Currency Exposure

What is Exposure

• Exchange Exposure is defined as the extent to which transactions, assets

and liabilities of an company are denominated in foreign currencies other
than the reporting currency of the enterprise itself.

• The reporting currency is normally the national currency of the parent

company.

• The exposure is measured by the value of the assets and liabilities or

transactions denominated in foreign currency.
Exchange risk is defined as the net potential gain or loss which can arise from
exchange rate changes due to the foreign exchange exposure of an enterprise.

For Ex. If an export deal is struck with a profit of 10% margin, and meanwhile
the foreign currency in which the deal is denominated depreciates by 15 % ,
the result would be a loss of 5%.
Exposure relates to the total value of assets, liabilities or cash flows of an
enterprise denominated in foreign currency,

while exchange risk relates to the excess or short fall in the cash flows or
value of assets or liabilities likely to arise on account of exchange rate
fluctuations
TYPES OF FOREIGN EXCHANGE EXPOSURE

Economists distinguish between three types of currency exposures

• Transaction exposures,
• Translation exposures,
• Economic exposures.
TRANSACTION EXPOSURE
Transaction exposure can be defined as the sensitivity of realized domestic
currency values of the firms contractual cash flows denominated in foreign
currencies to unexpected exchange rate changes.

• It is sometimes regarded as a short-term economic exposure.

• It deals with changes in cash flows that result from existing contractual
obligation denominated in foreign currency.

• It refers to the risk associated with the changes in the exchange rate
between the time enterprise initiates a transaction and settles it.
TRANSALATION EXPOSURE
• Translation exposure is defined as the likely increase or decrease in the
parent company’s net worth caused by a change in exchange rates since last
translation.

• This arises when an asset or liability is valued at the current rate.

• Translation exposure is measured as the net of the foreign currency

denominated assets and liabilities value at current rates of exchange.
ECONOMIC EXPOSURE
• Economic exposure can be defined as the extend to which the value of the
firm would be affected by un anticipated changes in exchange rates.

• An economic exposure is a managerial concept rather than an accounting

concept.

• Economic exposure to an exchange rate is the risk that a change in the rate
affects the company’s competitive position in the market and hence,
indirectly the bottom – line.
What is Transaction Exposure:
Transaction exposure is the level of uncertainty businesses involved in
international trade face. Specifically, it is the risk that currency exchange
rates will fluctuate after a firm has already undertaken a financial obligation.
Example of Transaction Exposure:
Suppose that a United States-based company is looking to purchase a product
from a company in Germany. The American company agrees to negotiate the
deal and pay for the goods using the German company's currency, the Euro.
Regardless of the change in the value of the dollar relative to the euro, the German
company experiences no transaction exposure because the deal took place in its
local currency. The German company is not affected if it costs the U.S. company
more dollars to complete the transaction because the price, as dictated by the sales
agreement, was set in euros.
Managing Transaction Exposure:
• The objective of a company in managing its transaction exposure is to
avoid losses that may occur due to exchange rate fluctuations.
• At the same time it should not forgo likely gains from favorable changes in
exchange rates. Basically there are two methods for hedging:

External Method and Internal Method.

External method or Hedging: Basic idea in hedging is to create a position in

the foreign currency in the direction opposite to the one that exists so that
ultimately the balance becomes zero. Following are the methods:
1 Forward Contract Hedge an exporter who has receivables in US dollar
with maturity after 6 months can sell this amount to a bank under forward
contract. On maturity, when the receivables realizes, this can be sold to
bank at forward rate agreed.

Example: For instance let us say that an importer has to pay USD100,000
after 6 months. The exchange rate is Spot= 40 Rs and 6MF= 42 Rs. If he
wants to hedge through forward market , he can book forward
CONTRACT AT 42 Rs, in which his outflow will be 42 lakhs.
2 Money market Hedge: also known as spot market hedge. Under this
method the company which has an exposure in a foreign currency covers it
by borrowing or investing the concerned currency in the money market and
square the position on the due date.
 The other way he can cover his position is to purchase dollar immediately in the
spot market and invest it in money market.

