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Currency Exposure

Gargi Sanati
NIBM
Classification

 Transaction Exposure
 Economic Exposure
 Translation Exposure
 Difference between Risk and Exposure

2
 Transaction Exposure – When a firm faces contractual
cash flows that are fixed in foreign currencies.
Suppose that an Indian firm sold its product to a
German Firm on three months credit terms and invoiced Euro
1 million.
If the firm does nothing about its exposure then it is
effectively speculating on the future receivables as it does not
know if the Rupee depreciate or appreciate against Euro.
Using three months spot rate to convert Euro receivables may
lead some financial loss.

3
 Japanese firm entering into a loan contract with a Swiss
bank that calls for the payment of SF 100 million for
principal and interest in one year.
 As yen/swiss franc exchange rate is volatile the Japanese
firm does not know how much it would take to buy SF 100
million spot in year’s time.
 Whenever a firm has foreign currency denominated
receivables or payables, it is subject to transaction
exposure and their settlement is likely to affect the firm’s
cash flow position.

4
Economic Exposure
 Economic exposure defined as the extent to which the value of the
firm would be affected by unanticipated changes in exchange rate.
 Market always has an allowance for anticipated change. An exporter
invoicing a foreign buyer in buyer’s currency will build an
allowance for the expected depreciation of that currency. Similarly,
a lender lending in foreign currency will build an allowance for the
expected depreciation.
 Changes in exchange rates can have a profound effect on the firm’s
competitive position in the world market.

 Suppose US$ depreciate against Japanese Yen, is most common


phenomenon since 1980’s
 Japanese car market would be forced to increase the dollar prices.
Dollar depreciation can adversely affects Japanese car market in
highly competitive US market.
Concept of Anticipated and Unanticipated Risk

Since actual changes only observable it is difficult to decompose risk in


anticipated and unanticipated changes
 Forward rate provides an expected value of the underlying risk
factor
 Spot rate of pound sterling in terms of Rs is Rs 80 and the six month
forward rate is 80.20
 We can say anticipated depreciation of the Rs is 20 paise per pound
in six month
After 6 months if the spot rate turns out to be Rs80.30/pound, then the
unanticipated depreciation is10 paise/pound
Effect of exchange rate volatility

 Changes in exchange rates can affect not only firms that are directly
engaged in international trade but also purely domestic firms.
 Consider a U.S. bicycle manufacturer who sources and sells only
in the U.S. Since the firm’s product competes against imported
bicycles it is subjected to foreign exchange exposure.
 Say, it faces competition from an importer, imports from
Taiwanese manufacturer. If Taiwanese dollar depreciates against
the US dollar importing bicycle becomes cheaper in Dollar
terms.
 One bicycle cost TD 150
 Exchange Rate TD50/$ = 3$
 Exchange rate TD 75/$ = 2$
Measuring Forex Beta

• Suppose a US firm owns an asset in Britain, the exposure can be


measured by the sensitivity of the dollar value (P) of the British
asset on the dollar/pound exchange rate (S)
Example
P = a + bS + e ;
If b=0, the dollar value of the asset is independent of exchange rate
movement. Currency exposure with no risk
Transaction Exposure

Outstanding obligation may include credit purchases, sales of goods or


services, borrowed or loaned funds denominated in foreign currencies.

Ex: Suppose one American Aircraft company exports a Jumbo Jet to British
Airways and billed £10 million payable in one year. The money market
interest rates and foreign exchange rates are given as follows:

The U.S. interest rate : 6.10% per annum


The U.K. interest rate: 9.00% per annum
The spot exchange rate: $1.50/£
The forward exchange rate: $1.46/£ (1 – year maturity)
Pound receivable can be hedged by using
 Forward market hedge
 Money Market Hedge
 Option Market Hedge
Managing Transaction Exposure
 Forward Market Hedge
Most direct and popular way of hedging transaction exposure is by
currency forward contract. The firm may sell its foreign currency
receivables forward to eliminate its exchange risk exposure.
Exporter company will sell forward its pound receivable, £10million
for delivery in one year in exchange for a given amount of US
dollar. Suppose it sells to a bank.
On the Maturity date of the contract, exporter has to deliver £10
million to the bank and in return take delivery of $14.6 million
dollar ($1.46 x 10 million), regardless of the spot exchange rate that
may prevail on the maturity date.
Since exporter’s pound receivable is exactly offset by the pound
payable (created by the forward contract), the company’s net pound
exposure becomes zero.
Once exporter enters into the forward contract, exchange rate
uncertainty becomes irrelevant for exporter.
Gains from Forward Hedge is computed
Gain = (F-ST) x £10 million

