International Finance Risk Management

INTERNATIONAL
FINANCE
F O R EIG N EXC H AN G E ( C U R R EN C Y )
R ISK MAN AG EM EN T
& ST R AT EG IES FOR MAN AGIN G
R EL AT ED EXPO SU R ES

Hisham Ahmed Rizvi
hisham.rzv@gmail.com
+91-9999171299

INTRODUCTION
• Risks faced by a firm
• What is financial risk?
• What is currency risk?
• Exposure & risk: Are they same?
• Measuring exposure
• Measuring risk
• Why should risk be managed?

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI |
HISHAM.RZV@GMAIL.COM

2

• Peculiar to a firm

Core Business
Risks

RISKS FACED BY A FIRM
Unsuccessful product
launch
Labour problems
Cyclical demand
fluctuations
Material supply problems
And so forth..

• All pervasive and affect
all firms in an industry
• Financial risks are a
subset of environmental
risks

Environmental
Risks

Exchange rate fluctuations
Interest rate fluctuations
Sudden price rise of goods
Shifts in government
policies
And so forth..

3

Credit risk

WHAT IS FINANCIAL
RISK?
RISK

A
situation
involving
exposure to danger.

SOURCE: Investopedia

Interest rate
risk

Currency risk

Market risk
Equity risk

SOURCE: Oxford Dictionary

Financial risk refers to the
chance
that
an
investment's
Financial Risk
actual return will be
FINANCIAL
different than expected. It
RISK
basically is exposure to the
danger of financial loss on
investments
made
by
investors.

Concentration
risk

Commodity
risk

Liquidity risk

Refinancing
risk

Legal risk

Model risk
Operational
risk
Political risk

Valuation risk


4

WHAT IS CURRENCY
RISK?
CURRENCY
RISK

It is a form of financial risk that arises from the change
in price of one currency against another. Whenever
investors or companies have assets or business
operations across national borders, they face currency
risk (or foreign exchange risk).

For example, if you are a U.S. investor and you have stocks in
Canada, the return that you will realize is affected by both the change
in the price of the stocks and the change in the value of the Canadian
dollar against the U.S. dollar. So, if you realize a 15% return in your
Canadian stocks but the Canadian dollar depreciates 15% against the
U.S. dollar, this will amount to no gain at all.

5

EXPOSURE & RISK: ARE
THEY SAME?*
*IN FINANCIAL CONTEXT
Each firm is “exposed” to unforeseen changes in a number of
variables in its environment. These variables are called Risk Factors.
E.g. Exchange rate fluctuation is a risk factor.
It is the measure of the sensitivity of a firm’s
performance to fluctuations in the relevant risk factor i.e.
EXPOSURE
whether or not a certain risk factor affects a firms
performance.
It is the measure of the extent of variability of the
RISK
performance attributable to the risk factor i.e. how much
does a risk factor affect a firms performance.
For example, between April 1992 and July 1995 the exchange rate
between rupee and US dollar was rock steady. For an Indian firm
involved in exports and imports from US, this meant that it had
significant exposure to this exchange rate (because the exchange
rate could have affected its performance) but it did not perceive
significant risk because the exchange rate was stable.

6

MEASURING EXPOSURE
Exposure of a firm to a risk factor is the sensitivity of the real value of
the firm’s assets, liabilities or operating income, expressed in its
functional currency, to unanticipated changes in the risk factor.
IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION:
• Functional currency: It is the primary currency of the firm in which
its financial statements are published. It is often the domestic currency
of their country.
• Real value: Values adjusted for inflation. (In practice though, it
becomes difficult to adjust all values with an uncertain inflation rate,
hence nominal values are only used)
• Unanticipated changes: Only unanticipated changes in the relevant
risk factor are to be considered because the market already makes
allowances for anticipated changes. For e.g. an exported invoicing a
foreign buyer in the buyer’s currency will build an allowance for the
expected depreciation of that currency. This is anticipated change.
INTERNATIONAL than expected, that becomes
However if the depreciation is more FINANCE PRESENTATION | HISHAM AHMED RIZVI |

7

MEASURING EXPOSURE
Q. How do we separate a given change in the risk factor into
anticipated and unanticipated components?
Ans. One possible way is by using forward rate.
FORWARD
RATE

A rate applicable to a financial transaction that will take
place in the future.

For example, suppose the price of a pound sterling in terms of rupees
right now (also called spot rate) is Rs 68.00 while the one month
forward rate is Rs 68.20. However one month later the spot rate turns
out to be Rs 68.30.
In this case, the anticipated depreciation is 20 paise per pound in one
month, while the unanticipated depreciation has been 10 paise per
pound.

8

MEASURING EXPOSURE:
AN EXAMPLE
A firm has a 90-day payable amounting to US $5,00,000 arising out of
raw material import transaction.
Current spot rate is Rs 40.60 per dollar. 3-month forward rate is Rs
40.80 per dollar. Actual rate 3 months later turns out to be Rs 41.00
per dollar.
• Therefore, the unanticipated depreciation of rupee is Rs 0.20 per
dollar.
• The loss on account of increase in rupee value of the payable is
(5,00,000*0.20) = Rs 1,00,000
According to the 3-month forward rate, the firm would have paid
(40.80*5,00,000) = Rs 2,04,00,000

But actually it will pay (41*5,00,000) = Rs 2,05,00,000

Rs 1,00,000 extra on account of unanticipated depreciation of rupee.

