DERIVATIVES:

Derivatives are financial instruments whose value is derived from other underlying
assets.

The term derivative refers to a type of financial contract whose value is dependent
on an underlying asset, group of assets, or benchmark. A derivative is set between
two or more parties that can trade on an exchange or over-the-counter (OTC).
These contracts can be used to trade any number of assets and carry their own
risks. Prices for derivatives derive from fluctuations in the underlying asset. These
financial securities are commonly used to access certain markets and may be
traded to hedge against risk.

Four Types of Derivative contracts

1. Futures

A futures contract, or simply futures, is an agreement between two parties for the
purchase and delivery of an asset at an agreed-upon price at a future date. Futures
are standardized contracts that trade on an exchange. Traders use a futures contract
to hedge their risk or speculate on the price of an underlying asset. The parties
involved are obligated to fulfill a commitment to buy or sell the underlying asset.6

For example, say that on Nov. 6, 2021, Company A buys a futures contract for oil
at a price of $62.22 per barrel that expires Dec. 19, 2021. The company does this
because it needs oil in December and is concerned that the price will rise before the
company needs to buy. Buying an oil futures contract hedges the company's risk
because the seller is obligated to deliver oil to Company A for $62.22 per barrel
once the contract expires. Assume oil prices rise to $80 per barrel by Dec. 19,
2021. Company A can accept delivery of the oil from the seller of the futures
contract, but if it no longer needs the oil, it can also sell the contract before
expiration and keep the profits.

In this example, both the futures buyer and seller hedge their risk. Company A
needed oil in the future and wanted to offset the risk that the price may rise in
December with a long position in an oil futures contract. The seller could be an oil
company concerned about falling oil prices and wanted to eliminate that risk by
selling or shorting a futures contract that fixed the price it would get in December.
It is also possible that one or both of the parties are speculators with the opposite
opinion about the direction of December oil. In that case, one might benefit from
the contract, and one might not. Take, for example, the futures contract for West
Texas Intermediate (WTI) oil that trades on the CME and represents 1,000 barrels
of oil. If the price of oil rose from $62.22 to $80 per barrel, the trader with the long
position—the buyer—in the futures contract would have profited $17,780 [($80 -
$62.22) x 1,000 = $17,780]. 7 The trader with the short position—the seller—in the
contract would have a loss of $17,780.

Cash Settlements of Futures

Not all futures contracts are settled at expiration by delivering the underlying asset.
If both parties in a futures contract are speculating investors or traders, it is
unlikely that either of them would want to make arrangements for the delivery of
several barrels of crude oil. Speculators can end their obligation to purchase or
deliver the underlying commodity by closing (unwinding) their contract before
expiration with an offsetting contract.

Many derivatives are in fact cash-settled, which means that the gain or loss in the
trade is simply an accounting cash flow to the trader's brokerage account. Futures
contracts that are cash-settled include many interest rate futures, stock index
futures, and more unusual instruments like volatility futures or weather futures.

2. Forwards

Forward contracts or forwards are similar to futures, but they do not trade on an
exchange. These contracts only trade over-the-counter. When a forward contract is
created, the buyer and seller may customize the terms, size, and settlement process.
As OTC products, forward contracts carry a greater degree of counterparty risk for
both parties.

Counterparty risks are a type of credit risk in that the parties may not be able to
live up to the obligations outlined in the contract. If one party becomes insolvent,
the other party may have no recourse and could lose the value of its position.

Once created, the parties in a forward contract can offset their position with other
counterparties, which can increase the potential for counterparty risks as more
traders become involved in the same contract.
CHARACTERISTICS FUTURES CONTRACT FORWARDS CONTRACT
Meaning A futures contract is a A forward contract is an
standardized contract, traded on agreement between two parties to
exchange, to buy or sell buy or sell underlying assets at
underlying instrument at certain specified date, at agreed rate in
date in future, at specified price. future.
Structure Standardized contract Customized contract
Counterparty Risk Low High
Contract size Standardized/Fixed Customized/depends on the
contract term
Regulation Stock exchange Self-regulated
Collateral Initial margin required Not required
Settlement On daily basis On maturity date

3. Options

An options contract is similar to a futures contract in that it is an agreement

between two parties to buy or sell an asset at a predetermined future date for a
specific price. The key difference between options and futures is that with an
option, the buyer is not obliged to exercise their agreement to buy or sell. It is an
opportunity only, not an obligation, as futures are. As with futures, options may be
used to hedge or speculate on the price of the underlying asset.

 If you buy an options contract, it grants you the right but not the obligation to buy
or sell an underlying asset at a set price on or before a certain date.

A call option gives the holder the right to buy a stock and a put option gives the
holder the right to sell a stock. Think of a call option as a down payment on a
future purchase.
Imagine an investor owns 100 shares of a stock worth $50 per share. They believe
the stock's value will rise in the future. However, this investor is concerned about
potential risks and decides to hedge their position with an option. The investor
could buy a put option that gives them the right to sell 100 shares of the underlying
stock for $50 per share—known as the strike price—until a specific day in the
future—known as the expiration date.

