Module -2 INTERNATIONAL RISK MANAGEMENT

MEANING OF RISK

Risk is defined as “a hazard; a peril; exposure to loss or injury”. Thus, risk

refers to the chance that some unfavorable event will occur.
RISK MANAGEMENT

The process of measuring or assessing risk and then developing strategies to

manage the risks is called risk management. In general, the strategies employed
include transferring the risk to another party, avoiding the risk, reducing the
negative effect of the risk and accepting some or all of the consequences of a
particular risk. Traditional risk management focuses on risks stemming from
physical or legal causes, for example, natural disasters, fires, accidents, death
and lawsuits.
Financial risk management, on the other hand, focuses on risks that can be
managed using traded financial instruments. Regardless of the type of risk
management, all large companies have risk management teams and small
companies and groups practice informal if not formal risk management.
In ideal risk management, a prioritization process is followed whereby the risks
with the greatest loss and the greatest probability of occurring are handled first,
and risks with lower probability of occurrence and lower loss are handled later.
In practice, the process can be very difficult and balancing between risks with a
high probability of occurrence but lower loss versus a risk with high loss but
lower probability of occurrence can often be mishandled.
RISK MANAGEMENT PROCESS / APPROACHES

Firms often use the following process of managing risks.

1. Identify the risks faced by the firm: Here the risk manager identifies the
potential risks faced by his or her firm.
2. Measure the potential effect of each risk: Some risks are so small as to be
immaterial, whereas others have the potential for dooming the company. It is
useful to segregate risks by potential effect and then to focus on the most
serious threats.
3. Decide how each relevant risk should be handled: In most situations,
risk exposure can be reduced through one of the following techniques.

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a) Transfer the risk to an Insurance company: Often, it is advantageous to

ensure against, hence transfer, a risk. However, insurability does not
necessarily mean that risk should be covered by insurance. In many
instances, it might be better for the company to self-insure, which means
bearing the risk directly rather than paving way for another party to bear
it.
b) Transfer the function that produces the risk to a third party: for example,
suppose a furniture manufacturer is concerned about the potential
liabilities arising from its ownership of a fleet of trucks used to transfer
products from its manufacturing plant to various points across the country.
One way to eliminate this risk would be to contract with a trucking
company to do the shipping, thus passing the risks to a third party.

c) Purchase derivative contracts to reduce risk: Commodity derivatives can

be used to reduce input risks. For example, a cereal company may use
corn or wheat futures to hedge against increases in grain prices. Similarly,
financial derivatives can be used to reduce risks that arise from changes
in interest rates and exchange rates.
d)Reduce the probability of occurrence of an adverse event: The expected loss
arising from any risk is a function of both the probability of occurrence and the
dollar loss if the adverse event occurs. In some instance, it is possible to reduce
the probability that an adverse event will occur. For example, the probability
that a fire will occur can be reduced by instituting a fire prevention programme,
by replacing old electrical wiring, and by using fire-resistant materials in areas
with the greatest fire potential.
e) Reduce the magnitude of the loss associated with an adverse event:
Continuing with the fire risk example, the dollar cost associated with a fire
can be reduced by such actions as installing sprinkler systems, designing
facilities with self-contained fire zones, and locating facilities close to fire
stations.
f) Avoid the activity that gives rise to the risk:

For example, a company might discontinue a product or service line because

the risks outweigh the rewards.

