Foreign Exchange Exposure

What is meant by exposure?  

Simply speaking, exposure is the risk of unanticipated change in exchange rate. It is the influence the value of those firms that are involved in international transactions.

How important is study of exposure?  

Some consider that exposure is IRRELEVANT. This argument is based on PPP theory which explains that the movement in exchange rate is matched by the movement in price and so the financial performance of a firm is not affected.

Example on irrelevance of exposure 
 

Suppose inflation in India is more than in US. As a result, the value of rupee depreciates as regards the dollar. The Indian company importing components from US will face cost escalation on account of higher import bill and its competitive power will come down against the domestic firms producing and marketing similar products.

  

But since the exchange rate changes have occurred because of higher rate of inflation, the cost of domestic firms too will escalate. There will then be no change in the competitive position between the domestic firm and the importing firm even after the changes in the exchange rate. Means exchange rate exposure is irrelevant.

If the exchange rate changes happen because of some other factors. there are so many factors and not only the inflation rate differential that influences the exchange rate.Exchange rate exposure is relevant    Because PPP is not applicable in the short run. Even if it would be the long run. the resulting exposure will then not be matched by changes in the inflation rate differential and the exchange rate exposure could really matter. . exchange rate exposure is irrelevant.

.Then«. .    Unstable exchange rates lead to instability in a firms growth and may lead to bankruptcy. Hence firms have to be vigilant And apply various hedging tools to protect themselves.

.   Hedging ± the management of exchange rate exposure by systematic and calculated methods.You should know«. Speculation ± the trial and error method by which profits are sought to be made in foreign exchange exposure.

Accounting or translation exposure. .Type of exposure    Basically two types : A). B). Economic exposure.

transaction exposure 2).Economic exposure    The economic exposure is further divided into 1). . Real operating or operating exposure.

Transaction exposure . a). Real operating exposure c).. Accounting exposure b).To summarise«     3 types of foreign exchange exposures.

Economic exposure on the other hand is the result of the altered cash flow of a company.What are these exposures?   Accounting/ translation exposure is derived from the consolidated financial statements of the parent company and it DOES NOT influence the cash flows of the company. .

it is concerned with changes in PRESENT CASH FLOWS .About economic exposure«. as a result of changes in the exchange rate In short.   Transaction exposure refers to the foreign exchange loss or gain on transactions already entered into and denominated in a foreign currency.

. Concerned with impact of exchange rate changes along with the changes in inflation rate on the cost and revenue structure of the firm.  Real operating exposure is related to changes in future cash flows.

It is the sensitivity of relalized domestic currency values of the firm¶s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes.TRANSACTION EXPOSURE    A Firm is faced transaction exposures when it is faces contractual cash flows that are fixed in foreign currencies. Transaction exposure arises from fixedprice contracting in a world where exchange rates are changing randomly. .

Export and import of goods and services on open account. Intra-firm flows in an international company. Borrowing and lending in a foreign currency & C). . B).How do firms become prone to transaction exposure?     Transaction exposure emerges mainly because of A).

Export and import on Open Account   It can cause appreciation or depreciation in the value of currency and hence on the profitability of the concern.1). . Example : the huge appreciation in terms of rupee Vs dollar has hit badly the earnings of Infosys.

transaction exposure is divided into 3 parts.According to Eitemann. Billing exposure ± exists between the billing of the shipment and the settlement of the trade payments. 2).    1). 3).quotation exposure ± created when the exporter quotes a price in foreign currency and exists till the importer places an order with the exporter at that price. . Backlog exposure ± exists between the placement of order by the importer and the shipping and billing by the seller.

depending on the appreciation or depreciation in the foreign currency. . Lenders and borrowers can benefit or suffer.2).Borrowing and lending in a foreign currency   Transaction exposure exists when borrowing or lending is done in a foreign currency.

