Foreign Exchange Exposure

27/10/14
 Chapter Outline
• Three Types of Exposure
• How to Measure Economic Exposure
• Operating Exposure: Definition
• An Illustration of Operating Exposure
• Determinants of Operating Exposure
• Managing Operating Exposure
 Meaning
• FX exposure is the sensitivity of the values of
assets, liabilities and cash flows of a firms to
changes in exchange rate of currencies. The
variability in the values of assets, liabilities and
cash flows induced by such exposure is
referred as FX risk.
 Three Types of Exposure
• Transaction Exposure
– Exchange rate risk as applied to the firm’s home
currency cash flows.
• Economic Exposure
– Exchange rate risk as applied to the firm’s
competitive position.
• Translation Exposure
– Exchange rate risk as applied to the firm’s
consolidated financial statements.
 Transaction Exposure
• Transaction risk refers to the variability in the
home currency values of the cash flows arising
from transaction already completed and
whose foreign currency values are
contractually fixed.
• Example:………..
Function of Management of Transaction Risk

Management of transaction risk involves three

important function:
• Assessing the extent of variability and identifying
whether it is likely to be favorable or adverse.
• Deciding whether to hedge or not to hedgeall or
part of the exposure.
• Choosing the optimal hedging techinque to suit
the situation.
Techniques for hedging the Transaction Risk

• Forward hedge
• Futures hedge
• Money Market hedge
• Currency option hedge
• Cross-Hedging
• Internal Hedging Strategy
o Hedging via Lead and Lag
o Currency Diversification
o Risk Sharing
o Hedging Through Invoice Currency
o Netting and Offsetting
• Should the Firm Hedge?
• What Risk Management Products do Firms
Use?
• Forward contract:
A forward contract is an agreement to
buy or sell a specified amount of currency at a
predetermined rate on a specified future date.
• It is negotiated b/w a business firm and a bank
that deals with foreign currencies.
• The exchange rates are applied for conversion
and the forward transactions are mentioned in
the contracts.
 Forward hedge