9

MEASURING EXPOSURE:
AN EXAMPLE
One straightforward way to define exposure is: “By how much will
the value of the payable change if the rupee-dollar rate changes
by 1 rupee per dollar?”
In this case, the value of the payable changes by 1,00,000 on a 20
paise change of rupee-dollar rate, therefore it will change by
5,00,000 for a rupee change.
Note here that the exposure is here is same as the value of the
foreign currency. (5,00,000)

A general rule is that if the foreign currency value of the exposed item is
fixed, exposure identically equals that value.


10

MEASURING RISK
Risk is the measure of the extent of variability of the performance
attributable to the risk factor (e.g. exchange rate). It depends on the size
of the exposure and the extent of fluctuations expected in the risk factor
(e.g. exchange rate).
In simple words, risk gives us a range within which the variation due to
the risk factor can take place. It can be arrived by analyzing the bestcase and worst-case scenarios for a firm.
For example, we have the following forecast by a financial consulting
outfit:
“In our view the most likely value of the spot rate three months
from now is Rs 41.00 per dollar, but it could be as high as Rs
41.50. There is a small probability that the dollar could fall to Rs
Scenario
Best-case
Worst-case
39.40.”
3-month spot rate

Rs 39.40

Rs 41.50

Rupee outlay to settle the Rs 1,97,00,000
Rs 2,07,50,000
payable

11

WHY SHOULD RISK BE
MANAGED?
Leads to lower demand for returns by
investors
• Investors can manage unsystematic risks (peculiar to a company)
by diversifying their portfolio (e.g. by buying stocks in oil as well as
aviation industry), but they have no control over systematic risks
(related to the industry and economy at large). Hence, greater the
systematic risk greater is the return demanded by investors.

Ensures better cash flows

• If the various risks associated with a firm are managed properly it
will ensure a steady and healthy cash flow for the firm thereby
ensuring that it takes full advantage of good investment
opportunities.

External financing can be avoided

• If risk is managed effectively, it will lead to ready availability of
internal funds for investments, and lower the reliance on external
funds like debt and new INTERNATIONAL FINANCE PRESENTATION |less preferred|
equity, which are always HISHAM AHMED RIZVI

12

WHY SHOULD RISK BE
MANAGED?
Financial distress can be avoided
• If not managed properly, the risks associated with a firm can lead
to a liquidity crunch. This will lead to the bankers, customers,
employees and suppliers to believe there is financial distress and
they may react in way which will affect future cash flows of the
firm.

Creation of “corporate value”

• Firms enhance shareholder wealth – create “corporate value” – by
making good investments in areas of product development, R&D,
advertising, promotion etc. This is possible only with a steady
stream of cash flows.

Increased investor confidence
• A firm that manages its risk effectively and consistently over a
period of time is well reputed by investors and bankers and
considered creditworthy. This ensures availability of credit when|
INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI
and if required.

13

HEDGING
• What is hedging?
• To hedge or not to hedge?


14

WHAT IS HEDGING?


15

HEDGING
• What is hedging?
• To hedge or not to hedge?


16

TO HEDGE OR NOT TO
HEDGE?
• Hedging is the taking of a position,
either acquiring a cash flow or an asset
or a contract (including a forward
contract) that will rise (or fall) in value
to offset a fall (or rise) in value of an
existing position.
• Hedging,
therefore,
protects the owner of
the existing asset from
loss
(but
it
also
eliminates any gain
resulting from changes
in exchange rates on
the
value
of
the
exposure).

17

TO HEDGE OR NOT TO
HEDGE?
Stockholders are much more capable of diversifying currency risk
than the management of the firm.

Opponents
of Hedging

Currency risk management does not add value to the firm and it
incurs costs.
Hedging might benefit corporate management more than
shareholders.
Reduction in risk in future cash flows improves the planning
capability of the firm.

Proponents
of Hedging

Management has a comparative advantage over the individual
shareholder in knowing the actual currency risk of the firm.
Reduction of risk in future cash flows reduces the likelihood that
the firm’s cash flows will fall below a necessary minimum.

18

CURRENCY
• Transactions exposure
EXPOSURE
• Translation exposure
• Operating exposure
• Economic exposure


19

TYPES OF CURRENCY
EXPOSURES
Currency Exposure
Long-Term

Short-Term
Accounting
(Translation
Exposure)

Anticipated
Changes

Cash Flow

Operating
Exposure

Strategic
Exposure

Unanticipated Changes
(Transactions Exposure)


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TYPES OF CURRENCY
EXPOSURESaffect firm value through:
Changes in exchange rate can


21

TYPES OF CURRENCY
EXPOSURES
ILLUSTRATIVE EXAMPLES:
A Taiwanese company has the following USD exposures:
1.
Owns a factory in Texas worth US$5 million.
2.
Agreement to buy goods worth US$2 million.
3.
Biggest competitor is a US company.
What happens if the NT dollar appreciates?
1.
NT$ value of US factory goes down (translation).
2.
NT$ cost of buying goods goes down (transaction).
3.
Global competitiveness of Taiwanese company decreases
(operating).


