MANAGEMENT OF FOREIGN EXCHANGE AND RISK MANGEMENT

Rahul Mukundan

INTRODUCTION

Business firm engaged in international business experience foreign exchange

exposure and risk. It may be recalled that foreign exchange exposure is a sensitivity of the value of

assets , liabilities and cash flow of a firm to change in exchange rate of currencies. The variability in

the value of assets , liabilities and cash flows induced by such exposure is referred to as foreign

exchange risk. Business enterprise have to design and implement proper risk management system

and methods to reduce or eliminate the risk arising from foreign exchange exposure

MANAGEMENT OF TRANSACTION RISK

Transaction risk refers to the variability in the home currency value of cash flow

arising from transactions already completed and whose foreign currency values are contractually

fixed . the variability in cash flows on account of exchange rate fluctuations may result in a gain or

loss to the firm ,depending on the direction of movement of exchange rates. The variability may be

significant or insignificant depending on the extent of movement of exchange rates . it is possible to

neutralize the impact of exchange rate fluctuations on cash flows and thus eliminate the variability

by adopting certain measure . this process of eliminating variability is known as hedging and the

measure used for achieving objectives are known as hedging techniques

Management of foreign exchange risk involves three important function

1. Assessing the extent of variability and identifying whether it is likely to be

favorable or adverse

2. Deciding whether to hedge or not to hedge all or part of the exposure

3. Choosing the optimal hedging technique to suit the situation

TECHNIQUE FOR HEDGING TRANSACTION RISK

A company that decide to hedge its transaction exposure may choose any of the following

techniques:

1. Foreword hedge

2. Future hedge

3. Money market hedge

4. Currency option hedge

FOREWARD HEDGE

If you are going to owe foreign currency in the future, agree to buy the

foreign currency now by entering into long position in a forward contract. If you are

going to receive foreign currency in the future, agree to sell the foreign currency now

by entering into short position in a forward contract.

MONEY MARKET HEDGE

This is the same idea as covered interest arbitrage.

To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it.

• It’s more efficient to buy the present value of the foreign currency payable today.

• Invest that amount at the foreign rate.

At maturity your investment will have grown enough to cover your foreign currency payable

OPTION MARKET HEDGE

Options provide a flexible hedge against the downside, while preserving the upside potential.

To hedge a foreign currency payable buy calls on the currency.

If the 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 option lets you sell the currency for the exercise price.

FUTURE HEDGE

While the use of short and long hedges can reduce (or eliminate in some cases - as below) both

downside and upside risk. The reduction of upside risk is certainly a limation of using futures to

hedge.

Short Hedges

A short hedge is one where a short position is taken on a futures contract. It is typically

appropriate for a hedger to use when an asset is expected to be sold in the future. Alternatively, it can

be used by a speculator who anticipates that the price of a contract will decrease

Long Hedges

A long hedge is one where a long position is taken on a futures contract. It is typically

appropriate for a hedger to use when an asset is expected to be bought in the future. Alternatively, it

can be used by a speculator who anticipates that the price of a contract will increase

CROSS HEDGING

A risk management strategy used in limiting or

offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities.

In effect, hedging is a transfer of risk without buying insurance policies.

Hedging employs various techniques but, basically, involves taking equal and

opposite positions in two different markets (such as cash and futures markets). Hedging is used also

in protecting one's capital against effects of inflation through investing in high-yield financial

instruments (bonds, notes, shares), real estate, or precious metals.

INTERNAL TECHNIQUES

Netting

Netting implies offsetting exposures in one currency with exposure in the same or another currency,

where exchange rates are expected to move high 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. It is of two types bilateral

netting & multilateral netting. In bilateral netting, each pair of subsidiaries nets out their own positions

with each other. Flows are reduced by the lower of each company’s purchases from or sales to its netting

partner.

Matching

The netting is typically used only for inter company flows arising out of groups receipts and payments.

As such, it is applicable only to the operations of a multinational company rather than exporters or

importers. In contrast, matching applies to both third parties as well inter-company cash flows. It can be

used by the exporter/importer as well as the multinational company. It refers to the process in which a

company matches its currency inflows with its currency outflows with respect to amount and timing.

Receipts generated in a particular currency are used to make payments in that currency and hence, it

reduces the need to hedge foreign exchange risk exposure

Leading and Lagging

It refers to the adjustment of intercompany credit terms, leading means a prepayment of a

trade obligation and lagging means a delayed payment. It is basically intercompany technique whereas

netting and matching are purely defensive measures. Intercompany leading and lagging is a part of risk-

minimizing strategy or an aggressive strategy that maximizes expected exchange gains. Leading and

lagging requires a lot of discipline on the part of participating subsidiaries. Multinational companies which

make extensive use of leading and lagging may either evaluate subsidiary performance in a pre-interest

basis or include interest charges and credits to overcome evaluation problem

Pricing Policy

In order to manage foreign exchange risk exposure, there are two types of pricing tactics:

price variation and currency of invoicing policy. One way for companies to protect themselves against

exchange risk is to increase selling prices to offset the adverse effects of exchange rate fluctuations. Selling

price requires the analysis of Competitive situation, Customer credibility, Price controls and Internal

delays.

MANAGEMENT OF OPERATING RISK

The term Operational Risk Management (ORM) is defined as a

continual cyclic process which includes risk assessment, risk decision making, and

implementation of risk controls, which results in acceptance, mitigation, or

avoidance of risk. ORM is the oversight of operational risk, including the risk of

loss resulting from inadequate or failed internal processes and systems; human

factors; or external events

THREE LEVELS OF ORM

In Depth

In depth risk management is used before a project is implemented, when there is plenty of

time to plan and prepare. Examples of in depth methods include training, drafting instructions and

requirements, and acquiring personal protective equipment.

Deliberate

Deliberate risk management is used at routine periods through the implementation of a

project or process. Examples include quality assurance, on-the-job training, safety briefs, performance

reviews, and safety checks.

Time Critical

Time critical risk management is used during operational exercises or execution of tasks.

It is defined as the effective use of all available resources by individuals, crews, and teams to safely and

effectively accomplish the mission or task using risk management concepts when time and resources are

limited. Examples of tools used includes execution check-lists and change management. This requires a

high degree of situational awareness

BENEFITS OF ORM

1. Reduction of operational loss.

2. Lower compliance/auditing costs.

3. Early detection of unlawful activities.

4. Reduced exposure to future risks

MANAGING TRANSLATION EXPOSURE

Translation or Accounting Exposure:

Is the sensitivity of the real domestic currency value of Assets and Liabilities, appearing in

the financial statements to unanticipated changes in exchange rates

Managers, analysts and investors need some idea about the importance of the foreign business.

Translated accounting data give an approximate idea of this.

- Performance measurement for bonus plans, hiring, firing, and promotion decisions.

- Accounting value serves as a benchmark to evaluate a discounted-cash flow valuation.

- For income tax purposes.

- Legal requirement to consolidate financial statements

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