International Financial Management

P G Apte

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3.1 The Nature of Exposure and
Risk
❆ Macroeconomic environmental risks
❆ Core business risks
❆ While core business risks are specific to a firm,
macroeconomic uncertainties affect all firms in the
economy
❆ Extent and nature of impact of even
macroeconomic risks crucially depend upon the
nature of a firm's business

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3.1 The Nature of Exposure and
Risk (contd.)
❆ The firm is "exposed" to uncertain changes in a
number of variables in its environment - Risk
Factors
❆ Long run response of the firm to these risks can
involve significant changes in the firm's strategic
posture
❆ Exchange rates and interest rates are two of the
key macroeconomic risk factors

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3.1 The Nature of Exposure and
Risk (contd.)
✸ Exchange rates, interest rates and inflation rates
are intimately interrelated
✸ Exposure and Risk
❆ Exposure is a measure of the sensitivity of the
value of a performance measure to changes in
the relevant risk factor
❆ risk is a measure of the variability of the value
of the performance measure attributable to the
risk factor

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3.1 The Nature of Exposure and
Risk (contd.)
❆ The magnitude of risk is determined by the
magnitude of exposure and the degree of
variability in the relevant risk factor e.g.
❆ Exchange rate risk depends on how sensitive is the
performance indicator to exchange rate
fluctuations and what is the extent of likely
fluctuations in the exchange rate.

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3.3 Exposure and Risk: A Formal
Approach
✸ Exposure of a firm to a risk factor is the sensitivity
of the real value of a firm's assets, liabilities or
operating income, expressed in its functional
currency, to unanticipated changes in the risk
factor
❆ Values of assets, liabilities or operating income
are to be denominated in the functional
currency of the firm

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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Exposure is defined with respect to the real
values
❆ The definition stresses that only unanticipated
changes in the relevant risk factor are to be
considered (The reason is that the firm will
have already made an allowance for
anticipated changes)

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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Consider the following notation
– ∆V : Change in the real domestic currency
value of an item
– S : The current value of the risk factor
∆Su : Unanticipated change in the value of the
risk factor e.g. exchange rate
❆ In Figures 3.5 and 3.6 we have plotted ∆V, on the
vertical axis and ∆Su, on the horizontal axis

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3.3 Currency Exposure: A Foreign
Currency Liability

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3.3 Currency Exposure: A Foreign
Currency Asset

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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ The relation between ∆V and ∆Su can be
represented by the following equation
∆V = β0 + β1(∆Su)
β1 is a measure of the sensitivity of V to changes
in S – “Exposure”
∆V is in million rupees and ∆Su is in rupees per
dollar, the units of measurement for the
exposure, β1, are millions of dollars
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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ When the foreign currency value of the exposed
item is contractually fixed, exposure identically
equals that value
❆ When foreign currency value itself is subject to
change, we have a more difficult situation. For
instance, impact of currency fluctuations on future
export volumes, prices, foreign currency revenues
and operating margins.

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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ In the case of items whose values are not
contractually fixed in foreign currency and are
subject to influences other than exchange rate an
exact measure of exposure cannot be arrived at.
Instead we must have a stochastic relation
∆V = β0 + β1(∆Su) + ε
– The symbol ε denotes a random variable which
represents the combined influence on ∆V of
factors other than unanticipated exchange rate
changes
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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ In practice it may be quite difficult to obtain
estimates of changes in real domestic currency
values of exposed items

❆ Estimation of exposure requires that the finance

manager should construct alternative scenarios of
exchange rates, interest rates and inflation rates
and examine the impact of each combination on
the various items in the firm's balance sheet and
projected income statement
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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Risk is the variance of the real domestic currency
value of assets, liabilities or operating income
attributable to unanticipated changes in exchange
rates
∆Vs = β0 + β1(∆Su)
∆Vs is the change in value attributable to
unanticipated change in the exchange rate
❆ Foreign exchange risk is defined as the variance of
∆Vs
var(∆Vs) = β12[var(Su)]
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3.3 Exposure and Risk: A Formal
Approach (contd.)

❆ A firm has a 90-day payable of 100,000 Swiss

francs. The current spot rate is Rs.28.00/SFr. The
90-day forward rate is Rs.28.50. The spot rate 90-
days hence is assumed to have a normal
distribution with a mean of Rs.28.50 and a
standard deviation of Rs.0.05.

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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Denote the spot rate by S0, and the spot rate 90-
days from today by S3. The total change in
exchange rate from today to 90-days from today is
(S3 - S0). This can be broken down into
S3 - S0 = [S3 - E(S3)] + [E(S3) - S0] = ∆Su + ∆Sa
E(S3) means "expected value of S3"
∆Su is the unanticipated component of the change
and ∆Sa is the anticipated component
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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Suppose the spot rate 90 days hence is 28.90

❆ The total change is Rs.0.90 (S3-S0), anticipated

change is 0.50 [E(S3)-S0] and unanticipated change
is 0.40 [S3-E(S3)]

❆ Since S3 has a normal distribution with mean

28.50 and standard deviation Rs.0.05, [S3 - E(S3)]
will have a normal distribution with mean zero
and standard deviation of Rs.0.05
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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Since the unanticipated change in the rupee value
of the payable is given by 100000(∆Su), it will
also have a normal distribution with mean zero
and standard deviation of Rs.5000
❆ One can say with 95% confidence that the
unanticipated change in the value of the payable
will lie between -10000 and +10000.