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TYPES OF RISKS

1. Political Risks – It refers to potential actions by a host government that would

reduce the value of a company’s investment. It includes at one extreme the
expropriation (it is a specific type of political risk in which government seizes
foreign assets. The seizure of assets can be with or without compensation).
Political risk ranges from the risk of loss (or gain) from unforeseen
government actions or other events of a political character such as acts of
terrorism to outright expropriation of assets held by foreigners. The extreme
form of political risk is when the sovereign country changes the “rules of
games” and the affected parties have no alternatives open to them.
2. Commercial Risks – It is a risk that affects the smooth cash flows and
profitability of a company. In the international business context, the
following are the variants of commercial risks.
i. Demand variability, sales price variability and input cost variability.
ii. A deal for buying or selling of goods is under negotiation. The price
of goods negotiated may be affected by fluctuations in the exchange rate.
iii. If a part of raw is imported, the cost of production will increase if
money supply is tightened following a depreciation of the home country.
3. Currency Risks - This risk arises out of the volatility or otherwise of the
currency and its strengths or weaknesses in terms of other currencies and
interest rates and relative degrees of inflation in the respective countries
which influence the exchange rates.
4. Market Risks – Risks of commodities, their quality and the change of
government policies of taxation, etc., are borne by the exporters. A policy
of a country encourages exports from the country. Hence some risks are to
be borne by the importers also.
5.Liquidity Risks – This risk occurs more in the case of over the counter (OTC)
derivatives, which are due to the non-standard structure, makes it to have no
secondary market.
6.Country Risks – This is different slightly from the currency risk and arises
out of the policies of economic and political nature and their external payments
position and their export earnings to service the foreign creditors, convertibility
or otherwise of their currencies etc., the government policies and socio-political
changes introduce more risks.

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7.Operation Risks – It exists due to inadequate control procedure like front and
back-office function not being separated or no effective internal audit function,
no proper MIS or functioning of treasury operations, no well laid out risk
management policy by the top management and the top management salaries
being excessively linked to treasury operations.
8.Inflation Risks – Inflation is a sustained rise in prices and a continuing increase
in the general price level. It is a phenomenon in a country characterized by a huge
volume of money circulation, where the value of money is less. During inflation,
a country experiences high prices of factors of production and finished goods.
Profits, employment level and economic activity level are high.
Inflation is always and everywhere a monetary phenomenon and can be
produced only by a more rapid increase in the quality of money than
output. The international business cycle is highly fluctuating. The
international business cycle consists of stages such as expansion,
contraction, revival and recession in economic activities. Recession in one
country may affect the other countries who are trading partners of the
country which is afflicted by inflation or recession. These fluctuations in
the economic activities of countries are very risky for international firms.
9.Interest Rate Risks - Risk emanating from a loan contracted at a higher or
floating rate linked to the base lending rate by an enterprise, a bank or an
insurance company is referred to as interest rate risk. All banks, firms (domestic
or multinationals) are sensitive to interest rate movements. The
interest rate risk results from a mismatch of maturity of assets and liabilities
respectively.
An MNC runs an interest rate risk arising from mismatched timing in re
pricing those assets and liabilities that are sensitive to the interest rate.
Interest rate risks increase financial charger on borrowing or into a capital
loss on bonds.
Interest Rates Risks lead to

i. Refinancing Risk – When bank holding longer-term assets than

liabilities
ii. Repayment Risk – When bank increase the cost of the asset to with an
increase in the cost of liability to maintain the same level of interest
margin

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iii. Reinvestment Risk – When a bank holds shorter-term assets compared to

liabilities and interest rates moves downward
iv. Insolvency Risk – Mismatch between the value of assets and liabilities
due to different maturity terms

10.Exchange Control Risks – It refers to government regulation imposed on

all foreign receipts and payments in the form of foreign currencies controlled
by the government. In other words, exchange control involves complete
government control over a foreign exchange market. According to this method,
the foreign exchanges earned by the exporters have to be surrendered to the
central bank which in turn sanctions and allocates all foreign payments in
respect of different currencies.
It affects the free flow of receipts and payments of foreign currencies from
country to another. This impacts the business, profitability, productivity
and marketing activities. The global firms need to address the exchange
control risks by verifying the country risk.
It means eventual losses incurred by enterprises due to adverse
movements of exchange rates between the dates of contract and payment.
Covering the foreign exchange risk is also known as hedging the risk.

