Foreign Exchange Exposure

•Transaction
•Translation
•Economic
 Forex Exposure
Forex Risk- is the possibility of loss to any
individual/business concern due to
unanticipated changes in exchange rate.
Forex Exposure- is the extent to which
transactions, assets and liabilities of an
enterprise are denominated in currencies
other than reporting currency of the
enterprise itself. The reporting currency is
generally the home currency of parent
company.
 Forex Exposure
• The exposure arises because the enterprise
denominates transactions in a foreign
currency or it operates in a foreign market.
• The exposure is measured by the value of
assets and liabilities or transactions
denominated to foreign currency.
 Forex Exposure

Transaction Exposure

Accounting Exposure

Translation Exposure

Currency Exposure

Contingent Exposure

Economic/Operating
Exposure
Competitive/Strategic
Exposure
 Transaction Exposure
• When business is conducted at international level, receipts
and payments are also made in foreign currency. The
unanticipated changes in exchange rate between two
currencies leads to forex exposure. The un-anticipation due
to transaction of currencies, in the form of receivables and
payables is referred to transaction exposure.
• T.E. arises because a receivable or payable is denominated
in a foreign currency.
• T.E. is concerned with how changes in exchange rate affect
the home currency value of foreign currency denominated
cash flows relating to transactions which have already been
entered into. Also called cash flow exposure.
• Since the gain/loss arises on converting the foreign
currency into domestic currency, so it is also called
conversion exposure.
 Situations which gives rise to T.E.
Conversion of currency at the time of ----
• Import payables or export receivables
denominated in a foreign currency.
• Repayment of loan or interest payment and vice-
versa.
• Making dividend or royalty payment and vice-
versa.
In every case foreign currency value of the item is
fixed, the uncertainty pertains to home currency
value.
T.E. usually has short time horizons and operating
cash flows are affected.
 Management of T.E.
• External Strategies/techniques
-Forwards
-Futures
-Options
-Money Market Hedge

• Internal S/T
-Exposure Netting
-Currency Invoicing
-Foreign Currency a/c
-Leading and Lagging
 Exposure Netting
It involves offsetting exposures in one currency with
exposures in another currency, where exchange rates are
expected to move in such a way that losses (gains) in the
first exposed position should be offset by gains (losses)
from the second currency exposure.
• Receivables>Payables=Net Receivables
• Receivables<Payables=Net Payables
If a company has both receivables and payables in a foreign
currency it need not hedge its receivables and payables
separately, but do so only for net position.
R=5000/-, P=4000/-, N=1000/- of exposure will be
considered.
In exposure netting, the entire exposure portfolio matters
rather than gain (loss) on any individual monetary unit
(currency). The gain in receivables is offset by loss in
payables and vice versa.
• In case of multi-currency transactions, the
currencies can be grouped into two-(i) those whose
value is likely to appreciate, (ii) those whose value is
likely to depreciate.
• The exposure due to receivables in a currency which
is likely to appreciate may be offset by payables in
another currency which also likely to appreciate.
• Alternatively, netting can be done by having near
equal amount of receivables in two currencies- one
likely to appreciate and other likely to depreciate.
• Netting assumes importance in the context of cash
management in an MNC with a number of
subsidiaries and extensive intra-company
transactions.
 Currency Invoicing
• The exchange risk can be avoided or transferred
by one party to another, if the transactions are
denominated in local (home) currency.
• This invoicing depends upon the relative
bargaining power of parties because in this case
other party may suffer.
• To strike a balance, the transactions may be
invoiced partly in home currency and partly in
foreign currency or full amount in any third
(stable) currency which is accepted to both.
• Also called Third country’s currency
denomination, Partial H.C. denomination or H.C.
denomination.
 Foreign currency accounts
• Exchange risk can be minimised if an account is
maintained abroad, in the currency of trade,
through which all transactions can be routed.
Dual advantage for the trader-
• Since exports can be paid for imports, the
exposure remains for only the net balance.
• In general conditions, the bank may apply buying
rate for exports and selling rate for imports with
spread bw the rates towards margin. Thus, the
loss of exchange in converting from foreign
currency into home currency is avoided.
 Leads and Lags
Leads the payment (pay/receive before any change/
preponement)
• When foreign currency is expected to be
depreciated– the exporter would like to receive
payments earlier than the normal date.
• When the foreign currency is expected to be
appreciated– the importer would like to pay
before normal date.
Lag the payment (pay/receive after any change/
postponement)
• Expectation of appreciation in foreign currency--
exporter would delay the receivables.
• Expectation of foreign currency depreciation–
importer will delay the payments.
 Translation Exposure
Also called accounting/balance sheet exposure
• An MNC may wish to translate the financial statement
of its subsidiaries/ affiliates in its home currency
(Parent’s financial statements) in order to compare
financial results.
• Generally, the investors and regulatory bodies wish to
know the real financial position of an enterprise as a
whole.
Translation exposure arises when a parent MNC is
required to consolidate a foreign subsidiary’s financial
statements with the parent’s own statements, after
translating the subsidiary statements from its
functional currency into parents’ home currency with
the changed exchange rate.
• Actual conversion of currencies does not take place
because the translation of assets, liabilities, profit/loss is
done notionally.
• The translation can be done at different rates-
- Historic rate- the exchange rate on the date the assets were
purchased or liability was aroused.
- Current rate- the rate prevailing on the date of preparation
of balance sheet.
- Average rate- the avg. rate prevailed throughout the year.
- Negotiated Rate- rate mutually decided
• Assets and liabilities are not liquidated, so no direct effect
on the cash flows.
• The difference bw exposed assets and exposed liabilities is
called Translation Exposure (TE).
- If EA>EL=positive/long/asset TE
- If EA<EL=negative/short/liability TE
• The translation gain/loss is shown as separate
component of shareholder’s equity in
Balance-sheet. This G/L does not affect the
current earnings but surely future earnings.
• Translation G/L is measured by the diff bw the
value of Assets/Liabilities at the historic rate
and current rate.
• T.G/L= A&L at current rate-A&L at historic rate.
 Translation
Exposure
Measurement Management
Methods Methods
Current/ non- Monetary/ non- Balance-sheet
current Exposure Netting
monetary Hedging