Assume the stock falls in value to $40 per share by expiration and the put option
buyer decides to exercise their option and sell the stock for the original strike price
of $50 per share. If the put option cost the investor $200 to purchase, then they
have only lost the cost of the option because the strike price was equal to the price
of the stock when they originally bought the put. A strategy like this is called
a protective put because it hedges the stock's downside risk.

Alternatively, assume an investor doesn't own the stock currently worth $50 per
share. They believe its value will rise over the next month. This investor could buy
a call option that gives them the right to buy the stock for $50 before or at
expiration. Assume this call option cost $200 and the stock rose to $60 before
expiration. The buyer can now exercise their option and buy a stock worth $60 per
share for the $50 strike price for an initial profit of $10 per share. A call option
represents 100 shares, so the real profit is $1,000 less the cost of the option—
the premium—and any brokerage commission fees.

In both examples, the sellers are obligated to fulfill their side of the contract if the
buyers choose to exercise the contract. However, if a stock's price is above the
strike price at expiration, the put will be worthless and the seller (the option writer)
gets to keep the premium as the option expires. If the stock's price is below the
strike price at expiration, the call will be worthless and the call seller will keep the
premium.

4. Swap
Swap is a derivative contract made between two parties to exchange cash flows
in the future. Interest rate swaps and currency swaps are the most popular swap
contracts, which are traded over the counters between financial institutions.
These contracts are not traded on exchanges. Retail investors generally do not
trade in swaps.
 Foreign Exchange Exposure
Definition: Foreign Exchange Exposure refers to the risk associated with the
foreign exchange rates that change frequently and can have an adverse effect on
the financial transactions denominated in some foreign currency rather than the
domestic currency of the company.
In other words, the firm’s risk that its future cash flows get affected by the
change in the value of the foreign currency, in which it has maintained its books
of accounts (balance sheet), due to the volatility of the foreign exchange rates,
is termed as foreign exchange exposure.
It is not only those firms who directly make the financial transactions in the
foreign currency denominations faces the risk of foreign exposure, but also, the
other firms who are indirectly related to the foreign currency is exposed to
foreign currency risk.
For example, if Indian company is competing against the products imported
from China and if the Chinese Yuan per Indian rupee falls, then the importers
enjoy decreased cost advantage over the Indian company. This shows, that the
companies not having any direct link to the forex do get affected by the change
in the foreign currency.
Types of Foreign Exchange Exposure
1. Transaction Exposure
2. Operating Exposure
3. Translation Exposure
Out of these three risks, the first two risks, i.e. transaction risk and the operating
risk are called “cash flow exposure” or “economic exposure”, while the
translation risk is called the “accounting exposure”.

1. The Transaction Exposure is a kind of foreign exchange risk involved in the

international trade wherein the cross-currency transactions (multiple currencies)
are involved. In other words, a risk faced by the company that while dealing in the
international trade, the currency exchange rates may change before making the
final settlement, is termed as a transaction exposure.

Whatever transaction takes place in business both cash and credit are involved.
Due to credit we have to manage accounts payable and accounts receivable
accounts. Whenever on international level any sale happens on credit accounts
receivables remains open and if we purchase on credit accounts payable remains
open i.e. transaction is not settled. So if any fluctuation happens in international
market it gives rise to transaction exposure (only happens when accounts are open)

If the Indian exporter has the receivable of $5,00,00, due five months hence, but in
the meanwhile the dollar depreciates relative to the rupee, then the exporter will
suffer the cash loss. But however, in the case of a payable of the same amount, the
exporter gains if the dollar depreciates relative to the rupee.

Thus, once the cross-currency contract has been agreed upon by the firms located
in two different countries for the specific amount of goods and money, the contract
value may change with the fluctuations in the foreign exchange rates. This risk of
change in the exchange rates is called the transaction exposure. The greater the
time gap between the agreement and the final settlement, the higher is the risk
associated with the change in the foreign exchange rates. However, the companies
could save themselves against the transaction exposure through hedging
techniques.

Transaction Exposure is for short term cash flows.

2. The Operating Exposure refers to the extent to which the firm’s future cash

flows get affected due to the change in the foreign exchange rates along with the
price changes. In other words, a risk that firm’s revenue will be adversely affected
due to the substantial change in the exchange rate and the inflation rate is called as
operating exposure.

Operating Exposure, like transaction exposure, also involves the actual or potential
gain or loss, but the latter is specific in nature and deals with a particular
transaction of the firm, while the former deals with certain macro level exposure
wherein not only the firm under concern gets affected but rather the whole industry
observes the change with the change in the exchange rates and the inflation rate.
Thus, with operating exposure, the entire economy is exposed to the foreign
exchange risk. Since, operating exposure is much broader in nature, and relates to
the entire investment of the firm so with the change in the exchange rates the
overall value of the firm gets altered. The firm’s value is comprised of the
operating cash flows and the total assets the firm possesses.
It is quite difficult to identify operating risk, as the cash flows largely depends on
the cost of firm’s inputs and the prices of its outputs which gets altered
significantly with the change in the foreign exchange rates. Also, such exposure
relates to the unseen challenges from the competitors, entry barriers, etc., which
are subjective in nature and are interpreted differently by different experts. Thus,
operating exposure influences the competitive position of the firm substantially.

