International Financial Management and Foreign Exchange Exposure - Essay Example

FOREIGN EXCHANGE EXPOSURE Table of contents page no Abstract-------------------------------------------------------------------------------------------------4 1. Introduction------------------------------------------------------------------------------------4 2. Advice on most advantageous method-----------------------------------------------------4 3. Discussion -------------------------------------------------------------------------------------5 3.1. Exchange rate exposure -------------------------------------------------------------5 3.1.1. Transaction exposure-------------------------------------------------------6 3.1.2. Translation exposure------------------------------------------------------ 7 3.1.3. Economic exposure----------------------------------------------------------7 4. The market strategies available for hedging the risk--------------------------------------8 4.1 Management of foreign exchange risk: economic risk------------------------------8 4.2 Management of foreign risk: transaction and translation risk -----------------------9 4.2.1. Operational hedges----------------------------------------------------------------9 4.2.1.1. Risk shifting (deal in home currency) ---------------------------------10 4.2.1.2. Leading and lagging------------------------------------------------------10 4.2.1.3. Matching10 4.2.1.4. Multilateral (exposure netting) ----------------------------------------10 4.2.2. Financial hedges (derivatives) ----------------------------------------------------11 4.2.2.1. Forward contracts---------------------------------------------------------11 4.2.2.2. Future contracts-----------------------------------------------------------11 4.2.2.3. Money marker hedges----------------------------------------------------12 4.2.2.4. Currency swaps-----------------------------------------------------------12 4.2.2.5. Option contracts (puts and calls) --------------------------------------13 5.0 conclusions--------------------------------------------------------------------------------------13 6.0 References ---------------------------------------------------------------------------------------14-15 Abstract This report investigates the nature of the exchange rate risks faced by the exporter in the day to day operations across the global economy. It also examines the market strategies that are available to the exporter to help hedge the risks. A brief description of the international market is outlined and the conditions that lead to the foreign exchange exposure. This discussion then focuses on the three basic classification of the foreign currency risk exposures: translation exposure, transaction exposure and economic exposure. This report has also considered two types of foreign exchange management techniques used in managing currency exchange rate risk. These techniques are ideal for an exporter who wishes to have stable cash flows subject to foreign exchange risk. It is concluded that multinational businesses and investors that engage in import or export of products and services or those that make foreign investments across the global economy should be aware of the risk exposures and the most appropriate hedging strategy for each type of risk. It is also suggested that special attention be given to economic exposure because it substantially impact the firm’s market value and expected future cash flows and even affects the competitive position of a firm that does not sell or operate overseas. 1. Introduction The purpose of this report is to identify the nature of the exchange rate risk faced by an exporter then describes the market strategies available for hedging the risk. By examining a range of academic materials, recently published book, magazine articles, journal articles and internet sites on the topic this report identifies the nature of the exchange rate risk faced by an exporter then describe the market strategies available for hedging the risk. Foreign exchange exposure comes about if an investor or a firm has an open position (un-hedged condition subject to exchange rate risk) in a foreign currency. There are two types of open position, open long and open short position (Homaifar, 2004). Open long position is one where a firm expects to receive foreign currency in future while open short position is one where the investor needs to pay foreign currency in future (Siddaiah, 2009). Foreign exchange risk therefore refers to the possibility or likelihood that a foreign currency may move in a direction that is detrimental to the investor. Specific risk in open log position is that the foreign currency may weaken against the domestic currency thereby decreasing the local currency equivalent (Poitras, 2002). On the other hand, specific risk in open short position is that the foreign currency may strengthen against the domestic currency thereby increasing the domestic currency equivalent (Homaifar, 2004). 2. Discussion 2.1. Exchange rate exposure Currency risk or exchange rate risk also known as foreign exchange risk refers to financial risks that result to the exposure to unanticipated fluctuations and changes in the rate of exchange between the two currencies (Gangopadhyay, 2005). The exporter is faced with foreign exchange risk that may pose severe financial problems and consequences when not managed efficiently, appropriately and effectively. Exchange rate risk if not managed appropriately cause the exporter to suffer indirect loss or direct losses in the respective net profit, cash flows, and in turn, in the market value of their stock due to a move in exchange rate (Poitras, 2002). Effective management of the currency risk requires that the exporter to determine the specific types of risk that he/she is exposed to, the appropriate strategies for hedging them and even the instruments that are available to deal with these exchange rate risk. This because the exporter is a participant in the currency markets because of his/her international operation. These foreign currency risk exposures are basically classified into three distinct types as follows: translation exposure, transaction exposure and lastly economic exposure (Gangopadhyay, 2005). These exposures pose risks to the exporter’s competiveness, financial reporting, market value and cash flows. 