FOREIGN EXCHANGE RISK

Foreign Exchange rate risk is defined as the variance of the real domestic currency value of assets, liabilities or
operating income attributed to anticipated changes in exchange rates. The extent of variability or sensitivity of
the operational variables to changes in a risk factor is referred to as Exposure. As the risk factor changes the
operational variables of a firm such as assets, liabilities, cash flows etc., are likely to vary and the variability
attributable to the risk factor is known as risk. Thus exposure to a risk factor leads to risk. Exchange rate
fluctuation is a macroeconomic risk factor. The exchange rates of for feign currencies keep on changing in the
short-term as well as in the long term, which have an impact on the domestic currency values of assets, liabilities
and cash flows of firms. This vulnerability likely to be caused in the domestic currency values of firm’s
assets, liabilities and cash flows due to the changes in the exchange rate of foreign
currencies is known as foreign exchange exposure.

Management of foreign exchange risk involves three important functions:

•Assessing the extent of variability and identifying whether it is likely
to be favorable or adverse
•Deciding whether to hedge or not to hedge all or part of the exposure

• Choosing an optimal hedging technique to suit the situation.

Types of Foreign Exchange Exposure

Foreign exchange exposure can be classified into three:

• Economic Exposure
• Transaction Exposure
• And Translation Exposure

Economic Exposure can be defined as the extent to which the value of the firm would be
affected by unanticipated changes in the exchange rates. Changes in the exchange rate
can have profound effect on the firm’s competitive position in the world market and thus
on its cash flows and market value. If a company’s operating cash flows are sensitive to
exchange rate changes, the company is again exposed to Currency Risk. Exposure to
currency risk can be properly measured by the sensitivities of the
•Future home currency values of the firm’s assets and liabilities.

• Firm’s operating cash flows to random changes in the exchange rate.

As the economy becomes increasingly globalized, more firms are subject to international
competition. Fluctuating exchange rates can seriously alter the relative
competitive positions of such firms in domestic and foreign markets, affecting
their operating cash flows. Formally Operating Exposure can be defined as the ex
tent to which the firm’s operating cash flows (operating revenues and cost streams)
would be affected by random changes in the exchange rates. Unlike the exposure of
assets and liabilities (such as accounts payable and receivable, loans denominated in
foreign currencies etc.) that are listed in the accounting statement
s, the exposure of operating cash flows depends on the effect of random exchange
rate changes on the firm’s competitive position, which is not readily measurable.
A firm’s operating exposure is determined by:
• the structure of the markets in which the firm sources its inputs, such
as labor and materials and sells its products.
• The firm’s ability to mitigate the effect of exchange rates changes by adjusting its markets, product mix and
sourcing.
A firm can use the following strategies for managing operating exposure:
1. Selecting low cost production sites
2. Flexible sourcing policies
3. Diversification of the market
4. Product differentiation and R& D efforts
5. Financial hedging procedure like Exchange forecasting, Assessing Strategic plan impact, Deciding Hedging
alternatives, Selecting Hedging Instruments and constructing a hedging program.

Transaction Exposure

A firm is subject to transaction exposure when it faces Contractual Cash Flows that are fixed in foreign
currencies. Suppose that a U.S. firm sold its product to a German client on three month credit terms and invoiced
DM 1 Million. When the firm receives DM 1 Million in there months, it have to convert (unless it hedges) the
Marks into Dollars at the spot Exchange rate prevailing on the maturity date, which cannot ne known in advance.
As a result the Dollar receipt from this foreign sale becomes uncertain; should the Mark appreciate or depreciate
against the Dollar, the Dollar receipt will be higher or lower. This situation implies that if the firm does nothing
about the exposure, it is effectively speculating on the future course of the exchange rate.

Transaction exposure can be hedged by financial contracts like forward, money market hedge, options
contract, as well as such operational techniques like Currency Diversification, Risk Sharing, Invoicing, leading/
lagging strategy and exposure netting (Netting and Offsetting).
A multinational company may have several cross-border transactions in different countries. Consolidation of all
the expected cash inflows and out flows in a particular currency for a specified future time period will reveal the
net transaction exposure in that currency. Such a multinational company that decides to hedge its transaction
exposure may choose any one of the following techniques to reduce the risk.