Exchange Control Restriction on Remittance

Exchange control restrictions on remittances refer to regulations imposed by a
government or central bank to control the movement of money across borders. These
restrictions are often put in place to manage foreign exchange reserves, stabilize the
national currency, prevent capital flight, or address economic challenges. The
specific rules and limitations vary from country to country.
The Foreign Exchange Management Act (FEMA) and the Foreign Exchange
Regulation Act (FERA) are two distinct legislations enacted by the Indian
government to regulate foreign exchange and payments.

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Foreign Exchange Regulation Act (FERA)

Enactment: FERA was enacted in 1973 and replaced the earlier Foreign Exchange
Regulation Act of 1947.
Objective: FERA was primarily focused on controlling and regulating foreign
exchange in India and dealing with foreign exchange violations. It had strict
provisions and penalties for contraventions.
Repeal: FERA was repealed in 1998 and replaced by FEMA due to various reasons,
including the need for a more liberalized and contemporary framework for foreign
exchange management.
Foreign Exchange Management Act (FEMA):
Enactment: FEMA came into force in 1999 and replaced FERA. It was introduced
to modernize and simplify the foreign exchange laws in India.
Objective: FEMA aims to facilitate external trade and payments and promote orderly
development and maintenance of the foreign exchange market in India. It also
focuses on encouraging external trade and payments and promoting the orderly
development and maintenance of the foreign exchange market.
Key Features: FEMA is more liberal compared to FERA and provides greater
flexibility in foreign exchange transactions. It emphasizes the management of
foreign exchange rather than control.
Both FEMA and FERA serve as exchange control mechanisms, but FEMA is the
current legislation governing foreign exchange transactions in India. It has a more
flexible and liberal approach, reflecting the economic reforms undertaken by the
Indian government in the late 20th century. If you are referring to exchange control
mechanisms in India.
Indian Government decided to throw Coca Cola as well as IBM out of India over
their refusal to follow the provisions of what was then the Foreign Exchange
Regulation Act (FERA). The provision stipulated that foreign companies should
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dilute their equity stake in their Indian associates to 60% per cent. Indian
Government wanted Coca Cola company to not just transfer 60% of the shares of its
Indian firm but also the formula for its concertante to Indian shareholders. The
company said it was agreeable to transferring a majority of shares but not the
formula, which it contended was a trade secret.
Under FEMA in India, Non-Residents face certain restrictions. These include,
a) NRIs are not allowed to maintain a regular resident savings accounts in India, they
are required to hold NRE (Non-Resident External) or NRO (Non-Resident Ordinary)
accounts which are designed to facilitate the handling of income earned abroad and
in India respectively.
b) NRIs are allowed to lend to and borrow from their close relatives who are
residents in India. The term “close relatives” is spouses, children and siblings. The
transactions should adhere to the guidelines set by Reserve Bank of India (RBI) and
must be genuine purpose
c) Non-Resident Indians (NRIs) may face certain restrictions or regulations when it
comes to owning and dealing with properties in India. The acquisition of agricultural
land and Real Estate in India by Non-Resident Indians (NRIs), is subject to certain
regulations and restrictions.
d) Non-Resident Indians (NRIs) are generally allowed to invest in the Indian stock
market. However, there are certain restrictions and guidelines imposed by the
Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI),
and other regulatory bodies. NRIs are required to open a separate NRI trading and
demat account under the Portfolio Investment Scheme (PIS) to invest in Indian
equities. This scheme is regulated by the RBI.

