Foreign Exchange risk

Management
 Foreign Exchange Risk
Foreign exchange risk is commonly defined as “the possibility of loss or profit resulted from
unexpected exchange rate changes”

Under floating exchange rate system, the value of currency changes with the market forces
which in turn change the values of assets and liabilities and cash flows – both present and
future.

All currencies can experience periods of high volatility which can adversely effect the profit
margins if suitable strategies are not in place to protect the cash flow from sudden currency
fluctuations
Types of Foreign
Exchange Exposure

11-3
 Types of Foreign Exchange Exposure
• Foreign exchange exposure is a measure of the potential change for a
firm’s profitability, net cash flow, and market value because of a
change in exchange rates
• An important task for the financial manager is to measure foreign
exchange exposure and to manage it so as to maximize or stabilize the
profitability, net cash flow, and market value of the firm
• The impact on a firm when foreign exchange rates change can be
classified into three kinds of exposure: transaction, operating, and
translation exposure
11-5
 Types of Foreign Exchange Exposure

• Transaction exposure measures changes in the value of existing foreign-

currency-denominated obligations, which incurred prior to an exchange rate
change but are not due to be settled until after the exchange rate change
• According to the above definition, the exchange rate changes cause the transaction
exposure for existing obligations, which start in the past and end in the future
• In general, this type of exposure can be defined as changes in cash flows of
current existing contractual obligations due to the movement of the exchange
rates
11-6
Types of Foreign Exchange Exposure
• Operating exposure, also called economic exposure,
competitive exposure, or strategic exposure, measures the
change in the present value of the firm resulting from any
change in future operating cash flows of the firm caused by an
unexpected change in exchange rates
• More specifically, the change in firms’ value depends on the
impact of the exchange rate change on future sales volume,
product prices, and costs in the following years
11-7
 Types of Foreign Exchange Exposure
• Translation exposure, also called accounting exposure, is the
potential for accounting-derived changes in owner’s equity to
occur because of the need to “translate” foreign currency financial
statements of foreign subsidiaries into a single reporting currency
to prepare worldwide consolidated financial statements
• This risk arises from that the exchange rates for acquiring assets,
liabilities, and equities are different from that for generating
consolidated financial statements So, comparing to time points of
11-8
acquiring assets, liabilities, and equities, changes of the exchange
rate at later time points cause the translation exposure
Exhibit 11.1 Comparison of Occurrence Time of the Three Foreign
Exchange Exposures on the Time Line
Time point when the
exchange rate changes

Translation exposure Operating exposure

Changes in reported owners’ equity Change in expected future cash flows
in consolidated financial statements for following years arising from an
caused by a change in exchange rates unexpected change in exchange rates

Transaction exposure
Impact of settling existing obligations, which entered into before changes
in exchange rates but to be settled after changes in exchange rates
11-9
Time
Types of Foreign Exchange Exposure
• Transaction exposure vs. Operating exposure
• Both transaction exposure and operating exposure exist because of
unexpected changes in future cash flows
• The difference between them:
• Transaction exposure is concerned with the uncertainty of future
cash flows which are already contracted
• Operating exposure focuses on expected future cash flows (not
yet contracted) that might change because a change in exchange
11-10
rates could altered international competitiveness
 Types of Foreign Exchange Exposure
• Tax consequence of foreign exchange exposures
• As a general rule, only realized foreign exchange losses are deductible for calculating
income taxes; Similarly, only realized foreign exchange gains create taxable income
• Losses from transaction exposure usually reduce taxable income in that year, but losses
from operating exposure may maintain for several years and thus reduce taxable income
over a series of future years
• Note that translation exposure could affect the parent company’s net worth or net income,
but it will not generate cash losses in practice, i.e., both the parent company and
subsidiaries will not lose any money physically during the translation of financial
statements
• Since losses from translation exposure are only “paper” losses, involving no cash flows,
they are not deductible from pretax income
11-11
Sources of Transaction
Exposure

