Risk Awareness and Foreign Exchange Exposure

Forex Market in India

• Forex trading is legal in India but is strictly regulated by SEBI and RBI.
• It involves exchange of one currency for another with the aim of generating a profit.
• It’s one of the most active markets globally with around $6.6 trillion traded daily by
individuals, companies and banks.
• Trading works –
• Currency pairs – Primary currency called as base currency and secondary currency
called as quote currency.
• Bid and ask price – 2 associated costs – bid price and asking price
• Leverage- presented in the form of ratios
• Going long and going short – Long position if you believe that a currency pair will
increase in price and vice versa.
• Fundamental and Technical Analysis – to predict future price of currency pairs.
• Placing Orders – some common forex trading orders include market orders, stop
orders, limit orders.
• Profit and Loss – fluctuations in the currency’s exchange rate
• Market liquidity – market offers the highest liquidity across asset classes as the
volume of trades is significantly high.
• Risk management – traders can use diversification tactics and effective position
sizing while using various orders
• Continuous market operations
Types of forex markets
• Futures market – it is a market place where traders can buy and sell standardized contracts for
future currency exchanges. These contracts are known as currency futures and include factors
such as the amount of currency, the agreed-upon exchange rate, and the settlement date
(expiry date). They are traded on organized exchanges.
• Options market – it allows traders to invest in currency options, which gives them the right
but not the obligation to buy or sell the contract at a predetermined price. It contains 2 option
types – call options and put options
• Forward market – a forward currency contract is a financial contract that allows traders to buy
or sell currency pairs in the future at a pre-determined exchange rate. Forward contracts are
used by corporations to hedge against foreign exchange risk. A company can protect itself
from currency fluctuations that could impact its financial performance.
• Spot market – most commonly used market places. It allows traders to exchange currencies
immediately at the prevailing market prices. The transactions are complete within 2 business
days known as ‘on the spot’.
 • Swaps market - Currency swaps are agreements between two parties to exchange a principal
and interest amount in different currencies only to be re-exchanged at a specific later date. At
least one of the interest rates in the agreement is fixed.
Spot and Forward Rates
Spot rates are current prices for immediate transactions, while forward rates are prices agreed upon
for future transactions. Both are used in finance to value assets like stocks, bonds, commodities, and
currencies.
Forward rates -
• A price set in advance for a future transaction
• Based on the spot rate plus an adjustment for the cost of holding the asset until the settlement
date
• Accounts for the market's expectations for future prices
• Can be an economic indicator of how the market expects the future to perform
How are spot and forward rates related?
• Spot rates are the starting point for calculating forward rates
• Forward rates are based on the spot rate and adjusted for the cost of holding the asset
• Forward rates are affected by the difference in interest rates between the two currencies and
the time to maturity of the contract.
• Spot and forward rates are important for making informed decisions about currency
conversion, hedging strategies, and investment planning.
Foreign Exchange Quotation
• Exchange rate quotations can be quoted in two ways – Direct quotation and Indirect
quotation. Direct quotation is when the one unit of foreign currency is expressed in terms of
domestic currency. Similarly, the indirect quotation is when one unit of domestic currency us
expressed in terms of foreign currency.
• In financial terms, the exchange rate is the price at which one currency will be exchanged
against another currency. The exchange rate can be quoted directly or indirectly.
• The quote is direct when the price of one unit of foreign currency is expressed in terms of
the domestic currency.
• The quote is indirect when the price of one unit of domestic currency is expressed in terms of
Foreign currency.
• Since the US dollar (USD) is the most dominant currency, usually, the exchange rates are
expressed against the US dollar. However, the exchange rates can also be quoted against other
countries’ currencies, which is called as cross currency.
• Now, a lower exchange rate in a direct quote implies that the domestic currency is
appreciating in value. Whereas, a lower exchange rate in an indirect quote indicates that the
domestic currency is depreciating in value as it is worth a smaller amount of foreign currency.
Cross Rate and Inverse Rate
Cross rate - A cross-exchange rate is the exchange rate between two currencies, using a third currency
as a reference. For example, the cross rate between the euro and the yuan is expressed in yen.
How to calculate a cross-exchange rate
• Identify the exchange rates of the two currencies against the third currency.
