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FOREIGN EXCHANGE RISK MANAGEMENT

CORE BUSINESS RISKS 1) Raw Material Shortage 2) Labour problem 3) Failure of new product / technology etc.

These risks are specific to firm and going tohave an impact on firms performance.

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MACRO ECONOMICENVIRONMENTAL RISK

1) Exchange rate variation 2) Interest rate variation

3) Inflation 4) Increase in prices of key

commodities like oil, steel, etc.

These are risks affects all firms in theeconomy but the nature of impact varies.

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FOREIGNEXCHANGE/CURRENCY

EXPOSURE / RISK

Foreign currency risk is the net potential gainor loss which arises from exchange ratechanges, to a foreign currency exposure of an enterprise.

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Currency risk is the risk that he domesticcurrency value of cash flows, denominatedin foreign currency may change because of the variation in the foreign exchange rate.

Currency exposure is a measure of thesensitivity of real value of enterprisesassets, liabilities and incomes express in its

functional currency (operating currency) tounanticipated changes in exchange rate.

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A project / firm has a currency exposure

when the currencies for its expenditure and revenues are not the same.

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Foreign currency risk management is the proper

management of foreign currency assets, liabilitiesincome and expenditure with a view to optimisingrupee earnings and minimizing rupee cost. Itinvolves selection of right currency for invoicingimports and exports, and for denominating loanswhere such choice exists, prepayment or delayed

payment of payables, postponements of receivables, judicious matching of imports andexports and, finally, proper usage of hedginginstruments and facilities available for the

purpose.

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Currency risk management has become

necessary for Indian business due to Increased cross border transaction : Indias

cross border trade has increased tremendously in post liberalisation era. Now India accounts for 1%of world trade in respect of visibles and 2% of world trade in respect of invisibles.

Increased volatility in currency : Increased domestic and overseas competition : Greater flexibility in hedging due to

liberalisation :

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OBJECTIVES OF FOREX RISK

MANAGEMENT Hedge against the risk of currency

exchange loss.

Speculative gains Smoothing earnings

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EXPOSURE AND RISK Exposure refers to foreign currency assets,

liabilities, income and expenditure whosevalues will change in terms of homecurrency in response to exchange ratefluctuations.

Risk is the likely or probable loss from suchforex exposure due to adverse exchangerate fluctuations.

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HEDGING V/S SPECULATION

Hedging is a transaction undertaken tooffset the forex risk.

Speculation involves or taking or creating aforex exposure deliberately for gainingfrom favorable exchange rate movement.

not hedging a risk amounts tospeculation

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Currency exposure can be divided into 1) Transaction exposure 2) Economic / operating

exposure 3) Translation exposure

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Transaction exposure

Deals with current cash flows. It ariseswhenever firms receivables or payables aredenominated in foreign currencies. Thisexposure will have an effect on thenetworking capital position and

profitability.

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This is the most common form of currencyexposure that arises when a firm has receivables or

payables denominated in foreign currency. This is a measure of the sensitivity of the

domestic currency value of assets and liabilities,which are denominated in a foreign currency tounanticipated changes in exchange rates, when thesaid assets or liabilities are liquidated.

The foreign-currency values of these items arecontractually fixed, i.e., they do not vary with theexchange rate. It is also known as contractualexposure.

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MEASUREMENT OF TRANSACTIONEXPOSURE

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MANAGING TRANSACTION

EXPOSURE INTERNAL HEDGING STRATEGIES

/TECHNIQUES EXTERNAL HEDGING STRATEGIES

/TECHNIQUES

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INTERNAL HEDGING STRATEGIES/TECHNIQUES

a) Natural hedge b) Invoicing in own currency C ) Split currency invoicing

D) Netting D) Leading and lagging e) Price adjustments

f) Risk sharing agreements g) Review of market product

combination

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EXTERNAL HEDGING STRATEGIES

/TECHNIQUES a) Currency forward contracts b) Currency future contracts

c) Currency options e) Money market hedge

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Translation Exposure

Accounting exposure also called translationexposure arises because financial statements

of foreign subsidiaries, which are stated inforeign currency, must be restated in the

parents reporting currency for the firm to

prepare consolidated financial statements

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Translation exposure is the potential for an

increase or decrease in the parents networth and reported net income caused by achange in exchange rates since the lasttranslation. Translated statements are used

by management to assess the performanceof foreign subsidiaries, amongst other things. Restatement of all subsidiarystatements into the single commondenominator of one currency facilitatesmanagement comparison.

