FOREIGN EXCHANGE RISK - INTERNATIONAL FINANCE

Notes 24 Pages

Bengaluru City University

Bachelor of Business Administration

Contributed by

Prajwal Hallale

INTERNATIONAL FINANCE
VI SEM BBA
SUSHMITHA V, ASST PROFESSOR, MES INSTITUTE OF MANAGEMENT
1

INTERNATIONAL FINANCE
UNIT 4: FOREIGN EXCHANGE RISK

Meaning:
The risk arising out of trading in the foreign exchange market is known as foreign exchange risk. These
risks are associated to unpredicted fluctuations in the value of currencies. Foreign exchange risk results
from the fluctuations in the exchange rate. Currency rate fluctuations affects the value of revenues,
cost, cash flows, assets and liabilities of a firm. These risks arise due to the volatility at rates and
frequent changes in exchange rates of countries. Any firms which are involved in collecting or paying
in foreign currency is exposed to foreign exchange risk.
Definition:
Corr S Pondent defined Exchange Risk as “Businesses that sell goods or services to customers overseas
and are paid in a foreign currency, are exposed to foreign exchange risk”.

Types of Foreign Exchange Risk:
1. Counter party risk:
It is risk that the other party in an agreement will be default. In an option contract, the risk is to the
option buyer that the writer will not buy or sell the underlying as agreed. In general, counter party risk
can be reduced by having an organization with extremely good credit act as an intermediary between
the two parties. It is the risk of loss due to the counter party defaulting on a contract during the life of
contract.
2. Market risk:
It is the risk of commodities, their quality and the changes in the government policy causes the market
risk which is borne by the exporter.
3. Country risk:
Risk arises out of the policies which are economic and political in nature like convertibility of currency,
external payment position, and the policies relating to government, socio-political changes etc, in other
words, political risk can be said as country risk.
4. Interest rate risk:
Risk due to the fall in the interest rate on the fixed income security as well as on the stock of money.
5. Legal risk:
Legal risk is the potential risk of financial loss arising from uncertainty of legal proceeding or change
in legislation, such as a foreign exchange control policy. A sales contract could be frustrated due to
changes in laws and regulations.
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6. Transit risk:
Transit risk is the risk of goods being damaged during the shipment from the place of origin to the
place of destination. Failure in addressing transit risk may result in heavy replacement cost or
performance risk.
7. Political / Sovereign risk:
Political / Sovereign risk refers to the complications that buyer or seller may expose due to unfavorable
political decisions or political changes that may vary the expected outcome of an outstanding contract.
Example of political/sovereign risk are changes in fiscal/monetary policy, war, riots, terrorism, trade
embargoes, etc.
8. Foreign Exchange Risk:
A buyer or seller may deal with foreign currencies in their daily course of business. This implies that
they are exposed to fluctuations in foreign exchange market which may result in paying more (by the
buyer) or receiving less (from the buyer) in terms of the local currency.
9. Cultural risk:
Different countries have their unique language and culture. The inability to appreciate / accept cultural
differences and /or language barrier may result in conflicts and non-completion of the sales contract.
10. Liquidity risk:
Risk occurs more in cases of OTC (Over the Counter) derivatives which are due to the non-standard
structure makes it to have no secondary market.
11. Economic risk:
Economic risk refers to unfavorable economic conditions in buyer’s or seller’s country which may
affect both parties in fulfilling their obligations. On the buyer side, economic risk may result in buyer's
insolvency or inability to accept the goods or services. On the other hand, seller may experience
difficulty in producing or shipping the goods.
12. Credit risk:
Buyer’s insolvency or credit risk refers to the inability of the buyer to honor full payment for goods or
services rendered on due date. This is a risk on seller associated with selling or supplying a product or
services without collecting full payment or experienced late payment.

Foreign Exchange Exposure:
Foreign Exchange Exposure is a measure of the potential for firm's profitability, net cash flow and
market value to change because of a change in exchange rate. In other words, Foreign Exchange
Exposure is the sensitivity of the real domestic currency value assets, liabilities, or operating incomes
to unanticipated changes in exchange rates (for better or worse). In general, exposure refers to the
degree to which a company is affected by exchange rate changes.
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Types of Foreign Exchange Exposure:
1. Economic exposure:
Economic exposure refers to the degree to which a firm's present value of future cash flow can
be influenced by exchanged rate fluctuations. This is more managerial concept than an
accounting concept. Economic exposure to an exchange rate is the risk that a difference in the
rate will affect the company’s competitive place in the market and hence it’s profits. Further,
economic exposure affects the profitability of the company over longer time span than
transaction or translation exposure.

