Foreign Exchange Risk Management

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Foreign Exchange Risk Management -

International financial environment,
International Business B Com Notes |
EduRev
International Business
B COM : FOREIGN EXCHANGE RISK MANAGEMENT - INTERNATIONAL

FINANCIAL ENVIRONMENT, INTERNATIONAL BUSINESS B COM NOTES |
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Many firms are exposed to foreign exchange risk - i.e. their wealth is affected
by movements in exchange rates - and will seek to manage their risk
exposure. This page looks at the different types of foreign exchange risk and
introduces methods for hedging that risk.
Types of foreign exchange risk
Transaction risk
This us the risk of an exchange rate changing between the transaction date
and the subsequent settlement date, i.e. it is the gain or loss arising on
conversion.
This type of risk is primarily associated with imports and exports. If a

company exports goods on credit then it has a figure for debtors in its
accounts. The amount it will finally receive depends on the foreign exchange
movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company,

most companies choose to hedge against such exposure. Measuring and
monitoring transaction risk is normally an important component
of treasury risk management.
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure

is acceptable. This will probably be dependent on whether the Treasury
Department is been established as a cost or profit centre.
Economic risk
Transaction exposure focuses on relatively short-term cash flows effects;

economic exposure encompasses these plus the longer-term affects of
changes in exchange rates on the market value of a company. Basically this
means a change in the present value of the future after tax cash flows due to
changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm's home currency strengthens then foreign competitors

are able to gain sales at your expense because your products have become
more expensive (or you have reduced your margins) in the eyes of customers
both abroad and at home.
If your firm's home currency strengthens then foreign competitors are able to
gain sales at your expense because your products have become more
expensive (or you have reduced your margins) in the eyes of customers both
abroad and at home.
Indirectly: Even if your home currency does not move vis-a -vis your
customer's currency you may lose competitive position. For example suppose
a South African firm is selling into Hong Kong and its main competitor is a
New Zealand firm. If the New Zealand dollar weakens against the Hong Kong
dollar the South African firm has lost some competitive position.
Even if your home currency does not move vis-a -vis your customer's
currency you may lose competitive position. For example suppose a South
African firm is selling into Hong Kong and its main competitor is a New
Zealand firm. If the New Zealand dollar weakens against the Hong Kong
dollar the South African firm has lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy to manage it is to

diversify internationally, in terms of sales, location of production facilities, raw
materials and financing. Such diversification is likely to significantly reduce
the impact of economic exposure relative to a purely domestic company, and
provide much greater flexibility to react to real exchange rate changes.
Translation risk
The financial statements of overseas subsidiaries are usually translated into

the home currency in order that they can be consolidated into the group's
financial statements. Note that this is purely a paper-based exercise - it is the
translation not the conversion of real money from one currency to another.
The reported performance of an overseas subsidiary in home-based currency

terms can be severely distorted if there has been a significant foreign
exchange movement.
If initially the exchange rate is given by $/£1.00 and an American subsidiary is

worth $500,000, then the UK parent company will anticipate a balance sheet
value of £500,000 for the subsidiary. A depreciation of the US dollar to $/
£2.00 would result in only £250,000 being translated.
Unless managers believe that the company's share price will fall as a result of
showing a translation exposure loss in the company's accounts, translation
exposure will not normally be hedged. The company's share price, in an
efficient market, should only react to exposure that is likely to have an impact
on cash flows.
Hedging transaction risk - the internal techniques
Internal techniques to manage/reduce forex exposure should always be

considered before external methods on cost grounds. Internal techniques
include the following:
Invoice in home currency
One easy way is to insist that all foreign customers pay in your home
currency and that your company pays for all imports in your home currency.
However the exchange-rate risk has not gone away, it has just been passed
onto the customer. Your customer may not be too happy with your strategy
and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a competitive

environment this is an unrealistic approach.
Leading and lagging
If an importer (payment) expects that the currency it is due to pay will

depreciate, it may attempt to delay payment. This may be achieved by
agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will

depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for immediate
payment.
The problem lies in guessing which way the exchange rate will move.
Matching
When a company has receipts and payments in the same foreign currency
due at the same time, it can simply match them against each other.
It is then only necessary to deal on the forex markets for the unmatched
portion of the total transactions.
An extension of the matching idea is setting up a foreign currency bank

account.
Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave a
similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction costs.
Hedging transaction risk - the external techniques
Transaction risk can also be hedged using a range of financial products.