The gain will be positive as long as the forward exchange rate is


greater than the spot rate on the maturity date, that is, F>ST, and
the gain will be negative, if the opposite holds. The firm
theoretically can gain as much as $14.6 million when the pound
becomes worthless, which, of course, is unlikely, whereas there
is no limit to possible losses.
 Suppose that on the maturity date of the forward contract, the spot
rate turns out to be $1.40/£, exporter would have received $14.0
million. Thus, one can say that exporter gained $0.6 million from
forward hedging. Needless to say, exporter will not always gain in
this manner. If the sport rate is, say, $1.50/£ on the maturity date,
then Boeing could have received $15.0 million by remaining
unhedged. Thus, one can say ex post that forward hedging cost
Boeing $0.40 million.
Receipts from the British Sale
Spot Exchange Unhedged Forward Hedge Gains/Losses
Rate Position from Hedge
on Maturity
Date(ST)
$1.30 $13,000,000 $14,600,000 $1,600,000
$1.40 $14,000,000 $14,600,000 $ 600,000
$1.46 $14,600,000 $14,600,000 0
$1.50 $15,000,000 $14,600,000 -$ 400,000
$1.60 $16,000,000 $14,600,000 -$1,400,000
Managing Transaction Exposure by
Money Market Hedge

Transaction exposure can also be hedged by lending and borrowing in


the domestic and foreign money markets.
In the above example, the firm may borrow in foreign currency to
hedge its foreign currency receivables. Exporter can eliminate the
exchange exposure arising from the British sale by first borrowing
in pounds, then converting the loan proceeds into dollars, which
then can be invested at the dollar interest rate.
The first important step in money market hedging is to determine the
amount of pounds to borrow. Since the maturity value of borrowing
should be the same as the pound receivable, the amount to borrow
can be computed as the discounted present value of the pound
receivable, that is, £10 million/(1.09) = £9,174,312.
Hedging by using money market

 When American exporter borrows £9,174,312, it then has to


repay £10 million in one year, which is equivalent to its pound
receivable.
 Step1: Borrow £9,174,312 in the U.K.
 Step2: Convert £9,174,312 into $13,761,468 at the current
spot exchange rate of $1.50/£
 Step3: Invest $13,761,468 in the United States
 Step4: Collect £10 million from British Airways and use it to
repay the pound loan.
 Step5: Receive the maturity value of the dollar invested, that is,
$14,600,918 = $13,761,468(1.061), which is the guaranteed dollar
proceeds from the British sale.
Cash Flow Analysis of a Money Market Hedge

Transaction Current Cash Flow


Cash Flow at
Maturity
1. Borrow pounds £ 9,174,312 -£10,000,000
2. Buy dollar spot with $13,761,468
pounds -£ 9,174,312
3. Invest in the $ -$13,761,468 $14,600,918
4. Collect pound £10,000,000
receivable
Net cash flow 0 $14,600,918
net cash flow is zero at the present time, implying that, apart from possible transaction
costs, the money market hedge is fully self-financing.
Option Market Hedging
 One possible shortcoming of both forward and money market hedges
is that these methods completely eliminate exchange exposure.
Consequently, the firm has to forgo the opportunity to benefit from
favourable exchange rate changes. let us assume that in the above
example, the spot exchange rate turns out to be $1.60 per pound on
the maturity date of the forward contract. In this instance, forward
hedging would cost the firm $1.4 million in terms of forgone dollar
receipts.
 Currency options provide such flexible “optional” hedge against
exchange exposure.
 Option is a contract giving the owner the right, but not the obligation,
to buy or sell a given quantity of an asset at a specified price at some
time in the future.
Transaction Exposure – Option Hedge

