• International Financial Management

• P G Apte

Introduction• Focus on the risk management process and the issues

involved in setting up and implementing an exposure management system

• Issues to be addressed– The company's strategic business posture, attitude

towards risk and its risk tolerance – Organizational design to implement a coherent policy– Monitoring and control mechanisms – Implications for managerial performance evaluation – Possible conflict of interest between a parent company

and its global subsidiaries

• HEDGING OBJECTIVES

• First, what is the hedging objective of the firm?

• Some of the best-articulated hedging programs in the corporate world will choose the reduction in the variability of corporate income as an appropriate target. This is consistent with the notion that an investor purchases the stock of the company in order to take advantage of the management’s core business expertise not financial market speculation.

• Other companies just believe that engaging in a forward outright transaction to hedge each of their cross-border cash flows in foreign exchange is sufficient to become “risk-free”. Yet, they are exposing their companies to unknown potential opportunity losses. And this could have an adverse impact their relative performance .

• Second, what is the firm's exposure to financial price risk?

• Transactions exposure, translation exposure economic exposure. It is important to measure and to have on a daily basis some notion of the firm's potential liability from financial price risk.

• Third, what are the various hedging instruments available to the corporate Treasurer and how do they behave in different pricing environments?

• When is it best to use which instrument is the question the corporate Treasurer must answer and choose the optimal hedging structure for a particular exposure and economic environment. Not every structure will work well in every environment. The corporate Treasury should be able to tailor the exposure using derivatives so that it fits the preferences and the view of the senior management and the board of directors.

Always keep in mind the risk-return tradeoff

The Risk Management Process

• Four Major Tasks– Selection of a target performance variable

– Identification of those environmental factors that might have significant impact on a firm's performance

– Assessing and, if possible quantifying the impact of each of the environmental risk factors on the target performance variable

– Choice of an appropriate mechanism or instrument to reduce or shift the risk

The Risk Management Process• Risk management can be viewed as a sequential

process consisting of the following steps– Choose an appropriate performance measure – Identify the key risk factors and assess the sensitivity of the

performance measure to each of them– Estimate the risk profile of the performance measure – Determine the desired risk profile – In many cases, a firm may have natural hedges and does

not need to execute a hedge transaction – Choice of the risk reduction mechanism – Execute the selected transaction – Monitor the performance of the selected risk reduction

mechanism

The Risk Management Process• Value At Risk (VAR) is a single, summary

statistical measure of possible loss in value of the portfolio due to normal market movements in the underlying risk factors over a given time horizon

• Industrial firms should utilize a similar measure called Cash Flow at Risk (CFAR) which attempts to link cash flows to the environmental risk factors

• These methodologies cannot incorporate risk of extreme events.

Objectives of Hedging Policy• Treasury staff must have a clear understanding

of the following aspects – Whether the risk management posture is to be

conservative or aggressive– The appropriate performance measure in terms of

which the efficacy of risk management will be evaluated

– The time horizon to be adopted in making risk management decisions

– Benchmark against which their performance would be judged

Organizational Issues

• The Three Main Considerations – Who should get involved in the establishment and

implementation of risk management policy

– What are the roles and responsibilities of the various participants

– Performance measurement and control systems

• Senior executives in other functional departments must be intimately involved

• Effective risk management is predicated upon the existence of structures and systems which facilitate information flows, allocation of responsibility and authority and performance evaluation

Organizational Issues• For multinational corporations a critical issue is

whether to centralize exposure management • Advantages of Centralization

– It minimizes duplication and permits economies of scale– Transactions costs can be minimized– A centralized exposure and cash management center

located in a major, efficient money market center can access a wide variety of instruments

– Managing translation exposure when global consolidation is required can be done more effectively from a centralized location

Organizational Issues

• Disadvantages of Centralization– The centralized staff may not be able to

appreciate the operational constraints and environment of local subsidiaries

– Local managers handling their own exposures would be able to develop closer relations with local banks

– Performance appraisal becomes more complicated

Organizational Issues• Measurement of hedging performance is a complex issue • Statistically, the performance of a particular hedging

program can be assessed by comparing the mean and variance of the operating cash flows attained with the chosen strategy with the mean and variance which would have been obtained by an alternative benchmark strategy

• “Budget Rate” is a kind of target exchange rate which would be used among other things as a benchmark for assessing the effectiveness of treasury risk management activities

Choice of Budget Rates : Current spot rate, relevant forward rate, a “forecast” rate.

What is the correct choice?

An Example

My company has a 6-month payable of GBP 250000.

GBP/INR Spot : 82.50 6-month Forward : 85.00

A forecast obtained from a consultant : 84.00

I cover 50% forward and leave 50% unhedged.

Six months later the spot rate is 83.50. I acquire the remaining 50% at that rate and settle the payable.

I have achieved a weighted average rate of 84.25. My CFO says this is worse than the spot rate at settlement and worse than the consultant’s forecast. Hence it should be recorded as bad performance.

Is he justified?

