International Business Finance

Chapter 3:
Management of Foreign Exchange
Exposure and Risk

By
Dr.Takele Fufa

1 January 2024
 Managing foreign exchange risk

 When the parties associated with a

commercial transaction are located in the
same country, the transaction is denominated
in a single currency.
 International transactions inevitably involve
more than one currency (because the parties
are residents of different countries).

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  Since most foreign currency values fluctuate
from time to time, the

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 However, foreign exchange gains and losses
resulting from international transactions,
which reflect transaction exposure, are
shown in the income statement for the current
period.
As a consequence of these transactional gains
and losses, the volatility of reported earnings
per share increases.

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 Three different strategies can be used to
minimize this transaction exposure.
1. Hedging in the forward exchange market.
2. Hedging in the money market.
3. Hedging in the currency futures market.

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  monetary value of an international
transaction measured in either the seller’s
currency or the buyer’s currency is likely to
change when payment is delayed.
 As a result, the seller may receive less
revenue than expected or the buyer may
have to pay more than the expected amount
for the merchandise.

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 Thus the term foreign exchange risk refers
to the possibility of a drop in revenue or an
increase in cost in an international transaction
due to a change in foreign exchange rates.
Importers, exporters, investors, and
multinational firms are all exposed to this
foreign exchange risk.

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 The international monetary system has
undergone a significant change over the
last 40 years.
The free trading Western nations basically
went from a fixed exchange rate system to a
“freely” floating rate system.

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 For the most part, the new system has proved
its agility and resilience during the most
t u r b u l e n t y e a r s of o i l p r i c e h i k e s a n d
hyperinflation of the last two decades.

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 The free market exchange rates have
responded and adjusted well to these adverse
conditions.
Consequently, the exchange rates have
fluctuated over a much wider range than
before.

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 The increased volatility of exchange markets
has forced many multinational firms, importers,
and exporters to pay more attention to the
function of foreign exchange risk management.

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 The foreign exchange risk of a multinational
company is divided into two types of exposure.
They are: accounting or translation exposure
and transaction exposure.
An MNC’s foreign assets and liabilities, which
are denominated in foreign currency units, are
exposed to losses and gains due to changing
exchange rates. This is called accounting or
translation exposure.
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 The amount of loss or gain resulting from this
form of exposure and the treatment of it in
the parent company’s books depend on the
accounting rules established by the parent
company’s government.
In the United States, the rules are spelled out
in the Statement of Financial Accounting
Standards (SFAS) No. 52.

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 U n d e r S F A S 52 a l l f o r e i g n t h e r a t e of
exchange in effect on the date of balance
sheet preparation.
An unrealized translation gain or loss is held in
an equity reserve account while the realized
gain or loss is incorporated in the parent’s
consolidated income statement for that period.

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 Thus SFAS 52 partially reduces the impact of
accounting exposure resulting from the
translation of a foreign subsidiary’s balance
sheet on reported earnings of multinational
firms.

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  Forward Exchange Market Hedge
 To see how the transaction exposure can be
covered in forward markets, suppose
Electricitie de France, an electric company
in France, purchases a large generator from
the General Electric Company of the United
States for 822,400 euros on February 21,
2006, and GE is promised the payment in
euros in 90 days.
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 Since GE is now exposed to exchange rate risk
by agreeing to receive the payment in euros in
the future, it is up to General Electric to find
a way to reduce this exposure.
One simple method is to hedge the exposure in
the forward exchange market with a 90-day
forward contract.

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 On February 21, 2006, to establish a forward
cover, GE sells a forward contract to deliver
the 822,400 euros 90 days from that date in
exchange for $1,000,000.
On May 22, 2006, 2 GE receives payment from
E l e c t r i c i t i e de F r a n c e and d e l i v e r s the
822,400 euros to the bank that signed the
c o n t r a c t . In r e t u r n the bank de l i ve rs
$1,000,000 to GE.
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 Money Market Hedge A second way to have
eliminated transaction exposure in the
previous example would have been to borrow
money in euros and then convert it to U.S.
dollars immediately.
When the account receivable from the sale is
collected three months later, the loan is
cleared with the proceeds. In this case GE’s
strategy consists of the following steps.
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 On February 21, 2006:
1. B o r r o w 8 0 6 , 2 7 5 e u r o s — ( 8 2 2 , 4 0 0
euros/1.02) = 806,274.51 euros—at the
rate of 8.0 percent per year for three
months.
You will borrow less than the full amount of
822,400 euros in recognition of the fact that
interest must be paid on the loan.

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 Eight percent interest for 90 days translates
into 2.0 percent. Thus 822,400 euros is divided
by 1.02 to arrive at the size of the loan before
the interest payment.
2.Convert the euros into the U.S. dollars in the
spot market. Then on May 22, 2006 (90 days
later):
3.Receive the payment of 822,400 euros from
Electricitie de France.
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 4. Clear the loan with the proceeds received
from Electricitie de France.
The money market hedge basically calls for
matching the exposed asset (account
receivable) with a liability (loan payable) in the
same currency.
Some firms prefer this money market hedge
because of the early availability of funds
possible with this method.
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 Currency Futures Market Hedge Transaction
exposure associated with a foreign currency
can also be covered in the futures market with
a currency futures contract.
The International Monetary Market (IMM) of
the Chicago Mercantile Exchange began trading
in futures contracts in foreign currencies on
May 16, 1972.

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 Trading in currency futures contracts also
made a debut on the London International
Financial Futures Exchange ( LIFFE) in
September 1982.
Other markets have also developed around the
world. Just as futures contracts are traded in
corn, wheat, hogs, and beans, foreign currency
f u t u r e s c o n t r a c t s a r e t r a d e d in t h e s e
markets.
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 Although the futures market and forward
market are similar in concept, they differ in
their operations.
To illus tra te the hedging proc e s s in the
currency futures market, suppose that in May
Bank of America considers lending 500,000
pesos to a Mexican subsidiary of a U.S. parent
company for seven months.

