Question

Identifying the way in which a business is exposed to foreign exchange rate changes is half the battle in dealing with its exposure. Applying the appropriate foreign exchange risk management techniques is the other half. Discuss.

Answer 1

a) What is a Foreign Exchange Rate?

A foreign exchange rate is the price of the domestic currency stated in terms of another currency. In other words, a foreign exchange rate compares one currency with another to show their relative values. Since standardized currencies around the world float in value with demand, supply, and consumer confidence, their values change relative to each over time. For instance, one US dollar in 2011 was worth about .68 Euros. In 2014, one US dollar is worth .75 Euros. This means the dollar has increased in value over this three-year span, but the Euro is still 25% more valuable.

b) What Does Foreign Exchange Rate Mean?

Since companies are developing increasingly larger international ties and investors, currency rate changes can affect different markets investing power drastically. Investors need to know how their investment will change with changes in their currency. Multi-national companies typically have one reporting currency that they prepare all of their financial statements in. US companies, for example, are required to produce a balance sheet and income statement along with other reports in US dollars.

They do, however, make special statements that report in other currencies. Companies like Nike and McDonald’s produce multiple financial statements converted in different currencies for investors around the world.

c) What is exposure in foreign exchange?

Foreign exchange exposure refers to the risk a company undertakes when making financial transactions in foreign currencies. All currencies can experience periods of high volatility which can adversely affect profit margins if suitable strategies are not in place to protect cash flow from sudden currency fluctuations. Exchange rate risk can usually be managed through effective, preemptive hedging.

When supply chain payments or critical accounts are based in foreign currencies, companies may choose to employ a targeted currency strategy to minimise foreign exchange exposure. These strategies usually involve contracts that allow companies to lock in an exchange rate for an extended period of time, often up to one to two years.

To be more specific, firms with positive expected exchange rate exposure reduce their exposure through selling currency forwards/futures, internal transactions with foreign subsidiaries, and the issuance of foreign currency debt, whereas firms with negative expected exchange rate exposure do so only through exchange rate

A firm’s financial exposure will depend on the extent to which financial hedges such as debt service on foreign currency debt and forward foreign exchange contracts reduce foreign exchange exposure; this may be determined from the data in the financial statements. The natural component of foreign exchange exposure recognizes that changes in foreign returns and unexpected declines in the value of a foreign currency are frequently associated with unexpected increases in inflation forecasts, so that dollar returns are naturally hedged to the extent that these unexpected increases in inflation increase foreign currency returns. The firm’s total natural exposure will depend on the extent to which a devaluation is commensurate with foreign relative inflation and on the extent to which net foreign currency cash flows can be immediately and fully adjusted to inflation.

d) What is Foreign Exchange Risk?

Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. Also known as currency risk, FX risk and exchange-rate risk, it describes the possibility that an investment’s value may decrease due to changes in the relative value of the involved currencies. Investors may experience jurisdiction risk in the form of foreign exchange risk.

There are three types of foreign exchange risk:

1. Transaction risk: This is the risk that a company faces when it's buying a product from a company located in another country. The price of the product will be denominated in the selling company's currency. If the selling company's currency were to appreciate versus the buying company's currency then the company doing the buying will have to make a larger payment in its base currency to meet the contracted price.
2. Translation risk: A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency.
3. Economic risk: Also called forecast risk, refers to when a company’s market value is continuously impacted by an unavoidable exposure to currency fluctuations.

e) How do exchange rates affect a business?

The ways in which businesses are effected by currencies can be roughly divided into transactional, translational, credit and liquidity risks. All four of these categories can then be subdivided a number of times to fit any and all kinds of businesses. But we’ll be focusing mainly on the transaction side – where the majority of foreign exchange impacts can be seen.

