Impact of Currency volatility on firms

Prepared by: - Presented to: -

Anushree Saha Dr. Anurag Agnihotri
Roll no.-19433
Section- FA
 Currency Volatility
Volatility in forex trading is a measure of the frequency and extent of changes in a
currency’s value. A currency might be described as having high volatility or low
volatility depending on how far its value changes from the average – volatility is a
measure of standard deviation. Volatility is the measurement of price variations.
Large price movements/changes are indicative of high volatility while smaller price
movements are low volatility.
As traders, price movements are what allow for profit. Larger price variations mean
more potential for profit as there is simply more opportunity available with these
bigger movements.

In this age of globalization, every company is looking to tap into the international
market, with increasing emphasis on global sourcing. Multinational firms may
operate in several different countries, and thus their operations involve multiple
foreign currencies. In this context, exchange rate fluctuation has emerged as a very
real problem. The three types of exposure that multinational firms face are:
transaction exposure, translation exposure and economic exposure.

Transaction exposure refers to changes in the value of cash flows that may arise due
to unexpected changes in the exchange rate. It measures the sensitivity of the home
currency value of cash inflows and outflows in the foreign currency to unanticipated
changes in exchange rates. A firm is subject to transaction exposure when it has
monetary items whose values are contractually fixed in foreign currencies and do not
change with the exchange rates.

Transaction exposure also arises when a firm borrows or lends in foreign currencies.
For instance, consider a firm in India that borrows US$ 1 million from a firm in New
York for three months. During a period if the dollar appreciates against the Indian
rupee, Mihir Dash the borrower will have a greater burden in terms of rupees. The
reverse takes place when the dollar depreciates.

Translation exposure arises when a firm has assets and liabilities denominated in
foreign currency which need to be translated in books of accounts in the domestic
currency for accounting purpose. This is also known as accounting exposure as it
relates only to the book value of the concerned assets or liabilities; in this case, there
is no actual conversion of currencies, as no cash transactions take place.

Economic or operating exposure is the effect of unexpected changes in the

exchange rates on the firm’s future operating cash flows. Such a change in the
exchange rates may affect the firm’s future cash flows directly through its revenues
and costs, and indirectly through its impact on the firm’s competitivenes by affecting
its consumers and competitors.

The major portion of business of Indian IT firms takes place in foreign countries,
particularly the U.S. According to NASSCOM President Mittal, rupee depreciation
helps them in the long term because it ensures competitiveness for the industry. But
in the short run, they do not really gain because as an industry they don’t want
currency movement to be in the centre of loss or profit, because most people want to
get what they have projected in terms of pricing.

In particular, experts suggest that a 1% depreciation in the rupee has a positive

impact of about 25-40 points on the margins of IT companies. A depreciating rupee
helps IT companies to improve their margins as they earn revenues in foreign
currency, but sudden fluctuations hamper the planning process for companies and
increase in a company's exposure to financial risk and drastically minimize savings.
Sharp fluctuations in the exchange rates hit the small- and mid- cap companies
harder than the large companies in their profitability.

More volatility means more trading risk, but also more opportunity for traders to gain
as the price moves are larger. Higher levels of volatility also mean that price
movements are even less predictable. Reversals can be more aggressive, and if a
trader finds themselves on the wrong side of the move, the potential loss can be
even higher in high-volatility environment as the increased activity can entail larger
price movement against the trader as well as in their favour.
Currency volatility is difficult to identify and track because volatility is, by its very
nature, unpredictable. But there are some methods to calculate the volatility that can
help traders predict what might happen:
While no indicator or set of indicators will perfectly predict the future, traders can use
historical price movements to get an idea for what might happen in the future. A key
component of this type of probabilistic approach is the ability to see the ‘big picture,’
or the general condition of the market being traded.

Measurement of the volatility

The Average True Range indicator stands above most others when it comes to the
measurement of volatility. ATR was created by J. Welles Wilder (the one who
created RSI, Parabolic SAR, and the ADX indicator), and is designed to measure the
True Range over a specified period of time.

