12.Foreign Exchange Exposure And Risk Management Flashcards
Outland Steel has a small but profitable export business. Contracts involve substantial delays
in payment, but since the company has had a policy of always invoicing in dollars, it is fully
protected against changes in exchange rates. More recently the sales force has become
unhappy with this, since the company is losing valuable orders to Japanese and German firms
that are quoting in customers’ own currency. How will you, as Finance Manager, deal with the
situation?
As a Finance Manager to deal with the situation two problems emerge – (i) the problem of
negotiating individual contracts and (ii) managing the company’s foreign exchange exposure.
The sales force can be allowed to quote in customer’s own currency and hedge for currency
risk by obtaining the forward contracts etc.
The finance manager can decide whether the company ought to insure. There are two ways of
protecting against exchange loss. Firstly, by selling the foreign currency forward and secondly,
to borrow foreign currency against its receivables, sell the foreign currency spot and invest the
proceeds in the foreign currency say dollars. Interest rate parity theory tells us that in free
market the difference between selling forward and selling spot should be exactly equal to
difference between the interest on the money one has to pay overseas and the interest one
earns from dollars.
“Operations in foreign exchange market are exposed to a number of risks.” Discuss.
A firm dealing with foreign exchange may be exposed to foreign currency exposures. The
exposure is the result of possession of assets and liabilities and transactions denominated in
foreign currency. When exchange rate fluctuates, assets, liabilities, revenues, expenses that
have been expressed in foreign currency will result in either foreign exchange gain or loss. A
firm dealing with foreign exchange may be exposed to the following types of risks:
(i) Transaction Exposure: A firm may have some contractually fixed payments and receipts in foreign currency, such as, import payables, export receivables, interest
payable on foreign currency loans etc. All such items are to be settled in a foreign
currency. Unexpected fluctuation in exchange rate will have favourable or adverse impact
on its cash flows. Such exposures are termed as transactions exposures.
(ii) Translation Exposure: The translation exposure is also called accounting exposure or
balance sheet exposure. It is basically the exposure on the assets and liabilities shown in
the balance sheet and which are not going to be liquidated in the near future. It refers to
the probability of loss that the firm may have to face because of decrease in value of
assets due to devaluation of a foreign currency despite the fact that there was no foreign
exchange transaction during the year.
(iii) Economic Exposure: Economic exposure measures the probability that fluctuations in
foreign exchange rate will affect the value of the firm. The intrinsic value of a firm is
calculated by discounting the expected future cash flows with appropriate discounting
rate. The risk involved in economic exposure requires measurement of the effect of
fluctuations in exchange rate on different future cash flows.
What is the meaning of:
(i) Interest Rate Parity and
(ii) Purchasing Power Parity?
(i) Interest Rate Parity (IRP): Interest rate parity is a theory which states that ‘the size of
the forward premium (or discount) should be equal to the interest rate differential
between the two countries of concern”. When interest rate parity exists, covered interest
arbitrage (means foreign exchange risk is covered) is not feasible, because any interest
rate advantage in the foreign country will be offset by the discount on the forward rate.
Thus, the act of covered interest arbitrage would generate a return that is no higher than
what would be generated by a domestic investment.
The Covered Interest Rate Parity equation is given by:
( ) ( ) D F
r1
S
F r1 +=+
Where (1 + rD) = Amount that an investor would get after a unit period by investing a
rupee in the domestic market at rD rate of interest and (1+ rF) F/S = is the amount that an
investor by investing in the foreign market at rF that the investment of one rupee yield
same return in the domestic as well as in the foreign market.
Thus, IRP is a theory which states that the size of the forward premium or discount on a
currency should be equal to the interest rate differential between the two countries of
concern.
(ii) Purchasing Power Parity (PPP): Purchasing Power Parity theory focuses on the
‘inflation – exchange rate’ relationship. There are two forms of PPP theory:-
The ABSOLUTE FORM, also called the ‘Law of One Price’ suggests that “prices of
similar products of two different countries should be equal when measured in a common
currency”. If a discrepancy in prices as measured by a common currency exists, the
demand should shift so that these prices should converge.
The RELATIVE FORM is an alternative version that accounts for the possibility of market
imperfections such as transportation costs, tariffs, and quotas. It suggests that ‘because of
these market imperfections, prices of similar products of different countries will not
necessarily be the same when measured in a common currency.’ However, it states that
the rate of change in the prices of products should be somewhat similar when measured in
a common currency, as long as the transportation costs and trade barriers are unchanged.
