This action might not be possible to undo. Are you sure you want to continue?
• • • • CORE BUSINESS RISKS 1) Raw Material Shortage 2) Labour problem 3) Failure of new product / technology etc.
• These risks are specific to firm and going to have an impact on firm’s performance.
• MACRO ECONOMIC ENVIRONMENTAL RISK • 1) Exchange rate variation • 2) Interest rate variation • 3) Inflation • 4) Increase in prices of key commodities like oil, steel, etc. • These are risks affects all firms in the economy but the nature of impact varies.
FOREIGN EXCHANGE/CURRENCY EXPOSURE / RISK
Foreign currency risk is the net potential gain or loss which arises from exchange rate changes, to a foreign currency exposure of an enterprise.
• Currency risk is the risk that he domestic currency value of cash flows, denominated in foreign currency may change because of the variation in the foreign exchange rate. • Currency exposure is a measure of the sensitivity of real value of enterprises assets, liabilities and incomes express in its functional currency (operating currency) to unanticipated changes in exchange rate.
• A project / firm has a currency exposure when the currencies for its expenditure and revenues are not the same’.
• Foreign currency risk management is the proper management of foreign currency assets, liabilities income and expenditure with a view to optimising rupee earnings and minimizing rupee cost. It involves selection of right currency for invoicing imports and exports, and for denominating loans where such choice exists, prepayment or delayed payment of payables, postponements of receivables, judicious matching of imports and exports and, finally, proper usage of hedging instruments and facilities available for the purpose.
Currency risk management has become necessary for Indian business due to
• Increased cross border transaction: India’s cross border trade has increased tremendously in post liberalisation era. Now India accounts for 1% of world trade in respect of visibles and 2% of world trade in respect of invisibles. • Increased volatility in currency: • Increased domestic and overseas competition: • Greater flexibility in hedging due to liberalisation:
• OBJECTIVES OF FOREX RISK MANAGEMENT • Hedge against the risk of currency exchange loss. • Speculative gains • Smoothing earnings
• EXPOSURE AND RISK • Exposure refers to foreign currency assets, liabilities, income and expenditure whose values will change in terms of home currency in response to exchange rate fluctuations. • Risk is the likely or probable loss from such forex exposure due to adverse exchange rate fluctuations.
• HEDGING V/S SPECULATION • Hedging is a transaction undertaken to offset the forex risk. • Speculation involves or taking or creating a forex exposure deliberately for gaining from favorable exchange rate movement. • “ not hedging a risk amounts to speculation”
• Currency exposure can be divided into • 1) Transaction exposure • 2) Economic / operating exposure • 3) Translation exposure
Deals with current cash flows. It arises whenever firm’s receivables or payables are denominated in foreign currencies. This exposure will have an effect on the networking capital position and profitability.
• This is the most common form of currency exposure that arises when a firm has receivables or payables denominated in foreign currency. • This is a measure of the sensitivity of the domestic currency value of assets and liabilities, which are denominated in a foreign currency to unanticipated changes in exchange rates, when the said assets or liabilities are liquidated. • The foreign-currency values of these items are contractually fixed, i.e., they do not vary with the exchange rate. It is also known as contractual exposure.
MEASUREMENT OF TRANSACTION EXPOSURE
MANAGING TRANSACTION EXPOSURE
• INTERNAL HEDGING STRATEGIES /TECHNIQUES • EXTERNAL HEDGING STRATEGIES /TECHNIQUES
• INTERNAL HEDGING STRATEGIES /TECHNIQUES • a) Natural hedge • b) Invoicing in own currency • C) Split currency invoicing • D) Netting • D) Leading and lagging • e) Price adjustments • f) Risk sharing agreements • g) Review of market – product combination
• EXTERNAL HEDGING STRATEGIES /TECHNIQUES • a) Currency forward contracts • b) Currency future contracts • c) Currency options • e) Money market hedge
• Accounting exposure also called translation exposure arises because financial statements of foreign subsidiaries, which are stated in foreign currency, must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements
• Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. Translated statements are used by management to assess the performance of foreign subsidiaries, amongst other things. Restatement of all subsidiary statements into the single ‘common denominator’ of one currency facilitates management comparison.
