Presentation on Foreign Exchange Risk Management By Anand S.

Awar (MBA 2010-01)

School of Business Studies Central University of Karnataka

Date: 30th March, 2012

FOREIGN EXCHANGE RISK MANAGEMENT Foreign-Exchange Risk

It is the probability of loss occurring from an adverse movement in foreign
exchange rates.

Adverse changes in exchange rates can make apparently profitable deals

unprofitable. The risk introduced into international business transactions by changes in exchange rates is referred to as foreign exchange risk. This risk usually affects businesses that export and/or import, but it can also

affect investors making international investments

FOREIGN EXCHANGE RISK MANAGEMENT

Types of Foreign Exchange Risk:

Foreign Exchange Risk

Transaction Exposure

Operating Exposure

Translation Exposure

FOREIGN EXCHANGE RISK MANAGEMENT [Link] Exposure

Transaction exposure refers to changes in the present cash flow of a firm consequent upon the exchange rate changes. The transaction exposure component of the foreign exchange rates is also referred to as a short-term economic exposure.

2. Operating Exposure
The variability in the future operating revenue, cost and profit of firms on account of exchange rate fluctuations is referred to as Operating Exposure.

3. Translation Exposure
Translation exposure is a mismatch between the translated value of assets and liabilities following exchange rate changes.

FOREIGN EXCHANGE RISK MANAGEMENT

Foreign Exchange Risk Management Techniques
Hedging Techniques
Internal Hedging Techniques External Hedging Techniques

1. Leading and Lagging 2. Invoice Currency 3. Currency Diversification 4. Risk Sharing 5. Shifting of Manufacturing Base 6. Netting

1. Forward Hedge 2. Futures Hedge 3. Currency Option Hedge 4. Money Market Hedge 5. Currency Swap Hedge 6. Parallel Loans 7. Cross Hedge

FOREIGN EXCHANGE RISK MANAGEMENT b. Internal Hedging Techniques 1. Leading and Lagging
Another technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. Lead means advancing the timing of receipt or payment of foreign currency. Lag means postponing the timing of receipt or of payment of foreign currency.
Sl. No. 1. Type of Account
Receivable

Anticipated Movement of Foreign Currency

Appreciation

Course of Action
Lag

2.
3. 4.

Payable
Receivable Payable

Depreciation
Depreciation Appreciation

Lag
Lead Lead

FOREIGN EXCHANGE RISK MANAGEMENT 2. Invoice Currency It involves shifting, sharing and diversifying exchange risk by appropriately choosing the currency of invoice. 3. Currency Diversification
Currency diversification means transacting in as many currencies as possible. The risk will be much lower if volatility of different currencies in which a firm transacts is negatively correlated to a high degree. The depreciation of one currency will be offset by the appreciation of another currency.

4. Risk Sharing
Risk sharing means the loss being shared by both of the transacting parties if exchange moves beyond the neutral zone.

FOREIGN EXCHANGE RISK MANAGEMENT 5. Shifting of Manufacturing Base

It involves the shifting of existing production centre to a place where there are substantial sales of its products.

6. Netting
A firm may be having both receivables and payables in the same currency. It is not necessary to hedge each receivable and payable separately. The strategy of hedging the net amount of receivables and payables is known as

netting.

FOREIGN EXCHANGE RISK MANAGEMENT

TYPES OF NETTING:
There are two types of netting; a) Bilateral Netting b) Multilateral Netting

Company X

US $ 1.5Million US $ 2 Million
Normal Movement of Funds

Company Y

Company X

US $ 0.5 Million

Company Y

Movement of Funds with Netting

FOREIGN EXCHANGE RISK MANAGEMENT

b) Multilateral Netting Parent Company
Subsidiary A

Subsidiary B

US $ 5,00,000
Subsidiary D

Subsidiary C

US $ 8,00,000 US $ 6,40,000 Exposure without Netting = US $ 78,90,000

FOREIGN EXCHANGE RISK MANAGEMENT

b) Multilateral Netting Parent Company
Subsidiary A

Subsidiary B

Subsidiary D

US $ 2,50,000
US $ 1,60,000

Subsidiary C

Exposure with Bilateral Netting = US $ 17,10,000

FOREIGN EXCHANGE RISK MANAGEMENT

b) Multilateral Netting Parent Company
Subsidiary A

Subsidiary B

Subsidiary D

Subsidiary C

US $ 4,10,000 Exposure with Multilateral Netting = US $ 14,10,000

FOREIGN EXCHANGE RISK MANAGEMENT b. External Hedge [Link] Hedge

A Forward contract is an agreement to buy or sell a specified amount of a currency at a predetermined rate on a specified future date. A forward contract is negotiated between a business firm and a bank that deals in foreign currencies. Example: Indian exporter has accounts receivable for exports worth $1,000 maturing in 90 days. Assume that1. Expected spot rate after 90 days is Rs.50.5/US$ 2. 90 days forward rate is Rs. 50/US

Solution: 1. No Hedge: US$1,000 Rs.50.50 = Rs. 50,500

2. Forward Hedge: US$1,000 Rs.50 = Rs. 50,000

FOREIGN EXCHANGE RISK MANAGEMENT [Link] Hedge

Currency futures are standard contracts used to hedge against currency risk. A futures contract like a forward contract, is an agreement between two parties to buy or sell certain quantity of currency at a predetermined time and at a certain price. Futures contracts are traded on organised or regulated exchanges. It requires the involvement of brokers and payment of margin money based on continuous marking-to-market process.