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3.3 Exposure and Risk: A Formal
Approach (contd.)
❆ Instead of variance, one can estimate the possible
range i.e. the difference between the highest and
lowest values of the item given certain
assumptions about the possible range of variation
in the exchange rate
❆ One can construct alternative scenarios of
exchange rate movements
❆ The "best case" and the "worst case" scenarios

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)
F ig u r e 3 . 9
T h e T a x o n o m y o f C u rre n c y E x p o s u re

C u rre n c y E x o p s u re

S h o rt T e rm L o n g T e rm

C a s h F lo w A c c o u n t in g S t r a t e g ic O p e r a t in g
( T r a n s la t io n )

C o n tra c tu a l A n t ic ip a t e d
( T r a n s a c t io n s )

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)

❆ Transactions Exposures result from an

unanticipated change in the exchange rate which
has an impact - favorable or adverse - on the
firm’s cash flows during the upcoming accounting
period. Most often, the term is used to denote
exposures on items the foreign currency values of
which are contractually fixed – export receivables,
import payables, interest payable etc.

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)

❆ Transaction risk can be defined as a measure of

variability in the value of assets and liabilities
when they are liquidated
❆ Points to be noted are
❆ Transactions exposures usually have short time
horizons;
❆ Operating cash flows are affected; exchange
gains/losses have tax implications

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)
• Anticipated cash flow exposure is the case when
a transaction is being negotiated, all the terms
have been more or less finalized but a contractual
arrangement is yet to be entered into
• Translation Exposure also called Balance Sheet
Exposure: It is the exposure on assets and
liabilities appearing in the balance sheet but which
are not going to be liquidated in the foreseeable
future

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)
Translation exposure arises when a firm has
❆ A foreign operation such as a branch, a joint venture or
100% subsidiary in a foreign currency.
❆ The home country law requires that the parent must
translate financial statements of foreign operations from
foreign to home currency and consolidate with parent
financial statements.
❆ Foreign currency fluctuations lead to translation gains
or losses. No cash flow implications
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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)

❆ Two relevant considerations:

- What rate to use for translation – current, historical,
average?
- how to report translation gains/losses?
❆ Finance theorists argue that translation losses and
gains are only notional accounting losses and
gains. No cash flow impact. Published financial
statements are affected.

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 Translation Methods
❆ For translating a foreign entity's balance sheet into
the parent's currency of reporting various methods
can be followed
•Closing rate method uses the rate prevailing on the
parent's balance sheet date
•Current-non current method uses the closing rate for
current assets and liabilities and historical rates for non-
current assets and liabilities
•Monetary-non monetary method translates monetary
assets and liabilities at the closing rate while non- monetary
assets and liabilities such as inventories are translated at
historical rates
•Temporal method – current rate for items reported at
current market value; historical rate otherwise.
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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)
❆ Exchange rate impact on future revenues, costs,
operating cash flows – operating exposure
❆ In the long run, exchange rate effects can even
undermine a firm's competitive advantage by
raising its costs above those of its competitors or
affecting its ability to service its market in other
ways
❆ Such competitive exposure is often referred to as
"Strategic Exposure" because it has significant
implications for some strategic business decisions
such as choice of markets, sourcing, location etc.
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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)

❆ Even if a firm has no direct involvement in any

cross-border transactions it is not immune to
exchange rate exposure
❆ “Indirect" exposure is also in the nature of
operating exposure faced by the firm where
changes in exchange rates will most likely have an
impact on its customers, suppliers and competitors
which in turn will force the firm to alter its
operations and strategies

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)
❆ An alternative but similar in spirit approach to
classification of currency exposure focuses on the
length of the time horizon and whether or not the
exposure impacts on the end-of-the horizon
financial statements
– Accounting exposure is used for short-term
exposures which will have an impact on the
financial results

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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)

❆ Operating exposure is defined as the sensitivity

of future operating profits to unanticipated
changes in the exchange rate and is horizon is
medium term
❆ Strategic exposure refers to a still longer
horizon and contemplates longer-term
operational flexibility such as changing
product-market mix, shifting location of
operations and adopting new technologies
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3.4 Classification of Foreign Exchange
Exposure and Risk (contd.)

❆ “Value-based" exposure which focuses on the

impact of currency fluctuations on market value
of the firm that takes into account both short-
term accounting exposures as well as operating
and strategic flexibility in responding to
currency movements

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3.5 Accounting Treatment of Transaction
and Translation Exposure (contd.)

❆ Apart from the transparency and information

content of the financial statements, the key
consideration in choosing the accounting
treatment of transaction and translation exposures
is its tax implications for the company as whole

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3.7 Interest Rate Exposure and
Risk
❆ An adverse movement in interest rates hurts the
firm by either increasing the cost of borrowing or
by reducing the return on investment or producing
capital losses on its asset portfolio

❆ For most Indian companies the idea of interest rate

risks is relatively new because of administered
rates and fragmented, compartmentalized capital
markets

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3.7 Interest Rate Exposure and
Risk
❆ With increasing recourse to external commercial
borrowings, Indian companies have had to
recognize and learn to manage interest rate risk
❆ Indian financial system has been moving in the
direction of market determined interest rates
❆ RBI has used tight money policies to counter
weakness of the rupee thus underlining the fact
that financial risk factors are often correlated

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