Operating exposure is for long term

Transactional Exposure + Operating Exposure = Economic Exposure

3. The Translation Exposure or Accounting Exposure is the risk of loss suffered

when stock, revenue, assets or liabilities denominated in foreign currency changes
with the movement of the foreign exchange rates. In other words, the translation
exposure stems from the requirement of converting the subsidiary’s assets and
liabilities (operating in another country) denominated in foreign currency in the
home currency of the parent company, at the time of preparing the consolidated
profit and loss statement and the balance sheet. Thus, any change in the foreign
exchange rate will have a considerable impact on the financial statements.

In translating the items denominated in foreign currency in the domestic

currency, an accountant encounters two issues:

1. Whether the financial statement items denominated in foreign currency are

converted at the current exchange rate or at the rate which was prevailing at
the time the transaction occurred (historical exchange rate)?

2. Whether the profit or loss that arises from the rate adjustments be taken into
the current period profit and loss statement or be postponed?

If there is any change in the exchange rate over the previous accounting period,
then the translation of the items denominated in the foreign currency will result in
foreign exchange gains or losses, except when there is a tax implication on these
items. The translation exposure is concerned with the recorded profits and the
balance sheet values and does not affect the overall value of the firm. Since the
gains or losses suffered due to the translation of financial items has no significant
impact on the stock prices of the firm. And the investors do believe that such risk
can be diversified and hence does not demand any extra premium for it.
Strategies for Managing Transaction Exposure

1. Futures Contracts: Futures contracts are usually exchange traded and they
have standardized and limited contract sizes, maturity dates, initial collateral, and
several other features. In general, it is not possible to exactly offset the position to
fully eliminate the exposure.

 Traded in exchange market

 Can’t offset position legally bound to fulfill the contract
 Taking short or long position and fixing strike rate to mitigate the risk
 Whether selling or buying, the 2 parties have to evaluate the current spot rate
and future expected rate and on the basis of the evaluation the strike rate is
determined.

2. Forward Contracts: If a firm has to pay (receive) some fixed amount of foreign
currency in the future (a date), it can obtain a contract now that denotes a price by
which it can buy (sell) the foreign currency in the future (the date). This removes
the uncertainty of future home currency value of the liability (asset) into a certain
value.

 Forwards are customized, traded in OTC, their stands an option of off-

setting the position for both buyer and seller
o E.g. If we have to receive 1000 USD after 6 months

Current spot rate = 70

So worth = 70*1000=70000 INR

But these are to be received in future so we don’t know the future spot
rate and hence we speculate the future spot rate

If USD appreciates we don’t need to hedge we will receive much

more

If INR appreciates i.e. future spot rate may be 1USD = 60INR

We will face loss and hence it is important to hedge.

3. Money Market Hedge: The money market hedge works in a similar manner as
a forward exchange, but with a few tweaks. Foreign exchange risk can arise either
due to transaction exposure (i.e., due to receivables expected or payments due in
foreign currency) or translation exposure, which occurs because assets or liabilities
are denominated in a foreign currency. Translation exposure is a much bigger issue
for large corporations than it is for small business and retail investors. The money
market hedge is not the optimal way to hedge translation exposure – since it is
more complicated to set up than using an outright forward or option – but it can be
effectively used for hedging transaction exposure.

If a foreign currency receivable is expected after a defined period of time and

currency risk is desired to be hedged via the money market, this would necessitate
the following steps:

1. Borrow the foreign currency in an amount equivalent to the present value of

the receivable. Why the present value? Because the foreign currency loan
plus the interest on it should be exactly equal to the amount of the
receivable.

2. Convert the foreign currency into domestic currency at the spot exchange
rate.

3. Place the domestic currency on deposit at the prevailing interest rate.

4. When the foreign currency receivable comes in, repay the foreign currency
loan (from step 1) plus interest.

Similarly, if a foreign currency payment has to be made after a defined period of

time, the following steps have to be taken to hedge currency risk via the money
market:

1. Borrow the domestic currency in an amount equivalent to the present value

of the payment.

2. Convert the domestic currency into the foreign currency at the spot rate.

3. Place this foreign currency amount on deposit.

4. When the foreign currency deposit matures, make the payment.

Note that although the entity who is devising a money market hedge may already
possess the funds shown in step 1 above and may not need to borrow them, there is
an opportunity cost involved in using these funds. The money market hedge takes
this cost into consideration, thereby enabling an apples-to-apples comparison to be
made with forward rates, which as noted earlier are based on interest rate
differentials.

