CHAPTER 3:

EXCHANGE RATE RISK MANAGEMENT

LECTURER: DR. GIANG VUONG
Dr. Giang Vuong 2
 TEN OF THE WORLD’S WORST CURRENCIES
▪ 1. Iranian Rial (IRR)
▪ [Link] Dong (VND)
▪ 3. Indonesian Rupiad (IDR)
▪ 4. Guinean (Africa) (GNF)
▪ 5. Lao Kip (LAK)
▪ 6. Sierra Leonean (West Africa) (SLL)
▪ 7. Uzebekistan Som, ( UZS)
▪ 8. Paraguayan (South America) Guarani (PYG)
▪ 9. Cambodian Riel (KHR)
▪ 10. Myanmar Kyat (MMK)

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CONTENT:
▪ Exchange Rates
▪ Exchange Rate Risk
▪ Conversion Exchange Impact Management
▪ Economic Exchange Impact Management
▪ Transitional Exchange Impact Management

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EXCHANGE RATE
Concept:
- The exchange rate is the price of a unit of one country's currency in
terms of another country's currency.
- Quotation currency is always equal to one.
- Valuation currency has a value different from one.
▪ Example: 1 USD ~ 25,000 VND

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 EXCHANGE RATE
▪ The process of expanding foreign markets:
Foreign currency: (China - RMB)
The third country’s currency has
Subsidiary 1 business relationships with the
(Vietnam) parent company and the subsidiary.
(Local currency: VND)

Local currency: the

currency of the
subsidiary country Domestic currency: (USD)
the currency of the parent
company – where the
headquarters of the parent
Subsidiary 2 company is located.
(Indonesia)
(Iranian Rial (IRR) Apple Inc.
Dr. Giang Vuong Parent Company (US) 6
AN EXAMPLE:
▪ MMC has its headquarters in France, has two subsidiaries: a subsidiary
(MMC1) located in the UK and another subsidiary (MMC2) located in the
USA, and has a commercial business with a company C based in China.
Please identify the Domestic currency, local currency, and foreign
currency.

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EXCHANGE RATE
▪ Classifications:
+ Nominal exchange rate: is the exchange rate listed at foreign currency
trading establishments and announced in the mass media.
+ Real exchange rate: Reflects the long-term real value fluctuations of
domestic currency compared to foreign currency under conditions of
changes in commodity prices. In other words, the exchange rate reflects the
inflation rate of the two currencies.

Re: Real exchange rate.

E: Nominal exchange rate.
f: domestic inflation rate.
f*: foreign inflation rate.

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 EXCHANGE RATE
+ Purchasing power parity exchange rate: Reflects the purchasing power correlation
between two currencies. In other words, this is the ratio between the amount of domestic
currency and the amount of foreign currency that can buy the same basket of goods.
𝑬𝒑𝒑𝒑 = 𝑷 / 𝑷 ∗
- Comparing the nominal exchange rate and the purchasing power parity exchange rate
helps businesses decide which market is more profitable to sell their products in.
- Specifically:
+ 𝐸 > 𝐸𝑝𝑝𝑝: exporting will be more profitable.
+ 𝐸 < 𝐸𝑝𝑝𝑝: exporting will not be profitable.
E: Nominal exchange rate.
𝐸𝑝𝑝𝑝: basket of goods.
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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(1) Inflation gap between countries:
- Given that other factors remain constant,
Inflation in a domestic country > Inflation in foreign countries.
▪ Price of exported products increases -> Decreases competitiveness of exported
products -> Export turnover decreases -> Foreign currency supply decreases ->
Foreign currency appreciates, Domestic currency depreciates, and vice versa.

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(1) Inflation gap between countries:
Given that other factors remain constant.

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(2) Interest rate differences between countries:
Given that other factors remain constant,
- Domestic interest rate > Foreign interest rate.
• Demand for deposits in domestic currency and investment in financial assets
denominated in domestic currency increases -> Demand for using domestic
currency increases -> Domestic currency appreciates and vice versa.

