Foreign exchange risk management articles

foreign exchange risk management best practices foreign exchange risk management in german non-financial corporations an empirical analysis
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12 Foreign Exchange Exposure and Risk Management Learning Objectives After going through the chapter student shall be able to understand • Foreign Exchange Market and its participants • Nostro, Vostro and Loro Accounts • Exchange Rate Determination • Exchange Rate Quotation • Exchange Rate Forecasting • Exchange Rate Theories (1) Interest Rate Parity (IRP) (2) Purchasing Power Parity (PPP) (3) International Fisher Effect (IFE) (4) Comparison of PPP, IRP and IFE Theories • Risk Management • Risk Considerations • Foreign Exchange Exposure • Types of Exposures (1) Transaction Exposure (2) Translation Exposure (3) Economic Exposure • Techniques for Managing Exposure (1) Derivatives (2) Money Market Hedge (3) Netting (4) Matching © The Institute of Chartered Accountants of India12.2 Strategic Financial Management (5) Leading and Lagging (6) Price Variation (7) Invoicing in Foreign Currency (8) Asset and Liability Management (9) Arbitrage • Strategies for Exposure Management (1) Low Risk: Low Reward (2) Low Risk: Reasonable Reward (3) High Risk: Low Reward (4) High Risk: High Reward • Hedging Currency Risk 1. Introduction Coupled with globalisation of business, the raising of capital from the international capital markets has assumed significant proportion during the recent years. The volume of finance raised from international capital market is steadily increasing over a period of years, across the national boundaries. Every day new institutions are emerging on the international financial scenario and introducing new derivative financial instruments (products) to cater to the requirements of multinational organisations and the foreign investors. To accommodate the underlying demands of investors and capital raisers, financial institutions and instruments have also changed dramatically. Financial deregulation, first in the United States and then in Europe and Asia, has prompted increased integration of world financial markets. As a result of the rapidly changing scenario, the finance manager today has to be global in his approach. In consonance with these remarkable changes, the Government of India has also opened Indian economy to foreign investments and has taken a number of bold and drastic measures to globalise the Indian economy. Various fiscal, trade and industrial policy decisions have been taken and new avenues provided to foreign investors like Foreign Institutional Investors (FII's) and NRI's etc., for investment especially in infrastructural sectors like power and telecommunication etc. The basic principles of financial management i.e., efficient allocation of resources and raising of funds on most favourable terms and conditions etc. are the same, both for domestic and international enterprises. However the difference lies in the environment in which these multi- national organisations function. The environment relates to political risks, Government's tax and investment policies, foreign exchange risks and sources of finance etc. These are some of the crucial issues which need to be considered in the effective management of international financial transactions and investment decisions. © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.3 Under the changing circumstances as outlined above, a finance manager, naturally cannot just be a silent spectator and wait and watch the developments. He has to search for "best price" in a global market place (environment) through various tools and techniques. Sometimes he uses currency and other hedges to optimise the utilisation of financial resources at his command. However, the problems to be faced by him in the perspective of financial management of the multinational organisations are slightly more complex than those of domestic organisations. While the concepts developed earlier in the previous chapters are also applicable here, the environment in which decisions are made in respect of international financial management is different and it forms the subject matter of this chapter for discussion. In this chapter we shall describe how a finance manager can protect his organisation from the vagaries of international financial transactions. 2. Foreign Exchange Market The foreign exchange market is the market in which individuals, firms and banks buy and sell foreign currencies or foreign exchange. The purpose of the foreign exchange market is to permit transfers of purchasing power denominated in one currency to another i.e. to trade one currency for another. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells machine tools to Japanese company for yen. Ultimately, however, the U.S. company will be interested in receiving dollars, whereas the Japanese exporter will want yen. Because it would be inconvenient for the individual buyers and sellers of foreign exchange to seek out one another, a foreign exchange market has developed to act as an intermediary. Transfer of purchasing power is necessary because international trade and capital transactions usually involve parties living in countries with different national currencies. Each party wants to trade and deal in his own currency but since the trade can be invoiced only in a single currency, the parties mutually agree on a currency beforehand. The currency agreed could also be any convenient third country currency such as the US dollar. For, if an Indian exporter sells machinery to a UK importer, the exporter could invoice in pound, rupees or any other convenient currency like the US dollar. But why do individuals, firms and banks want to exchange one national currency for another? The demand for foreign currencies arises when tourists visit another country and need to exchange their national currency for the currency of the country they are visiting or when a domestic firm wants to import from other nations or when an individual wants to invest abroad and so on. On the other hand, a nation's supply of foreign