EG

Export to US > 1000 USD > receivables > lend

Import to UK > 500 GBP > payables > invest

 We go to the money market of US raise loan where sinking fund i.e.

principle + interest amount = (900+100)=1000
Convert it into INR at current spot rate. Later we repay the 1000 USD to be
received to bank.

 If 1 GPB = 100 INR

So actual amount to be paid after 6 months based on current spot rate =
500*100= 50000 INR
We convert INR now into GBP at current spot
We invest the amount now where maturity of investment is equal to maturity
of payables
So that on maturity we will receive (P+I) = 500 GBP and we will settle the
accounts
How much to invest?
Account Payable = 500GBP
500 GBP payable to Mr. X after 1 year
Convert amount y into GBP @ current spot rate
Let it be 1 GBP = 105 INR
 Future value = 500GBP
 PV =?
 FV = PV (1+r) ^n
 500 = PV (1+8%) ^1
 PV = 463
 Therefore we have to invest 463 GBP @ 8% (interest rate prevalent in the
money market) to receive 500 GBP after one year
So, how much INR to convert?
1 GBP= 105 INR
463 GBP = 48615 INR

48615 INR is to be converted @ spot rate = 105 INR = 1GBP

i.e. 463 GBP
Invest 463 GBP @ 8%
We will receive 500 GBP after 1 year
Hence accounts payable will be settled

4. Currency Swaps: A currency swap involves an agreement between two parties

to exchange a series of cash flows in one currency for a series of cash flows in
another currency, at agreed intervals over an agreed period. This is done to convert
a liability in one currency to some other currency. Its purpose is to raise funds
denominated in other currency. One party holding one currency swaps it for
another currency held by other party. Each party would pay the interest for the
exchanged currency at regular interval of time during the term of the loan. At
maturity or at the termination of the loan period each party would re-exchange the
principal amount in two currencies.

 Maturity period way beyond forward contracts

 Not a single contract like forwards but a portfolio of contracts
 E.g. inflows of 5 years have 5 different rates. In swaps we sign single
contract for all 5 years in 5 different rates.

Note: The major difference between an option and the hedging techniques
mentioned above is that an option usually has a nonlinear payoff profile. They
permit the removal of downside risk without having to cut off the profit from
upside risk.

 The strategies discussed above hedge the risk and hence cover the loss but
we at the same time cannot avail the opportunities in the market and gain
 profit. For the purpose of capitalizing on profit we have the alternative of
options (put/call)

The decision of choosing one among these different financial techniques should be
based on the costs and the penultimate domestic currency cash flows (which are
appropriately adjusted for the time value) based upon the prices available to the
firm.

5. Currency Options: Currency options are contracts which provides the holder
the right to buy or sell a specified amount of currency for a specified price over a
given time period. Currency options give the owner of the agreement the right to
buy or sell but not an obligation. The owner of the agreement has a choice whether
to use or not to use the option based on the exchange rates. He/she can choose to
sell or buy the currency or let the option lapse. The writer of the option gets a price
for granting this option. The price payable is known as premium. The fixed price at
which the owner can sell or buy the currency is called as strike price or the
exercise price. Options giving the holder a right to buy are called call options and
Options giving the holder a right to sell is called put options. It is possible to take
advantage of the potential gains through currency options. For example, If an
Indian business firm has to purchase capital goods from the USA in US$ after
three months, the company should buy a currency call option. There are two
possibilities. First, if the dollar depreciates, then the exchange rates will be
favorable as spot rate will be less than the strike price and the company can buy the
US$ at the prevailing spot rate, as it will cost less. Second, if the dollar appreciates,
then the exchange rates will be unfavorable as spot rate will be more than the strike
price and the company can opt to use its right and buy the US$ at the strike price.
Hence, in both the cases the company will be paying the less to buy the dollar to
pay for the goods.

 When we enter a call option we have a choice to buy or not to buy and when
we enter a put option we have a choice to sell or not to sell.
 The “or not” choice in the above gives us the opportunity to mitigate risk
and at the same time having the opportunity to gain profits.
Uncertainty about existence of exposure

Uncertainty about existence of exposure arises when there is an uncertainty in

submitting bids with prices fixed in foreign currency for future contracts. The firm
will pay or receive foreign currency when a bid is accepted, which will have
denominated cash flows. It is a kind of contingent transaction exposure. In these
cases, an option is ideally suited.

 Contingent Exposure: When we do not know in future whether or not we

will face transaction exposure (receiving inflows/paying outflows). The best
alternative in such scenarios is options contract.

6. Cross Hedging: Cross Hedging means taking opposing position in two

positively correlated currencies. It can be used when hedging of a particular
foreign currency is not possible. Even though hedging is done in a different
currency, the effects would remain the same and hence cross hedging is an
important technique that can be used by companies.

