Unit 5: Managing Foreign Exchange

Exposure
Exchange risk-types of exposure-Tools & techniques of
foreign exchange risk management- Management of
Translation exposure-Functional versus reporting
currency-Translation methods (simple problems related to
methods of translation)-Management of Transaction
exposure-Risk management products-Management of
Economic exposure-Managing economic exposure-
Marketing management of exchange risk-production
management of exchange risk.
 Currency Market

International
currency markets
The market in which
are made up of
participants from
banks, commercial
around the world
companies, central
are able to buy, sell,
banks, investment
exchange and
management firms,
speculate on
hedge funds, retail
different currencies.
forex brokers and
investors.
The foreign exchange market (forex, FX, or
currency market) is a global decentralized
market for the trading of currencies.

This includes all aspects of buying, selling and

exchanging currencies at current or determined
prices. In terms of volume of trading, it is by far
the largest market in the world.
The Foreign Currency Market is virtual. There is no one
central physical location that is the foreign currency
market.

It exists in the dealing rooms of various central banks,

large international banks, and some large corporations.

The dealing rooms are connected via telephone,

computer, and fax. Some countries co-locate their
dealing rooms in one center.

Exchange rates for the various currencies are set in this

market.
Spot Exchange
• The spot exchange is the simplest contract. A spot exchange
contract identifies two parties, the currency they are buying or
selling and the currency they expect to receive in exchange.
• The currencies are exchanged at the prevailing spot rate at the
time of the contract. The spot rate is constantly fluctuating.
• When a spot exchange is agreed upon, the contract is defined
to be executed immediately.
• Documentation is sent and received from both
parties detailing the exchange rate agreed upon and
the amounts of currency involved.
• The funds actually move between banks two days
after the spot transaction is agreed upon.
 Forward Exchange
• The forward exchange contract is similar to the spot
exchange. However, the time period of the contract is
significantly longer.
• These contracts use a forward exchange rate that differs
from the spot rate.
• The difference between the forward rate and the spot
rate reflects the difference in interest rates between the
two currencies.
• Forward exchange contracts are settled at a specified
date in the future.
• The parties exchange funds at this date.
• Forward contracts are typically custom written
between the party needing currency and the bank, or
between banks.
 Foreign Exchange Market Features

1. Foreign exchange market is the only market

which is open 24 hours a day, except for
weekends unlike equity or commodities market
which are open only for few hours.
2. Volume of transactions which are executed in
foreign exchange market is extremely huge
because of many big players in foreign exchange
market. Foreign exchange markets are more
liquid than any other market because of this
reason.
3. Foreign Exchange Market are present in every
country and therefore geographically they
are located everywhere in the world, which
makes them quite unique.
4. Foreign exchange markets are the most
difficult market to trade in as the exchange
rates of countries are affected by so many
factors like interest rates, liquidity, geo
political factor and so on.
• Foreign exchange market is a big player
market, because mostly it is the big banks and
government who are the players in foreign
exchange market.
Management of Transaction exposure-Risk
management products-Management of Economic
exposure-Managing economic exposure- Marketing
management of exchange risk-production
management of exchange risk.
Foreign Exchange Risk Management Strategy??
Foreign Exchange Risk Management Strategy

Foreign exchange risk management strategy or FX

hedging strategy are terms used to define all the
measures devised by businesses or investors to protect
the value of their cash flows, assets or liabilities from
adverse fluctuations of the exchange rate.
Types of Foreign Exchange Risk
Fundamentally, there are three types of foreign
exchange exposure companies face:
• Transaction exposure,
• Translation exposure, and

• Economic (or operating) exposure.

 Transactional Exposure
International accounting essentially
begins with the recording of Foreign
transactions. A transaction in relation to
importing, exporting, foreign borrowings
and lending, and forward contracts,
taking place between parties belonging to
two different countries, is said to be
International transaction.
 Transactional Exposure
The exposure occurs, for example, due to the time difference
between an entitlement to receive cash from a customer and the
actual physical receipt of the cash or, in the case of a payable,
the time between placing the purchase order and settlement of
the invoice.
Hedging Techniques for Forex Risk - MNC’s
For Transaction Exposure

Financial and Operational

Techniques
 Hedging

• A hedge is a position that is taken as a temporary substitute

for a later position in another asset or liability or to protect
the value of an existing position in an asset or liability until the
position can be liquidated.
• Hedging can be easily understood as insuring against the big
loss.
Hedging Forex Risk- the external techniques
Forwards, Futures, Options, Swaps
1. Forward contracts
• The forward market is where you can buy and sell a currency, at a
fixed future date for a predetermined rate, i.e. the forward rate of
exchange. This effectively fixes the future rate.

2. Money market hedges

• The basic idea is to avoid future exchange rate uncertainty by making
the exchange at today's spot rate instead. This is achieved by
depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur. This effectively fixes the future rate.
Purchased Asset on 01/07/2017 for $ 1,00,000.
• Amount is to be settled on 31/12/2017.
• Interest Rate Prevailing :
India – 10% - 12% US: 5% - 6%
6 month forward rate available on 01/07/2017 is
$1 = ₹ 66.40 – ₹ 67.60

Spot Rate on 01/07/2017 is ₹ 64 - ₹ 65

3.Futures contracts
• Futures contracts are standard sized, traded hedging instruments.
• The aim of a currency futures contract is to fix an exchange rate at some
future date, subject to basis risk.

