Foreign Exchange Exposure - Investortonight

What is Foreign Exchange Exposure?

Foreign exchange exposure is the sensitivity of the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.

It can also be defined as a measure of the potential for firm’s profitability, net cash flow and market value to change because of a change in exchange rates.

A crucial task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow and market value of the company

Adler and Dumas have defined ‘exposure as the sensitivity of changes in the real domestic currency value of assets, liabilities or operating incomes due to unanticipated change in exchange rates.

Exposure measures the extent to which the value of goods in terms of domestic currency is changed due to unanticipated changes in the exchange rate. Exposure exists on both domestic and foreign assets.

Exposure can be measured with the slope of the regression line between value of assets and liabilities and unanticipated changes in the exchange rate.

Let the value of assets and liabilities be denoted by ∆VAL and the unanticipated change in the exchange rate by ∆ER. As per the regression, the line can be denoted as:

∆VAL = α + β ∆ER + e_t

where ∆VAL is the change in the value of an asset or a liability, ∆ER is the change in exchange rate, et is error term, á is intercept and â is the sensitivity of the change in the value of assets or liabilities in response to a change in the value of exchange rate.

Foreign Exchange Risk

Foreign exchange risk is the risk that the domestic currency value of cash flows, denominated in foreign currency, may change because of the variation in the foreign exchange rate. There would not be any foreign exchange risk if the exchange rates were fixed. Thus, the exchange risk may be defined as the variability of the firm’s value resulting from the unanticipated exchange rate changes.

Foreign exchange risk is measured by the variance of the domestic currency value of assets, liabilities, or operating income that is attributable to unanticipated changes in exchange rates

There are two broad types of foreign exchange exposures:

Economic exposure
Accounting exposure or Translation exposur

Economic exposure has been further divided into:

Transaction exposure
Operating exposure

Types of Foreign Exchange Exposure

Transactions Exposure

Whenever a foreign currency is transacted, there will be certain risks involved at the time of entering into transaction and at the time of realization of the cash of the transaction due to the difference in time period.

This is due to the exchange rate movement that resulted into a change in the domestic currency value of the transaction. This change in the value of the transaction results in gains or losses which involve definite movement.

For example, let there be a deal for export of T-shirts to an importer in the US. If the exporter quotes the price of a T-shirt as ₹ 250/ per piece and $1 US = ₹62, it will cost the exporter $4.03. By the time payment arrives, $1 US = 60. As a result, the exporter will get ₹241.80/ per piece.

So, the exporter is at a loss of ₹ 8.20 per piece. If the order was of 1000 pieces, the exporter would bear a total loss of ₹ (1000×8.20) = 8,200.

Various types of transactions that contribute to transaction exposure are as follows:

Accounts payable in foreign currencies
Accounts receivable in foreign currencies
Non-recorded commitments to pay in foreign currency
Non-recorded commitments to accept payments in a foreign currency
Debt payments to be made in foreign currency
Commitments to accept loan-re-payments in foreign currency
Anticipated payments from foreign subsidiaries
Unperformed forward exchange contracts

Techniques of Managing Transaction Exposure

Transaction exposure arises due to unpredictable movement of exchange rate and the open positions in assets or liabilities or both.

Therefore, hedging involves entering into a financial counter-transaction to offset the risk associated with long or short unhedged positions in a foreign currency at a future point in time.

An MNC can hedge its transaction exposure using the following hedging techniques:

Forward contract

If a firm is required to pay a specific amount of foreign currency in the future, it can enter into a contract that fixes the price for the foreign currency for a future date. This eliminates the chances of suffering due to currency fluctuations.

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 the disequilibrium between money and foreign exchange market.

The importer has two possibilities: to take advantage of interest rate differentials in the money markets and the premiums and discounts existing in the forward foreign exchange market.

Hedging with Future Contract

Future is a standardized instrument. Therefore, while hedging with futures one must ensure that the hedge will not exactly match the transaction in size and maturity.

The importer has a transaction worth $100,000 and the size of dollar future is also $100,000. The importer will buy one future that will mature on a particular date and the currency will be available with the hedger at the time of maturity only.

The maturity date of the future may not be suitable to the hedger because the date of payment to the supplier is fixed in the contract and may not match with the maturity of the future.

Hedging with Options

Currency options give the individual the right to exercise a buy or sell transaction of a currency and the purchaser of the option is not obliged to exercise the right that he has purchased after paying a premium.

In the case of hedging with options, the option is exercised and the hedge comes into operation if the prices surpass the expectations.

This type of hedging is usually resorted when non-performance of contract is expected. In India, cross-currency option hedges are permitted. In this kind of hedge, one is not allowed to hedge the currency of invoicing with domestic currency but a foreign currency is hedged with another foreign currency.

Hedging Through Currency Invoicing

During the negotiation of an import contract, if an importer of a country with weak currency get goods invoiced in domestic currency and the exporter invoice the goods in a strong currency, the risk shifts from one company to the other.