• Choose one currency as the base and the other as the quote.
• Use the formula: Cross Rate = (Rate of Currency A against Currency C) / (Rate of Currency B
against Currency C).
• Calculate the cross rate using the formula.
Why are cross exchange rates useful?
• Cross exchange rates are useful for international travel and trade, where one currency needs to
be exchanged for another without using the native currency.
Factors that affect cross rates
• Inflation rates can affect the value of currencies. When inflation increases, a currency's value
may decrease and become less valuable in comparison to other currencies.
• The cross rate is the exchange rate between two currencies, calculated from their respective
exchange rates with a third currency, often known as the base currency. These rates are used
in situations where the currencies being exchanged are not commonly traded directly against
each other in the foreign exchange market.
• Inverse Rate - An inverse rate is the reciprocal of a direct rate, and is used in exchange rate
calculations and in finance.
• The inverse method uses the inverse exchange rate to calculate the domestic amount when
converting from one currency to another.
• The inverse method multiplies or divides the foreign amount by the exchange rate.
• The inverse method is used when a direct rate is not available from the exchange rate
provider.
• An inverse floating rate note, or inverse floater, is a bond or debt instrument where the
coupon rate moves in the opposite direction to short-term interest rates.
• When interest rates rise, the coupon rate on an inverse floater falls.
• When interest rates fall, the market price and yield of an inverse floater increase.
International Arbitrage
• International arbitrage is the act of buying and selling the same quantity of an asset in two
different markets simultaneously. International arbitrage works on the principle of price
differential created due to the inefficiencies of the market. International arbitrage entails a
trader buying a security from a market at a lower price and selling a similar quantity of
security in another market at a higher price to earn a riskless gain. If both the markets are in
the same country, it would be called a simple arbitrage trade, but as per international arbitrage
definition, both the markets should be in different countries. International arbitrage
opportunities are not very common as price differentials reach an equilibrium as soon as they
are spotted. If there is a price equilibrium in the market, there will be no space for
international arbitrage. The most common types of international arbitrage trades are the
 buying and selling of International Depository Receipts (IDR), currencies and the same stock
registered in two different countries.
• Types – The three major types of international arbitrage are covered interest arbitrage, two-
point arbitrage and triangular arbitrage.
• Covered interest arbitrage: When a trader uses a forward contract to hedge against the
exchange rate risk while investing in a higher-yielding currency, it is known as covered
interest arbitrage. In a covered interest arbitrage, the word ‘cover’ means to hedge against
fluctuations in the exchange rate and ‘interest arbitrage’ means to take advantage of an
interest rate differential. Covered interest arbitrage is complex trading maneuvers and requires
sophisticated setups.
• Two-point arbitrage: A two-point arbitrage is a simple trading technique where a trader buys a
security in one market and sells it at a higher price in a geographically different market.
According to the dominant economic theory, the exchange rate of a currency should be the
same all across the world. But due to certain factors like difference in time zones and lag in
the exchange rate, a price differential gets created. To take advantage of the situation, a trader
can buy the currency in the market where it is priced lower and sell in a market where the
currency is priced higher. A gain can be made only if the exchange rate is higher than the
transaction cost.
• Triangular arbitrage: A triangular arbitrage or three-point arbitrage is an advanced version
of the two-point arbitrage. It involved three currencies or securities instead of two. A
triangular arbitrage opportunity arises when there is a mismatch in the exchange rate of three
different currencies. In a three-point international arbitrage, the trader sells currency ‘A’ and
buys currency ‘B’. Then he/she sells currency ‘B’ and buys currency ‘C’. In the last leg of the
arbitrage, he/she sells currency ‘C’ and buys currency ‘A’.
• There are different types of arbitrages, from cash and carry to reverse cash and
carry and statistical arbitrage. Also called stat arb, it is a term that defines a set of trading
strategies where mathematical modelling is used to determine price differences between
securities. The strategy makes use of the concept of short-term mean reversion. Statistical
arbitrage is also bracketed under a set of algo trading strategies, where trades are executed on
the basis of the algorithm that is preset.
• If statistical arbitrage is employed, then price movement across several securities is tapped
into after an analysis of price differences and patterns between these instruments. Statistical
arbitrage is used by hedge funds and investment banks as well as an effective strategy.
