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Foreign Exchange Risk Management

pdf F oreign exchange (FX) is a risk factor that is often overlooked by small and mediumsized enterprises (SMEs) that wish to enter, grow, and succeed in the global marketplace. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy foreign buyers today are increasingly demanding to pay in their local currencies. From the viewpoint of a U.S. exporter who chooses to sell in foreign currencies, FX risk is the exposure to potential financial losses due to devaluation of the foreign currency against the U.S. dollar. Obviously, this exposure can be avoided by insisting on selling only in U.S. dollars. However, such an approach may result in losing export opportunities to competitors who are willing to accommodate their foreign buyers by selling in their local currencies. This approach could also result in the non-payment by a foreign buyer who may find it impossible to meet U.S. dollar-denominated payment obligations due to the devaluation of the local currency against the U.S. dollar. While coverage for non-payment could be covered by export credit insurance, such “what-if” protection is meaningless if export oppor­ tunities are lost in the first place because of the “payment in U.S. dollars only” policy. Selling in foreign currencies, if FX risk is successfully managed or hedged, can be a viable option for U.S. exporters who wish to enter and remain competitive in the global marketplace. Key Points

The following sections list FX risk management techniques considered suitable for new-to-export U.S. The FX instruments mentioned below are available in all major currencies and are offered by numerous commercial lenders. The exporter can then demand cash in advance. not to make a profit from FX rate movements. However. Another non-hedging technique is to net out foreign currency receipts with foreign currency expenditures. • U. • The volatilenature of the FX market poses a great risk of sudden and drastic FX rate movements. Non-Hedging FX Risk Management Techniques The exporter can avoid FX exposure by using the simplest non-hedging technique: price the sale in a foreign currency. the U. dollar value of the foreign proceeds. • The primary objective of minimize potential currency FX risk management is to losses.S.S. which are unpredictable and frequent. A spot transaction is when the exporter and the importer agree to pay using today’s exchange rate and settle within two business days.• Most foreign buyers generally prefer to trade in their local currencies to avoid FX risk exposure. A variety of options are available for reducing short-term FX exposure. exporter who exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a differ- . SME exporters who choose to trade in foreign currencies can minimize FX exposure by using one of the widely-used FX risk management techniques available in the United States. not all of these techniques may be available in the buyer’s country or they may be too expensive to be useful. For example. SME companies. which may cause significantly damaging financial losses from otherwise profitable export sales. and the current spot market rate will determine the U.S.

exporter will be obligated to deliver 125 million yen in 30 days.S.S. suppose U. to deliver an agreed amount of foreign currency to the lender in exchange for dollars at a specified rate on or before the expiration date of the option. The risk is further reduced if those peso-denominated export and import transactions are conducted on a regular basis. the U. The U. If the foreign currency is collected sooner. exporters are advised to pick forward delivery dates conservatively.S. Note that there are no fees or charges for forward contracts since the lender hopes to make a “spread” by buying at one price and selling to someone else at a higher price. regardless of what may happen to the dollar-yen exchange rate over the next 30 days. FX Options Hedges If there is serious doubt about whether a foreign currency sale will actually be completed and collected by any particular date. Accordingly. U. and FX risk is minimized. an FX option may be worth considering. Such a forward contract will ensure that the U. Under an FX option.S. As opposed to a forward con- . when using forward contracts to hedge FX risk. the exporter can hold on to it until the delivery date or can “swap” the old FX contract for a new one with a new delivery date at a minimal cost. exporter can eliminate FX exposure by contracting to deliver 125 million yen to his bank in 30 days in exchange for payment of $1 million dollars. if the Japanese buyer fails to pay on time. If the company’s export and import transactions with Mexico are comparable in value. pesos are rarely converted into dollars. goods are sold to a Japanese company for 125 million yen on 30-day terms and that the forward rate for “30-day yen” is 125 yen to the dollar. For example. the exporter or the option holder acquires the right. which enables the exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a delivery date from three days to one year into the future. FX Forward Hedges The most direct method of hedging FX risk is a forward contract. exporter can convert the 125 million yen into $1 million. However.S.ent Mexican trading partner. but not the obligation.

but the fee would be forfeited. If the value of the foreign currency goes down. which is similar to a premium paid for an insurance policy.tract. . they can be significantly more costly than FX forward hedges. While FX options hedges provide a high degree of flexibility. an FX option has an explicit fee. the exporter is protected from loss. if the value of the foreign currency goes up significantly. On the other hand. the exporter can sell the option back to the lender or simply let it expire by selling the foreign currency on the spot market for more dollars than originally expected.