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(2) Interest rate differences between countries:

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(3) Increase/decrease in national income in countries:
- With other factors remaining constant,
▪ Domestic national income increases > National income abroad ->
Demand for goods and services in that country increases faster than
abroad (including goods from abroad) -> Demand for foreign currency
increases -> Foreign currency appreciates and vice versa.
-

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(3) Increase/decrease in national income in countries:

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 EXCHANGE RATE
▪ Factors that affect the exchange rate:
(4) Exchange rate expectation:
- Expectations of a currency's appreciation or depreciation by participants in the
foreign exchange market.
- Expectations of a foreign currency's appreciation > Buy more foreign currency
-> Demand for foreign currency increases -> Foreign currency appreciates and vice
versa.

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(4) Exchange rate expectation:

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EXCHANGE RATE
▪ Factors that affect the exchange rate:
(5) Government intervention:
- Through international trade policy (increase exports, reduce imports, or tariff
regulations).
- Through international investment policy.
- Through monetary policy: Increase/decrease the money supply and interest
rates.
- Through exchange rate policy: Regulations on foreign exchange transactions,
exchange rate fluctuation range, and through open market operations.

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DISCUSSION
▪ The CHIPS and Science Act is a U.S. federal statute enacted by the 117th United
States Congress and signed into law by President Joe Biden on August 9, 2022.
▪ How does this Act affect Nvidia Corporation and Intel Corporation?

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Dr. Giang Vuong 20
EXCHANGE RATE
Ø Exchange rate regimes:
- Fixed exchange rate regime.
- Free-floating exchange rate regime.
- State-managed floating exchange rate regime.

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EXCHANGE RATE
* Impact of exchange rates on the business operations of enterprises:
- For international trade.
- For international investment.
- For multinational companies: Direct impact on the company's cash flow
through business activities in the global environment, and can reduce the
company’s value.
- For import-export companies: Exchange rate fluctuations can
increase/decrease input costs or decrease/increase revenue.
- For credit institutions: Foreign exchange trading activities and foreign
currency credit activities of credit institutions are also affected.

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EXCHANGE RATE RISK
Ø Definition of Exchange rate risk:
- Exchange rate risk is also known as currency risk, foreign exchange risk, or
the risk of exchange rate fluctuations.
- This type of risk refers to the losses that an international financial transaction
may incur due to currency fluctuations,
- Describes the possibility that the value of trade and investment may decrease
due to changes in the relative value of related currencies.

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 EXCHANGE RATE RISK
EXCHANGE RATE CHANGE

Conversion Exchange Impact: Economic Exchange Impact:

Changes in the consolidated financial Increased changes in expected future
statements occur due to changes in cash flows occur due to changes in
exchange rates. exchange rates.

Transaction Exchange Impact:

Rate changes affect business payments.

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 EXCHANGE RATE RISK
▪ Definition: Transaction exchange risk exists when a company's future cash transactions are
affected by fluctuations in exchange rates.
▪ Stages of transaction exchange impact:

(2) Buyer placed (3) The seller delivers

(t1) Seller quotes the goods to the buyer (4) Buyer pays
order at the asking
price to buyer and records the seller.
price at time t1
receivable account.

Quotation exchange Order Fulfillment Exchange Payment exchange rate

rate risk Rate Risk

Time of quotation - Time of Order completion time after

contract signing Payment time required
contract signing
after sold
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EXCHANGE RATE RISK
Information on current
economic situations, Information on current
estimates of different and estimated cash flows
countries, and historical for each currency at
exchange rate each subsidiary
movements

Managing exchange rate Measuring the risk of

Exchange rate prediction
volatility risk: exchange rate volatility

- How will risk impact cash flows

based on exchange rate forecasts?

- Should risk be hedged, and what

hedging techniques should be
used?
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EXCHANGE RATE RISK
▪ Measuring the impact of exchange rate transactions:
- MNC forecasts net cash flows (inflows and outflows) of all branches and
subsidiaries in each currency, usually short-term.
- Forecasts expected exchange rates: Point or Range.
- Determines net cash flows in local currency.
- Measures the overall risk of transaction exchange impact.

