Course International Financial Management

Topic Foreign Exchange Exposure

Faculty Kshama M. S.
 Learning Objectives

At the end of this session, you will be able to:

➢ Learning Objective 1: Country Risk Analysis

➢ Learning Objective 2: Hedging

➢ Learning Objective 3: Different Techniques Of Managing Exposure

 COUNTRY RISK ANALYSIS
INTRODUCTION
Country risk assessment, also known as country risk analysis, is the
process of determining a nation's ability to transfer payments.

It takes into account political, economic and social factors, and is

used to help organisations make strategic decisions when conducting
business in a country with excessive risk.

Country risk refers to the uncertainty associated with investing in a particular country, and
more specifically the degree to which that uncertainty could lead to losses for investors.

This uncertainty can come from any number of factors including political, economic, exchange-
rate, or technological influences. In particular, country risk denotes the risk that a foreign
government will default on its bonds or other financial commitments increasing transfer risk.
 COUNTRY RISK ANALYSIS
UNDERSTANDING COUNTRY RISK
Country risk is critical to consider when investing in less-developed nations. To the degree that
factors such as political instability can affect the investments in a given country, these risks are
elevated because of the great turmoil that can be created in financial markets. Such country risk
can reduce the expected Return on Investment (ROI) of securities being issued within such
countries, or by companies doing business is such countries.

Investors may protect against some country risks, like exchange-rate risk, by hedging; but other
risks, like political instability, do not always have an effective hedge.

Thus, when analysts look at Sovereign Debt, they will examine the business fundamentals—what is
happening in politics, economics, general health of the society, and so forth—of the country that is
issuing the debt. Foreign direct investment—those not made through a regulated market or
exchange—and longer-term investments face the greatest potential for country risk.
COUNTRY RISK: https://www.investopedia.com/terms/c/countryrisk.asp
 DIFFERENT TYPES OF COUNTRY RISK
1. POLITICAL RISK
Political risk determines a country's political stability, either
internally or externally.
E.g.: military coup/war, corruption etc.

2. SOVEREIGN RISK
There is some crossover between political and sovereign risk,
although the latter – also known as sovereign default risk –
primarily examines debt.
E.g.: government agency refuses to carry out debt refunding
 DIFFERENT TYPES OF COUNTRY RISK
3. NEIGHBOURHOOD RISK
Neighbourhood risk, also known as location risk, may not be the
direct fault of the country with which your clients are dealing,
but instead is caused by trouble elsewhere.

4. SUBJECTIVE RISK
Subjective risk is about attitudes and can include social
pressures and consumer opinions – whether to certain types of
goods or certain types of enterprise.
 DIFFERENT TYPES OF COUNTRY RISK
5. ECONOMIC RISK
Economic risk encompasses a wide range of potential issues
that could lead a country to renege on its external debts or
that may cause other types of currency crisis (i.e.
recession). A major factor here is economic growth.

6. EXCHANGE RISK
Any predicted loss created by sudden changes in exchange rate
are generally covered under the exchange risk factor.
 DIFFERENT TYPES OF COUNTRY RISK
7. TRANSFER RISK
This is where the host government becomes unwilling or
unable to permit foreign currency transfers out of the
nation. Sweeping controls such as these may be a side effect
of a nation in crisis attempting to prevent creditor panic
turning into significant capital outflow.
 TECHNIQUES OF MANAGING EXPOSURE - HEDGING
WHAT IS A HEDGE?
To hedge, in finance, is to take an offsetting position in
an asset or investment that reduces the price risk of an
existing position. A hedge is therefore a trade that is
made with the purpose of reducing the risk of adverse
price movements in another asset.

Hedging is an advanced risk management strategy that involves buying or selling an

investment to potentially help reduce the risk of loss of an existing position.
HEDGING: https://www.investopedia.com/terms/h/hedge.asp
 HEDGING
HEDGING MOST OF THE EXPOSURE
Some MNCs hedge most of their exposure so that their value is not highly influenced by exchange
rates. MNCs that hedge most of their exposure do not necessarily expect that hedging will always be
beneficial.

In fact, such MNCs may even use some hedges that will likely result in slightly worse outcomes than
no hedges at all, just to avoid the possibility of a major adverse movement in exchange rates.
Hedging most of the transaction exposure allows MNCs to more accurately forecast future cash flows
(in their home currency) so that they can make better decisions regarding the amount of financing
they will need.