The value of dollar invested will be so decided that together with the interest
earned, the amount received from the investment at the end of 6 months will be
USD100,000.
Assuming an interest of 10% on the investment, the principal required to be
invested can be calculated as follows: 1.05x = USD100000 then,
X= USD 95328
( on 1 USD, interest is .05 USD for 6 months, therefore the amount at the end
of 6 months is 1.05USD. ) at the end of 6 months, the investment of USD
95238 will become 100000 USD which can be used to pay import. For
buying 95238 dollar immediately, the company has to pay Rs 38,09,520 at the
spot rate. Assuming, rate of 16%, importer borrows this 3809520 for 6
months.
Principal 38,09,520
Interest 3,04,762 ( 16% for 6 months)
Total 41,14,282.
By covering through money market, the company ends up paying 41,14,282
instead of 42 lakhs.
3 Hedging with Options: Option contract provides an opportunity to
the hedger not only to cover this exposure but also to gain from any
favorable changes in exchange rate.

In Option contact, premium is paid upfront and is not recoverable

whether it is exercised or not.
4 Hedging with Future: due to intense competition in future market,
currency futures are available with thin margin. They may prove to be good
tool for hedging where large exposure is involved and is expected to mature
near the due date of future contracts.
Choice of Hedging Instrument:
1 The policy of the firm
2 Size of exposure
3 View on the currency involved.
4 Availability of hedging instrument
5 Duration of the exposure.
Internal Hedge:
1 Exposure Netting: if a company has both receivable and payables in a
foreign currency,

2 Cross Hedging: it is used to manage exposure in minor currencies for

which traditional instruments like forward and future are not available.
3 Denomination in Local Currency: the exchange risk can be totally
avoided if the transaction is denominated in local currency. In such a
case the exchange risk is borne by the other party.

4 Foreign currency accounts: a trader who is engaged in both exports

and imports, the exchange risk can be minimized if an account is
maintained abroad, in the currency of the trade.
 5 Leads and Lags: when the local currency is expected to be
appreciate, the exporter would press for payment earlier and it is said
to Lead the payment.

When local currency is likely to devalue, the exporter would likely

to delay the payment. This is known as Lag.
Translation Exposure:
Translation exposure (also known as translation risk) is the risk that a
company's equities, assets, liabilities, or income will change in value as a
result of exchange rate changes.

This occurs when a firm denominates a portion of its equities, assets,

liabilities, or income in a foreign currency.
It is also known as "accounting exposure.”
Translation exposure is most evident in multinational organizations since a
portion of their operations and assets will be based in a foreign currency.

It can also affect companies that produce goods or services that are sold in
foreign markets even if they have no other business dealings within that
country.
Translation risk can lead to what appears to be a financial gain or loss
that is not a result of a change in assets, but in the current value of the
assets based on exchange rate fluctuations.

For example, should a company be in possession of a facility located in

Germany worth €1 million and the current dollar-to-euro exchange rate is 1:1,
then the property would be reported as a $1 million asset.
Transaction vs. Translation Exposure

• Transaction exposure involves the risk that when a business transaction is

arranged in a foreign currency, the value of that currency may change
before the transaction is complete.

• Translation risk focuses on the change in a foreign-held asset’s value based

on a change in exchange rate between the home and foreign currencies.
Methods of Translation:

a) Current/ Non Current Method CA and CL are valued at current rate

and Non Current asset and non CL at historical rates.

b) Monetary/ Non Monetary Methods Under this method,

monetary assets and liabilities are valued at current rates and Non
Monetary items like Inventory, furniture are translated at historical
rates.
c) Temporal Method it is similar to second one except for inventories
and investments. They are translated at current rates if they are valued
at the market price.