11-12
 Sources of Transaction
Exposure
• Transaction exposure measures gains or losses that arise from
the settlement of existing financial obligations whose terms
are stated in a foreign currency
• The sources of transaction exposure include
• Purchasing or selling goods and services in foreign currencies
through credit accounts (to form the A/P or A/R on the balance
sheet)
• Borrowing or lending funds in foreign currencies
• Entering into foreign exchange or foreign currency derivative
contracts
11-13
Purchasing or Selling through Credit
Account
 The most common example of transaction exposure arises
when a firm has a receivable or payable denominated in
foreign currencies
 For each trade of goods and services, the total transaction
exposure consists of quotation, backlog, and billing
exposures (see Exhibit 11.3)
 Suppose that a U.S. firm sells merchandise on credit account
to a Belgian buyer for €1,000,000 to be made in 60 days.
The current exchange rate is $1.12/€, so the seller expects to
receive $1,120,000
 For the exchange rate to become $1.08/€ ($1.15/€), the seller
will receive $1,080,000 ($1,150,000)
 Thus exposure (or risk) means not only the probability of some
losses but also the probability of some gains
11-14
Exhibit 11.3 The Life Span of the Transaction Exposure for Trades
of Goods and Services

Time and Events

t1 t2 t3 t4
Seller quotes a price Buyer places Seller ships Buyer settles A/R
in foreign currency to firm order with products and with cash in
buyer (in verbal or seller at price bills buyer foreign currency
written form) offered at time t1 (becomes A/R) quoted at time t1

Time between quoting Time it takes to Time it takes to

a price and reaching a fill the order after get paid in cash after
contractual sale contract is signed A/R is issued

11-15
Quotation Backlog Billing
Exposure Exposure Exposure
 Time Span of Transaction Exposure
• ※After the price is quoted at t1, if the exchange rate changes
against the seller at t2, the seller may earn less or even suffer
losses. So the transaction exposure starts from t 1
• ※At t3, the seller books foreign-currency-denominated receivables
at the exchange rate of that time point, but changes in exchange
rate between t3 and t4 will affect the received cash flow in domestic
dollars at t4, that is the billing exposure
• ※The transaction exposure on credit account is actually the billing
exposure
 Borrowing or Lending Foreign
Currencies
• A true case for the transaction exposure over foreign debt is about the
Grupo Embotellador de Mexico (Gemex)
• Gemex, the largest bottler of PepsiCo outside the U.S., had U.S. dollar debt
of $264 million in 1994
• The Mexico’s new peso was pegged at Ps3.45/$ since Jan. 1, 1993, but the
peso was forced to float in Dec. 1994 because of economic and political
events and the exchange rate stabilized near Ps5.5/$
• So, the debt in pesos is from Ps910 million to Ps1452 million, which
increases by 59%
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 Entering into Foreign Exchange or Foreign
Currency Derivative Contracts

• Suppose a U.S. firm purchases ￥100 million through a foreign exchange

forward contract at the forward exchange rate ￥100/$ after 90 days
• When a firm enters into a foreign exchange derivatives contract, it deliberately
creates a transaction exposure
• The motive to create transaction exposure could be the need for hedge the
account payable of ￥100 million after 90 days
• If the spot exchange rate becomes ￥110/$ (￥90/$) after 90 days, the U.S. firm
will have a transaction loss (gain) through this foreign exchange forward contract
• On the other hand, if the spot exchange rate is ￥110/$ (￥90/$) after 90 days,
the account payable of ￥100 million after 90 days have a transaction gain (loss)
11-18
 Sources of Transaction
Exposure
※ Note that cash balances in foreign currency DO NOT create transaction
exposure, even though their domestic currency value changes immediately
with a change in exchange rates
• Since the firm does not have the obligation to transfer cash in foreign currency
into cash in domestic currency, there is no transaction exposure for the cash in
foreign currency
• This kind of risk is reflected in the consolidated statement and thus classified
as the translation exposure
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 Translation Exposure
• Potential for increase/ decrease in parent’s net worth & reported income due to forex change.
• Translation method differ:
• based on operation
• Integrated Foreign Entity: cash flow integrated w/ parent
• Self-sustaining Foreign Entity –independent of parent
• based on functional currency (currency of economic activity)
• Which currency is functional? Not a discretionary management decision!
• Cash flow
• Sales prices
• Sales market
• Expenses
20
• Financing
• Intercompany tranactions
 Translation Methods
Current (Closing) Rate Method Temporal Method
Assets & Liabilities: translate @ current rate (as of Assets & Liabilities:
balance sheet date). -Monetary: translate @ current rates.
-Non-monetary (inventory & fixed assets): @
historical rates
Income statement Items: translate @ actual rate Income Statement Items: translated @ average rates
when items incurred. except for depreciation & cost of goods sold (@
historical rates)

Distributions: dividends translated @ the rate on Distributions: dividends translated @ the rate on
date of payment. date of payment.

