EXPOSURES (RISKS) IN

FOREIGN CURRENCY
Transaction, Translation
and Economic Exposures
Kinds of Exposures
• Exchange rates change continuously which affects
performance of multinational corporations.
• Risk emanating from changes in exchange rates is referred
as exposures.
• Impact of changing exchange rates in the income
statement, values of assets and liabilities or business
outlook are of three distinct types:
• Translation Exposure
• Transaction Exposure
• Economic Exposure

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Exposures Defined
Translation Transaction Economic
Exposure Exposure Exposure
Changes in the Changes in the
Changes in the
income amount of
amount of
statement, and future cash
future cash
values of flows, for
flows
assets and contracts
determined by
liabilities; entered in
future
denominated foreign
competitive
in foreign currency but
position.
currency not settled

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Features of Exposures
Translation Transaction Economic
Exposure Exposure Exposure
Real
Real
Notional Retrospective
Prospective;
Retrospective as well as
prospective Concerns
Concerns
both local
only foreign Concerns only
and foreign
currency foreign
currency
currency

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Managing Exposures
• Of the three exposures transaction exposure is most
important because
– It impacts the immediate cash flows,
– Translation exposure is notional and not real, and
– Economic exposure has long term implications and deals with
rather uncertain future affecting one and all and not one.
• Objectives are not well defined:
– “Eliminate all exchange rate risks”: Shall we do business in
foreign countries in foreign currencies.
• Managing translation and economic exposure create
transaction exposure.
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Managing Transaction Exposure
Tactical Strategic
Forward
Hedge Invoicing

Money
Market Risk Sharing
Hedge

Futures Exposure
Hedge Netting

Options Leading and

Hedge Lagging

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Forward Hedge
Selective Hedging: Because hedging has cost.
Account Receivable:
• Depreciating local currency (Appreciating foreign currency);
DO NOT HEDGE
• Appreciating local currency (Depreciating foreign currency);
SELL FORWARD
Account Payable:
• Depreciating local currency (Appreciating foreign currency);
BUY FORWARD
• Appreciating local currency (Depreciating foreign currency);
DO NOT HEDGE
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Forward Hedge – Account Receivable
INFOSYS expects to receive US $ 10 M after 6 months.
Spot rate: Rs 65/$; 6-m Forward Rate: Rs 63/$
(Indicates depreciating US dollar/appreciating rupee)
Hedging Decision:
– Hedge only if future spot rate is expected to be lower than
the forward rate of Rs 63/$.
If yes:
– Sell $ 10 M forward at Rs 63,
– INFOSYS realises Rs 630 M after 6 months; irrespective of
future spot rate.
– INFOSYS realises a fixed rate that is known today.
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Forward Hedge – Account Payable
TISCO needs to pay US $ 10 M after 6 months.
Spot rate: Rs 65/$; 6-m Forward Rate: Rs 67/$
(Indicates depreciating rupee/appreciating US dollar)
Hedging Decision:
– Hedge only if future spot rate is expected to be higher
than the forward rate of Rs 67/$.
If yes:
– Buy $ 10 M forward at Rs 67,
– TISCO pays Rs 670 M after 6 months; irrespective of
future spot rate.
– TISCO fixes liability at a fixed rate that is known today.
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Cost of Forward Hedge
• Normally reckoned by the forward premium/
discount over spot rate.
(F1 – S0)/S0
True cost of forward hedge:
(F1 – S1)/S0
• True cost of forward hedge cannot be calculated
in advance.
• Would be dependent upon the future spot rate.

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Money Market Hedge
• Does not use forward market at all.
• Uses spot market and money markets in two
currencies.
• Involves simultaneous actions of a) borrowing in
one currency, b) its spot conversion, and c)
investing in another currency, using money
markets of the two currencies.
• Enables locking-in of a fixed exchange rate for
receivable/payable.
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Money Market Hedge
Account Receivable
INFOSYS expects to receive $ 10 M after 6 months.
Spot rate: Rs 65/$; Interest Rates Rupee: 10%, $: 14%
(Indicates depreciating US dollar/appreciating rupee)
Hedging:
– Borrow US dollar 10/1.07M at 14%; matures to $10M in 6-m
– Convert in rupees at spot rate to realise Rs 65x10/1.07 M,
– Invest rupees for 6 months at 10%;
Maturity value = 65 x 1.05 x 10/1.07 M.
Effective rate realised = Rs 63.7850
– Pay US dollar borrowed from the receivable.
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Money Market Hedge
Account Payable
TISCO needs to pay US $ 10 M after 6 m.
Spot rate: Rs 65/$; Interest Rates Rupee: 14%, US $: 10%
(Indicates appreciating dollar/depreciating rupee)
Hedging:
– Borrow rupees at 14% for 6-m,
– Convert rupees at spot rate to US dollar,
– Invest US dollar for 6-m at 10% so as to mature to $10 M.
Effective Exchange Rate:
– US dollar needed for investment = 10/1.05 M
– Rupees needed to be borrowed today = 65 x 10/1.05 M
– Rupees loan to be repaid = 65 x 1.07 x 10/1.05 M
Effective exchange rate = Rs 66.2381/$
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 Money Market Vs Forward Hedge
• Money market is a home-made forward rate.
• If IRP holds money market and forward market will
give identical results.
• If IRP is distorted, there would be different rates.
Hence a corporate manager has a choice between
money market & forward market hedges.
• For receivable: choose the hedge that gives higher rate.
• For payable: choose the hedge that give lower rate.