Types of statistical arbitrage strategies- There are many strategies that are bracketed under
statistical arbitrage trading. Some of them are:
• Market neutral arbitrage: This strategy is about going long on an asset that’s undervalued
and taking a short position on an asset that’s overvalued at the same time. The long position is
expected to go up in value while the short continues to drop, and the increase and decrease are
at the same levels.
• Cross asset arbitrage: This model taps into the price difference between an asset and its
underlying.
• Cross market arbitrage: This model exploits the difference between the same asset across
markets.
 • ETF arbitrage: This is also a cross-asset arbitrage technique wherein the differences between
an ETF’s value and the assets underlying are spotted. This is employed to ensure that an
ETF’s price is in line with the price of the assets underlying.
Advantages –
• Risk-free profits: Traders can earn profits with minimal or no risk, as arbitrage exploits price
discrepancies across various markets.
• Market efficiency: By identifying and exploiting price discrepancies, arbitrageurs help align
prices, ensuring that securities are fairly valued.
• Liquidity improvement: Market liquidity often increases when arbitrageurs are around.
Increased liquidity benefits all market participants by narrowing bid-ask spreads and making
it easier to buy and sell assets.
• Income diversification: Traders can diversify their income through an additional strategy
such as arbitrage. This strategy does not rely on market direction and can generate profits
regardless of broader market trends, mitigating potential profit loss when market volatility
occurs.
Disadvantages –
• Execution risk: The profitability of an arbitrage strategy depends very much on a trader's
ability to execute precise traders very quickly. Delays, errors in trade execution, or system
failures can erode or eliminate the expected profits.
• Transaction costs: Profits via arbitrage strategies tend to be minimal, making them sensitive
to changes in broker fees, taxes, and exchange fees. High costs can cut or eliminate profit
margins.
• Liquidity risk: While arbitrageurs provide market liquidity, they are susceptible to liquidity
risk. Slippage in trades can occur, making it difficult for the arbitrageur to close out positions
on time, potentially causing losses.
• Model risk: As the LTCM example above showed, statistical arbitrage in particular, given its
reliance on mathematical models, introduces the risk that the models are flawed or fail to
account for extreme or changing market conditions.
• Regulatory and legal risk: Changes in the law and regulations can affect arbitrage strategies,
particularly for cross-border transactions.
• Real-World Examples of Arbitrage
• Example of Spatial Arbitrage
A real-world example of spatial arbitrage occurred in the cryptocurrency markets in December
2017. Bitcoin (BTCUSD) was trading at different prices on multiple cryptocurrency exchanges.
BTCUSD was priced at around $19,000 on U.S. exchanges while trading as high as $22,000 on South
Korean exchanges like Bithumb.
Traders were likely buying BTCUSD on U.S. exchanges and selling it on South Korean exchanges,
profiting from the price discrepancies less transaction and transfer costs. This became known as the
Kimchi premium
• Example of Statistical Arbitrage
Another example of statistical arbitrage concerns Long-Term Capital Management (LTCM), a hedge
fund that used statistical arbitrage in the 1990s. One of their trades involved the identification of price
inefficiencies between U.S. Treasury bonds, with LTCM betting that the prices of long-term and short-
term bonds would align. Despite these strategies, LTCM failed catastrophically when market
conditions shifted. At that point, the U.S. government had to step in with an offer of billions in
emergency loans to protect other firms
• Example of Merger Arbitrage
• The acquisition of LinkedIn in 2016 by Microsoft (MSFT) is an example of merger arbitrage.
When MSFT announced its intention to buy LinkedIn for $26.2 billion, or $196 per share,
LinkedIn's stock, trading around $131 per share before the announcement, quickly
jumped. Nevertheless, it still traded below the offer price because of uncertainty about the
deal's completion.
• Merger arbitrageurs could have used this chance to buy the shares at a discount to the offer
price. As the deal progressed and regulatory approvals were secured, LinkedIn's stock price
inched toward the $196 offer price. Once the deal was completed, the arbitrageurs who had
bought the target shares earlier could profit from the difference.
• How Do Regulatory Changes Impact Arbitrage Opportunities?
