Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

Management of Foreign Exchange Exposure

and Risk
Dr. Ch. Venkata Krishna Reddy
Associate Professor
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Session Plan

• Management of Foreign Exchange Exposure and Risk

– An Overview of Foreign Exchange Exposure and Risk
– Types of Exposure
• Transaction Exposure
• Economic Exposure
• Translation Exposure

Dr. Ch. Venkata Krishna Reddy

04/05/2021 International Financial 2
Management
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Foreign Exchange Exposure

• Exchange rates are very volatile. Consequently, the

dollar value of an MNC’s future payables or receivables
position in a foreign currency can change substantially
in response to exchange rate movements.
• Which may positive or negative impact on firm
profitability
Dr. Ch. Venkata Krishna Reddy
04/05/2021 International Financial 3
Management
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Types of Exposure
• Transaction Exposure
• Economic Exposure
• Translation Exposure

Dr. Ch. Venkata Krishna Reddy

04/05/2021 4
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Transaction exposure
Transaction exposure- is the sensitivity of the
firm’s contractual transactions in foreign
currencies to exchange rate movements.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 5
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Economic exposure
Economic exposure-sensitivity of the firm’s
cash flows to exchange rate movements.
Eg. Impact of a stronger ETB on export
earnings.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 6
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Translation exposure

Translation exposure-exposure of the

MNC’s consolidated financial statements
to exchange rate fluctuations.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 7
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Managing Transaction exposure

Transaction exposure
Futures hedge-for small transactions
Forward hedge-for large transactions
Money market hedge
Currency option hedge

Dr. Ch. Venkata Krishna Reddy

04/05/2021 8
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Definition of a Forward Contract

• A forward contract is an agreement between
two parties that calls for the delivery of an asset
on a specified future date at a price that is
negotiated at the time of entering into the
contract.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 9
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Forward Contracts (Cont…)

• Every forward contract has a buyer and a seller.
• The buyer has an obligation to pay cash and take
delivery on the future date.
• The seller has an obligation to take the cash and
make delivery on the future date.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 10
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Definition of a Futures Contract

• A futures contract too is a contract that calls for the delivery
of an asset on a specified future date at a price that is fixed
at the outset.
• It too imposes an obligation on the buyer to take delivery
and on the seller to make delivery.
• Thus it is essentially similar to a forward contract.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 11
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Forward versus Futures

• Yet there are key differences between the two types of
contracts.
• A forward contract is an Over-the-Counter or OTC contract.
• This means that the terms of the agreement are negotiated
individually between the buyer and the seller.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 12
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Forward vs. Futures (Cont…)

• Futures contracts are however traded on organized futures
exchanges, just the way common stocks are traded on
stock exchanges.
• The features of such contracts, like the date and place of
delivery, and the quantity to be delivered per contract, are
fixed by the exchange.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 13
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Forward vs. Futures (Cont…)

• The only job of the potential buyer and seller
while negotiating a contract, is to ensure that
they agree on the price at which they wish to
transact.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 14
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Options
• An options contract gives the buyer the right to transact
on or before a future date at a price that is fixed at the
outset.
• It imposes an obligation on the seller of the contract to
transact as per the agreed upon terms, if the buyer of the
contract were to exercise his right.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 15
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Rights
• What is the difference between a Right and an
Obligation.
• An Obligation is a binding commitment to perform.
• A Right however, gives the freedom to perform if
desired.
• It need be exercised only if the holder wishes to do so.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 16
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Rights (Cont…)
• In a transaction to trade an asset at a future date,
both parties cannot be given rights.
• For, if it is in the interest of one party to go through
with the transaction when the time comes, it
obviously will not be in the interest of the other.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 17
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Rights (Cont…)
• Consequently while obligations can be imposed on both the
parties to the contract, like in the case of a forward or a
futures contract, a right can be given to only one of the two
parties.
• Hence, while a buyer of an option acquires a right, the seller
has an obligation to perform imposed on him.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 18
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Options (Cont…)
• We have said that an option holder acquires a right to
transact.
• There are two possible transactions from an investor’s
standpoint – purchases and sales.
• Consequently there are two types of options – Calls and
Puts.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 19
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Options (Cont…)
• A Call Option gives the holder the right to acquire the
asset.
• A Put Option gives the holder the right to sell the asset.
• If a call holder were to exercise his right, the seller of the
call would have to make delivery of the asset.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 20
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Options (Cont…)
• If the holder of a put were to exercise his right, the seller
of the put would have to accept delivery.
• We have said that an option holder has the right to
transact on or before a certain specified date.
• Certain options permit the holder to exercise his right
only on a future date.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 21
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Options (Cont…)
• These are known as European Options.
• Other types of options permit the holder to
exercise his right at any point in time on or before
a specified future date.
• These are known as American Options.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 22
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Longs & Shorts

