Currency Risks, Transaction exposure, Translation exposure, Economic exposure

<< Sources of financial distress, Effects of financial distress, Reorganization

Future payment situation – hedging, Currency futures – features, CF – future payment in FCY >>

Corporate Finance FIN 622

Lesson 38

CURRENCY RISKS

We shall cover following topics in this hand out:

Types Of Currency Risks

o Transaction exposure

o Translation exposure

o Economic exposure

Methods Of Protection Against Transaction Exposure

o Internal Methods

o External methods

Currency Risks

We can classify foreign risk exposure into three broad categories:

- Transaction exposure

- Translation exposure

- Economic exposure

Translation Exposure:

In real world, a single transaction (sales and receipt) may take some period of time. For example, you sold

goods to a foreign customer on 15 December 2005, and customer promised payment after two months.

Now during these two months the exchange rate may fluctuate on either side and this will result in

exchange gain or loss. These transactions may include import or export of goods on credit terms, borrowing

or investing in foreign currency, receipt of dividend from foreign subsidiary. This type of exposure can be

safeguarded by using hedging instruments.

Translation Exposure:

When a business has several subsidiary located in different foreign land, then it needs to consolidate its

financial results of overall operations. Translation exposure effects the financials of the group when it

translates its assets, liabilities and income to home currency from various currencies.

The widely used mean of protecting against translation exposure is known as balance sheet hedging. In this

method, assets and liabilities are matched of offset in order to reduce the net effect of translation. For

example, a company may try to reduce its foreign currency dominated assets if it fears a devaluation of

foreign currency. At the same time, it may increase its liabilities by seeking loans in the local currency and

slowing down payment to creditors. The firm may try to equate its foreign currency assets and liabilities

then it will have no net exposure to change in exchange rates.

Economic Exposure:

This type of exposure affects the value of the company. Any adverse exchange rate fluctuation will reduce

the present value of all the future cash flow, thus reducing the value of the company. It is difficult to

measure the dollar value effect on the value of the firm.

For instance, a Pakistani firm is operating in other country through a subsidiary. Assuming that the foreign

country in question devalues it currency unexpectedly, this will be a bad happening for the home firm. This

is because every local currency unit of profit earned would now be worthless when repatriated to Pakistan.

On the other hand, if could be a good news as the subsidiary might now find it profitable to export goods

to the rest of the world.

If a firm manufactures all its products in one country and that country's exchange rate strengthens, the firm

will find its export expensive to the rest of the world. Sales will be stagnant if not lowering and the cash

flow and value of the firm will also deteriorate.

On the other side, if a firm has decentralized production facilities around the world and bought its inputs

from all over the world, it is unlikely that the currencies of all its operations would revalue at the same time.

It would therefore, find that although it was losing exports from some of its productions facilities, this

would not be the case in all of them.

When borrowing in more than one currency, firms must be aware of foreign exchange risk. Therefore,

when a firm borrows in US dollars it must settle this liability in the same currency. If US $ then strengthens

against the home currency this can make interest and principal repayments far more expensive. However, if

borrowing is spread across several currencies it is unlikely they will all move in one direction upward or

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Corporate Finance FIN 622

downward and economic exposure is reduced to considerable extent. Borrowing is foreign currency is

justified if returns will then be earned in that currency to finance repayment and interest.

Protection against Transaction Risk

Fluctuations in foreign exchange market do not stop. A company may have several thousand foreign

currency units in payable and receivable transactions. Such payments and receipts are going to take place in

future thus exposing a company to adverse fluctuations, resulting in exchange losses.

For example, a Pakistani enterprise is required to make US $ 100,000 to a US exporter within two months

time. The company anticipates that dollar will strengthen against the local currency (or local currency will

weaken against the US $), it means that Pakistani firm will need to spend more local currency units to buy

the dollars in question. This type of risk can be reduced if not eliminated, by hedging.