[5][2][6] market value.1 Transaction exposure 1. competitiveness. the firms face a risk of changes in the exchange rate [5][2] between the foreign and domestic currency. [edit]Economic exposure A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy [3][4] are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately. Such outcomes could be troublesome as export profits could be negated entirely or [6] import costs could rise substantially. and financial reporting. Economic exposure can affect the present value of future cash flows. To realize the domestic value of its foreign-denominated cash flows.Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an [1][2] exposure to unanticipated changes in the exchange rate between two currencies.2 Economic exposure 1. but economic exposure can be caused by other . and translation exposure. meaning a 10% decline in the value of a receivable or a 10% rise in the value of a payable.4 Contingent exposure 2 Measurement o     2. Contents [hide]  1 Types of exposure o o o o  1. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating. the firm must exchange foreign currency for domestic currency. the firm's future cash flows. Such exchange rate adjustments can severely affect the firm's position with regards to its competitors.1 Value at Risk 3 Management 4 History 5 Project finance 6 References [edit]Types of exposure Foreign currency exposures are generally categorized into the following three distinct types: transaction exposure. These exposures pose risks to firms' cash flows. Exchange rates may move by up to 10% within any single year. Firms generally become exposed as a direct result of activities such [7] as importing and exporting or borrowing and investing. economic exposure. and ultimately the firm's [5][2] value. which can significantly affect a firm's cash flows. [edit]Transaction exposure A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency.3 Translation exposure 1. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically.

Variance represents exchange rate risk by the spread of exchange rates. A shift in exchange rates that influences the demand for a good in some country would also be an [6] economic exposure for a firm that sells that good. [edit]Measurement If foreign exchange markets are efficient such that purchasing power parity. [edit]Contingent exposure A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. As all firms generally must prepare consolidated financial statements for reporting purposes. For example. a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. A deviation from one or more of the three international parity conditions generally [9] needs to occur for an exposure to foreign exchange activities and investments which may not be mere international transactions. which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. from the mean exchange rate in a probability distribution. Using the VAR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain [4] period of time with a given probability of changes in exchange rates. [5][8] so a firm may prefer to manage contingent exposures. contingent on the outcome of some contract or negotiation. In foreign exchange. Translation gives special consideration to assets and liabilities with regards to foreign exchange risk. [edit]Translation exposure A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of [5][2] foreign subsidiaries from foreign to domestic currency. [edit]Value at Risk Practitioners have advanced and regulators have accepted a financial risk management technique called value at risk (VAR). the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. it could have a significant impact on a firm's reported earnings and therefore its stock price. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations. such as future cash flows from fixed assets. interest rate parity. whereas standard deviation represents exchange rate risk by the amount exchange rates deviate. Banks in Europe have been authorized by the Bank for International Settlements to employ VAR models of their own design in establishing capital requirements for given levels of market risk. Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. and the international Fisher effect hold true. and for automatically squaring deviation values. [edit]Management See also: Foreign exchange hedge . on average. whereas exposures to revenues and expenses can often be managed ex ante by managing [8] transactional exposures when cash flows take place. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments. While translation exposure may not affect a firm's cash [6] flows. a relevant factor would be the rate of change of the spot exchange rate between currencies. While waiting. a firm or investor needn't protect against foreign exchange risk due to an indifference toward international investment decisions. be they positive or negative. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure. A higher standard deviation would signal a greater currency risk. Alternatives such as average [4] absolute deviation and semivariance have been advanced for measuring financial risk. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk.

Financial restructuring is typically the consequence and is common for megaprojects. and the Argentine peso crisis. and exposure netting. schedule delays. the costs of servicing debt become larger than the revenues [13] available to do so. substantial losses from foreign exchange have led firms to pay closer attention [12] to foreign exchange risk. Following this logic.Managers of multinational firms employ a number of foreign exchange hedging strategies in order to protect against exchange rate risk. options. the United States Federal Accounting Standards Board specifies when and where to use certain methods such as the temporal method and current rate method. using a policy of flexible sourcing in its supply chain management. Firms may exercise alternative strategies to financial hedging for managing their economic or operating exposure. Megaprojects have been shown to be prone to ending up in debt traps where. [edit]History Many businesses were unconcerned with and did not manage foreign exchange risk under the Bretton Woods system of international monetary order. foreign exchange derivatives such as forward contracts. Since translation exposure arises from discrepancies between net assets and net liabilities on a balance sheet solely from exchange rate differences. Translation exposure is largely dependent on the accounting standards of the home country and the translation methods required by those standards. diversifying its export market across a greater number of countries. or with operational techniques [5] such as currency invoicing. [edit]Project finance Foreign exchange risk has been shown to be particularly significant and particularly damaging for very large. or by implementing strong research and development activities and differentiating its products in pursuit of greater inelasticity and less foreign exchange [5] risk exposure. by carefully selecting production sites with a mind for lowering costs. The outbreak of currency crises in the 1990s and early 2000s. [5] Foreign exchange derivatives may also be used to hedge against translation exposure. futures contracts. a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. and swaps. . Asian currency crisis. such as the Mexican peso crisis. unforeseen foreign currency and interest rate increases. due to cost overruns. Transaction exposure is often managed either with the use of the money markets. 1998 Russian financial crisis. It wasn't until the onset of floating exchange rates following the collapse of the Bretton Woods system that firms perceived an increasing risk from exchange rate fluctuations and began trading [10][11] an increasing volume of financial derivatives in an effort to hedge their exposure. leading and lagging of receipts and payments. Such projects are typically financed by very large debts denominated in foreign currencies. For example. Firms can manage translation exposure by performing a balance sheet hedge. one-off investment megaprojects.