currencies arises from foreign tourist expenditures in the nation, from export earnings, from receiving foreign investments, and so on. For example, suppose a US firm exporting to the UK is paid in pounds sterling (the UK currency). The US exporter will exchange the pounds for dollars at a commercial bank. The commercial bank will then sell these pounds for dollars to a US resident who is going to visit the UK or to a United States firm that wants to import from the UK and pay in pounds, or to a US investor who wants to invest in the UK and needs the pounds to make the investment. © The Institute of Chartered Accountants of India12.4 Strategic Financial Management Thus, a nation's commercial banks operate as clearing houses for the foreign exchange demanded and supplied in the course of foreign transactions by the nation's residents. Hence, four levels of transactor or participants can be identified in foreign exchange markets. At the first level, are tourists, importers, exporters, investors, etc. These are the immediate users and suppliers of foreign currencies. At the next or second level are the commercial banks which act as clearing houses between users and earners of foreign exchange. At the third level are foreign exchange brokers through whom the nation's commercial banks even out their foreign exchange inflows and outflows among themselves. Finally, at the fourth and highest level is the nation's central bank which acts as the lender or buyer of last resort when the nation's total foreign exchange earnings and expenditures are unequal. The central bank then either draws down its foreign exchange reserves or adds to them. 3. Market Participants The participants in the foreign exchange market can be categorized as follows: (i) Non-bank Entities: Many multinational companies exchange currencies to meet their import or export commitments or hedge their transactions against fluctuations in exchange rate. Even at the individual level, there is an exchange of currency as per the needs of the individual. (ii) Banks: Banks also exchange currencies as per the requirements of their clients. (iii) Speculators: This category includes commercial and investment banks, multinational companies and hedge funds that buy and sell currencies with a view to earn profit due to fluctuations in the exchange rates. (iv) Arbitrageurs: This category includes those investors who make profit from price differential existing in two markets by simultaneously operating in two different markets. (v) Governments: The governments participate in the foreign exchange market through the central banks. They constantly monitor the market and help in stabilizing the exchange rates. 4. Nostro, Vostro and Loro Accounts 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. © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.5 5. Exchange Rate Determination An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often termed the reference currency. For example, the rupee/dollar exchange rate is just the number of rupee that one dollar will buy. If a dollar will buy 100 rupee, the exchange rate would be expressed as Rs 100/ and the rupee would be the reference currency. Equivalently, the dollar/ rupee exchange rate is the number of dollars one rupee will buy. Continuing the previous example, the exchange rate would be 0.01/Rs (1/100) and the dollar would now be the reference currency. Exchange rates can be for spot or forward delivery. The foreign exchange market includes both the spot and forward exchange rates. The spot rate is the rate paid for delivery within two business days after the day the transaction takes place. If the rate is quoted for delivery of foreign currency at some future date, it is called the forward rate. In the forward rate, the exchange rate is established at the time of the contract, though payment and delivery are not required until maturity. Forward rates are usually quoted for fixed periods of 30, 60, 90 or 180 days from the day of the contract. (a) The Spot Market: The most common way of stating a foreign exchange quotation is in terms of the number of units of foreign currency needed to buy one unit of home currency. Thus, India quotes its exchange rates in terms of the amount of rupees that can be exchanged for one unit of foreign currency. Illustration 1 If the Indian rupee is the home currency and the foreign currency is the US Dollar then what is the exchange rate between the rupee and the US dollar? Solution US 0.0217/`1 reads "0.0217 US dollar per rupee." This means that for one Indian rupee one can buy 0.0217 US dollar. In this method, known as the European terms, the rate is quoted in terms of the number of units of the foreign currency for one unit of the domestic currency. This is called an indirect quote. The alternative method, called the American terms, expresses the home currency price of one unit of the foreign currency. This is called a direct quote. This means the exchange rate between the US dollar and rupee can be expressed as: ` 46.08/US reads "` 46.08 per US dollar." Hence, a relationship between US dollar and rupee can be expressed in two different ways which have the same meaning: • One can buy 0.0217 US dollars for one Indian rupee. • ` 46.08 Indian rupees are needed to buy one US dollar. (b) The Forward Market: A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the currency at some future date. They agree to transact a specific amount of currency at a specific rate at a specified future date. The forward exchange rate is © The Institute of Chartered Accountants of India12.6 Strategic Financial Management set and agreed by the parties and remains fixed for the contract period regardless of the fluctuations in the spot exchange rates in future. The forward exchange transactions can be understood by an example. A US exporter of computer peripherals might sell computer peripherals to a German importer with immediate delivery but not require payment for 60 days. The German importer has an obligation to pay the required dollars in 60 days, so he may enter into a contract with a trader (typically a local banker) to deliver Euros for