Unit 4

FOREIGN EXCHANGE RISK AND RISK HEDGING STRATEGIES.

Transaction Risk, Translation Risk, Economic Risk. Risk Hedging Strategies: Internal –
Netting, Leads and Lags. External – Forwards, Futures, Options, Money-market Hedging,
Currency Swaps.

Meaning of Risk

Risk is defined in financial terms as the chance that an outcome or investment's actual gains
will differ from an expected outcome or return. Risk includes the possibility of losing some
or all of an original investment.

Meaning of Risk Management

Risk management refers to the practice of identifying potential risks in advance, analysing
them and taking precautionary steps to reduce/curb the risk.

Types of Risks

• Transaction Risk (Contractual Exposure)

• Translation Risk (Accounting Exposure)
• Economic Risk (Economic Exposure)

Transaction Risk

Unforeseen and unexpected fluctuations in the foreign exchange which will have an impact
on the transaction value.

Transactions from which transaction risk arises-

• Purchase and sale of goods and services on credit.

• When the prices of goods and services are stated.
• Acquiring assets or incurring liabilities denominated in foreign currencies.
• Being a party to an unperformed foreign exchange forward contract.

Types of Transaction Risk

1. Foreign Exchange Risk

Foreign exchange risk is the unforeseen fluctuation of foreign exchange, which can affect the
expected transaction value. This risk is especially important to consider for cross-border
transactions or deals with countries that have relatively high currency volatility. Foreign
Exchange Risk is also called economic exposure.
2. Commodity Risk

Similar to foreign exchange, commodity risk considers the unexpected fluctuation of

commodity prices. While commodity fluctuation affects all sectors, it is a primary
consideration in the Oil & Gas and Mining sectors.

3. Interest Rate Risk

Interest rate risk examines how interest rate fluctuation can affect transaction value.
Depending on the changes in rates, this risk can affect the ability of the purchasing party to
raise the necessary capital for the transaction and can impact the debt obligations of the
selling party. For companies that engage in debt covenant agreements with financial
institutions, interest rate fluctuation can impact the company’s ability to meet its obligations
established in the covenant.

4. Time Risk

As market conditions and companies change with time, there is a higher probability that the
initial transaction agreement conditions will become unfavourable the longer the negotiation
process is extended. As a result, deals can fall through due to the favourable conditions no
longer being present for both parties. The longer a deal takes to finalize, the longer the
transaction is exposed to the other risks.

5. Counterparty Risk

When engaging in transactions, there is a risk that the counterparty will not complete their
contractual obligations agreed upon in the transaction. In instances where counterparties
default on their contractual obligations, it is often due to the effects of the previously stated
transaction risks.

Ways to Manage Transaction Risk

• Refinancing
In a fluctuating interest rate environment, companies often look to refinance their debt
when interest rates are declining. Debt refinancing allows companies to reduce their
debt obligations and to borrow at more attractive rates. To ensure that a party is
eligible for refinancing, the borrowing party can include renegotiation clauses in their
contracts that allow for refinancing adjustments when notable interest rate changes.
• Due Diligence
To reduce the possibility of the counterparty defaulting on their contractual
obligations, parties will undergo an extensive due diligence process to assess various
components of the transaction before coming to an agreement. In situations where the
counterparty has a higher risk of defaulting, the purchasing party may place a default
risk premium into the transaction agreement to create an incentive for taking on more
risk.
Translation Risk

Risk associated with changes in company’s equity, assets, and liabilities as a result of
fluctuation in exchange rates.

The assets and liabilities of an MNC are usually denominated in the currency of county in
which Parent Company is located. The financial statements of subsidiaries in different
countries should be consolidated by parent company to prepare consolidated financial
statement of accounts by converting the statements in parent country currency.

As per the principle of consistency, the company should use the uniform technique of
accounting.

Current/Non-current Method

• Current assets and liabilities having a one-year or lesser maturity are translated at the
current exchange rate.
• Noncurrent assets and liabilities are converted at the past exchange rate that prevailed
when the asset or liability was recorded in the books.
• Under this method, a foreign subsidiary owning current assets in excess of the current
liabilities will incur a translation gain if the local currency appreciates.
• The income items are usually calculated at the prevailing exchange rate.
• While the depreciating items falling under non-current items are calculated at the
historical exchange rate.

Monetary/Nonmonetary Method

• In this method, all monetary balance sheet accounts such as cash, notes payable,
accounts payable and marketable securities of a foreign subsidiary are converted at
the current exchange rate.
• The remaining nonmonetary balance sheet accounts and shareholder’s equity are
converted at the past exchange rate when the account was recorded.
• This method works on the philosophy that monetary accounts are similar as their
value is equivalent to an amount of money, the value of which changes with
fluctuations in exchange rates.
• The monetary/nonmonetary method categorizes accounts on the basis of similarities
of attributes rather than maturities.