 We have strong currencies that are frequently traded and we have weak
currencies that are traded very less
 If we have transaction exposure in weak currencies, there is difficulty in
managing hedging because instruments are rarely available for such
currencies.
 Now what to do?
 We have an alternative of cross hedging wherein we see which strong
currency is correlated with our weak currency
 We hedge in strong currency to mitigate risk in weak currency ( by taking
opposite positions)
 E.g. Asian currencies have positive correlation with Japanese yen
 After 8th months we have to receive 10000 Nepal currency
 Hence we go for future/forwards/swaps/options hedging in yen
 If yen depreciates Nepal currency also depreciates and hence risk is
managed.
 Seeing how much correlation is important. If currencies are perfectly
correlated (cr =1) than net effect is zero
 The stronger the correlation the more effective the cross hedging.
 E.g. We have exposure in Thai Baht
 1000 Thai Baht inflow to be received after 3 months
 We want INR after 3 months
 We are unable to find the contract to hedge the same
 We instead hedge the currency that is positively correlated i.e. Japanese Yen
 At spot rate we will buy Japanese yen
 After 3 months if Thai Baht appreciates we will have profit but it will be
nullified since Japanese Yen will also appreciate and we will face loss
 Similarly if Thai Baht depreciates we will face loss but same will be covered
as Japanese yen will also depreciate and we will have profit

Strategies for Managing Operating Exposure

 Operating exposure is long term while transaction exposure is short term

 In operating exposure we don’t know the amount of receivables and
payables and we speculate the same based on the past historic data while
in transaction exposure we know the amount.
 We don’t know the rate of exchange in both and that gives the rise to
exposure and need to hedge the same.
 Swaps can be used to mitigate the risk in operating exposure same as
transaction exposure as the contract is for long period of time while other
strategies of transaction exposure are meant for shorter period of time
 Generally the strategies to manage operating exposure lie in three aspects
of diversification;
o Financial Diversification: Raising finances in different money
markets (India, US, UK)
o Market Diversification: Selling in multiple markets and not in one
place.
o Production Strategy: Plant locations and raw material import not
limited to one place
A. Financial Strategies

1. Risk Sharing Agreements:

Currency risk sharing generally involves a legally binding price adjustment clause,
wherein the base price of the transaction is adjusted if the exchange rate fluctuates
beyond a specified neutral band or zone. Risk sharing thus occurs only if the
exchange rate at the time of transaction settlement is beyond the neutral band, in
which case the two parties split the profit or loss.

By fostering cooperation between the two parties, currency risk sharing eliminates
the zero-sum game nature of currency fluctuations, in which one party benefits at
the expense of the other.

Still, the degree of currency risk sharing will depend on the relative bargaining
position of the two parties and their willingness to enter into such a risk-sharing
arrangement. If the buyer (or seller) can dictate terms and perceives there is little
risk of their profit margin being affected by currency fluctuation, they may be less
willing to share the risk.

 2 parties sign a contract to share the risk related to appreciation /

depreciation in currencies.
 E.g. A and B enter into a forward contract
 They agree to exchange INR and USD
 Forward spot rate = 74 INR is determined
 A band is determined around this spot: 72INR to 76 INR
 If future spot rate goes beyond the band parties share the loss
 For e.g. if rate appreciates i.e. it becomes say 80 INR, A and B share the
profit and loss in the following way: (80-74)/2 = 3, i.e. 3 INR by each A and
B: the rate will be 74+3 = 77
 Similarly if rate depreciates: i.e. it becomes say 70, A and B share the profit
and loss in the following way: (74-70)/2 = 2, i.e. 2 INR by each A and B: the
rate will be 74-2 = 72
 If it lies within the band the contract will mature at 74
2. Parallel Loans:

In back-to-back or parallel loan, two companies in different countries borrow

offsetting amounts from one another in each other's currency. For example, an
Indian company imports high-end perfumes and cosmetic products from USA and
sells in India. It operates a branch office in USA to procure cosmetic products and
export it to India. Let us name this company as Indian importer. The Indian
importer’s major expenses are in USD while earnings are in Indian Rupees. The
Indian exporter (exporting to Wal-Mart and earnings in USD) gives loan of let us
$15000 to the branch office of Indian importer. The Indian importer gives an
equivalent amount of loan in INR to Indian exporter. The day this back-to-back
loan was given, the spot rate is INR42/USD. Indian exporter gives a loan of
$15000 to the branch office. The Indian importer gives a loan of INR 630,000 to
Indian exporter. It is clearly evident that both companies managed to get their
forex requirement without going to forex market. However, back-to-back loans
have inherent disadvantage. A party wanting to mitigate forex risk must find out a
willing counterparty to take opposite position.

 Indian company subsidiary in US needs USD to pay its obligations

 We see if any US company has subsidiary in India who needs INR
 We take loan and pay obligations of US company in India
 We see the (P+I) amount and interest rate in US and the US company pays
our obligations there.
 E.G. US business has Indian subsidiary (A) needs INR
 Indian businesses has US subsidiary (B) needs USD
 Both have exposure in foreign market
 They can take parallel loan and avoid entering into forex and hence there is
no exposure
 US business needs 1 lakh Indian rupee and the rate of interest is India is 5%
 Indian business pays 5% interest for 10 years
 5000 for 10 years = 50000 INR as interest and the principal amount =
100000 INR
 Total paid to US business = 100000+50000=150000 INR
 Spot rate = 74 : 150000 INR = 2027 USD
  US company raises equivalent loan in US (P+I) and gives same to Indian
company
 We have to check what is the rate of interest in US market: for instance let’s
say it is 7%
 FV=PV(1+r)^n
 2027=PV(1+.07)^10
 PV = 1029 USD
 Interest paid is = 2027-1029=998 USD

3. Exposure Netting:

Exposure netting is a method of hedging currency risk by offsetting exposure in

one currency with exposure in the same or another similar currency.

