PPT-IFM-exposure and risk

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EXPOSURE AND RISK

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Foreign Exchange Exposure

‘the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates’


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both foreign and domestic assets and liabilities could be exposed to effects of exchange rate movements

not only assets and liabilities, but even operating incomes can be exposed to exchange rate movements

exposure measures the sensitivity of changes in real domestic-currency value of assets, liabilities and operating incomes

exposure measures the responses only to the unexpected changes in the exchange rate as the expected changes are already discounted by the market

Exposure is on the amount of assets, liabilities and operating income that is at risk from unexpected changes in exchange rates

Sensitivity can be measured by the slope of the regression equation between two variables

Two variables are the unexpected changes in the exchange rates resultant change in the domestic-currency value of assets, liabilities and operating incomes

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The resultant change can be divided into four categories for the purpose of measurement of exposure.

Foreign currency assets and liabilities which have fixed foreign-currency values.

Foreign currency assets and liabilities with foreign-currency values that change with an unexpected change in the exchange rate.

Domestic currency assets and liabilities.

Operating incomes5

Foreign Exchange Risk“The variance of the domestic-

currency value of an asset, liability, or operating income that is attributable to unanticipated changes in exchange rates”

for exchange rate risk to be present, the presence of two factors is essential. One is the variability of exchange rates, and the second is exposure.

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Variability of domestic-currency value of an asset, liability or operating income which is not linked to exchange rate movements,

or Where the changes in exchange rates are

perfectly predictable,

Does not create any exchange rate risk.

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Foreign Exchange Risk

Foreign Exchange Risk

Exposure is measurable in terms of the slope of a regression equation between exchange rate movements and changes in the values of assets or liabilities,

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uSaV *

Exchange rate risk can be expressed as a function of exposure and variance of exchange rate.

V = change in the domestic value of assets, liabilities and operating income a = the slope of the regression lineSu = unexpected change in the exchange rate varV = exchange rate risk.

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Foreign Exchange RiskuSaV *

]*var[)var( uSaV

]var[*)var( 2 uSaV

Effects of Exchange Rates on Exporters and Importers

Even with no foreign assets or liabilities or foreign currency payables or receivables, changes in exchange rates will affect operations. Devaluations raise export prices in home-currency terms and at the same time raise export sales. Therefore, home-currency revenue is increased by devaluations. Devaluations raise an exporter's profits. The gains are reduced by using tradable inputs and may be in any case removed in the long run by free entry of new firms or by general inflation brought about by devaluation.

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Devaluation lowers prices in foreign currency units (while raising prices in units of the devalued currency) and raises an exporter's sales. Total revenues increase because the percentage sales increase exceeds the price reduction.

(Production costs also increase, but an exporter's total revenues will rise more than total costs, and so profits will increase.)

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Import prices rise in units of the devalued currency and fall in units of foreign currency. The quantity of imports will fall from devaluation. The importer's sales revenues will fall in terms of the devalued currency because price increases are smaller than quantity reductions.

Total costs also fall, but if profi ts are being made, not by as much as total revenues.

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Classification of Forex Exposure

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Currency Exposure

Accounting Operating

Translation Transaction Contingent Competitive

Transaction Exposure

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Measure of

• sensitivity of the home currency value of assets and liabilities • which are denominated in foreign currency, • to unanticipated changes in exchange rates,• when the assets or liabilities are liquidated(it arises from contractual, foreign currency, future cash flows)

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Transaction Exposure

Situations which generates transaction exposure:

A currency has to be converted in order to make or receive payment for goods and services.A currency has to be converted to repay a loan or make an interest payment ( or receive a repayment or an interest payment)A currency has to be converted to make a dividend payment, royalty payment etc.

Translation Exposure

• Translation exposure is also called the balance sheet exposure.

• 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.

• Translation risk is the related measure of variability.

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Example: a company having a foreign currency deposit would need to translate its value into its domestic currency for the purpose of reporting at the time of preparation of its financial statements.

Any exposure arising out of exchange rate movement and the resultant change in the domestic-currency value of the deposit would classify as translation exposure.