D) Current rates: under this all are translated at current rates.

Managing Translation Exposure:

1 Balance Sheet Hedge: it consists in bringing about balance between the

exposed assets and liabilities so that the net exposure is zero.

If the net exposed assets are more than the exposed liabilities, the
exposure can be made zero by increasing the liability of functional
currency of the subsidiary unit without a corresponding increase in the
asset.

2 Exposure Netting: same as that of Transaction exposure.

3 Leading and Lagging: a company with a positive transaction exposure
has to increase the exposed liability or decrease the exposed assets.

This can be done by expediting the realization of assets (leading) or

delaying the payment of liabilities ( lagging).

4 Forward Contract: it is the method to minimize the translation loss

arising out of the translation exposure.
What Is Economic Exposure?
Economic exposure is a type of foreign exchange exposure caused by the
effect of unexpected currency fluctuations on a company’s future cash flows,
foreign investments, and earnings.

EX: small Indian manufacturers that sell only in their local markets and do not export their
products would be adversely affected by a stronger Rupee, since it would make imports from
other jurisdictions such as Asia and North America cheaper and increase competition in Indian
markets.
• Economic exposure is a type of foreign exchange exposure caused by the
effect of unexpected currency fluctuations.
 Exposure increases as foreign exchange volatility increases and decreases
as it falls.

 Can be mitigated either through operational strategies or currency risk

mitigation strategies.
The degree of economic exposure is directly proportional to currency
volatility. Economic exposure increases as foreign exchange volatility increases
and decreases as it falls.

Economic exposure is obviously greater for multinational companies that have

numerous subsidiaries overseas and a huge number of transactions involving
foreign currencies.
Unlike transaction exposure and translation exposure (the two other types of
currency exposure), economic exposure is difficult to measure precisely and hence
challenging to hedge.

Economic exposure is also relatively difficult to hedge because it deals with

unexpected changes in foreign exchange rates, unlike expected changes in currency
rates, which form the basis for corporate budgetary forecasts.
 Measuring Economic Exposure:
It is possible to estimate with certain basic assumptions regarding the impact
likely on each item of cash flow. Following assumptions can be made:
1 all variables remain same
2 sales price will change, costs will remain same
3 sales price will change/ costs will also change
4 Sales volume will change/ sales price and cost remain same
5 Sales price will remain same/ costs will change.
Managing Economic Exposure:
1 Marketing: strategies:
A market selection: It may shift emphasis from market whose currency
have depreciated to those whose currencies have appreciated.

B Pricing: It involves consideration as:

i) whether to retain the market share or retain the profit margin.
ii) how frequently can the price be changed.

C Product Decision: the ideal time for launching the product in the
foreign market will be when the home currency has depreciated.
2 Production Strategies:a MNCs with production and sourcing base in
different countries can manage the economic exposure by choosing the right
production and sourcing bases. The input can be procured from foreign
countries when the local currency appreciates in value.
3 Financial Strategies: Some methods used in managing translation
exposure can be used here also:

A Balance sheet hedge

B Leading and Lagging

C Parallel loads and SWAPS

D Currency invoicing.
Basic Hedging Techniques

ASSET LIABILITY
Hard Currency Increase Decrease
(likely to appreciate)
Soft Currency Decrease Increase
(Likely to
depreciate)
DEPRECIATION APPRECIATION
1. Sell local currency forward 1. Buy local currency forward
2. Reduce level of local currency cash 2. increase level of local currency cash

3.Tighten credit 3. Relax local currency terms.

4. Delay collection of hard currency 4.Speed up collection of soft currency
receivables receivables
5. Increase imports of hard currency goods 5. Reduce imports of soft currency goods

6. Borrow locally 6. Reduce local borrowing

7. Delay payment of payable 7. Speed up payment
8. Speed up payment of inter subsidiary 8.Delay payment
account payment
9. Delay collection of inter subsidiary account 9. Speed up collection
receivable