Exposure netting has the objective of reducing a company’s exposure to exchange

rate (currency) risk. It is especially applicable in the case of a large multinational
company, whose various currency exposures can be managed as a single
portfolio; it is often challenging and costly to hedge each and every currency risk
of a client individually when dealing with many international clients.

A firm’s exposure netting strategy depends on a number of factors, including the

currencies and amounts involved in its payments and receipts, the corporate policy
with regard to hedging currency risk, and the potential correlations between the
different currencies to which it has exposure.

Exposure netting allows companies to manage their currency risk more holistically.
If a company finds that correlation between exposure currencies is positive, the
company would adopt a long-short strategy for exposure netting. The reason for
doing so is that with a positive correlation between two currencies, a long-short
approach would result in gains from one currency position offsetting losses from
the other. Conversely, if the correlation is negative, a long-long strategy would
result in an effective hedge in the event of currency movement.

 Used by businesses that have many subsidiaries across the world and deal
with many currencies
  For e.g. we have 5 subsidiaries, we see what are the inflows and outflows
from them and instead of managing them individually we analyze them and
hedge collectively. If from subsidy A we have 1000 USD inflow and in
subsidy B we have 1000 USD outflow so we net them or if it is different we
only manage the difference between the inflow and the outflow or if we have
outflow or if we have outflow in Korean Won and inflow in Japanese Yen
(positively correlated) we can net them.
 The basis is that the individual exposures need not to be hedged we hedge
them collectively.

4. Cash Flow Matching:

This is the simplest form of mitigating economic exposure by matching foreign

currency inflows and outflows. For example, if a European company has
significant inflows in US dollars and is looking to raise debt, it should consider
borrowing in US dollars.

 Natural hedge: exposure is naturally managed by cash inflows and outflows

 For e.g. 1000 USD inflow is due in future and at the same time 1000USD is
due for outflow so exposure is hedged naturally
 We have to analyze maturities
 Here denominations should be same as well as maturities

5. Lead and Lag:

Leads and lags in international business most commonly refer to the alteration of
normal payment or receipts in a foreign exchange transaction based on an expected
change in exchange rates.

When a corporation or government entity has the ability to control the schedule of
payments being received or made, then that organization may opt to pay earlier
than or delay the payment later than scheduled. These changes would be made in
anticipation of capturing the benefit from a change in currency exchange rates.
These dynamics hold true both for small and large transactions. If a company in
one country were about to acquire a corporate asset in another country, and the
target company's country currency was expected to decrease in value relative to the
acquiring company's country, then delaying the purchase would be in the interest
of the acquiring company.

A strengthening of the currency being paid out would lead to a decreased payout
for the entity in question, while a weakening of the currency would lead to
increased costs the longer the payment was delayed. Because it amounts to a
timing strategy, leading and lagging implies risks. A lack of proper execution may
result in an unfavorable outcome.

When a business has an expected foreign exchange transaction as the result of a

deal, it may need to buy or sell a certain currency. If the company believes the
currency may move in a certain direction they may choose to speed up the
transaction or delay it to take advantage of the potential outcome. Normal price
movement from supply and demand between countries can be very difficult to
forecast, but certain political events may have a known timeline and can be more
easily anticipated (consider the UK's Brexit vote as an example).

Accelerating a transaction is known as "leading" while slowing it down is known

as "lagging." For example, if a U.S. company has agreed to buy a Canadian asset
then it will need to buy Canadian dollars and sell U.S. dollars to complete the
transaction. If the company believes the Canadian dollar is going to strengthen
against the U.S. dollar they will accelerate the transaction (lead) before the price of
the asset increases in U.S. dollar terms. Conversely, if the company believes the
Canadian dollar will weaken, they will hold off payment (lag) in the hope the asset
becomes cheaper in U.S. dollar terms.

 Depends upon how much market info you have

 Speculation based
 E.g. business in India and an item exported to US
 1000 dollars to be received after 3 months
 If we speculate US dollar will appreciate further we defer our receivables
from 3 to say 4 months so as to receive higher inflow, this is called lagging
 If we speculate USD will depreciate we provide a discount and ask for
payment before 3 months in order to avoid loss. This is called leading
 Leading and lagging depends on whether we have inflows or outflows
 Further it is mere speculation, actual outcomes may be different
B. Market Strategy:

1. Market Selection:

A major strategic consideration for a company is what market to sell in and the
relative marketing support to devote to each market. For example, a company
might decide to pull out of markets that have become unprofitable due to real
exchange rate changes and more aggressively pursue market share or expand into
new markets when the real exchange rate depreciates. These decisions depend on
the fixed costs associated with establishing or increasing market share. Market
selection and market segmentation provide the basic parameters within which a
company can adjust its marketing mix over time.