True Range is specified as the greater of:

 High of the current period less the low of the current period
 The high of the current period less the previous period’s closing value
 The low of the current period less the previous period’s closing value

Absolute values are used in the above computations to determine the ‘true range.’
So the largest of the above three numbers is the ‘true range,’ regardless of whether
the value was negative or not. Once these values are computed, they can be
averaged over a period of time to smooth out the near-term fluctuations (14 periods
is common). The result is Average True Range.

After traders have learned to measure volatility, they can then look to integrate the
ATR indicator into their approaches in one of two ways.

 As a volatility filter to determine which strategy or approach to employ

  To measure risk (stop distance) when initiating trading positions

Some of the other indicators are:

 Bollinger Bands: These can be used to indicate if a market is overbought or

oversold, increasing the chance of prices to move in the opposite direction
 Average true range: This is used as a measure of volatility, and it can be
applied to trade exit methods with a trailing stop to limit the losses
 Relative strength index: One can use this to measure the magnitude of price
changes, again indicating whether a currency has been overbought or
oversold.

Traders can look for the low-volatility environment to continue, or they can look for it
to change. It means that traders can approach low-volatility by trading the range
(continuation of low-volatility), or they can look to trade the breakout (increase in
volatility).The difference between the two conditions is huge as range-traders are
looking to sell resistance and buy support while breakout traders are looking to do
the exact opposite. Further, range-traders have the luxury of well-defined support
and resistance for stop placement while breakout traders do not. And while
breakouts can potentially lead to huge moves, the probability of success is
significantly lower. This means that false breakouts can be abundant, and trading the
breakout often requires more aggressive risk-reward ratios.

High and low volatile currencies

With some of the most volatile currency pairs, traders should expect frequent
fluctuations. Major currency pairs tend to be more stable than emerging pairs, the
more liquid currency pairs tend to have less volatility. Some of the most volatile
currency pairs are:

 USD/ZAR (United States Dollar/South African Rand)

 USD/RUB (United States Dollar/Russian Ruble)
 USD/BRL (United States Dollar/Brazilian Real)
 USD/TRY (United States Dollar/Turkish Lira).

AUD/JPY volatility

AUD/JPY is another pair that has historically been considered volatile. The below
chart shows the asset's price movement, again alongside ATR. The circled portion is
just one example of where ATR hit new heights as the AUD/JPY rate fell rapidly.

Currencies traditionally seen as having low volatility are:

 EUR/GBP (Euro/Pound Sterling)

 NZD/USD (New Zealand Dollar/United States Dollar)
 USD/CHF (United States Dollar/Swiss Franc)
 EUR/USD (Euro/United States Dollar)

One can use different indicators when trading high and low volatility currencies. For
lower volatility currencies, one can look to use support levels. These show where the
forex market has moved up and pulled back again, so they can be used to trade by
helping to predict the market’s movements.

Causes of currency fluctuations

Currency fluctuations arise from the floating exchange rate system, which is followed
by most major economies. The exchange rate system against others depends on
various factors such as relative supply and demand for currencies, economic of
countries, inflation outlook, capital flows, and so on. As these factors are
continuously changing, currencies fluctuate with them.
The fluctuation of a country’s currency can have a far-reaching impact on the
country’s economy, consumers, businesses and remittance. This means that
whether a country’s currency appreciates or depreciates, it will have both positive
and negative impacts on a country’s economy, depending on the sector.
The Economy-
One of the most prominent impacts of currency fluctuations can be seen in
international trade. Generally, a weaker currency stimulates exports and makes
imports expensive, thus decreasing the country’s trade deficit depending on the
sector. On the other hand, a strong currency can export and make imports cheaper,
effectively widening the trade deficit. While it is generally assumed that a strong
currency is a good thing for a nation’s economy but actually it might not be so.
An unjustifiable strong currency can cause a drag on the economy over the long
term, as entire industries are uncompetitive and thousands of jobs are lost. As GDP
is directly linked to exports, a weaker currency may actually help the country’s
economy, to popular belief. On the other hand, a depreciating currency can result in
inflation as the cost of importing goods increases.
Currency fluctuations also have a direct impact on the monetary policy of a country,
as exchange rates play an important role in deciding exchange rates set by a
country’s central bank. Constant currency fluctuations can also affect the market
adversely, cause it to become volatile, and affecting both local and foreign trade.

