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Intl biz lesson6

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International business course at ESEC BCN. Bachelor 3. …

International business course at ESEC BCN. Bachelor 3.
Lesson 6: Foreign exchange risk

Published in: Business, Economy & Finance

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  • 1. International BusinessForeign exchange riskProfessor: Marc Arza marc@futura.cat
  • 2. 1. Foreign exchange riskForeign exchange exposure is one of the mostimportant risks of international business practice.Business operations in between two countries witha different currency will always represent a risk forone or both of the players as the operation willnecessarily be in a different currency than the onethey usually operate with. Any exchange ratefluctuation during their business operations willchange the money/value relation and obviouslyimpact results.Sellers are favoured by a lower exchange rate asbuyers will prefer a higher exchange rate.Financial operations, on the other hand, requirelower interest rates, linked with a currency lowervalue (higher interest rates attract savings andinvestments and so will tend to increase acurrency exchange rate).
  • 3. 2. Foreign exchange reference (strong) currenciesMost international business transactions are conducted in a limited set of referencecurrencies: dollars (USD - $), euros (EUR - €), brittish pounds (GBP - £) and japaneseyens (JPY - ¥). These strong currencies are convertible into almost any other worldcurrency and being used as a reference are reliable and more stable than othercurrencies.After the gold standard was abandoned in the seventies the exchange rate of worldcurrencies is fixed by the exchange market (supply/demand) and influenced by thefollowing criteria: - Supply & demand (Central banks role) - Higher inflation = Lower value - Higher interest rate = Higher value - Economic performance
  • 4. 3. Foreign exchange restrictionsAlthough most global currencies are freely floatingpresently (subject to free market exchange ratesetting) some countries still use restrictions to controlthe value of their exchange rate limitting the currencyconversion. The reason for this may be to preventcapital flight or to keep an artifficial value because ofpolitical/economic interests.Some of this weak currencies echange policiesinclude:- Exchange restrictions (forbidding exchange or limitting it to certain transactions)- Dual exchange rate (using different exchange rates depending on the final use)- Advanced import deposit (requiring a deposiit to exchange currency to control the use)
  • 5. 4. Foreign exchange exposureForeign exchange exposure is normally broken into: transaction exposure, translationexposure, and economic exposure.Transaction exposure is typically defined as the extent to which the income fromindividual transactions is affected by fluctuations in foreign exchange values. Suchexposure includes obligations for the purchase or sale of goods and services atpreviously agreed prices and the borrowing or lending of funds in foreign currencies.Translation exposure is the impact of currency exchange rate changes on the reportedconsolidated results and balance sheet of a company. Translation exposure is basicallyconcerned with the present measurement of past events. (Example: A US firm with asubsidiary in Mexico. If the value of the Mexican peso depreciates significantly against thedollar this would substantially reduce the dollar value of the Mexican subsidiarys equity.This would reduce the total dollar value of the firms equity reported in its consolidatedbalance sheet raising the apparent leverage of the firm (its debt ratio), which couldincrease the firms cost of borrowing).Economic exposure is the extent to which a firms future international earning power isaffected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinctfrom transaction exposure.
  • 6. 5. Reducing foreign exchange exposureReducing Transaction and Translation Exposure: A number of tactics can help firmsminimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates.Firms can minimize their foreign exchange exposure through leading and laggingpayables and receivables--that is, collecting and paying early or late depending onexpected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when aforeign currency is expected to depreciate and paying foreign currency payables beforethey are due when a currency is expected to appreciate. A lag strategy involves delayingcollection of foreign currency receivables if that currency is expected to appreciate anddelaying payables if the currency is expected to depreciate. Leading and lagging involvesaccelerating payments from weak-currency to strong-currency countries and delayinginflows from strong-currency to weak-currency countries.
  • 7. 5. Reducing foreign exchange exposureSeveral other tactics can reduce transaction and translation exposure: . Financial solutions: forwards, options and SWAPs — Local debt financing can provide a hedge against foreign exchange risk. As will any policy directed to link income and expenses currencies (being paid in the same currency in which expenses are denominated). — Transfer prices can be manipulated to move funds out of a country whose currency is expected to depreciate. — It may make sense to accelerate dividend payments from subsidiaries based in countries with weak currencies.
