Foreign Exchange Risk/Exposure Management

In today’s global economy, any company trading in international markets is impacted by exchange rate fluctuations. The impact of exchange rate fluctuations directly affects the profitability of the firm. Exchange risk is the effect that unanticipated exchange rate changes have on the value of the assets, liabilities and operating income of the firm. This exchange risk determines the foreign exchange exposure of a firm. The degree of the foreign exchange risk exposure depends on how much of the assets and liabilities are exposed.

Every company faces exposure to foreign-exchange risk as soon as it chooses to either maintain a presence in a foreign country or when it chooses to finance it operations in foreign currencies. In addition, foreign trade and loans may also involve foreign exchange risk. International financial managers compare potential losses with the cost of avoiding these losses for a company. Measuring foreign exchange exposure is a task that results in measuring the potential of a firm’s future profitability, net cash flow and market value as well as the firms level of liquidity available to mitigate against foreign exchange fluctuations.

There are three basic type of exchange exposure as given below: ? Translation Exposure – Translation exposure is often called accounting exposure. It refers to the “changes in value of the income statement and balance sheet items when they are expressed at consolidation from local currency terms to the monetary unit of the parent company” (Carrada-Bravo, 2003, p. 148). For a cross-border firm, it is essential that it must periodically remeasure all of its global operations into a single currency for reporting purposes.

This requires that the balance sheets and income statements of all affiliate operations worldwide are translated and consolidated into the currency of the parent company. As a balance sheet item in the equity section, it does not impact tax liability or substantially impact financial analysis. However, the adjusted gain or loss may be very significant in a volatile currency environment, and if the operation is liquidated, the gain and loss affects income (Shoup, 1998, p. 165).

? Transaction Exposure – Transaction exposure refers to “the potential; change in the value of outstanding obligations due to changes in the exchange rate between the inception of a contract and the settlement of the contract” (Kim, 2002, p. 221). This type of exposure arises whenever the firm consults for or is contractually obliged to make or receive a payment at a future date denominated in a foreign currency. Hence, transaction exposures can arise from operating and free cash flows, e. g. debt or equity service obligation arising from the funding of the firm’s business.

The risk here involves uncertainty about a specific identifiable cash flow, and it is known as transaction exposure because it involves actual gain or loss due to conversion or one currency into another. Transaction exposure is more visible than translation exposure and hence gets more attention from currency managers (Shoup, 1998, p. 165). ? Economic Exposure – Economic exposure is also known as operating exposure, competitive exposure or revenue exposure. This is defined as “the potential for the change in the present value of future cash flows due to a unexpected change in the exchange rate” (Carrada-Bravo, 2003, p.

150). Economic exposure measures the impact of an exchange rate on the net present value of expected future cash flows from a foreign investment project. Future effects of currency changes generally occur under the category of economic risk. This is difficult to measure but may be more significant than the other two risks because it relates to the long-term profit performance and hence the value of the firm (Kim, 2002, p. 222). Managing Foreign Exchange Rate Exposure I. Translation Exposure – Overview Translation exposure measures the effect of an exchange rate on published financial statements of a firm.

Foreign currency assets and liabilities that are translated at the current exchange rate are considered to be exposed. From another perspective, translation exposure affects an organization by affecting the value of foreign currency balance sheet items such as accounts payable and receivable, foreign currency cash and deposits, and foreign exchange debt. Longer-term assets and liabilities, such as those associated with foreign operations, are likely to be particularly impacted. Foreign currency debt can also be considered as a source of translation exposure (Kim, 2002, p. 220-221). Current Rate & Temporal Translation

If exchange rates have changed since the previous accounting period, the translation of financial statement items denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains and losses often depends on the rules that govern translation. There are two translation methods most widely used by MNCs: current rate & temporal translation. The current rate method has been followed by UK, European, Asia, Australian, and New Zealand. It is currently permitted for self-sustaining operations under international, US, Canadian, UK, European, Australian and Asian accounting standards.

All the foreign operation’s assets and liabilities are translated at the exchange rate ruling on balance date. Profit and loss items are translated using exchange rates ruling at the times of the transactions or approximations thereto. The current rate method is the simplest of all the methods (Kim, 2002, p. 225). The temporal method is sometimes required by international, US, Canadian, European, and Australian counties’ accounting standards and is generally to be applied only where foreign investment is integrate i. e.

where the overseas firm frequently exposes the reporting firm to currency risk because of financial and/or operating interdependencies. Under the temporal method, assets and liabilities are translated suing exchange rates corresponding to their valuation: historical-cost-valued items are translated using historical exchange rates; items at current or revalued amounts are translated using exchange rates ruling at their valuation or revaluation. Revenues and expenses are translated using exchange rates at the time of the translated (Kim, 2002, p. 225). Managing Translation Exposure – Hedging Strategies & Practices

Translation exposure is the exposure of an MNCs consolidated financial statement to exchange rate measurements. To measure translation exposure, MNCs can forecast their earnings in each foreign currency and then determine the potential exchange rate movements of each currency relative to their home currency. Even if translation exposure does not affect cash flows, it is a concern of many MNCs because it can reduce an MNC’s consolidated earnings and thereby cause a decline in is stock prices. Thus, some MNCs may consider hedging their translation exposure.