Equity Items: Common stock & Paid-in capital Equity Items: Common stock & Paid-in capital
translated @ historical rates. Retained earnings +/- translated @ historical rates. Retained earnings +/-
income/loss for the year. income/loss +/- imbalance from translation.

Translation Adjustments: not included into Translation Adjustments: unrealized forex gains/
21
consolidated income but in equity reserve account. losses included in primary earnings.
 US Translation Procedures
Purpose: Need to translate foreign subs statement into US$

If subs financial statements kept in $,

no need for translation.

Is local currency
functional currency?

No Yes

Is US$
Use current rate method
functional currency?

1. Remeasure from foreign

currency to functional No Yes Remeasure to US$
by temporal method by temporal method
2. Translate to US$
by current rate method
22
 Hyperinflation Countries

• FAS #52: US subs in countries where cumulative inflation 100%+

over 3 years use temporal method
• Why? B/c if current rate method, depreciation understated & profits overstated
=> book value of PP&E would disappear.
• International Practices:
• Integrated subsidiaries: re-measure using temporal method.
• Self-sustaining subsidiaries: translate by current rate method.
23
 Translation Exposure - India
• As per the AS 11 requirement, if a foreign operation is treated as “integral foreign entity”
then the consolidation of report should be done as the “Monetary/NonMonetary
Method”.AS 11 require the assets and liabilities, both monetary and nonmonetary, of the
non-integral foreign operation should be translated at the “current rate method”. Different
countries have different accounting requirement (known as Generally accepted Accounting
Principles or GAAPs) for treating a foreign operation in different manner and also the
method applicable for consolidating foreign operation. For a given company, translation
exposure varies from country to country depending on which country’s GAAP has been
used to prepare the consolidated statement. Indian companies like Infosys, ICICI Bank and
Wipro with their ADRs ( American Depository Receipts1 ) listed in stock exchanges of USA
is required to prepare their consolidated report as per US GAAP as well as Indian GAAP.
 Translation Example
• Suppose EUR depreciated 16.67% from $1.2/EUR to
$1.0/EUR
• Functional currency EUR, Parent: US$
• PP&E, common stock acquired @ $1.276/EUR
• Inventory purchased/manufactured @ $1.218/EUR
• Exposed assets:asset whose value drops w/ depreciation of
functional currency & rises w/ appreciation of functional
currency.
• Net exposed assets: exposed assets – exposed liability
• Implications:
• Appreciation -> increase net exposed assets.
• Depreciation -> decrease net exposed assets.
25
 How to manage accounting
•
exposure?
Balance Sheet Hedge –requires equal amount of exposed forex
assets & liabilities on consolidated balance sheet
• Termed monetary balance under temporal method
• Cost:
• Costly if borrowing cost of parent higher.
• How to manage it if depreciation expected?
• Reduce EUR exposed assets, no change on EUR exposed liab.
• Increase EUR exposed liabilities, no change on EUR exposed assets.
• When balance sheet hedge justified?
• Subs to be liquidated
• Firm has debt covenants to maintain debt/equity ratios
• Management evaluated on basis of certain income statement and
balance sheet measures
• Subs operating in hyperinflationary country
26
 Management of Transaction
Exposure
• Transaction exposure can be managed by operating, financial, and
contractual hedges
• The term operating hedge refers to an off-setting operating cash flow arising
form the conduct of business
• For example, the payments in a foreign currency could be offset by the foreign
currency cash inflow generated from operating activities, e.g., from sales. This
kind of hedge for the transaction exposure is also termed natural hedge
• Operating hedge could also employ the use of risk-sharing agreements, leads and
lags in payment terms, and other strategies (discussed in detail in Ch 10 of IFM
by Vyuptakesh Sharan)

