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Exchange rate risk can be broadly defined as the risk that a companys performance will be affected by exchange rate movements.
Classification of Exchange Rate Risk/Currency Exposure
1. Accounting Exposure:
Transaction exposure Translation exposure
2. Economic Exposure
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Transaction Exposure
The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.
Example. If IBM sells a Mainframe computer to Royal Dutch Shell in England, it typically will not be paid until a later date. If that sale is priced in Pounds, IBM has a pound exposure.
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Measurement of transaction exposure involves two steps: 1. Determining the projected net amount of inflows or outflows in each foreign currency, and 2. Determine the overall risk of exposure to those currencies.
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($1,000,000)
$4,000,000 ($3,000,000)
Four alternatives to manage transaction/currency exposure: 1. Remain unhedged 2. Hedge in the forward market 3. Hedge in the money market 4. Hedge in the options market
US three-month borrowing interest rate: 8% (or 2%/qtr.) US three month investment interest rate: 6% (or 1.5%/qtr.) June put options in OTC (bank) market for 1,000,000: strike price $1.75 (nearly at-the-money); 1.5% premium or strike price $1.71 (out-of-the-money): 1.0% premium Daytons foreign exchange advisory service forecasts that the spot rate in three months will be $1.76/
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Unhedged Position
Scout Finch may decide to accept the transaction risk. If she believes the foreign exchange advisor, she expects to receive: 1,000,000 X $1.76 = $1,760,000 (in three months) However, the above amount is at risk. If the pound should fall to say, $1.65/ , she will receive only $1,650,000 Exchange risk is not one sided, however; if the transaction is left uncovered and the pound strengthens even more than forecast by the advisor, Dayton will receive considerably more than $1,760,000.
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Scout Finch should borrow 975,610 now and in three months repay that amount plus 24,390 of interest from the sale proceeds of the account receivable. Dayton would exchange the 975,610 loan proceeds for dollars at the current spot exchange rate of $1.7640/ , receiving $1,720,976 at once.
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Future value of the loan proceeds at the end of three months under each of the three investment assumptions
Received today $1,720,976 $1,720,976 $1,720,976 Invested in Full value in three months Treasury 6%/yr or 1.5%/qtr $1,746,791 Debt cost 8%/yr or 2.0%/qtr $1,755,396 Cost of capital 12%/yr or 3.0%/qtr $1,772,605 Rate
Because the proceeds in three months from the forward hedge would be $1,754,000, the money market hedge is superior to the forward hedge if scout Finch used the loan proceeds to replace a dollar loan (8%) or to conduct general business operations (12%). The forward hedge would be preferable if Dayton merely if Dayton merely invested the pound loan proceeds in dollar-denominated money market instruments at 6% annual interest.
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Translation Exposure
Translation Exposure also called Balance Sheet Exposure , arises because financial statements of foreign subsidiaries which are stated in foreign currency must be restated in the parents reporting currency for the firm to prepare consolidated financial statements.
Illustration. Suppose an Indian company has a UK subsidiary. At the beginning of the parents financial year the subsidiary has real estate, inventories, and cash valued at , respectively, 1,000,000, 200,000 and 150,000. The spot rate is Rs 68 per sterling. However, during the year, there has been a drastic depreciation of the pound to Rs. 65. Due to this translated value of its assets has declined from Rs. 9.18 crore to Rs. 8.775 crore.
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Funds Adjustment
Sell local currency forward Reduce levels of local-currency cash and marketable securities Reduce local currency receivables Delay collection of hard-currency receivables Increase imports of hard-currency goods Borrow locally Delay payment of accounts payable Speed up dividend & fee remittances to parent and other subsidiaries Speed up payment of intersubsidiary accounts payable Invoice exports in foreign currency and imports in local currency Buy local currency forward Increase levels of local-currency cash and marketable securities Relax local-currency credit items Speed up collection of soft-currency receivables Reduce imports of soft-currency goods Reduce local borrowing Accelerate payment of A/P Delay dividend and fee remittances to parent and other subsidiaries Delay payment of of intersubsidiary accounts payable Invoice exports in local currency and imports in foreign currency
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Economic Exposure
Economic Exposure, also called operating exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates. Economic exposure and transaction exposure are related in that they both deal with future cash flows. They differ in that the latter stems from exchange gains or losses on foreign-currency-denominated contractual obligations whereas the former attempts to assess and manage the impact of exchange rate movements on the firms future cash flows, which are not fixed in either the home currency or the foreign currency.
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The previous example makes it clear that operating exposure depends upon: Change in nominal exchanges rate Change in selling price (output price). Change in the quantity of output sold. Change in operating costs, that is, quantities and prices of inputs.
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Economic Exposure & Real Exchange Rate Balance Sheet of Aquarius Garments (Current exchange rate is Rs. 45/USD) Assets
Cash 5,00,000
Liabilities
A/C Payable 6,000,000
L.T. Debt
Equity
60,000,000
76,500,000
100,000,000 142,500,000
142,500,000
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Total
90,000,000 45,000,000
67,500,000 67,500,000 8,000,000 10,000,000 10,000,000 39,500,000 15,800,000 23,700,000 10,000,000 33,700,000
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Economic Exposure
Scenario I: The rupee will depreciate to Rs. 47. Price for home sales will be raised by 10% while the foreign currency price for US buyers will be raised by 5%. There will be a loss of sales at home of 3% while US sales will remain unchanged. Labour costs will increase by 10%, domestic material costs by 15% and cost of imported materials by 5%.
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Total
96,030,000 49,350,000
73,500,000 71,880,000 8,000,000 10,000,000 10,000,000 43,880,000 17,552,000 26,328,000 10,000,000 36,328,000
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Economic Exposure
Scenario II: We now anticipate that the rupee depreciates to Rs. 50. The firm lowers its dollar price for US sales by 5% (from $20 to $19). The price for home sales is raised to Rs. 950, equivalent to the foreign price at the new exchange rate. Export sales volume increases by 6% while home sales volume by 5%. Assumptions regarding costs are same as in Scenario I except he cost of imported materials, which is projected to increase by 10%. The projected P/L statement is given below. Now a small real deprecation of the rupee has caused the operating cash flow to increase marginally due to the increase in physical sales volume.
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Total
99,750,000 50,350,000
79,790,000 70,310,000 8,000,000 10,000,000 10,000,000 42,310,000 16,924,000 25,386,000 10,000,000 35,386,000
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Economic Exposure
Scenario III: finally we consider the case where the rupee actually appreciates in nominal terms to Rs 42. This could happen if there is a surge in capital inflows and the central bank does not prevent the dollar from falling. The firm raises dollar prices for US sales by 8% and loses 10% of sales volume. At home, rupee prices are left unchanged from the base case scenario but still there is a loss of 2% in domestic sales. There is no change in the rupee cost of imported materials, domestic material costs increase by 15 %. While labour cost goes up by 8%. The projected P/L statement shows a deterioration in the firms cash flow as a result of this substantial real appreciation of the rupee.
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Total
88,200,000 40,824,000
70,356,000 58,668,000 8,000,000 10,000,000 10,000,000 30,668,000 12,267,200 18,400,800 10,000,000 28,400,800
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