TOPIC 4: RISK AND INTERNATIONAL TRADE AND FINANCE

Objectives:

i) Highlight types of risks in international finance

ii) Discuss currency exposures

In addition to normal business and financial risk, companies face extra risks connected with trading and
investing overseas. These risks can be separated into political risk and foreign exchange risk.

Political or Country Risk

Political risk (also known as country risk) includes the problems of managing subsidiaries geographically
separated and based in areas with different cultures and traditions, and political or economic measures
taken by the host government affecting the activities of the subsidiary.

Whilst a host country will wish to encourage the growth of industry and commerce within its borders,
and offer incentives to attract overseas investment (such as grants), it may also be suspicious of outside
investment and the possibility of exploitation of itself and its population. The host government may
restrict the foreign companies' activities to prevent exploitation or for other political and financial
reasons. Such restrictions may range from import quotas and tariffs limiting the amount of goods the
firm can either physically or financially viably import, to appropriation of the company's assets with or
without paying compensation. Other measures include restrictions on the purchasing of companies,
especially in sensitive areas such as defense and the utilities - such restrictions could be an outright ban,
an insistence on joint ventures or a required minimum level of local shareholders. In order to prevent
the "dumping" of goods banned elsewhere (e.g. for safety reasons) a host government may legislate as
to minimum levels of quality and safety required for all goods produced or imported by foreign
companies.

Host governments, particularly in developing and underdeveloped countries, may be concerned about
maintaining foreign currency reserves and preventing a devaluation of their national currency. In order
to do this they may impose exchange controls. This is generally done by restricting the supply of foreign
currencies - thus limiting the levels of imports and preventing the repatriation of profits by MNCs by
restricting payments abroad to certain transactions. This latter method often causes MNCs to have funds
tied up unproductively in overseas countries.

Foreign Exchange or Currency Risk

Exchange rate risk applies in any situation where companies are involved in international trade. It arises
from the potential for exchange rates to move adversely and, thereby, to affect the value of transactions
or assets denominated in a foreign currency.

There are three main types of exchange rate risk to which those dealing overseas (importers, exporters,
those with overseas subsidiaries or parents, and those investing in overseas markets) may be exposed.

a) Transaction exposure
This occurs when trade is denominated in foreign currency terms and there is a time delay between
contracting to make the transaction and its monetary settlement. The risk is that movements in the
exchange rate, during the intervening period, will increase the amount paid for the goods/services
purchased or decrease the value received for goods/services supplied.

(b) Translation exposure

This arises where balance sheet assets and liabilities are denominated in different currencies. The risk is
that adverse changes in exchange rates will affect their value on conversion into the base currency.

Any gains or losses in the book values of monetary assets and liabilities during the process of
consolidation are recorded in the profit and loss account. Since only book values are affected and these
do not represent actual cash flows, there is a tendency to disregard the importance of translation
exposure. This is, though, a false assumption since losses occurring through translation will be reflected
in the value of the firm, affecting the share price and hence, shareholders' wealth and perceptions
among investors of the firm's financial health.

(c) Economic exposure

This refers to changes in the present value of a company's future operating cash flows, discounted at the
appropriate discount rate, as a result of exchange rate movements.

To some extent, this is the same as transaction exposure, and the latter can be seen as a sub-set of
economic exposure (which is its long-term counterpart). However, economic exposure has more wide
ranging effects. For example, it applies to the repatriation of funds from a wholly-owned foreign
subsidiary where the local currency falls in value in relation to the domestic currency of the holding
company. It can also affect the international competitiveness of a firm - for example, a UK company

purchasing commodities from Germany and reselling them in China would be affected by either a
depreciation (loss of purchasing power) of sterling against the Euro and/or an appreciation of Yuan.

It can also affect companies who are not involved in international trade at all. Changes in exchange rates
can impact on the relative competitiveness of companies trading in the domestic market visa-a-vise
overseas companies when imports become cheaper. Thus, reduced operating cash flows may be a
consequence of a strengthening domestic currency - a situation which has affected UK companies in the
late 1990s.