4. Options
• A currency option is a right, but not an obligation, to buy or sell a currency
at an exercise price on a future date. The right will only be exercised to
protect against an adverse movement, i.e. the worst-case scenario.
• A call option gives the holder the right to buy the underlying currency.
• A put option gives the holder the right to sell the underlying currency.
5. Swaps

• Swaps are derivative instruments that involve an agreement between two parties to
exchange a series of cash flows over a specific period of time.
• Types – Interest Rate Swap, Currency Swap, Commodity Swap, Credit Default Swap

The main objectives of a Swaps are:

• Investment objectives or repayment scenarios may have changed.
• It may be financially beneficial to switch to newly available alternate stream of cash
flows compared to the existing one.
• Access to capital markets, in which it may be impossible to borrow directly.
• Forex swaps are especially useful when dealing with countries that have exchange
controls and/or volatile exchange rates.
 Operational Techniques for Managing Transaction
Exposure

Leading and Lagging

Leading and lagging involve manipulating currency cash flows in
accordance with the fluctuations. Paying off liabilities when the
currency is appreciating is known as leading. While delaying when the
currency is falling in called lagging.
Re-invoicing Centers
A re-invoicing center is a central financial subsidiary within a
multinational corporation (MNC) that handles intra-firm transactions
in different currencies, acting as an intermediary to manage currency
risks, tax liabilities, and transfer pricing by reissuing invoices
 Translation Exposure
This is the translation or conversion of the financial statements
(such as P&L or balance sheet) of a foreign subsidiary from its
local currency into the reporting currency of the parent. This
arises because the parent company has reporting obligations to
shareholders and regulators which require it to provide
a consolidated set of accounts in its reporting currency for all its
subsidiaries.
 Issues in International Accounting
• International Transaction
• Foreign Currency Translation
• Consolidation of Foreign Financial Statements
• Accounting for Price Level Changes
• Foreign Exchange Risk Management
• Transfer Pricing
• Segment Reporting
• International Financial Statement Analysis
 Foreign Currency Translation of
Financial Statements

• The Current Rate Method

• The Monetary/ Non-Monetary Method
• The Temporal Method
• The Current / Non Current Method
 • Assume that a foreign subsidiary of a US
multinational has the following:
i. Cash FC 100
ii. Accounts Receivables = FC 150
iii. Inventory = FC 200
iv. FA = FC 250
v. CL = FC 100
vi. Long Term Debt = FC 300
vii. Net Worth = FC 300
Further assume historical Ex rate = $2 = FC 1.
The Current rate is $1 = FC 1
Suppose a US parent establishes a subsidiary in Europe.
The accounts of the subsidiary are denominated in
Euros, so the parent’s translation exposure is the Euro.
The rate which prevailed (Historical) was $1.00/Euro.

1. Assume current rate at 25% depreciation of the Euro

against the dollar.

2. Assume a 20% appreciation of the Euro against the

dollar.

Prepare the translated B/S showing Cumulative

Translation Adjustment (CTA) under the four translation
methods.
 Assets Euros €
Cash and marketable securities 2,500
Accounts receivable 2,500
Inventory 2,500
Plant and equipment 7,500
Total assets 15,000
Liabilities
Accounts payable 2,500
Short-term debt 2,500
Long-term debt 5,000
Net worth 5,000
Total Liabilities 15,000
A company in US is conducting financial plan for
next year. It has no foreign subsidiaries, but
more than half of its sales are from exports. Its
foreign cash inflows to be received from exports
and cash outflows to be paid for imports is given
below:
Currency Inflows Outflows
Canadian Dollars (C$) C$ 35,000,000 C$ 2,500,000
German Euro (€) € 55,00,000 € 16,00,000
Australia (AU $) AU $ 1,50,000 AU $ 1,20,000
India ₹ ₹ 60,00,000 ₹ 80,00,000
Currency Spot Rate 1 Yr Fr Rate
Canadian Dollars (C$) $ 0.70 $ 0.75
German Euro (€) $ 1.09 $ 1.12
Australia (AU $) $ 0.63 $ 0.66
India ₹ $ 0.012 $ 0.015
 Soln.