There are two types of measures that can reduce the transaction exposure. These are:

Internal methods:

- Invoicing in home currency

- Leading and lagging

- Multilateral netting

External methods:

- Forward contract

- Money market hedges

- Currency futures

- Currency options

- Currency swaps

Internal methods:

Invoicing in home currency

This will eliminate the need of exchange of currency upon receipt. However, the seller would be compelled

to revise its prices periodically.

Seller can invoice:

- In home currency

- Currency that is stable than home currency

- Currency with a positive forward markets

Buyer's preferable currency is:

- Own currency

- Stable than own currency

- Currency he has

- Currency of the industry

Leading & lagging:

- Leading refers to making payment before falling due.

- Lagging means to defer or delay the payment or settling the payment well past due date

If the currency of payer is weakening against the other currency (of buyer) than it is beneficial to

pay early. For example, if a Pak importer need to pay for import bill and predicts that Pak rupees

will weak against the dollar in future, then it is advisable to pay as early as possible.

However, if Pak rupee is foreseen strengthening against dollar, then delaying payment would be

financially advantageous.

These issues are from payer's standpoint and will be opposite for payee.

Matching of receipts and payments:

For-ex exposure can be partially hedged by matching payments and receipts of same currency.

For example, a company will receive US $ 1 million during the next quarter and will need to pay US

$ 1.2 million in the same period, and then the net exposure will be US $ 200,000/- as 1 million

payments and receipt are net off.

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Matching receipts and expenditures is a very useful way of hedging currency exposure. It can be

organized at group level by the finance department so that currency income for one of the group

companies can be matched with the expenditure of another company. In order to reduce the

transaction exposure to maximum level, it is of immense importance that forecast of amount and

timings of foreign currencies are reliable.

External Hedging Methods:

Forward Rate Agreements:

Under this method, hedging refers to making an investment to reduce the risk of adverse price movements

in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures

contract.

Using this method, we can fix the exchange rate now for a future transaction of the needed currency.

Because spot rates are changing every day and fixing the exchange rate for future date `now' reduces the risk

to significant extent.

A forward contract is binding upon both the parties currency dealer and a company/client. This means

that both parties must honor their commitment to sell or buy the foreign currency on the specified date and

amount. By hedging against the risk of an adverse exchange rate movement with a forward contract, the

company also closes an opportunity to benefit from a favorable change in the spot rate.

Hedging is based on the assumption or estimate that it will be expensive to pay US $ in three months time

because of the fact the PKR will be weakening against US $. Therefore, a company enters into a contract to

buy x dollars after 3 months at an exchange rate of Rs 60/ US $ decided now. At the maturity date both

parties have to honor their respective commitments of buying and selling of US $ at agreed rates.

Now if on the maturity date, the spot ex rate is Rs 61/US $, (PKR weakened against US $), then the

company has actually eliminated the loss and benefited financially.

However, if the spot rate on maturity date is Rs. 59/US $, (contrary to its estimation of weak local currency,

local currency strengthened) then the company has missed the opportunity to benefit from this favourable

sport rate.

For best results, one must possess the knowledge of Forex market with a vision of future to estimate that

which currency will weaken against which other one.

Timing of cash flow is of crucial importance in hedging contract.

Money Market Hedging:

Money markets are wholesale (large-scale) markets for lending and borrowing of money for short term.

Bank are major player of money markets and companies seek their services to hedge against the ex rate

fluctuations in short term.

As forward ex rate (which is agreed now) is derived from sport rates using interest rates, a money market

hedge can produce the same results as of forward contract.

There will be two situations:

- A company is to receive money in foreign currency (FCY) at a future date and will exchange it into

local currency, and

- A company needs to pay foreign currency (FCY) at some future date and will use local currency to

buy the FCY to make payment

Scenario: Future Income in FCY

What is needed at this point is to fix the exchange value of the future currency income.

A hedge will be created by fixing the value of income now in local currency.

We can do it:

Borrow now in foreign currency (the same that the company will receive in future). The maturity of both

loan and receipt should be the same.

The loan + interest on FCY loan should equal the amount of FCY future receipt.

When the FCY receipt hit the account, loan will be paid off.

The FCY loan can be converted to local currency immediately and may be put to a short-term deposit to

earn interest.

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