Supplier payments

While supplier payments and exporting are some of the more upfront ways in which exchange rates can affect you and your business, there are a plethora of ways currency volatility can trickle into your business. These are namely transactional, translational, credit and liquidity exposures:

Sales forecasts

For multinational companies, sales forecasts can be any of the following: headache, hindrance, tailwind or motivator. Where they become more complicated is when sales are listed in another currency and what looks like a firm beat on your well thought-out sales forecast turns to pennies when the exchange rate moves against you.

Balance sheet hedging

Any finance director or CFO who’s got experience dealing with multinational companies will know that holding assets and liabilities in a variety of currencies can be a burden. When you’re creating or submitting financial documents, balance sheets can be subject to sharp revisions or remeasurements if the value of an asset or liability has changed due to foreign exchange fluctuations. A loan taken out in Japanese yen will look very different on your sterling-denominated balance sheet from one quarter to another if currency markets are volatile, unpredictable and changing.

These are just a few examples of ways in which currency markets can impact individual businesses. For the broader economy, the implications of a volatile currency can be more nuanced.

The broader economy

While the effects of fluctuating exchange rates aren’t immediately obvious for those buying goods on the high street, paying your gas bill or procuring machinery for your new venture, the nature of the UK economy leaves businesses and the wider economy highly sensitive (for better or worse) to movements in the price of the pound.

f) Techniques of foreign exchange risk management

The value of a currency changes frequently due to various factors in the market such as inflation, interest rates, current account deficits, trade terms, political and economic performance etc. That ultimately affects firms and individuals engaged in international transactions. Foreign exchange risk is a form of financial risk that arises from the change in the price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face forex risk. Such risk must be managed in order to ensure better cash flows, manage unsystematic risks, avoid external financing, avoid financial distress, enhance shareholders wealth, and increases investor confidence.

Foreign exchange (FX) risk is an intrinsic part of doing international business. The values of major currencies constantly fluctuate against each other, creating income uncertainty for your business. Many businesses like to eliminate this uncertainty by locking in future exchange rates. But some businesses regard exchange rate movements as a profit opportunity.

The simplest way of eliminating foreign exchange risk is to make and receive payments only in your own currency. But your cash flow risk can increase if customers time payments to take advantage of exchange rate fluctuations. You might also lose customers to competitors who offer more currency flexibility and your suppliers may be unwilling to accept payments in what is to them a foreign currency. So you may therefore find that competitive pressures force you to explore a risk management strategy that helps manage your foreign exchange risk more efficiently.

The techniques of foreign exchange risk management are as follows;

Risk Sharing: The seller and buyer agree to share the currency risk in order to keep the long-term relationship based on the product quality and supplier reliability.

Diversification: It can be done by firms by using funds in more than one capital market and in more than one currency.

Natural hedging: The relationship between revenues and costs of a foreign subsidiary sometimes provides a natural hedge, giving the firm ongoing protection from exchange rate fluctuations.

Payments netting: This method can be used if the companies having exposed in the multiple currencies. This method gives an easy control to the company at the time of conversion, because all the payments are netted to one single transaction and allow the company follows a consistent policy and this also allows to reduce transaction cost also.

Leading and Lagging: This method works by adjusting the payments required reflecting future currency movements. It is a zero-sum game because if there is a receivable blocked in their respective currency it will allow them to use it against payable in the same currency.

Cross Hedging: If a conversion consists of more than one currency then cross hedging is used for example if an importer receiving payment in Chinese yuan, it cannot be directly converted into INR so it is first converted into USD and then INR so in these type of transaction Cross Hedging is used.

Overseas Loans/ Foreign currency: denominated debt: A Trade can avail the loan in two different currencies. Credit in home currency which have exchange rate risk and other is in foreign currency which is free from exchange rate risk. Usually, this method is used if your payments or receivables are in foreign currency.

Money market Hedge: It is a costly and unused strategy, In this method, the companies borrow in foreign currency and lends in same currency which will lead to losing on their spread. Instead of this strategy there can use forward hedging.

Borrowing Policy: Every company needs to have a strong borrowing policy. It needs to know whether to go for long-term loans or working capital loans.