22

TRANSLATION
• Introduction & example
EXPOSURE

• Methods
• Strategies to manage translational
exposure


23

TRANSLATION
EXPOSURE
Translation exposure, also called Accounting
Exposure or Balance Sheet exposure, arises because
TRANSLATION financial statements of foreign subsidiaries – which are
EXPOSURE
stated in foreign currency – must be restated in the
parent’s reporting currency for the firm to prepare
consolidated financial statements.
• Translation exposure is the potential for an increase or decrease in
the parent’s net worth and reported net income caused by a change in
exchange rates since the last translation.
• The accounting process of translation, involves converting these
foreign subsidiaries financial statements into home currencydenominated statements.
• It is the exposure on assets and liabilities appearing in the balance
sheet but which are not going to be liquidated in the foreseeable
future.
• It has no direct impact on cash flows of aPRESENTATION
firm.
INTERNATIONAL FINANCE

| HISHAM AHMED RIZVI |

24

TRANSLATION
EXPOSURE
• No cash gains or losses are involved but translation exposure
affects the published financial statements and hence may affect
market valuation of the parent company's stock.
Indian company law does not require translation and consolidation of
foreign subsidiaries financial statements with those of the parent
company, unless the foreign operations are an integral part of the parent
business for e.g. a branch.
• However, major stock exchanges require it as one of their listing
requirements.
• As more and more Indian firms are going multinational, they are
increasingly considering translation and consolidation of foreign
subsidiaries, and hence are becoming vulnerable to translational
exposure.


25

TRANSLATION
EXPOSURE: AN
EXAMPLE
AN INDIAN COMPANY WITH A U.K.
Financial details of U.K. Subsidiary
SUBSIDIARY
Particular

March 31, 2012
(£1=Rs85)

March 31, 2013
(£1=Rs70)

Value in £

Translated
value

Real Estate

£1,000,000

Rs 85,000,000

£950,000

Rs 66,500,000

Inventories

£200,000

Rs 17,000,000

£250,000

Rs 17,500,000

Cash

£150,000

Rs 12,750,000

£160,000

Rs 11,200,000

Total

£1,350,000

Rs 102,000,000

£1,360,000

Rs 95,200,000

Value in £

Translated
value


26

TRANSLATION
EXPOSURE

• Methods
• Strategies to manage translational
exposure

Regardless of which method is employed, a translation method must not only
designate at what exchange rate individual balance sheet and income
statement items are remeasured, but also designate where any imbalance is
to be recorded (current income or an equity reserve account).


27

CURRENT/NONCURRENT
METHOD
• The underlying principle
is that assets and
liabilities
should
be
translated based on their
maturity.
 Current assets (like
Cash) translated at the
spot rate. e.g. DM2=$1
 Noncurrent assets (like
Net
Fixed
Assets)
translated
at
the
historical rate in effect
when the item was first
recorded on the books.
e.g. DM3=$1

Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities and
Equity

Local
Current/
Currency
Noncurrent
2,100 DM
$1,050
1,500 DM
$750
3,000 DM
$1,000
6,600 DM
$2,800
1,200 DM
$600
1,800 DM
$600
2,700 DM
$900
900 DM
$700
--------------6,600 DM
$2,800


28

MONETARY/NONMONETA
RY METHOD
• The underlying principle is
that monetary accounts
have a similarity because
their value represents a
sum of money whose
value changes as the
exchange rate changes.

Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities and
Equity

Local
Monetary/
Currency
Nonmonetary
2,100 DM
$1,050
1,500 DM
$500
3,000 DM
$1,000
6,600 DM
$2,550
1,200 DM
$600
1,800 DM
$900
2,700 DM
$900
900 DM
$0
--------------6,600 DM
$2,400

• All
monetary
balance
sheet accounts (cash,
marketable
securities,
accounts receivable, etc.)
of a foreign subsidiary are
translated at the current
exchange
rate.
e.g.
All other (nonmonetary) balance sheet accounts (common stock) are
DM2=$1
translated at the historical exchange rate in effect when the account was first
recorded. e.g.DM3=$1
29

TEMPORAL METHOD
• The underlying principle is that assets and liabilities should be translated
based on how they are carried on the firm’s books.

• Balance sheet accounts are translated at the current spot exchange rate
if they are carried on the books at their current value.
• Items that are carried on the books at historical costs are translated at
the historical exchange rates in effect at the time the firm placed the item
on the books.
• Gains or losses resulting from remeasurement are carried directly to
current consolidated income, and not to equity reserves (increased
variability of consolidated earnings).