It's crucial for NRIs to stay informed about the regulatory landscape and comply
with the applicable laws in both their home country and India. Seeking advice from
financial and legal professionals with expertise in cross-border transactions and

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NRI-related matters can help navigate the complexities and ensure compliance
with all relevant regulations. Additionally, regulations may change over time, so
periodic updates are essential.
INFLATION

Inflation is the rate at which the general level of prices for goods and services is
rising, and, subsequently, purchasing power is falling. Central banks attempt to
stop severe inflation, along with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum .
STAGES OF INFLATION

Sustained price rise or inflation may be of various magnitudes. They are

i. Creeping inflation – When the rise in prices is very slow like that of a snail
or creeper, it is called creeping inflation. In terms of speed, a sustained rise
in prices of annual increase of less than 3 – 4 % per annum is characterized
as creeping inflation. Such an increase in prices is regarded as safe and
essential for economic growth.
ii. Walking or trotting inflation – When the prices rise moderately and the
annual inflation rate is a single digit it characterizes walking inflation. In
other words, the rate of rising in prices is in the intermediate range of 3 – 7
% per annum or less than 10 %. Inflation at this rate is a warning signal for
the government to control it before it turns into running inflation.
iii. Running inflation – When prices rise rapidly like the running of a horse at
a rate of speed of 10 to 20 % per annum, it is called running inflation. Such
inflation affects the poor and middle class adversely. Its control requires
strong monetary and fiscal measure, otherwise, it leads to hyperinflation.
iv. Hyperinflation – When prices rise very fast at double or triple-digit rates
from more than 20 to 100 % per annum or more, it is usually called runaway

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inflation or galloping inflation. It is a situation when the rate of inflation

becomes immeasurable and uncontrollable. Prices rise many times every
day. Such a situation brings a total collapse of the monetary system because
of the continuous fall in the purchasing power of the currency.

The standard world average rate is close to 3.5 – 4 % per annum. Any increase in
the price level above this point will affect MNCs in terms of profitability and
productivity. The risks associated with inflation rate are currency risk, economic
risk, commercial risk, political risk and so on.

EXCHANGE RATE

Exchange rates are determined by demand and supply. But governments can
influence those exchange rates in various ways. The extent and nature of
government involvement in currency markets define alternative systems of
exchange rates. In this section, we will examine some common systems and
explore some of their macroeconomic implications.

There are three broad categories of exchange rate systems. In one system,
exchange rates are set purely by private market forces with no government
involvement. Values change constantly as the demand for and supply of
currencies fluctuate. In another system, currency values are allowed to change,
but governments participate in currency markets to influence those values.
Finally, governments may seek to fix the values of their currencies, either through
participation in the market or through regulatory policy.

TYPES OF EXCHANGE RATE

Free-Floating Systems
In a free-floating exchange rate system, governments and central banks do not

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participate in the market for foreign exchange. The relationship between

governments and central banks on the one hand and currency markets on the other
is much the same as the typical relationship between these institutions and stock
markets. Governments may regulate stock markets to prevent fraud, but stock
values themselves are left to float in the market. The U.S. government, for
example, does not intervene in the stock market to influence stock prices.

Fixed Exchange Rates

In a fixed exchange rate system, the exchange rate between two currencies is set
by government policy. There are several mechanisms through which fixed
exchange rates may be maintained. Whatever the system for maintaining these
rates, however, all fixed exchange rate systems share some important features.
EXCHANGE RATE RISKS AND MANAGING EXPOSURES

Exchange rate risk or exchange rate exposure results from fluctuations in the
exchange rate. Currency rate fluctuations affect the value of revenues, costs,
cash flows, assets and liabilities of a business organization. Transactions of
business firms with foreign entities could be in the form of exports, imports,
borrowing, lending, portfolio investment and direct investment. So a firm with
any one or more types of transactions is subject to exchange rate exposure.