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 Money Market Vs Forward Hedge
• Cost associated with money market
• Bid - Ask spread in the spot market
• Difference in lending and borrowing rates
• Use appropriate rates.

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Money Market & Forward Hedge
ITC expects to receive £ 10,000 in 6 months. Following scenario exists
Spot: 80.20 – 80.50; 6-m Forward: 81.50 – 82.00
Interest Rates Rs: 10.00 – 10.50; £: 5.50 – 6.00
Forward Hedge:
Sell £ forward at Rs 81.50 (forward bid rate)
Money Market Hedge:
• Borrow £ at 6% (£ borrowing rate) for 6-m (£ borrowed = 10,000/1.03)
• Convert spot; Get Rs 10,000 x 80.20/1.03 (spot bid rate)
• Invest Rupees for 6-m; realise 10,000 x 80.20 x 1.05/1.03
Effective rate = Rs 81.76 (higher than forward)
CHOOSE MONEY MARKET HEDGE

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Invoicing/Risk Sharing
• No invoicing in foreign currency will eliminate foreign
exchange risk altogether.
• The foreign exchange risk shifts from one party to another.
(from seller to buyer for receivable, from buyer to seller
for payable).
• Depends upon relative position of customer and supplier,
and will be accepted by the counterparty only if it feels
benefited.
CAUTION:
• Not to use spot rate but use forward rate for analysis of
such negotiations.

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Invoicing/Risk Sharing
• Invoicing transfers entire risk of foreign exchange rates on the
counterparty.
• Foreign currency risk between buyer and seller can be shared by
linking payment to the exchange rate prevailing at the time of
payment (suitable for long term contracts).
EXAMPLE
If exchange rate is between Payment (% of invoice)
Rs/$ 61.00 and 62.99 102%
63.00 and 64.99 101%
65.00 and 66.99 100%
67.00 and 68.99 99%
69.00 and 66.99 98%

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Exposure Netting
• Hedging need not be done for entire amount
outstanding. Netting to be done by:
– Adjusting receivable against payable in the same
currency, Receivable and payable provide natural hedge.
– Combining exposure across all subsidiaries, and
– Treating similar currencies as one.
• Receivable in euro and payable in dollar provide natural hedge if
euro and dollar are positively correlated with rupee.
• Receivable in euro and receivable in dollar provide natural hedge if
euro and dollar are negatively correlated with rupee.
• Reduces cost of hedging.
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Cross Hedge
• When no forward contract is available in currency of exposure.
• Cross Hedge: When positions in spot and forward are on
different assets, one needs to hedge with spot and forward
positions on related and not on identical assets. Hedge through a
currency having linkage with the currency of exposure, and on
which forward contract is available.
(Exposure in Chinese Yuan pegged to dollar can be hedged with forward in
dollar)
• Need to establish the relationship and find degree of correlation
using past data.
• Greater the value of R2 (explains the fraction of variation
explainable) in the regression, better is the cross hedge.
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Leading and Lagging
• Decision to avail or extend credit terms.
• When tools of hedging are not available:
• If foreign currency appreciating:
– Lead the payable (pay as low as possible)
– Lag the receivable (receive as much as possible)
• If foreign currency depreciating:
– Lag the payable
– Lead the receivable
• Must compare with cost of funds.
• Also use forward rate instead of spot rate.
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 From One Currency to Another

TRANSLATION EXPOSURE

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Need for Translation
• Also called Accounting exposure.
• The impact of the changes in the exchange rates on the
consolidated accounts with respect to profitability,
assets and liabilities of the MNCs.
• MNCs are required to consolidate accounts of all its
subsidiaries in the domestic currencies.
• The accounts of each subsidiary are drawn in the
currency of the host, and therefore need to be
translated from the foreign currency to domestic
currency.