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EXCHANGE RATE RISK
▪ EXAMPLE:

Table: Predicted cash flows Table 2: Predicted

Currency Inflows Outflows Currency Point Range

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EXAMPLE 1:

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EXAMPLE 1:

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EXAMPLE 2:

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EXAMPLE 2:

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Currency Net cash flows Predicted exchange rate Net cash flows (US)

Currency Net cash flows Predicted exchange rate Net cash flows (US)

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EXCHANGE RATE RISK
• Step 1: Identification
- Determine the impact of exchange rate risk.
• Step 2: Analysis
- Consider whether it is necessary to hedge against this exchange rate impact.
- “B–C” analysis.
• Step 3: Response
- Select appropriate hedging techniques.

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EXCHANGE RATE RISK
▪ Basic prevention techniques:

(1) Hedging prevention: Building an offsetting currency position so that

any losses that occur due to the exchange rate risk of the original
currency will be offset by the gains of a hedge currency position.

(2) Natural prevention: Must arrange the currency basket; arrange the inflow and
outflow. (Example: Change from production market to consumption market ->
Change position -> Natural prevention).

(3) Hedging in the foreign exchange market by using: Forward contracts,

Futures contracts, Money market, Currency options.

Note: Must stand on the parent company's money perspective to maximize the parent company's benefits.

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Dr. Giang Vuong 36
EXCHANGE RATE RISK
Case 1:
▪ MNC A needs $10 million to buy X and $20 million to buy Y one year later,
and will receive $30 million when converting the cash inflows of Z.
▪ After 1 year, X increases by 10%, Y increases by 20%, and Z decreases by
10%.
▪ ∑ the amount of money spent on X and Y = $10 million x 1.1 + $20 million x
1.2 = $35 million.
▪ ∑ the amount of money received from Z = $30 million x 0.9 = $27 million.
▪ Total amount of money lost = $8 million.

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Dr. Giang Vuong 38
EXCHANGE RATE RISK
Case 2:
▪ MNC A needs $10 million to buy currency X, $20 million to buy Y, and
$30 million to buy currency Z one year later.
▪ After 1 year, currency X and currency Y increase by 20%, and
currency Z decreases by 20%.
▪ ∑ purchase amount of X and Y = 10 million USD x 1.2 + 20 million USD
x 1.2 = 36 million USD.
▪ ∑ purchase amount of Z = 30 million USD x 0.8 = 24 million USD.
Company A's USD cash flow is not affected.

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EXCHANGE RATE RISK
Natural hedging (natural prevention):
▪ Requires the firm to match or balance foreign currency inflows and outflows by
appropriately structuring its currency basket.
▪ The objective is to reduce foreign exchange exposure through operational
decisions rather than financial derivatives.
Example: Shifting production from the home country to the consumption (sales)
market changes the firm’s currency exposure. By realigning operating positions,
foreign exchange risk can be naturally hedged.

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EXCHANGE RATE RISK
Natural hedging (natural prevention):
▪ Currency positions:
Same position: Both currencies generate cash inflows, or both generate cash outflows.
Opposite (different) positions: One currency generates a cash inflow while the other
generates a cash outflow.
▪ Exchange rate correlations:
Positive correlation: The exchange rate of the parent company’s (domestic) currency
appreciates, and/or the exchange rate(s) of the subsidiary’s foreign currency(ies)
depreciate.
Negative correlation: The exchange rate of one foreign currency appreciates while
the exchange rate of another foreign currency depreciates.
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EXCHANGE RATE RISK
Natural hedging (natural prevention):
▪ A firm arranges its foreign currency inflows and outflows to reduce overall transaction
risk arising from exchange rate fluctuations.
▪ This is achieved by managing the size and direction (buy/sell position) of exposures in
different currencies rather than using financial derivatives.

▪ Currency positions and correlations:

* Currency position:
+ Same position → both currencies generate cash inflows, or both generate cash
outflows.
+ Opposite positions → one currency generates a cash inflow while the other generates
a cash outflow.
* Correlation between currencies:
+ Positive correlation → two currencies tend to appreciate or depreciate together.
+ Negative correlation → one currency appreciates while the other depreciates.