 American exporter purchased a put option on 10 million British


pounds with an exercise price of $1.46. Assume that the option
premium (price) was $0.02 per pound. Exporter thus paid $200,000
(= $0.02 x 10 million) for the option. This transaction provides
Exporter with the right, but not the obligation, to sell up to £10
million for $1.46/£.
 If the spot exchange rate turns out to be $1.30 on the expiration date.
Since American exporter has the right to sell each pound for $1.46,
it will certainly exercise its put option on the pound and convert £10
million into $14.6 million. The main advantage of options hedging
is that the firm can decide whether to exercise the option based on
the realised spot exchange rate on the expiration date.
Option Hedge cont…

 As American Exporter paid $200,000 upfront for the option. Considering


the time value of money, this upfront cost is equivalent to 212,200
(=$200,000 x 1.061) as of the expiration date.
 under the options hedge, the net dollar proceeds from the British sale
become $14,387,800 $14,387,800 = $14,600,000 - $212,200
Since, American exporter is going to exercise its put option on the pound
whenever the future spot exchange rate falls below the exercise rate of
$1.46, it is assured of a minimum dollar receipt of $14,387,800 from the
British sale.
In an alternative scenario where the pound appreciates against the dollar.
Assume that the spot rate turns out to be $1.60 per pound on the expiration
date. In this event, Exporter would have no incentive to exercise the
option. It will rather let the option expire and convert £10 million into $16
million at the spot rate. Subtracting $212,200 for the option cost, the net
dollar proceeds will become $15,787,800 under the option hedge
Cross Hedging for Minor Currencies

 If a firm has receivables or payables in major currencies such as


the British pound, euro, and Japanese Yen, it can easily use
forward, money market or option contracts to manage its exchange
risk exposure
 If the firm has position in minor currencies such as Korean Won,
Thai Bhat, Czech Koruna, it may be either very costly or
impossible to use financial contracts in these currencies. This is
because financial markets of developing countries are relatively
underdeveloped and often highly regulated.
 In the absence of direct hedging scenario the cross hedging
techniques are used. It involves hedging a position in one asset by
taking a position in other.
Example of Cross Hedging

 If a US firm has an account receivable in Korean won and not able to hedge its
won position it will take a position in another currency with which Korean won
has a very high positive correlation
 Since the won/dollar exchange rate is highly correlated with the yen/dollar
exchange rate, the US firm may sell a yen amount, which is equivalent to the
won receivable, forward against the dollar thereby cross hedging its won
position.

 The effectiveness of cross hedging technique would depend on the stability and
the strength of the won/yen correlation.
 Japanese Yen derivatives contracts are fairly effective in cross-hedging
exposure to minor Asian currencies such as the Indonesian Rupiah, Korean
Won, Philippine Peso and Thai Bhat.
 Likewise, German mark derivatives can be effective in cross- hedging
exposures in some Central and East European currencies, such as the Czech
Koruna, Estonian Kroon and Hungarian Forint
Hedging through Invoice Currency
The Firm can shift, share, or diversify exchange risk by appropriately choosing
the currency of invoice.
 Shifting
If in the above example American exporter invoices $15 million rather than
£10 million for the sale of the aircraft, then it does not face exchange
exposure anymore.
However exchange exposure does not disappear; it has merely shifted to
British importer. British Airways now has an account payable denominated
in US dollars.
 Sharing
Instead of shifting the exchange exposure entirely to British Airways,
American exporter may invoice half of the bill in the US $ and half in
pound. In this situation there is always a chance of market loss. Only an
exporter with substantial market power can use this approach.
 Diversifying
SDR currency portfolio also may be used. SDR currency portfolio
comprises four currency: the US dollar, the Euro, the Japanese Yen, the
British Pound.
Hedging via Lead and Lag
 Lead: To pay/collect early. The firm would prefer to lead soft
currency receivable and hard currency payable.
 Lag: To pay or collect late. The firm would prefer to lag hard
currency receivable and soft currency payable
 Soft currency: Likely to depreciate
 Hard Currency: Likely to appreciate
 Example: American exporter would prefer to lead the pound
receivable or British airways to pay early in dollar because of likely
depreciation of pound.
 Some difficulties
 British airways would prefer to lag the payment of pound and has no incentive
to prepay unless exporter offers a substantial discount
 It may hamper future sale of American Exporter
Lead/lag more effective in case of intra firm trade
Indian Importer American Exporter
 Invoice in Rupees (soft currency)
 American exporter has to convert it back into $. Wants to take lead
because if Rs depreciate exporter would get less amount in $ for a
certain amount of RS.
 Invoice in $ (hard currency)
 importer lead the hard currency payable, If $ appreciates importer has
to pay more in terms of Indian Rs for a fixed amount of US$