2.1.1. Transaction exposure This is a short term or medium term exposure which arises due to the exchange rate fluctuations which affect the exporter’s future obligations to receive foreign currency denominated payments (Gangopadhyay, 2005). Since the exporter has a contractual cash flow (receivable in three months) which is denominated in foreign currency (US Dollars), the contract value (US$5 million) is subject to unanticipated fluctuations or changes in the rate of exchange. The exporter will have to convert the foreign currency to his/her domestic currency in order to realize the local value of his/her foreign denominated cash receipt. He/she therefore faces a risk of change or movement in the rate of exchange between the two currencies, US Dollars and Sterling Pounds due to the volatility of the foreign exchange market. These currency rate fluctuations can be both favorable and unfavorable for instance, if the exchange rate moves up, by let’s say 5%, the value of the receivable will decline by 5%, however, if the exchange rate decreases by 5%, the receivable will increase by 5%. Basically, such outcomes are troublesome because export profits are negatively affected. 2.1.2. Translation exposure This is a medium term and long term exposure which arises due to the currency exchange rate fluctuations which affect the exporter’s consolidated financial statements, especially when the exporter has foreign subsidiaries i.e. it refers to the extent to which financial reporting of the investor is affected by the changes in the exchange rates (Frydman & Goldberg, 2007). For reporting purposes, the UK based exporter will have to prepare consolidated financial statements. This process requires that, for uniformity purposes, its foreign liabilities and assets or foreign subsidiaries financial statements are translated from foreign to domestic currency. Even though this exposure may not affect the exporter’s cash flows, it could however have a significant impact on the reported earnings and hence affecting the prices of stock. Translation could either be done at the average rate of exchange of the period or at the end-of-the-period exchange rate, depending on the accounting regulations that affect the parent company (Matsumoto & Engel, 2009) In addition, when using average rate to translate the income statements, the prevailing current rate of exchange is used. The main difference between translation and transaction exposure is that in translation exposure, losses and incomes from various types of risk have different accounting treatments. 2.1.3. Economic exposure, also referred to as operating exposure This is a long term exposure and is caused by unanticipated currency exchange rate changes that may substantially impact the exporter’s market value and expected future cash flows (Machiraju, 2002). Even if the exporter does not sell or operate overseas, these unexpected exchange rate fluctuations may greatly affect its competitive position, consequently affecting the value of the firm. For instance, a firm in the UK that only supplies goods or services locally has to deal with cheap imports from U.S. hence more competitive if the sterling pound strengthens markedly. Operating exposure may affect the present value of the future cash flows. In addition to international transactions that expose a firm to exchange rate risk, economic exposure also results from other business investments and activities such as future cash flows from fixed assets. The two primary factors that determine operating exposure includes: the ease with which a firm adjusts its source of inputs, market and product mix in response to currency movements, for instance the easier it is, the lesser the economic exposure while the less flexible it is, the greater the economic exposure; and also the nature of the market where the firm sells its product and purchases its inputs (Kapil, 2011). Is the market competitive or monopolistic? Economic exposure is greater when either the prices of the firm’s product or the cost of the firms input are sensitive to currency changes, if there is negative correlation between the firm’s product prices or the firm’s input costs. However, when both of them are sensitive or insensitive to currency fluctuations, economic exposure is reduced because the effects offset each other. 3. The market strategies available for hedging the risk For the exporter to protect himself/ herself against exchange rate risk and consequently stabilize the receipt, he/ she can employ various foreign exchange hedging strategies. The following strategies can be employed: 3.1. Management of foreign exchange risk: economic risk Economic exposure is long term and involves unknown future cash flows and therefore to hedge against them, the exporter can use restructuring and operational hedge (Siddaiah, 2009). One such strategy under operational hedge includes global diversification (Correia, 2007). The exporter should diversify its sales to produce natural hedges for its unanticipated foreign exchange exposures. For this strategy to produce desired results (stabilize the overall home currency equivalent cash flow), the currencies associated with this market should not move in the same direction (Correia, 2007). Restructuring on the other hand requires that the exporter shift the sources of the revenues or costs to other locations so that the cash outflows and cash inflows in foreign currency are matched (Siddaiah, 2009). For instance, the exporter should decide to increase or reduce sales in specific countries. 3.2. Management of foreign exchange risk: transaction risk and translation risk In most cases transaction risk or exposure is short term and involves future known cash flows. This type of risk exposure is covered or hedged against using different techniques. In the hedging process, a firm usually negotiates a financial contract that establishes a situation opposite to the foreign exchange exposure it wishes to hedge (Siddaiah, 2009). For example, the exporter has an open long position in foreign currency hence will offset it with a short position in the same currency. There are two types of foreign exchange management techniques used in managing transaction risk (Poitras, 2002), these are: 3.2.1. Operational hedges These are internal organizational strategies that should be used by the exporter to deal with the currency exposures. Mechanisms under this strategy include: 3.2.1.1. Risk shifting (deal in home currency) This mechanism requires that overseas sales and purchases are invoiced in home or domestic currency (Poitras, 2002). The exporter should therefore insist that the customer pay in local currency. This method transfers risk to the other party however it may not be commercially acceptable. 