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Export management and logistics
Foreign exchange risk management
Juhi Kashyap MBA - IB

liabilities.currency value of assets. The extra rupee he pays is not due to an increase in interest rate but because of unfavourable exchange rate. liabilities. Conversely he will gain if the rupee is stronger. or operating incomes to unanticipated changes in exchange rates. the amount borrowed in foreign currency is to be repaid in the same currency or in some other acceptable currency. All such items are to be settled in a foreign currency. The fluctuation in the exchange rate causes uncertainty and this uncertainty gives rise to exchange rate risk. Three types of Exposure: . Such exposures are termed as transactions exposures. Unexpected fluctuation in exchange rate will have favourable or adverse impact on its cash flows. to convert the results of foreign operations from the local currency to the home currency . export receivables. import payables. or operating income that is attributable to unanticipated changes in exchange rates This risk relates to the uncertainty attached to the exchange rates between two currencies.Transaction or Contractual Exposure A firm may have some contractually fixed payments and receipts in foreign currency.Operating or Economic Exposure . It is measured by the variance of the domestic . . such as. for purposes of reporting and consolidation. Thus if the foreign currency becomes stronger than (say) Indian rupees. Exposure of foreign exchange risk Foreign Exchange Exposure is the sensitivity of the real domestic currency value of assets. interest payable on foreign currency loans etc.Foreign exchange risk management Foreign exchange risk is the exposure of a company’s financial strength to the potential impact of movements in foreign exchange rates. the Indian borrower has to repay the loan in terms of more rupees than the rupees he obtained by way of loan.Translation or Accounting Exposure Arises from the need. For example.

quantified in terms of exposures. Exposure is defined as a contracted. which are unpredictable and frequent.Economic exposure measures the probability that fluctuations in foreign exchange rate will affect the value of the firm. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management. projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. Foreign Exchange Risk Management Framework . not to make a profit from FX rate movements. The risk involved in economic exposure requires measurement of the effect of fluctuations in exchange rate on different future cash flows. Moment in time when exchange rate changes Translation (Accounting) exposure Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates (Economic) Operating exposure Change in expected future cash flows arising from an unexpected change in exchange rates Transaction exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time Foreign exchange risk management Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates. The primary objective of FX risk management is to minimize potential currency losses. The intrinsic value of a firm is calculated by discounting the expected future cash flows with appropriate discounting rate.

A heuristic for firms to manage this risk effectively is presented below which can be modified to suit firm-specific needs i.e. The risk that a transaction would fail due to market-specific problems should be taken into account. the first step for a firm is to develop a forecast on the market trends and what the main direction/trend is going to be on the foreign exchange rates. It is important to base the forecasts on valid assumptions. Risk Estimation: Based on the forecast. The firm also has to decide whether to manage its exposures on a cost centre or profit centre basis. Hedging: Based on the limits a firm set for itself to manage exposure. It is imperative to have stop loss arrangements in order to rescue the firm if the forecasts turn out wrong. the firms then decides an appropriate hedging strategy. some or all the following tools could be used. a measure of the Value at Risk (the actual profit or loss for a move in rates according to the forecast) and the probability of this risk should be ascertained. there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken. the Systems Risk that can arise due to inadequacies such as reporting gaps and implementation gaps in the firms’ exposure management system should be estimated. Benchmarking: Given the exposures and the risk estimates. The period for forecasts is typically 6 months. Hedging strategies and instruments are explored in a section. it then has to deploy resources in managing it. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time. For this. a probability should be estimated for the forecast coming true as well as how much the change would be. Finally. Forecasts: After determining its exposure. the firm has to set its limits for handling foreign exchange exposure. Stop Loss: The firms risk management decisions are based on forecasts which are but estimates of reasonably unpredictable trends.Once a firm recognizes its exposure. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. There are various financial instruments available for the firm to choose from: futures. forwards. options and swaps and issue of foreign debt. Along with identifying trends. .

INTERNAL HEDGING STARTEGIES  Invoicing A firm may be able to shift the entire risk to another party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency. what the market trends are and finally whether the overall strategy is working or needs change. the actual exchange/ interest rate achieved on each exposure and profitability vis-à-vis the benchmark and the expected changes in overall exposure due to forecasted exchange/ interest rate movements and effective in controlling the exposures.Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open contracts after marking to market. but in the . A firm may be able to reduce or eliminate currency exposure by means of internal and external hedging strategies.