• Regulatory changes can affect market conditions, transaction costs, and the legal environment
for trading. While some regulations may create new opportunities by introducing
inefficiencies or restrictions that can be exploited, others may reduce the profitability or
feasibility of existing arbitrage strategies by increasing costs, restricting market access, or
enhancing market transparency.
• How Does Arbitrage Contribute to Market Efficiency?
• Arbitrage is a key mechanism through which markets achieve efficiency. By eliminating price
discrepancies, aligning the prices of related securities, providing liquidity, and correcting mis-
pricings quickly, arbitrageurs help ensure that security prices reflect all available information.
This process not only stabilizes markets but also facilitates more accurate pricing of risks and
returns, benefiting all market participants and contributing to the overall health and efficiency
of the global financial system.
Management Accounting Exposure
• Transaction Exposure -
• This exposure arises when a company has assets and liabilities the value of which is
contractually fixed in foreign currency and these items are to be liquidated in the near future.
For example, the value of assets in the form of foreign currency receivables or liabilities in
the form of foreign currency payables will be sensitive to the exchange rate. Likewise,
currency rate fluctuations would impact loans, interest, dividend and royalty etc. to be paid to
the foreign entities or to be received from them.
• To illustrate, let us consider that a company buys raw material from abroad the contractual
price of which is $100. The payment will be settled after a credit period of six months within
the current financial year. Till the date of settlement, this company has a transaction exposure
of $100. If dollar appreciates during six months period, the company will have to pay more in
rupees than what it would have paid on the date of contract. Conversely, depreciation of dollar
will result in a smaller rupee outflow. Either way, the company remains under an uncertainty
as to what rupee outflow will take place on the settlement date. This uncertainty of cash flows
 is what constitutes the exposure/risk. Like receivables or payables, repayment of principal and
interest to foreign entities due during the current financial year also gives rise to transaction
exposure.
• From the above description, it becomes clear that transaction exposures affect operating cash
flows during the current financial year and they have short time frame. As they arise from
contractually fixed items, they are also called contractual exposures.
• Examples -
• a foreign currency receivable or payable arising out of sales or purchases of goods and
services is to be liquidated in near future
• a foreign currency loan or interest due thereon is to be paid or received shortly;
• payment of dividend or royalty etc. is to be made or received in foreign currency.
• Translation Exposure –
• Translation exposure arises from the variability of the value of assets and liabilities as they
appear in the balance sheet and are not to be liquidated in near future. Translation of the
balance sheet items from their value in foreign currency to that in domestic currency is done
to consolidate the accounts of various subsidiaries. Therefore, translation exposure is also
known as Consolidation Exposure or balance sheet exposure.
• For the purpose of illustration, let us take an Indian parent company having a subsidiary in the
USA. In the beginning of the year, the US subsidiary has capital equipment, inventory and
cash valued at $200 000, $100 000 and $20 000 respectively. The exchange rate is Rs 45 per
dollar. Therefore, the translated value of these assets is Rs 1,44,00,000. At the end of the year,
the assets are $210 000 (capital equipment), $105000 (inventory) and $10000 (cash)
respectively. At the exchange rate of Rs 46 per dollar, the translated value becomes Rs 1,
49,50,000. Thus, there is a translation "gain" of Rs 5,50,000 on asset side of the balance sheet.
Likewise, there must have been a translation "loss" on liabilities of the subsidiaries such as,
debts. denominated in dollars.
• Here; it must be noted that there is no movement of cash since these assets and liabilities are
not being liquidated. Simply, their value is being worked out in the currency of the parent
company. Thus, translation "gains" or "losses" are notional, assuming that there is no tax
implications related thereto. As a matter of fact, the main difference between transaction
exposure and translation exposure is that while the former has effect on cash flows, the latter
does not.
• A view about translation exposure is that it is only notional in character since the translation
losses or gains will differ according to the accounting practices. However, this view is not
accepted unanimously. That is why an attempt is made to measure and manage it.
• Economic Exposure –
• Economic exposure measures the risk that the value of a security will decline due to an
unexpected change in relative foreign exchange rates. Security analysts should include
expected changes in exchange rates in forecasted cash flows.
