MODULE- 4

FOREIGN EXCHANGE
EXPOSURE
 What is Foreign Exchange Exposure?
• Simply put, foreign exchange exposure is the risk
associated with activities that involve a global
firm in currencies other than its home currency.
• Essentially, it is the risk that a foreign currency
may move in a direction which is financially
detrimental to the global firm.
• Given our observed potential for adverse
exchange rate movements, firms must:
– Assess and Manage their foreign exchange exposures.
• FE Exposure can be defined as the risk of loss
stemming from exposure to adverse foreign exchange
rate movements.
• FE exposure is used to describe the degree at which
the potential/future profitability, net cash flow and
perceived market value of a firm’s value changes as a
result of change in exchange rate, i.e. to say that it is a
company’s probability of making either a loss or profit
as a result of movements in ER.
• FE Exposure relates to the effect of unexpected ER
changes on the value of the firm. In particular, it is
defined as the possible direct loss or indirect loss in the
firm’s cash flows, assets & liabilities, net profit & in
turn, its stock market value from an exchange rate
move.
 TYPES OF EXPOSURE:
• There are three distinct types of foreign exchange exposures that
global firms may face as a result of their international activities.
• These foreign exchange exposures are:
• Transaction exposure
– Any MNC engaged in current transactions involving foreign
currencies.
• Economic exposure
– Results for future and unknown transactions in foreign
currencies resulting from a MNC long term involvement in a
particular market.
• Translation exposure (sometimes called “accounting” exposure).
– Important for MNCs with a physical presence in a foreign
country.
 Economic Exposure
• Economic Exposure: Results from the “physical” entry (and on-going
presence) of a global firm into a foreign market.
– This is a long term foreign exchange exposure resulting from a
previous FDI location decision.
• Over time, the firm will acquire foreign currency denominated
assets and liabilities in the foreign country.
• The firm will also have operating income and operating costs in the
foreign country.
– Economic exposure impacts the firm through contracts and
transactions which have yet to occur, but will, in the future, because of
the firm’s location.
• These are really “future” transaction exposures which are
unknown today.
– Economic exposure can have profound impacts on a global firm’s
competitive position and on the market value of that firm.
 TRANSACTION EXPOSURE:
• Transaction Exposure means changes in the
present cash flow of a firm consequent upon the
exchange rate changes.
• TE is basically the cash flow risk and deals with
the effect of exchange rate moves on
Transactional account exposure related to
receivables (export contracts), payables (import
contracts), or repatriation of dividends.
• Transaction Exposure= Rupee worth of accounts
receivable (payable) when actual settlement is
made minus Rupee worth of accounts receivable
(payable) when the trade transaction was
initiated.
• Transaction Exposure emerges mainly on account
of:
– Export & Import of commodities on open account.
– Borrowing & Lending in Foreign Currencies.
– Intra-firm flow in MNCs.
• Transaction Exposure is of three types:
– Quotation Exposure– it is created when the exporter
quotes a price in FC & exists till the importer places an
order at that price.
– Backlog Exposure– this exists between the placement
of order by the importer & the shipping and billing by
the seller.
– Billing Exposure– it exists between the billing of the
shipment & the settlement of the trade payments.
 Translation Exposure:
• Translation/Accounting Exposure is the mismatch between the
translated value of assets and liabilities following the ER change.
It emerges on account of consolidation of financial statements of
different subsidiaries of a parent MNC. When the ER changes,
value of the consolidated financial statement also changes. The
extent of this change represents the magnitude of Translation
Exposure (TsE).
• Size of the TsE depends on:-
– The extent of change in the related currencies.
– Extent of involvement of subsidiaries in parent’s business.
– Location of subsidiaries in countries with stable/unstable
currencies.
– Methods of translation.
 Measurement of Foreign Exchange
Exposure
• There are many methods available to cover or
hedge the exposure to risk.
• Measurement and Management of Foreign
Exchange Risk/ exposure are as follows:
• Measurement of Economic Exposure
• Measurement of Transaction Exposure
• Measurement of Translation Exposure
Measurement for Economic Exposure
• The degree of operating exposure to exchange
rate fluctuations is significantly higher for a
firm involved in international business than
for a purely domestic firm.
• Operating exposure is crucial to operations of
the firm in the long run.
• If an MNC has subsidiaries around the world,
each subsidiary will be affected differently by
fluctuations in currency.
• One method of measuring a MNCs operating
exposure is to classify the cash flow into
different items on the income statement and
predict movement of each item in the income
statement based on a forecast of exchange
rates.
• This will help in developing an alternative
exchange rate scenario and the forecasts for
the income statement item can be revised.
 Measurement for Transaction Exposure