Even if . there is a tendency not to use that country’s currency in trade invoicing. it can use a receivable to settle all or part of a payable and take a hedge only for the net DEM payable or receivable. In the following cases invoicing is used as a means of hedging: 1. The risk is reduced but not eliminated  Netting and Offsetting: A firm with receivables and payables in diverse currencies can net out its exposure in each currency by matching receivables with payables. it may diminish the firm’s competitive advantage if it refuses to invoice its cross-border sales in the buyer’s currency. Basket invoicing offers the advantage of diversification and can reduce the variance of home currency value of the payable or receivable as long as there is no perfect correlation between the constituent currencies. Thus a firm with exports to and imports from say Germany need not cover each transaction separately.presence of well functioning forwards markets this will not yield any added benefit compared to a forward hedge. This way both the parties share exposure. Another possibility is to use one of the “standard currency baskets” such as the SDR or the ECU for invoicing trade transactions. British importer of fertilizer from Germany can negotiate with the supplier that the invoice is partly in DEM & partly in Sterling. At times. Trade between a developed and a less developed country tends to be invoiced in the developed country’s currency. Another hedging tool in this context is the use of “currency cocktails” for invoicing. 4. 2. Thus for instance. If a country has a higher and more volatile inflation rate than its trading partners. 3. Trade in primary products and capital assets are generally invoiced in a major vehicle currency such as the US dollar. Trade between developed countries in manufactured products is generally invoiced in the exporter’s currency.

The net exposure in a given currency at a given date is simply the difference between the total inflows and the total outflows to be settled on that date. EXTERNAL HEDGING TECHNIQUES A.USD interest payable 4. the company must have continuously updated information on inter-subsidiary payments position as well as payables and receivables to outsiders.e. To be able to use netting effectively.000 2.the timings of the two flows do not match. Simply shifting the exposure in time is not enough. i.NLG payable 3.000 100. The general rule is lead.000 300. it might be possible to lead or lag one of them to achieve a match. conversely. lead receivables and lag payables in weak currencies. Both these tools exist as a response to the existence of market imperfections.  Leading and lagging: Another internal way of managing transactions exposure is to shift the timing of exposures by leading or lagging payables and receivables. Using hedging for forwards market: In the normal course of business. Thus suppose ABC Co.000.USD purchased forward 6. advance payables and lag. has the following items outstanding: Item 1.e.USD receivable 2. postpone receivables in “strong” currencies and.USD loan installment due Value 800. a firm will have several contractual exposures in various currencies maturing at various dates. i. One way of ensuring efficient information gathering is to centralise cash management.USD payable 5. it has to be combined with a borrowing/lending transaction or a forward transaction to complete the hedge.000 200.000 Dates to maturity 60 90 180 60 60 60 .000 250.

g. Borrow NLG in the euroNLG market for 90 days.000 at 90 days.000)-(200.000 90 Its net exposure in USD at 60 days is: (800. e.7. the firm can hedge the 60 day USD exposure with a forward sale and the 180 day USD exposure with a forward purchase. can use the money market for hedging transactions exposure. Thus in the above example.000 Whereas it has a net exposure in NLG of –1.g. It has access to Euro deposit markets in DEM as well as NLG. ABC Co.000.000 while for the NLG exposure it can buy NLG 1. . 4.: Suppose a German firm ABC has a 90 day Dutch Guilder receivable of NLG 10. can sell forward USD 650. A contractual net inflow of foreign currency is sold forward and a contractual net outflow is bought forward.000. to pay off a short-term bank loan or finance inventory.000.000+250.000 90 day forward.000)=+USD 650. Convert spot to DEM.NLG purchased forward 1. which have access to international money markets for short-term borrowing as well as investment. 3. 2. Thus in the example. This removes all uncertainty regarding the domestic currency value of the receivable or payable. The use of forward contracts to hedge transactions exposure at a single date is quite straightforward. to hedge the 60 day USD exposure.000. use it to pay off the NLG loan.000. E. Hedging with the money market: Firms. When the receivable is settled. For exposure at different dates the obvious solution is to hedge each exposure separately with a forward sale or purchase contract as the case may be. B. Use DEM in its operations.000+300. To cover this exposure it can execute the following sequence of transactions: 1.