• Forward Hedge: Which is a customized bilateral contract where the terms of the contract are determined on
the basis of negotiation between the contracting parties; which enables a firm to ‘lock in’ an exchange rate for its
future transaction of buying or selling a foreign currency, and thereby eliminating uncertainty regarding future
cash flow values.
• Future Hedge: Which is a Standardized Contract bought and sold in a futures exchange with the terms such
as quantity, mark to market margin and delivery date being specified by the exchange; which again enables a
firm to ‘lock i n’ an exchange rate for its future transaction of buying or selling a foreign currency, and thereby
eliminating uncertainty regarding future cash flow values.
• Money market Hedge: involves taking a money market position to cover a future payables or receivables
position. If a firm has payables in foreign currencies, it can hedge this position by borrowing domestic currency,
converting it into currency of the payables and then investing the foreign currency (E.g., Creating a short term
deposit in foreign currency) for a period matching the maturity period of the payables. This investment for the
period together with the interest earned will provide the foreign currency for liquidating the payable. In the
money market hedge, the cost of hedging is in the form of interest, while in the forward hedging the forward rate
differential represents the cost of hedging.
• Currency Option Hedge: For a firm having foreign currency receivables, depreciation of the foreign currency
is an unfavorable movement resulting in a loss, while appreciation of the foreign currency is a favorable
exchange rate movement that brings a gain. On the other hand, for a firm having foreign
currency payables, depreciation of the foreign currency is a favorable movement resulting
in gain, while appreciation of the foreign currency is an Unfavorable exchange rate
movement that brings loss. In such cases, a currency option hedge insulates a firm from
unfavorable exchange rate movements and allows the firm to benefit from favorable
movements in exchange rate. Currency option involves purchasing a currency option by
paying a specific price known as Option Premium. There are two types of options here;

Call Option and Put Option.

A Currency Call Option gives the holder of the option the right to buy the currency at a
specified rate known as exercise price within a specified period. But
he is not obliged to buy at the exercise price if such exercise price turns out
to be unfavorable to him. A foreign currency payable can be hedged by purchasing
call options in foreign currency concerned. Such a call option will give the firm the right
to buy the required foreign currency at a specified date at the exercise price. If the foreign
currency appreciates and moves above the exercise price, the firm can exercise the option
to buy the foreign currency at the exercise price. In an appreciating market the call option
provides protection. If the foreign currency depreciates to a level below the exercise
price, it would be advantageous to buy the foreign currency from the spot market where
the spot rate is below the exercise price. In such a case the option to buy the currency at
the exercise price need not be exercised. Thus the currency call option provides
protection in case of unfavorable movements in the exchange rate and the opportunity to
gain in case of favorable movement.

Where as, a Currency Put Option gives the holder of the option the right to sell the currency at a specified rate
known as exercise price within a specified period. When the foreign currency is received, the firm holds the put
opt ion can exercise the put option to sell the currency at the exercise price if the market price is below the
exercise price on account of foreign currency depreciation. The possibility of incurring a loss on account of
foreign currency depreciation can be thus be hedged. On the contrary, if there is any appreciation in the foreign
currency value and the market exchange rate moves above the exercise price, the firm can let the option expire
unexercised and sell the foreign currency in the spot market to realize higher domestic currency value. Thus loss
can be avoided in case of an unfavorable movement in the exchange rate and profit c an be achieved in case of
favorable exchange rate movement.

• Cross Hedging: may be adopted in such a situation where a particular foreign currency which is not
frequently traded has not any facility to hedge with. Thus it involves hedging in another foreign currency which
is positively correlated to the desired foreign currency. However the effectiveness of cross hedging strategy
depends on the closeness of the correlation between the two foreign currencies.
• Internal Hedging like: leading/ lagging strategy, Netting and Offsetting, Currency Diversification, Invoicing,
Risk Sharing Etc.,

A. Leading and Lagging:

Leading involves advancing the timing of a foreign currency payable or receivable in order to avoid the adverse
impact of the expected movements in exchange rates, especially when there is an expected unfavorable
movement in the exchange rate. For a firm having foreign currency payable denominated in US $, appreciation
of the US $ would be an unfavorable movement. In such a case it would be advantageous to the firm to advance
the timing of the payment or settle the payment immediately, foregoing the usual period of credit and there by
availing the discount for cash payment. Similarly a firm having foreign currency receivable denominated in US
$, depreciation of the US $ would be an unfavorable movement. Here, the firm would like to realize the
receivable earlier in order to avoid adverse impact of currency depreciation.