FOREIGN EXCHANGE RISK MANAGEMENT 3. Currency Option Hedge

A currency option is an agreement whereby the option buyer gets the right to buy or sell an underlying foreign currency in exchange for a base currency. Currency option hedge involves purchasing a currency option by paying a specific price known as Option Premium. There are two types of options call option and put option.

Example: Continuing the previous example, assume that 1. A 90-day put option is having a strike price of Rs. 52 and a premium of Re.0.5 per dollar. Solution: Rs.(52-0.5) US$ 1,000 = Rs. 51,500

FOREIGN EXCHANGE RISK MANAGEMENT 4. Money Market Hedge

Money market hedge involves a money market position in order to cover a future payables or receivables position.

The use of borrowing and lending transactions in foreign currencies to lock in

the home currency value of a foreign currency transaction. Firms which have access to international money markets for short-term borrowing as well as investments, can use the money market for hedging transaction exposure.

FOREIGN EXCHANGE RISK MANAGEMENT For Receivables 1. Borrow foreign currency at borrowing rate. 2. Convert the borrowed foreign currency into local currency at spot rate. 3. Invest the converted amount at investment rate. 4. Use receivables to repay the loan.
For Payables 1. Borrow domestic currency at borrowing rate. 2. Convert the borrowed domestic currency into foreign currency at spot rate. 3. Invest the converted amount at investment rate. 4. Use proceeds from investment to pay the liability.

FOREIGN EXCHANGE RISK MANAGEMENT Example: Continuing the previous example, assume that 1. Borrowing rates in India and US are 10% and 12% p.a. respectively. 2. Investment rates in India and US are 8% and 10% p.a. respectively. 3. Spot rate is Rs. 49/US$. Solution:
1. Borrow Present Value of Dollar Receivable (1,000/1.03) = $970. 87 2. Convert Borrowed $ into Rs. at Spot Rate ($970.87 Rs.49) = Rs. 47, 572

4. Use Receivables ($1,000) to Repay the Loan.

3. Invest Converted Rs. At Investment Rate (Rs. 47,572.82 1.02) = Rs. 48,524.27

FOREIGN EXCHANGE RISK MANAGEMENT Comparison among Alternatives of Hedging Techniques:

Sl. No. 1. 2. 3. Hedging Technique
No Hedge Forward Hedge Currency Option Hedge

Receipts (In Rs.)

50,500 50,000 51,500

4.

Money Market Hedge

48,524

Recommendation: Currency Option Hedge

FOREIGN EXCHANGE RISK MANAGEMENT 5. Currency Swap Hedge

A currency swap is a foreign-exchange agreement between two parties to exchange the principal and/or interest payments of a loan in one currency for equivalent amount of loan in another currency. At the maturity of the swap, the principal amount is exchanged back. There are three different ways in which currency swaps can exchange loans: 1) Exchange of only the principal with the counterparty. 2) Exchange of only interest payment. 3) Exchange of both loan principal and interest payment.

FOREIGN EXCHANGE RISK MANAGEMENT Example: An Indian MNC is required to finance capital expenditure of its
Japanese subsidiary whose cost is 5,00,000. Similarly, Japanese MNC is required to finance capital expenditure of its Indian subsidiary whose cost is Rs.2,50,000. Spot rate is Rs.1/ 2.

Table: Interest Rate

Company
Indian MNC Indian MNC

Capital Market
Indian Capital Market Japanese Capital Market

Interest Rate (In %)

8% 10% 11% 9%

Japanese MNC Indian Capital Market Japanese MNC Japanese Capital Market

FOREIGN EXCHANGE RISK MANAGEMENT Currency Swap: Step 1 Initial Exchange of Principal Amount
Principal (Yen) Japanese Subsidiary

Principal (Yen)

Principal (Yen)

Indian Firm

Principal (Rupees)

Swap Bank

Principal (Rupees)

Japanese Firm

Borrow from Indian Capital Market

Borrow from Japanese Capital Market

FOREIGN EXCHANGE RISK MANAGEMENT Currency Swap: Step 2 Exchange of Interest

Interest (Rupees) Lender of Indian Rupee

Interest (Rupees)

Interest (Rupees) Swap Bank Interest (Yen)

Indian Firm

Interest (Yen)

Japanese Firm

Income (Yen) from Japanese Subsidiary

Income (Rupees) from Indian Subsidiary

FOREIGN EXCHANGE RISK MANAGEMENT Currency Swap: Step 3 Re-exchange of Principal Amount on Maturity
Principal (Rupees) Lender of Indian Rupee

Principal (Rupees)

Principal (Rupees) Swap Bank Principal (Yen)

Indian Firm

Principal (Yen)

Japanese Firm

Principal (Yen) from Japanese Subsidiary

Principal (Rupees) from Indian Subsidiary

FOREIGN EXCHANGE RISK MANAGEMENT 6. Parallel Loans

A parallel loan occurs when two business firms in separate countries arrange to borrow each others currency for a specific period of time.

At an agreed terminal date they return the borrowed currencies.

US Parent Company Direct Loan in US Dollars
Indian Subsidiary in USA Indirect

Indian Parent Company

Financing

Direct Loan in Rupees

US Subsidiary in India

FOREIGN EXCHANGE RISK MANAGEMENT 7. Cross Hedging

It is adopted when the desired currency cannot be hedged. It involves hedging in another foreign currency which is positively correlated to the desired foreign currency. The effectiveness of the cross hedging strategy depends on the closeness of correlation between the two currencies.