Can cause profit or loss to the units depending on whether there is appreciation or depreciation of the currency.3). . Intra-firm flow in an International Company   Happens when funds flow among the different units that are located in different countries.

.Consolidated net exposure  It considers both the inflows and outflows of funds and it is the net amount that determines the size of transaction exposure.

150 Rs.41/ yen 850 Rs.0. in s million Import Export Prechange rate Postchange rate 1.68/L .Find out the transaction gain/loss on the basis of the following data pertaining to India¶s foreign trade : Particular Us $ . milln in million 650 800 625 Rs.0.47/$ Rs.45/$ Japanese British L.70/L Rs.40/ yen Rs. Yen.250 1.

. alter the amount and risk element of a company¶s future revenue and cost stream.REAL OPERATING EXPOSURE  Happens when changes in exchange rate together with rates of inflation.

which are not fixed in either the home currency or the foreign currency. .Facts about Operating Exposure :    Addresses the issues of how to assess and manage the impact of exchange rate changes on the firm¶s future cash flows. the firm¶s profit margin measured in either currency is influenced by exchange rate. Neither the prices nor the quantities of outputs and inputs are fixed and all are subject to change when exchange rates change. Consequently.

Some output markets can become relatively more or less attractive compared to others.Impact of Operating Exposure     Can be felt well beyond just pricing and invoicing decisions. . Input sourcing decisions may have to be reviewed. the firm may even decide to relocate its production facilities. In some cases.

in this period. Also. some US corporations shifted manufacturing facilities abroad in order to retain their cost competitiveness. so that they could reduce costs.Examples on Operating Exposure seriousness :  Due to the rising dollar during the first half of eighties. a number of US companies shifted their sourcing of components and materials abroad rather than buy from US suppliers. .

.   Laker Airways was a British Airline which existed in the late seventies. It offered simple flights to British tourists visiting US. The companies business grew rapidly so that it expanded its fleet and financied the purchase with US $ borrowing.

tourist traffic from UK to US shrank. This coupled with the transactions exposure on its debt service. created enormous difficulties for the firm eventually leading to bankruptcy. as the dollar rose steeply against the pound sterling.  During the first half of eighties. .

the east asian currency crisis. After. Indian exports of gems and jewellery to the Western markets suffered a competitive disadvantage visà-vis exporters from East Asia. in which some of those currencies dropped by as much as 50% against the US $. .

.  The recent outcry over the rising Rupee against the $. Even their market capitalisation has suffered a reduction. has infact drastically reduced the earnings potential of several big indian software firms.

To summarise:    Unanticipated changes in exchange rates can have a serious and sustained impact on a firms revenue and costs. . This may threaten its very survival in its existing markets and viability of its existing lines of business. This may force the company to restructure the company¶s operations.

.But the most important about operating exposure is.  A company is subject to operating exposure even when it has LITTLE OR NO DIRECT INVOLVEMENT in international markets..

Sources all its inputs from domestic suppliers Then« .How can this happen???????????     Let us consider a domestic firm whichProduces exclusively for the domestic market.

Changes in exchange rates for such firms can affect in the following ways:   The firms competitors may be importing a competing product. . Example: if the home currency appreciates. Changes in the home currency exchange rate affect their costs and hence their competitive posture. they may reduce their prices as compared to domestic firms.

. Even though the firm sources all its inputs from domestic suppliers. may have imported inputs or competition from imports. This is called as ³INDIRECT OPERATING EXPOSURE´. they in turn and their suppliers in turn. Changes in exchange rate affect their costs and hence the prices they offer to our domestic firms.

faces indirect exposure because many of its customers are exporters of finished leather goods. . Example : a manufacturer of chemicals used in leather industry.  Consumers of the firms output may have direct exposure to exchange rates. A change in their fortunes has an impact on our domestic firms.

 Changes in exchange rate may lead to changes in wages due to their impact on the cost of living index which affects all the firms in the economy. . They may also lead to macroeconomic policy shifts like monetary tightening in the face of depreciation home currency or changes in trade policies which again impacts all the firms in the country.