For hedging, some MNCs use forward contracts or futures contracts to hedge translation exposure. Specifically they can sell currency forward that their foreign subsidiaries receive as earning. In this way, they create a cash outflow in the currency to offset the earning received in that currency (Madura, 2006, p. 382). The effects that translation exposure has on transaction exposure are usually recognized to ensure an efficient hedging strategy. This is because the concept of translation exposures disregards influences on cash flows and may only result in unrealized profits and losses.

Multinational groups may move assets and liabilities denominated in local currency to foreign operations, transfer prices can be adjusted, payment of dividends can be accelerated etc. to reduce the translation exposure. This is because the number of items i. e. assets denominated in a devaluating currency that face translation exposure was reduced. Hedging strategies dealing with translation exposure, only regard accounting effects. However, it is rational to manage translational exposure, as they influence the reported income, which may influence bankruptcy and other costs such as taxes, credit costs etc (Heidrich, 2007, p.

11-12). II. Overview of Transaction Exposure Transaction exposure measures how the home currency value of a firm’s foreign currency denominated contractual cash flows would be affected by exchange rate fluctuations. Transaction exposure arises from the possibility of incurring exchange gains or losses on transactions already entered into which is denominated in a foreign currency. Measurement of Transaction Exposure Although transaction exposure is often include under accounting exposure, it is more properly a cash flow exposure and hence a part of economic exposure.

Transaction exposure arises only if the company’s commitments lead it to engage in foreign currency denominated sales or purchases. Multinational corporations can measure their transaction exposure by determining their future payables and receivables position in carious currencies along with the variability levels and correlations of these currencies. From this information, they can asses how their revenue and costs may change in response to various exchange rate scenarios (Shoup, 1998, p. 97). Basics of Foreign Currency Accounting Foreign currency accounting is one of the most controversial areas in accounting.

In the USA, accounting for foreign currency transactions and translation of foreign denominated financial statements is covered in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 52 (1981) SFAS 32. Foreign currency accounting issues affect the financial reporting for companies that operate in foreign countries. Transaction gains and losses occur when a transaction is denominated in a currency other than the functional currency of the business entity. The above mentioned basis requires the application of the functional currency concept.

A functional currency is the currency of the primary economic environment in which it operates. Under this concept, a foreign entity’s assets, liabilities, and operations are all measured in the functional currency. A foreign currency transaction exists when the transaction is settled in a currency other than the company’s functional currency. It is required that a foreign currency transaction be recorded in the books of accounts when it is begun i. e. the date of transaction, then may be at certain interim reporting dates, and finally when it is settled.

On each of these three dates, the foreign currency transaction must be recorded in functional currency, using the spot rate on that date for translation (Siegel, Shim, 2006, p. 894). Managing Transaction Exposure – Hedging Strategies & Practices Management of transactional exposures has two significant dimensions. First, the treasurer must decide whether and to what extent any exposure should be explicitly hedged. Having decided to hedge whole or part of an exposure, the treasurer must evaluate alternative hedging strategies. Transactional exposure, more than any other kind, is most adaptable to management by financial hedging.

This is because of the like characteristics of the exposure and the hedging vehicles. Assets and liabilities are contractual in nature; they are monetized, and have a known value. They often have a known duration. The short term financial contracts that are used to manage transaction exposure in the short term have the same strategies. The instruments include futures, forward contracts and options. It also includes short-term borrowings. However, these instruments are useful up to about a year. Beyond that, the market gets very thin and pricing becomes more of an art form than a math form.

There are instruments called long-term forward contracts that go out to five years or more. However, they are not very popular because they are very illiquid and the pricing is also imprecise. There is also a way to hedge a multi-year exposure by continuously rolling over six-month forward or futures contract, but this is not a perfect solution either. The forward rates are always changing because of changes in the interest rate differentials, which are left unhedged (Shoup, 1998, p. 99-103; Apte, 2006; p. 383). III. Overview of Operating Exposure

Even if a company has hedged its foreign currency receivables and payables and has no foreign assets or liabilities, there is still an important element of foreign exchange exposure – the operating exposure which occurs because current and more importantly future profits from operations depend on exchange rates. The techniques for hedging assets and liabilities are not designed to eliminate operating exposure which is in fact so difficult to eliminate that it has been called residual foreign exchange exposure (Levi, 2005, p. 230). Measuring the Impact of Operating Exposure

Operating exposure cannot be estimated from accounting statements like contractual or accounting. The measurement of operating of operating exposure requires an understanding of the structure of the markets in which the company and its competitors obtain labor and materials and sell their products and also of the degree of their flexibility to change markets, products mi, sourcing and technology. Measuring a firm’s operating exposure requires a longer-term perspective, viewing the firm as an ongoing concern with operations whose cost and price competitiveness could be affected by exchange rate changes.

