Chapter III: Steps towards foreign exchange risk management

A. Exposure Measurement

 Identifying Exposures:
With the rapid growth of the global investment environment, more and more businesses
are taking an enlightened view of their role in the market and the organizations have
started to look beyond the domestic markets, making foreign exchange risk management
an important role of the treasury department. When the foreign currencies exposure is
ineffectively managed, it can significantly impact profit margins, and the companies are
exposed to variations in the reported cash flows.

Usually, there are two types of firms dealing with multi-currency portfolio, firms using
foreign currency market for investments to make profits and firms that use the same for
hedging to protect their capital, and dealing with the multi-currency portfolio requires an
understanding of the economic exposure and the foreign currency exposure. The
economic exposure risk reflects the change in the present value of the company’s future
cash flows due to some unanticipated revision in the currency rates. Simply put, it is the
measure of how the cash flows of firm are altered by a unit unexpected change in the
exchange rate at time t, and is measured using the formula mentioned below:

Total unexpected change in Firm value in Foriegn Currency(Vt )

Economic Exposure(E t ) = Unexpected change in the Spot value(St )

To understand the nature of the underlying economic exposure, a more insightful

approach is required which must consider the expected and the unexpected changes in the
future cash flows and the discounting rates. A specific type of probability distribution lies
behind these expected future cash flows which explain the risk factors.
The relative magnitude of risk can be defined by dispersion or the amount of spread, in
that distribution, like variance or the standard deviation. If a certain kind of risk is not
adequately described by variance, then we can use some other measures like skewness or
kurtosis to quantify the risk. Parametric as well as Gaussian distribution approaches
should also be considered to identify the risks associated with the currency portfolio. The
former approach requires certain parameters, i.e. pre-defined set of assumptions, for
example, normalized average returns, standard deviation, and correlation between the
identified risk factors. In addition, one must carefully look into the correlation among
currencies and the inherent volatility underlying currencies, combining them with the
associated economic exposure.

 Measuring Maximum Exposure:

The economic exposure is often hedged as residual risk. It sometimes becomes difficult
to measure this exposure as it depends on the political and economic conditions
prevailing, which at times becomes unpredictable. By managing the economic exposure,
the shape of future’s transaction and translation exposure can be altered and even much
reduced. We have various methods to measure economic exposure; capital market model
is an extensively used model to measure the exposure. Cash flow is another method used
 to quantify the exposure. The detailed discussion on the cash flow method is given
below:

Cash flow model:

Although, the capital market approach is extensively used to measure the exchange
exposure, but it has been observed that by using this method, the past found levels of
exchange rate exposure were low for most of the firms, even when the firms under study
had fairly large foreign operations. Therefore, to avoid such paradox, we use the cash
flow method to measure the exchange rate exposure. The cash flow model uses a basic
model to measure the firm’s exposure without using the stock return and the market
return data. The model given below was developed by Bodnar and Marston to measure
the economic exposure:

𝛿 = ℎ1 + (ℎ1 − ℎ2 )((1⁄𝑟) − 1)

In the above equation 𝛿 is the exposure elasticity and it is a function of three variables:
 ℎ1 : Foreign currency-dominated revenue as a percentage of the total revenue.
 ℎ2 : Foreign currency-dominated costs as a percentage of the total costs.
 𝑟: Profits as a percentage of total revenue.

The delta calculated using the above model can be positive as well as negative. The
following can be interpreted from the sign of the value of delta:
 The profits of the firm with a positive delta will increase with domestic currency
appreciation.
 The profits of the firm with a negative delta will decrease with domestic currency
depreciation.
The cash flow model is one of the effective models to measure the exchange rate
exposure, especially when the stock return data is not available.

Let us consider a small example to understand the interpretation of the cash flow model.
We choose a random sample of 30 companies, where ten firms are chosen each from
CNX Nifty, CNX midcap, CNX small cap index for the study. CNX Nifty is the
benchmark index of the National Stock Exchange (NSE), CNX midcap index constitutes
the mid cap firms and CNX small cap index constitutes small cap companies.
The exchange rate exposure can be calculated with the help of the capital market
approach but it can be misleading since not all the firms with a significant part of their
income or expenses in foreign currency are statistically exposed. Therefore, we have
sufficient argument to use the cash flow model for the measurement of the exchange rate
exposure. The table below shows the results for the exchange rate exposures calculated
using the cash flow model for the sample taken for the study. The exchange rate
exposures predict the variability of the profits to the exchange rate movements. For
example, the studies show that the petroleum companies are highly sensitive to exchange
rate fluctuations and have a higher value of delta.
CNX NIFTY EXPOSURE
A -0.70
B -0.60
 C -1.36
D -1.25
E -1.00
F -0.40
G 1.97
H -0.22
I 3.52
J 0.56