 Which countries to enter and what segment to enter

 We can diversify by entering different countries in same segment

2. Market Share vs. Profit Margin:

In response to changes in real exchange rates, a company has to make a decision

regarding market share versus profit margin. This involves the decision regarding
foreign currency price of foreign sales. Such a decision should be made by setting
the price that maximizes profits for the company. Additionally, the decision on
how to adjust the foreign currency price in response to exchange rate changes will
depend upon how long the real exchange rate change is expected to persist, the
extent of economies of scale that occur from maintaining large quantity of
production, the cost structure of expanding output, the price elasticity of demand,
and the likelihood of attracting competition if high unit profitability is apparent.
The longer the exchange rate change is expected to persist, the greater the price
elasticity of demand, the greater are the economies of scale and the greater is the
possibility of attracting competition, the greater will be the incentive to lower
home currency price and expand demand in light of a home currency depreciation,
and to keep home currency price fixed and maintain demand in light of a home
currency appreciation.

 If our segment is price sensitive we will lose customers if we raise price on

account of forex changes as it increases our cost but if we don’t increase
price our profit will decrease
  If price is increased sales decrease
 If price is not increased profit margin decreases because of increased cost
which is a result of interest rate fluctuations\
 In such cases we need to decide whether we want market share or profit
margin this is called Hobson’s Choice

3. Promotional Strategy:

An essential issue in any marketing program is the size of the promotional budget
for advertising, selling and merchandising. These budgets should explicitly build in
exchange rate impacts. An example is European ski areas in the mid-1980s. When
the dollar was strong, they found that they obtained larger returns on advertising in
the U.S. for ski vacations in the Alps as the costs compared to the Rocky
Mountains has fallen due to the currency movements.

 Whatever we do as a part of promotional mix it comes with a certain budget

 Promotional budget is to be set in accordance with the revenue it generates
 Revenue should be greater than the cost, ROI is to be analyzed
 E.g. 100 INR is the cost of promotion

Rupee depreciates

New cost 120

Cost increased while revenue decreased

 If rupee appreciates cost decreases and ROI increases

4. Product strategy:

Companies often respond to exchange risk by altering their product strategy, which
deals with areas such as new-product introduction, product line decisions, and
product innovation. One way to cope with exchange rate fluctuations is to change
the timing of the introduction of new products. For example, because of the
competitive price advantage, the period after home currency depreciation may be
the ideal time to develop a brand franchise.
i. Changing Product Line: Exchange rate fluctuations also affect product line
decisions. Following home currency devaluation, a firm will potentially be able to
expand its product line and cover a wider spectrum of consumers both at home and
abroad. Conversely, home currency appreciation may force a firm to reorient its
product line and target it to a higher-income, more quality-conscious. Less price-
sensitive constituency. Volkswagen, for example, achieved its export prominence
on the basis of low-priced, stripped-down, low-maintenance cars. The appreciation
of the Deutsche mark in the early 1970s, however, effectively ended VW's ability
to compete primarily on the basis of price. The company lost more than $310
million in 1974 alone attempting to maintain its market share by lowering DM
prices. To compete in the long run Volkswagen was forced to revise its product
line and sell relatively high-priced cars to middle-income consumers, from an
extended product line, on the basis of quality and styling rather than cost.

 We extend product line if our domestic currency depreciates as we can

decrease the price. If earlier we were targeting affluent market we can now
target middle income market.
 We can also increase the product line depth
 E.g. if we earlier sold a car for 10 lakh but due to forex fluctuations our cost
increases now we are able to sell at 12 lakh but our segment is price
sensitive. So we bring in a new variant of this car within a budget of 10 lakh
with new features.

ii. Product Innovation: The equivalent strategy for firms selling to the industrial
rather than consumer market and confronting a strong home currency is product
innovation, financed by an expanded research and development (R&D) budget. For
example, Japanese exporters responded to the rising yen by shifting production
from commodity type goods to more sophisticated high-value products. Demand
for such goods, which embody advanced technology, high-quality standards, and
other non-price features, is less sensitive to price increases caused by yen
appreciation

 We should invest in R&D and innovate the product, differentiating it

manages price sensitivity. Customers don’t mind to pay extra for additional
features.
C. Production Strategy:

1. Sourcing Flexibility:

Companies may have alternative sources for acquiring key inputs. The substitute
sources can be utilized in case the exchange rate fluctuations make the inputs
expensive from one region. Raw material should be purchased from a place whose
currency is depreciating in comparison to the home currency.

 If we choose US for importing raw material and USD appreciates in

comparison to INR our cost will increase
 We should switch to import from a country whose currency depreciates in
comparison to our currency.

