Foreign exchange exposure & risk mannagement1

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  • P G apte, IFM
  • Foreign exchange exposure & risk mannagement1

    1. 1. University Business school
    2. 2. COUNTRY RISK Transfer Risk Sovereign Risk Contagion Risk Currency Risk Indirect Country Risk Macro- economic Risk COUNTRY RISK Transfer Risk Sovereign Risk Contagion Risk Currency Risk Indirect Country Risk Macro- economic Risk
    3. 3.  Technical forecasting  Fundamental forecasting  Market based forecasting  Mixed forecasting
    4. 4.  It involves the use of historical exchange rate data to predict future values.
    5. 5.  It is based on fundamental relationship between economic variables and exchange rates. ◦ e= f[ INF, INT, GC, EXT] ◦ e=% change in the spot rate ◦ INF= change in the differential between U.S. inflation & the foreign country’s inflation ◦ INT= change in the differential between U.S. interest rate & the foreign country’s interest rates ◦ INC= change in the differential between U.S. income level & the foreign country’s income level ◦ GC= change in government controls ◦ EXT= change in expectations of future exchange rates.
    6. 6.  Spot rate  Forward rate ◦ F= s(1+p)
    7. 7.  Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them.  Translation exposure= (exposed assets- exposed liabilities) ( change in exchange rate)
    8. 8.  This exposure refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations.  The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates.  Whoever makes a contract denominated in a foreign currency bears transaction risk.
    9. 9.  Changes in competitive position as a result of permanent changes in exchange rates.  Every company buying or selling abroad or even just competing with foreign companies has economic risk.
    10. 10. Translation methods Single rate method Current rate method Multiple rate method Current/non- current method Monetary/non- monetary method Temporal method
    11. 11.  Balance sheet: All current assets and current liabilities are translated into the home currency at the current exchange rate.  Income statement/P&L a/c: translated at average exchange rate for the period cover. AER = Total ER/Number of years  Revenue and expenses related to non-current assets and long term borrowings at the historical cost.
    12. 12. Liabilities / Sources Assets/ Applications Share Capital Fixed Assets Reserve surplus Investment Secured Loan Current Assets Unsecured Loan Loan & Advances Current Liabilities & Provision Miscellaneous Expenditure Profit/Loss A/c t t t= current rate Rest of the balances are on historical cost Net current assets= current asset- current liabilities +ve NCA: CA>CL -ve NCA: CA<CL
    13. 13.  Monetary items: are those that represent a claim to receive or an obligation to pay a fixe amount of foreign currency unit, e.g. cash, accounts receivables, current liabilities, account payable and long term debt.  Non-monetary items: inventory, fixed assets, long term investment.  Monetary items: current rates  Non-monetary items: historical rates  P/L= AER except COGS, depreciation or those related to non-monetary item.
    14. 14.  Modified version of monetary/non monetary method.  Inventory translated at current rate if shown in the balance sheet at market value.
    15. 15.  All balance sheet and income statement items are translated at current rate except equity.  Equity = historical rate.  COGS and Depreciation = Actual exchange rate/weighted average exchange rate.  Dividend paid = exchange rate on payment date.  Gains/loss reported separately in cumulative translation adjustments.
    16. 16. Accounts Functional currency Current/n on current Monetary/ non monetary Temporal Current rate Cash 100 Accounts receivable s 150 Inventory 200 Fixed assets 250 Total 700 Current liablities 100 Long- term debt 300 Gains/loss
    17. 17. Accounts Functional currency Current/n on current Monetary/ non monetary Temporal Current rate Cash 100 100 100 100 100 Accounts receivable s 150 150 150 150 150 Inventory 200 200 400 200 200 Fixed assets 250 500 500 500 250 Total 700 950 1150 950 700 Current liablities 100 100 100 100 100 Long- term debt 300 600 300 300 300 Gains/loss -350 150 -50 300
    18. 18.  Net exposure in currency (i)- Net exposure in currency (i) New spot Rate (i/r) old spot Rate (i/r) r= reporting currency (U.S) i= Euro  New spot rate = 1.1786/$1.0  Old spot rate = 1.1000/$1.0 300 - 300 1.1786/1.00 1.1000/1.00 -$18.2
    19. 19.  Balance sheet hedge: it is never entity specific. It basically arises on account mismatch of assets and liabilities denominated in same currency.  A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.  These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.  Example: Assets 7645 Liabilities 5819 ◦ 1826 (difference)
    20. 20.  Derivative Hedge: how much forward we need to hedge exposure of -$18.2. for this they are making forward sell.  Forward contract position in functional currency= Potential translation loss f (r/i)-expected spot (r/i) r= reporting currency U.S i= Euro 18.2 = $140 1/1.393-1/1.1786 So we need to forward sell $140 to hedge
    21. 21.  Inaccurate earning forecasts  Inadequate forward contracts for some currencies  Accounting distortions  Increased transaction exposure
    22. 22.  Reporting currency: it is currency which enterprise use to present financial statements.  Foreign currency: currency other than reporting currency.  Foreign operation: any subsidiary associate of a reporting enterprise.  India is adopting at temporal rate.
    23. 23.  This exposure refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations.  The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates.  Whoever makes a contract denominated in a foreign currency bears transaction risk.  Determine the projected net amount of currency inflows or outflows in each foreign currency  Determine the overall exposure to those currencies.
    24. 24.  Transaction exposure arises from:  Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.  Borrowing or lending funds when repayment is to be made in a foreign currency.  Being a party to an unperformed foreign exchange forward contract.  Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