dollars in 60 days at a forward rate – the rate today for future delivery. So, a forward exchange contract implies a forward delivery at specified future date of one currency for a specified amount of another currency. The exchange rate is agreed today, though the actual transactions of buying and selling will take place on the specified date only. The forward rate is not the same as the spot exchange rate that will prevail in future. The actual spot rate that may prevail on the specified date is not known today and only the forward rate for that day is known. The actual spot rate on that day will depend upon the supply and demand forces on that day. The actual spot rate on that day may be lower or higher than the forward rate agreed today. An Indian exporter of goods to London could enter into a forward contract with his banker to sell pound sterling 90 days from now. This contract can also be described as a contract to purchase Indian Rupees in exchange for delivery of pound sterling. In other words, foreign exchange markets are the only markets where barter happens – i.e., money is delivered in exchange for money 6. Exchange Rate Quotation 6.1 American Term and European Term: Quotes in American terms are the rates quoted in amounts of U.S. dollar per unit of foreign currency. While rates quoted in amounts of foreign currency per U.S. dollar are known as quotes in European terms. For example, U.S. dollar 0.2 per unit of Indian rupee is an American quote while INR 44.92 per unit of U.S. dollar is a European quote. Most foreign currencies in the world are quoted in terms of the number of units of foreign currency needed to buy one U.S. dollar i.e. the European term. 6.2 Direct and Indirect Quote: As indicated earlier, a currency quotation is the price of a currency in terms of another currency. For example, 1 = `48.00, means that one dollar can be exchanged for `48.00. Alternatively; we may pay `48.00 to buy one dollar. A foreign exchange quotation can be either a direct quotation and or an indirect quotation, depending upon the home currency of the person concerned. A direct quote is the home currency price of one unit foreign currency. Thus, in the aforesaid example, the quote 1 =`48.00 is a direct-quote for an Indian. An indirect quote is the foreign currency price of one unit of the home currency. The quote Re.1 =0.0208 is an indirect quote for an Indian. (1/` 48.00 =0.0208 approximately) © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.7 Direct and indirect quotes are reciprocals of each other, which can be mathematically expressed as follows. Direct quote = 1/indirect quote and vice versa The following table is an extract from the Bloomberg website showing the Foreign Exchange Cross rates prevailing on 14/09/2012. USD  CNY  JPY  HKD  INR  KRW  SGD  EUR  USD –  0.1583 0.0128 0.129 0.0184 0.0009 0.8197 1.3089 CNY 6.3162 –  0.0809 0.8147 0.1161 0.0057 5.177 8.2667 JPY 78.08 12.362 –  10.072 1.435 0.0701 64 102.17 HKD 7.7526 1.2274 0.0993 –  0.143 0.0069 6.3546 10.148 INR 54.405 8.613 0.6955 7.005 –  0.0488 44.505 71.067 KRW 1,114.65 176.5476 14.2965 143.9908 20.4965 –  914.8582 1,459.05 SGD 1.2202 0.1932 0.0156 0.1574 0.0224 0.0011 –  1.5961 EUR 0.7642 0.121 0.0098 0.0986 0.014 0.0007 0.6263 –  Source :http://www.bloomberg.com/markets/currencies/cross-rates/ Students will notice that the rates given in the rows are direct quotes for each of the currencies listed in the first column and the rates given in the columns are the indirect quotes for the currencies listed in the first row. Students can also verify that in every case above 6.3 Bid, Offer and Spread: A foreign exchange quotes are two-way quotes, expressed as a 'bid' and an offer' (or ask) price. Bid is the price at which the dealer is willing to buy another currency. The offer is the rate at which he is willing to sell another currency. Thus a bid in one currency is simultaneously an offer in another currency. For example, a dealer may quote Indian rupees as `48.80 - 48.90 vis-a-vis dollar. That means that he is willing to buy dollars at `48.80/ (sell rupees and buy dollars), while he will sell dollar at ` 48.90/ (buy rupees and sell dollars). The difference between the bid and the offer is called the spread. The offer is always higher than the bid as inter-bank dealers make money by buying at the bid and selling at the offer. Bid - Offer % Spread = × 100 Bid It must be clearly understood that while a dealer buys a currency, he at the same time is selling another currency. When a dealer wants to buy a currency, he/she will ask the other dealer a quote for say a million dollars. The second dealer does not know whether the first dealer is interested in buying or selling one million dollars. The second dealer would then give a two way quote (a bid/offer quote). When the first dealer is happy with the ‘ask’ price given by the second dealer, he/she would convey “ONE MINE”, which means “I am buying one million dollars from you”. If the first dealer had actually wanted to sell one million dollars and had asked a quote, and he is happy with the ‘bid’ price given by the second dealer, he/she would convey “ONE YOURS”, which means “I am selling one million dollars to you”. © The Institute of Chartered Accountants of India12.8 Strategic Financial Management 6.4 Cross Rates: It is the exchange rate which is expressed by a pair of currency in which none of the currencies is the official currency of the country in which it is quoted. For example, if the currency exchange rate between a Canadian dollar and a British pound is quoted in Indian newspapers, then this would be called a cross rate since none of the currencies of this pair is of Indian rupee. Broadly, it can be stated that the exchange rates expressed by any currency pair that does not involve the U.S. dollar are called cross rates. This means that the exchange rate of the currency pair of Canadian dollar and British pound will be called a cross rate irrespective of the country in which it is being quoted as it does not have U.S. dollar as one of the currencies. 