The management of exchange rate risk will involve hedging against adverse movements in order to
contain the extent of any exposure. At the operating level, the focus of attention is primarily on
managing the exposure caused by transaction and economic risk, both essentially being underpinned by
cash flows. The techniques which we shall examine in the following sections, then, relate essentially to
these aspects of exposure, with the greater emphasis on transaction exposure

As with managing interest rate risk, these techniques fall into two categories:

Internal, or natural, techniques - those which are effected entirely by the financial organization and
structure of the company itself; and

External, or transactional, techniques - those using the range of derivative instruments which are
effected by the use of third party services, such as banks and specialist exchanges.
Although both types of technique provide effective means of covering the exposure, certain external
techniques offer the possibility of taking advantage of favorable movements in exchange rates to
generate profits INTERNATIONAL FINANCE

INTERNAL METHODS OF MANAGING EXCHANGE RATE RISK AND EXPOSURE

a) Currency invoicing

The first approach is simply to invoice foreign customers in the currency of the seller. Invoicing for goods
supplied, and paying for goods received, in a company's domestic currency removes the exchange rate
risk for that company - but only one party to an exchange between foreign companies can have this
facility, and the other bears the risk of exchange rate fluctuations. However, the advantages of removing
exchange rate risk need to be weighed against those of invoicing in the foreign currency. These include
marketing advantages such as the ease for the customer of dealing in his own currency and the
possibility of purchasing at a discount if the foreign currency is depreciating relative to the domestic
currency. In fact, often the only way to win a contract overseas is to deal in the currency of that market.

One way to prevent one or both parties being subject to exchange rate risk is for the firms involved to
set a level of exchange rate to use for a transaction regardless of what the actual exchange rate is on the
day the money is transferred.

b) Netting

This is an internal settlement system used by multinational companies with overseas subsidiaries. It
involves offsetting (netting out) the outstanding foreign exchange positions of subsidiaries against each
other through a central point - the group treasury.

Suppose there are two overseas subsidiaries in different countries. Subsidiary A expects to receive a
payment in one month's time for the sale of goods to the value of $2m, while subsidiary B has to make a
payment of $3m in one month's time to a supplier. The central treasury can offset the two exposures
and set up an external hedge for the net risk of $1 m. This negates the need for two separate hedges to
be carried out - the first to cover the $3m against a rise in exchange rates against the dollar and second
to cover the $2m against a fall in exchange rates against the dollar. The single hedge is more efficient
and cost-effective.

c) Matching

This is the process of matching receipts in a particular currency with payments in the same currency.
This prevents the need to buy or sell the foreign currency and thus reduces exchange rate risk to the
surplus or deficit the firm has of the foreign currency. It is a cheap method of reducing or eliminating
exchange rate risk provided that the receipts precede the payments, and the time difference between
the two is not too long.

For example, where a company is selling to the US and has outstanding receipts denominated in $, it
could purchase raw materials in the same currency. The one transaction will offset the other and
minimize the exchange exposure that requires external hedging. It therefore does not matter whether
the $ strengthens or weakens against the domestic currency.
Alternatively, a firm could match, say, dollar currency receipts from the export of goods to the US with a
dollar loan. The receipts will be used to payoff the loan. This again secures the matching of an asset with
a liability.

This process can be made easier either by having a bank account in the foreign country or a foreign
currency account in a firm's own country, and putting in all receipts and taking from it all payments in
the overseas currency. The exchange rate risk on the surplus or deficit can be avoided by utilizing one of
the other methods of risk management.

Matching may also be used to reduce translation exposure - offsetting an investment in assets in one
currency with a corresponding liability in the same currency. For example, the acquisition of an asset
denominated in Yen could be achieved by borrowing funds in Yen. As the exchange rate against the Yen
varies, the effect it has on the translated value of the asset and liability will increase and decrease in
concert. The amount of the reduction in exposure will depend on the extent to which the expected
economic life of the asset corresponds with when the loan matures.

d) Leads and Lags

This final method of hedging internally involves varying payment dates to take advantage of the
exchange rate - for example, paying either before or after the due date, depending on exchange rate
movements. The effectiveness of this is dependent on how well exchange rate movements can be
anticipated. A company will only pay in advance if it expects the domestic currency to weaken, but if it
misreads the movement and the exchange rate strengthens, advance payment may prove expensive.

Leads are advance payments for imports to avoid the risk of having to pay more local currency if the
supplier's currency increases in value.

Lags involve slowing down the exchange of foreign receipts by exporters who anticipate a rise in the
value of the foreign currency received. When this occurs, they will then benefit by an exchange rate in
their favour.