30

CURRENT RATE
METHOD
• All balance sheet items
(except
for
stockholder’s
equity)
are translated at the
current exchange rate.
DM2=$1
• Very simple method in
application.
• The biggest advantage
of the current rate
method is that the gain
or loss on translation
does not pass through
the income statement
but goes directly to a
reserve
account
(reducing variability of
reported earnings).

Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity

Local
Currency
DM2,100
DM1,500
DM3,000
DM6,600
DM1,200
DM1,800
DM2,700
DM900
-------DM6,600

Current
Rate
$1,050
$750
$1,500
$3,300
$600
$900
$900
$360
$540
$3,300


31

HOW VARIOUS
TRANSLATION METHODS
Balance Sheet WITH A CHANGE FROM
Local
Current/
Monetary/
DEAL Currency Noncurrent Nonmonetary Temporal Current
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
Net fixed assets
Total Assets
Current
liabilities
Long-Term
debt
Common stock
Retained earnings
earnings
CTA
Total
Liabilities and
Equity

1,500 DM
3,000 DM
6,600 DM
1,200 DM

$750
$1,000
$2,800
$600

$500
$1,000
$2,550
$600

$900
$1,000
$2,950
$600

$750
$1,500
$3,300
$600

1,800 DM

$600

$900

$900

$900

2,700 DM
900 DM
-------6,600 DM

$900
$700
-------$2,800

$900
$150
-------$2,550

$900
$550
-------$2,950

$900
$360
$540
$3,300

Spot exchange rate

INTERNATIONAL FINANCE PRESENTATION

32

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
1,500 DM
$750
$500
$900
$750
Net fixed assets
3,000 DM
$1,000
$1,000
$1,000
$1,500
Total Assets
6,600 DM
$2,800
$2,550
$2,950
$3,300
Book
Current
1,200 DM
$600
$600
$600
$600
value of
liabilities
inventory
Long-Term
1,800 DM
$600 historic $900
$900
$900
debt
rate
Common stock
2,700 DM
$900
$900
$900
$900
Retained earnings
900 DM
$700
$150
$550
$360
earnings
CTA
----------------------------$540
Total
6,600 DM
$2,800
$2,550
$2,950
$3,300
Liabilities and
Book value of inventory
Current value of inventory
INTERNATIONAL FINANCE
at spot exchange rate PRESENTATION| at spot 33
exchange rate.
Equity
| HISHAM AHMED RIZVI

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
Net fixed assets
Total Assets
Current
liabilities
Long-Term
debt
Common stock
Retained earnings
earnings
CTA
Total
Liabilities and
Equity

1,500 DM
3,000 DM
6,600 DM
1,200 DM

$750
$1,000
$2,800
$600

$500
$1,000
$2,550
$600

$900
$1,000
$2,950
$600

$750
$1,500
$3,300
$600

1,800 DM

$600

$900

$900

$900

2,700 DM
900 DM
-------6,600 DM

$900
$900
$900
$900
$700
$150
$550
$360
---------------------$540
$2,800
$2,550
$2,950
$3,300
historic
spot exchange rate.
rate
34

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
Net fixed assets
Total Assets
Current
liabilities
Long-Term
debt
Common stock
Retained earnings
earnings
CTA
Total
Liabilities and
Equity

1,500 DM
3,000 DM
6,600 DM
1,200 DM

$750
$1,000
$2,800
$600

$500
$1,000
$2,550
$600

$900
$1,000
$2,950
$600

$750
$1,500
$3,300
$600

1,800 DM

$600

$900

$900

$900

2,700 DM
900 DM
-------6,600 DM

$900
$700
-------$2,800
spot rate

$900
$150
-------$2,550

$900
$550
-------$2,950

$900
$360
$540
$3,300


35

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
Net fixed assets
Total Assets
Current
liabilities
Long-Term
debt
Common stock
Retained earnings
earnings
CTA
Total
Liabilities and
Equity

1,500 DM
3,000 DM
6,600 DM
1,200 DM

$750
$1,000
$2,800
$600

$500
$1,000
$2,550
$600

$900
$1,000
$2,950
$600

$750
$1,500
$3,300
$600

1,800 DM

$600

$900

$900

$900

2,700 DM
900 DM
-------6,600 DM

$900
$700
-------$2,800

$900
$150
-------$2,550

$900
$550
-------$2,950

$900
$360
$540
$3,300

historical rate

spot rate


36

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
Net fixed assets
Total Assets
Current
liabilities
Long-Term
debt
Common stock
Retained earnings
earnings
CTA
Total
Liabilities and
Equity

1,500 DM
3,000 DM
6,600 DM
1,200 DM

$750
$1,000
$2,800
$600

$500
$1,000
$2,550
$600

$900
$1,000
$2,950
$600

$750
$1,500
$3,300
$600

1,800 DM

$600

$900

$900

$900

2,700 DM
900 DM
-------6,600 DM

$900
$700
-------$2,800

$900
$150
-------$2,550

$900
$550
-------$2,950

$900
$360
$540
$3,300

historical rate


37

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
Net fixed assets
Total Assets
Current
liabilities
Long-Term
debt
Common stock
Retained earnings
earnings
CTA
Total
Liabilities and
Equity