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 EXCHANGE RATE RISK
Natural hedging (natural prevention):
Impact on overall transaction risk
* Same position + positive correlation → Resonance effect
+ Exchange rate movements reinforce each other, increasing overall transaction
risk.
* Opposite positions + negative correlation → Cancellation effect
+ Exchange rate movements offset each other, reducing overall transaction risk.

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EXCHANGE RATE RISK
Hedging (Financial) Prevention:
▪ The firm creates a compensating currency position so that any loss arising from
exchange rate movements in the base (exposure) currency is offset by gains from
the hedging currency position.
▪ This approach relies on financial techniques rather than operational adjustments.
Key principles:
▪ The parent company’s currency (domestic currency) is used as the benchmark for
measuring exchange rate exposure.
▪ Priority of benefits: Risk reduction is assessed primarily from the parent
company’s perspective, followed by the subsidiary.

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EXCHANGE RATE RISK
Hedging (Financial) Prevention:
▪ Lead and lag strategies:
+ Lead: Accelerating the timing of payments or receipts to take advantage of
expected favorable exchange rate movements.
+ Lag: Delaying payments or receipts to benefit from anticipated future
exchange rate changes.

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EXCHANGE RATE RISK
▪ EXAMPLE:

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EXCHANGE RATE RISK
90-day receivables: 400,000 EUR. EUR loan interest rate = 1.02 (Must convert from 8% / year to
3 months)
1, Jan to 1, April: there is 400,000 EUR from the maturity receivable (cash inflow).
The company wants to fix the EUR exchange rate on 1/1, so the company will create a loan, with
the loan term exactly equal to the maturity of the receivable.
We will borrow a EUR from the bank (on 1/1) and will mature this loan exactly on 1/4, with the
amount must be less than 400,000. EUR so that when the repayment is due, the loan payment
and interest must match exactly 400,000 EUR.
So, the total amount of EUR needed to borrow is 400,000 EUR/ 1.02 = 392,157 EUR
After the company has 392,157 EUR, the company will convert to the spot exchange rate to
know how many USD it needs to buy EUR.
Thus, the company has fixed the 90-day receivable with a value of 400,000 EUR as of 1 January
(according to the exchange rate of January 1).
-> The company is no longer affected by exchange rate risk.
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EXCHANGE RATE RISK
When the local currency is expected to appreciate:
- Buy local currency forwards to lock in the future exchange rate.
- Buy local currency call options to benefit from appreciation while limiting downside risk.
- Increase holdings of local-currency cash and marketable securities.
- Reduce local currency payables to avoid higher repayment costs after appreciation.
- Accelerate receivables denominated in weak (foreign) currencies to convert them earlier into
local currency.
- Reduce local borrowing to avoid higher real debt burdens after appreciation.
- Increase local currency payables
- Delay dividend payments and remittances to the parent company and other subsidiaries.
- Invoice exports in local currency and imports in foreign currency to shift exchange rate risk
outward.

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EXCHANGE RATE RISK
When the local currency is expected to depreciate:
• Sell local-currency forward contracts to lock in the current exchange rate.
• Buy put options on the local currency to benefit from depreciation while limiting downside risk.
• Reduce holdings of local-currency cash and marketable securities.
• Tighten trade credit denominated in local currency to limit exposure.
• Delay collection of receivables denominated in strong (foreign) currencies.
• Increase imports priced in strong (foreign) currencies to accelerate payments before further
depreciation.
• Increase local-currency borrowing to repay later with a weaker currency.
• Delay payment of local-currency payables to benefit from depreciation.
• Increase dividends and remittances to the parent company and other affiliates.
• Increase payments to internal branches and delay the collection of receivables from branches.
• Invoice exports in foreign currency and imports in local currency to shift exchange rate risk
outward.

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 MULTIPLE CHOICE TEST
▪ Question 1: A multinational company headquartered in the U.S, the company
opened a branch in Vietnam. If the local currency tends to depreciate against
the domestic currency in the next year, the subsidiary should transfer profits
to the parent company.
A. Transfer at the beginning of next year.
B. Transfer at the end of this year.
C. No impact.
D. Not enough data to conclude.

