or real. Since the cash flows do not
change with inflation, they move entirely with nominal
rates.
Also, because transaction exposure focuses only known,
contractual amounts and as such will generally only
include cash flows of short horizon, financial instruments
for hedging them will be easily available and quite
inexpensive.
 What Risks Should be Hedged?
3. Economic Exposure
Economic exposure is ultimately what the firm should be
concerned with. For ultimately investors are concerned
with the value and riskiness of the firm itself.
Indeed, even transaction exposures should be evaluated in
terms of whether they are associated with an underlying
economic exposure.
When considering hedging a know outflow or cost, the
firm needs to evaluate the revenue side operations; and
when considering a known inflow or revenue, the firm
needs to evaluate the cost side.
For whenever the currency movement affects revenues
and costs equally, only the profit margin is truly exposed.
 What Risks Should be Hedged?
For treating economic exposure, financial hedges have
two main shortcomings:
1. Horizon. Outside of swaps, most financial hedges
become quite expensive over longer horizons. While
swaps can provide an inexpensive way to construct a
series of long-dated forward contracts, they require
accurate assessment of future cash flows.
For hedging future cash flows are uncertain, long-
horizoned futures contracts are unavailable, and the costs
of long-horizoned options will be prohibitively large.
 What Risks Should be Hedged?
2. Real vs. Nominal. Financial hedges can only hedge
nominal amounts. If there are real changes in home
currency costs and revenues, nominal hedges may be
quite ineffective.
As we have seen, real and nominal exchange rates
coincide reasonably well in developed countries, but the
correspondence is usually weak for emerging economies.
 Economic Exposure in the Long Run
Recall that economic exposure is only concerned with
changes in the market value of the firm that result from
real exchange rate changes.
Hence, if RPPP holds in the long run, changes in the real
exchange rate should balance out in the long run.
This is what we saw with most of the developing countries
that saw large short-term swings in the real exchange rate.
Thus, long-term hedging activity may not be entirely
needed or productive.
Where then is the value in hedging economic exposure?
 Economic Exposure in the Long Run
Recall that most of our arguments for hedging activities
focus on the short-run:
1. Ensuring that the firm (or manager) gets to the long run.
2. Minimizing systematic shareholder risks.
3. Achieving short-run tax, monitoring, and investment
efficiencies.
Hence, a shorter-horizon perspective which focuses on the
economic exposure of highly-known nominal cash flows
may be reasonable after all.
In other words, only exposures which pose a material
threat to the value of the firm’s periodic cash flows should
be hedged.
 What else can be done?
In addition to financial hedges, a number of operational
activities exist which can be used to efficiently reduce the
risks posed by exchange rate movements.
Whereas financial hedges effectively eliminate the
exposure of certain cash flows by creating an offsetting
position, other activities exist which can mitigate the
overall level of cash flow exposures themselves.
Essentially these activities fall into two categories:
1. Marketing management.
2. Production management.
 Marketing Management
Marketing management focuses on increasing sales in
countries in which the real exchange rate has appreciated
and restructuring sales in countries where the real
exchange rate has declined. Marketing management has
three main dimensions:
1. Promotional strategy. If the marginal cost of promoting
a product does not rise as much as the marginal benefit in
response to an appreciation, it will make sense to shift
promotional resources from undervalued currencies
towards overvalued currencies.
 Marketing Management
2. Product design and development.
Although new products will generally be introduced based
on long-run competitive merits calculated at the long run
real exchange rate, the optimal time to introduce new
products may be when the exchange rate is high.
When revenues are relatively high in home currency terms,
it may be easier to justify high market entry costs -
particularly if these costs are partially determined in the
home currency.
Effectively, having a new product to introduce to a market
is like owning a long-dated call option. When the currency
becomes sufficiently appreciated, the option should be
exercised - the product should be introduced.
 Marketing Management
3. Pricing strategy. If firms have some flexibility to adjust
prices and ‘pass-through’ the exchange rate effects, they
may want to take advantage of this in responding to
exchange rate changes.
Specifically, firms selling in overvalued currencies will
want to lower the local currency price to capture larger
market share, while those operating in undervalued
currencies will raise prices to maintain profit margins.
Certainly firms in more competitive industries face less
flexibility in terms of their pricing schedules.
 Production Management
Just as marketing activities focus on firms that are
overvalued, production activities will focus on countries
where currencies are undervalued.
Certainly a firm will face less flexibility on the production
side than on the sales side. Nonetheless, to the extent
possible, a firm has a number of potential production
responses to shifts in exchange rates:
1. Since the costs of labor-intensive production activities
are most likely to fluctuate with real exchange rate
changes, they should be shifted from overvalued to
undervalued currencies.
In this way, having a flexibility with respect to production
sourcing acts as a portfolio of currency options which
benefit from exchange rate variability.
 Production Management
2. Similarly, input components can be sourced from
countries with depreciated exchange rates at the expense
of countries with high exchange rates.
This activity is essentially enforcing the law of one price
for traded goods, and as such, opportunities may be
limited.
3. While expansions of capacity, introductions of new
technology, and other efforts to improve productivity
should be based on long-run comparative advantage and
real exchange rates, again, the optimal time to introduce
such changes may be when the currency is depreciated.
The investment can be easily justified since its costs are
likely to be lower and the facility is already realizing a
comparative advantage and operating at high volume.
 Production Management
Similar to new product introduction, opportunities to
expand capacity or introduce new production
technologies behave as a put option on the currency.
The option should be exercised when the currency is
depreciated and costs are low.
Generally, production management will require a high
degree of flexibility from the outset. Since this flexibility
will generally take the form of excess capacity, it must
come at some cost.
Nonetheless, the option-like nature of this flexibility adds
value to the firm from both risk management and profit
maximization standpoints.
 Foreign Exchange Risk Management
In managing foreign exchange risk several points are
worth keeping in mind:
1. Focus attention on risks which have a material impact
on the expected value and systematic risk of the firm
to shareholders.
2. Measure exposures and risks accurately:
- recognize any potentially offsetting effects in costs,
revenues, quantities, or pass-through.
- take into account offsetting movements in
exposures to other currencies.
- apply appropriate measures of risk: RPPP for
exposures not linked to interest rates and UIP for
those that are interest sensitive (i.e. cash deposits).
 Foreign Exchange Risk Management
3. Use risk management to control risks in the short-run,
while relying on firm, manager, and exchange rate
fundamentals to dominate in the long-run.
4. Don’t ignore opportunities to manage exchange rate
risks from the operational side.
5. Recognize that risk management often creates more
risk than it eliminates - no firm (or municipality) ever
went bankrupt solely due to insufficient risk
management, plenty have gone bankrupt as a result of
too much.
6. Keep in mind that investment banks make more
money when you worry about FX risk than when you
don’t.