1,500 DM
3,000 DM
6,600 DM
1,200 DM

$750
$1,000
$2,800
$600

$500
$1,000
$2,550
$600

$900
$1,000
$2,950
$600

$750
$1,500
$3,300
$600

1,800 DM

$600

$900

$900

$900

2,700 DM
900 DM
-------6,600 DM

$900
$700
-------$2,800

$900
$150
-------$2,550

$900
$550
-------$2,950

$900
$360
$540
$3,300

From income statement


38

HOW VARIOUS
TRANSLATION METHODS
Local
Current/
Monetary/
Rate
DM3 TO DM2 $1,050
= $1 $1,050 $1,050 $1,050
Cash
2,100 DM
Inventory
1,500 DM
$750
$500
$900
$750
Net fixed assets
3,000 DM
$1,000
$1,000
$1,000
$1,500
Total Assets
6,600 DM
$2,800
$2,550
$2,950
$3,300
Current
1,200 DM
$600
$600
$600
$600
liabilities
Long-Term
1,800 DM
$600
$900
$900
$900
debt
Common stock
2,700 DM
$900
$900
$900
$900
Retained earnings
900 DM
$700
$150
$550
$360
earnings
CTA
----------------------------$540
Total
6,600 DM
$2,800
$2,550
$2,950
$3,300
Liabilities and
Under the current rate method, a “plug” equity account named
Equity cumulative translation adjustment makes the balance sheet balance.
39

TRANSLATION
EXPOSURE

• Methods
• Strategies to manage translational exposure


40

MANAGING
TRANSLATION
EXPOSURE:
• Two common methods used for managing translation exposure are
BALANCE SHEET HEDGE
called balance sheet hedge and derivates hedge.
Making an investment to reduce or control risk.
HEDGE
Investors use this strategy when they are unsure of
what the market will do.
• In simple language, a hedge is used to reduce any substantial
losses/gains. A hedge can be constructed from many types of
financial instruments, including stocks, derivative products, futures
contracts etc.
It involves equating the amount of exposed assets in an
BALANCE
exposure currency to exposed liabilities in that currency,
SHEET HEDGE
so that the net exposure is zero.
• To create a balance sheet hedge, once transaction exposure has
been controlled, often means creating new transaction exposure.
Hence this is not always a very wise option.

41

MANAGING
TRANSLATION
EXPOSURE:
A derivative is a
DERIVATIVESfinancial ofcontract which such as an
HEDGE derives its
DERIVATIVES value from the performance another entity
asset, index, or interest rate, called the "underlying".
• Derivatives allow risk related to the price of the underlying asset to be
transferred from one party to another.

• For example, a wheat farmer and
a miller could sign a futures contract to
exchange a specified amount of cash for a
specified amount of wheat in the future.
• Both parties have reduced a future risk:
for the wheat farmer, the uncertainty of the
price, and for the miller, the availability of
wheat.

42

SHOULD FIRMS HEDGE
TRANSLATION
EXPOSURE?
YES

NO

- Investors don’t have
- The value of the firm is
enough information to
the PV of cash flows.
estimate cash flows and
- Translation exposure
instead must rely on
doesn’t effect cash flows,
reported earnings.
so we should ignore it.
- If reported earnings are
distorted by translation
issues, investors will
misvalue the firm.

43

TRANSACTION
EXPOSURE
• Strategies to manage transaction
exposure


44

TRANSACTION
EXPOSURE
The risk, faced by companies involved in international
TRANSACTION trade, that currency exchange rates will change after the
EXPOSURE
companies have already entered into financial
obligations.
• It stems from the possibility of incurring exchange gains or losses on
transactions already entered into and denominated in a foreign
currency.
• Transaction exposure is short term in nature.
• It has a direct impact on cash flows of a firm.


45

TRANSACTION
EXPOSURE:
EXAMPLES
• A currency has to be converted in order to make or receive a
payment for goods or services on a particular date in future;
• A currency has to be converted to repay a loan or make an interest
payment on a particular date in future;
• A currency has to converted to make a dividend payment, royalty
payment etc. whose foreign currency amount is fixed.
For e.g. suppose a firm receives an export order. It fixes a price,
manufactures the product, makes the shipment and gives 90 days credit
to the buyer who will pay in his currency.
Then, the company has transaction exposure from the time it
accepts the order till the time the payment is received and
converted to home currency.

46

TRANSACTION
EXPOSURE:
EXAMPLES
Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian
buyer for €1,800,000 payment to be made in 60 days. (S0 = $0.90/€)
The U.S. seller expects to exchange the €1,800,000 for $1,620,000
when payment is received.
• Transaction exposure arises because of the risk that the U.S. seller
will receive something other than $1,620,000.
• If the euro weakens to $0.8500/€, then Trident will receive
$1,530,000
• If the euro strengthens to $0.9600/€, then Trident will receive
$1,728,000
• Thus, exposure is the chance of either a loss or a gain.