How an Exchange Rate Affects a business

An increase in the value of the dollar means one dollar can buy more of the
foreign currency essentially getting more for the same money. Businesses that
import and export goods are highly sensitive to fluctuations in the exchange rate.
But even if one trade domestically, you still have an indirect currency risk by virtue
of the wider economy.

Most senior executives understand that volatile exchange rates can affect the dollar
value of their company’s assets and liabilities denominated in foreign currencies.
However, not many of them understand that exchange rates can have a serious impact
on operating profit. Fewer corporations have given managers responsibility for
overseeing this operating exposure.
Exchange rates are more volatile in the world of managed floating rates than during the
period of U.S. expansion in the international economy. More and more, countries follow
divergent monetary policies. At the same time, markets are becoming more and more
global. The United States has no longer 70% or 80% world market share in key
industries but shares markets more equally with Europe and Japan.

Because of these changes, exchange rates affect the operating profits of companies in
globally competitive industries, whether or not they export their products outside. In
fact, changes in exchange rates can often affect the operating profit of companies that
have no foreign operations but that face important foreign competition in their domestic
market.

By understanding the long- and short-run behaviour of exchange rates, we can

understand how they affect operating profit. In the long run, changes in the nominal
dollar-foreign currency exchange rates tend to be about equal to the differences
between the U.S. and foreign inflation rate in the price of traded goods.

If the U.S. inflation rate is 4% higher than Germany’s during the year, the deutsche
mark will tend to be strengthen approximately 4% against the dollar. This long-term
relationship between exchange rates and price levels, usually called purchasing power
parity (PPP), implies that changes in competitiveness between countries, which would
otherwise arise because of unequal inflation rates, tend to be offsets by corresponding
changes in exchange rates.

Foreign exchange exposure measures the extent of fluctuation of a firm’s future cash
flows with the respect to exchange rate movements. Foreign exchange exposure is a
significant risk factor for firms engaged to international business. Jorion (1990) has
observed that the volatility of exchange rates is substantially higher than that of
interest rates or of inflation. However, it is difficult to directly measure future cash
flows, researchers have generally examined the foreign exchange exposure by
examining how firm’s market value responds to changes in exchange rates.

In the short run of six months to several years, however, exchange rates are often
volatile and greatly influence the competitiveness of companies selling to the same
market but getting materials and labour from different countries. This short-run change
in relative competitiveness results from changes in the nominal exchange rates that are
not offset the difference in inflation rates in the two countries.

If the deutsche mark strengthens 4% against the dollar and the German inflation rate is
1%, a U.S. exporter to a German market primarily by German producers would see its
dollar price rise 5%. If, however, the inflation rate in the United States is 4%, or
3% higher than the German inflation rate, the operating margin of the U.S. producer will
rise by one percentage point only.

This shows that the change in relative competitiveness does not depend on changes in
the exchange rate—the number of deutsche marks obtained for each dollar—but on
changes in the real exchange rate, which are changes in the nominal exchange rate
minus the difference in inflation rates in the two countries. Thus, in the case of the U.S.
exporter to Germany, the change in the nominal exchange rate will be 4% but the
change in the real exchange rate (which was affected by operating profit) is only 1%.
Jorion 1990 proposed a regression methodology for measuring exchange rate
exposure at firm level, taking stock returns as dependent variable and rate of change
of weighted exchange rate and market returns as the independent variables. He
found very weak support for the exchange rate exposure, but significant cross-
sectional differences in the exposure of U.S. multinationals.