These are introduced below with links to more detailed pages.
Forward contracts
The forward market is where you can buy and sell a currency, at a fixed future
date for a predetermined rate, i.e. the forward rate of exchange. This
effectively fixes the future rate.
Money market hedges
The basic idea is to avoid future exchange rate uncertainty by making the
exchange at today's spot rate instead. This is achieved by
depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur. This effectively fixes the future rate.
Futures contracts
Futures contracts are standard sized, traded hedging instruments.
The aim of a currency futures contract is to fix an exchange rate at some

future date, subject to basis risk.
Options
A currency option is a right, but not an obligation, to buy or sell a currency at

an exercise price on a future date. If there is a favourable movement in rates
the company will allow the option to lapse, to take advantage of the
favourable movement. The right will only be exercised to protect against an
adverse movement, i.e. the worst-case scenario.
A call option gives the holder the right to buy the underlying currency.
A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures but result
in an asymmetric risk exposure.
Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for
a period and then re-swap them at the end of the period at an agreed swap
rate. The swap rate and amount of currency is agreed between the parties in
advance. Thus it is called a fixed rate/fixed rate swap.
The main objectives of a forex swap are:
To hedge against forex risk, possibly for a longer period than is possible on
the forward market.
Access to capital markets, in which it may be impossible to borrow directly.
Forex swaps are especially useful when dealing with countries that have
exchange controls and/or volatile exchange rates.
Currency swaps
A currency swap allows the two counter parties to swap interest rate
commitments on borrowings in different currencies.
In effect a currency swap has two elements:
An exchange of principal in different currencies, which are swapped back at

the original spot rate - just like a forex swap.
An exchange of interest rates - the timing of these depends on the individual

contract.
The swap of interest rates could be fixed for fixed or fixed for variable.
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Foreign Exchange Risk Management -

B COM : FOREIGN EXCHANGE RISK MANAGEMENT - INTERNATIONAL

The document Foreign Exchange Risk Management - International financial

All you need of B Com at this link: B Com (/search/B Com)

Types of foreign exchange risk

This type of risk is primarily associated with imports and exports. If a

As transaction risk has a potential impact on the cash flows of a company,

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?

The corporate risk management policy should state what degree of exposure

Transaction exposure focuses on relatively short-term cash flows effects;

There are two ways in which a company is exposed to economic risk.

Directly: If your firm's home currency strengthens then foreign competitors

Economic risk is difficult to quantify but a favoured strategy to manage it is to

The financial statements of overseas subsidiaries are usually translated into

The reported performance of an overseas subsidiary in home-based currency

If initially the exchange rate is given by $/£1.00 and an American subsidiary is

Hedging transaction risk - the internal techniques

Internal techniques to manage/reduce forex exposure should always be

Invoice in home currency

Achievable if you are in a monopoly position, however in a competitive

Leading and lagging

If an importer (payment) expects that the currency it is due to pay will

If an exporter (receipt) expects that the currency it is due to receive will

An extension of the matching idea is setting up a foreign currency bank

The company would "win some, lose some".

In the short run, however, losses may be significant.

One additional advantage of this policy is the savings in transaction costs.

Hedging transaction risk - the external techniques

Transaction risk can also be hedged using a range of financial products.

Money market hedges

Futures contracts are standard sized, traded hedging instruments.

The aim of a currency futures contract is to fix an exchange rate at some

A currency option is a right, but not an obligation, to buy or sell a currency at

The main objectives of a forex swap are:

Access to capital markets, in which it may be impossible to borrow directly.

In effect a currency swap has two elements:

An exchange of principal in different currencies, which are swapped back at

An exchange of interest rates - the timing of these depends on the individual

Related Video: Foreign Exchange Market - International financial

Offer running on EduRev: Apply code STAYHOME200

Foreign Exchange Market - International financial environment, International Business

Author Views Rating

Arshit Thakur (/1929415?publi… 385 4.9

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