47

TRANSACTION
EXPOSURE

• Strategies to manage transaction
exposure


48

MANAGING
TRANSACTION
EXPOSURE
Strategies
Contractual
Hedges

Forward
Market Hedge

Financial
Hedges
Swaps

Operating
Strategies
Risk Shifting

Money Market
Hedge

Price adjustment
clauses

Options Market
Hedge

Exposure
Netting

Futures Market
Hedge

Risk Sharing

49

MANAGING
TRANSACTION
EXPOSURE:
FORWARD MARKET
An over-the-counter marketplace that sets the price of a
HEDGE instrument or asset for future delivery.
FORWARD
financial
MARKET

Contracts entered into in the forward market are binding
on the parties involved.

• If you are going to owe a foreign currency on future, agree to buy the
foreign currency now by entering into long position in a forward
contract.
• If you are going to receive a foreign currency on future, agree to sell
the foreign currency now by entering into short position in a forward
The buying of a security such as a stock, commodity or currency, with
contract.
the expectation that the asset will rise in value is called long position.
The sale of a borrowed security, commodity or currency with the
expectation that the asset will fall in value is called short position.

50

MANAGING
TRANSACTION
EXPOSURE:
FORWARD MARKET
EXAMPLE: You are a US importer of British woolens and you have just
HEDGEinventory. Payment of £100M is due in one year. How
ordered next year’s
can you fix the cash outflow in dollars?
Answer: One
way is to put
yourself in a
position that
delivers £100M in
one year – a long
forward contract
on the pound.


51

MANAGING
TRANSACTION
EXPOSURE:
FORWARD MARKET
HEDGE


52

MANAGING
TRANSACTION
EXPOSURE:
FORWARD MARKET
HEDGE


53

MANAGING
TRANSACTION
EXPOSURE:
•MONEY currency payable, buy the foreign currency today
To hedge a foreign MARKET HEDGE
&hold it.
1. Buy the present value of the foreign currency payable today
2. Invest that amount at the foreign rate
3. At maturity your investment will have grown enough to cover for your
foreign currency payable.
A US based importer of Italian bicycles. What can he do in this
situation?
• In one year owes €100,000 to an Italian supplier
• The spot exchange rate is $1.25 = €1.00
• The one year interest rate in Italy is 4%
Can hedge this payable by buying €96,153.85 = €100,000/(1.04) today
and investing it at 4% in Italy for one year.
At maturity he will have €100,000 = €96,153.85*(1.04)

54

MANAGING
TRANSACTION
EXPOSURE:
A US based importer of Italian bicycles. What can he do in this
MONEY MARKET HEDGE
situation?
• In one year owes €100,000 to an Italian supplier
• The spot exchange rate is $1.25 = €1.00
• The one year interest rate in Italy is 4%


55

MANAGING
TRANSACTION
EXPOSURE:
OPTIONS isMARKET buyer the right, but
An option a contract that gives the
OPTIONS
not
buy
HEDGEthe obligation,ortobeforeora sell an underlying asset at a
specific price on
certain date.
• To hedge a foreign currency payable buy calls on the
currency.
• If the call currency appreciates, your call option lets you buy
the currency at the exercise price of the call.
• To hedge a foreign currency receivable buy puts on the
currency
• If the currency depreciates, your put options lets you sell the
Two types of options are:
currency for the exercise price.
• A call gives the holder the right to buy an asset at a certain price
within a specific period of time.
• A put gives the holder the right to sell an asset at a certain price
within a specific period of time.

56

MANAGING
TRANSACTION
EXPOSURE:
OPTIONS MARKET
HEDGE


57

MANAGING
TRANSACTION
EXPOSURE:
OPTIONS MARKET
HEDGE


58

MANAGING
TRANSACTION
EXPOSURE:
OPTIONS MARKET
HEDGE


59

MANAGING
TRANSACTION
EXPOSURE:
OPTIONS MARKET
HEDGE


60

MANAGING
TRANSACTION
EXPOSURE:
OPTIONS MARKET
HEDGE


61

MANAGING
TRANSACTION
EXPOSURE:
FUTUREScontract is as an arrangement between two
MARKET
A futures
FUTURES
parties to
an asset
HEDGE for abuy or sell price. at a particular time in the
CONTRACT
future
particular
• Futures contracts are one of the most common derivatives used
to hedge risk. The main reason that companies or corporations use
future contracts is to offset their risk exposures and limit themselves
from any fluctuations in price.
• When a company knows that it will be making a purchase in the
future for a particular item, it should take a long position in a futures
contract to hedge its position.
• If a company knows that it will be selling a certain item, it should take
a short position in a futures contract to hedge its position.
• Futures market hedge is similar to hedging with forwards

62

MANAGING
TRANSACTION
EXPOSURE:
OPERATING
STRATEGIES
• Strategy for risk shifting

Risk Shifting

• Denominating exports in a strong currency.
• Denominating imports in a weak currency.
• Outcome depends on:
• Bargaining power or parties involved.
• Competitiveness of firm’s particular business
Exposure Netting

• Offsetting exposures in one currency with exposures in the same or
another currency, when exchange rates are expected to move in
such a way that losses or gains on the first exposed position should
be offset by gains or losses on the second currency exposure.
• A firm’s currency exposures can be viewed as a portfolio.
• Exposure netting depends on the correlation between currencies.