Indian Exporter and American Importer


 Invoice in $
 Exporter would prefer lag the hard currency receivable. Same amount
of $ would earn more RS
 Invoice in Rs
 Importer would prefer lag the soft currency payable. For same amount
of Rs importer has to pay less amount of $
Exposure Netting

 A multinational firm should not consider deals in isolation, but


should focus on hedging the firm as a portfolio of currency
positions.
 As an example, consider a U.S.-based multinational with
Korean won receivable and Japanese yen payable. Since the
won and the yen tend to move in similar directions against
the U.S. dollar, the firm can just wait until these accounts
come due and just buy yen with won.
 Even if it’s not a perfect hedge, it may be too expensive or
impractical to hedge each currency separately.
Exposure Netting
 Many multinational firms use a reinvoice
center. Which is a financial subsidiary that nets
out the intrafirm transactions.
 Once the residual exposure is determined, then
the firm implements hedging.

McGraw-Hill/Irwin 13-26 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:

$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30

McGraw-Hill/Irwin 13-27 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
With this:

$15

$40

McGraw-Hill/Irwin 13-28 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Translation Exposure

 Exists when a firm wish to translate financial statement items from a


foreign currency into its home currency in order to prepare consolidated
financial statements or to compare financial results. It sometimes known as
the accounting exposure as it measures the effect of an exchange rate
change on published financial statements of a firm.
 Translation exposure does not consider actual conversion of one currency
to another. They are purely on paper
Translation Methods
 Four methods of foreign currency translation
 the current/noncurrent method
 the monetary/nonmonetary method
 the temporal method
 and the current rate method.

 The Current/non current method: . The underlying principle of this


method is that assets and liabilities should be translated based on
their maturity.
 Current assets and liabilities, which by definition have a maturity of
one year or less, are converted at the current exchange rate.
 Noncurrent assets and liabilities are translated at the historical
exchange rate in effect at the time the asset or liability was first
recorded on the books.
 Monetary/Nonmonetary method - all monetary balance sheet accounts of a
foreign subsidiary are translated at the current exchange rate. All non-
monetary balance sheet accounts, including stockholders’ equity, are
translated at the historical exchange rate in effect when the account was
first recorded.

 Temporal Method- Monetary accounts such as cash, receivables and


payables (both current and noncurrent) are translated at the current
exchange rate. Other balance sheet accounts are translated at the current
rate, if they are carried in the books at the current rate; if they are carried at
historical costs they are translated at the rate of exchange on the date the
items are placed on the books.
 As fixed asset and inventory are usually carried at the historical costs, the
temporal and monetary/non-monetary methods will typically provide the
same translation.

 Current Rate Method: All balance sheet items (except for stockholder’s
equity) are translated at the current exchange rate.
 Very simple method in application.
 A “plug” equity account named cumulative translation adjustment is used to
make the balance sheet balance.
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained 900 DM $700 $150 $550 $360
earnings
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
Equity Spot exchange rate 14-32
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with a Change from
DM3 to DM2 = $1
Current value of Inventory = 1800DM
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 Book $600 $600 $600
liabilities value of
Long-Term 1,800 DM $600 inventor $900 $900 $900
debt y
historic
Common stock 2,700 DM $900 $900 $900 $900
rate
Retained 900 DM $700 $150 $550 $360
earnings
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
Book value of Current value of
Equity
inventory at spot inventory at spot 14-33
McGraw-Hill/Irwin
exchange rate© 2001 by The McGraw- exchange rate.
Copyright
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and histori spot exchange rate.
Equity c rate 14-34
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and spot rate
Equity 14-35
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
historical spot rate
Equity 14-36
rate McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
historical
Equity 14-37
rate McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
From income statement
Equity 14-38
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw-
How Various Translation Methods Deal with a Change
from DM3 to DM2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current


Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earnings 900 DM $700 $150 $550 $360
earnings
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and Under the current rate method, a “plug” equity account named
Equity cumulative translation adjustment makes the balance sheet 14-39
McGraw-Hill/Irwin
Copyright © 2001 by The McGraw- balance.