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MULTIPLE CHOICE TEST
▪ Question 2: A multinational company headquartered in the U.S, the company
opened a branch in Vietnam. If the local currency tends to increase against the
domestic currency in the next year, the subsidiary should transfer profits to the
parent company.
A. Transfer at the beginning of next year.
B. Transfer at the end of this year.
C. No impact.
D. Not enough data to conclude.

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MULTIPLE CHOICE TEST
▪ Question 3:
The parent company needs to export products to the branch to sell to the local
market, if the local currency tends to depreciate against the domestic currency
in the next year, the parent company should:
A. Export at the beginning of next year.
B. Export at the end of this year.
C. No impact.
D. Not enough data to conclude.

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MULTIPLE CHOICE TESTS
▪ Question 4:
The parent company needs to export products to the branch to sell to the local
market, If the local currency tends to increase against the domestic currency in
the next year, the parent company should:
A. Export at the beginning of next year.
B. Export at the end of this year.
C. No impact.
D. Not enough data to conclude.

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MULTIPLE CHOICE TEST
▪ Question 5:
If the subsidiary owes the parent company $200,000 and the local currency is
expected to depreciate against the domestic currency over the next year, the
subsidiary should.
A. will pay at the begging of next year to the parent company.
B. will pay at the end of this year to the parent company.
C. No impact.
D. Not enough data to conclude.

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MULTIPLE CHOICE TEST
▪ Question 6:
If the subsidiary owes the parent company $200,000 and the local
currency is expected to increase against the domestic currency over the
next year, the subsidiary should.
A. will pay at the beginning of next year to the parent company.
B. will pay at the end of this year to the parent company.
C. No impact.
D. Not enough data to conclude.

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EXCHANGE RATE RISK
(3) Prevention in the foreign exchange market:

FORWARD FUTURE CURRENCE MONEY

HEDGE HEDGE OPTION MARKER
HEDGE HEDGE

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EXCHANGE RATE RISK
▪ FORWARD AND FUTURE CONTRACTS:
- MNCs estimate the real cost of hedging:
RCHp = NCHp - NCp
+ RCHp = Real cost of hedging.
+ NCHp = Nominal cost of hedging.
+ NCp = Nominal cost without hedging.
- When RCHp < 0 -> Hedging should be performed.

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EXCHANGE RATE RISK

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EXCHANGE RATE RISK
• Option contracts:
- Hedging payables is buying currency call options.
- Hedging receivables is buying currency put options.
Guidelines:
- Hedging payables means that we have to pay money in the future.
From this moment on, we must choose to buy currency call options (at this time
we have fixed the exchange rate of the foreign currency needed for the
payable at this moment) so that when the payables are due, we have foreign
currency to pay.
- Hedging receivables is buying currency put options and vice versa.

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EXCHANGE RATE RISK

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EXCHANGE RATE RISK

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EXCHANGE RATE RISK

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EXCHANGE RATE RISK
▪ Exercise:
Nashville Sc receives 600,000 Euros after 90 days, with a put option with the strike price
of $1.45. Option purchase price is $0.03/ EUR.
Case Exchange rate at Option fee Amount Total Amount
payable due paid for 1 amount paid for
euro paid for 1 600,000
euro Euro
1 $1.44 $0.03 $1.45 $1.42 $852,000
2 $1.46 $0.03 $1.46 $1.43 $858,000
3 $1.51 $0.03 $1.51 $1.48 $888,000

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EXCHANGE RATE RISK
▪ Monetary market hedge:

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EXCHANGE RATE RISK

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EXCHANGE RATE RISK

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COMPARISON HEDGING TECHNIQUES
Hedging techniques are compared to determine:
-Minimize the value of payables
-Maximize the value of receivables

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DISCUSSION
▪ Let’s compare five hedging exchange rate risk techniques (natural
hedging, options, forwards, futures, and swaps).