On the other hand, Bodnar and Gentry examined industry-level exposures in U.S.,
Canada, and Japan, and found significant exposure for some industries in all three
countries. It is found that the exchange risk sensitivity of U.S. multinational firms in
the period 1978-89, and reported that exchange rate fluctuations affected firm value.
They also found that differences in exchange risk sensitivity were related to firm-
specific variables such as sales and assets.

Because changes in real exchange rates reflect deviations from PPP, over long periods
of time the cumulative changes in the real exchange rate seems to be smaller than that
of the nominal exchange rate. The volatility of real exchange rates in the time frame of
six months to several years, however, caused an exaggerated variability in operating
margin.

The value of the firm equals the present value of all expected future cash flows. If a
change in the foreign currency exchange rate affects a firm’s expectations of current
and future cash flows, it can indirectly impact the market value of its equity. It is this
concept to which I refer as firm value. The complexities of the relationship between
exchange rate changes and firm value are compounded by whether the firm has
assets abroad or liabilities denominated in a foreign currency, or both. Thus, the
firm’s exposure and sensitivity of its value to changes in the exchange rate, could
vary significantly depending on the geographical locations of its assets and the
currency composition of its corporate debt.

Which sectors have increased exposure to exchange rate fluctuations?

Debt held by firms in emerging market economies in a currency other than their own
poses create extra complications these days. When the U.S. Fed does eventually
raise interest rates, the accompanying further strengthening of the U.S. dollar will
mean an emerging market’s own currency depreciate against the higher value of the
U.S. dollar, and would make it increasingly difficult for the firms to service their
foreign currency-denominated debts if they have not been properly hedged.

In the latest Global Financial Stability Report, it is found out that firms in emerging
markets have increased their debt-to-assets ratios by generally also increased their
overall sensitivity to changes in the exchange rate commonly called exchange-rate
exposure.

It is measured by estimating firms’ exposure indirectly, based on the reaction of their

stock returns to changes in the exchange rate. This estimate of foreign exchange
exposure in the principle accounts for financial hedges, such as swaps, and natural
hedges, such as export-oriented firms’ receipts in a currency other than their own, as
well as local market conditions. It is estimated that these foreign-exchange
exposures using data from thousands of individual publicly-listed firms. Estimating
these exposures is advantageous because firm-level data on foreign currency
holdings are generally unavailable.

Various observers have pointed to the rise of foreign currency-denominated bond

issuance by many emerging markets. Various papers, including this, have
documented the rise of emerging market bond issuance in foreign-currency
denominations; however, focusing on bonds is not just enough to obtain a good
picture of firms’ overall foreign exchange exposures.

 First, bank lending remains the most important source of financing for many
firms, accounting for over 80 percent of corporate debt.

 Second, firms may take currency risk using financial instruments such as
swaps.

 Third, overall foreign-currency exposure depends on other factors, such as

the composition of firms’ balance sheets, including their assets, and the
nature of their business operations. For example, export-oriented firms’
receipts in a currency other than their own, typically the U.S. dollar, can serve
as “natural” hedges against their debt obligations in foreign currencies,
whereas firms importing inputs from abroad are naturally exposed to the risk
of local currency depreciation.

An estimated foreign exchange exposure highlights the differences across

sectors. For example, firms in non-tradable sectors, such as construction, tend to
have positive foreign exchange exposures – that is, local currency depreciation
affects them adversely. This reflects the fact that sectors like real estate tend to do
well during periods of capital inflows and currency appreciations. In contrast, export-
oriented firms, such as those in the mining sector, tend to have negative foreign
exchange exposures, because they benefits from a depreciation of the local
currency.

The evolution of foreign exchange exposures after the global financial crisis also
differs across regions. For instance, foreign currency exposures appear to have risen
in the most of the Latin America, on average, after the crisis. Furthermore, outside of
Asia—Europe, the Middle East, Africa and Latin America—the fraction of the firms
with positive foreign exchange exposures increased across all sectors from 2010 to
2014.