3.2.1.2. Leading and lagging In order to take advantage of foreign exchange rate fluctuations, the exporter should use lead payments, pay in advance or lagged payments, delay payments beyond their due date. Leading and lagging are a form of speculation (Poitras, 2002). The exporter should lead or lag payments for the operating expenses. Leading is beneficial to the exporter if this currency were strengthening against his own while lagging would be appropriate for the exporter if the currency were weakening. 3.2.1.3. Matching When the exporter has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other (Poitras, 2002). It is therefore only necessary to deal on the foreign exchange markets for the unmatched portion of the total transactions. 3.2.1.4. Multilateral (exposure) netting This method only applies to transfers within a group of companies. Matching can be used for both intragroup transactions and those involving third parties. The main objective of multilateral netting is to save transactions costs by netting off inter-company balances before arranging payment (Poitras, 2002). The exporter matches the outflows and inflows in different currencies caused by trade so that it is only necessary to deal on the foreign exchange market for the unmatched portion of the total transactions. 3.2.2. Financial hedges (derivatives) 3.2.2.1. Forward contract There are two types of markets, spot market and forward market. A spot market is where one buys and sells a currency now, immediate deliver, the spot exchange rate (Eales & Choudhry, 2003). The forward market on the other hand is where one buys and sells a currency at fixed future rate for a predetermined rate, the forward exchange rate. A forward exchange contract is therefore a binding contract between two parties (bank and customers) for the sale and purchase of a specified quantity of stated foreign currency at a rate of exchange fixed at the time and date the contract is made for a future performance (Mishra, 2007).. Since the exporter has an open long position, expects to receive cash, he/she should hedge with a forward sale of the foreign currency. The forward contracts therefore allow the exporter to lock in the domestic currency equivalent of an expected foreign currency cash flow (Mishra, 2007). 3.2.2.2. Future contracts These are standardized contracts for the sale or purchase at a set future date of a set quantity of currency. They are exchange-based instruments traded on a regulated exchange. Futures are therefore standardized contracts that are traded on an organized exchange (Lyons, 2000). The buyer and seller of a contract do not transact with each other directly. Selling the futures contract means supplying the contract currency and buying the future contract imply receiving the contract currency. The exporter should therefore enter into a future contract with the bank so that he/she can receive the local currency equivalent even when the foreign exchange rate fluctuates (Mishra, 2007).. 3.2.2.3. Money market hedges Money market hedge involves borrowing in one currency, converting the money borrowed into another currency and putting the money on deposit until the time the transaction is completed with a hope of taking advantage of favorable interest rate movements (Clark & Ghosh 2004). Since the exporter anticipates a foreign currency receipt, the following steps can be used to take advantage of exchange rate fluctuation (Mishra, 2007). Step 1: borrow the appropriate amount in the foreign currency Step 2: convert it immediately to home currency Step 3: place it on deposit in the home currency Step 4: when the cash is received, repay the foreign currency loan and take the cash from the home currency deposit account. In money market operations, the relevant exchange rates are the SPOT rates. 3.2.2.4. Currency swaps This is a technique whereby two companies borrow in the currencies and markets where each is able to get the best and favorable rates and then swapping the cash flows. It can in terms of interest rates or currency. In interest rate swap is where the parties involved agree to exchange or swap exchange interest rate cash flows. It is normally used for both speculating and hedging. Currency swap is where the two parties exchange the amount borrowed by each (Flavell, 2013) 3.2.2.5. Option contract (puts and calls) This is a contract that gives the buyer or the owner the right (but not obligation) to sell or buy a specific instrument or asset at a predetermined price, strike price, at a predetermined future date. A call gives the owner a right to purchase the instrument or asset at a specified future date. A put conveys the right to sell. 4. Conclusion This report has identified three main categories of exchange rate risk and five basic derivatives used to hedge against the risk exposures. In addition, the report has examined four operational hedges available to the exporter to reduce the currency risk. After investigating the nature of exchange rate risk and their effect on the exporter’s competiveness, financial reporting, market value and cash flows, it was suggested that appropriate hedging mechanisms be identified to stabilize the future cash flows. References Clark, E., & Ghosh, D. (2004). Arbitrage, hedging, and speculation: The foreign exchange market. Westport, Conn. [u.a.: Praeger. Correia, C. (2007). Financial management. Cape Town: Juta. Eales, B. A., & Choudhry, M. (2003). Derivative instruments: A guide to theory and practice. Oxford: Butterworth-Heinemann. Flavell, R. R. (2013). Swaps and other derivatives. Hoboken, N.J: Wiley. Frydman, R., & Goldberg, M. D. (2007). 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