• Economic exposure results from those items which have an effect on cash flows but the value
of which is not contractually defined, as is the case of transaction exposure. Some examples
of operating exposure are given below;
a) Tender submitted for a contract remains an item of operating exposure until the award of contract.
Once the contract is awarded, it becomes transaction exposure.
b) A deal for buying or selling of goods is under negotiation. The price of goods being negotiated may
be affected by fluctuations in the exchange rate.
c) If a part of raw material is imported, the cost of production will increase following a depreciation of
the home currency.
d) Interest cost on working capital requirements may increase if money supply is tightened following
a depreciation of the home currency.
e) Domestic inflation will increase input costs of the firm even if there is no change in the exchange
rate. This will adversely affect its competitiveness vis-a-vis the firms of other countries.
• Exchange rate will affect future revenues as well as costs and hence operating profits. Since
these effects are of long-term nature and impact the competitiveness of firms, operating
exposure is also called Strategic Exposure. It influences the long-term business decisions
such as products, markets, sources of supply and location of production facilities etc.
• For example, continued appreciation of dollar in early eighties rendered many American
firm’s uncompetitive vis-a-vis their competitors because the value of revenue streams
denominated in foreign currencies diminished when converted into dollars. On the contrary,
in later part of eighties, many Japanese and German companies were not able to keep their
operating income at satisfactory level due to fall of dollar. Some of these companies shifted
their manufacturing activities in USA:
• Thus, we see that the operating exposure may occur when firm has direct involvement in
foreign transactions as well as when it does not have a direct involvement. Fluctuation in
exchange rate has an effect on customers and suppliers as well as competitors. A firm selling
only in domestic market with inputs denominated only in home currency is still exposed to
competition from importing firms. An appreciation of home currency will put it at a
disadvantage vis-a-vis another firm that sells imported product.
Hedging Strategy
• A hedge is an investment that is selected to reduce the potential for loss in other investments
because its price tends to move in the opposite direction. This strategy works as a kind of
insurance policy, offsetting any steep losses in other investments.
• The term hedging can be used to describe diversifying a portfolio by buying shares in a
conservative bond fund to offset potential losses in more volatile stock funds.
• In the financial world, where traders constantly buy and sell assets, some of them highly
risky, hedging typically involves trading in derivatives, which can be effective hedges because
their relationship with their underlying assets is clearly defined.
• There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also
chips away at potential gains.
• Hedging isn’t free. In the case of the flood insurance policy example, the monthly payments
add up, and if the flood never comes the policyholder gets nothing. Still, most people would
choose to limit their losses.
• In the world of professional investing, hedging works in the same way. Investors and money
managers use hedging practices to reduce and control their exposure to risks. They use
various tools for the purpose, many of them based on derivatives.
• Hedging with Derivatives –
• Derivatives are financial contracts whose price depends on the value of some underlying
security. Futures, forwards, and options contracts are common types of derivatives contracts.
• The effectiveness of a derivative hedge is expressed in terms of its delta, sometimes called the
hedge ratio. Delta is the amount that the price of a derivative moves per $1 movement in the
price of the underlying asset.
• The specific hedging strategy, as well as the pricing of hedging instruments, depends largely
upon the downside risk of the underlying security against which the investor wants to hedge.
Generally, the greater the downside risk, the greater the cost of the hedge.
• Downside risk tends to increase with higher levels of volatility and over time; an option that
expires after a longer period and is linked to a volatile security will be more expensive as a
means of hedging.
• In general, the higher the strike price, the more expensive the put option will be, but the more
price protection it will offer as well. These variables can be adjusted to create a less expensive
option that offers less protection, or a more expensive one that provides greater protection.
• Hedging with a Put Option –
• A common way of hedging in the investment world is through put options. Puts give the
holder the right, but not the obligation, to sell the underlying security at a pre-set price on or
before the date it expires.
• For example, if Morty buys 100 shares of Stock PLC at $10 per share, he might hedge his
investment by buying a put option with a strike price of $8 expiring in one year. This option
gives Morty the right to sell 100 shares of that stock for $8 anytime in the next year.
• Let’s assume he pays $1 for the option, or $100 in premium. If the stock is trading at $12 one
year later, Morty will not exercise the option and will be out $100. He’s unlikely to fret,
though, because his unrealized gain is $100 ($100 including the price of the put).