Exchange rate fluctuations can affect not only firms that are directly engaged
in international trade but also pure domestic firms. For example, an Indian
leather goods manufacturer who sources only domestic materials and sells
exclusively in the Indian market, with no foreign currency receivables or
payables. This seemingly purely domestic firm can be subject to foreign
exposure if it competes against imports, say, from a Chinese leather goods
manufacturer. When Chinese Yuan depreciates against Indian Rupee, this is
likely to lean to a lower rupee price of Chinese goods, increasing their sales in
India, thus harming Indian manufacturer.
Exchange exposure / risk are classified into three categories:

v. Transaction Exposure
vi. Translation Exposure
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vii. Economic Exposure

Transaction and translation exposures are also termed as the accounting exposure

i. Transaction Exposure

This exposure arises when a company has asset 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, 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 the 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 a certainty 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 give rise
to transaction exposure.

From the above example, 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. Some examples of transaction exposure could be as
follows:
i.A foreign currency receivable or payable arising out of sales or
purchase of goods and services to be liquidated in the near future;
ii. A foreign currency loan or interest due there on is to be paid or
received shortly;
iii.Payment of dividend or royalty, etc., is to be made or received
in foreign currency.

The techniques used for hedging purpose can be categorized in two classes:

a. Internal Techniques – These are basically the internal arrangements either

between different subsidiaries of the same MNC or between two

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transacting but unrelated companies. They are termed internal as the firm
does not take recourse to any external agency or market to apply these
techniques.

The major techniques or methods included in this category are:

i. Choice of a particular currency for invoicing receivable and payables:

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 of 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 technique 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 SDRs (Special Drawing Rights).
ii. 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. The 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

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will advance (lead) the settlement in similar situation.

iii.Netting:

Normally, different affiliates of a multinational company have

dealings between themselves and their parent. 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.

For example, Company A sells its products to Company B for

$100,000 and buys from B for $75,000. The movement of funds will
appear as given below.

A $100,000
Company A Company B B $75,000

The combined exposure of the companies A and B is obviously

$175,000. But, by netting, the net exposure is reduced to
$25,000 as shown below.

Company A Company B
B $25,000

iv.Back-to-back credit 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 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 in
Japan) has a subsidiary in USA while Microsoft (an MNC in USA)
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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 countries (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.

v. Sharing Risk:

Any two companies from two different countries can practice this
technique. The basic principle underlying this technique is that
neither the benefit ofthe favorable 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.

b. External Techniques – These techniques are known as External techniques

simply because the various instruments that are used are external to a
business organization. In order to hedge through one or more of these
instruments, a company has to enter into a contractual agreement with
external agencies dealing in these instruments. For this reason, they are also
called Contractual Techniques.

The major techniques in this category are:

i. Use of Currency Forward Market: forward contracts are the oldest and
the simplest form of derivation contracts. A forward contract is an
agreement between two persons for the purchase and sale of a

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commodity or financial asset at a specified price to be delivered at a

specified future date.
ii. Use of Money Market: Money market hedging is a technique where the
individual or the MNC borrows from one market and invests in the
other market at prevailing interest rates. This is done to protect oneself
from exchange rate fluctuations and thereby clearly estimate the
amount payable or receivable in a transaction.
iii. iii. Use of Currency Options Market: An options contract is one which
gives the right but not the obligation to buy and sell a commodity or
currency at the specified price at a future date. The holder can either
exercise the contract or can leave the contract and buy or se;; the
commodity or currency at the prevailing market price.
Iv.Use of Currency Futures Market: A futures contract is similar to forwards
contracts in its operation. However future contracts are standardized in size and
maturity and can be purchase and sold in size and maturity and can be purchased
and sold in an organized exchange only.
ii. Translation Exposure

This arises from the variability of the value of the 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.

Example, Let us take an Indian parent company with a

subsidiary in US. Assets at the beginning of the year with

US subsidiary (exchange rate = Rs.45/$)

Office equipment - $200,000

Inventory$100,000

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Cash - $20,000

Translated value of the assets = Rs.144 lacs

Assets at the end of the year with US subsidiary

(exchange rate = Rs.46/$) Office equipment $210,000

Inventory -$100,500

Cash - $10,000

Translated value of the assets = Rs. 149.50 lacs

Thus, there is a translation Gain = Rs. 5.5 lacs on the assets side of Indian
balance sheet. Likewise there must have been a translation loss in dollars
on the liabilities side of US balance sheet.
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 and translation
exposure is that while the former has effect on cash flows, the latter does
not.