7. Exchange Rate Forecasting The foreign exchange market has changed dramatically over the past few years. The amounts traded each day in the foreign exchange market are now huge. In this increasingly challenging and competitive market, investors and traders need tools to select and analyze the right data from the vast amounts of data available to them to help them make good decisions. Corporates need to do the exchange rate forecasting for taking decisions regarding hedging, short-term financing, short-term investment, capital budgeting, earnings assessments and long-term financing. 7.1 Techniques of Exchange Rate Forecasting: There are numerous methods available for forecasting exchange rates. They can be categorized into four general groups- technical, fundamental, market-based, and mixed. (a) Technical Forecasting: It involves the use of historical data to predict future values. For example time series models. Speculators may find the models useful for predicting day-to-day movements. However, since the models typically focus on the near future and rarely provide point or range estimates, they are of limited use to MNCs. (b) Fundamental Forecasting: It is based on the fundamental relationships between economic variables and exchange rates. For example subjective assessments, quantitative measurements based on regression models and sensitivity analyses. In general, fundamental forecasting is limited by: • the uncertain timing of the impact of the factors, • the need to forecast factors that have an immediate impact on exchange rates, • the omission of factors that are not easily quantifiable, and • changes in the sensitivity of currency movements to each factor over time. (c) Market-Based Forecasting: It uses market indicators to develop forecasts. The current spot/forward rates are often used, since speculators will ensure that the current rates reflect the market expectation of the future exchange rate. (d) Mixed Forecasting: It refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts developed. © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.9 8. Exchange Rate Theories There are three theories of exchange rate determination- Interest rate parity, Purchasing power parity and International Fisher effect. 8.1 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: F 1 + r = 1 + r () () DF S Where, (1 + r ) = Amount that an investor would get after a unit period by investing a rupee D F rate of interest and (1+ r ) is the amount that an in the domestic market at r D F S investor by investing in the foreign market at r that the investment of one rupee yield F same return in the domestic as well as in the foreign market. The Uncovered Interest Rate Parity equation is given by: S 1 r + r = () 1 + r DF S Where, S = Expected future spot rate when the receipts denominated in foreign currency is 1 converted into domestic currency. Thus, it can be said that Covered Interest Arbitrage has an advantage as there is an incentive to invest in the higher-interest currency to the point where the discount of that currency in the forward market is less than the interest differentials. If the discount on the forward market of the currency with the higher interest rate becomes larger than the interest differential, then it pays to invest in the lower-interest currency and take advantage of the excessive forward premium on this currency. 8.2 Purchasing Power Parity (PPP): Why is a dollar worth ` 48.80, JPY 122.18, etc. at some point in time? One possible answer is that these exchange rates reflect the relative purchasing powers of the currencies, i.e. the basket of goods that can be purchased with a dollar in the US will cost ` 48.80 in India and ¥ 122.18 in Japan. Purchasing Power Parity theory focuses on the ‘inflation – exchange rate’ relationship. There are two forms of PPP theory:- © The Institute of Chartered Accountants of India12.10 Strategic Financial Management 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. An alternative version of the absolute form that accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas embeds the sectoral constant. 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. In Equilibrium Form: P D S = α P F Where, S(`/) = spot rate P = is the price level in India, the domestic market. D P = is the price level in the foreign market, the US in this case. F α = Sectoral price and sectoral shares constant. For example, A cricket bat sells for ` 1000 in India. The transportation cost of one bat from Ludhiana to New York costs ` 100 and the import duty levied by the US on cricket bats is ` 200 per bat. Then the sectoral constant for adjustment would be 1000/1300 = 0.7692. It becomes extremely messy if one were to deal with millions of products and millions of constants. One way to overcome this is to use a weighted basket of goods in the two countries represented by an index such as Consumer Price Index. However, even this could break down because the basket of goods consumed in a country like Finland would vary with the consumption pattern in a country such as Malaysia making the aggregation an extremely complicated exercise. The RELATIVE FORM of the Purchasing Power Parity tries to overcome the problems of market imperfections and consumption patterns between different countries. A simple explanation of the Relative Purchase Power Parity is given below: Assume the current exchange rate between INR and USD is ` 50 / 1. The inflation rates are 12% in India and 4% in the US. Therefore, a basket of goods in India, let us say costing now ` 50 will cost one year hence ` 50 x 1.12 = ` 56.00.A similar basket of goods in the US will cost USD 1.04 one year from now. If PPP holds, the exchange rate between USD and INR, one year hence, would be ` 56.00 = 1.04. This means, the exchange rate would be ` 53.8462 / 1, one year from now.This can also be worked backwards to say what should have been the exchange rate one year before, taking into account the inflation rates during last year and the current spot rate. © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.11 Expected spot rate = Current Spot Rate x expected difference in inflation rates (1 + I ) d E(S ) = S x 1 0 (1 + 1 ) f Where E(S ) is the expected