Management of economic exposure:
• Selecting low-cost production location:
Domestic currency will become stronger in future. It will have an effect of
reducing competitive position of the firm. In such a case it can choose to set up
it’s production facilities in a foreign country where the cost is low. Low cost
can be due to lower price of factor of production such as land, labour, or
depreciating currency of that country.
• Adopting of flexible sourcing policy:
Easy way of reducing economic exposure is to buy inputs from the place where
the cost is low. By doing so it is not limited to raw material but also the firm
can hire low cost manpower from abroad.
• Making R&D effort for product differentiation:
R&D aims at strengthens competitive position of a firm against the adverse
effect of exchange rate changes. It brings gain in productivity, reduction in cost
that the firms offer.
• Hedging through financial product:
For effective management of economic exposure financial product should be
used as supplementary. The firm can use forward futures or option contract
which can be rolled as per the demand. The firm can borrow or end foreign
currencies on long term basis.

2. Transaction exposure:
This exposure refers to the extent to which the future value firm’s domestic cash flow is
affected by exchange rate fluctuations. It arises from the possibility of incurring foreign
exchange gains or losses on transaction already entered into and denominated in a foreign
currency. The degree of transaction exposure depends on the extent to which a firm's
transaction is in foreign currency. For example, the transaction in exposure will be more if the
firm has more transactions in foreign currency.

Management of transaction exposure:
The techniques used for hedging is of two types. Internal techniques and External techniques.
A. Internal techniques or methods of transaction exposure
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The major techniques or methods included in this category are:
• Choice of a particular currency for involving receivable and payables:
A firm can negotiate with its counter party to receive or make payments in
its own currency, which very closely with its own currency. For example, if
an Indian Company is able to invoice its sales and purchases in rupees, then
its revenues and costs will not be affected at all by currency fluctuations.
Thus, its currency exposure will be totally eliminated. This is the simplest
techniques to hedge exchange exposure.
• Leads and lags:
Leads and lags can be explained by simple example, a firm has payable of
USD 200 due in three months. Fearing depreciation of rupee, it may
renegotiate to make payment in two months. Conversely, importing firms
will delay the payment if an appreciation of home currency is anticipated
and exporting firms will advance the settlement in similar situation.
• Netting:
Netting is a technique where transaction entities try to match the maturity
dates and currencies of receivable and payable between themselves. For
example, a company A sells its products to company B for 50,000 and buys
from B for 25,000. The combined exposure of the companies A & B is
obviously 75,000. But, by netting, the exposure is reduced to 25,000.
• Back-to-back credit swap:
Under this method, two companies, located in two different companies,
agree to exchange loans in their respective currencies. Loans are given for a
pre-decided fixed period at a pre-decided exchange rate. On maturity, the
sums are again re-exchanged. This arrangement can work effectively
between MNCs of two different countries, each having subsidiaries in the
country of the other.
• Sharing risk:
The two companies practice this technique. The basic principle of this
technique is that neither the benefit of the favorable movement of the
exchange rate should go to one party nor the entire loss due to the
unfavorable movement of the exchange rate entire benefit is due to favorable
movement of exchange rate and loss is due to unfavorable movement of
exchange rate.
B. External techniques for management of transaction exposure:
• Use of currency forward market.
• Use of money market.
• Use of currency options market.
• Use of currency futures market.

3. Translation exposure:
It arises from the consolidation of assets and liabilities measured in foreign currencies into one
reporting currency. If the same exchange rate is used to restate each asset and liability on
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income statements and balance sheets, there will be no imbalances resulting from the
restatement. If different exchange rates are used for different items in the financial statements,
an imbalance will happen. This restatement, called translation, follows rules set up by a parent
firm’s government, an accounting association, or by the firm itself. The translation process
involves complex rules that sometimes reflect a compromise between historical and current
exchange rates.

Measuring translation exposure:
There are several methods to translate foreign currency accounts into the reporting currency.
There are three methods that predominate: the current / non-current method, the monetary /
non-monetary method, also called the temporal method in the U.S., and the current rate method.
• Current / non-current method:
The current/non-current method was widely used prior to 1976 in the U.S. The
accounting principle behind this method is that assets and liabilities should be translated
based on their maturity. All current assets and liabilities, which by definition have a
maturity of one year or less, are translated into the domestic currency at the current
exchange rate, that is, at the exchange rate in effect on the date of the statement. Non
current assets and liabilities are translated at historic exchange rates, that is, at the
exchange rates that were in effect on the date the assets were acquired or the liabilities
incurred.
• Monetary / non-monetary method:
According to this method, all monetary items are translated at the current rate while
non-monetary are translated at historical rates. Income statement items are translated at
the average exchange rate for the period, except for items such as depreciation and cost
of goods sold that are directly associated with non-monetary assets and liabilities. These
accounts are translated at their historical rates.
• Temporal method:
This method is a modified version of the monetary/non-monetary method. The only
difference is that under the temporal method, inventory is usually translated at the
current rate in the balance sheet at market values. In the monetary/non-monetary
method inventory is always translated at the historical rate. Under the temporal method,
income statement items are normally translated at an average exchange rate for the
period. However, cost of goods sold and depreciation are translated at historical rates.
• Current rate method:
An important feature of this new standard is that translation gains and losses are
deferred and accumulated on the balance of the parent corporation, bypassing the
income statement. Translation gains or losses are reported separately and accumulated
in a separate equity account named cumulative translation adjustment and thus, are
reported directly to stockholder’s equity. When the gain or loss of a given investment
is realized, it is reported as net income or loss for the period. Then, the translation gains
or losses due to that investment are removed from the cumulative translation
adjustments.

