FX management

7/29/2019 FX management

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FMS BHU

Export management and

logisticsForeign exchange risk management

Juhi Kashyap

MBA - IB


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Foreign exchange risk management

Foreign exchange risk is the exposure of a companys financial strength to the potential

impact of movements in foreign exchange rates. It is measured by the variance of the

domestic - currency value of assets, liabilities, or operating income that is attributable to

unanticipated changes in exchange rates

This risk relates to the uncertainty attached to the exchange rates between two currencies.

For example, the amount borrowed in foreign currency is to be repaid in the same currency or

in some other acceptable currency.

Thus if the foreign currency becomes stronger than (say) Indian rupees, the Indian borrower

has to repay the loan in terms of more rupees than the rupees he obtained by way of loan. Theextra rupee he pays is not due to an increase in interest rate but because of unfavourable

exchange rate. Conversely he will gain if the rupee is stronger. The fluctuation in the

exchange rate causes uncertainty and this uncertainty gives rise to exchange rate risk.

Exposure of foreign exchange risk

Foreign Exchange Exposure is the sensitivity of the real domestic currency value of assets,

liabilities, or operating incomes to unanticipated changes in exchange rates.

Three types of Exposure:

- Transaction or Contractual Exposure

A firm may have some contractually fixed payments and receipts in foreign currency, such

as, import payables, export receivables, interest payable on foreign currency loans etc. All

such items are to be settled in a foreign currency. Unexpected fluctuation in exchange rate

will have favourable or adverse impact on its cash flows. Such exposures are termed as

transactions exposures.

- Translation or Accounting Exposure

Arises from the need, for purposes of reporting and consolidation, to convert the results of

foreign operations from the local currency to the home currency

- Operating or Economic Exposure


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Economic exposure measures the probability that fluctuations in foreign exchange rate will

affect the value of the firm. The intrinsic value of a firm is calculated by discounting the

expected future cash flows with appropriate discounting rate. The risk involved in economic

exposure requires measurement of the effect of fluctuations in exchange rate on different

future cash flows.

Foreign exchange risk management

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure

is defined as a contracted, projected or contingent cash flow whose magnitude is not certain

at the moment and depends on the value of the foreign exchange rates. The process of

identifying risks faced by the firm and implementing the process of protection from these

risks by financial or operational hedging is defined as foreign exchange risk management.

The primary objective of FX risk management is to minimize potential currency losses, not to

make a profit from FX rate movements, which are unpredictable and frequent.

Foreign Exchange Risk Management Framework

Moment in time whenexchange rate changes

Translation(Accounting) exposure

Transaction exposure

(Economic)Operating exposure

Time

Changes in reported owners equityin consolidated financial statements

caused by a change in exchange rates

Change in expected future cash flowsarising from an unexpected change in

exchange rates

Impact of settling outstanding obligations entered into before change

in exchange rates but to be settled after change in exchange rates

Moment in time whenexchange rate changes

Translation(Accounting) exposure

Transaction exposure

(Economic)Operating exposure

TimeTime

Changes in reported owners equityin consolidated financial statements

caused by a change in exchange rates

Change in expected future cash flowsarising from an unexpected change in

exchange rates

Impact of settling outstanding obligations entered into before change

in exchange rates but to be settled after change in exchange rates


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Once a firm recognizes its exposure, it then has to deploy resources in managing it. A

heuristic for firms to manage this risk effectively is presented below which can be modified

to suit firm-specific needs i.e. some or all the following tools could be used.

Forecasts: After determining its exposure, the first step for a firm is to develop a forecast on

the market trends and what the main direction/trend is going to be on the foreign exchange

rates. The period for forecasts is typically 6 months. It is important to base the forecasts on

valid assumptions. Along with identifying trends, a probability should be estimated for the

forecast coming true as well as how much the change would be.

Risk Estimation: Based on the forecast, a measure of the Value at Risk(the actual profit or

loss for a move in rates according to the forecast) and the probability of this risk should be

ascertained. The risk that a transaction would fail due to market-specific problems should be

taken into account. Finally, the Systems Risk that can arise due to inadequacies such as

reporting gaps and implementation gaps in the firms exposure management system should be

estimated.

Benchmarking: Given the exposures and the risk estimates, the firm has to set its limits for

handling foreign exchange exposure. The firm also has to decide whether to manage its

exposures on a cost centre or profit centre basis.

A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm

are not adversely affected beyond a point. A profit centre approach on the other hand is a

more aggressive approach where the firm decides to generate a net profit on its exposure over

time.

Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides

an appropriate hedging strategy. There are various financial instruments available for the firm

to choose from: futures, forwards, options and swaps and issue of foreign debt. Hedging

strategies and instruments are explored in a section.

Stop Loss: The firms risk management decisions are based on forecasts which are but

estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements

in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain

monitoring systems in place to detect critical levels in the foreign exchange rates for

appropriate measure to be taken.


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Reporting and Review: Risk management policies are typically subjected to review based

on periodic reporting. The reports mainly include profit/ loss status on open contracts after

marking to market, the actual exchange/ interest rate achieved on each exposure and

profitability vis--vis the benchmark and the expected changes in overall exposure due to

forecasted exchange/ interest rate movements and effective in controlling the exposures, what

the market trends are and finally whether the overall strategy is working or needs change.

A firm may be able to reduce or eliminate currency exposure by means of internal and

external hedging strategies.

INTERNAL HEDGING STARTEGIES

InvoicingA firm may be able to shift the entire risk to another party by invoicing its exports in its

home currency and insisting that its imports too be invoiced in its home currency, but in the


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presence of well functioning forwards markets this will not yield any added benefit compared

to a forward hedge. At times, it may diminish the firms competitive advantage if it refuses to

invoice its cross-border sales in the buyers currency.

In the following cases invoicing is used as a means of hedging:

1. Trade between developed countries in manufactured products is generally invoiced inthe exporters currency.

2. Trade in primary products and capital assets are generally invoiced in a major vehiclecurrency such as the US dollar.

3. Trade between a developed and a less developed country tends to be invoiced in thedeveloped countrys currency.

4. If a country has a higher and more volatile inflation rate than its trading partners, thereis a tendency not to use that countrys currency in trade invoicing.

Another hedging tool in this context is the use of currency cocktails for invoicing. Thus for

instance, British importer of fertilizer from Germany can negotiate with the supplier that the

invoice is partly in DEM & partly in Sterling. This way both the parties share exposure.

Another possibility is to use one of the standard currency baskets such as the SDR or the

ECU for invoicing trade transactions.

Basket invoicing offers the advantage of diversification and can reduce the variance of home

currency value of the payable or receivable as long as there is no perfect correlation between

the constituent currencies. The risk is reduced but not eliminated

Netting and Offsetting:A firm with receivables and payables in diverse currencies can net out its exposure in each

currency by matching receivables with payables. Thus a firm with exports to and imports

from say Germany need not cover each transaction separately; it can use a receivable to settle

all or part of a payable and take a hedge only for the net DEM payable or receivable. Even if


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7.NLG purchased forward 1,000,000 90

Its net exposure in USD at 60 days is:

(800,000+300,000)-(200,000+250,000)=+USD 650,000

Whereas it has a net exposure in NLG of1,000,000 at 90 days.

The use of forward contracts to hedge transactions exposure at a single date is quite

straightforward. A contractual net inflow of foreign currency is sold forward and a

contractual net outflow is bought forward. This removes all uncertainty regarding the

domestic currency value of the receivable or payable. Thus in the above example, to hedgethe 60 day USD exposure, ABC Co. can sell forward USD 650,000 while for the NLG

exposure it can buy NLG 1,000,000 90 day forward.

For exposure at different dates the obvious solution is to hedge each exposure separately with

a forward sale or purchase contract as the case may be. Thus in the example, the firm can

hedge the 60 day USD exposure with a forward sale and the 180 day USD exposure with a

forward purchase.

B. Hedging with the money market:

Firms, which have access to international money markets for short-term borrowing as

well as investment, can use the money market for hedging transactions exposure.

E.g.: Suppose a German firm ABC has a 90 day Dutch Guilder receivable of NLG

10,000,000. It has access to Euro deposit markets in DEM as well as NLG. To cover this

exposure it can execute the following sequence of transactions:

1. Borrow NLG in the euroNLG market for 90 days.2. Convert spot to DEM.3. Use DEM in its operations, e.g. to pay off a short-term bank loan or finance

inventory.

