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Foreign Exchange Risks

Exchange Risk
• Exchange Risk is the probability that a company will be unable to
adjust prices and costs to offset changes in the exchange rate.
• Exposure – Degree to which a company is affected by exchange rate
changes
Types of FE Risks

Types of Risks

Economic exposure Accounting exposure

Current/non current Monetary/nonmonetary


Transaction exposure Operating exposure Temporal method Current rate method
method method
Economic exposure
• Risks arising from economic factors through economic transactions and
other economic activities
• Based on the extent to which the value of the firm will change when
exchange rate changes
• ∆PV/∆e ≠ 0 - firm is exposed to currency risk
• Exchange risk is the variability in the firm’s value that is caused by
uncertain exchange rate changes
• Transaction exposure – arises out of various types of transactions that
require settlement in a foreign currency.
• Operating exposure – arises because currency fluctuations can alter a
company’s operating cash flows.
Accounting exposure (translation exposure)
• For the purpose of reporting and consolidation, financial statements
of foreign operations has to be converted from local currency to
home currency, prior to consolidation with the parents’ financial
statements.
• Current exchange rate or historical exchange rate.
• Translation exposure – Difference between exposed assets and
exposed liabilities.
• Rules that govern translation – accounting standards
• Four methods
Methods of foreign exchange translation
Method Balance sheet account items Method of translation
Current/noncurrent method Current assets and liabilities Current exchange rate
Noncurrent assets and liabilities Historical exchange rate
Monetary/Nonmonetary method Monetary balance sheet items Current exchange rate
Nonmonetary balance sheet items Historical exchange rate
Temporal method Monetary balance sheet items Current exchange rate
Nonmonetary balance sheet items Current exchange rate
if they are carried on the books at
current value
Nonmonetary balance sheet items Rate of exchange on the date the
if they are carried on the books at item was placed on the books
historical value
Current rate method All balance sheet items The current exchange rate (except
for stockholders’ equity)
Strategies for managing risk
• Negotiate a lower price
• Absorb the price increase
• Minimize exchange risk
Exchange risk avoidance
Change/diversify sourcing
Currency diversification
Exchange Risk adaptation
Hedging
Hedging a particular currency exposure means establishing an
offsetting currency option such that whatever is lost or gained on the
original currency exposure is exactly offset by a corresponding foreign
exchange loss or gain on the currency hedge.
• Hedging situations
Hedging transaction exposure
Hedging balance sheet exposure
Hedging economic exposure
Methods of hedging
• Forward contracts
• Futures
• Currency Options
• Money market hedge – borrowing and lending in the domestic and
foreign currency markets.
• Hedging by lead and lag – To lead is to pay or collect early and to lag
means the opposite.
• Exposure netting – offsetting exposures in one currency with
exposures in the same or another currency .
References
• Cherunilam, F., International Business - Text and Cases, Fifth Edition
PHI Learning Pvt. Ltd. , Delhi