CNX MIDCAP EXPOSURE

ABB Ltd. -10.70
ABN Ltd. -5.60
ARB Ltd. -1.36
AHE Ltd. -2.25
AT Ltd. 3.68
BHG Ltd. 0.85
BE Ltd. -1.05
BA Ltd. 2.19
AP Ltd. 3.52
JP Ltd. 4.05

CNX SMALLCAP EXPOSURE

ABG Ltd. -6.70
ABO Ltd. -30.60
AR Ltd. -3.36
AO Ltd. -2.25
AI Ltd. 4.68
AR Ltd. 1.85
BER Ltd. -0.09
BEML Ltd. -0.01
APA Ltd. 0.12
JPF Ltd. 4.99

Studies show that the results obtained from the capital market approach are counter
intuitive and it makes the further analysis difficult and unreliable, therefore the cash flow
model which uses the foreign currency cash flows to measure the firm’s exchange rate
exposure is more useful and reliable. This model will be very efficient for the firm to
formulate strategies to manage the economic exposure and find the factors influencing
the exposure.

 Understanding Functional currency/Local currency

Functional currency is a term generally applied for multinational companies. It is the

currency of the primary economic environment in which the entity works. It is very
 necessary to establish the functional currency for the proper measurement of the overall
business performance and for the accurate representation of the financial state of the
company.
The primary environment in which the entity operates is generally the one in which it
generates and expends cash. The assets, liabilities, and operations of a foreign entity shall
be measured using functional currency of that entity. The local currency is the currency,
in which the foreign subsidiary executes its business transactions, which may or may not
be same as the functional currency.

The functional currency of an entity reflects the underlying transactions, events and
conditions that are relevant to it. Once, the functional currency of an entity is determined,
it is not changed unless there is a change in the underlying transactions, events and
conditions.

Following are the factors that an entity considers while determining its functional
currency:
 The currency of the country whose competitive forces and regulations mainly determines
the sale prices of its goods and services.
 The currency which influences the sale prices for goods and services, i.e. the currency in
which the sale prices of the goods and services are settled and denominated.
 The currency in which the funds from financial activities like debts and equity
instruments are generated.
 The currency in which the receipts from operating activities are generally retained.
 The currency that influences labour, material, and other costs for providing goods or
services.

There are certain additional economic factors that must be considered individually or collectively
while determining the functional currency of a foreign operation:
 Whether the cash flows from the activities of the foreign operation directly affect the cash
flows of the reporting entity and available for settlement to it.
 Whether the cash flows from the activities of the foreign operation are enough to service
the normally expected debt obligations without funds being made available by the
reporting entity.
 Whether the transactions with the reporting entity are a high or a low proportion of
foreign operations activities.
 Whether the foreign operation activities are carried out as an extension of the reporting
entity rather than being carried out independently.

There might be cases where the above-mentioned indicators are mixed making the facts more
varied and complex and the functional currency is not obvious, in that case the management’s
judgment is required and is crucial in determining the appropriate functional currency which
most suitably represents the economic effects of the underlying transactions, events and
conditions.

Let us consider the examples where the functional currency of a foreign operation might be same
as that of the parent currency.
a. A subsidiary US manufacturer or a foreign sales branch that primarily takes orders from
foreign customers for the US manufactured goods. It bills and collects from foreign
customers in US dollars and might have a warehouse to provide timely delivery of the
product to those foreign customers.
b. A foreign shipping subsidiary that primarily transports from a US Company’s foreign mines
to the US for processing in US Company’s smelting plant.

Other than cash flow, one of the other widely used methodology for measuring foreign exchange
risk is the Balance sheet/Accounting/Translation exposure which measures the effect of changes
in exchange rate in the financial statements of a company. We call the foreign-currency assets
and liabilities as exposed when they are translated at the current exchange rate. In accounting
terms, the difference between exposed assets and exposed liabilities is called the net exposure.
Foreign currency depreciation will result in exchange losses when exposed assets are greater
than exposed liabilities, while foreign currency appreciation will result in exchange gains.
Whereas if the exposed liabilities are greater than the exposed assets, foreign currency
depreciation will result in exchange gains while foreign currency appreciation will result in
exchange losses.

Since exchange rates change between different accounting periods, the translation of financial
statement items denominated in foreign currencies are likely to result in foreign exchange
gains/losses. The extent of such gains/losses depend majorly on the underlying governing
translation. The four most widely used translation methods by the companies include
current/non-current, monetary/non-monetary, temporal, and current rate.

1. Current/noncurrent method (to be completed by Shrishti)