• If the stock is trading at $0, on the other hand, Morty will exercise the option and sell his
shares for $8, for a loss of $300 ($300 including the price of the put). Without the option, he
stood to lose his entire investment.
• Hedging through Diversification –
• Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge.
For example, Rachel might invest in a luxury goods company with rising margins. She might
worry, though, that a recession could wipe out the market for conspicuous consumption. One
way to combat that would be to buy tobacco stocks or utilities, which tend to weather
recessions well and pay hefty dividends.
• This strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods
maker might thrive, but few investors would be attracted to boring countercyclical stocks,
which might fall as capital flows to more exciting places.
 • It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move
in opposite directions. They could both drop due to one catastrophic event, as happened
during the financial crisis.
• Spread Hedging
• For investors in index funds, moderate price declines are quite common and highly
unpredictable. Investors focusing on this area may be more concerned with moderate declines
than severe ones. In these cases, a bear put spread is a common hedging strategy.
• In this type of spread, the index investor buys a put that has a higher strike price. Next, she
sells a put with a lower strike price but the same expiration date.
• Depending on how the index behaves, the investor thus has a degree of price protection equal
to the difference between the two strike prices (minus the cost). While this is likely to be a
moderate amount of protection, it is often sufficient to cover a brief downturn in the index.
• Hedging and the Everyday Investor
• Most individual investors don't trade derivative contracts. Investors with a long-term strategy,
such as those saving for retirement, can ignore the day-to-day fluctuations of the markets.
• For investors who fall into the buy-and-hold category, there may seem to be little or no reason
to learn about hedging. Still, because large companies and investment funds tend to engage in
hedging practices regularly, and because these investors might follow or even be involved
with these larger financial entities, it’s useful to understand what hedging entails to
comprehend the actions of these larger players.
Exchange Management Risk
• Management of Transaction Exposure - The techniques used for hedging purpose can be
categorized in two classes: (a) Internal techniques and (b) External techniques.
Internal Techniques -
• Choice of a particular currency for invoicing
A firm can negotiate with its counter party to receive or make payments in its own currency or another
currency, which moves very closely with its own currency. For example, if an Indian company is able
to invoice all its sales and purchases in rupees, then its revenues and costs will not be affected at all by
currency fluctuations. Thus, its currency exposure will be totally eliminated.
On the face of it, this is the simplest techniques to hedge exchange exposure. However, it is easier
said than done. A company should be in a very strong bargaining position in order to impose the
currency of its choice on its counterparts. For example, companies selling essential products like
petroleum may be able to impose currency of their choice. Otherwise, for a majority of transactions,
companies will have to negotiate hard to have such a choice.
In some cases, it may be possible to diversify exchange exposure by using currency basket units like
SDR (special drawing rights). The SDR comprises five currencies, the US dollar, the Japanese yen,
the British pound, the German mark and the French franc. The last two currencies have since ceased
to be in use, after the introduction of euro. Since the SDR is a weighted portfolio of several
currencies, its value is more stable than the value of any individual constituent currency.
• Leads and Lags
A firm will accelerate or delay receiving from or paying to foreign counter parties, depending upon
what is beneficial to it. In case, home currency is expected to depreciate, a firm would like to expedite
(lead) payments of the payables due. On the other hand, an exporting firm will be better off by
delaying (lagging) the receipts in foreign currency. It should be kept in mind that the action of leading
or lagging will not be possible without a cost for the firms desiring to do so. For example, a firm has
payables of $100 due in three months. Fearing depreciation of rupee, it may renegotiate to make
payment in two months.
Conversely, importing firms will delay (lag) the payment if an appreciation of home currency is
anticipated and exporting firms will advance (lead) the settlement in similar situation.
For example, a firm has payables of euro 100 000 due in one month. Anticipating appreciation of
rupee, it delays payment to 3 months. The rates after one month and three months turn out to be Rs 56
per euro and Rs 55.50 per euro respectively. As a result, the firm stands to save Rs 50000 [100000
(56.00 - 55.50)] by delaying payments. Of course, it will have to negotiate with its counter party and
as a result, the savings will be less than Rs 500 000. Let us suppose that the counter party agrees to
delay the settlement if it is paid euro 100 750 instead of euro 100 000. So, the Indian firm will
effectively be paying Rs 5,591,625. Still the firm saves Rs 8,375 (100 000 x 56 - 100 750 x 55.50).