Lagging, on the other hand involves postponement of timing of foreign currency payable
or receivable in order to take advantage of favorable movements in the ex change rate. For a firm having foreign
currency receivable, appreciation of the foreign currency is a favorable movement which is likely to yield more
home currency value for the receivable. In such a case the firm would like to postpone t he realization of the
receivable in order to take advantage of the favorable situation. It may offer extended credit period to the foreign
firm. Similarly a fir m having foreign currency payable, depreciation of the foreign currency has a favorable
impact. In order to take advantage of the situation the firm would like to postpone the payment as much as
possible. It may seek an extended credit period from the foreign firm.

Currency Diversification: The movements of exchange rates of different currencies against each other show
diverse patterns in terms of direction and volatility. A firm which deals exclusively in one or two currencies
would find its cash flow values fluctuating in tune with the volatility of those currency exchange rate s. While
some currencies appreciate, there may be other currencies which are depreciating. Here, the firm which has
dealings in diverse currencies would find movement in different currencies offsetting each other.

Risk Sharing: is an internal arrangement between two contracting parties; the ex porter and importer whereby
the loss arising from exchange rate fluctuations is shared by both the parties as per an agreed formula. This is
embedded by a risk sharing formula in the trade contract itself. This risk sharing comes into effect only when the
exchange rate moves beyond a predetermined exchange rate band. I f the spot exchange rate at the time of
settlement is outside the predetermined band, the loss is shared between the parties either equally or in some
agreed proportion.

Invoicing: Trade between the developed countries and developing countries or lesser developed countries tends
to be invoiced always in the currency of the developed countries. Transaction exposure arises because of
invoicing it in a foreign currency. A firm would be able to shift this transaction exposure to the other
party by invoicing its transactions (both import and export) in its home currency itself. Thus the strategy of
invoicing involves invoicing foreign currency transactions in the home currency to eliminate fluctuations in the
home currency values of receivables or payables. Even though this policy is useful in eliminating transaction
exposure it may adversely affect the competitive position of the firm. Suppose an Indian firm is exporting goods
to U.S. market which is invoicing its export in INR to avoid transaction exposure. In the U.S. market the price o
f the product would be quoted in the U.S $ based on the exchange rate. When the U.S .Dollar depreciates against
the Indian Rupee, the $ price of the product would rise in the U.S. market. Higher price of the product may thus
render it less competitive.
The operating exposure of a firm is influenced by a variety of factors such as the geographical coverage of
markets, demand elasticity of the product in different markets, input prices, currency composition of operating
costs etc., . Assessment and evaluation of operating risk is intrinsically a difficult task and simultaneous changes
in several variables may further complicate the task. Thus management of operating risk may require adoption of
several measures relating to production, marketing and finance functions of a multinational business with a view
to stabilize its future revenue and cost streams.
Translation Exposure
Transaction exposure exists because multi national companies have to translate the
financial data of their subsidiaries into the home currency for preparing consolidated
financial statements. This exposure does not affect the cash flows but it affects the value
of the assets and liabilities, and incomes and expenditures (including the accounting
profit) in the financial statements. An adverse impact on the reported earnings can affect
the market value and goodwill of the firm
. The four recognized methods for consolidating the financial reports of an MNC include
the current or non-current method, the monetary or non- monetary method, the temporal
method, and the current rate method. As per FASB 52 (Financial Accounting Standard Board), the functional
currency of the foreign entity must be translated into the reporting currency in which the consolidated statements
are reported. Two ways to control translation risk are: Balance Sheet Hedge and Derivatives Hedge.