Spot rate in time period 1 1 S is the current spot rate (Direct Quote) 0 I is the inflation in the domestic country (home country) d I is the inflation in the foreign country f According to Relative PPP, any differential exchange rate to the one propounded by the theory is the ‘real appreciation’ or ‘real depreciation’ of one currency over the other. For example, if the exchange rate between INR and USD one year ago was ` 45.00. If the rates of inflation in India and USA during the last one year were 10% and 2% respectively, the spot exchange rate between the two currencies today should be S = 45.00 x (1+10%)/(1+2%) = ` 48.53 0 However, if the actual exchange rate today is ` 50,00, then the real appreciation of the USD against INR is ` 1.47, which is 1.47/45.00 = 3.27%. And this appreciation of the USD against INR is explained by factors other than inflation. PPP is more closely approximated in the long run than in the short run, and when disturbances are purely monetary in character. 8.3 International Fisher Effect (IFE): International Fisher Effect theory uses interest rate rather than inflation rate differentials to explain why exchange rates change over time, but it is closely related to the Purchasing Power Parity (PPP) theory because interest rates are often highly correlated with inflation rates. According to the International Fisher Effect, ‘nominal risk-free interest rates contain a real rate of return and anticipated inflation’. This means if investors of all countries require the same real return, interest rate differentials between countries may be the result of differential in expected inflation. The IFE theory suggests that foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation. The nominal interest rate would also incorporate the default risk of an investment. The IFE equation can be given by: r – P = r – ΔP D D F F or P – P = ΔS = r –r D F D F The above equation states that if there are no barriers to capital flows the investment will flow in such a manner that the real rate of return on investment will equalize. In fact, the equation represents the interaction between real sector, monetary sector and foreign exchange market. © The Institute of Chartered Accountants of India12.12 Strategic Financial Management If the IFE holds, then a strategy of borrowing in one country and investing the funds in another country should not provide a positive return on average. The reason is that exchange rates should adjust to offset interest rate differentials on the average. As we know that purchasing power has not held over certain periods, and since the International Fisher Effect is based on Purchasing Power Parity (PPP). It does not consistently hold either, because there are factors other than inflation that affect exchange rates, the exchange rates do not adjust in accordance with the inflation differential. 8.4 Comparison of PPP, IRP and IFE Theories: All the above theories relate to the determination of exchange rates. Yet, they differ in their implications. The theory of IRP focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. This relates to a specific point in time. Conversely, PPP theory and IFE theory focuses on how a currency’s spot rate will change over time. While PPP theory suggests that the spot rate will change in accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differentials. PPP is nevertheless related to IFE because inflation differentials influence the nominal interest rate differentials between two countries. Theory Key Variables Basis Summary Interest Rate Parity Forward rate Interest rate The forward rate of one (IRP) premium (or differential currency will contain a discount) premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest arbitrage will provide a return that is no higher than a domestic return Purchasing Power Percentage Inflation rate The spot rate of one currency Parity (PPP) change in spot differential. w.r.t. another will change in exchange rate. reaction to the differential in inflation rates between two countries. Consequently, the purchasing power for consumers when purchasing goods in their own country will be similar to their purchasing power when importing goods from foreign country. © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.13 International Fisher Percentage Interest rate The spot rate of one currency Effect (IFE) change in spot differential w.r.t. another will change in exchange rate accordance with the differential in interest rates between the two countries. Consequently, the return on uncovered foreign money market securities will on average be no higher than the return on domestic money market securities from the perspective of investors in the home country. 9. Risk Management Whether it is investing, driving, or just walking down the street, everyone exposes himself or herself to risk. A person’s personality and lifestyle play a big deal on how much risk he can comfortably take on. If an investor invests in stocks and has trouble sleeping at nights because of his investments, then probably he is taking on too much risk. A ‘risk’ is anything that can lead to results that deviate from the requirements. Risk has two parameters – there must be an uncertainty about the outcome and the ‘outcome’ has to matter in terms of a ‘utility’. According to Tom Gilb, risk can be defined as “An abstract concept expressing the possibility of unwanted outcomes”. Deciding what amount of risk an investor can take on while allowing him to get rest at night is his most important decision. Risk Management is, “any activity which identifies risks, and takes action to remove or control ‘negative results’ (deviations from the requirements).” Effective risk management strategies have become increasingly necessary due to the dynamic nature of the business environment. Globalization is resulting in new markets, new competitors, and new products. Technological advances are dramatically accelerating the pace of business and the volatility of financial markets. A new relationship between the public and private sectors is contributing to restructured markets and greater deregulation. Volatility