However, it must be kept in mind that home currency may further appreciate if such actions are
generalized.
• Netting - Normally, different affiliates of a multinational company have dealings between
themselves and with their parent. For example, a subsidiary supplies semi-finished product to
its parent which, in turn, sells the final product to the subsidiary. If sales value of subsidiary to
the parent is $100 while that of the parent to the subsidiary is $125. Now, the total exposure
of the two (parent and subsidiary) combined is $225. But this exposure can be reduced to $25
if both of them resort to what is called netting of exposures. As the name implies, netting is a
technique where transacting entities try to match the maturity dates and currencies of
receivables and payables between themselves. As a result, net exposures are reduced to
balance amounts. Netting can be either bilateral or multilateral. If it is done between two
companies, it is called bilateral. It is called multilateral, if done between more than two
transacting companies. Transacting companies may belong to the same MNC or they may be
unrelated entities. However, it is easier to practice it between different companies belonging
to the same MNC.
• Back-to-back G edit Swap –
Under this method, two companies, located in two different countries, agree to exchange loans in
their respective currencies. Loans are given for a pre-decided fixed period at a pre-decided exchange
rate. On maturity, the sums are again re-exchanged. This arrangement can work effectively between
MNCs of two different countries, each having subsidiaries in the country of the other. For example,
Mitsubishi (an MNC of Japan) has a subsidiary in USA while Microsoft (an MNC of USA) has a
subsidiary in Japan. The subsidiary of Mitsubishi located in USA needs to raise a dollar loan whereas
the subsidiary of Microsoft located in Japan needs yen loan. Each parent company can advance loans
to the subsidiary of the other in the former's home currency.
The loan amount is equivalent in the two currencies. (US dollar and Japanese yen). After the period of
loans is over, the sum will again be re-exchanged. Thus, the two companies have been able to manage
their exchange risk internally.
• Sharing Risk
Any two companies from two different countries can practice this technique. The basic principle
underlying this technique is that neither the benefit of the favourable movement of the exchange rate
should go to one party nor the entire loss due to the unfavorable movement of the exchange rate
should be borne by the other party. For example, Airbus Industries (a French company) has sold
aircrafts to a UK company. One way is to invoice the whole sales price of •10 million in euros. In this
case the French company has shifted the entire exchange risk to the UK Company. Or, alternatively
the sales can be invoiced as £7 million. This means that the exchange risk is now totally shifted to the
French company. The third possibility is that the sales be invoiced as •5 million plus £3.5 million.
This arrangement enables both the parties to share the exchange risk.
Risk sharing can take different forms. For example, the two transacting parties (business organizations
located in different countries) establish a Base Exchange rate and a permissible band around this base
rate, also called Neutral Zone at the time of contract. As long as the exchange rate at the time of
settlement is within the permissible band/neutral zone around the base rate, settlement takes place
applying the base exchange rate. However, in case, exchange rate at the time of settlement is beyond
the neutral zone, then its effects on the parties are shared as per a pre-determined formula.
External Techniques –
• Use of Currency Forward Market:
Currency Forward Market is the most frequently used market for covering the exchange risk. An
organization having foreign currency receivables will sell them forward whereas the one having
foreign currency payables will buy forward.
• Use of Money Market
We consider that only spot exchange rate and money market data (interest rates) are available.
Hedging in the money market means that the exporter, by making use of the money market, should be
able to know what definite amount in his own currency (i.e. euro) he is going to receive after 3
months.
• Use of Currency Options Market:
Here, we are going to see how; options can be used for hedging currency exposures. The
distinguishing feature of options is that they protect against the unfavorable movement of the
exchange rate but allow the benefit of favourable change.
• Use of Currency Futures Market
Another important derivative instrument that can be used for hedging currency exposure is Futures.
Currency futures have four maturities: March, June, September and October respectively. Since these
are standardized in terms of contract value, exposures (if they are not exact multiples of contract size)
are either over hedged or under hedged.