After comparing the change in foreign currency exposures with the change in the
debt-to-assets ratio for listed firms. Interestingly, the construction sector, where this
ratio grew rapidly, is among the sectors perceived by stock markets are having
strongly increased exposure to exchange rate fluctuations since the crisis. These
findings suggest that emerging markets must have prepared for the implications of a
continued appreciation of the U.S. dollar as the U.S. Fed begins to normalize
monetary policy.
Bodnar and Marston developed a model of foreign exchange exposure dependent
on only three variables - the percentage of the firm's revenues and expenses on the
denominated in foreign currency and its profit rate. They suggested that the low
levels of exposure found by previous empirical studies may be due to operational
hedges, Mihir Dash wherein multinational firms match their foreign currency
revenues and costs.

It is analysed that the foreign exchange risk exposure of the firms listed in Ghana
with respect to USD, GBP, Euro, and a weighted exchange rate index. They found
that foreign exchange exposure was highest against USD (55%), followed by GBP
(35%), and Euro (10%). El-Masry studied the foreign exchange exposure of non-
financial UK firms with respect to their size and foreign operations. They found
evidence of significant in foreign exchange exposure, with higher impact on larger
firms as compared to small and medium firms, and higher impact on firms with
higher foreign exchange revenue.

How currency volatility affects the IT firms?

A study was done on the impact of foreign exchange exposure in the IT sector and it
is found that the result of the study has a negative impact on profitability. Thus,
downward movements in the exchange rate would benefit small- and mid-cap IT
firms but would adversely affect large-cap firms, and vice versa for upward
movements. This is clearly a short-run phenomenon. Thus, small- and mid-cap firms
should come against a rise in exchange rates in the short run, while large-cap firms
should be against a fall in exchange rates in the short run.

Also, IT firms should continuously monitor their foreign exchange exposure for
contingency planning, especially when exchange rates are very volatile. Though the
results of the study it indicates that most of the IT firms have low to moderate foreign
exchange exposure, so that the impact of exchange rate fluctuations would not be
expected to be severe, it is better for firms to carefully monitor the foreign exchange
trends and take appropriate steps in case of high volatility in exchange rates. Large
IT companies in particular should undertake hedging in order to reduce their foreign
exchange exposure levels. Also, companies may consider routing payments through
subsidiary companies in order to eliminate transaction exposure.

The results of the study are in contrast to the previous studies. The high foreign
exchange exposure of a small segment of small-cap IT firms was not evidenced in
the current study, perhaps due to insolvency or suspension of operations. This
suggests that foreign exchange exposure may be a predictor for financial distress for
small-cap IT firms.

Another observation with respect to the results is that the foreign exchange exposure
has decreased overall in 2009-12 as against 2005-07. This is probably the fallout of
the global financial crisis of 2008-09, as well as subsequent Euro-zone crises. In
fact, due to the spells of high volatility in exchange rates in 2007, most large IT firms
have adopted foreign exchange hedging strategies such as forwards and options in
the short-run and currency swaps in the long-run. Further, changes in the US
outsourcing policies under the Obama administration post-global financial crisis have
forced IT firms to shift to markets other than the US, particularly Europe and Asia,
and the domestic market, thereby reducing their foreign exchange exposure.
Conclusion
There are some limitations inherent in the present study. The sample size taken for
study is small hence it may not be possible to generalize the results of the study to
all IT firms. Also, the study is based on previous data, which is of limited use, for
example, if the company is exposed to several different currencies. There is great
scope to develop a more comprehensive framework, incorporating measures of
multiple sources of risk would be more appropriate for understanding risk
management in IT companies. There is scope for more rigorous study along these
lines. Also, further study can examine foreign exchange exposure in other sectors,
for example, comparing product-based industries with service-based industries.