0475/4)]= DEM 0.9038/[1+ (0.74%) is 0.055/4)] = NLG 0.1035) =DEM 0. E.5010/20 180 days forward: 5. The market rates are as follows: DKK/USD Spot: 5. For instance. Since forward premia/ discounts are related to Euromarket interest differentials between two currencies.064)= DEM 0.00 Comparing the forward cover against the money market cover. each NLG sold will give an inflow of DEM (1/1.8939 Pay off the NLG loan when the receivables mature.4110 Euro $: 9 1/2/ 9 ¾ . domestic firms may not be allowed access to the Euromarket in their home currency or non-residents may not be permitted access to domestic money markets. The present value of this (at 4. 90 days later.9864/1. With forward cover. The payment is due in 180 days. This will lead to significant differentials between the Euromarket and domestic money market interest rates for the same currency. A Danish firm has imported computers worth $ 5 million from a US supplier.Suppose the rates are as follows: NLG/DEM Spot: 101025/35 90day forward: 1. Thus the money markets cover.4095/ 5. borrow NLG 1/[1+ (0. sell this spot to get DEM (0.0008 per NLG of receivable or DEM 8000 for the 10 million-guilder receivable.8931 To cover using the money market. such an imperfection will present opportunities for cost saving. Sometimes the money market hedge may turn out to be the more economical alternative because of some constraints imposed by governments. there is a net gain of DEM 0.1045/65 EuroNLG interest rates: 5 1/4/5 ½ EuroDEM interest rates: 4 3/4/5.9038.g. for each NLG of receivable.9864.

e. from third countries.3969 [=5.0141 per dollar of payable or DKK 70. etc. International tenders: Foreign exchange inflows will materialise only if the bid is successful. Having decided to hedge an exposure. Foreign currency receivables with substantial default risk or political risk. acquit $ 0. there are contingent foreign currency outflows too. It will have to repay DKK 5.4110.e. If execution of the contract also involves purchase of materials. Cash flows those are contingent on other events. This represents a saving of DKK 0. Options are particularly useful for hedging uncertain cash flows.Euro DKK: 6 1/4/ 6 ½ Domestic DKK: 5 1/4/ 5 ½ The Danish government has imposed a temporary ban on non-residents borrowing in the domestic money market. the firm can borrow DKK 502525 at 5. all available alternatives foe executing the hedge should be examined. (Or writing a call option.50% in a Euro $ deposit to accumulate to one dollar to settle the payable. C. the host government of a foreign subsidiary might suddenly impose restrictions on dividend repatriation. This is a “covered call” strategy). A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while an inflow can be hedged by buying a put option. For each dollar of payable.2525* 1.g. 180 days later. b. Typical situations are: a. Hedging with Currency Options: Currency options provide a more flexible means to cover transactions exposure. forward cover involves an outflow of DKK 5.9547 in the spot market and invest this at 9. . 180 days from now. From the above example it is clear that from time to time cost saving opportunities may arise either due to some market imperfection or natural market conditions.0275]. which an alert treasurer can exploit to make sizeable gains. i.5%. Instead for each dollar of payable. equipments.500 on the $5 million payable.

77. Hedging with currency futures: .00. At maturity.00.00. i. On June 1.00. A Call option: Instead the firm buys call options on DEM 5. Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%. D.8175/85 90-day Swap points: 60/55 September calls with a strike of 2.000) St. he will find himself to be over insured and short in DEM. iii..8130/PS or PS0.82 (DEM/GBP) are available for a premium of 0.20p per DEM.3546 and PS[5.850. If at maturity the pound sterling/ DEM spot rate is St. Forward hedge: If the firm buys DEM 5. The market rates are as follows: DEM/GBP Spot: 2.000 payable due on September 1.c. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/bonds currently worth say DEM 50 million. the sterling value of the payable is (5.3546)+1025] = PS 178325 for St>=0.g. ii. Evaluating the forward hedge versus purchase of call options both with reference to an open position. If he sells Dem 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates.000)(0.00. which he is planning to liquidate in 6 months time.00. E. Open position: Suppose the firm decides to leave the payable unhedged.000 forward at the offer rate of DEM 2.3557/ DEM.3557)=PS 1.000)St +1025] for St<= 0.000 * 0. its cash outflow will be PS [(5. a UK firm has a DEM 5.000 for a total premium expense of PS 1000.00.3546. the value of the payable is PS (5.