• If you are going to owe foreign currency in the

future, agree to buy the foreign currency now
by entering into long position in a forward
contract.
• If you are going to receive foreign currency in
the future, agree to sell the foreign currency
now by entering into short position in a
forward contract.
 Example………….!
• Let us consider an Indian firm which has
exported goods of worth US $ 100,000 to USA.
The firm is expecting to receive US $ 100,000
after 90 days.
• The spot exchange rate is Rs. 40.50/US $ and,
• 90 days forward rate is Rs. 40.00/US $
 Future Hedging
• A future contract is a standardized contract
bought and sold in a futures exchanges with
the terms such as quantity and delivery date
being specified by the exchange.
• Futures trading requires the involvement of
brokers and payment of margin money based
on continuous marking-to-market process.
 Money Market Hedge
A money market hedge involves taking a money
market position to cover a future payables or
receivables position.
• If the firm has payables in a foreign currency, it
can hedge this position by borrowing domestic
currency, converting it into the currency of the
payables and then investing in the foreign
currency for a period matching the maturity
period of the payables.
 Options Market Hedge
• Options provide a flexible hedge against the
downside, while preserving the upside potential.
• To hedge a foreign currency payable buy calls on
the currency.
– If the currency appreciates, your call option lets you
buy the currency at the exercise price of the call.
• To hedge a foreign currency receivable buy puts
on the currency.
– If the currency depreciates, your put option lets you
sell the currency for the exercise price.
Hedging Techniques Foreign currency payables
Future Hedge Purchase of a futures
contract on the required
currency
Forward Hedge Enter into the forward
contract to purchase the
required currency
Money market Hedge Borrow local currency,
convert into required
currency &t invest it till the
time of payment
Currency option Hedge Purchase of a call option on
the required currency
Foreign currency receivables
Sale of a futures contract on
the expected currency
Enter into the forward
contract to sell the expected
currency
Borrow local expected,
convert into required
currency, invest it & repay
the loan when the foreign
currency is received
Purchase of a put option on
the expected currency
 Cross-Hedging
• Cross-Hedging involves hedging a position in
one asset by taking a position in another
asset.
• The effectiveness of cross-hedging depends
upon how well the assets are correlated.
 Internal Hedging Strategy
• Internal strategy means a firm may make use of certain
internal strategies to reduce its transaction exposure. The do
not involve external contracts or derivatives market
operations; these results from certain arrangements in the
natural or ordinary operations of the firm. It is also called as
Natural Hedge.
• Leading & Lagging
• Currency Diversification
• Risk Sharing
• Invoicing
• Netting & Offsetting
 Should the Firm Hedge?
• Not everyone agrees that a firm should hedge:
– Hedging by the firm may not add to shareholder
wealth if the shareholders can manage exposure
themselves.
– Hedging may not reduce the non-diversifiable risk
of the firm. Therefore shareholders who hold a
diversified portfolio are not helped when
management hedges.
 Should the Firm Hedge?
• In the presence of market imperfections, the
firm should hedge.
– Information Asymmetry
• The managers may have better information than the
shareholders.
– Differential Transactions Costs
• The firm may be able to hedge at better prices than the
shareholders.
– Default Costs
• Hedging may reduce the firms cost of capital if it
reduces the probability of default.
 What Risk Management Products do Firms
Use?
• Most U.S. & Indians firms meet their
exchange risk management needs with
forward, swap, and options contracts.
• The greater the degree of international
involvement, the greater the firm’s use of
foreign exchange risk management.
 Operating Exposure
• The effect of random changes in exchange
rates on the firm’s competitive position, which
is not readily measurable.
• A good definition of operating exposure is the
extent to which the firm’s operating cash flows
are affected by the exchange rate.
 Determinants of Operating Exposure

• Recall that operating exposure cannot be

readily determined from the firm’s accounting
statements as can transaction exposure.
The firm’s operating exposure is determined by:
• The market structure of inputs and products: how
competitive or how monopolistic the markets facing
the firm are.
• The firm’s ability to adjust its markets, product mix,
and sourcing in response to exchange rate changes.
 Managing Operating Exposure
• Selecting Low Cost Production Sites
• Flexible Sourcing Policy
• Diversification of the Market
• R &D and Product Differentiation
• Financial Hedging
 Selecting Low Cost Production Sites : A firm may wish
to diversify the location of their production sites to
mitigate the effect of exchange rate movements. e.g.
Honda built North American factories in response to
a strong yen, but later found itself importing more
cars from Japan due to a weak yen.
 Flexible Sourcing Policy: Sourcing does not apply only
to components, but also to “guest workers”. e.g.
Japan Air Lines hired foreign crews to remain
competitive in international routes in the face of a
strong yen, but later contemplated a reverse strategy
in the face of a weak yen and rising domestic
unemployment.
  Diversification of the Market: Selling in multiple
markets to take advantage of economies of scale
and diversification of exchange rate risk.
• R &D and Product Differentiation: Successful
R&D that allows for
– cost cutting
– enhanced productivity
– product differentiation.
• Successful product differentiation gives the
firm less elastic demand—which may translate
into less exchange rate risk.
• Financial Hedging: The goal is to stabilize the
firm’s cash flows in the near term.
• Financial Hedging is distinct from operational
hedging.
• Financial Hedging involves use of derivative
securities such as currency swaps, futures,
forwards, currency options, among others.
 Translation Exposure
• The effect that unanticipated changes in exchange
rates has on the firm’s consolidated financial
statements.
– An accounting issue.
 Hedging Translation Exposure
• If the managers of the firm wish to manage
their accounting numbers as well as their
business, they have two methods for dealing
with translation exposure.
– Balance Sheet Hedge
– Derivatives Hedge
 Thank You
Have a nice
day……….!