• Transaction exposure measures gains or losses that

arise from the settlement if existing financial obligation
whose terms are stated in foreign currency.
• Two steps are involved:
– Determine the projected net amount of currency inflows
and outflows in each foreign currency.
– Determine the overall exposure to those currencies.
• The first step in transaction exposure is the projection
of the consolidated net amount of currency inflows or
outflows for all subsidiaries, classified by currency
subsidiary.
• Subsidiary A may have net inflows of $6,00,000
while subsidiary B may have net outflows of
$7,00,000. The consolidated net inflows here
would be- $1,00,000.
• If the other currency depreciates, subsidiary A will
be adversely affected while subsidiary B will be
favorably affected.
• The net effect of the dollars depreciation on the
MNCs is minor since an offsetting effect takes
place.
• While assessing the MNCs exposure, it is
advisable, as a first step, to the determine the
MNCs overall position in each currency.
 Measurement for Translation Exposure

• There are mainly four methods for measuring

translation exposure:
• Monetary/ Non- Monetary Method
• Temporal Method
• Current & Non- Current Method
• Current Rate Method
• Monetary/ Non- monetary Method:
– This method distinguishes between monetary
assets and liabilities and non- monetary assets
and liabilities.
– Monetary items are cash, accounts, payables,
accounts receivables, etc. are translated at current
exchange rate.
– Non- monetary items are inventory, fixed asset,
long term investments are translated at historical
rate.
• Temporal Method:
– It can be defined as a method of translating
foreign currency through the use of exchange
rates based on the time of acquisition of asset and
liabilities.
• Current and Non-current Method:
– In this method all current assets and liabilities are
translated into domestic currency at current
exchange rate.
– Each non-current item is translated at historical
exchange rate (i.e. at the rate when it is
purchased)
• Current Rate Method:
– It is the simplest and the most popular method all
over the world.
– All the balance sheet and income items are translated
at the current rate of exchange except for
stockholder’s equity.
– The two main advantage are:
• (1) The relative proportion of individual balance sheet
accounts remain the same hence do not distort the various
balance sheet ratios like the debt- equity ratio, current ratio,
etc.
• (2) The variability in reported earnings due to foreign
exchange gain or losses is eliminated as the translation
gain/loss is shown in separate account i.e. Cumulative
Translation Adjustment (CTA).
Management of Foreign Exposure
• Foreign exchange risk/ exposure refers to
fluctuations in the domestic cur4ency value
assets, liabilities, income and expenditure due
to unanticipated changes in exchange rate.
• Methods to hedge exposure risks are:
• Management of Economic Exposure
• Management of Transaction Exposure
• Management of Translation Exposure
 Management of Economic Exposure
• Economic/ Operating Exposure is long term in
nature and can scarcely be identified.
• Managing economic exposure calls for
designing the firm’s marketing, production,
and financing strategy to protect the firm’s
earning power in exchange rate fluctuations.
Types of Strategies for Economic Exposure

• Financial Strategy
• Marketing Strategy
– Market Selection
– Product Planning
– Pricing Policy
• Production Strategy
– Product Sources
– Input Mixing
– Plant Location
Management of Transaction Exposure
• There are two methods available to a firm to
hedge its transaction exposure:

1. Internal Techniques of Hedging

2. External Techniques of Hedging
 Internal Techniques of Hedging
• Exposure Netting and Offsetting
– It involves offsetting exposures in one currency with
exposures in the same or another currency, where
exchange rates are expected to move in such a way
that losses/ gains on the first exposed position should
be offset by gain/ loss on second currency exposure.
– Bilateral Netting
• Involves two parties feasible between any two transaction
companies.
– Multilateral Netting
• Netting with more than two parties among MNCs having
subsidiaries
• Risk – Sharing
– Contractual arrangement through which the buyer
and seller agree to share exposure.
• Parallel Loans
– It is often known as a back to back loan or credit swap
loan
– The amount of loan moves within the country but it
serves the purpose of cross- border loan.
• Leading & Lagging
– is taking the lead to collect from foreign currency
designated debtors before they are due and to initiate
lead to pay foreign currency to designated creditors.
• Matching of Cash flows
– A firm matches its foreign currency inflow with the
outflow in that currency not only in respect of size but
also in timing. But a firm must have inflow and
outflow in same currency.
• Pricing of Transaction
– The pricing policy adopted is of two kinds: namely
price variation, and the currency of invoicing.
– Price variation involves marking up or making down of
the sale price to counter the adverse effect of
exchange rate.
• Invoicing/ Billing in Desired Currency
– Invoicing sales as well as purchase in the home
currency is an ideal method of hedging foreign
exchange risk.
 External Techniques of Hedging
• Forward Market Hedge
• Future Market Hedge
• Money Market Hedge
• Options Market Hedge
– Call Option- Gives the Seller Right
– Put Option- Gives the Buyer Right
Management of Translation Exposure
• Following Methods are used to hedge
translation exposure:
1. Hedging Through Fund Adjustment
2. Entering Into Forward Contract Hedge
3. Exposure Netting
4. Other Methods
 Implications For Managing Foreign
Exchange Exposure
• Be Selective
• Seek more than one quotation
• Choose a Proper mix of currencies and
Interest Rate
• Interest Rate Forecasting
• Establish Rapport with the Banker
• Act Swiftly
THANK YOU….