(Ask Rate). starting six months from now at a interest rate of 7.a. A firm may be able to reduce or eliminate interest rate exposure by mean of following hedging strategies. a futures hedge is much easier to unwind since there is an organized exchange with a large turnover. A receivable is hedged by selling futures while a payable is hedged by buying futures.20 – 7.  The bank is willing to accept a three month USD deposit starting six months from now. at an interest rate of 7. and a time .a.30% P. A futures hedge differs from a forward hedge because of the intrinsic features of future contracts.  Forward rate Agreements: A FRA is an Agreement between two parties in which one of them (The seller of FRA). Banks will enter into forward contracts only with corporations (and in rare cases individuals) with the highest credit rating. This is to be interpreted as follows. The important thing to note is that there is no exchange of principal amount. A typical FRA quote from a bank might look like this: USD 6/9 months: 7. a specified amount of funds. it easier and has greater liquidity. in a specific currency.Hedging contractual foreign currency flows with currency futures is in many respects similar to hedging with forward contracts.20% P.  Interest rate futures: Interest rate futures are one of the most successful financial innovations in recent years. (Bid Rate). maturing nine months from now. at an interest rate fixed at the time of agreement. The underlying asset is a debt instrument such as a treasury bill.a. contracts to lend to other (Buyer).30% P.  The bank is willing to lend dollars for three months. Second. a bond. for a specific period starting at a specified future date. The advantages of futures are.

g.  Interest Rate Swaps: A standard fixed-to-floating interest rate swap. A fixed income fund manager might use bond futures to protect the value of her fund against interest rate fluctuations. Speculators bet on interest rate movements or changes in the term structure in the hope of generating profits. It is notional because the parties do not exchange this amount at any time. A corporate treasurer who expects some surplus cash in near future to be invested in short-term instruments may use the same as insurance against a fall in interest rates. In a standard swap the notional principal remains constant through the life of the swap.  Interest rate Options: . Interest rate futures are used by corporations. The key feature of this is: The Notional Principal: The fixed and floating payments are calculated if they were interest payments on a specified amount borrowed or lent. known in the market jargon as a plain vanilla coupon swap (also referred to as “exchange of borrowings”) is an agreement between two parties in which each contracts to make payments to the other on particular dates in the future till a specified termination date. three-month Eurodollar time deposits and US treasury notes and bonds. known as the fixed ratepayer. makes fixed payments all of which are determined at the outset. The LIFFE has contracts on Eurodollar deposits. banks and financial institutions to hedge interest rate risk. sterling time deposits and UK government bonds. A corporation planning to issue commercial paper for instance can use TBill futures to protect itself against an increase in interest rate. For e. the International Monetary Market (a part of Chicago Mercantile Exchange) has a futures contract on US government treasury bills. The Chicago Board of Trade offers contracts on long-term US treasury bonds. One party.deposit in a bank and so on. The other party known as the floating ratepayer will make payments the size of which depends upon the future evolution of a specified interest rate index (such as the 6-month LIBOR). it is only used to compute the sequence of payments.

Factors affecting the decision to hedge foreign currency risk The following section describes the factors that affect the decision to hedge and then the factors affecting the degree of hedging are considered. Leverage: Firms with high leverage have greater incentive to engage in hedging because doing so reduces the probability. Highly levered firms avoid foreign debt as a means to hedge and use derivatives. . Sales growth: Sales growth is a factor determining decision to hedge as opportunities are more likely to be affected by the under investment problem. without an obligation to do so. the buyer of the option must pay the seller an up-front premium stated as a fraction of the face value of the contact. As interest rate cap consists of a series of call options on interest rate or a portfolio of calls.A less conservative hedging device for interest rate exposure is interest rate options. A call option on interest rate gives the holder the right to borrow funds for a specified duration at a specified interest rate. which protects a lender against fall in interest rate on rate dates of a floating rate asset. Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale. thus further reducing their cost of hedging. A cap protects the borrower from increase in interest rates at each reset date in a medium-to-long-term floating rate liability. Risk management involves fixed costs of setting up of computer systems and training/hiring of personnel in foreign exchange management. Moreover. Liquidity and profitability: Firms with highly liquid assets or high profitability have less incentive to engage in hedging because they are exposed to a lower probability of financial distress. an interest rate floor is a series or portfolio of put options on interest rate. large firms might be considered as more creditworthy counterparties for forward or swap transactions. In both cases. The book value of assets is used as a measure of firm size. A put option on interest rate gives the holder the right to invest funds for a specified duration at a specified return without an obligation to do so. and thus the expected cost of financial distress. An interest rate collar is a combination of a cap and a floor. Similarly.