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INTERNATIONAL FINANCE
VI SEM BBA
SUSHMITHA V, ASST PROFESSOR, MES INSTITUTE OF MANAGEMENT
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Transaction exposure
Economic exposure
1.Contract specific.
1.General in nature; relates to entire
investment.
2.Cash flow losses due to change in exchange
rate.
2.Opportunity losses.
3.It is objective because it depends on
outstanding obligation which existed before
changes in exchange rates but were settled
after the changes in exchange rates.
3.It is subjective because it depends on
estimate future cash flows for an arbitrary time
horizon.
4.Easy to compute the cash flow loss.
4.Difficult to compute the opportunity loss.
5.Simple accounting technique can be used to
compute the losses.
5.A good variance accounting is needed to
isolate the effect of exchange rate change on
sales volume, costs and profit margins.
6.Firms normally have some policies to cope
with transaction exposure.
6.No such policies.
7.Avoidance requires third party cooperation.
7.Avoidance requires good strategic planning.
8.The duration of exposure is same as contract.
8.The duration is the time required for the
restructuring of operation through such means
as changing products, sources etc.,
9.Only source of uncertainty is the future
exchange rate.
9.Many sources of uncertainty like future
exchange rate and its effect on sales, price and
costs.

Hedging:
Meaning:
Hedging is covering the loss. It ultimately involves no gains no loss. It involves the making of two
equal and opposite transactions by the hedger and if the price moves either, way the hedger losses on
one transaction and gains on the other.
Needs of Hedging:
A. The changes in the exchange rate do cause both gain and loss to firm’s involved in foreign
transaction but the gains and losses tend to average out over a period.
B. The shareholders are competent enough to minimize the currency risk through diversification
of their investment portfolio.
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C. Hedging does not add to the value of the firm but uses scares resources and might lower the
value of the firm.
D. When the market is in equilibrium in respect of parity condition the expected net present value
of hedging is zero.
Hedging of transaction exposure:
The technique of hedging transaction exposure is categorized as internal techniques and external
techniques.
i. Internal techniques:
This form a part of the firm’s regulatory financial management and do not involve any
contractual relationship with any party outside the firm.
ii. External techniques:
This involves contractual relationship with any part outside the firm for insuring against
potential foreign exchange loss.
The techniques of Hedging are:
A. Contractual hedges-
• Forward market hedge
• Hedging through currency futures
• Hedging through currency options
• Money market hedge
B. Natural hedges-
• Lead and lags
• Cross hedging
• Currency diversification
• Risk sharing
• Pricing of transactions
• Parallel loans
• Currency swaps
• Matching of cash flows.