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EXERCISE 1:
▪ IBM Corporation has a payable of GBP 200,000 due in 180 days. The current exchange rate is
$1.50. The 180-day forward rate for GBP is $1.47.
Spot rate of USD after 180days Probability
Interest rate GBP USD
1.43 20%
Deposits in 180 days 4.5% 4.0%
1.46 70%
Loans in 180 days 4.2% 5.0%
1.52 10%

A GBP call option expiring in 180 days has a strike price of $1.48 and a call price of $0.03.
A GBP put option expiring in 180 days has a strike price of $1.49 and a put price of $0.02.
IBM Corporation considers using:
(1) Forward contract; (2) Money market; (3) Options; (4) No hedge.
Requirement: Should IBM Corporation hedge this liability?

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 EXERCISE 2:
▪ IBM Corporation has a receivable of SFr 1,100,000 due in 120 days. The current exchange rate is $0.63. The
120-day forward rate for SFr is $0.72. IBM Corporation considers using: (1) Forward contract, (2) Money
markets, (3) Options, (4) No hedge.

Interest rate SFr USD An SFr put option expiring in 120 days has a
Deposits due to one year 6.25% 6.75% strike price of $0.68 and a put price of $0.04.

Loans due to one year 6.91% 7.01% An SFr call option expiring in 120 days has a
strike price of $0.66 and a call price of $0.03.
Spot rate of USD after 120 Probability
days Required: Should IBM Corporation hedge this
0.6 20% receivable?

0.7 30%
0.75 50%

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 EXERCISE 3:
▪ IBM Corporation has a payable of 250,000 GBP due in 90 days. The current exchange rate is $1.45. The
90-day forward rate for GBP is $1.48.

A GBP call option expiring in 90 days has a

Interest GBP USD strike price of $1.51 and a call price of $0.04.
Deposits due to 90days 4.2% 4.1% A GBP put option expiring in 90 days has a
Loans due to 90 days 4.9% 5.2% strike price of $1.52 and a put price of $0.03.
IBM Corporation considers using:
Spot rate of USD after 90days Probability (1) Forward contract
1.49 30% (2) Money Market
1.53 60%
(3) Options
1.5 10%
(4) No hedge
Required: Should IBM Corporation hedge
this liability?

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EXERCISE 4:
▪ IBM Corporation has a receivable of SFr900,000 due in 180 days. The current exchange rate is
$0.59. The 180-day forward rate for SFr is $0.78. IBM Corporation considers using: (1) Forward
contracts; (2) Money markets; (3) Options; (4) No hedge.

Interest rate SFr USD An SFr put expiring in 180 days has a strike
Deposits in one year 6.55% 6.65%
price of $0.72 and a put price of $0.05.
Loans in one year 6.98% 7.02% An SFr call expiring in 180 days has a strike
price of $0.75 and a call price of $0.06.
Required: Should IBM Corporation hedge this
Spot rate of USD after 180 days Probability receivable?
0.61 40%
0.70 30%
0.73 30%

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EXERCISE 5:
▪ Boeing Co. has a JPY500,000 payable in 120 days. The current exchange rate is 2.40 USD, and the
120-day JPY forward rate is 2.52 USD.
A JPY call option expiring in 120 days has a strike price
Interest rate JPY USD
of $2.30 and a call price of $0.35.
Deposits due to 120 4.2 4.1%
days % A JPY put option expiring in 120 days has a strike price
of $2.52 and a put price of $0.40.
Loans due to 120 days 4.9 5.2%
% Boeing Co. considers using:
Spot rate of USD after Probability
120 days (1) Forward contract
2.45 25% (2) Money market
2.53 30%
(3) Options
2.58 45%
(4) No hedge
Required: Should IBM Corporation hedge this payable?

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 EXERCISE 6:
Boeing Co. has a receivable of SFr 1,300,000 due in 90 days. The current exchange rate is $0.42. The
90-day forward rate for SFr is $0.72. Boeing Co. is considering using: (1) Forward contracts; (2)
Money markets; (3) Options; (4) No hedge.

Interest rate SFr USD An SFr put expiring in 90 days has a strike
Deposits due to one year 6.05% 6.58% price of $0.68 and a put price of $0.04.
Loans due to one year 6.24% 6.92% An SFr call expiring in 90 days has a strike
price of $0.64 and a call price of $0.05.