11-27
 Management of Transaction
Exposure
 A financial hedge refers to either an off-setting debt obligation (such as
a loan) or some type of financial derivative such as an interest rate swap
 To eliminate the transaction exposure, firms can borrow foreign currencies
today to prepare for the settlement of A/Rs in foreign currencies in the future
 Due to the borrowing activities, this kind of hedge is classified as financial
hedge
 Contractual hedges employ the forward, futures, and options contracts
to hedge transaction exposures
 The Trident case as follows illustrates how contractual and financial
hedging techniques may be used to protect against transaction exposure

11-28
 Hedging – Meaning

• A foreign exchange hedge is a method used by companies

to eliminate or "hedge" their foreign exchange risk
resulting from transactions in foreign currencies.
 Hedging

 MNEs possess a multitude of cash flows that are sensitive to

changes in exchange rates, interest rates, and commodity
prices
 These three financial price risks are the subject of the growing field
of financial risk management
 Many firms attempt to manage their currency (foreign exchange)
exposures through hedging
 Hedging is the taking of a position, acquiring either a cash flow, an
asset, or a contract (e.g., a forward contract) that will rise (fall) in
value and offset a fall (rise) in the value of an existing position
 While hedging can protect the owner of an asset from a loss, it also
eliminates any gains from an increase in the value of that asset
11-30
Reasons for Hedging
Foreign Exchange Risk

11-31
 Why Hedge
• PPP theory does not always work ( Since PPP theory proposes that change
in purchasing power changes price and thus wipes out loss or gain on the
exchange volatility)
• To maintain cash flows both present and future

• NPV of hedging is always positive.

 Why Hedging is preferred
• Proponents of hedging cite the following arguments:
• Hedge can reduce the variance of future cash flows and thus may
increase the firm’s present value by reducing the discount rate
• Firms should focus on the main business they are in and take
activities to minimize risks arising from interest rates, exchange rates,
and other market variables
• Management is in better position than shareholders to recognize
disequilibrium conditions quickly and to undertake the hedging
activities immediately
• Management has a comparative advantage over individual shareholders
in estimating the actual currency risk of the firm and taking the
correct hedging strategy
11-33
 Why Hedging is favoured
• Reduction in risk in future cash flows improves the
planning capability of the firm. Therefore, the firm can
undertake more investment projects that it might not
consider before
• Since a firm must generate sufficient cash flows to make
debt-service payments, reduction of risk in future cash
flows reduces the likelihood that the firm’s cash flows will
fall below a necessary minimum (This minimum level of
cash flows is also terms as the point of financial distress)
11-34
 Why Hedge?
• What is to be gained by the firm from hedging?
• The major motive for firms to hedge is to increase the present value of firms
• The value of a firm, according to financial theories, is the present value of all
expected future cash flows in the future
• For expected cash flows with higher uncertainty (or risk), a higher discount rate
should be applied to calculating the present value and thus a lower present
value for these cash flows is generated
• A firm that hedges these foreign exchange exposures reduces the variance (or
risk) in the value of future expected cash flows (see Exhibit 11.2 on the next
slide)
• Thus, a lower discount rate is employed to calculate the present value of
expected future cash flows, which implies the increase of the present value of
the firm
11-35
Exhibit 11.2 Impact of Hedging on the Expected
Cash Flows of the Firm