  • 8. 5. Reducing exposure (financial tools)Spot rate: The current exchange rate at the moment of a transaction.Forward contract: A forward exchange contract is a non-standardized contract between two parties to buy or sell currency at a specified future time at a price agreed today. A tool to fix the value of a future exchange rate. The forward price of such a contract is commonly contrasted with the spot price. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.Option contract: Is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.SWAP: Using a spot & a forward contract at the same time (or two forwards for different currencies) to cover against possible exchange rate variations.
  • 9. 5. Reducing foreign exchange exposureReducing Economic Exposure: Reducing economic exposure requires strategicchoices that go beyond the realm of financial management. The key to reducing economicexposure is to distribute the firms productive assets to various locations so the firmslong-term financial well- being is not severely affected by adverse changes in exchangerates.The post1985 trend by Japanese automakers to establish productive capacity in NorthAmerica and Western Europe can partly be seen as a strategy for reducing economicexposure (it is also a strategy for reducing trade tensions). Before 1985, most Japaneseautomobile companies concentrated their productive assets in Japan. However, the rise inthe value of the yen on the foreign exchange market has transformed Japan from alowcost to a high-cost manufacturing location over the past 10 years. In response,Japanese auto firms have moved many of their productive assets overseas to ensuretheir car prices will not be unduly affected by further rises in the value of the yen. Ingeneral, reducing economic exposure necessitates that the firm ensure its assets are nottoo concentrated in countries where likely rises in currency values will lead to damagingincreases in the foreign prices of the goods and services they produce.
  • 10. 5. Reducign foreign exchange exposureThe firm needs to develop a mechanism for ensuring it maintains an appropriate mix oftactics and strategies for minimizing its foreign exchange exposure.- Central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers to set guidelines for subsidiaries to follow.- Firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure.- The need to forecast future exchange rate movements cannot be overstated, though. The best that can be said is that in the short run, forward exchange rates provide reasonable predictions of exchange rate movements, and in the long run, fundamental economic factors--particularly relative inflation rates--should be watched because they influence exchange rate movements.- Firms need to establish good reporting systems so the central finance function (or in- house foreign exchange center) can regularly monitor the firms exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered.Tthe firm should produce monthly foreign exchange exposure reports.
  • 11. 6. FOREX case: The small Irish company Lily OBriensA wooden spoon and a saucepan were Mary Ann OBriens start-up tools 12 years agowhen, with a recipe for honeycomb crisp hearts, she launched a small venture makingIrish handcrafted chocolates for local shops. Today as managing director of Lily OBriens -which is named after her daughter - she has a factory in Newbridge, Co Kildare, employs100 people and makes 500 tons of luxury chocolates a year.The company is heavily reliant on Britain as an export market and British Airways is oneof her biggest customers. So Gordon Browns decision to keep sterling out of theeurozone means the accountants at Lily OBriens must remain busy watching exchangerate fluctuations with Irelands nearest neighbour for some time to come."Im a chocolatemanufacturer, not a currency trader," Mrs OBrien says. "But I have to study the ratesevery day, and I have been preparing for the day when we have parity.(...)
  • 12. FOREX case: The small Irish company Lily OBriens(...)The euro weakness against sterling has been great for our profits for the past few yearsbut the euro has strengthened so we have to factor that in now. And ultimately, for a smallor medium-sized company, exchange rate volatility could wipe you out."Since Ireland abandoned the punt in 1999 with the launch of the euro, Mrs OBrien hasensured the company sources all its ingredients, and its boxes, ribbons and packaging, inthe eurozone. "We have to try not to buy in sterling." Despite yesterdays decision, Britainwill remain a crucial export market for cultural and gastronomic reasons,although thecompany now exports to the United States, Australia and New Zealand. "The euro area isflooded with chocolate, and tastes are different. The British tend not to eat as much darkchocolate as the French, Belgians or Swiss."Mrs OBrien would rather concentrate on innovation by designing new centres and fillingsso that she can compete with her Belgian rivals than check the foreign exchange rates.But the Chancellors announcement came as little surprise. "The currency risk has beenpart of the business since we started. So we just manage it, and were used to it."