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Exchange rate risk and exposure

Exchange rate risk of an MNC


Transaction exposure Consolidation exposure Economic exposure

Transaction exposure

Trade transaction with foreign countries when billing is done in foreign currencies (export/import).

Banking and financial transactions done in foreign currencies like lending and borrowing or equity participation.

Consolidation (Translation) exposure


Due to direct/indirect investments in Foreign countries. It depends on

Existing exchange rate Accounting practices of the countries

Economic exposure
It rises due to

Economic factors like inflation, deflation in the country Value of the currency

Evaluation of Transaction exposure


MNC in export business
Currency Indian Rupees 200,000 US dollar in Rs. 100,000 Pound Sterlings in Rs. 50,000 Japanese yen in Rs. 70,000 Total exchange exposure +220,000

Receivabl es

Total exchange exposure position is Rs 220,000 (100,000+50,000+70,000)

MNC in import business

Currency

Indian Rupees

US dollar in Rs.

Pound Sterlings in Rs.

Deutschm arks in Rs.

French francs in Rs.

Total exchange exposure

Supplier s

-125,000

-50,000

-60,000

-100,000

-30,000

-240,000

Rs.240,000 is a debt on the company

Post

Indian Rupees 10,000

US dollar in Rs. 45,000

Pound Sterlings in Rs. 50,000

Deutsch marks in Rs. -

French francs in Rs. 10,000

Total exchange exposure 105,000

Amount receivables from debtors Forward sale of foreign currency Orders received Amount payable to creditors Forward purchase of foreign currency

-15,000

-20,000

-35,000

50,000 -60,000

25,000 -

10,000 -46,000

-16,000

10,000 -

45,000 -62,000

20,000

24,000

11,000

55,000

Orders placed for purchase


Net exposure position

-10,000

-35,000

-25,000

-70,000

80,000

23,000

-71,000

6,000

38,000

Evaluation of translation Exposure


(In India rupees)

Assets Fixed assets Stocks Receivables Cash Total

200,000 50,000 30,000 10,000 290,000

Liabilities Equity 140,000 Long-term debt 80,000 Short-term debt 70,000

290,000

Translation exposure
(In US dollar)

Assets
Fixed assets 200,000/35 =5,714 Stocks Receivables Cash Total 50,000/35= 30,000/35= 10,000/35= 1,429 857 285 8,285 Equity

Liabilities
140,000/35=4,000 80,000/35= 2,285 Long-term debt

Short-term debt 70,000/35= 2,000

8,285

Balance sheet is presented in terms of US dollars, using a conversion rate of Rs. 35 = US$1

Closing rate method: All assets and liabilities, except

the owners equity, are converted on the basis of the prevailing exchange rate.
(In US dollar)

Assets
Fixed assets 200,000/36 =5,556 Stocks Receivables Cash Total 50,000/36=1,388 30,000/36=833 10,000/36=277 8,054

Liabilities
Equity Long-term debt 140,000/35=4,000 80,000/36=2,222

Short-term debt 70,000/36=1,944

8,166

Balance sheet is presented in terms of US dollars, using a conversion rate of Rs. 36 = US$1

Monetary/Non-monetary method: the monetary items (cash, receivables, debt) are translated at the closing rate while rest (fixed assets, stocks, equity) are retained at historic rates. Assets
Fixed assets 200,000/35=5,714 Stocks 50,000/35=1,428

Liabilities
Equity Long-term debt 140,000/35=4,000 80,000/36=2,222

Receivables
Cash Total

30,000/36=833
10,000/36=277 8,252

Short-term debt 70,000/36=1,944

8,166

In this method there is a gain of US$ 86. It is used in Latin American Countries

Current/Non-current method: The current assets and liabilities are translated at the closing rate while the rest are retained at historic costs.

Assets
Fixed assets 200,000/35=5,714 Stocks Receivables 50,000/36=1,389 30,000/36=833

Liabilities
Equity Long-term debt 140,000/35=4,000 80,000/35=2,286

Short-term debt 70,000/36=1,944

Cash
Total

10,000/36=277
8,213 8,230

In this method there is a loss of US$ 17.

Evaluation of economic exposure

An appreciation of local currency results into a reduction of

cash inflows as well as outflows.