The estimate of operating exposure will not be as accurate as the estimate of contractual exposure. Furthermore, treasury staff needs to have successful dialogs with operating management to obtain this information (Aliber, Click, 1993, p. 319). Managing Operating Exposure – Hedging Strategies & Practices The impact of operating exposure can be felt well beyond just pricing and invoicing decisions. Also, a firm is subject to operating expenses even when it has little or no direct involvement in international markets.

Operating exposure can be looked upon as a combination of two effects – the conversion effect and the competitive effect. The conversion effect refers to the changes in home currency value of a given foreign currency cash flow while the competitive effect refers to the impact of the exchange rate changes arising out of changes in prices and quantities. The former is similar to transactions exposure while a meaningful analysis of the latter must enquire into the factors which determine the price impact and the quantity impact of change rate changes (Aliber, Click, 1993, p. 320).

Companies have the following two types of business options for managing operating exposure: i. Managing by Changing Operating Policies – One of the most popular methods of hedging operating exposure involves siting of manufacturing facilities i. e. shifting production to a country that is more promising with potential for significant penetration. Exposures may also be reduced by changing the mix of marketing and production. This strategy is especially appropriate for an acquisition-minded growing company. Yet another means of reducing exposure from foreign currency is the modification of product line.

This strategy is most appropriate for companies that have a product line extremely sensitive to price-change i. e. a low cost product with little or no differentiation. The product may either be modified or can be re-targeted and promoted to a different market segment (Shoup, 1998, p. 92-93). ii. Managing by Changing Financing Strategies – One of the most effective ways to avoid risk of exposure is to eliminate it i. e. not to remain in the market of the particular currency creating the exposure. In fact many companies anticipating the risk have decided to pull out from certain markets for pre-decided periods of time.

Some authors have also suggested currency matching of inputs and outputs as a method for managing operating exposure i. e. reduce the variation of its profits. However, analysts are skeptical that the method would interfere with another competing goal of increasing expected profits (Shoup, 1998, p. 92-93). Operating Exposure Management in Practice There have been a number of investigations of corporate currency exposure management practices. One of the key findings is that very few companies undertake an accurate, quantitative assessment of how unanticipated exchange rate impact on the value of their firm.

In fact most firms find it extremely difficult to gauge the long-term exposure of their business to currency fluctuations. Surprisingly a large number of firms appear to think that they are not exposed to currency risk of any kind or that the risk is trivial. Companies deal with long-term operating exposure by on-balance sheet operating mechanisms such as setting up plants and sourcing of inputs in different currency areas; have foreign subsidiaries borrow in local currencies; employee wages indexed to exchange rate; redesign or update products to cater to more price-inelastic market segments.

That is to say, the practice of long-term operating exposure is much less precise and sophisticated than what the development of the theory would suggest even among firms in advanced countries (Apte? 2006, p. 437-438). References Aliber RZ, Click RW, (1993), “Readings in International Business: A Decision Approach”, Published: MIT Press, Massachusetts Apte PG, (2006), “International Financial Management”, 4th Edition, Published: Tata McGraw-Hill, New Delhi Carrada-Bravo F, (2003), “Managing Global Finance in the Digital Economy”, Published: Greenwood Publishing Group, Westport, Connecticut

Conklin DW, (2005), “Cases in the Environment of Business: International Perspectives”, Published: SAGE, Thousand oaks, California Heidrich CS, (2007, “Foreign Currency Translation According to IAS 21 and IAS 39 in Consolidated Financial Statements Considering Intragroup Foreign Currency Hedging Strategies”, Published: GRIN Verlag, Norderstedt, Germany Kim KA, (2002), “Global Corporate Finance: Text and Cases”, 5th Edition, Published: Wiley-Blackwell, Malden, Massachusetts Levi MD, (2005), “International finance”, 4th Edition, Published: Routledge and Taylor & Francis Group, New York

Madura J, (2006), “International Financial Management”, 8th Edition, Published: Cengage Learning & Thomson Higher Education, Ohio Shoup G, (1998), “The International Guide to Foreign Currency Management”, Published: Lessons Professional Publishing & Fitzroy Dearborn Publishers, Chicago Shoup G, (1998), “Currency Risk Management: A Handbook for Financial Managers, Brokers, and Their Consultants”, Published: Lessons Professional Publishing & Fitzroy Dearborn Publishers, Chicago Siegel JG, Shim JK, (2006), “Accounting Handbook”, 4th Edition, Published: Barron’s Educational Series, New York