A view about translation exposure is that 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.
The four methods used for foreign currency translation are:

a.The Current /Non-current Method – The basic principle behind the

current/non-current 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
theywere recorded for the first time in the balance sheet. It is obvious that
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under this method, there will be a translation gain (loss) if the foreign
currency (the currency in which the subsidiary keep its books) appreciates
(depreciates) in case the subsidiary has net positive working capital.
Reserve will happen in case of net negative working capital. Working
capital is defined as current assets – current liabilities.

b.The Monetary/Non-monetary Method - As per this method, all monetary items

of balance sheet of a foreign subsidiary are translated at the current exchange rate.
These termsinclude cash, marketable securities, accounts receivables and
accounts payables, etc. All non monetary items in 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 similarity of attributes rather than similarity of maturity.

c.The 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 theyare recorded in the balance sheet at historical value.

d.The Current 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.
iii. Economic Exposure

This 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. An example of economic exposure, tender submitted for a
contract remains an item of economic exposure until the award of the
contract. Once the contract is awarded, it becomes transaction exposure.
Exchange rate will affect future revenues as well as costs and hence
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operating profits. Since these effects are of long-term nature and impact
the competitiveness of firms. Economic exposure is also called Operating
or Strategic Exposure. It influences the long term business decisions such
as products, markets, sources of supply and location of production
facilities, etc.
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 – In case domestic currency is

already strong or is expected to become stronger in near future, it will
have an effect of reducing competitive position of the firm. In such a
situation, it can choose to set up its production facilities in a foreign
country where costs are lower. Lower cost can be due to lower prices of
factors of production such as land or labor or depreciating currency of
that country.

ii. )Adopting flexible sourcing policy – Another way of reducing the

economic exposure is to buy inputs from where they have lower cost.
Sourcing from low cost countries is not limited to raw material or
accessories but, also, the firms can hire low cost manpower from abroad.
In the past, Japan Airlines did hire foreign employees to maintain their
competitiveness in aviation industry. Likewise, many Japanese
companies depended heavily on low cost countries like Thailand,
Malaysia, Philippines and China to buy inputs such as spare parts and
intermediate products.

iii.Diversifying the market – Diversification of the market of the firm’s

product will reduce its economic exposure. Suppose Tata Motors sells its
cars in Europe as well as in China. Also, suppose rupee appreciates against
the European currency, Euro, and depreciates against the Chinese Yuan.
The effect of these developments will be opposed to each other. While the
sales of Tata cars will reduce in the European market, they are likely to
increase in the Chinese market. So reduction in the European market is
offset by the increase inthe Chinese market. As a result, the cash flow of
Tata Motors will be much more stable than they would be if it sold its cars
only in one of the two markets. Of course, this strategy cannot work if all
rates moved in the same direction. Normally, that does not happen. Hence,
diversified market does not help in reducing economic exposure.
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Module -2 INTERNATIONAL RISK MANAGEMENT

Iv Making R & D effort for product differentiation – R & D activity aims at

strengthening competitive position of a firm against the adverse effect of
exchange rate changes. R & D can bring about gains in productivity, reduction
in costs and, most importantly, differentiation in products that the firm offers.
New or differentiated products have inelastic demand. That is, their demand is
not or less sensitive to price variations. Price inelasticity would make the firm
immune to economic exposure.

V Hedging through financial products – Though various ways outlined above will
be necessary for effective management of economic exposure, financial products
should be used as supplements as far as possible. The firm can use forwards, futures
or options contracts. These contracts can be rolled over several times, if the
situation so demands. Also, the firm can borrow and or lend foreign currencies on
long term basis.

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