Foreign currency exposure

and
risk management

www.StudsPlanet.com

That part of companys volume of business which may

what
exposure
means
get affected by movements in exchange rates

May / may not be favourable

Unpredictable - One can only forecast a strong
probability..
How fast the exchange rate moves.

www.StudsPlanet.com

what exposure means

ERR is inherent in the business of all multinational

enterprises as they are to make or receive payments in

foreign currencies

Hence foreign exchange risk has become an integral

part of the management activities of any MNC

www.StudsPlanet.com

Types of exposures.

Accounting Exposures

Transaction Exposure
Translation Exposure

Operating / Economic Exposure

www.StudsPlanet.com

Transaction exposure

www.StudsPlanet.com

Different types of transactions

Transactions that can have an impact on currency
movements
Trade related
Export bills receivables / Import Bills Payable
Advance payments exports
Loan repayments
Repatriation of investments
www.StudsPlanet.com

Different types of transactions

Transactions that can have an impact on currency
movements
Interest payments / receivables
Inward remittances
Whether these transactions will be concluded before
the next balance sheet
www.StudsPlanet.com

Transaction Exposure

How it generated
When it is generated and how it ends
Conceived at the time of quoting a price in foreign
currency
Given birth when the quotation is accepted
Anniversaries on due dates and if not met on due
dates crystallizes into an exposure
Final stage extinguished when FC bought / sold
www.StudsPlanet.com

Transaction Exposure Risk

Risk in adverse movement of exchange rates from

the time the transaction is budgeted till the time of
exposure is extinguished by sale / purchase of a
foreign currency against domestic currency.

www.StudsPlanet.com

Impact of Transaction Exposure..

It will be of short term in nature

Will have an impact on cash flow of a company

www.StudsPlanet.com

Impact of Transaction Exposure..

It will be of short term in nature

Will have an impact on cash flow of a company

www.StudsPlanet.com

Hedging Transaction Exposure

Since exposure arises due to unanticipated movement of

exchange rate , entering into a financial counter-transaction
at a future point in time is known as hedging

www.StudsPlanet.com

Basic Objectives of Formulating Hedging

Strategy
Hedging is an attempt to reduce the losses due to
unexpected or unanticipated changes in exchange rate
But hedging has associated costs; therefore costs are to be
weighed against returns and the fulfillment of objective of
maximisation of value of the firm
Firms by nature are risk takers therefore the hedging
strategy is not to eliminate total risk but to maximise the
value of the firm
www.StudsPlanet.com

Hedging Transaction Exposure

The amount receivable ( exports) is technically referred
as long position
The amount payable ( imports) is technically referred
as short position
The MNCs will have both types of positions

www.StudsPlanet.com

Hedging Transaction Exposure

The basic rule of hedging is:
The payables (short position) in a currency in the future is
to be hedged with buying (long position) in the same
currency in the forward; and receivables (long position) in
a currency in the future is to be hedged with selling (short
position) the same currency in the forward
www.StudsPlanet.com

Instruments of Hedging
1. Forward contract
2. Money market hedge
3. Future contract
4. Option contract
5. Currency invoicing
6. Exposure netting
7. Currency Risk Sharing

www.StudsPlanet.com

Forward Contract
A forward contract is an agreement made today between a
buyer and a seller to exchange the commodity or instrument
for cash at a predetermined future date at a price agreed
upon today
In a forward contract, two parties agree to do a trade at some
future date, at a stated price and quantity
No money changes hands at the time the deal is signed
www.StudsPlanet.com

Forward Contract
Forward contracts are not traded on an exchange, they are
said to trade over the counter (OTC)
The secondary market do not exist for the forward
contracts and faces the problem of liquidity and
negotiability
Forward contracts face counter party risk
The longer the time period, larger is the counterparty risk
www.StudsPlanet.com

Hedging with Forward contract

Suppose an importer has imported a machine worth $ 1,00,000

The machine is expected to arrive in a month when the amount
is payable
The current exchange rate is $1= Rs. 46.75
He expects to move the rate to $1= Rs. 47.75
He checks the forward market and finds that one month
forward rate is $1= Rs. 47.50
The importer buys $1,00,000 as the dollar was cheaper in the
forward market as compared to his own perception

www.StudsPlanet.com

Money Market Hedge

Money market hedge involves mixing of foreign
exchange and money markets to hedge at the
minimum cost

It involves taking advantage of disequilibrium between

the two markets

www.StudsPlanet.com

Money Market Hedge

One possibility:

The importer buys that amount of dollars in the spot market which

when deposited in the US at US interest grows to $1,00,000 in one

month

Second possibility:

The importer buys $1,00,000 in the forward market and to make the
payment in Indian rupees, deposits that much amount in the bank
deposit to grow to honour the contract
www.StudsPlanet.com

Futures Contract
A futures contract is a financial security, issued by an
organised exchange to buy or sell a commodity, security or
currency at a predetermined future date at a price agreed
upon today
Futures are exchange traded contracts to sell or buy
financial instruments or physical commodities for future
delivery at an agreed price
www.StudsPlanet.com

Futures Contract
The contract expires on a pre-specified date which is called
the expiry date of the contract
On expiry, futures can be settled by delivery of the
underlying asset or cash
The futures contract relates to a given quantity of the
underlying asset and only whole contracts can be traded
www.StudsPlanet.com

Currency Futures
Currency Futures means a standardised foreign exchange
derivative contract traded on a recognized stock exchange
to buy or sell one currency against another on a specified
future date, at a price specified on the date of contract
Currency future contracts allow investors to hedge against
foreign exchange risk
Reserve Bank of India Act, 1934 permitted currency futures
trading with effect from August 6, 2008.
www.StudsPlanet.com

Forwards Vs. Futures

Two parties negotiate a forward transaction
Party A

Party B

Futures is structured as two transactions

Party A

Clearing
House

www.StudsPlanet.com

Party B

Difference between Forward Hedge and a

Future Hedge
Forward Market Hedge

Future Hedge

Contracts executed by banks

Contracts executed by
brokerage houses of future
exchanges

Tailor-made contracts

Standardised contracts

Price quoted reflects bankers Price paid is determined by

perception of future price
forces of demand and supply
Contract bilateral between two Contract with the future
parties
exchange
www.StudsPlanet.com

Options
An option is a contractual agreement that gives the option
buyer the right, but not the obligation, to purchase (call
option) or to sell (put option) a specified instrument at a
specified price at any time of the option buyers choosing by
or before a fixed date in the future

The buyer / holder of the option purchases the right from

the seller/writer for a consideration which is called the
premium
www.StudsPlanet.com

Options
Seller (writer)

Purchaser (holder)

Premium

Striking or exercise price

www.StudsPlanet.com

Options
European

Option: The holder of the option can

only exercise his right ( if he so desire)
on the expiration date

American Option : The holder can exercise his right any

time between purchase date and
expiration date
www.StudsPlanet.com

Options
Call Option :
A call option gives the buyer the right to buy a fixed number
of shares/commodities at the exercise price upto the date of
expiration of the contract

Put Option:
A put option gives the buyer the right to sell a fixed number of
shares/commodities at the exercise price upto the date of
expiration of the contract
www.StudsPlanet.com

Options Example
Current price of oil is $65 per barrel.
An airlines company feels oil prices might rise 6 months later &
wishes to hold an option to buy oil 6 months hence at, at most $67.
An oil refinery feels prices will fall 6 months later & wishes to hold
an option to sell oil 6 months hence at, at least $67.
Both companies approach the exchange and place their orders.
Exchange has options which fulfill the requests at $67 per barrel.
1.
2.
3.
4.
5.
6.

What is the expiration period ?

Is Airline Company a holder or writer ?
Is Oil Refinery a holder or writer ?
What option type does Airline Company hold ?
What option type does Oil Refinery hold ?
What are the Strike Prices ?
www.StudsPlanet.com

Features of Options
The option is exercisable only by the owner, namely

the

buyer of the option

The owner has limited liability
Options have high degree of risk to the option writers
Options involve buying counter positions by the option
sellers
Options are popular because they allow the buyer profits
from favourable movements in exchange rate
www.StudsPlanet.com

Call Option - Example

Call option grants the owner the right to purchase a specified
financial instrument for a specified strike price over a
specified period of time
I buy a call today for $0.33 for 15 barrels oil, strike price $50,
exercise date June 1 2010 Todays oil price is $49 per barrel.
Tomorrow If the oil price is $52 my intrinsic value = $2,
option premium = $0.45 (say)
MTM (mark-to-market) = $(0.45 - 0.33)*15 = $0.12*15 =
$1.80
www.StudsPlanet.com

Call Option - Example

If the oil price is $60 on June 1 2010 (the spot price) then
I would exercise my option (i.e. buy the oil from the
counter-party).
I could then sell oil in the open market for $60, i.e. the
payoff would be worth $10; my profit would be $10 minus
the premium I paid for the option $0.33 = $9.67.
Net gain = $9.67*15 = $145.05
www.StudsPlanet.com

Call Option - Example

If however the spot price is $40 then I would not exercise
the option. I would buy the stocks in the open market for
$40, why waste $50 on it? The option would expire
worthless

Thus, in any future state of the world, I am certain not to

lose money on the underlying by owning the option; my
loss is limited to the premium I have paid.
www.StudsPlanet.com

Put Option - Example

Put option grants the owner the right to sell a specified financial

instrument for a specified strike price over a specified period of time.