The table below shows UK Exporter UK Importer

the scope for leading
and lagging by financial
managers of importers
or exporters:
Expectation of

Foreign currency Receiving foreign Paying foreign currency

currency

Devaluation Leads Lags

Revaluation Lags Leads

Expectation of Foreign Importer Foreign Exporter

Sterling Paying in sterling Receiving sterling

Revaluation Leads Lags

Devaluation Lags Leads

EXTERNAL METHODS OF MANAGING EXCHANGE RATE RISK AND EXPOSURE

Forward contracts
Forward foreign exchange contracts are a binding agreement between two parties to exchange an
agreed amount of currency on a future date at an agreed fixed exchange rate. The exchange rate
is fixed at the date the contract is entered into.
Forward contracts are binding and must be executed by both parties. As we saw in the previous
unit, they are not exchange regulated and one problem of this is that one of the parties might
default. However, they do not - like futures contracts - come in standard sizes and have fixed
delivery dates. Rather, they are over the counter (OTC) instruments - in which the contract can
be tailor made to suit the needs of the parties and delivery dates can range from a few days to
upwards of several years.
In most cases, forward contracts have a fixed settlement date. This is appropriate where the cash
transaction being hedged will take place on the same day that the forward contract is settled.
However, there is no guarantee that the two days will tally - for example, a customer may be late
paying - in which case the fixed settlement date is less than optimal. An alternative, to provide
flexibility, is an "option date forward contracf'. This offers a choice of dates on which the user
can exercise the contract, although there is a higher premium payable on the contract for such an
additional benefit.
The purpose of a forward exchange rate contract is to purchase currency at a future date at a
price fixed today. As such, it provides a complete hedge against adverse exchange rate
movements in the intervening period. Consider the following example.
A UK company needs to pay A$1 m to a Australian company in three months' time. The current
spot and forward exchange rates for sterling are as follows:
A$/£
Spot 2.060 - 2.065

3 months forward 4 - 3 cents pm

What would be the cost in sterling to the UK company if it enters into a forward contract to
purchase the A$1 m needed?
Note the way in which the rates are quoted. The spot rate spread shows the sell and buy prices -
the banks will sell A$s for sterling at the rate of A$2.060/£, and buy A$s in return for sterling at
the rate of A$2.065/£. The forward rate is quoted in terms of the premium ("pm") in cents which
the Australian dollar is to sterling in the future. If the currency is at a premium, it is
strengthening and the A$ will buy more pounds forward than it will spot or, conversely, the
pound will buy less A$ forward than it will spot. (If the quoted forward rate had been, say, "3
cents dis" this would indicate a weakening of the currency.)
To calculate the cost of the forward contract, we need to convert the forward rate premium into
an exchange rate. Because it is a premium, we need to subtract the amount from the spot to give
the following sell/buy forward rates:
(2.060 - 0.04) - (2.065 - 0.03) = 2.020 - 2.035 A$/£
The cost of buying A$1 m forward, therefore, is:
A$1,000,000 = 495 050
2.020 '
Whilst we have said that forward contracts are binding, they can be closed out by entering into
an opposite contract to sell the currency - either at the spot rate or through a different forward
rate. Partial close-outs can also be arranged where, for example, the full amount of the forward
contract is not required. However, these arrangements are costly and, hence, rare.
Currency swaps
In general, a swap relates to an exchange of cash flows between two parties - as we saw in
relation to interest rate swaps in the previous unit. Thus, currency swaps relate to an exchange of
cash flows in different currencies between two parties. They are agreements to exchange both a
principal sum and the interest payments on it in different currencies for a stated period. Each
party transfers the principal and then pays interest to the other on the principal received.
Swaps are arranged, through banks, to suit the needs of the parties involved. The two key issues
in setting up a currency swap are:
 the exchange rate to be used; and
 whether the exchange of principal is to take place at both commencement and maturity,
or only on maturity.
The following example illustrates the general principles.
A German company is seeking to invest £20m in the UK and has been quoted an interest rate of
8% on sterling in London, whereas the equivalent loan in Euros is quoted at 7% fixed interest in
Frankfurt. At the same time, a UK company wants to invest an equivalent amount in its German
subsidiary and has been quoted an interest rate of 7.5% to raise a loan denominated in Euros on
the Frankfurt Exchange. It could, however, raise the £20m in sterling in London at 5% fixed
interest.
In the absence of a swap, each company would have to accept the quoted terms for its loan
denominated in the foreign currency. This would result in both companies paying a higher rate
than would apply if the loan was raised in their domestic currency. A swap agreement would
involve each company taking out the loan in its own domestic currency and then exchanging the
principals. Each company would pay the interest on the principal received - i.e. the other
company's loan - and at the end of the loan period, the principals would be swapped back.
The exchange rate to be applied is clearly crucial. If we assume that this is agreed as €1.25 = £1,
the swap would be conducted as follows.
 The UK Company borrows £20m in England at an interest rate of 5% pa. It then swaps the
principal of £20m for €25m (at the agreed exchange rate) with the German company. The
German company pays the interest payments on the £20m loan (at 5% interest) to the UK
Company, which then pays the bank. At the end of the loan period, the principal of €25m is
swapped back for the £20m with the German company.
 The German company borrows €25m in Frankfurt at an interest rate of 7% pa. It then swaps
this principal with the UK Company which pays the interest payments on the loan (at 7%
interest) to the German company, which then pays its bank. At the end of the loan period, the
principal of £20m is swapped back for the €25m with the UK [Link] Company now has
€25m available for investment at 7% interest. German company now has £20m available for
investment at 5% interest
Currency Futures
A currency futures contract is an agreement to purchase or sell a standard quantity of foreign
currency at a pre-determined date. As we saw previously, futures have standard quantities and
delivery dates set by the exchange on which the contracts are traded. As we have also seen, most
of, many of these contracts are not delivered, but are closed out.
The process of hedging exchange rate risk through the futures market is the same as we
examined in relation to interest rate exposure in the previous unit. Thus, a UK company
exporting to the USA and invoicing in US dollars, would need to hedge against a rise in the
exchange rate (sterling strengthening relative to the dollar) in the period before payment is
received.
If we assume that payment is due in two months' time, the exporter will need to sell dollars then
in exchange for sterling. The strategy would be, therefore, to take out a three-month sterling
futures contract and close it out in two months' time - i.e. buy sterling futures now, hold them for
two months and then sell them to cancel out the obligation to deliver the underlying currency.
Any profit on the contract (the difference between the buying and selling prices) will offset any
loss on the dollars received from an exchange rate rise over the period.
We can illustrate the process in more detail by reference to the actions of a speculator who is
anticipating a rise in the value of the $ against the pound. He will, therefore, take a position to
sell sterling futures in anticipation that the future cost (in dollars) of buying the pounds necessary
to meet the contract obligation will be less than the proceeds of the sale under the contract.
If the current spot rate is $1.900/£ and December sterling futures are trading at $1.875/£, what
will be the gain or loss on five sterling futures contracts if the spot rate in December is $1.800/£?
(The standard size of sterling futures is £62,500.)
 Sale of five December contracts (each of which is for £62,500) at the agreed rate of $1.875/£
results in proceeds of:

5 x £62,500 x $1.875 = $585,937.50

 Purchase of the equivalent amount in sterling in December at the spot rate of $1.8/£ results in
an outlay of:

5 x £62,500 x $1.8 = $562,500

 The gain on the transaction is $23,437.50 or, converting this into pounds at the December spot
rate, £13,020.
The advantage for the speculator of using the futures contract compared to the alternative of
buying sterling at the current spot rate is that he only needs to put down a small deposit (the
margin account) as opposed to an "up front" investment of $593,750 (£312,500 x $1.9).
Hedging using futures and forwards contracts
We can also consider the difference between a hedge using forward contracts and a hedge using
futures contracts.
In December, a UK exporter invoices its US customer for $407,500 payable on 1 February. The
exporter needs to hedge against a change in exchange rates whereby sterling becomes stronger
relative to the dollar and he receives less pounds than now upon exchange of the dollars received
in February. To hedge this exchange rate exposure, the company could take out either a forward
contract or a futures contract. Which would be more appropriate given the following rates?
In December:

Spot rate $1.9575 - 1.9595/£

February forward rate $1.9550 - 1.9575/£
March sterling futures contracts $1.9655
March sterling futures contracts $1.9600/£ (Contract size is £62,500)
Those applying on 1 February:
Spot rate $1.9670 - 1.9690/£
March sterling futures contracts $1.9655/£ (Contract size is £62,500)
Using a forward contract would require the exporter to commit to the sale of the dollar
receivables (i.e. $407,500) at the February forward price of $1.9575/£, resulting in proceeds of:

$407,500 = £208 173

1.9575 '