※ Hedging will not increase the expected value for a cash flow. Actually, if taking the
hedging cost into account, hedge transactions will decrease the expected cash flow
※ Hedging reduces the variability of future cash flows about the expected value of the
distribution. This reduction of distribution variance is a reduction of risk 11-36
 Hedging is not always
good.
 However, is a reduction in the variability of future cash flows to
be a sufficient reason for currency risk management? Opponents
of currency hedging commonly make the following arguments
 Shareholders are much more capable of diversifying currency risk
according to their individual preferences and risk tolerance than the
management of the firm
 Although currency risk management can reduce the variance, it
reduces the expected cash flow due to hedging costs.
 So, the net benefit of hedge depends on the trade-off between these two effects
 Hedging activities are sometimes conducted to benefit the
management at the expense of the shareholders
 For instance, the true goal of hedging the variance of the company’s income is
to ensure the bonus of the management 11-37
 Why should a firm not Hedge?
• Management may overuse the expensive hedge
• Management may believe that it will be criticized more severely for incurring
foreign exchange losses than for incurring similar or even higher hedge costs in
avoiding the foreign exchange loss
• Possibly due to the accounting rules: because the foreign exchange losses appear in
the income statements as a highly visible item or as a footnote, but the hedging costs
are buried in operating or interest expenses
• Efficient market theorists believe that investors can see through the
“accounting veil” and therefore have already factored the foreign exchange
effect into a firm’s market valuation
• Although the translation exposure are only “paper” losses, there are still some firms
to hedge this risk
• However, the above argument implies that it is not necessary to hedge the
translation (accounting) exposure
11-38
 Techniques of Hedging ( Ref Ch 10 IFM
by Sharan)
• Contractual Hedges • Natural Hedges
* Forward market hedges * Leads & Lags
* Hedging through Currency Futures and * Risk Sharing
Options
* Pricing of Transactions
* Money Market Hedge
* Matching cash flows
* Parallel Loans
* Currency Swaps
* Currency Diversification
* Cross Hedging
 Forward Contracts
• These are foreign exchange contracts offered by market maker banks.
• They will sell foreign currency forward, and
• They will buy foreign currency forward
• Market maker banks will quote exchange rates today at which they will carry out
these forward agreements.
• These forward contracts allow the global firm to lock in a home currency
equivalent of some “fixed” contractual foreign currency cash flow.
• These contracts are used to offset the foreign exchange exposure resulting from an
initial commercial or financial transaction.
 Example # 1: The Need to
Hedge
• U.S. firm has sold a manufactured product to a German company.
– And as a result of this sale, the U.S. firm agrees to accept payment of €100,000 in 30
days.
– What type of exposure does the U.S. firm have?
• Answer: Transaction exposure; an agreement to receive a fixed amount of foreign currency
in the future.
– What is the potential problem for the U.S. firm if it decides not hedge (i.e., not to
cover)?
• Problem for the U.S. firm is in assuming the risk that the euro might weaken over this
period, and in 30 days it will be worth less (in terms of U.S. dollars) than it is now.
• This would result in a foreign exchange loss for the firm.
 Hedging Example #1 with a Forward

• So the U.S. firm decides it wants to hedge (cover) this foreign exchange
transaction exposure.
– It goes to a market maker bank and requests a 30 day forward quote on the euro.
– The market marker bank quotes the U.S. firm a bid and ask price for 30 day euros, as
follows:
– EUR/USD 1.2300/1.2400.
– What do these quotes mean:
• Market maker will buy euros in 30 days for $1.2300
• Market maker will sell euros in 30 days for $1.2400
 Example #2: The Need to Hedge
• U.S. firm has purchased a product from a British company.
• And as a result of this purchase, the U.S. firm agrees to pay the U.K. company
£100,000 in 30 days.
• What type of exposure is this for the U.S. firm?
• Answer: Transaction exposure; an agreement to pay a fixed amount of foreign currency in the
future.

• What is the potential problem if the firm does not hedge?

• Problem for the U.S. firm is in assuming the risk that the pound might strengthen over this period,
and in 30 days it take more U.S. dollars than now to purchase the required pounds.
• This would result in a foreign exchange loss for the firm.
 Hedging Example #2 with a Forward

• So the U.S. firm decides it wants to hedge (cover) this foreign exchange
transaction exposure.
– It goes to a market maker bank and requests a 30 day forward quote on pounds.
– The market maker quotes the U.S. firm a bid and ask price for 30 day pounds as follows:
– GBP/USD 1.7500/1.7600.
– What do these quotes mean:
• Market maker will buy pounds in 30 days for $1.7500
• Market maker will sell pounds in 30 days for $1.7600
 So What will the Firm Accomplished
with the Forward Contract?
• Example #1: The firm with the long position in euros:
• Can lock in the U.S. dollar equivalent of the sale to the German company.
• It knows it can receive $123,000
• At the forward bid: $1.2300/$1.2400
• Example #2: The firm with the short position in pounds:
• Can lock in the U.S. dollar equivalent of its liability to the British firm:
• It knows it will cost $176,000
• At the forward ask price: $1.7500/$1.7600
 Advantages and Disadvantages of the
Forward Contract
• Contracts written by market maker banks to the “specifications” of the global
firm.
• For some exact amount of a foreign currency.
• For some specific date in the future.
• No upfront fees or commissions.
• Bid and Ask spreads produce round transaction profits.
• Global firm knows exactly what the home currency equivalent of a fixed amount
of foreign currency will be in the future.
• However, global firm cannot take advantage of a favorable change in the foreign
exchange spot rate.
 Hedging- External/ Contractual