I buy a put option today at $ 0.5 to sell 10 coal per metric tons on
June 1, 2010, at $50 per metric ton. Today coal price is $48 per
metric tons.

Tomorrow If the share price is $49 my intrinsic value = $1, option

premium = $0.6 (say)

MTM (mark-to-market) = $(0.6 - 0.5)*10 = $0.1*10 = $1

www.StudsPlanet.com

Put Option - Example

On June 1, 2010 the coal price is $40 (spot price) I would
exercise my option (i.e. sell the share to the counter-party)

I could then buy coal in the open market for $40, i.e. the
payoff would be $10; my profit would be $10 minus the
premium of $ 4.5 I paid for the option = $0.5.

Net gain = $0.5*10 = $5

www.StudsPlanet.com

Put Option - Example

If, however, the spot price is more than the strike price, say, $60,

then I would not exercise the option. I would sell such a share in the
open market for $60, and earn more than I would by selling through
the option.

My option would be worthless and I would have lost the premium for
the option.

Thus, in any future state of the world, I am certain not to lose money
by owning the option; my loss is limited to the premium I have paid.

www.StudsPlanet.com

Option Benefits
Holder (Buyer who has
gone Long)

Writer (Seller who has

gone Short)

Call

Right to Buy
No Obligation
Premium Pay

No Right
Obligation to Sell
Premium Receive

Put

Right to Sell
No Obligation
Premium Pay

No Right
Obligation to Buy
Premium Receive

www.StudsPlanet.com

Hedging with Options

In the case of hedging with options, if the price surpass the
expectations, only then the option is exercised and the
hedge comes into operation

This kind of hedging is usually resorted when there is a

possibility of non-performance of contract

The cost involved in purchasing an option is called

premium

www.StudsPlanet.com

Hedge through Currency Invoicing

If during the negotiation of an import contract, an importer of
a country having weak currency may get goods invoiced in
domestic currency and the exporter from this country should
invoice goods in strong currency

The risk shifts from one party to the other

www.StudsPlanet.com

Exposure Netting
Netting means the net of payables and receivables
The exposure, if netted, is reduced so also the cost of
hedge

www.StudsPlanet.com

Currency Risk Sharing

It is the practice of introducing a clause in the

transaction contract

The parties would declare a neutral zone within which

the risk is not shared

www.StudsPlanet.com

MNCs and Transaction Exposure

Management

The companies dealing in multicurrency environment

or multicurrency cash flows need to prepare cash
budgets to know the exact extent of transaction
exposure

The net transaction exposure is arrived at on quarterly

basis
www.StudsPlanet.com

Foreign currency inflow-outflow cash budget

Q-1

Q-2

Q-3

Q-4

Total

RECEIPTS

American Dollars ($)

300

280

320

400

1300

British Pound(BP)

20

25

18

40

103

Canadian Dollars(C$)

40

25

45

45

155
0

DISBURSEMENTS

American Dollars ($)

200

160

240

300

900

British Pound(BP)

40

15

20

40

115

Canadian Dollars(C$)

20

40

75

20

155

Japanese Yen (JPY)

10

30

20

20

80
0

NET EXPOSURE

American Dollars ($)

100

120

80

100

400

British Pound(BP)

-20

10

-2

-12

Canadian Dollars(C$)

20

-15

-30

25

-10

-30

-20

-20

-80

Japanese Yen (JPY)

www.StudsPlanet.com

MNCs and Transaction Exposure

Management
The net positive transaction exposure (+ ve flows) indicates

strengthening of domestic currency against foreign currency

($) will cause loss to the firm and depreciation makes it
profitable

The net negative transaction exposure (- ve flows) indicates

strengthening of domestic currency against foreign currency

($) will give profit to the firm and weakening of domestic
currency would cause the loss

www.StudsPlanet.com

Hedging Transaction Exposure of MNCs

MNCs by nature are risk takers and they take risk when
adequate compensation is present in the venture
In a multicurrency environment, it is not necessary that
foreign exchange risk to be zero for international business
to become attractive for the firm
Strategies to decrease transaction exposure:

International Diversification
Hedging
www.StudsPlanet.com

Thank You
Best of Luck.

www.StudsPlanet.com