Forward Leading and

contract Lagging
Temporal
Current Rate
Swaps Transfer Pricing
 Balance-sheet hedging
It means to bring about a balance bw the EA and
EL, so that net exp becomes zero.
• In case of ATE= EA>EL
The exp can be made zero by increasing the
liability amount in the functional currency
(foreign currency) of subsidiary unit without
making any change in asset.
• In case of LTE= EA<EL
By increasing the amount of assets in subsidiary
books.
Leading and Lagging-
• ATE= EA>EL
- Delay in payment of liabilities=EL (Lags)
- Expediting(Hasten) the realisation of assets= EA
(Leads)

Transfer Pricing-
The price at which goods, assets and liabilities are
transferred from parent company to subsidiary or
branch or vice versa.
• ATE= EA>EL
-Transfer price of assets can be shown lesser than
actual, thus, decrease in amount of assets and
net will be zero.
 Economic/Operating Exposure
MNCs generally not only export/import finished
products, but raw materials also. So, whenever
there is a change in exchange rate, it will have
direct or indirect impact on the cost of product,
price of product, sale of product, revenues of firm
and overall financial position of the firm and
overall financial position of the firm or operations
of the firm. So, any unexpected change in
exchange rate affecting operations of the firm is
called operating exposure.
Operating exposure arises when unexpected
exchange rate changes make an impact (directly/
indirectly) over the future cash flows/operating
cash flows of the co.
Contingent- Impact of unanticipated exchange
rate changes over the firm’s revenues,
operating costs and operating net flows in the
coming future.
Competitive/Strategic- Impact of unanticipated
exchange rate changes over the
competitiveness of the firm.
It may be due to a) increase in costs, b)
inability to service the market in normal way.
 Feature of EE/OE
• Generally a medium/long run aspect
• Total impact of a real exchange rate change on
firm’s sales, costs and revenues depends upon
the response of consumers, suppliers,
competitors and Govt.
• Macro-economic shock
• Exchange rate change affects both future and
current cash flows.
• Measurement of EOE is very difficult as it s an
impact of various economic factors, like- D&S,
Inflation rate, extent of competition etc.
 Management of EOE

Marketing I/ S
Production Finance I/S Strategic I/S
I/S
-Product
-Market Selection Sourcing -Balance
sheet -Diversification of
-Product Strategy -Input Mix Hedging operating Base
-Pricing Strategy -Plant -Leading and strategy
-Promotional Location Lagging -Diversification of
Strategy -Raising -Parallel Firm’s financing
Productivity Loans Strategy
-Place/ Distribution
Strategy -Currency
Invoicing
MANAGING OPERATING EXPOSURE
II.Marketing Strategy
A. Market Selection:
use competitive advantage to carve out
market share when currency values
change

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MANAGING OPERATING EXPOSURE
B. Pricing strategy: Expectations critical
1. If HC depreciates, exporter gains
competitive advantage by
increasing unit profitability or
market share.
2. The higher price elasticity of
demand, the more currency risk
the firm faces by other product
substitution.

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MANAGING OPERATING EXPOSURE

C. Product Strategy
exchange rate changes may alter
1. The timing of new product
introductions,
2. Product deletion
3. Product innovations

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MANAGING OPERATING EXPOSURE
III. Product Management Adjustments
A. Input mix “shop the world”
B. Shift production among plants
C. Plant relocation (new)
D. Raising productivity

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MANAGING OPERATING EXPOSURE
IV. Planning For Exchange-Rate Changes
A. Develop contingency plans
with plausible scenarios
before the impact of a
currency change makes itself
felt.
e.g. flexible mfg systems

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 Economic Exposure Vs Accounting Exposure
Economic Exposure Accounting Exposure

1. Concerned with flows, not just accounting Focus only on accounting values - a change in
figures, and the resulting impact on the market accounting value due to translation, in itself,
value of the firm may not affect the firm's cash flows - except
through its effect on taxes.
2. Economic Exposure is forward-looking. Is backward-looking. Relates to past decisions
It focuses on future cash flows. as reflected in the subsidiary's financial
statements. It ignores cash flows from future
operations.
3. Considers all cash flows whether or not they are Looks only at items on the balance sheet or
recorded in financial statements. income statement.

4. Also applies to firms without foreign Arises only when a firm has foreign subsidiaries.
subsidiaries including exporting firms, import-
competing firms, or potential import competing
firms.
5. Depends on economic realities. Exchange rate Depends on the accounting rules chosen. The
induced changes in prices, costs, and sales subsidiary's accounting rules (inventory
volume as their effect of firm value- depending valuation method/ depreciation method) affect
on the economic environment in which the firm its accounting value, and translating accounting
operates. values can be done in many different ways.

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