The futures contract hedge would require the exporter to take a long position in sterling futures -
i.e. a commitment to buy sterling at the rate of $1.9600/£ - with the intention of closing out the
contract on 1 February, prior to the receipt of the dollars. If sterling does strengthen against the
dollar, this position will result in a gain. However, if the exchange rate falls, then the exporter
will lose on the futures contract, but gain in the cash market.
The number of sterling futures contracts necessary to cover the exposure is:
$407,500 1.9600 * 1 £62,500 = 3.33
The gain/loss on the futures transaction is calculated as follows:
• Buy four March contracts in December at $1.9600/£:
4 x £62,500 x $1.9600 = $490,000
• Sell four March futures contracts in February at $1.9655
4 x £62,500 x $1.9655 = $491,375
Gain through closing out:
$491,375 - $490,000 = $1,375
Converting this into sterling at the February spot rate gives a gain of:
$1,375 = £698
1.9690
The total proceeds from the futures hedge is calculated by adding this gain to the proceeds of the
exchange of the dollars received on 1 February at the then current spot rate of 1.9690$/£:
$407,500 = £206 957 + £698 = £207 655
Currency Options
A currency option gives the holder the right, but not the obligation, to buy (in the case of a call
option) or sell (a put option) a specified amount of currency at an agreed exchange rate (the
exercise price) at a specific future date.
The principles of currency options are the same as those discussed in the previous unit in respect
of other types of option. Thus, using the options market to hedge exchange rate exposure sets a
limit on the loss that can be made in the case of adverse movements in exchange rates, but also
allows the holder to take advantage of favorable movements.
The following example illustrates their use.
At the beginning of July, a UK company purchased goods to the value of $300,000 from its US
supplier on three months' credit, payable at the end of September. The spot exchange rate is
currently $1.95/£, and for the purposes of the example, we shall assume that it falls to $1.88/£ by
the end of September, coinciding with the expiry of the option.
Because the company needs to pay for the goods in dollars, it needs a strategy which enables it to
sell pounds and buy dollars. The two choices are a long put or a short call. The short call, though,
can only provide protection against exchange rate losses up to the cost of the premium, so the
favored strategy would be a long put. (Check with the previous unit to ensure that you
understand the various pay-off profiles for these different types of option.)
The relevant sterling options offered on the Philadelphia exchange (the major market for
currency options) are at the following prices:
Strike price 1.93 1.94 1.95
September puts 2.32 2.65 3.22
Contracts expire on a monthly basis and are for denominations of exactly half of those for futures
contracts. Thus, the standard contract sizes for sterling options are £31,250.
In this case, the company decides to buy a September put option with a strike price of $1.93/£. It
could have opted for a different strike price, but this would have incurred higher premiums
(albeit for a higher degree of protection).
The strategy works in the following way:
 The company needs to raise $300,000 which, at the exercise price of $1.93/£, equates to
£155,440. To cover this amount, it will need to purchase five standard contracts. The premium
paid will be:

2.32 x £31 250 x 5 = $3625

100' ,
In sterling, at the current exchange rate, that is:
3,625 = £ 1.859
1.95 '
 Because the spot exchange rate has declined during the period (the dollar having
strengthened), it is advantageous to exercise the put option - i.e. less pounds will need to be
exchanged at the exercise price than at the spot price to buy the required amount of dollars.

Total proceeds from exercising all five option contracts:

5 x £31,250 x $1.93 = $301,562 (covering the liability) The net sterling cost of the transaction
will be:
£156,250 + £1,859 = £158,109
If the option was not exercised, then the liability in dollars would need to be realized by selling
sterling on the spot market. The cost involved here would be:
$300,000 = £ 159 574
1.88 '
Thus, using a long put results in a saving of: £159,574 - £158,109 = £1,465

MONEY MARKET HEDGE ON RECEIVABLES

A money market hedge on receivables involves borrowing the currency that will be received and
using the receivables to pay off the loan.
EXAMPLE
Recall the Viner Co. will receive SF200,000 in 6 months. Assume that it can borrow funds
denominated in Swiss francs at a rate of 3 percent over a 6-month period. The amount that it
should borrow so that it can use all of its receivables to repay the entire loan in 6 months is:
Amount to borrow = SF200,000 (1-.0.015)
= SF197,000
If Viner Co. obtains a 6-month loan of SF197,000 from a bank, it will owe the bank SF200,000
in 6 months. It can use its receivables to repay the loan. The funds that it borrowed can be
converted to dollars and used to support existing operations.
If the MNC does not need any short-term funds to support existing operations, it can still obtain a
loan as explained above, convert the funds to dollars, and invest the dollars in the money market.
EXAMPLE
If Viner Co. does not need any funds to support existing operations, it can convert the Swiss
francs that it borrowed into dollars. Assume the spot rate is presently $.70. When Viner Co.
converts the Swiss francs, it will receive:
Amount of dollars received from loan = SF197,000 x $.70 = $137,900
Then the dollars can be invested in the money market. Assume that Viner Co. can earn 2 percent
interest over a 6-month period. In 6 months, the investment will be worth:
$137,900x (1.01) = $ 139,279
Thus, if Viner Co. uses a money market hedge, its receivables will be worth $139,279 in 6
months.