in financial markets was a natural outcome of changes in the flow of funds worldwide following the first oil crisis in the 1970s, the collapse of the fixed foreign exchange rate system, monetarist practices adopted by many central banks, the advancement of communications and technology, and the acceptance of deregulation of financial systems around the world during the 1980s. Unpredictable changes in interest rates, yield curve structures, exchange rates, and commodity prices, exacerbated by the explosion in international expansion, have made the financial environment riskier today than it ever was in the past. For this reason, boards of directors, shareholders, and executive and tactical management need to be seriously concerned that corporate risk management activities be adequately assessed, prioritized, driven by strategy, controlled, and reported. © The Institute of Chartered Accountants of India12.14 Strategic Financial Management Organizations around the globe are therefore overwhelmingly focused on the most fundamental of financial principles: risks = returns. Executives are undertaking major initiatives to manage the risk side of this equation, and, in doing so, are examining global treasury alternatives and employing comprehensive and integrated risk management strategies. Each organization faces a unique set of parameters with respect to, for example, industry sector, product mix, organizational goals, business culture, and risk tolerances. Consequently, an organization must tailor its risk management framework to meet its particular needs. Organizations are now concerned with the problems faced by any firm whose performance is affected by the international environment. Indeed, even companies that operate only domestically but compete with firms producing abroad and selling in their local market are affected by international developments. For example, Indian clothing or appliance manufacturers with no overseas sales will find Indian sales and profit margins affected by exchange rates, which influence the prices of imported clothing and appliances. Similarly, bond investors holding their own government's bonds, denominated in their own currency, and spending all their money at home are affected by changes in exchange rates if exchange rates prompt changes in interest rates. Specifically, if governments increase interest rates to defend their currencies when they fall in value on the foreign exchange markets, holders of domestic bonds will find their assets falling in value along with their currencies: bond prices fall when interest rates increase. It is difficult to think of any firm or individual that is not affected in some way or other by the international environment. Jobs, bond and stock prices, food prices, government revenues and other important economic variables are all tied to exchange rates and other developments in the global financial environment. 10. Risk Considerations A multinational organization operates in more than one country. This implies that it functions in different environments. However, the degree of risk is different in different countries. It has been observed that international diversification is often more effective than domestic diversification in reducing company's risk in relation to its expected return because the economic cycles of different countries do not tend to be completely synchronized. For example, if a company is in a particular line of business, say power and telecom facilities, invests in another unit in the same country, both the existing and the new units are subjected to the same environmental risks and the return from the new plant is likely to be highly co- related with return from existing plant. This implies that there is no change in the environmental risks and perceptions in the same country both for existing and new units. However, had the management decided to invest the same money in the similar business but in a different country, there would have been change in environmental risk as well as reward perception since both the units now function in different environments. This mechanism probably reduces the risk facing the business and improves chances of rewards. The political instability and unfavourable Government can seriously endanger the very existence and functioning of the multi-national organizations. It is therefore advisable that before making investment abroad, the organisation should realistically assess the political instability and risk of that country in which investment is proposed to be made. In other words, the company will have to forecast the political instability of the country, which is possible by assessing the degree of stability of the existing government, its attitude towards foreign © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.15 investment, incentives offered and the quickness in processing foreign investment proposals. If the assessment reveals that political risks is high, the company may decide not to invest even if very high returns are expected to be made and vice-versa. There are several types of risk that an investor should consider and pay careful attention to. They are: 10.1 Financial Risk – It is the potential loss or danger due to the uncertainty in movement of foreign exchange rates, interest rates, credit quality, liquidity position, investment price, commodity price, or equity price, as well as the unpredictability of sales price, growth, and financing capabilities. Balance sheet and cash flow hedges as well as derivatives tools mitigate financial risks by reducing uncertainty faced by firms. However, these strategies and instruments themselves are manifestations of the different types of financial uncertainty in that further risks arise from their use. 10.2 Business Risk – On a micro scale, business risk involves the variability in earnings due to variation in the cash inflows and outflows of capital investment projects undertaken. This risk, also known as investment risk, may materialize because of forecasting errors made in market acceptance of products, future technological changes, and changes in costs related to projects. On an aggregated basis variability in earnings may derive from the degree of efficient diversification that the firm has achieved in its operations and its overall portfolio of assets. The firm can reduce this risk, also referred to as portfolio risk, by seeking out capital projects and merger candidates that have a low or negative correlation with its present operations. 