Temporal Method

• In the temporal method, monetary accounts, both current and noncurrent, such as
receivables, payables, and cash, are converted at the current exchange rate.
• The other balance sheet accounts, if carried out on the books at current value, are
converted at the current rate.
• However, if they are carried out in the past, they are converted into the historical rate
of exchange that prevailed during that time.
 • Cost of goods sold and depreciation are converted at the historic rates if the balance
sheet accounts associated with it were carried out at historical costs.

Current Rate Method

• Under this method, all balance sheet accounts except for the stockholder’s equity
are converted at the prevailing current exchange rate.
• The income statement items are converted at the existing exchange rate on the
dates the items are recognized.

Hedging translation risk

Currency Swaps

These are a settlement between two entities to exchange cash flows denominated for a
particular currency for a fixed time frame. Currency amounts are swapped for a
predetermined period, and interest is paid during that time span.

Currency Options

The Currency option gives the right to the party to exchange the amount of a particular
currency at an agreed exchange rate. However, the party is not obligated to do so.
Nevertheless, the transactions must be conducted on or before a set date in the future.

There are two types of currency options: calls and puts.

• Buying a call option gives the holder the right to buy a currency pair for the strike
price on or before the expiry date,.
• Buying a put option gives the holder the right to sell a currency pair for the strike
price on or before the expiry date.

Forward Contracts

Under the forward contracts, two entities fix a specific exchange rate to interchange two
currencies for a future date. The settlement for the agreed amount of currencies is conducted
on a particular future date which is pre-decided.
Economic Risk

Economic risk also called operating exposure, is a measure of the change in the future cash
flows of a company as a result of unexpected changes in foreign exchange rates.

Effects of Economic Exposure

Since unanticipated rate changes affect a company’s cash flows, economic exposure can
result in serious negative consequences for the company’s operations and profitability. A
stronger foreign currency may make production inputs more expensive, causing decreased
profits.

Furthermore, economic exposure can undermine the company’s competitive position. For
example, if the local currency strengthens, local manufacturers will face more intense
competition from foreign manufacturers whose products will become cheaper.

Mitigation of Economic Exposure

There are two main strategies to mitigate economic exposure: operational and currency risk
mitigation.

Operational strategy- Operational strategy is aiming to adjust or change the current

company’s operations to prevent possible risks associated with future currency fluctuations.
The operational mitigation strategy may involve the following steps:

• Diversification of production facilities and markets of products: The expansion of

operating facilities and sales to a mixture of markets.
• Sourcing flexibility: A company considers the acquisition of its key inputs from
different regions.
• Diversification of financing: A company may seek financing from capital markets in
different regions.

Currency risk mitigation strategy- The main goal of the currency risk mitigation strategy is
to minimize or eliminate economic exposure through hedging. Some of the currency risk
mitigation strategies are:

• Matching currency flows: A company matches the foreign currency outflows with
foreign currency inflows.
• Currency risk-sharing agreements: A company enters into a currency risk-sharing
agreement with its supplier/customer. According to this agreement, the sale/purchase
contract is executed at a predetermined price. Thus, both parties share the potential
currency risk.
• Currency swaps: A company can use currency swaps to obtain the required cash
flows in foreign currency at the desired exchange rate. The counterparties will
exchange the interest and principal in one currency for the same in another currency at
fixed dates until the maturity of the swap.
 Point of Difference Transaction Risk Operational Risk
Cash Flow Transaction exposure is Operational Risk is
driven by transactions that transaction exposure as well
have already been contracted as operating exposure which
for, and hence they are of a is related to future cash
short-term nature. flows.
The risk associated impacts
the core value of a business
The risk associated is limited rather than one particular
Nature of Risk to the contract or transaction transaction or contract and is
under discussion. the risk to the present value
of future operating cash
flows.
Transaction risk is the most Given its anticipatory nature,
Identification easily identifiable foreign economic exposure is not
exchange risk easy to identify
Transaction exposure arises Economic exposure can arise
only when you enter into a without having any
Cause and Scope contract involving future transaction exposure, and
receivables/payables in hence the scope remains
foreign currency. Hence the wide.
scope remains narrow.
Transaction exposure is more Economic exposure is linked
Characteristics technical and tactical in to a firm’s strategy and hence
nature is fundamental in nature
Most firms seldom apply any
hedging strategy for
Transaction exposures are managing economic
Hedging Application hedged more frequently by exposure and believe in
most companies. natural hedging.

Types of hedging

• Internal Hedging
• External Hedging

Internal Hedging - Internal hedging strategies are strategies that companies can adopt using
resources that are available to them within their business.

Internal hedging techniques-

➢ Netting
➢ Leads and Lags
➢ Price Variation
➢ Invoicing in foreign currency
➢ Asset Liability Management

Netting - A method of reducing credit, settlement and other risks of financial contracts by
aggregating (combining) two or more obligations to achieve a reduced net obligation.
Types of netting

Bilateral netting: Netting refers to offsetting of all claims arising from dealings between two
parties, to determine a net amount payable or receivable from one party to other.