• Foreign Currency Options

• When transaction is uncertain, currency options are
a good hedging tool in situations in which the
quantity of foreign exchange to be received or paid
out is uncertain.
 Hedging- Futures and options
• A call option
is valuable when a firm has offered to buy a foreign asset at a fixed
foreign currency price but is uncertain whether its bid will be
accepted.
• The firm can lock in a maximum currency price for its tender offer,
while limiting its downside risk to the call premium in the
event its bid is rejected.
 Currency Futures and options
• A put option
allows the company to insure its profit margin against adverse movements in the foreign
currency while guaranteeing fixed prices to foreign customer

options
Adjusting fund flows
altering either the amounts or the currencies of the planned cash flows of the
parent or its subsidiaries to reduce the firm’s local currency accounting exposure
MANAGING TRANSACTION EXPOSURE

• MONEY MARKET HEDGE

1.Definition:
simultaneous borrowing and lending activities in two different
currencies to lock in the domestic currency value of a future foreign
currency cash flow
 MANAGING TRANSACTION
EXPOSURE
• H. CROSS-HEDGING
1. Often forward contracts not available in a certain currency.
2. Solution: a cross-hedge
- a forward contract in a related currency.
3. Correlation between 2 currencies is critical to success of this hedge.
 Currency swaps
• Refer to a spot sale of a currency combined with a forward repurchase of the
same currency-as part of a single transaction.
• Swap rate: is the difference between the spot and forward rates in the
currency swap. (a yearly basis)
• While banks quote & do outright forward deals with their non-bank
customers, in inter bank market forwards are done in form of swaps.
• The swap margin is given such that the last digit coincides with the same
decimal place as the last digit of the spot price.
 Currency Swaps
• Swap transaction between currencies A and B consists of spot purchase
(sale) of A coupled with a forward sale(purchase) of A both against B .
The amount of one currency is identical in the spot and forward deals
• E.g. A customer will sell US dollars spot and buy US dollars 2 months
forward against canadian dollars to the bank.
• Forward –Forward Swaps – Can be looked as two spot-forward swaps –
Purchase (sale) of Currency A 3 month forward and simultaneous
sale(purchase ) of currency A 6 month forward against currency B.
 Currency Swaps
• The transaction is broken as
1. Sell A spot and buy 3 month forward against B
2. Buy A Spot and sell 6 month forward against B
Uses of Swaps :
Roll over forward positions to cover long term exposures :
Risk Management in
Practice

11-55
 Risk Management in Practice
• The following paragraphs summarized the results of many surveys of
corporate risk management practices in recent years
1. Treasury function:
• The treasury function of most private firms, which is the group typically
responsible for transaction exposure management, is usually considered a
cost center
• It is not suited to treat the treasury as a profit center. Since assets with higher
risk will provide higher expected returns, if the treasury operates as a profit
center, it might tolerate more risks that should be hedged
11-56
 Risk Management in Practice
2. Currency risk managers are expected to err on the conservative side when managing
the firm’s money
 Although transaction exposures exist before they are actually booked as foreign-currency-
denominated receivables or payables, many firms do not allow the hedging of quotation
exposure or backlog exposure as a matter of policy
 Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the
exposure actually occurring is considered to be less than 100%
 These conservative policies dictate that contractual or financial hedges should be placed only
on existing exposures
 An increasing number of firms, however, are actively hedging not only backlog exposures,
but also selectively hedging quotation and anticipated exposures
 Anticipated exposures are transactions for which there are–at present–no contracts or agreements between
parties, but that are anticipated on the basis of historical trends and continuing business relationships
11-57
 Risk Management in Practice
3. Which contracts are used for hedge?
• In practice, transaction exposure management programs are generally divided along an
“option-line”; those that use options and those that do not
• Those firms that do use currency options are generally more aggressive in their tolerance of
currency risk
• Firms that do not use currency options rely almost exclusively on forward contracts and
money market hedge
• For extremely conservative and risk-intolerant firms, they hedge all existing exposures with
forwards and hedge a variety of backlog and anticipated exposures with options