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Does Translation Exposure Matter?
It does not because
• As long as profits of the subsidiary are not remitted it
does not matter irrespective of its depreciation or
appreciation.
• Cash flows will go to meet the asset and liabilities in that
currency.
• If position worsens in one year it may improve in the
next period.
• Cash flows to the parent are not affected unless parent
opts to remit profit/cash back to parent.
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Does Translation Exposure Matter?
It may matter because
• Can affect earnings:
 Impact on share price since markets are driven by
earnings and the PE ratio.
• Value of assets and liabilities would change and
therefore various ratios such a debt equity ratio,
current ratio, profitability ratio may change.
 Affects ability to generate financial resources
either by debt or by equity.
• Cash flows????
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Impact of Translation
• Impact is governed by
– Extent of dependence of parent on
subsidiary (Suzuki-Maruti).
– Strength of foreign currency
(Subsidiary in Africa vs. Europe, Currency
crisis of South East Asia)
– Accounting/Translation method

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Translation Rates/Methods
• Many rates are available
– Opening Rate
– Closing Rate
– Average Rate
– Historical (Actual) Rate
• At what rate to translate the accounts??

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Defining Exchange Rates
Closing Rate
• The rate prevailing at the time of translation.
• Would change from period to period.
Historical Rate
• The rate that prevailed on the date when transaction
actually took place.
• Would not change from one period to another, and
instead remains constant.
Equity
• Irrespective of method of translation equity would always
be translated at the historical rate.
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Translation Methods
Current • Current items at closing rate.
Non-Current • Non-Current items at historical rates.

Monetary • Monetary items at closing rate.

Non-Monetary • Non-Monetary items at historical rate

• Same as Monetary/Non-Monetary except

Temporal Inventories at current rates.

All Current • All items at current rate.

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 Specifying Translation Rates
Current/ Monetary/ Temporal All
Non-Current Non-Monetary Current
Cash C C C C
Receivable C C C C
Payable C C C C
Inventory C H C C
Fixed Assets H H H C
LT Debts H C C C
Equity Always historical

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Choosing Translation Method
• No method can be said to be superior/inferior to
another. All have some merits.
• Consistency of method used period after period is
more important than the method itself.
• The method used once must be followed
subsequently, else effect of changed method must
be quantified and highlighted in the financial
statements.
• Indian accounting standards allow translation
using Monetary/Non-Monetary method.

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Handling Translation
• Balance sheet of subsidiary is denominated in
currency of the host nation and is balanced.
• Different items of balance sheet are translated at
different rates giving rise to mismatch of assets and
liabilities upon translation in local (parent’s)
currency.
• The difference in the balance sheet upon
translation is adjusted in a separate reserve account
“Reserves on account of Translation” in the equity.
– If asset > liabilities : Equity increases
– If asset < liabilities : Equity decreases

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Handling Translation - Example
Ex Rate: Closing and stock: Rs 70/€, Current/ Monetary/ All Current
Equity & Fixed assets: Rs 60/€, LT Debt: Non Current Non Monetary
Rs 65/€
Equity 800 H 48,000 H 48,000 H 48,000
LT Debt 600 H 39,000 C 42,000 C 42,000
Current Liabilities 600 C 42,000 C 42,000 C 42,000
Total 2,000 129,000 132,000 132,000
Fixed Assets 900 H 54,000 H 54,000 C 63,000
Stocks 600 C 42,000 H 42,000 C 42,000
Account Receivable 400 C 28,000 C 28,000 C 28,000
Cash 100 C 7,000 C 7,000 C 7,000
Total 2,000 131,000 131,000 140,000
Translation Reserve in Equity + 2,000 - 1,000 + 8,000
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Measuring Translation Exposure
Liabilities and Assets Foreign Current/ Monetary/ All Current
of subsidiary currency Non Current Non Monetary
Equity 800
LT Debt 600 C 600 C 600
Current Liabilities 600 C 600 C 600 C 600
Total 2,000 600 1,200 1,200
Fixed Assets 900 C 900
Stocks 600 C 600 C 600
Account Receivable 400 C 400 C 400 C 400
Cash 100 C 100 C 100 C 100
Total 2,000 1,100 500 2,000
Translation Exposure A 500 L 700 A 800

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What Affects Translation Exposure
• Items translated at historical rates do not give
rise to translation exposure as the value
remains constant period after period.
• Only items that are translated at current rate
give rise to translation exposure as their value
changes period after period.
• Assets and liabilities translated at current rate
provide natural hedge, and therefore are can
be netted for assessing quantum of exposure.