This exposure is mostly notional, as there is no real gain or loss due to exchange rate movements since the asset or liability does not stand liquidated at the time of reporting, hence, the name -accounting exposure

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Translation Exposure

Operating Exposure

“The extent to which the value of a firm stands exposed to exchange rate movements, the firm’s value being measured by the present value of its expected cash flows”.

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Result of economic consequences (rather than accounting consequences, as in the case of transaction and translation exposure) of exchange rate movements on the value of a firm, and hence, is also known as economic exposure

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Operating Exposure

Some situations giving rise of operating exposure are

(1) An export or import deal is being

negotiated and quantities and prices are yet to be finalized. Any fluctuation in the exchange rate will influence both quantities and prices and then it will be converted into transaction exposure.

(2) A firm has submitted a tender bid on an equipment supply contract. If the contract is awarded, transaction exposure will arise.

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Operating Exposure

(3) A firm imports a product from abroad and sells it in the domestic market. Supplies from abroad are received continuously. But, for marketing reasons the firm has to publish a home currency price list which holds good for six months.

While home currency revenues will remain more or less certain, the costs measured in terms of home currency are exposed to currency fluctuations.

In all the three cases currency movements will affect future cash flows.

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Operating Exposure

Management of Transaction and Translation Exposure

The price received in rupee terms by an Indian exporter for goods exported by him will not be known till he actually converts the foreign currency receipts into rupees

Toyota of Japan enters into a loan contract with Deutschbank that calls for payment of DM100 million for principal and interest in one year.

To the extent that the yen/Deutschmark exchange rate is uncertain, Toyota does not know how much yen will be required to buy DM100 million spot after one year.

If the yen appreciates (depreciates) against the Deutschmark, a smaller (larger) yen amount will be required to retire the DM-denominated loan.

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Transaction Exposure: Whenever a company is committed to a forex

denominated transaction

Result: Future forex inflow / outflowAny change in exchange rate between the time the transaction is entered into and the time it is settled in cash leads to a change in home currency value of cash inflow/outflow

Protective Measures: Foreign currency transactions whose cash flow exactly offset the cashflows of transaction exposure

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Management of Transaction Exposure

Forward Market HedgeMoney Market HedgeRisk ShiftingPricing DecisionsExposure NettingCurrency Risk SharingForex Options

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Forward Market HedgeA company that is long a foreign currency will sell the foreign currency forward

A company that is short a foreign currency will buy the foreign currency forward.


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Management of Transaction ExposureForward Market Hedge

An Indian firm is importing computers from the USA and needs to pay $1,00,000 after 3 months to the exporter

• Book a 3-month forward contract to buy $1,00,000

• If the 3-month forward rate is Rs.44.50/$, the cost to the Indian firm will be locked at Rs.44,50,000

• Whatever be the actual spot price at the end of three months, the firm needs to pay only the forward rate

• A forward contract eliminates transaction exposure completely

Forward Market Hedge

Cost of a forward hedge is measured as the difference between the forward rate and the expected spot rate for the relevant maturity

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Money Market Hedge

A money market hedge involves simultaneous borrowing and lending

activities in two different currencies to lock in HC value of a future foreign currency cash flow


Money Market Hedge

A German firm has a 90 day Dutch Guilder receivable of NLG 10,000,000. It has access to Eurodeposit markets in DEM as well as NLG.

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Money Market Hedge

To cover this exposure it can make the following set of transactions:

Borrow NLG in the euro NLG market for 90 days.Convert to DEM at spotUse DEM in its operations.When the receivable is settled, use it to pay off the NLG loan

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Suppose the rates are as follows: NLG/DEM spot: 1.1025/35,90 day forward: 1.1045/65EuroNLG interest rates: 5.25/5.50EuroDEM interest rates 4.75/5.00

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Comparison of forward cover against money market cover

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With forward cover, each NLG sold will give an inflow of DEM(1/1.1065) = DEM 0.9038, 90 days later. The present value of this at (4.75% p.a.) is 0.9038 / [1+(0.0475/4)] = DEM 0.8931

To cover using the money market, for each NLG of receivable, borrow NLG 1/[1+(0.055/4)] =NLG 0.9864

Sell this at spot rate to get DEM(0.9864/1.1035) =DEM 0.8939.

Pay off the NLG loan when the receivable matures.