11-58
 Risk Management in Practice

4. Proportional hedges
• Many MNEs have established rather rigid transaction exposure risk management
policies that mandate proportional hedging
• These policies generally require the use of forward contract hedges on a percentage
(e.g., 50%, 60%, or 70%) of existing transaction exposures
• The remaining portion of the exposure is then selectively hedged on the basis of the
firm’s risk tolerance, the view of exchange rate movements, and the confidence level
about the view

11-59
 Risk Management in Practice
5. Full hedge only at favorable forward exchange rates
 Many firms require that when there is a favorable forward exchange rate, full forward-
cover is put in place; Otherwise, they may adopt the proportional hedges
 More specifically, for the account receivables (payables) of Trident case, the full
forward-cover strategy is adopted when the forward exchange rate is at premium
(discount), i.e., the forward exchange rate is higher (lower) than the spot exchange rate,
$1.7640/￡
 The reason is that if firms use forward contracts to hedge when the forward rate is
unfavorable, a certain foreign exchange loss will be shown in the income statement
 For the management, it is difficult to explain why there is still a foreign exchange loss after
conducting a hedging transaction

11-60
 Risk Management in Practice

6. Other derivatives
• Recently, many other complex options are employed to hedge the
exchange rate risk, like range forwards, participating forwards,
average rate options, etc.

11-61
 Internal hedging (natural hedging)
• Netting is probably one of the most used methods.

The idea is to reduce the number of transactions that a

firm needs to make in order to cover an exposure. It
requires the firm to have a centralized organization of its
cash management.

The centralization means that the company collects

foreign currency cash flows between subsidiaries and
groups them together so as an inflow offsets an outflow
in the same currency. 62
Situation before netting

63
Situation after netting

64
• Two types of netting exist: bilateral and multilateral netting.

• Netting is an appropriate and easy to implement technique

to hedge transaction exposure.

65
 Matching
• Matching is similar in concept to netting.
A company tries to match its currency inflows by amount and
timing with its expected inflows.

• Matching can be achieved by matching in terms of currencies

that tend to move closely together over time (positively or
negatively correlated currencies). 66
 Pre-payment
• Import commitments can include an option to prepay.

This is used if currency is thought to appreciate; then prepaying

enables the company to pay at a lower rate.

There are some limits set by governments, which restrict the use
of this method. 67
 Leading and lagging

• Companies can do the above techniques (accelerate or delay the

original payment) but within its divisions or subsidiaries. In this
case it is called leading and lagging.

If the currency of a subsidiary is going to appreciate it may

accelerate its payment (leading) and realize the payment before
the currency appreciates. The reverse is true if a currency is
expected to depreciate, then the company will delay its payment 68

(lagging).
 Long term structural changes

• Restructuring is a more complex task than hedging a currency

transaction. However, once the restructuring is finished, the
reduction of the exposure has a long-term effect.

The firm can act on four parameters: change the sales, change
the foreign suppliers, change the foreign production factories or
change the foreign debt. The idea is to change the relationship
between cash inflows and outflows.

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 Price adjustments
• Price adjustments can be made in different manners.

First, when the local currency of a subsidiary is devaluating, the

subsidiary can increase the price, so as to cancel the effect of
devaluation. This technique is particularly used in countries
where devaluation is high and where derivative markets are
inefficient.
70
Second, the company can change the currency of billing.

Third, the firm can use export currency of billing to transfer

profits from one affiliate to another. The purpose is to raise
or lower intergroup selling prices by billing rate adjustment
so that profits appear in hard currency or low-tax companies.
This techniąue is very aggressive and can be forbidden by
71
regulation.
 MANAGING EXPOSURE

CURRENCY RISK SHARING

• 1. Developing a customized hedge contract
• 2. The contract typically takes the form of a Price
Adjustment Clause, whereby a base price is adjusted
to reflect certain exchange rate changes.
 MANAGING TRANSACTION
EXPOSURE

• CURRENCY RISK SHARING (con’t)

3. Parties would share the currency risk beyond a neutral zone of
exchange rate changes.
4. The neutral zone represents the currency range in which risk is
not shared.