4. When the receivable is settled, use it to pay off the NLG loan.


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Suppose the rates are as follows:

NLG/DEM Spot: 101025/35 90day forward: 1.1045/65

EuroNLG interest rates: 5 1/4/5

EuroDEM interest rates: 4 3/4/5.00

Comparing the forward cover against the money market cover. With forward cover, each

NLG sold will give an inflow of DEM (1/1.064)= DEM 0.9038, 90 days later. The present

value of this (at 4.74%) is

0.9038/[1+ (0.0475/4)]= DEM 0.8931

To cover using the money market, for each NLG of receivable, borrow NLG 1/[1+ (0.055/4)]

= NLG 0.9864, sell this spot to get DEM (0.9864/1.1035)

=DEM 0.8939

Pay off the NLG loan when the receivables mature. Thus the money markets cover; there is a

net gain of DEM 0.0008 per NLG of receivable or DEM 8000 for the 10 million-guilder

receivable.

Sometimes the money market hedge may turn out to be the more economical alternative

because of some constraints imposed by governments. For instance, domestic firms may not

be allowed access to the Euromarket in their home currency or non-residents may not be

permitted access to domestic money markets. This will lead to significant differentials

between the Euromarket and domestic money market interest rates for the same currency.

Since forward premia/ discounts are related to Euromarket interest differentials between two

currencies, such an imperfection will present opportunities for cost saving.

E.g. A Danish firm has imported computers worth $ 5 million from a US supplier. The

payment is due in 180 days. The market rates are as follows:

DKK/USD Spot: 5.5010/20

180 days forward: 5.4095/ 5.4110

Euro $: 9 1/2/ 9


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Euro DKK: 6 1/4/ 6

Domestic DKK: 5 1/4/ 5

The Danish government has imposed a temporary ban on non-residents borrowing in

the domestic money market. For each dollar of payable, forward cover involves an outflow of

DKK 5.4110, 180 days from now. Instead for each dollar of payable, the firm can borrow

DKK 502525 at 5.5%, acquit $ 0.9547 in the spot market and invest this at 9.50% in a Euro $

deposit to accumulate to one dollar to settle the payable. It will have to repay DKK 5.3969

[=5.2525* 1.0275], 180 days later. This represents a saving of DKK 0.0141 per dollar of

payable or DKK 70,500 on the $5 million payable.

From the above example it is clear that from time to time cost saving opportunitiesmay arise either due to some market imperfection or natural market conditions, which an alert

treasurer can exploit to make sizeable gains. Having decided to hedge an exposure, all

available alternatives foe executing the hedge should be examined.

C. Hedging with Currency Options:

Currency options provide a more flexible means to cover transactions exposure. A

contracted foreign currency outflow can be hedged by purchasing a call option (or selling a

put option) on the currency while an inflow can be hedged by buying a put option. (Or

writing a call option. This is a covered call s trategy).

Options are particularly useful for hedging uncertain cash flows, i.e. Cash flows those

are contingent on other events. Typical situations are:

a. International tenders: Foreign exchange inflows will materialise only if the bid issuccessful. If execution of the contract also involves purchase of materials,

equipments, etc. from third countries, there are contingent foreign currency outflows

too.

b. Foreign currency receivables with substantial default risk or political risk, e.g. thehost government of a foreign subsidiary might suddenly impose restrictions on

dividend repatriation.


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c. Risky portfolio investment: A funds manager say in UK might hold a portfolio offoreign stocks/bonds currently worth say DEM 50 million, which he is planning to

liquidate in 6 months time. If he sells Dem 50 million forward and the portfolio

declines in value because of a falling German stock market and rising interest rates,

he will find himself to be over insured and short in DEM.

E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on September 1. The market

rates are as follows:

DEM/GBP Spot: 2.8175/85

90-day Swap points: 60/55

September calls with a strike of 2.82 (DEM/GBP) are available for a premium of 0.20p per

DEM. Evaluating the forward hedge versus purchase of call options both with reference to an

open position.

i. Open position: Suppose the firm decides to leave the payable unhedged. If atmaturity the pound sterling/ DEM spot rate is St., the sterling value of the payable

is (5,00,000) St.

ii. Forward hedge: If the firm buys DEM 5,00,000 forward at the offer rate of DEM2.8130/PS or PS0.3557/ DEM, the value of the payable is PS (5,00,000 *

0.3557)=PS 1,77,850.

iii. A Call option: Instead the firm buys call options on DEM 5,00,000 for a totalpremium expense of PS 1000.

At maturity, its cash outflow will be

PS [(5,00,000)St +1025] for St=0.3546.

Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%.

D. Hedging with currency futures:


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Hedging contractual foreign currency flows with currency futures is in many respects similar

to hedging with forward contracts. A receivable is hedged by selling futures while a payable

is hedged by buying futures.