    25. 25.  Suppose a U.S. firm, IBM, sells merchandise on account to a Belgian buyer for:  €2,00,000 payment to be made in 60 days.  S0 = $0.9000/€  The U.S. seller expects to exchange the €2,000,000 for €1,800,000 when payment is received.
    26. 26.  Transaction exposure arises because of the risk that the U.S. seller will receive something other than $1,800,000.  If the euro weakens to $0.8500/€, then Trident will receive $1,700,000  If the euro strengthens to $0.9600/€, then Trident will receive $1,920,000  Thus, exposure is the chance of either a loss or a gain.
    27. 27.  Hedging is the taking of a position, either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (fall) in value to offset a fall (rise) in value of an existing position.  Hedging, therefore, protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure).
    28. 28.  Future Hedge  Forward Hedge  Money market hedge  Currency option hedge Hedging Long-term transaction exposure  Long-term forward contracts  Currency swap  Parallel loan Alternative Hedging Techniques Leading and lagging Cross-hedging Currency diversification
    29. 29.  Purchasing Currency Futures: A firm that buys a currency futures contract is entitled to receive a specified amount in a specified currency for a stated price on a specified date. E.g. for future payables.  Selling currency futures: A firm that sells a currency futures contract is entitled to Sell a specified amount in a specified currency for a stated price on a specified date. E.g. for future receivables.
    30. 30.  A forward contract hedge is very similar to a future contract hedge, except that forwards contracts are commonly used for large transactions, whereas future contract tend to be used for smaller amounts.
    31. 31.  It involves taking a money market position to cover a future payables or receivables position. ()  Money market hedge on payables  Money market hedge on receivables.
    32. 32.  Hedging payables with currency call options- A currency call option provides the right to buy a specified amount of a particular currency at a specified price within a given period of time.  Hedging receivables with currency put options.
    33. 33.  Hedging of Receivables  Sell futures or forward  Money market hedge  borrow foreign currency to be received  convert to domestic currency  invest for future use  Buy Put Option  Hedging of Payables   Buy futures or forward  Money market hedge  borrow home currency  convert to foreign currency  invest for future use  Buy Call Option
    34. 34.  Long-term forward contract  Currency swap ()  Parallel loan/back-to-back loan  Alternative hedging techniques  Leading& lagging()  Cross- hedging  Currency diversification
    35. 35.  Limitations of hedging an uncertain amount  Limitations of repeated short-term hedging.
    36. 36.  It can be defined as the extent to which the value of the firm would be affected by unanticipated change in exchange rates.  Change in expected cash flow arising because of an unexpected change in exchange rates.  Changes in competitive position as a result of permanent changes in exchange rates.
    37. 37. Transaction exposure Economic exposure Contact specific General relates to the entire investment Cash flow losses due to an exchange rate change are easy to compute. Simple financial accounting techniques can be used to compute losses due to transaction exposure Opportunity losses caused by an exchange rate change are difficult to compute. A good variance accounting is needed to isolate the effect of exchange rate change on sales volume, costs & profit margin Firms generally have some policies to cope with transaction exposure Firms generally do not have policies to cope with transaction exposure Avoidance sometimes requires third- party cooperation Avoidance require good strategic planning The duration of exposure is the same as the time period of contract The duration of exposure is the time required for the restructuring of operations through such means as changing product, markets, sources & technology Relates to nominal contracts whose value is fixed in foreign currency terms Relates to cash flow effects through changes in cost, price and volume relationships.
    38. 38.  Transaction exposure: is an uncertain domestic currency value of a cash flow which is known and fixed in foreign currency terms.  Economic exposure: is an uncertain domestic currency value of a cash flow whose value is uncertain even in foreign currency terms. E.g. cash flow from a foreign subsidiary.
    39. 39.  Exposure to currency risk can be properly measure by the Sensitivities of 1. The future home currency values of the firm’s assets/liabilities 2. The firm’s operating cash flow to random changes in exchange rates. P= a+b*S+e A= constant E= random error P= local currency price of asset B= sensitivity of the dollar value of asset (p) to exchange rate. Cov( p,s)/ Var (s)
    40. 40.  Marketing initiatives ◦ Market selection ◦ Product strategy ◦ Pricing strategy ◦ Promotional strategy  Production initiatives ◦ Product sourcing ◦ Input mix ◦ Plant location ◦ Raising productivity
    41. 41.  Market selection: market to sell, market segmentation.  Pricing strategy: std economic proposition of setting the price that max dollar profits  Promotional strategy  Product strategy: product line decisions, product innovations.
    42. 42.  Input mix: outsourcing  Shifting production among plants  Plant location  Raising productivity
    43. 43.  Fluctuations in interest rate affect a firm’s cash flow by affecting interest income on financial assets and interest expenses on liabilities. To put it another way, the market values of a firm’s portfolio of financial assets and liabilities fluctuates with interest rates.
    44. 44. 1. Net interest income: interest income on assets minus interest exposure on liabilities. Monitoring of this account will reveal the sensitivity of firm’s profitability to changes in interest rates. 2. Net equity exposure: sensitivity of the firm’ s net worth to interest rates.
    45. 45.  Forward rate agreements  Interest rate options  Interest rate caps, floors and collars  Options on interest rate futures.

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