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The difference between exposed assets and

exposed liability is called translationexposure.

Eg; US subsidiary at France has monetary

assets of 200 mn FFr and monetary liabilityof 100 mn FFr. The exchange rate declinesfrom FFr 4/$ to FFr 5/$

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The potential foreign exchange loss oncompany's exposed net monetary assets of

100 mn FFr would be 5mn FFr.

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Translation principles in many countries areoften a complex compromise betweenhistorical and current market valuation.Historical exchange rates can be used for certain equity accounts, fixed assets andinventory items while current exchangerates can be used for current assets, currentliabilities, income and expense items.

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Current Rate Method The current rate method is the most

prevalent in the world today. Under this

method, all financial statement line itemsare translated at the current exchange ratewith few exceptions.

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Assets and liabilities : All assets andliabilities are translated at the current rate of exchange; that is, at the rate of exchange ineffect on the balance sheet date

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Income statement items : All items,including depreciation and cost of goods

sold are translated at either the actualexchange rate on the dates the variousrevenues, expenses, gains and losses were

incurred or at an appropriately weightedaverage exchange rate for the period.

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Distributions : Dividends paid are translated

at the exchange rate in effect on the date of payment

Equity items : Common stock and paid in

capital accounts are translated at historicalrates. Year-end retained earnings consist of the original year-beginning retained

earnings plus or minus any income or lossfor the year.

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Gains or losses caused by translation

adjustments are not included in thecalculation of consolidated net income.Rather, translation gains or losses are

reported separately and accumulated in aseparate equity reserve account (on theconsolidated balance sheet) with a title suchas cumulative translation adjustment (CTA).

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The biggest advantage of the current ratemethod is that the gain or loss on translationdoes not pass through the income statement

but goes directly to a reserve a/c. This

eliminates the variability of reportedearnings due to foreign exchange translationgains or losses. A second advantage of thecurrent rate method is that the relative

proportions of individual balance sheetaccounts remain the same.

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Monetary and Non-monetary method . Monetary assets (these are primarily cash,

marketable securities, accounts receivable andlong-term receivables) and monetary liabilities

(primarily current liabilities and long-term debt)are translated at current exchange rates Non-monetary assets and liabilities (primarily

inventory and fixed assets) are translated athistorical rates

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Income statement items : Average exchangerate for the period except for depreciationand cost of goods sold ( which are directlyassociated with non monetary assets or liability). These are translated at historicalrate.

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Temporal Method This method is same as monetary and non

monetary method. Only difference is thatinventory is translated at current rate if inventory is shown in the balance sheet atmarket value. ( in the above method it istranslated at historical value)

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Operating exposure

Operating exposure also known aseconomic exposure. This exposure refers to

the degree to which a firms present value of future cash flows can be influenced byexchange rate fluctuations.

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Deals with impact of exchange rate on thefirms future cash flows from operationswhich are not fixed in either home currencyor foreign currency.

Neither the prices nor quantities of outputsor inputs are fixed and all are subject tochange when exchange rate changes.

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Economic exposure is a more managerialconcept that an accounting concept . acompany can have an economic exposure tosay pound/rupee rates even if it does not

have any transaction or translation exposurein the british imports. If the pound weakens,the company loses its competitiveness.

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The economic exposure to an exchange rateis the risk that a variation in the rate willaffect the companies competitive position inthe market and hence its profits .

It affects the profitability of the companyover a larger time span than transaction or translation exposure .

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. under the Indian exchange control ,economic exposure cannot be hedged while

both transaction and translation can behedged.

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operating exposure to currency risk dependson the effect of unexpected changes in the exchange rate on the firms

output prices (e.g., product prices) and inputcosts (e.g., raw materials, labor costs, etc.).

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Diff bet transaction and economic

exposure Contract specific

Cash flow loss can beeasily computed

Cos do have policiesto cope up with it

Duration is same astime period of contract

General, relates toentire investment.

V difficult to computeopportunity losses.

Do not have any policies to cope up.

Relatively longer duration

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MANAGING ECONOMIC EXPOSURE1 Marketing Initiatives

A Market selection;

B Product strategyC Promotional strategyD Pricing strategy

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2 Production initiatives A Input mix

B shifting production among plants

C Plant location D Raising productivity