Spot rate of USD after 90 Probability Required: Should IBM Corporation hedge this
days receivable?
0.61 40%
0.70 30%
0.73 30%

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ECONOMIC EXCHANGE RISK MANAGEMENT

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ECONOMIC EXCHANGE RISK MANAGEMENT
Definition:
- Economic exchange risk exists when the company's future cash flows are affected
by exchange rate fluctuations.
- MNC cash flows include: operating cash flows (operating CF) and financing cash flows
(financing CF).
+ Operating cash flows: receivables, payables, rent, royalties, license fees, management
fees, etc., between branches, parent companies, subsidiaries within the same group
(intra-company) or between the company and outside companies (inter-company).
+ Financial cash flows: loan payments, equity injection, dividend payments, etc., also
within and outside the group.

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 ECONOMIC EXCHANGE RISK MANAGEMENT
IMPACT OF EXCHANGE RATE RISK ON ECONOMY

The first business impact that occurs due to a The transaction impact occurs after the business impact,
rise or fall in foreign currency is the impact on when there are payment commitments that cause the
a company's future profits and costs. company to engage in foreign currency transactions.

- Economic exchange rate impacts on MNCs vary because:

+ Diversity of business markets.
+ Foreign competitors.
+ Fluctuation of exchange rates.

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 ECONOMIC EXCHANGE RISK MANAGEMENT
Transactions affecting cash inflows Impact of domestic currency Impact of domestic currency
in domestic currency appreciation on transactions depreciation on transactions

1. Domestic sales Reduce Increase

2. Export sales Reduce Increase
3. Interests received from foreign Reduce Increase
investments

4. Import costs Reduce Increase

5. Interest payments on foreign Reduce Increase
currency

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 ECONOMIC EXCHANGE RISK MANAGEMENT
▪ MEASURING THE IMPACT OF EXCHANGE RATE RISK ON ECONOMY:
* Method 1: Analysis of income forecasts in the income statement affected by exchange rate
fluctuations.
* Method 2: Regression method according to the following formula:
PCFt = a0 + a1*et+ µt
PCFt is the % change in inflation-adjusted cash flows in domestic currency during period t.
A0 is constant.
A1 is the regression coefficient.
µt is an error.

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Method 1: Analysis of income forecasts in the income statement

affected by exchange rate fluctuations

❖ Multinationals can determine their exposure by assessing the sensitivity of

their inflows and outflows to potential exchange rate scenarios.

❖ Multinationals can reduce their exposure by restructuring their operations to

balance exchange rate-sensitive cash flows.

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 ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Madison example: Madison operates in the US and Canada. Some company information
is as follows:
- The company sells in the US and Canada;
- Most of the raw materials for production are purchased from Canada, paid for in CAD

sales

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ECONOMIC EXCHANGE RISK MANAGEMENT

Gross profits

EBT

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ECONOMIC EXCHANGE RISK MANAGEMENT
Num Indicator CAD = 0.75 CAD = 0.8 CAD = 0.85
1 Revenue 303 307,2 310,4
2 COGs 200 210 220
(3)=(1)-(2) Gross profits 103 97,2 90,4
(4)=(5)+(6) Operating costs 60,3 60,72 61,04
5 Fixed costs 30 30 30
30,3=303 * 30,72 31,04 =
(6)=(1)*10% Variable costs 10% =307,2*10% 310,4*10%
(7) = (3)- (4) EBIT 42,7 36,48 29,36
8 Interest expenses 10,5 11 11,5
(9)=(7)-(8) EBT 32,2 25,48 17,86

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ECONOMIC EXCHANGE RISK MANAGEMENT
Managing Madison's Economic Exchange Impact:
• Madison's EBT is inversely proportional to the appreciation of the CAD.
• Madison can reduce its risk by increasing sales in Canada, reducing its
raw material orders in Canada, and borrowing less in CAD.
• Additionally, Madison can increase its raw material orders in a foreign
currency that is weaker than the USD.