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 The bank purchases the pesos in the spot
market, delivers them to the borrower, and
simultaneously hedges its transaction exposure
by selling December contracts in pesos for the
same amount.
In December when the loan is cleared, the
bank sells the pesos in the spot market and
buys back the December peso contracts.

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 The transactions are illustrated for the spot and
futures market in Table 21–3 :

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  While the loan was outstanding, the peso
declined in value relative to the U.S. dollar.
 Had the bank remained unhedged, it would
have lost $1,950 in the spot market.
 By hedging in the futures market, the bank
was able to reduce the loss to $1,300.
 A $650 gain in the futures market was used
to cancel some of the $1,950 loss in the spot
market.
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 These are not the only means companies have
for protecting themselves against foreign
exchange risk.
Over the years, multinational companies have
developed elaborate foreign asset management
programs, which involve such strategies as
switching cash and other current assets into
strong currencies, while piling up debt and
other liabilities in depreciating currencies.
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 Companies also encourage the quick collection
of bills in weak currencies by offering sizable
discounts, while extending liberal credit
in strong currencies.

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 Aims and Methods of Exchange
control

 The important purposes of exchange control are

– To Conserve Foreign Exchange
– To Check Capital Flight
– To Improve Balance of Payments
– To Curb Conspicuous Consumption
– To make Possible Essential Imports
– To Protect Domestic Industries
– To Check Recession-induced Exports into the
Country
32 – To regulate foreign companies.
 Aims and Methods of Exchange
control

The important purposes of exchange control are

– To regulate Export and Transfer of Securities
– Facilitate Discrimination and Commercial Bargaining
– Enable the Government to Repay Foreign Loans
– To Lower the Price of National Securities held
Abroad
– To Freeze Foreign Investments and Prevent
Repatriation of Funds
– To Obtain Revenue

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 Aims and Methods of Exchange
control

 The various methods of exchange control may be

broadly classified into
– (1) Unilateral methods and
– (2) Bilateral/multilateral methods.

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 Unilateral Methods

 Unilateral measures refer to those methods

which may be adopted by a country
unilaterally i.e., without any reference to or
understanding with other countries. The
important unilateral methods are outlined
below. Regulation of Bank Rate A change in
the bank rate is usually followed by changes
in all other rates of interest and this may
affect the flow of foreign capital.
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 Unilateral Methods

 For example, when the internal rates of

interest rise, foreign capital is attracted to
the country.
 This causes an increase in the supply of
foreign currency and the demand for
domestic currency in the foreign exchange
market and results in the appreciation of
the e x t e r n a l v a l u e of the c u r r e n c y . A
lowering of the bank rate is expected to
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 Bilateral/Multilateral Methods

 The important bilateral/multilateral

methods are the following:
 Private Compensation Agreement Under this
method, which closely resembles barter, a
firm in one country is required to equalise
its exports to the other country with its
imports from that country so that there will
be neither a surplus nor a deficit.

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 Bilateral/Multilateral Methods

 Clearing Agreement Normally, importers

have to make payments in foreign currency
and while exporters are paid in foreign
currency.
 Under the clearing agreement, however,
importers make payments in domestic
currency to the clearing account and
exporters obtain payments in domestic
currency from the clearing fund.
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 Bilateral/Multilateral Methods

 Thus, under the clearing agreement, the

importer does not directly pay the exporter
and hence, the need fore foreign exchange
does not arise, except for settling the net.
balance between the two countries.
 Standstill Agreement
– The standstill agreement seeks to provide
debtor country.

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 Bilateral/Multilateral Methods

 preventing the movement of capital out of

the county through a moratorium on the
outstanding short- term foreign debts
Payments Agreement Under the payments
agreement, concluded between a debtor
country and a creditor country, provision is
made for the repayment of the principal and
i n t e r e s t by the d e b t o r c o u n t r y to the
creditor country.
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 Exposure Categories:

 Transaction exposure;
 Translation exposure and;
 Economic exposure

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 Transaction exposure

 Transaction exposure is the exchange

gains and losses that arise from the
settlement ( conversion) of foreign
currency transactions.
 Unlike translation gains and losses,
transaction gains and losses have a direct
effect on cash flows as they result from
a currency conversion process.
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 Translation exposure

 Translation exposure is measuring the

parent currency effects of foreign
exchange changes on foreign currency
assets, l iabilities, revenues, and
expenses.

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 Economic Exposure

 Economic exposure is the effect of

foreign exchange rate changes on a
firm’s future costs and revenues.

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 Managing Foreign Exchange Risk

 Foreign Exchange Risk refers to the risk involved in

fluctuating exchange rates
 It affects importers, exporters, investors,
multinational corporations
 Some Strategies for Dealing with Foreign Exchange
Risk:
–Forward Exchange Market Hedge
–Money Market Hedge
–Currency Futures Market Hedge
–Options Market Hedge
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 Managing foreign exchange
exposure

1. Determining specific foreign exchange exposures:

 By currency and amounts (where possible)
2. Exchange rate forecasting:
 Determining the likelihood of “adverse” currency
movements.
3. Assessing the impact of the forecasted
exchange rates on company’s home currency
equivalents
 Impact on earnings, cash flow, liabilities…

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 Managing foreign exchange
exposure

4. Deciding whether to hedge or not:

 Determine whether the anticipated impact of the
forecasted exchange rate change merits the need
to hedge.
5. Selecting the appropriate hedging instruments:
 What is important here are:
 Firm’s desire for flexibility.
 Cost involved with financial contracts.
 The type of exposure the firm is dealing with.

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