63

MANAGING
TRANSACTION
EXPOSURE:
OPERATING
Risk Sharing
STRATEGIES
• Both parties reach agreement to share the currency risk associated
with a deal.
• Risk sharing arrangements
• Price adjustment clause
• Neutral zone
• Outside neutral
Currency Collarszone
• Providing protection if the currency moves outside an agreed-on
range. This agreement is arrived on both parties at the time of the
financial deal.

Leading and Lagging
• leading (accelerate timing of depreciating currency)
• lagging (delay timing of appreciating currency)

64

OPERATING
EXPOSURE

• Strategies to manage operating exposure


65

OPERATING EXPOSURE
OPERATING
EXPOSURE

Operating exposure, also called economic exposure,
competitive exposure, and even strategic exposure
on occasion, measures any change in the present value
of a firm resulting from changes in future operating cash
flows caused by an unexpected change in exchange
rates.

• Measuring the operating exposure of a firm requires forecasting and
analyzing all the firm’s future individual transaction exposures
together with the future exposures of all the firm’s competitors and
potential competitors worldwide.

• Operating exposure is far more important for the long-run health of
a business than changes caused by transaction or translation
exposure.


66

ATTRIBUTES OF
OPERATING EXPOSURE
• The cash flows of a multinational firm can be divided into operating
cash flows and financing cash flows.

• Operating cash flows arise from intercompany (between unrelated
companies) and intracompany (between units of the same company)
receivables and payables, rent and lease payments, royalty and
license fees and assorted management fees.
• Financing cash flows are payments for loans (principal and
interest), equity injections and dividends of an inter and intracompany
nature.


67

FINANCIAL & OPERATING
CASH FLOWS BETWEEN
PARENT & SUBSIDIARY


68

MEASURING THE
IMPACT OF OPERATING
EXPOSURE
An unexpected change in exchange rates impacts a firm’s
expected cash flows at four levels, depending on the time
horizon used:
 Short run
 Medium run: Equilibrium case
 Medium run: Disequilibrium case
 Long run


69

MEASURING THE
IMPACT OF OPERATING
EXPOSURE
SHORT RUN
IMPACT
• The first level impact is on the one-year operating budget; the gain or
loss depends on the currency of denomination (currency of expected
cash flows)
• In the short run, it is difficult to change the exposure due to implied
obligations, such as purchase or sales commitments, because the
currency of denomination cannot be changed.
• It is also difficult to change sales prices or to renegotiate factor costs


70

MEASURING THE
IMPACT OF OPERATING
EXPOSURE
MEDIUM RUN – PARITY CONDITIONS
HOLD
• The second level impact is on expected medium-term cash flows.

• If parity conditions hold, the firm should be able to adjust prices and
factor costs over time to maintain the expected level of cash flows, if
no real variables have changed.
• The country of cash flow origination and its monetary, fiscal, and
balance of payments policies will determine whether firms can adjust
prices and costs.
• Example: If Volvo is selling cars to Germany and the DM depreciates
because the German money supply rises, Volvo will be protected if it
can raise its DM prices, so that the Krona price is maintained.

71

MEASURING THE
IMPACT OF OPERATING
EXPOSURE
MEDIUM RUN – CHANGE IN REAL
VARIABLES
• If the firm is not able to adjust prices and costs because the change
in exchange rates has been accompanied by real changes, so that
relative prices have been altered.
• Example: If the DM has depreciated relative to the Krona because
German investors have lost confidence in the German economy and
are moving their capital to Sweden, the wealth of German investors
has dropped, the real price of a Swedish car has risen and Volvo may
not be able to raise its prices proportionately. There is less than
perfect pass-through.


72

MEASURING THE
IMPACT OF OPERATING
EXPOSURE
LONG
RUN
• Long-run cash flows beyond five years could be affected. Cash flows
will be influenced by the reactions of existing and potential
competitors to exchange rate changes when real variables are
affected.
• In principle, all firms subject to international competition, domestic or
multinational, are subject to foreign exchange operating exposure in
the long run, whenever real variables are affected.


73

OPERATING EXPOSURE:
AN EXAMPLE


74

OPERATING
EXPOSURE

• Strategies to manage operating exposure


75

MANAGEMENT OF
OPERATING EXPOSURE:
STRATEGIC
•DIVERSIFICATION
The objective of both operating and transaction exposure
management is to anticipate and influence the effect of unexpected
changes in exchange rates on a firm’s future cash flows, rather than
merely hoping for the best.
• To meet this objective, management can diversify the firm’s
operating and financing base.

• Management can also change the firm’s operating and financing
policies.
• If a firm’s operations are diversified internationally, management is
prepositioned both to recognize disequilibrium when it occurs and to
react competitively.

• Recognizing a temporary change in worldwide competitive conditions
permits management to make changes in operating strategies.