Organizational Issues• The current spot rate is totally irrelevant• Forward rate is a rate which can actually be

locked in if the treasurer chooses to do so.• While the decision in respect of whether to

hedge or not to hedge, or hedge partially can certainly be guided by management's currency views, the responsibility for forecasting errors should not be assigned to the treasury manager responsible for hedging unless it is an in-house forecast

Information System for Exposure Management

• Requires a well designed management information system (MIS)

• The three types of exposures – transactions, translation and operating must be clearly separated

• Evolve a procedure for assessing the risk associated with these exposures by adopting a clearly articulated forecasting method

• If a discretionary hedging posture is to be adopted, stop-loss guidelines must be clearly articulated

• All exposed positions including their hedges if any should be monitored at frequent intervals

Information System for Exposure Management

• When a particular exposure is extinguished, a performance assessment must be carried out by comparing the actual all-in rate achieved with the benchmark

• Periodic reviews must be carried out

A survey of corporate treasurersand financial officers

Do you agree or disagree with the following statements?

Mean

score

“Managing transaction exposure is important.” 1.4

“Managing economic exposure is important.” 1.8

“Managing translation exposure is important.” 2.4

Key: 1= strongly agree, ... 3=neutral, ... 5=strongly disagree

Transaction exposure is viewed as the most important currency risk

exposure

Risk Management in Practice: which goals?

• The treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center.

• The treasury function is not expected to add profit to the firm’s bottom line.

• Currency risk managers are expected to err on the conservative side when managing the firm’s money.

Risk Management in Practice: which exposures?

• Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy

• Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%

• An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures based on historical trends and past business relationship.

• Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties.

• Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges.

No. of Top Challenges Companies

7 Getting timely and accurate reporting of exposures from business units

4 Obtaining accurate forecast of non-booked exposures

3 Resources and information to perform economic assessment of currency risk

2 Designing optimal balance sheet structure that minimize non-functional currency balances

2 Monthly exposures stale by the time balance sheet is closed

2 Lack of policy and procedures: no program in place

2 Lack of automation in consolidating exposures (reliance on Excel)

1 Forward points on long-dated forwards

1 Concern, unfamiliarity, lack of resources to handle derivatives

1 Complying with FAS 133

Survey of Mid-sized American Companies

INTERNAL AND EXTERNAL RISK MANAGEMENT METHODS

Internal methods are a part of a firm’s organisational financial management and do not resort to special contractual relationships outside the group of companies concerned while external methods use contractual means to insure against potential foreign exchange losses.

The main internal methods for managing foreign currency exposures in terms of short term cash flows are matching, leading and lagging, netting, balance sheet hedging and pricing policies. For longer-term cash flows, the main way is through international diversification in manufacturing, distribution, and financing decisions. External methods are forward contracts and derivatives such as currency futures, options on currency futures, currency options and currency swaps.

PRODUCTS USED FOR TRANSACTIONS EXPOSURE

Evidence of Derivative use for Hedging FX Risk in Indian Firms

Reliance Industries

Currency Swaps 1064.49Options Contracts 2939.76Forward Contracts 5764.10Earnings in all businesses are linked toUSD. The key input, crude oil ispurchased in USD. All export revenuesare in foreign currency and local pricesare based on import parity prices aswell.

Maruti Udyog

Forward Contracts6411 (INR-JPY)70 ($-INR)Import/Royalty payable in Yen andExports Receivables in dollars.Currency swaps 124.70(USD -INR) Interest rate and forex risk.

Mahindra and Mahindra

Forward Contracts 350 (INR-JPY)2(INR-EUR) ; 27.3($-INR)Trade payables in Yen and Euro andexport receivables in dollars.Currency Swaps 5390 (JPY-INR) Interest rate and foreign exchange risk.

Arvind Mills

Forward Contracts152.98 ($-INR)2.25 (GBP-INR)5 (INR-$)703.6721.88Option Contracts 1 2 2.5 ($-INR) 547.16Most of the revenue is either in dollarsor linked to dollars due to export.

Infosys

Forward Contracts 119 ($-INR) 529Options ContractsRange barrier options4 ($-INR)8 (INR-$)2 ($-INR)3 (Eur-INR)1836971Revenues denominated in thesecurrencies.

Tata Consultancy Services

Forward Contracts15 (Eur-INR)21 (GBP-INR)265.75Option Contracts 8 3 0 ($-INR)47.5 (Eur-INR)76.5 (GBP-INR)4057Revenues largely denominated inforeign currency, predominantly US$,GBP, and Euro. Other currencie includeAustralian $, Canadian $, South AfricanRand, and Swiss Franc

Ranbaxy

Forward Contracts 2894.589 Exposed on accounts receivable andloans payable. Exposure in USD andJap Yen

Dr. Reddy’s Labs

Forward Contracts 398 ($-INR)11(Eur $)Options Contracts 30 (EUR-$)Foreign currency earnings throughexport, currency requirements forsettlement of liability for import of goods.

Summary• The risk management process involves several steps

starting with identification and assessment of risk and leading up to the choice of specific risk reduction devices and their execution

• Exposure management policy must be guided by clearly defined objectives including the firm's risk-return tradeoff and relevant horizon for risk management

• The choice of benchmarks for assessing the effectiveness of hedging is a complex and important issue

• Another important issue is whether to centralize the exposure management function