• The difference between exposed assets and exposed liability is called translation exposure. • Eg; US subsidiary at France has monetary assets of 200 mn FFr and monetary liability of 100 mn FFr. The exchange rate declines from FFr 4/$ to FFr 5/$
• The potential foreign exchange loss on company's exposed net monetary assets of 100 mn FFr would be 5mn FFr.
• Translation principles in many countries are often a complex compromise between historical and current market valuation. Historical exchange rates can be used for certain equity accounts, fixed assets and inventory items while current exchange rates can be used for current assets, current liabilities, income and expense items.
• Current Rate Method
• The current rate method is the most prevalent in the world today. Under this method, all financial statement line items are translated at the current exchange rate with few exceptions.
• Assets and liabilities: All assets and liabilities are translated at the current rate of exchange; that is, at the rate of exchange in effect on the balance sheet date
• Income statement items: All items, including depreciation and cost of goods sold are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses were incurred or at an appropriately weighted average exchange rate for the period.
• Distributions: Dividends paid are translated at the exchange rate in effect on the date of payment • Equity items: Common stock and paid in capital accounts are translated at historical rates. Year-end retained earnings consist of the original year-beginning retained earnings plus or minus any income or loss for the year.
• Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the consolidated balance sheet) with a title such as cumulative translation adjustment (CTA).
• The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve a/c. This eliminates the variability of reported earnings due to foreign exchange translation gains or losses. A second advantage of the current rate method is that the relative proportions of individual balance sheet accounts remain the same.
• Monetary and Non-monetary method.
• Monetary assets (these are primarily cash, marketable securities, accounts receivable and long-term receivables) and monetary liabilities (primarily current liabilities and long-term debt) are translated at current exchange rates • Non-monetary assets and liabilities (primarily inventory and fixed assets) are translated at historical rates
• Income statement items: Average exchange rate for the period except for depreciation and cost of goods sold ( which are directly associated with non monetary assets or liability). These are translated at historical rate.
• Temporal Method
• This method is same as monetary and non monetary method. Only difference is that inventory is translated at current rate if inventory is shown in the balance sheet at market value. ( in the above method it is translated at historical value)
• Operating exposure also known as economic exposure. This exposure refers to the degree to which a firms present value of future cash flows can be influenced by exchange rate fluctuations.
• Deals with impact of exchange rate on the firms future cash flows from operations which are not fixed in either home currency or foreign currency. • Neither the prices nor quantities of outputs or inputs are fixed and all are subject to change when exchange rate changes.
• Economic exposure is a more managerial concept that an accounting concept . a company can have an economic exposure to say pound/rupee rates even if it does not have any transaction or translation exposure in the british imports. If the pound weakens, the company loses its competitiveness.
• The economic exposure to an exchange rate is the risk that a variation in the rate will affect the companies competitive position in the market and hence its profits . • It affects the profitability of the company over a larger time span than transaction or translation exposure .
• . under the Indian exchange control , economic exposure cannot be hedged while both transaction and translation can be hedged.
• operating exposure to currency risk depends on the effect of unexpected • changes in the exchange rate on the firm’s output prices (e.g., product prices) and input costs (e.g., raw materials, labor costs, etc.).
Diff bet transaction and economic exposure
• Contract specific • Cash flow loss can be easily computed • Co’s do have policies to cope up with it • Duration is same as time period of contract • General, relates to entire investment. • V difficult to compute opportunity losses. • Do not have any policies to cope up. • Relatively longer duration
• MANAGING ECONOMIC EXPOSURE 1 Marketing Initiatives A Market selection; B Product strategy C Promotional strategy D Pricing strategy
• • • • •
2 Production initiatives A Input mix B shifting production among plants C Plant location D Raising productivity
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.