A futures hedge differs from a forward hedge because of the intrinsic features of

future contracts. The advantages of futures are, it easier and has greater liquidity. Banks will

enter into forward contracts only with corporations (and in rare cases individuals) with the

highest credit rating. Second, a futures hedge is much easier to unwind since there is an

organized exchange with a large turnover.

A firm may be able to reduce or eliminate interest rate exposure by mean of followinghedging strategies.

Forward rate Agreements:A FRA is an Agreement between two parties in which one of them (The seller of

FRA), contracts to lend to other (Buyer), a specified amount of funds, in a specific currency,

for a specific period starting at a specified future date, at an interest rate fixed at the time of

agreement. A typical FRA quote from a bank might look like this:

USD 6/9 months: 7.207.30% P.a.

This is to be interpreted as follows.

The bank is willing to accept a three month USD deposit starting six months fromnow, maturing nine months from now, at an interest rate of 7.20% P.a. (Bid Rate).

The bank is willing to lend dollars for three months, starting six months from now at ainterest rate of 7.30% P.a. (Ask Rate).

The important thing to note is that there is no exchange of principal amount.

Interest rate futures:Interest rate futures are one of the most successful financial innovations in recent

years. The underlying asset is a debt instrument such as a treasury bill, a bond, and a time


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deposit in a bank and so on. For e.g. the International Monetary Market (a part of Chicago

Mercantile Exchange) has a futures contract on US government treasury bills, three-month

Eurodollar time deposits and US treasury notes and bonds. The LIFFE has contracts on

Eurodollar deposits, sterling time deposits and UK government bonds. The Chicago Board of

Trade offers contracts on long-term US treasury bonds.

Interest rate futures are used by corporations, banks and financial institutions to hedge

interest rate risk. A corporation planning to issue commercial paper for instance can use T-

Bill futures to protect itself against an increase in interest rate. A corporate treasurer who

expects some surplus cash in near future to be invested in short-term instruments may use the

same as insurance against a fall in interest rates. A fixed income fund manager might use

bond futures to protect the value of her fund against interest rate fluctuations. Speculators bet

on interest rate movements or changes in the term structure in the hope of generating profits.

Interest Rate Swaps:A standard fixed-to-floating interest rate swap, known in the market jargon as a plain vanilla

coupon swap (also referred to as exchange of borrowings) is an agreement between two

parties in which each contracts to make payments to the other on particular dates in the future

till a specified termination date. One party, known as the fixed ratepayer, makes fixed

payments all of which are determined at the outset. The other party known as the floating

ratepayer will make payments the size of which depends upon the future evolution of a

specified interest rate index (such as the 6-month LIBOR). The key feature of this is:

The Notional Principal:

The fixed and floating payments are calculated if they were interest payments on a specified

amount borrowed or lent. It is notional because the parties do not exchange this amount at

any time; it is only used to compute the sequence of payments. In a standard swap the

notional principal remains constant through the life of the swap.

Interest rate Options:


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A less conservative hedging device for interest rate exposure is interest rate options. A call

option on interest rate gives the holder the right to borrow funds for a specified duration at a

specified interest rate, without an obligation to do so. A put option on interest rate gives the

holder the right to invest funds for a specified duration at a specified return without an

obligation to do so. In both cases, the buyer of the option must pay the seller an up-front

premium stated as a fraction of the face value of the contact.

As interest rate cap consists of a series of call options on interest rate or a portfolio of

calls. A cap protects the borrower from increase in interest rates at each reset date in a

medium-to-long-term floating rate liability. Similarly, an interest rate floor is a series or

portfolio of put options on interest rate, which protects a lender against fall in interest rate on

rate dates of a floating rate asset. An interest rate collar is a combination of a cap and a floor.

Factors affecting the decision to hedge foreign currency risk

The following section describes the factors that affect the decision to hedge and then the

factors affecting the degree of hedging are considered.

Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale. Risk

management involves fixed costs of setting up of computer systems and training/hiring of

personnel in foreign exchange management.

Moreover, large firms might be considered as more creditworthy counterparties for forward

or swap transactions, thus further reducing their cost of hedging. The book value of assets is

used as a measure of firm size.

Leverage: Firms with high leverage have greater incentive to engage in hedging because

doing so reduces the probability, and thus the expected cost of financial distress. Highly

levered firms avoid foreign debt as a means to hedge and use derivatives.

Liquidity and profitability: Firms with highly liquid assets or high profitability have less

incentive to engage in hedging because they are exposed to a lower probability of financial

distress.

Sales growth: Sales growth is a factor determining decision to hedge as opportunities are

more likely to be affected by the under investment problem.


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FX management

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