An MNC will compare the cash flow that would be expected from each hedging technique before
determining which technique to apply. As per the basic rule of hedging, the payables in a currency in
the future should to be hedged with buying in the same currency in the forward, whereas, receivables
in a currency in the future should be hedged with selling the same currency in the forward.
HEDGING
 HEDGING

When an MNC considers hedging transaction exposure, it must identify its degree of
transaction exposure, as discussed in the previous Webinar.

Next, it must consider the various techniques to hedge this exposure so that it can decide
which hedging technique is optimal and whether to hedge its transaction exposure.

The following discussion explains the process by which an MNC identifies the optimal
hedging technique for a particular transaction and determines whether to hedge that
transaction.
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
Transaction exposure arises due to unpredictable movement of exchange rate and the open
positions in assets or liabilities or both.

Therefore, hedging involves entering into a financial counter-transaction to offset the risk
associated with long or short unhedged positions in a foreign currency at a future point in
time.

An MNC can hedge its transaction exposure using the following Important hedging techniques:
❖ Forward contract
❖ Future contract
❖ Money market hedge
❖ Currency option hedge
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
1. Hedging with Forward Contracts:
A forward contract is one where a counterparty agrees to
exchange a specified currency at an agreed price for
delivery on a fixed maturity date. Forward contracts are one
of the most common means of hedging transactions in
foreign currencies.

When a firm has an agreement to pay (receive) a fixed

amount of foreign currency at some date in the future, in
most currencies it can obtain a contract today that specifies
a price at which it can buy (sell) the foreign currency at the
specified date in the future.
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE

2. Hedging with Future Contracts:

Future is a standardized instrument. Therefore, while
hedging with futures one must ensure that the hedge will
not exactly match the transaction in size and maturity.

These are equivalent to forward contracts in function,

although they differ in several important features. Futures
contracts are exchange traded and therefore have
standardized and limited contract sizes, maturity dates,
initial collateral, and several other features.
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
Forward contracts and futures contracts allow an MNC to lock in a specific exchange
rate at which it can purchase a specific currency and, therefore, allow it to hedge
payables denominated in a foreign currency.

A forward contract is negotiated between the firm and a financial institution such as a
commercial bank and, therefore, can be tailored to meet the specific needs of the firm.
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
EXAMPLE: Coleman Co. is a U.S.-based MNC that will need 100,000 euros in one year. It could
obtain a forward contract to purchase the euros in one year. The one-year forward rate is
$1.20, the same rate as currency futures contracts on euros. If Coleman purchases euros one
year forward, its dollar cost in one year is:

The same process would apply if futures contracts were used instead of forward contracts.
The futures rate is normally very similar to the forward rate, so the main difference would be
that the futures contracts are standardized and would be purchased on an exchange, while
the forward contract would be negotiated between the MNC and a commercial bank.
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE

3. Money Market Hedge

A money market hedge involves taking a money market position to cover a future payables or
receivables position. If a firm has excess cash, it can create a simplified money market hedge.

It can also be thought of as a form of financing for the foreign currency transaction.

Money market hedge involves mixing of foreign exchange and money markets to hedge at the
minimum cost. It involves taking advantage of the disequilibrium between money and foreign
exchange market. The importer has two possibilities: to take advantage of interest rate
differentials in the money markets and the premiums and discounts existing in the forward
foreign exchange market.
TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
 TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
4. Hedging with options
Options are similar to forwards but with one key difference. They
give the right but not the obligation to buy or sell currency at some
point in the future at a predetermined rate.
A company can therefore:
• exercise the option if it is in its interests to do so
• let it lapse if:
– the spot rate is more favourable
– there is no longer a need to exchange currency
Options are most useful when there is uncertainty about the timing of the transaction or when
exchange rates are very volatile.

In case of hedging with options, the option is exercised and the hedge comes into operation if the
prices surpass the expectations. This type of hedging is usually resorted when non-performance of
contract is expected.
TECHNIQUES OF MANAGING TRANSACTION EXPOSURE
 Summary

Key points discussed in this session:

➢ Country risk analysis & its Types

➢ How Hedging is connected with Exposure

➢ The various Techniques to manage all three Exposure & how Managing Exposure can
increase MNC’s value
 References
Book References:
➢ International Finance: Theory and Policy, Global Edition-Krugman Paul R; Obstfeld Maurice; Melitz J Marc
➢ International Financial Management, Eleventh Edition by Jeff Madura
➢ International Finance: Fourth Edition by Maurice D. Levi
➢ International Financial Management, Second Edition by Geert Bekaert, Robert Hodrick

E-References:
➢ https://www.investopedia.com/terms/c/countryrisk.asp

➢ https://www.investopedia.com/terms/h/hedge.asp