10.3 Credit Risk (i.e, default risk) – Government Securities (G-Secs) and Treasury bills have sovereign risk associated with them – i.e. read zero credit risk, whereas securities issued by Corporates suffer from the risk of non-payment or delayed payment of interest and principal as and when they become due. 10.4 Interest Rate Risk – Interest rate prevailing in a economy is influenced, inter alia, by the demand for and supply of money and the inflation rates. These parameters keep changing continuously and hence interest rates also fluctuate. An investor’s investment in a financial security suffers from the fluctuating interest rates as price of the security and yield expectations are inversely related. Therefore, when interest rates rise, the value of a portfolio reduces. 10.5 Liquidity Risk – This is the possibility for an investor to experience losses due to the inability to sell or convert assets into cash immediately or in instances where conversion to cash is possible but at a loss. These may be caused by different reasons such as trading in securities with small or few outstanding issues, absence of buyers, limited buy/sell activity or underdeveloped market. Even government securities which are the most liquid of fixed income securities may be subjected to liquidity risk particularly if a sizeable volume is involved. In the equity markets, the liquidity risk is captured by ‘impact cost’ percentage. 10.6 Market/Price Risk - This is the possibility for an investor to experience losses due to changes in market prices of securities. It is the exposure to the uncertain market value of a portfolio due to price fluctuations. © The Institute of Chartered Accountants of India12.16 Strategic Financial Management 10.7 Reinvestment Risk – This is the risk associated with the possibility of having lower returns or earnings when maturing funds or the interest earnings of funds are reinvested. Investors who redeem and realize their gains run the risk of reinvesting their funds in an alternative investment outlet with lower yields. Similarly, the investor is faced with the risk of not being able to find good or better alternative investment outlets as some of the securities in the fund matures. 10.8 Country Risk – This is the possibility for an investor to experience losses arising from investments in securities issued by/in foreign countries due to changes in forex rates (transaction, translation and economic exposures) or due to expropriation actions by the host governments. All businesses trading overseas and increasingly in domestic markets will have some exposure to exchange rate movements either directly or indirectly. Whilst exposure to exchange rate movements may be an inevitable part of everyday activity, the risk arising from such exposure can be controlled. 6 © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.17 11. Foreign Exchange Exposure “An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose magnitude is not certain at the moment. The magnitude depends on the value of variables such as Foreign Exchange rates and Interest rates.” In other words, exposure refers to those parts of a company’s business that would be affected if exchange rate changes. Foreign exchange exposures arise from many different activities. For example, travellers going to visit another country have the risk that if that country's currency appreciates against their own their trip will be more expensive. An exporter who sells his product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter's home currency will be lower. An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the local currency cost greater than expected. Fund Managers and companies who own foreign assets are exposed to fall in the currencies where they own the assets. This is because if they were to sell those assets their exchange rate would have a negative effect on the home currency value. Other foreign exchange exposures are less obvious and relate to the exporting and importing in ones local currency but where exchange rate movements are affecting the negotiated price. 12. Types of Exposures The foreign exchange exposure may be classified under three broad categories: Moment in time when exchange rate changes Translation exposure Operating exposure Change in expected cash flows arising Accounting-based changes in because of an unexpected change in consolidated financial statements exchange rates caused by a change in exchange rates Transaction exposure Impact of setting outstanding obligations entered into before change in exchange rates but to be settled after the change in exchange rates Time 12.1 Transaction Exposure: It measures the effect of an exchange rate change on outstanding obligations that existed before exchange rates changed but were settled after the exchange rate changes. Thus, it deals with cash flows that result from existing contractual obligations. © The Institute of Chartered Accountants of India12.18 Strategic Financial Management Example: If an Indian exporter has a receivable of 100,000 due in six months hence and if the dollar depreciates relative, to the rupee a cash loss occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain occurs. The above example illustrates that whenever a firm has foreign currency denominated receivables or payables, it is subject to transaction exposure and their settlements will affect the firm’s cash flow position. 12.2 Translation Exposure: Also known as accounting exposure, it refers to gains or losses caused by the translation of foreign currency assets and liabilities into the currency of the parent company for consolidation purposes. 