The formula for computing the forward rate using the inflation rates in domestic and
foreign countries is as follows:
F = S )i+1(
)i+1(
F
D
Where F= Forward Rate of Foreign Currency and S= Spot Rate
iD = Domestic Inflation Rate and iF= Inflation Rate in foreign country
Thus PPP theory states that the exchange rate between two countries reflects the relative
purchasing power of the two countries i.e. the price at which a basket of goods can be
bought in the two countries.
Write short notes on the following:
(a) Leading and lagging
(b) Meaning and Advantages of Netting
(c) Nostro, Vostro and Loro Accounts
(a) Leading means advancing a payment i.e. making a payment before it is due. Lagging
involves postponing a payment i.e. delaying payment beyond its due date.
In forex market Leading and lagging are used for two purposes:-
(1) Hedging foreign exchange risk: A company can lead payments required to be made
in a currency that is likely to appreciate. For example, a company has to pay
$100000 after one month from today. The company apprehends the USD to
appreciate. It can make the payment now. Leading involves a finance cost i.e. one
month’s interest cost of money used for purchasing $100000.
A company may lag the payment that it needs to make in a currency that it is likely
to depreciate, provided the receiving party agrees for this proposition. The receiving
party may demand interest for this delay and that would be the cost of lagging.
Decision regarding leading and lagging should be made after considering (i) likely
movement in exchange rate (ii) interest cost and (iii) discount (if any).
(2) Shifting the liquidity by modifying the credit terms between inter-group entities: For
example, A Holding Company sells goods to its 100% Subsidiary. Normal credit
term is 90 days. Suppose cost of funds is 12% for Holding and 15% for Subsidiary.
In this case the Holding may grant credit for longer period to Subsidiary to get the
best advantage for the group as a whole. If cost of funds is 15% for Holding and
12% for Subsidiary, the Subsidiary may lead the payment for the best advantage of
the group as a whole. The decision regarding leading and lagging should be taken
on the basis of cost of funds to both paying entity and receiving entity. If paying and
receiving entities have different home currencies, likely movements in exchange
rate should also be considered.
(b) It is a technique of optimising cash flow movements with the combined efforts of the
subsidiaries thereby reducing administrative and transaction costs resulting from
currency conversion. There is a co-ordinated international interchange of materials,
finished products and parts among the different units of MNC with many subsidiaries
buying /selling from/to each other. Netting helps in minimising the total volume of inter-
company fund flow.
Advantages derived from netting system includes:
(1) Reduces the number of cross-border transactions between subsidiaries thereby
decreasing the overall administrative costs of such cash transfers
(2) Reduces the need for foreign exchange conversion and hence decreases
transaction costs associated with foreign exchange conversion.
(3) Improves cash flow forecasting since net cash transfers are made at the end of
each period
(4) Gives an accurate report and settles accounts through co-ordinated efforts among
all subsidiaries.
(c) In interbank transactions, foreign exchange is transferred from one account to another
account and from one centre to another centre. Therefore, the banks maintain three
types of current accounts in order to facilitate quick transfer of funds in different
currencies. These accounts are Nostro, Vostro and Loro accounts meaning “our”, “your”
and “their”. A bank’s foreign currency account maintained by the bank in a foreign
country and in the home currency of that country is known as Nostro Account or “our
account with you”. For example, An Indian bank’s Swiss franc account with a bank in
Switzerland. Vostro account is the local currency account maintained by a foreign
bank/branch. It is also called “your account with us”. For example, Indian rupee account
maintained by a bank in Switzerland with a bank in India. The Loro account is an account wherein a bank remits funds in foreign currency to another bank for credit to an account
of a third bank.
Briefly explain the main strategies for exposure management.
Four separate strategy options are feasible for exposure management. They are:
(a) Low Risk: Low Reward- This option involves automatic hedging of exposures in the
forward market as soon as they arise, irrespective of the attractiveness or otherwise of the
forward rate.
(b) Low Risk: Reasonable Reward- This strategy requires selective hedging of exposures
whenever forward rates are attractive but keeping exposures open whenever they are not.
(c) High Risk: Low Reward- Perhaps the worst strategy is to leave all exposures
unhedged.
(d) High Risk: High Reward- This strategy involves active trading in the currency market
through continuous cancellations and re-bookings of forward contracts. With exchange
controls relaxed in India in recent times, a few of the larger companies are adopting this
strategy.