Thus with money market cover, there is a net gain of DEM 0.0008 per NLG of receivable or DEM 8000 for the 10mn Dutch guilder receivable

Risk Shifting

Firms typically attempt to invoice exports in strong curencies and imports in weak currencies

Is it possible to gain from Risk Shifting?

Not possible if one is dealing with informed customers and suppliers



Pricing DecisionsThe general rule for credit sales overseas is to convert

between the foreign currency price and the home currency price by using forward rate , not the spot rate.

If the HC price is high enough, the exporter should follow through the sale.

If the HC price of a foreign currency denominated import is low enough, the importer should follow through the purchase.

Exposure Netting

Offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in in such a way that losses(gains) on the first exposed position should be offset by gains(losses) on the second currency exposure.


Exposure Netting

Exposure netting involves one of three possibilities:

1. A firm can offset a long position in a currency with a short position in the same currency.

2. If the exchange rate movements of the two currencies are positively correlated, then the firm can offset a long position in currency with a short position in the other

3. If the currency movements are negatively correlated, then short( or long) positions can be used to offset each other.

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Currency Risk sharing

Currency risk sharing can be implemented by developing a customised hedge contract imbedded in the underlying trade transaction.

The hedge contract typically takes the form of a price adjustment clause, whereby a base price is adjusted to reflect certain exchange rate changes.

The neutral zone represents the currency range in which risk is not shared. The parties would share the currency risk beyond a neutral zone.


Foreign Currency options


Funds adjustmentsEntering into forward contractsExposure netting

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Management of Translation Exposure

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Basic strategy for hedging translation exposure

Assets Liabilities

Hard Currencies

(likely to appreciate)

Increase Decrease

Soft Currencies(likely to

depreciate)

Decrease Increase

Direct Funds adjustmentsLC devaluation anticipated:

pricing exports in hard currencies and imports in local currency.

Investing in hard currency securities

Replacing hard currency borrowings with local currency loans


Indirect Funds adjustments

Adjusting transfer prices on sale of goods between affiliates

Speeding up payment of dividends, fees and royalties

Adjusting leads and lags of intersubsidiary accounts

( the hedging process of devaluation would be reversed for revaluations)


Basic Hedging Techniques

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Depreciation Appreciation

Sell local currency forward Buy local currency forward

Reduce levels of local currency cash and marketable securities

Increase levels of local currency cash and marketable securities

Tighten credit( reduce local currency

receivables)

Relax local currency credit terms

Delay collection of hard currency receivables

Speed up collection of soft currency receivables

Increase imports of hard currency goods

Reduce import of soft currency goods

Borrow Locally Reduce local borrowing

Delay payment of accounts payable

Speed up payment of accounts payable

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Basic Hedging Techniques

Depreciation Appreciation

Speed up dividend and fee remittances to parent and

other subsidiaries

Delay dividend and fee remittances to parent and

other subsidiaries

Speed up payment of intersubsidiary accounts

payable

Delay payment of intersubsidiary accounts

payable

Delay collection of intersubsidiary accounts

receivable

Speed up collection of intersubsidiary accounts

receivable

Invoice exports in foreign currency and imports in local

currency

Invoice exports in local currency and imports in

foreign currency

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Management of Economic Exposure

“The extent to which the value of a firm stands exposed to exchange rate movements, the firm’s value being measured by the present value of its expected cash flows”.

Result of economic consequences (rather than accounting consequences, as in the case of transaction and translation exposure) of exchange rate movements on the value of a firm, and hence, is also known as economic exposure

Economic exposure cannot be managed by the traditional hedging techniques due to the unpredictability of the changes in the cash flows. Rather, it requires various marketing, production and financial management strategies

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Marketing Strategies

The marketing manager analyzes the effect of a change in the exchange rate and evaluate the strategy required to manage the exposure. The four strategies available:Market selection,Pricing strategy,Promotional strategy, andProduct strategy.

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Market selection

This strategy is useful when the actual or anticipated change in the real exchange rate is likely to persist for a long time. Involves selection of the markets in which the firm wishes to market its products and providing relevant services to provide the firm an edge in these markets.(Depreciation of the currency of a market - pull out , Appreciation of the currency of a market – enter)

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Pricing Strategy

Two main issues involved in developing a pricing strategy

the choice between market share and profits, frequency of price adjustments.