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Impact of Translation
Exposure Exchange Rate IMPACT ON NET WORTH

If Assets > Subsidiary currency Increase in value of assets is larger

Liabilities appreciates than liabilities (Net worth increases)

If Assets > Subsidiary currency Increase in value of assets is smaller

Liabilities depreciates than liabilities (Net worth decreases)

If Assets < Subsidiary currency Increase in value of assets is smaller

Liabilities appreciates than liabilities (Net worth decreases)

If Assets< Subsidiary currency Increase in value of asset is smaller

Liabilities depreciates than assets (Net worth increases)

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Managing Translation Exposure
• Balance Sheet Hedge:
– Matching exposures on the asset and
liability sides that are translated at current
rates i.e. (so that they nullify each other).
– Assets and liabilities provide natural hedge.
– Not always feasible, and desirable.

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Managing Translation Exposure
Derivatives Hedge:
– Would create transaction exposure; Not advisable to have
cash flow implications for what is notional.
– Means taking speculative position on the foreign exchange
rate movements.
• Need to hedge only the translation difference of the net profit
amount. Can be covered by a forward contract.
• Example: A subsidiary of Indian firm is expected to earn $ 10,000
in profit for the coming year. Current exchange rate is Rs 65. If $
depreciates to Rs 60 by next year the profit would be Rs 6 lacs
instead of Rs 6.5 lacs. The Indian firm can sell $ 10,000 forward.
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Not To Hedge Translation Exposure
• Inaccuracy of forecast of profit
• Availability of forward contract??
• Translation exposure is transformed to transaction
exposure. (Changing notional exposure into cash flow)
• Taxability: Gain/loss on translation doesn’t affect tax.
Gains on forward contract will be taxed.
• If cash flows of subsidiary to be retained for future use by
the subsidiary then managing translation exposure
seems irrelevant.
• Not managing saves cost.

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 Changing Exchange Rates and Competitive Position

ECONOMIC EXPOSURE

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Defining Economic Exposure
• Economic exposure is concerned with impact of
changes in exchange rates on the
– Value of the firm referred as Economic Exposure
– Cash flows of the firm referred as Operating
Exposure
• Value of the firm is reflected in stock price.
• Economic exposure refers to unanticipated changes in
the value of firm. Anticipated changes are already
discounted in the stock price.

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Economic Exposure Affects All
• Appreciation/depreciation of the local currency has impact on all
firms irrespective of their national status (MNC or domestic).
• All firms face competition: domestic as well as foreign
firms/products.
• Change in exchange rate alters the competitive position of the firm
due to change in prices of the product from foreign suppliers.
• The degree of impact will be different for different firms depending
upon:
– Reliance on inputs/outputs from foreign suppliers
– Level of competition from foreign products.

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Impact of Economic Exposure
• Distinct from transaction exposure: results from the fixed
contract obligations denominated in foreign currency.
• Pure domestic firms do not have translation and
transaction exposures but do have economic exposure.
– If rupee depreciates: Domestic firms face less
competition from foreign products as they become
relatively dearer
– If rupee appreciates: More competition as foreign
products become relatively cheaper.
• For MNCs the degree of economic exposure is relatively
high as compared to domestic firm.

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Transaction Vs Economic Exposures

Transaction Exposure Economic Exposure

Contract specific
Relates to transaction costs
Tactical
Changes in nominal exchange
rates
Economy specific
Relates to opportunity costs
Strategic
Changes in real exchange rates

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Economic Exposure and PPP
• Change in real exchange rate and not in nominal
exchange rates causes economic exposure.
• Any change in exchange rate consistent with inflation
rates should have no impact on the relative
competitive position of the firm with respect to foreign
competition.
• Changes in exchange rate consistent with inflation
changes nominal exchange rate but not the real
exchange rate.
• If PPP holds the real exchange rate remains constant.