12.3 Economic Exposure: It refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is the overall impact of exchange rate changes on the value of the firm. The essence of economic exposure is that exchange rate changes significantly alter the cost of a firm’s inputs and the prices of its outputs and thereby influence its competitive position substantially. Effects of Local Currency Fluctuations on Company’s Economic Exposure (Cash inflow) Variables influencing the inflow Revaluation Devaluation of cash in Local currency impact impact Local sale, relative to foreign Decrease Increase competition in local currency Company’s export in local currency Decrease Increase Company’s export in foreign currency Decrease Increase Interest payments from foreign investments Decrease Increase Effects of Local Currency Fluctuations on Company’s Economic Exposure (Cash outflow) Variables influencing the Revaluation Devaluation outflow of cash in local currency impact impact Company’s import of material Remain the same Remain the same the same denoted in local currency Company’s import of material Decrease Increase denoted in foreign currency Interest on foreign debt Decrease Increase 13. Techniques for Managing Exposure The aim of foreign exchange risk management is to stabilize the cash flows and reduce the uncertainty from financial forecasts. To hedge any transaction is to buy certainty to make sure that unexpected exchange rate movements will have no impact on our operations. What determines the price of this certainty? © The Institute of Chartered Accountants of India Foreign Exchange Exposure and Risk Management 12.19 • Flexibility Do we want to have perfect coverage? • Opportunity – Do we want the chance to gain on the upside? • Efficiency – How (liquid/transparent /regulated) is the market? Distribution after Probability Risk Management Distribution before Risk Management Financial Distress Firm Value The above graphs show that the value of the firm increases after the risks are hedged. There are a range of hedging instruments that can be used to reduce risk. Hedging alternatives include: Forwards, futures, options, swaps, etc. Example: Swedish company has got a sales order to an American customer. Delivery time is in three months and price is in US dollar. ™ Open position No hedging. If the Swedish Kroner (SEK) increases in value the Swedish company loses. ™ Forward contract An exchange rate quoted today for settlement at a future date. ™ Futures contract A standardized agreement for settlement at a future date. ™ Money market hedge Borrow US dollar today and exchange the proceeds to local currency. ™ Options contract A contract giving the Swedish company the right, but not the obligation to sell US dollar at an agreed rate. Provides a hedge and a chance to win. 13.1 Derivatives: A derivatives transaction is a bilateral contract or payment exchange agreement whose value depends on - derives from - the value of an underlying asset, reference rate or index. Today, derivatives transactions cover a broad range of underlyings - interest rates, exchange rates, commodities, equities and other indices. © The Institute of Chartered Accountants of India12.20 Strategic Financial Management In addition to privately negotiated, global transactions, derivatives also include standardized futures and options on futures that are actively traded on organized exchanges and securities such as call warrants. The term derivative is also used to refer to a wide variety of other instruments. These have payoff characteristics, which reflect the fact that they include derivatives products as part of their make-up. While the range of products is diverse it is not complicated. Every derivatives transaction is constructed from two simple building blocks that are fundamental to all derivatives: forwards and options. They include: • Forwards: forwards and swaps, as well as exchange-traded futures. • Options :privately negotiated OTC options (including caps, collars, floors and options on forward and swap contracts), exchange-traded options. Diverse forms of derivatives are created by using these building blocks in different ways and by applying them to a wide assortment of underlying assets, rates or indices. (a) Forwards-Based Derivatives There are three divisions of forwards-based derivatives: • forward contracts; • swaps; • futures contracts. (i) The Forward Contract: The simplest form of derivatives is the forward contract. It obliges one party to buy, and the other to sell, a specified quantity of a nominated underlying financial instrument at a specific price, on a specified date in the future. There are markets for a multitude of underlyings. Among these are the traditional agricultural or physical commodities, currencies (foreign exchange forwards) and interest rates (forward rate agreements - FRAs). The volume of trade in forward contracts is massive. The change in value in a forward contract is broadly equal to the change in value in the underlying. Forwards differ from options in that options carry a different payoff profile. Forward contracts are unique to every trade. They are customized to meet the specific requirements of each end-user. The characteristics of each transaction include the particular business, financial or risk-management targets of the counterparties. Forwards are not standardized. The terms in relation to contract size, delivery grade, location, delivery date and credit period are always negotiated. In a forward contract, the buyer of the contract draws its value at maturity from its delivery terms or a cash settlement. On maturity, if the price of the underlying is higher than the contract price the buyer makes a profit. If the price is lower, the buyer suffers a loss. The gain to the buyer is a loss to the seller. ™ Forwards Rates: The forward rate is different from the spot rate. Depending upon whether the forward rate is greater than the spot rate, given the currency in consideration, the forward may either be at a 'discount' or at a 'premium'. Forward premiums and discounts are usually expressed as an annual percentages of the difference between the spot and the forward rates. © The Institute of Chartered Accountants of India

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