2. Plant Location:

Diversifying the production facilities to other countries were currency is

depreciating in comparison to home currency would mitigate the risk inherent.
However, in such cases, the companies have to forgo the advantage earned
by economies of scale.

 Transportation cost is involved and if the country’s currency where our plant
is located appreciates our cost increases
 We need to switch to some other country whose currency is depreciating to
avoid increased cost.
 For this we need to have plants in different countries.
 Here we need to analyze:
o Total cost of relocating
o Economies of scale
Strategies to Manage Translation Exposure

Methods to translate

1. Current and Non-Current Methods:

1. Current/Non-current Method

The values of current assets and liabilities are converted at the exchange rate that
prevails on the date of the balance sheet. On the other hand, non-current assets and
liabilities are converted at a historical rate.

Items on a balance sheet that are written off or converted into cash within a year
are called current items, such as short-term loans, bills payable/receivable, and
sundry creditors/debtors. Any item that remains on the balance sheet for more than
a year is a non-current item such as machinery, building, long-term loans, and
investments.

 Identify the entries in the balance sheet

 Set them as per, divide them as current assets and non-current assets and
current and non-current liabilities
 All current assets and liabilities are translated at spot rate
 Non-current assets and liabilities are translated at historical rate i.e. the rate
at the time when such an item was incurred (no risk, as rate and amount is
certain).
 Risk arises in current assets and liabilities
 If currency appreciates both current assets and current liabilities increase and
similarly if currency depreciates both current assets and liabilities decrease.
 Then where is the problem?
 The problem arises when CA is not equal to CL
 The translation exposure is difference between CA and CL i.e. equal to the
net working capital
 4 situations may arise
1. NWC is positive and home currency appreciates: translation loss
2. NWC is positive and home currency depreciates: translation gain
3. NWC is negative and home currency appreciates: translation gain
4. NWC is positive and home currency depreciates: translation loss
2. Monetary/Non-monetary Method

All monetary accounts are converted at the current rate of exchange, whereas non-
monetary accounts are converted at a historical rate.

Monetary accounts are those items that represent a fixed amount of money, either
to be received or paid, such as cash, debtors, creditors, and loans. Machinery,
buildings, and capital are examples of non-monetary items because their market
values can be different from the values mentioned on the balance sheet.

 We have to differentiate as monetary assets and non-monetary assets,

monetary and non-monetary liabilities.
 Monetary assets/liabilities, e.g. cash, amount, receivables, payables: the
value of which doesn’t change
 Non-monetary assets/liabilities: e.g. equity ,land, plant & machinery,
inventory: BV different from MV
 Non-monetary items are converted at historic rate.
 Monetary items are converted at current rate
 The extent of translation exposure lies in the difference between MA and
ML i.e. the net monetary assets.
 Same 4 scenarios apply here as in previous method

3. Temporal Method:

The temporal method is similar to the monetary/non-monetary method, except in

its treatment of inventory. The value of inventory is generally converted using the
historical rate, but if the balance sheet records inventory at market value, it is
converted using the current rate of exchange.

 If inventory (finished goods, WIP) is entered in books of accounts on

historical amount, then the risk would be same as in monetary/non-monetary
method
 If they are entered at market value/rate, so its conversion will take place at
future spot rate and results/risk will differ.
4. All Current Rate Method

The current rate method is the easiest method, wherein the value of every item in
the balance sheet, except capital, is converted using the current rate of exchange.
The stock of capital is evaluated at the prevailing rate when the capital was issued.

 Stock holders’ equity (common stock: equity & preference share) conversion
at historic rate. All other items are converted at future spot rate
 In this method we have the most risk

NOTES:

Consistency Principle: Whatever translation method is used in one year should be

continued further.

FASD:

NOTE 8: Every translation should be done through temporal method.

Note 8 was revoked and now we have note 52

NOTE 52: Every translation should be done through all current method

 The loss/gain as per translation exposure has effect only on valuation of a

firm
 There is no effect on cash inflows or outflows
Example:

1 INR = 3 PKR- historic rate

1 INR = 2 PKR- current rate

1. Cash inflow = 1000 PK

 Current/non-current method= 500 INR (current rate)

 Monetary / non-monetary method=500 INR (current rate)
 Temporal method=500 INR (current rate)
 All current method=500 INR (current rate)

2. Inventory = 2000 PKR

 Current/non-current method= 1000 INR (current rate)

 Monetary / non-monetary method= 666.67 INR (historic rate)
 Temporal method= 1000 INR (current rate)
 All current method= 1000 INR (current rate)

3. Fixed assets = 5000 PKR

 Current/non-current method= 1666.7 INR (historic rate)

 Monetary / non-monetary method= 1666.7 INR (historic rate)
 Temporal method=1666.7 INR (historic rate)
 All current method= 2500 INR (current rate)

4. Current liabilities = 3000 PKR

 Current/non-current method= 1500 INR (current rate)

 Monetary / non-monetary method= 1500 INR (current rate)
 Temporal method= 1500 INR (current rate)
 All current method= 1500 INR (current rate)