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International financialmanagement

HARISHA.B.V. AIP(FINANCE AND CONTROL)

IIM BANGALORE

MODULE 3

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FOREIGN EXCHANGE RISK MANAGEMENT

Measuring accounting exposuretransaction exposuretranslation exposure

Managing accounting exposureHedging

Measuring and Managing economic exposure Managing interest rate exposure.

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Exchange rate risks

Transaction exposure Translation exposure / consolidation

exposure Economic Exposure

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Risk

Risk is the measure of deviation from theexpected value .

The risk that cannot be removed is called asSystematic risk or Un-diversifiable risk.Systematic risk includes shortage in money

supply, economic policy followed by thecountry etc. However, a part of risk that can be removed

is called as Unsystematic risk or Diversifiablerisk.. An investor can reduce such risk byholding currencies of various countries.

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Transaction exposure

The following situations give rise totransaction exposure.

1. Trade transactions with foreign countrieswhen billing is done in foreign currencies.

2. Banking and financial transactions done in

foreign currencies like lending and borrowing or equity participation .

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Consolidation /TranslationExposure

When balance sheets are consolidated ,thevalue of assets and liabilities expressed inthe national currency varies as a function ofthe variation of the currency of the countrywhere investment was made.

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Economic Exposure

The economic exposure refers to the change inexpected cash flows as a result of an unexpectedchange in exchange rates.

If US company in French reduces the French prices for the products can increase the marketshare , conversely if French franc weakens against

dollar then French company will have morecompetitiveness than US company.

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Techniques of Hedging

Internal hedging External hedging

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Internal techniques

Choosing a particular currency for invoice. Leads and lags Indexation clauses in contracts Netting Shifting the manufacturing base Center of re invoicing Swaps Discount.

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External hedging

Covering risk in the forward /future market Covering in the money market

Covering in the option market Covering through swaps.

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Translation exposure

The different methods of translation varyfrom one country to another, each methodhas its own advantages and disadvantages.

Methods1. Current rate method2. Current /Non current method3. Monetary /non monetary method4. Temporal method

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Current rate method

It is also called as closing rate method. All items of the income statement and

balance sheet are translated at current rate . This method is preferred in those countries

the currencies are periodically adjusted toinflation.

The net worth of the company will bemaintained on the historical rate only.

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Current / Non current method

Current assets and current liabilities of thesubsidiary are translated at current rate .

The fixed assets and liabilities are translatedat historical rate.

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Monetary /Non monetary method

Items that represent a claim or receive . All liabilities and current assets are shown

under current rate .(except inventory) All fixed assets , inventory and net worth

under historical rate

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Temporal method

Historical rate for those which are stated athistorical rate.

Current rate for those which are stated atreplacement cost or realizable value.

Similar to monetary/non monetary method

but even stock will be shown under currentrate.

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Balance sheet

Assets Rs liabilities Rs Fixed assets 200000 equity 140000 Stocks 50000 long term 80000 Receivables 30000 short term 70000 Cash 10000

The historical rate is 45Rs/$ and spot is 46

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problem

Suppose a French firm has an Indian subsidiary.The total translation exposure is estimated to beIndian Rs 1 million .the exchange rates are asfollows.

Spot Rs 6.00 12 months forward Rs 6.0600 The French company anticipates a depreciation of

6% of the Indian Rupee. If company wants to avoid the potential loss what

amount of Indian Rs it has sell forward.

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Loss = x( 1 / forward - 1/ anticipated spot)