A. Contractual hedges:
a) Forward market hedge:
Here the exporter sells forward and the importer buys forward, and the foreign currency
in which the trade is invoiced.
b) Future contract:
In process of hedging at currency market option the importer buys a call option or sells
a put option or performs both functions at the same time.
c) Currency option:
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The exporter buys a put option and sells a call option or performs both the functions
consecutively.
d) Money market hedge:
This hedge involves a money market position to cover a future payables or receivables
position. This may be covered or uncovered. If the firm has enough of cash out of
business operations to buy the foreign currency or to repay the foreign currency loan is
called as a covered hedge. If it purchases foreign currency with borrowed funds or
repays the foreign currency loan by purchasing foreign currency in the spot market, it
is known as an uncovered money market hedge.
B. Natural hedges:
It is applied when the contractual hedge fails to produce good results. Contractual hedge
provides only temporary protection. Currency to which the firm is exposed cannot be hedged
in view of the absence of a forward market or of a market for derivatives. So, when a perfect
contractual hedge is not available, the firm adopts the natural hedge. The different techniques
adopted in case of natural hedges are:
a) Lead and lags:
Leads means accelerating or advancing the timing of receipts or of payment of foreign
currency. Log is just the reverse and means decelerating or postponing the timing of
independent firms. They may also be found in intra-firm transactions.
b) Cross-hedging:
It is adopted when the desired currency cannot be hedged.
c) Currency diversification:
The smaller the number of currencies in which a firm transacts, the greater will be the
magnitude of risk and vice-versa. The risk will be much lower if volatility of different
currencies in which a firm transacts is negatively correlated to a high degree to lower
the size of exposure, a firm is advised to diversify its operations in a large number of
currencies as a hedging tool.
d) Risk sharing:
It is a contractual arrangement through which the buyer and the seller agree to share the
exposure. Both the parties agree if their business relationship is a long term one. Under
this arrangement, a base rate is fixed with mutual consent i.e., the current spot rate. A
neutral zone is also agreed upon which a few points minus and plus the base rate. When
the exchange rate changes within the neutral zone, the transactions take place at the
base rate, but if the exchange rate crosses the neutral zone, the risk is shared equally by
two parties.
e) Pricing of transactions:
In exposure management, the pricing policy adopted is of two kinds, namely price
variation, and the currency invoicing. Price variation involves marking up or making
down of sale price of counter the adverse effect of exchange rate changes. The normal
rate is to charge the price of foreign currency on the basis of forward rate and not the
spot rate.
f) Parallel loans:
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It is often known as a back-to-back loan or credit swap loan. Under this agreement, the
amount of loan moves within the country but it serves the purpose of a cross-border
loan. At the same time, such loans are not exposed to the changes in the exchange rate
because the funds do not move across the national border.
g) Currency swaps:
Here two borrowers exchange the currency of borrowings with each other through a
swap dealer.
h) Matching of cash flow:
Here the firm matches its foreign currency inflow within the outflow in that currency
not only in of respect of size but also in respect of timing. But for this purpose, the firm
must have both inflows and outflows in the same currency.
Techniques of hedging operating exposure are:
I. Financial Strategy:
It includes contractual and natural hedges used for long-term transaction exposure.
However, they are of little use because the effects of currency changes on the expected cash
flows are difficult to predict. The financial strategy includes:
a. Long term transaction exposure hedging tools like currency swaps, parallel loans,
etc.,
b. Matching of liabilities with assets.
II. Marketing Strategy:
The strategy influenced by the geography of the market, dominance of the firm in the
international market and the elasticity of demand. The marketing strategy include:
a. Modification of market selection:
It considers the issue of market segmentation. A firm that sells differentiated
products to more affluent customers may not be harmed much by foreign currency
devaluation.
b. Product planning:
Firm can innovate or introduce a new product or bring modification in the feature
of the existing product which fills the gap if there is appreciation of the home
currency.
c. Pricing policy:
It includes raising or lowering of prices of the product following the exchange rates.
Pricing policy depends on elasticity of demand, economies of scale, cost structure
of the firm. Appreciation in dollar will shrink the profit if the prices is increased,
depreciation will increase the profit.
III. Production Strategy:
The production strategy focuses primarily on the product resources, inside mixing and plant
location. :
a. Product sources:
If the currency of the country supplying inputs appreciations, the input-buying firm has
to find some other sources of supply that may be cheaper. Strategy is to have multiple
sources of input which avoid the risk of exchange fluctuations.
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b. Input mixing:
If a firm unable to buy cheaper inputs from any source, it can arrest rise in the cost of
production through mixing local inputs by conducting R&D which may cost cheaper.
c. Plant location:
Firm can locate its plant in a country whose currency has depreciated provided the
inputs are available there.

Derivatives:
A derivative is a financial product whose value is derived from the value of another underlying asset,
such as a stock, bonds, commodities, currencies, interest rates and market are hedgers, speculators and
arbitragers.
In a simple term derivative can be explained:
• A derivative is a financial instrument.
• Whose value changes in response to the change of price of the underlying financial instrument
like interest rate, exchange rate, security price, commodity price, etc.,
• This requires no initial investment or very lesser initial investments.
• It is settled in future date.
Examples: Forward, Futures, Swaps and Option contract, Stock index futures.

Advantages of Derivatives:
1. It is a powerful for risk control.
2. Most of the insurance companies uses derivatives by means of providing to hedge against
advertises of unfavorable market movement in return for premium.
3. For pooling of assets most of the insurance companies use interest rate swaps and options.
4. It can be used by investors to create investments that do not exist in market place to achieve a
particular investment goal.
Disadvantages of Derivatives:
1. Monitoring and controlling it becomes a difficult task.
2. It is not as per the Accounting and Tax rules.
Instruments of Derivatives:
The most popular Derivatives instrument are Forwards, Futures, Options and Swaps.
1. Forwards:
A forward contract is a customized contract between two bodies where the settlement takes
place on a specific date in future at today’s pre-agreed price.
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FOREIGN EXCHANGE RISK - INTERNATIONAL FINANCE

FOREIGN EXCHANGE RISK - INTERNATIONAL FINANCE

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