If local currency depreciates the cash flows are affected in opposite direction. Depreciation of local currency results into an increase of operating revenues as well as expenses. There is no specific method for calculating the quantum of exposure.

It depends on forecasting and anticipatory survey.

Internal techniques of Hedging

To reduce exchange rate risk:

Choosing a particular currency for invoice Leads and lags Indexation clauses in contacts Netting Shifting the manufacturing base Centre of reinvoicing Swaps

Choice of the currency of Invoicing

To avoid exchange rate risk companies invoice their exports in the national currency and pay their suppliers in the national currency. In the countries of European Union, the use of European Currency Unit (ECU) is gaining popularity.

Leads and Lags

This technique consists of accelerating or delaying receipt or payment in foreign exchange as warranted by the position/expected position of the exchange rate.
In case of depreciation of national currency, importing enterprises like to clear their dues in foreign currencies Exporting enterprises prefer to delay the receipt from their debtors abroad.

Indexation clauses in contracts

A contract may contain a clause whereby prices are adjusted in such a manner that fluctuations of exchange rate are absorbed without any visible impact. If the currency of the exporting country appreciates, the price of exports is increased to the same extent or vice-versa.

Netting (Internal compensation)

An enterprise may reduce its exchange risk by making and receiving payments in the same currency.

It can be bilateral or multilateral.

Bilateral Netting

When two companies have trade relations and do buying and selling reciprocally.
Parent Co. $80,000 $100,000 Funds movement without netting Subsidiary Co.

Parent Co.

$20,000

Subsidiary Co.

Funds movement with netting

Multilateral Netting
Parent Co. 16 10 20 Subsidiary B 16 Subsidiary C 50 40 8 9 15 20 Subsidiary A

12
Subsidiary D

10

Funds movement without Netting

Multilateral netting
Parent Co.
10 1 8 Subsidiary B 12 Subsidiary D Funds movement with Partial Netting

Subsidiary A

Parent Co.
8 Subsidiary B 2

Subsidiary A

5 Subsidiary C

Subsidiary C

10

Subsidiary D Funds movement with Netting

Switching the base of the manufacture


Switching the base of the manufacture may be useful so that costs and revenues are in the same currency. Japanese car manufacturers have opened factories in Europe.

Reinvoicing Centre

A reinvoicing centre of a multinational group does billing in respective national currencies of subsidiary companies and receives the invoices made in foreign currency from each one of them.
Pay in foreign currency Pay in foreign currency

Clients (Debtor)

Reinvoicing Centre

Supplier (Creditor)

Pay in Local currency

Pay in local currency

Subsidiary A,B

Receipts and payments through Reinvoicing Centre

Swaps in Foreign Currencies

Swap is an agreement reached between two parties which exchange a predetermined sum of foreign currencies with a condition to surrender that sum on a pre-decided date.

Various types of Swaps: Cross-credit swaps Back-to-back credit swaps Export swaps

Cross credit swaps


There is an exchange of foreign currencies between a parent company and a bank in a foreign country.
American parent Co.
US dollar loan Indian rupee loan

Indian Bank

Subsidiary A

Reimbursement in US dollar

Reimbursement in Indian rupees

Back-to-back credit Swaps

Two companies located in two different countries may agree to exchange loans in their respective currencies for a fixed period.

Kodak USA

Fuji Japan

Lends

in US $ to

Lends

in Japan yen to

Fuji USA

Kodak Japan

Basic hedging techniques


If depreciation in anticipated

If appreciation is anticipated

Sell local currency forward Reduce levels of local currency cash and marketable securities Delay collection of hard currency receivables Accelerate imports of hard currency goods before depreciation of local currency Borrow locally

Buy local currency forward Increase levels of local currency cash and marketable securities Speed up collection of hard currency receivables Reduce imports of soft currency goods Borrow locally

Basic hedging techniques


If depreciation in anticipated

If appreciation is anticipated

Delay payments of local accounts payable Speed up remittance of dividend to the parent company Speed up payments of intersubsidiary accounts payable Delay collection of intersubsidiary accounts receivable

Speed up payments of accounts payable Delay remittance of dividend to the parent company Delay payments of intersubsidiary accounts payable Speed up collection of intersubsidiary accounts receivable

Text Book
International Financial Management by Jain,Peyrad &Yadav,PublisherMacmillan