Multilateral Netting - it involves settling the financial obligation among multiple parties. In
this method, a central exchange or unit acts as a liaison between the parties involved to
ensure proper regulation of transactions. Companies with multiple subsidiaries prefer this
method to settle payment disputes and ensure the smooth running of the business.

Leads and lags-

Leads and lags in international business usually refer to the deliberate acceleration or
delaying of payments due in a foreign currency in order to take advantage of an expected
change in currency exchange rates.

Leads refer to accelerating the payment when the payer expects depreciation of currency
against another currency in the future.

Lags refer to delaying the payment and extending till the last day of expiry of the contact
when the payer predicts future appreciation in the value of currency against another currency.

Price Variation - It involves increasing selling prices to counter exchange rate fluctuations
through insertion of Indexation Clauses.

Invoicing in foreign currency Choosing an external currency which is standard or a strong

currency as the mode of settling the transaction.

Asset Liability Management It is used to manage balance sheet, income statement or cash
flow exposures by aggressively shifting cash inflows into currencies expected to be strong or
increase exposed cash outflows denominated in weak currencies. Alternatively, a firm may
practice defensive approach, matching of cash inflows and outflows according to currency
denomination, irrespective of whether they are in strong or weak currencies.
External Hedging -Hedging FX transactions through an external third party through forward
trades and option trades.

External hedging techniques are

• Forwards
• Futures
• Options
• Swaps

Currency Forwards- A currency forward is a tailor made and customized agreement that
allows the buyer to lock in an exchange rate the day on which the agreement is made for a
future date. Currency forwards are traded over-the-counter (they are not traded on a central
exchange).

Currency Futures- Futures contracts are standardized contact to exchange one currency for
another at a specified date in the future at a price (exchange rate) that is fixed on the date of
agreement.

Difference between currency forwards and futures

Basis Currency futures Currency forwards

Meaning A futures contract is a A forward contract is a
standardized contract that private agreement between
trades on a futures exchange. two individuals or entities.
Type of Contract A futures contract is a Forwards contract is a
standardized contract customized or tailor-made
contract.
Traded in Futures contracts trade on Forwards contact, on the
recognized stock exchanges. other hand, trade OTC (over
the counter).
Settlement Settlement on Futures Forward’s contract, it is on
contracts is on a daily basis. the maturity date.
Risk risk factor is low risk factor is high
Chances of Default Futures contracts trade on Forwards contracts are
popular stock exchanges private agreements.
Size of Contract Futures market, the contracts Forwards market, the size of
are standardized. size of the the contract varies on the
contract is fixed. basis of contract terms.
Regulation Futures contracts trade on Forwards contract, on the
popular stock exchanges, other hand, is self-regulated.
they are regulated by the
stock exchange.
Suitability Traders can use futures On the other hand, forward
contracts for speculation contracts serve both hedging
purposes. and speculation purposes.
Liquidity in the futures market makes it better than the forwards market. Also, transparency
and regulations in the futures market make it less risky and more secure for investors.

Currency Options- A currency option (also known as a forex option) is a contract that gives
the buyer the right, but not the obligation, to buy or sell a certain currency at a specified
exchange rate on or before a specified date. For this right, a premium is paid to the seller.

There are two types of currency options – the put option and the call option.

• Put option gives you the right but not the obligation to sell currency at a specific
price on a certain date.
• Call option, which gives you the right to buy currency at a certain rate at a specific
price on a certain date.

International Money Market

The international money market can be regarded as the market for short term financing and
investment instruments that are issued or traded internationally.

Functions of Money Market

• Short Term Funds for Banks and Private Entities
• Short Term Funds for Governments
• Helps In Implementing Monetary Policy Implementation
• Promotes Liquidity
• Promotes Utilization of Funds Across Sectors
• Financing International Trade

Money Market Hedging

A money market hedge is a technique for hedging foreign exchange risk using the money
market, the financial market in which highly liquid and short-term instruments. It is a
technique used to lock in the value of a foreign currency transaction in a company's domestic
currency.
The money markets involve the lending and borrowing of money.
So, a money market hedge involves lending or borrowing in the money market to hedge
foreign currency risk.

Currency Swaps-

A currency swap contract (also known as a cross-currency swap contract) is a derivative

contract between two parties that involves the exchange of interest payments, as well as the
exchange of principal amounts in certain cases, that are denominated in different currencies.
Although currency swap contracts generally imply the exchange of principal amounts, some
swaps may require only the transfer of the interest payments.

Types of currency swaps include the following:

• Fixed vs. Float: One leg of the currency swap represents a stream of fixed interest
rate payments while another leg is a stream of floating interest rate payments.
• Float vs. Float (Basis Swap): The float vs. float swap is commonly referred to as
basis swap. In a basis swap, both swaps’ legs both represent floating interest rate
payments.
• Fixed vs. Fixed: Both streams of currency swap contracts involve fixed interest rate
payment.