Exposure Netting

The net of payables and receivables is termed as netting. The exposure is reduced if it is possible to net the payables and receivables. In this case, the cost of the hedge is also reduced.

Currency Risk Sharing

An agreement to share currency risk between an international seller and buyer to spread out the impact of currency rate changes is called currency risk-sharing. This is done by developing a customized hedge in which the base price is adjusted to reflect certain exchange rates.

Operating Exposure

Operating exposure has an impact on the firm’s future operating costs and cash flows. Since the firm is valued as a going concern entity, its future revenues and costs are to be affected by the exchange rate changes.

If the firm succeeds in passing on the impact of higher input costs fully by increasing the selling price, it does not have any operating risk exposure as its operating future cash flows are likely to remain unaffected.

In addition to supply and demand elasticities, the firm’s ability to shift production and sourcing of inputs is another major factor affecting operating risk exposure.

Managing Economic Exposure

The objective of operating exposure management is to predict unexpected movements in exchange rates and find out the effect of this movement on the firm’s future cash flows. A strategic policy is to be designed to meet the adverse effects on future cash flows.

The policies can be any one of the following or a mix of these:

Diversification

An MNC may resort to diversification to hedge the operating risk. It would require forecasts on exchange rate, inflation rate and interest rates. Predicting these variables, the MNC can decide about the diversifying operations or financing sources or both.

Diversifying operations: Diversification provides flexibility in operations. If an MNC’s operations are well diversified in currencies that do not move together, the risk is minimized. Management is prepositioned to find the disequilibrium when it occurs and reacts competitively.
Diversifying financing: By adopting diverse financing sources, an MNC would be prepositioned to take the advantage of deviation from the International Fisher effect. If interest rate differentials do not equal the expected changes in exchange rates, opportunities to lower a firm’s cost of capital will exist.

Changing operating policies

Operating exposure can be managed by changing the operating policies. The three operating policies which are normally employed are:

Using leads and lags in payments: A firm has a payable in hard currency, and if depreciation is expected then the payables are to be lead and receivables are to be lagged. In case of soft currencies, converse is true. This applies to all payables and receivables such as debt payment and lending. Leading and lagging are largely feasible between subsidiaries and parent.
Sharing currency risk with customers: If the firms have a continuous longterm buyer and supplier relationship, then such a risk sharing may be agreed upon between them. The risk sharing clauses can be introduced in trading agreements. These clauses are intended to smooth out the impact on both parties of volatile exchange rate movements.
Re-invoicing centres: It is a separate corporate subsidiary that manages transaction exposures due to intra-company trade. The manufacturer subsidiary sells the output to distribution affiliates that by selling to re-invoicing centre, which in turn resells the goods to the distribution affiliate. Re-invoicing centre can only handle paperwork and has no inventory.

Translation Exposure

When an MNC creates an asset or borrows a loan from any other country, the value will depend on the movement in the exchange rate. When the foreign currency assets or liabilities have to be converted into home currency for closing the books for the year, there may be differences in the exchange rates of the currencies.

Managing Translation Exposure

Since subsidiaries operate in foreign countries, their assets and liabilities are denominated in foreign currencies and these assets and liabilities are to be translated into domestic currency for consolidation into parent’s balance sheet for the purpose of annual report.

The procedure to consolidate the balance sheet is regulated by Accounting Standard Boards, but there are four methods of translation of balance sheet.

Monetary and non-monetary methods

This method helps in differentiating between monetary assets and liabilities, for example, receivables and payables and non-monetary assets and liabilities, for example, physical assets and liabilities.

Monetary items such as cash, accounts payables, accounts receivables are translated at the current exchange rate and the non-monetary items like inventory, fixed assets, long-term investments are translated at historical rates.

Income statement items are translated at an average exchange rate during the period except current receivables and payables related to non-monetary asset liabilities, i.e. depreciation expenses and cost of goods sold are translated at the same rate as the corresponding balance sheet items.

The advantage of this method is that foreign non-monetary assets are carried at their original cost in parent’s consolidated statement. This approach is consistent with the practice of original cost treatment of domestic assets of the parent firm.

Temporal method

In this method, inventory is translated at the historical exchange rate just like monetary and non-monetary methods, but it is also translated at the current rate if these are shown in the balance sheet at market value.

Current and non-current methods

In this method, all current assets and liabilities are translated into domestic currency at the current exchange rate. Each noncurrent item is translated at the historical exchange rate.

Thus, in this method, the cash and working capital of a subsidiary after appreciation of the parent’s currency will result in translation losses and its appreciation will provide translation profits.

Current rate method

In this method, all balance sheet and income statement items are translated at the current rate except equity. If a firm’s foreign currency-denominated assets are more than its liabilities, a devaluation must result in a loss and a revaluation in a gain.