  The analysis and the management of operating exposure are at the same time more important and considerably more difficult than contractual transactions exposure. Because operating exposure can have significant long-term impact on future business of the firm and its strategic posture. .To conclude..

   It is more difficult because it involves too many questions and assumptions And no simple hedges like forward contracts are available. This makes operating exposure hedging highly IMPRACTICABLE if not IMPOSSIBLE !!!!! .

. 2).e quantities and prices of inputs.What are the factors on which operating exposure depends?     1).Changes in nominal exchange rate.change in operating costs. i. 4). 3). Changes in the quantity of the output sold. Changes in selling price or output price.

Beginning of the year.       An indian co exports carpets to UK. the rate is Rs.Consider this example. .5600 per unit.68/L Price is 200L Sales at this price is 100unit/month Domestic S.8000/unit. its operating margin is Rs. Thus.P is Rs.

05 .s15640 from each unit.74.15/1. Operating costs increases to Rs.9200 If its operating margin in real terms is to be maintained.47=68*1. But this means that real exchange rate must remain unchanged as 74. the firm is unaffected. it must get R.Over the year. If exchange rate increases to rs. the following have happened------       Uk prices up by 5% Indian prices up by 15% It can raise UK price to 210L without affecting sales.47. ie Rs.6440.

How to manage operating exposure?   Operating exposure covers a much longer horizon than contractual transactions exposures. Long-maturity forward contracts are not easily available even in major currencies of the world. .

everyone knows !!!! .      Altering the firms operations consisting of pricing.. However. Choice of markets.The only ways then are. these are not easily alterable. Sourcing of materials Location of production etc.

 Strong rupee set to hurt companys' earnings .

. Emerges on account of consolidation of financial statements of different units of a multinational firm. they are consolidated. To ascertain overall profitability and evaluate comparitive performance of different subsidiaries.Translation Exposure    Also known as accounting exposure.

.How is this objective achieved?  By translating and transforming the items of the financial statements of subsidiaries denominated in different currencies into the domestic currency of the parent company.

What happens in this process?   When the currency of any of the host countries changes its value its translated value in the domestic currency of the parent company changes and also the picture of the consolidated statement. . The extent of this change represents the TRANSALATION EXPOSURE.

Relevancy of accounting exposure  Accounting exposure irrelevant because it does not influence the cash flow nor the subsidiary¶s earning actually converted into the parent¶s currency. Accounting exposure relevant ± because the change in the value of the currency of the host countries has an impact on the net worth of the firm as a whole. .

Temporal method. Monetary/non-monetary method. .Methods of translation     1). Current/non-current method. 3). 4). Current rate method 2).

1). Current rate method :   Also known as the closing rate method. In this method. . all items of the balance sheet and the P&L A/c are translated at current rate or the post change rate.

.Demerits of current rate method  Fixed assets are also translated at current rate and that goes against the principles of accounting.

Few income statement items which by virtue of being closely related to the non-current assets and long-term liabilities are translated at pre-change or historical rate. .Current/non-current method :     Current assets & current liabilities ± translated at current rate or the post change rate. Income statement items are translated at the average of exchange rate. The fixed assets and long term liabilites are translated at the historical or pre-change rate or a rate at which they were acquired.the prechange and the post-change rate.

at current rate.Investments are non-monetary. Cash. Monetary. Income statements items ± average rate.Monetary/non-monetary method :        Under this method. Income statements items closely related ot non-monetary assets and liabilities are translated at historical rate. AR. FA. the assets and liabilities are classified as monetary and nonmonetary.at historical rate. Non-monetary. . AP are monetary.Stock.

. the same norm as applicable for monetary/non-monetary method. For income statement items. Items stated at replacement cost. realisable value. market value or expected future value are translated at current rate.Temporal method    Uses historical rate for the items that are stated at historical cost.

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