Management of Translation Exposure –
• Current/Non-current Method: The basic principle behind the current/ noncurrent method is
that assets and liabilities are translated on the basis of their maturity. Current assets and
liabilities are translated at the current exchange rate. Noncurrent (long-term) assets and
liabilities are translated at the historical exchange rate which prevailed at the time when they
were recorded for the first time in the balance sheet. It is obvious that under this method, there
will be a translation gain (loss) if the foreign currency (the currency in which the subsidiary
keeps its books) appreciates (depreciates) in case the subsidiary has net positive working
capital. Reverse will happen in case of net negative working capital. The reader will recall
that net working capital is defined as current assets minus current liabilities.
As regards the income statement (or profit-loss account), the most items, under this method, are
translated at the average exchange rate for the accounting period. Only the revenues and expenses
associated with the noncurrent assets and liabilities, such as depreciation expense, are translated at the
historical rate applicable to the corresponding balance sheet item.
• Monetary/Nonmonetary Method: As per this method, all monetary items of balance sheet
of a foreign subsidiary are translated at the current exchange rate. These terms include cash,
marketable securities, accounts receivables and accounts/notes payable etc. All the
nonmonetary items in the balance sheet, including equity, are translated at the historical
exchange rate. The main difference between this method and current/noncurrent method is
with respect to items such as inventory, long-term debts and other long-term receivables. This
method distinguishes items on the basis of similarly of attributes rather than similarity of
maturity.
The income statement items, under this method, are translated at the average exchange rate for the
accounting period. The revenue and expense items associated with nonmonetary items such as cost of
goods sold and depreciation are translated at the historical rates applicable to the corresponding
balance sheet item.
• Temporal Method: Under this method, monetary accounts such as cash, receivables and
payables, irrespective of their maturity (whether short-term or long-term) are translated at the
current rate. Other items are translated at the current rate if their value is written in the
balance sheet at current rather than historical valuation. On the other hand, if these items are
carried at historical costs, they are translated at the historical rate. For example, inventory and
fixed assets will have the same translated value under temporal as well as monetary/
nonmonetary method if they are recorded in the balance sheet at historical value.
Most income statement items, under this method are translated at the average exchange rate for the
accounting period. Depreciation and cost of goods sold are translated at historical rates applicable to
corresponding balance sheet items if they have been carried at historical costs.
• Current Rate Method: This is the simplest method to use. Under this method, all items of
the balance sheet are translated at the current rate except equity, which is translated at the
exchange rates which existed on the dates of issuance. In this method, a Cumulative
Translation Adjustment (CTA) account is created to make the balance sheet balance since
translation gains/losses do not go through the income statement unlike in other three methods.
Income statement items, ender this method, are translated at the exchange rate on the dates the
revenue/expense items were recognized. However, to avoid too many exchange rates, a more practical
way is to use an appropriately weighted average exchange rate for the period of translation.
• Management of Economic Exposure
With the increasing pace of globalization of economy, more and more firms are subject to
international competition. Volatile exchange rates can affect the firms in domestic as well as foreign
markets. The value of assets/liabilities and operating cashflows can change because of the exchange
rate fluctuations. Unlike transaction exposure which relates to contractually determined assets and
liabilities such as receivables and payables etc., the exposure of operating cashflows depends on the
effect of exchange rate changes on the firm's competitive position. The problem is that competitive
position is not readily measurable. It is quite possible that a firm's operating exposure may be much
larger than contractual or transaction exposure. It is determined by the structure of the markets in
which the firm sources its inputs, such as labor and material and sells its products.
In practice, exchange rate change is almost never fully absorbed through price adjustments of goods.
One alternative is to pass the cost shock fully to selling price (complete pass-through) and the other is
to fully absorb the shock (zero pass-through). However, firms often do resort to partial pass-through.
But price adjustment can, at best, be a short-term measure to manage economic exposure. Since a firm
is exposed to exchange risk mainly through the effect of exchange rate changes on its competitive
strength, exposure management is to be seen in terms of the firm's long-term strategic planning.
Managing operating exposure cannot be a short-term tactical issue. It is to be considered in a longer
perspective. The measure could be such as (i) selecting low-cost production location, (ii) adopting
flexible sourcing policy, (iii) diversifying the market, (iv) making R&D effort for product
differentiation and (v) hedging through financial products.