• The buyer of a forward, futures, or options contract is known as the
Long.
• He is said to have taken a Long Position.
• The seller of a forward, futures, or options contract, is known as the
Short.
• He is said to have taken a Short Position.
• In the case of options, a Short is also known as the option Writer.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 23
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Comparison of Futures/Forwards versus

Options
Instrument Nature of Long’s Nature of Short’s
Commitment Commitment
Forward/Futures Obligation to buy Obligation to sell
Contract
Call Options Right to buy Obligation to sell

Put Options Right to sell Obligation to buy

Dr. Ch. Venkata Krishna Reddy
04/05/2021 24
International Financial Management
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Swaps
• A swap is a contractual agreement between
two parties to exchange specified cash flows
at pre-defined points in time.
• There are two broad categories of swaps –
Interest Rate Swaps and Currency Swaps.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 25
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Interest Rate Swaps

• In the case of these contracts, the cash flows being exchanged,
represent interest payments on a specified principal, which are
computed using two different parameters.
• For instance one interest payment may be computed using a fixed
rate of interest, while the other may be based on a variable rate
such as LIBOR( London Inter Bank Operation Rate).

Dr. Ch. Venkata Krishna Reddy

04/05/2021 26
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Interest Rate Swaps (Cont…)

• There are also swaps where both the interest
payments are computed using two different variable
rates – For instance one may be based on the LIBOR
and the other on the Prime Rate of a country.
• Obviously a fixed-fixed swap will not make sense.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 27
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Interest Rate Swaps (Cont…)

• Since both the interest payments are denominated in the
same currency, the actual principal is not exchanged.
• Consequently the principal is known as a notional principal.
• Also, once the interest due from one party to the other is
calculated, only the difference or the net amount is
exchanged.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 28
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Currency Swaps
• These are also known as cross-currency swaps.
• In this case the two parties first exchange principal
amounts denominated in two different currencies.
• Each party will then compute interest on the amount
received by it as per a pre-defined yardstick, and
exchange it periodically.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 29
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Currency Swaps (Cont…)

• At the termination of the swap the principal amounts
will be swapped back.
• In this case, since the payments being exchanged are
denominated in two different currencies, we can have
fixed-floating, floating-floating, as well as fixed-fixed
swaps.
Dr. Ch. Venkata Krishna Reddy
04/05/2021 30
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Currency forward contract

 agreement between buyer and seller to trade
currencies at a specific rate on a specific date
Currency future contract
 similar to forward contract, except that it is
traded in an organized exchange
 indemnity is available in case of default
Dr. Ch. Venkata Krishna Reddy
04/05/2021 31
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps:

• Borrow the foreign currency in an amount equivalent to the present value of the receivable.
Why the present value? Because the foreign currency loan plus the interest on it should be
exactly equal to the amount of the receivable.
• Convert the foreign currency into domestic currency at the spot exchange rate.
• Place the domestic currency on deposit at the prevailing interest rate.
• When the foreign currency receivable comes in, repay the foreign currency loan (from step 1)
plus interest.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 32
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Similarly, if a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the
money market:

• Borrow the domestic currency in an amount equivalent to the present value

of the payment.
• Convert the domestic currency into the foreign currency at the spot rate.
• Place this foreign currency amount on deposit.
• When the foreign currency deposit matures, make the payment.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 33
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Dr. Ch. Venkata Krishna Reddy

04/05/2021 34
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Dr. Ch. Venkata Krishna Reddy

04/05/2021 35
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Dr. Ch. Venkata Krishna Reddy

04/05/2021 36
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Dr. Ch. Venkata Krishna Reddy

04/05/2021 37
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Dr. Ch. Venkata Krishna Reddy

04/05/2021 38
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Dr. Ch. Venkata Krishna Reddy

04/05/2021 39
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance
Managing Economic exposure

Economic exposure
through restructuring - shifting sources of costs and
revenues to other locations to match cash inflows and
outflows in foreign currencies.

Dr. Ch. Venkata Krishna Reddy

04/05/2021 40
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Possible Strategies to Hedge Economic Exposure

Pricing Policy
Hedging with Forward Contracts
Purchasing Foreign Supplies
Financing with Foreign Funds
Revising Operations of Other Units
Dr. Ch. Venkata Krishna Reddy
04/05/2021 41
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

MANAGING TRANSLATION EXPOSURE

• Translation exposure occurs when an MNC translates each

subsidiary’s financial data to its home currency for consolidated
financial statements. Even if translation exposure does not affect
cash flows, it is a concern of many MNCs because it can reduce an
MNC’s consolidated earnings and thereby cause a decline in its
stock price.
– Hedging with Forward Contracts
Dr. Ch. Venkata Krishna Reddy
04/05/2021 42
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Next Topic
• International Capital Budgeting

Dr. Ch. Venkata Krishna Reddy

04/05/2021 43
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Thank you

Dr. Ch. Venkata Krishna Reddy

04/05/2021 44