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ EXERCISE 1:
Sumitoro (Japan) operates in the US and Japan. Some information about the company is as follows:
- The company sells products in the US and Japan;
- Most of the raw materials for production are purchased in the US, paid in USD.
Requirement: Measure the economic impact of exchange rate

Indicator JPY USD Predicted Predicted USD/JPY

Revenue revenue revenue exchange
in Japan in US rate
COGS 150 140
300 80 117
Fixed costs 300
304 80 124
Variable costs 10%
307 80 132
Interest costs 5 8

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Strategy for managing economic exchange rate impact:
+ Try to increase revenue in the consumer market.
+ Try to reduce costs in the production market.
+ Convert the production market to the consumer market and find another
production market.

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Strategy for managing economic exchange rate impact:

1) Marketing Strategy
2) Production Management Strategy
3) Financial Management Strategy

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Strategy for managing economic exchange rate impact:

1) Marketing Strategy
- Select markets and supporting marketing strategies
to develop each market.
- Change product strategy (introduce new products,
improve products) to adapt to exchange rate changes.
- Pricing strategy: consider market share and profit.

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Strategy for managing economic exchange rate impact:

2) Production Management Strategy

- Selecting inputs to produce the product: finding
alternative sources of inputs that are cheaper.
- Shifting production prices between plants: increasing
production in a country where the currency is
depreciating and reducing production in a country
where the currency is appreciating.
- Improving production efficiency: high automation,
negotiating wages, and cutting profits.

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ECONOMIC EXCHANGE RISK MANAGEMENT
▪ Strategy for managing economic exchange rate impact:

3) Financial Management Strategy

- Determine the debt structure to ensure
that the decrease in profits is offset by the
reduction in costs in servicing the loans.
- The implementation method is foreign
currency financing.
+ Type of loan.
+ Loan amount.

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 TRANSITION RISK MANAGEMENT

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TRANSITION RISK MANAGEMENT
(1) Definition:
▪ Transition risk arises when an MNC converts the financial figures of its subsidiaries
into domestic currency for consolidated financial statements.
▪ Investors and shareholders rely on this information to assess the value of the
company.

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TRANSITION RISK MANAGEMENT
(2) Factors affecting transition risk management:
1) Subsidiary contribution level.
2) Subsidiary operating location.
3) Accounting method.
Transformation risk does not directly affect cash flow, but MNCs
are still concerned because of its potential impact on
consolidated financial statements.

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 TRANSITION RISK MANAGEMENT
▪ (3) Accounting method (conversion):
a) Current/Occurrence Method
- All current assets and liabilities are translated at the current exchange rate.
- Long-term assets and liabilities, equity, are translated at the exchange rate at
the time of their occurrence (Book rate).
- Income statements are translated at the average exchange rate throughout the
reporting period.

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 TRANSITION RISK MANAGEMENT
▪ (3) Accounting method (conversion):
b) Monetary/non-monetary method:
- Monetary assets and liabilities are translated at the current exchange rate.
- Other items in the balance sheet are translated at the exchange rate that
occurred (recorded).
- Income statements are translated at the average exchange rate during the
reporting period, except:
- Non-monetary liabilities are translated at the current exchange rate.
- Cost of goods sold (COGS) is translated at the exchange rate that occurred
(recorded).
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TRANSITION RISK MANAGEMENT
▪ (3) Accounting method (conversion):
c) Time method:
- Same as the monetary/non-monetary method, except that inventories are
converted at the current exchange rate.
- Revenue and cost of goods sold are converted at the average exchange rate.

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TRANSITION RISK MANAGEMENT
▪ (3) Accounting method (conversion):
d) Current exchange rate method:
- All items on the balance sheet are translated at the current exchange rate.
- Items on the income statement are translated at the average exchange rate.

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TRANSITION RISK MANAGEMENT
- Use a hedging strategy when it is necessary to prepare consolidated
financial statements for the parent company.
- Capital adjustment: change the amount or currency (or both) of cash flows
to reduce the impact of translation risk.
- Create an exchange rate impact network:
+ Select negatively correlated currencies to offset each other.
+ The loss caused by a depreciation of one currency can be offset by a rise in
another currency.

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WRAP UP!
Do you have any questions? Please!

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