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Market share vs. profit margin

Domestic currency appreciates:• reduce its domestic currency prices (thus maintaining

the foreign currency prices at the pre-appreciation level)

--- profit margins come down

• maintain the domestic currency prices (which would result in an increase in the foreign currency price)

--- fall in the market share (which would affect the profits of the firm)

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Domestic currency depreciates:

• increase the domestic currency price ( profit margin goes up) - called price skimming

• maintain price at the pre-depreciation level (thus reducing the foreign currency price to increase its market share - called penetration pricing.

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The greater the price elasticity - the higher the incentive to take a hit on profit margins rather than on market shares.

• it may not always be possible to regain lost market share subsequently. Even if it is possible, the cost may be prohibitive.

• This brings the expected duration of the change in the exchange rate into the picture. Longer the expected duration, less is the importance of lost sales.

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In case of large economies of scale, it may make more sense to forego larger profit margins and to try to make up the lost profit through higher volumes.

Lower the economies of scale - more important defending the profit margins.

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Frequency of price adjustments:Exchange rates move even on a minute-to-minute basis. A firm’s sales may get affected by frequent price changes, because of the resultant risk faced by its consumers. On the other hand, a firm may lose on account of unfavorable exchange rate movements if it delays the change in the price of its product. Finally, a balance between the two needs to be arrived, based on the

(1)level of uncertainty the firm’s customers are ready to face,

(2)the duration for which the exchange rate movement is likely to persist and

(3)the loss expected to be incurred by not changing the prices.

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Promotional strategy

• Change in the exchange rate would change the domestic-currency cost of overseas promotion

• Effect of exchange rate movements on promotional costs is also in the form of the expected revenues that can be generated per unit of expenditure on promotion

• A devaluation of the domestic currency may improve the competitive position of an exporting firm, thus increasing the expected revenue per unit of promotional cost. This may persuade the firm to increase the promotional expenditure in those markets.

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Product Strategy• Timing of introduction of new products

Introduce a new product when there is a price advantage (e.g., in case of an exporting firm, when the domestic currency has depreciated)

Hold back the products from the market when the conditions are not favourable

• Making product-line decisions

Company having to change its products in accordance with the exchange rate movements (involves producing high-end products at the time of an appreciation in the domestic currency, and producing mass products at the time of a depreciation) 56

• Product innovations

Appreciating domestic currency and extremely competitive conditions in the international market :

Protect cash flows by regularly coming up with innovative products. (offering differentiated product to customers, the firm may be able to protect its foreign currency price and profits)

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Product Strategy

Production Management of Exchange Riskexchange rate movements are too large and long

lasting

marketing strategies are not effective

long-term decisions to protect the firm from harmful effects of an unfavorable exchange rate movement

StrategiesInput mix

Product sourcingPlant location

Raising productivity58


Input mix• on the profits of an exporting firm caused by an

appreciating domestic currency • source more inputs in the international markets

than in the domestic market• reduce the costs at the time of reducing

revenues• protect profits to some extent

Oroutsource the intermediated inputs, either from

producers in the country where the firm is selling its final product, or from producers of a country whose currency is closely linked to that of the country in which it markets its products 59

Production Strategies

Product sourcing

• Distribute production among different production centers( in different countries)

• firm can reallocate production to increase the quantity produced in the country whose currency has depreciated, and reducing production in countries whose currency has appreciated

• Due to this flexibility, an MNC faces less economic exposure than a company having production facilities in only one country

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Problems of multiple production facilities

• economies of scale not being utilized resulting 1. in higher per unit cost2. excess capacities3. higher fixed costs in times of low production

requirements

• availability of an important raw material in a particular country

• protest by labor unions to shifting of production

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Plant location

Companies, which do not have multiple production facilities, may be forced to set up such facilities abroad as a response to exchange rate movements,

(which change the relative cost advantages of countries).

Firms may even decide to set up production facilities in third-world countries for labor-intensive products due to the low labor cost there, without there being any specific advantage due to exchange rate movements.

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Raising productivity

Appreciation of the domestic currency

costs of an exporting firm in terms of the foreign currency increases

product uncompetitive in the international market

force the firm either to (1)bear a cut in the profit margin or (2)to lose market share

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Documents

PPT-IFM-exposure and risk