Question

How can a firm reduce its operating economic exposure to foreign exchange risk. What actions could the firm take to reduce its risk?

What are some possible reasons for foreign direct investment?

Answer 1

A firm can reduce its operating economic exposure to foreign exchange risk through hedging.

Hedging refers to taking off-setting position in two separate but related financial instruments such that the impact of the risk factor is mitigated or eliminated. A very simple example is: Say a company completes a delivery today but payment will be received in a foreign currency a month later but based on exchange rate today. A company should immediately hedge this position by entering into a transaction where payment by it has to be made in the same foreign currency a month later but based on exchange rate today. If this happens, the company receives payments in the foreign currency a month later and pays out the same amount in the second transaction thus without incurring any gains / losses due to exchange rate fluctuation.

Hedging can be natural or (intellectual) man made.

A natural hedge is by taking offsetting positions in two securities. For example: Buying shares of ABC Cements and shorting (selling) shares of another cement company say PQR cement. A natural hedge is a method of reducing risk by investing in two different items whose performance tends to cancel each other. A natural hedge does not involve the use of sophisticated financial tools such as derivatives or futures contracts. It’s a natural hedge. Gain in one will offset the loss in other. Insurance is a natural hedge.

An artificial hedge is by taking the offsetting position in derivative market by making use of options, futures, forwards or even swaps.

Hedging can be used to manage risks arising due to fluctuations in prices, interest rate, or foreign exchange rates. Commonly used instruments are future contracts, options (Call and Put option on the stock of two different companies operating in same sector), sale and purchase of rights to goods and services for delivery at different dates.

Swap is a private agreement between two parties to exchange future cash flows from an agreed asset. In other words, it is a series of forward contracts with the agreement to exchange payments on specified date.

Currency rate Swap

Liability in one currency is converted to another currency to address the currency exchange rate risk. The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

Example:

Sundaram Corporation (“SC”), a USA based firm having $ as functional currency has a need for funds in € and Bhargava Corporation (“BC”), a Europe based company having € as functional currency has a need for funds in $. The two enter into a five-year currency swap for $ 100 mn. Let's assume the exchange rate at the time is $ 1.50 / €. Explain the procedure of this currency swap.

Solution:

• First, the firms will exchange principals. So, SC pays $ 100 mn to BC, and BC pays € 100 / 1.50 mn = € 67 mn (rounded off to nearest integer). This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).
• Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal.
• Since SC has borrowed in €, it must pay interest in € based on a euro interest rate. Likewise, BC, which borrowed in $, will pay interest in $, based on a dollar interest rate.

• For this example, let's say the agreed-upon dollar-denominated interest rate is 6%, and the euro-denominated interest rate is 2%. Thus, each year, SC pays = € 67 mn x 2% = € 1.34 mn to BC. In return, BC pays = $ 100 mn x 6% = $ 6 mn to SC.
• As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $ 1.30 / €, then SC's payment to BC = € 1.34 mn x $ 1.30 / € = $ 1.74 mn < $ 6 mn payable by BC to SC. In practice, BC would pay the net difference = 6 – 1.74 = $ 4.26 mn to SC.

• Finally, at the end of the swap (usually also the date of the final interest payment), SC and BC re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Reasons for FDI

1. Benefits to the overall economy: The capital reaches the point where it is required at the cheapest cost resulting into highest growth.
2. Individuals / investors / lenders get the best reward at the reduced risk.
3. Individuals / investors / lenders are able to achieve geographical diversification in their portfolio.
4. FDI enables the investors to provide strategic guidance and expertise to the investee companies elsewhere. That's how cross pollination of ideas, thoughts and best practices occur.
5. Recipient countries of FDI are able to create employment opportunities, offer employment to more people, undertake infrastructure development and thus see improvement in standard of life. Since employment goes up and hence the total income in the country goes up, the government is able to collect more money through direct and indirect taxes in the economy.
6. Thus FDI leads to an overall benefits to the entire ecosystem.