Inflows Outflows Net Flow Spot Exposure

Currency
(a) (b) (a-b) Rate In $
(C$) 35,000,000 2,500,000 32,500,000 $0.70 22,750,000
(€) 5500000 1600000 3,900,000 $1.09 4,251,000
(AU $) 150000 120000 30,000 $0.63 18,900
₹ 6000000 8000000 -2,000,000 $0.012 -24,000
 Economic Exposure
This type of foreign exchange exposure is caused by the effect of
unexpected and unavoidable currency fluctuations on a
company’s future cash flows and market value, and is long-term
in nature. This type of exposure can impact longer-term strategic
decisions such as where to invest in manufacturing capacity.
Managing Economic Exposure
1. Marketing Initiatives
2. Production Initiatives
Managing Economic Exposure
• 1. Marketing Initiatives
– Market Selection
– Product Strategy
– Pricing Strategy
– Promotional Strategy
 Market Selection
Market Selection & Segmentation:
• Exporters must decide where to sell their products
(market selection).
• They should also consider market segmentation within
different countries.
Impact of Currency Devaluation:
• Companies selling differentiated products to affluent
customers may be less affected by foreign currency
devaluation.
• Mass marketers, on the other hand, are more vulnerable
to such economic changes.
Opportunity after Currency Depreciation:
• If the home currency depreciates, firms targeting
upper-income groups may now find it easier to compete
in mass markets abroad due to better pricing.
 Product Strategy
1. Product Strategy Adjustments
Companies can modify their strategies in two ways:
• Product Line Decisions – Expanding or narrowing product
offerings.
• Product Innovations – Enhancing products or developing new
ones.
2. Response to Currency Depreciation (Weaker Home Currency)
• Firms can expand their product line since their products become
more affordable in global markets.
• This allows them to target a broader range of consumers both
domestically and internationally.
 Product Strategy
3. Response to Currency Appreciation (Stronger Home
Currency)
• Firms may need to reposition their product offerings.
• The focus shifts to high-income, quality-conscious, and
less price-sensitive customers.
• Firms must differentiate through premium quality
rather than price competitiveness.
4. Industrial vs. Consumer Market Strategy
• Companies selling in the industrial market (B2B) need a
different approach.
• In the case of a strong home currency, they should
focus on product innovation, backed by higher R&D
investment, to stay competitive.
 Pricing Strategy
• Rising Dollar Impact:
– A strong dollar makes U.S. goods more expensive for foreign
buyers.
– Firms face a Hobson's choice (a difficult decision with limited
options):
• Keep prices constant → Maintains profit margin but may lose sales and
market share.
• Reduce prices → Protects market share but lowers profit margins.
• Weak Dollar Impact:
– A weaker dollar makes U.S. goods cheaper in foreign markets.
– Firms can:
• Use lower prices to regain lost market share.
• Increase prices to recover previous losses caused by the strong dollar.
• This highlights the trade-off between pricing strategy,
market share, and profitability in global markets.
 Promotional Strategy
1. Importance of Promotional Budget
• The size of the promotional budget is a crucial factor in any marketing
strategy.
• Exchange rate changes can influence the effectiveness and returns on
promotional spending.
2. Impact of Domestic Currency Devaluation (Weaker Home Currency)
• When a country's currency depreciates, its exports become cheaper
and more competitive in global markets.
• As a result, firms may experience higher returns on their marketing
and advertising investments due to improved price positioning of
their products.
3. Impact of Foreign Currency Devaluation (Stronger Home Currency)
• If a foreign country's currency depreciates, the firm’s products
become relatively expensive, making exports less competitive.
• This reduces the effectiveness of marketing expenditures, possibly
requiring a fundamental shift in product strategy.
 Production Initiatives
• 2. Production Initiatives
– Product Sourcing
– Input Mix
– Plant Location
– Raising Productivity
 Production Initiatives

Product Sourcing & Plant Location

• Product Sourcing: Companies can source raw
materials from countries with favourable
exchange rates to reduce costs.
• Plant Location: By relocating production to
countries with lower currency risks or
cheaper labour, firms can stay competitive.
 Input Mix
1. Manufacturing Shift vs. Outsourcing
• Manufacturing Shift: Companies establish overseas
facilities to mitigate exchange rate risks.
• Outsourcing: A more flexible approach where companies
purchase more components from foreign suppliers instead
of fully relocating production.

2. Benefits of Outsourcing in Exchange Rate Risk

Management
• Flexibility: Companies can switch suppliers based on
exchange rate fluctuations.
• Cost Efficiency: By sourcing inputs from countries with
stable or favourable exchange rates, firms reduce costs.
• Risk Diversification: Reduces dependency on a single
country’s currency fluctuations.
 Locational Shifts
1. The Role of Currency Movements in Production Decisions
• Currency Devaluation: Increases production in countries where the
currency has weakened (reducing costs in home currency terms).
• Currency Revaluation: Reduces production in countries where the
currency has strengthened (increasing costs in home currency
terms).
2. Prerequisite for Production Shifting
• A company must have an established network of plants worldwide
to implement this strategy effectively.

3. Benefits of Production Shifting

• Cost Optimization: Leverages currency movements for cost
efficiency.
• Operational Flexibility: Quickly adjusts production to market
conditions.
• Risk Diversification: Reduces dependency on a single country’s
economy.
Many Japanese firms have relocated
production to:
✔ Taiwan
✔ South Korea
✔ Singapore
✔ Other developing nations
✔ United States (to manage the impact of a
high Yen)
 Raising Productivity
• Raising Productivity through closing
inefficient plants,
• Automation
• Employee motivation to improve
productivity.