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Nominal and Real Exchange Rates
• Assume rupee is devalued by 5% and inflation rates in
India and UK are 3% and 2% respectively. If nominal
exchange rate was F0 the nominal rate at the end of 1 year
shall be 0.95 F0.
• If actual rate changed by 1% there is no change in the
relative purchasing power of the currencies. The change in
real exchange rate is 4% and not 5%.
• The real exchange rate is given by
Actual rate  PPP rate
Change in real rate 
PPP rate

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Only Changes in Real Rates Matter
– US firm has an Indian subsidiary currently earning Rs 6,500
equivalent to $ 100 at current exchange rate of Rs 65/$.
– Inflation in India and USA are 10% and 0% respectively. As per PPP
the exchange rate after a year should be Rs 71.50/$ (Rupee
depreciating by 10%). The comparative position is as below:
Now A year later
Sales in Rupees 16,500 18,150
Cost in Rupees 10,000 11,000
Profit 6,500 7,150
Equivalent $ 100 100
– All sales and cost will increase in India by 10% and so will the
profit. Position of US parent remains unaffected.

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Pegging – No Solution
• Exchange Rate pegged to a currency (China)
• Would it cause economic exposure?
• Exporter from China (fixed rate Yuan 10/$)
• Inflation 10% in China 0% in USA
Now Later
Selling Price $ 10 Yuan 100 Yuan 100
Cost in Yuan 40 44
Profit 60 ($ 6) 56 ($5.60)
• Profit declines despite no change in nominal
exchange rate, because real rate has changed.

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Measuring Economic Exposure
• Measure the sensitivity of cash flow with
respect to exchange rate.
• Operating cash flows, Assets and Liabilities
all change the value of the firm.
– Impact on operating cash flows: Operating
exposure
– Impact on assets and liabilities: Economic
exposure
• Most people regard both as same

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Measuring Economic Exposure
• Scenario Analysis:
– Concerned with forecast of changes in cash
flows with changing exchange rates.
– Classify items of revenue and expenses, and
– project subjectively the cash flows with varying
exchange rate scenario.
– Need to have a) access to internal information
about costing and pricing, b) be domain expert
to know impact on costing and pricing of the
products.

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Managing Economic Exposure
• Marketing
– Diversifying markets
– Pricing strategy
– Product differentiation
• Production
– Input mix
– Shifting production
– Plant Locations
– Raising productivity
• Financial
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Measuring Economic Exposure
• Regression analysis
R=a+bF+e
R = Value of cash flow,
F = Exchange rate,
a, b are regression coefficients, and e = error
• Use stock price as proxy to cash flow.
• Stock price is available in public domain.
• Can be done by people external to the firm.

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What Can Be Managed
What can be hedged:
R = a+bF+e
Var (R) = b2 Var (F) + Var (e)

Can be hedged

Cannot be hedged

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Manage or Not to Manage
Not to manage at all because:
• Economic hedge is superset of transaction exposure,
• Manage transaction exposure well to manage economic exposure.
Financial hedge:
Advantage:
– Marketing and Production related hedges are extremely
strategic.
– Financial hedge is easy to implement, forward, futures and
options provide easy solutions.
Disadvantage:
– Amounts to taking a speculative position in FE market.
– Converts economic exposure to transaction exposure.

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Forward and Economic Exposure
• One rupee change in exchange rate effects the
cash flow by Rs 5,700. Depreciation of rupee
leads to increased cash flow while appreciation
reduces the cash flow.
• Protection required against appreciation of
rupee (depreciation of $)
THE STRATEGY:
• Sell $ forward equivalent to beta coefficient i.e.
Sell forward $ 5,700

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Sensitivity of Cash Flow
Scenario Prob $ Cash flow Ex Rate R
1 1/3 1,000 45 45,000
2 1/3 1,100 46 50,600
3 1/3 1,200 47 56,400
Average 46 50,667

Var (F) = 1/3{(45 - 46)2+(46 - 46)2+(47 - 46)2} = 2/3

Cov (R,F) = 1/3{(45,000 – 50,667)(45 – 46) + (50,600 –

50,667)(46 – 46) +(56,400 – 50,667)(47 – 46)}
= 11,400/3 = 3,800

Beta Coefficient 
Cov (R , F)

 p(R  R )(F  F)
Var(F)  p(F  F)2
Beta coefficient = 3,800/2/3= 5,700

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Forward and Economic Exposure
• Assumed forward rate = Rs 46/$
• Profit/Loss on the forward contract
Exchange Rate Profit/Loss -
45 5,700 x 1 = 5,700
46 5,700 x 0 = 0
47 5,700 x -1 = - 5,700

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Sensitivity with Forward
• Variance of cash flow with and without the forward
contract
Ex Rate R CFforward Total
45 45,000 5,700 50,700
46 50,600 0 50,600
47 56,400 -5,700 50,700
Variance of CF 216,62,222 2,222
• Variance of the cash flow reduces drastically. The
remaining variance (2222) can not be diversified away or
eliminated.

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