76

MANAGEMENT OF
OPERATING EXPOSURE:
STRATEGIC
• If a firm’s financing sources are diversified, it will be prepositioned to
DIVERSIFICATION international Fisher
take advantage of temporary deviations from the
effect.
• However, to switch financing sources a firm must already be wellknown in the international investment community.
• Again, this would not be an option for a domestic firm (if it has limited
its financing to one capital EFFECT:
INTERNATIONAL FISHERmarket).
An economic theory that states that an expected change in the current
exchange rate between any two currencies is approximately equivalent
to the difference between the two countries' nominal interest rates for
that time.
Calculated as:
"E" represents the % change in the exchange rate
"i1" represents country A's interest rate
"i2" represents country B's interest rate FINANCE PRESENTATION
INTERNATIONAL


77

MANAGEMENT OF
OPERATING EXPOSURE
Operating and transaction exposures can be partially
managed by adopting operating or financing policies that
offset anticipated foreign exchange exposures.
The four most commonly employed proactive policies
are:
 Matching currency cash flows
 Risk-sharing agreements
 Back-to-back or parallel loans

 Currency swaps


78

MANAGEMENT OF
OPERATING EXPOSURE:
MATCHING CURRENCY
CASH-FLOWS
EXAMPLE:
A US firm has continuing export sales to Canada.
In order to compete effectively in Canadian markets, the
firm invoices all export sales in Canadian dollars.
This policy results in a continuing receipt of Canadian
dollars month after month.
This endless series of transaction exposures could be
continually hedged with forwards or other contractual
agreements.


79

MANAGEMENT OF
OPERATING EXPOSURE:
MATCHING CURRENCY
CASH-FLOWS

Exposure: The sale of goods to Canada creates a foreign currency
exposure from the inflow of Canadian dollars
Hedge: The Canadian dollar debt payments act as a financial hedge by
requiring debt service, an outflow of Canadian dollars

80

MANAGEMENT OF
OPERATING EXPOSURE:
MATCHING CURRENCY
CASH-FLOWS
 One way to offset an anticipated continuous long
exposure to a particular company is to acquire debt
denominated in that currency (matching).
 Another alternative would be for the US firm to seek out
potential suppliers of raw materials or components in
Canada as a substitute for US or other foreign firms.

 In addition, the company could engage in currency
switching, in which the company would pay foreign
suppliers with Canadian dollars.


81

MANAGEMENT OF
OPERATING EXPOSURE:
RISK SHARING
AGREEMENTS
Currency Clauses: Risk-Sharing
 An alternate method for managing a long-term cash
flow exposure between firms is risk sharing.
 This is a contractual arrangement in which the buyer
and seller agree to “share” or split currency movement
impacts on payments between them.
 This agreement is intended to smooth the impact on
both parties of volatile and unpredictable exchange rate
movements.


82

MANAGEMENT OF
OPERATING EXPOSURE:
BACK TO BACK LOANS
Back-to-Back Loans:
 A back-to-back loan, also referred to as a parallel loan
or credit swap, occurs when two business firms in
separate countries arrange to borrow each other’s
currency for a specific period of time.
 At an agreed terminal date they return the borrowed
currencies.
 Such a swap creates a covered hedge against
exchange loss, since each company, on its own books,
borrows the same currency it repays.

83

MANAGEMENT OF
OPERATING EXPOSURE:
BACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary crossborder financing without incurring direct currency exposure.

84

MANAGEMENT OF
OPERATING EXPOSURE:
BACK TO BACK LOANS
There are two fundamental impediments to widespread
use of the back-to-back loan:
 It is difficult for a firm to find a partner, termed a
counterparty for the currency amount and timing
desired.
 A risk exists that one of the parties will fail to return the
borrowed funds at the designated maturity – although
each party has 100% collateral (denominated in a
different currency).


85

MANAGEMENT OF
OPERATING EXPOSURE:
CURRENCY SWAPS
Currency Swaps:
 A currency swap resembles a back-to-back loan except
that it does not appear on a firm’s balance sheet.
 In a currency swap, a firm and a swap dealer or swap
bank agree to exchange an equivalent amount of two
different currencies for a specified amount of time.
For Example:
A Japanese corporation and U.S. corporation would like
to enter into a cross currency swap which would allow
them to use foreign currency cash inflows to service
debt.

86

MANAGEMENT OF
OPERATING EXPOSURE:
CURRENCY SWAPS


87

MANAGEMENT OF
OPERATING EXPOSURE:
OTHER STRATEGIES
• Use of Marketing Strategies
• Market Selection
• Pricing Strategy/Product Strategy
• Promotional Strategy
• Use of Production Management
• Input mix
• Plant Location & Shifting production among plants
• Raising Productivity (i.e. lowering costs)
• Financial Hedging techniques may also be used


88

THANK YOU
ARUSHI SHARMA |
arushi.sharma888@gmail.com
DIVIK GIRDHAR | divikgirdhar@gmail.com
DIVYA GUPTA | gupta.divya2310@gmail.com


89

International Finance Risk Management

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