Risk Analysis in Foreign Transactions - Essay Example

RISK ANALYSIS IN FOREIGN TRANSACTIONS For any firm operating on an international level or on domestic there is always the concern of the risk posed by direct or indirect currency exposure. In one way or the other and every firm in the market is affected by drastic fluctuations of currency. The only option there is for these firms is to reduce the risk or eliminate it all together depending on the capacity level (Papaioannou, 2006). This is what analysts refer to as hedging. It is a daunting and complex task considering the amount of data that needs to be collected and the complexities involved in correct measuring of the current risks exposure and decide on the correct strategy to be adopted to counter the risk (Papaioannou, 2006). The sources of foreign exchange risks in a business can arise from different transactions depending on the level of operation for example where the business imports or exports, where other costs such as capital expenditure is denominated in foreign currency, where income for exports is received in foreign currency, where business loans are denominated in foreign currency and have to be paid in the same (Dominguez & Tesar, 2001). These and other factors make it important for a business to continually analyze the risk aspect facing the business in terms of foreign exchange. This paper is particularly interested in discussing exhaustively the major objectives of a business in analyzing foreign exchange risks and the popular techniques used in analyzing foreign exchange risk. As such the paper is structured into these two sections Foreign exchange risk analysis objectives Tax objectives- When a business protects against fluctuating currency, it reduces the volatility of the pre-tax value of the company. The effect of this is that it decreases the expected tax from the company and as such increases the expected post tax value of the business. This is very beneficial to the business in terms of maintaining a healthy balance sheet that is an important tool whenever the business is looking for internal or external funding. If insured, the insurance can be able to cover the risk of having the revenue eaten away by losses in the taxable income (Popov & Stutzmann, 2003). Protecting against financial distress- A firm should at any cost avoid financial distress as it the worst thing that can happen to any business that in a competitive market. Financial distress is majorly caused by lack of prudent financial management for example borrowing more than the company can afford to pay. In this case however it can be caused by an unprecedented fluctuation in foreign currency (Allayannis, Brown & Klapper, 2002). Hedging reduces the expected cost of financial distress and raises the expected income to the company’s claimholders. Consequently the reduction in financial instability in the firm will increase the expected value of the firm. Sticking to the company’s investment policy- While it is possible to get external funding to run a company and take care of expansion plans, the external source of funding is expensive as compared to the internal funding. A company is therefore expected to only result to external funding only when the internal sources of finance are not capable of supplying the expected amount. As such the company should do everything to reduce volatility of its cash flow. One way of doing this is having a hedging plan that will measure the risk in currency fluctuations and mitigate against its effects on the company’s cash flow (Allan, 2003). Manager’s risk aversion - In many organizations, a manager is rewarded depending on earnings he makes for the company. For this manager then it is vital that he takes care of each and every aspect of the business that can increase or reduce earnings for the business. He is typically a manager who is more risk averse and approaches all transactions with caution. The tendency to be risk averse will be reflected on the hedging policy that this manager adopts (Crabb, 2001). Essentially this will mean that the company will have stable incomes at least in the short run however in the long run the shareholders will not benefit from this approach. So one objective of the risk analysis in foreign exchange will be for a manager ensuring he keeps his job and gets rewarded for maintaining a stable revenue flow. Protecting bondholders- Once a company has taken up a debt, it gets the incentive and the green light to invest in risky projects that it would have not with it is limited financial reserves. Essentially this will transfer the wealth from the debt holders to the shareholders. When the project gets to be profitable the debt holders get at most the nominal at maturity however the bear the greatest risks incase the project fails. The bondholders therefore have to protect themselves fro the wealth transfer. One of the options to do so is compelling the company to have a working hedging policy, thus in many companies it is not a matter of preference but a requirement from their financiers (Hakala , Wystup, 2002). Reducing the cost expenditure of capital goods- This is especially true for a business that is importing capital equipments to facilitate its expansion. The increase in this expenditure arises from the falling in value of domestic currency exchange rate (Marrison, 2002). Analyzing the cost of investing overseas- For multinationals and rapidly expanding companies wishing to set up shops in foreign countries, one of the objectives of analyzing the fluctuations in currencies is to evaluate the cost of either investing locally or overseas. The latter is preferred when the value of the domestic currency is high and vice-versa when the value decreases (Ihrig, 2001). Risk analysis techniques There are many techniques used to analyze the risk posed by currency fluctuations they range from the simplest to the most complex that require great expertise and highly sophisticated computing (Neely & Weller, 2011). These are some of the techniques used. 1. Value at Risk calculation (VaR) This is a probability technique that is most preferred by financial institutions. It is quite complex and difficult to use. It only predicts the fluctuation effect up to 99% accuracy basing on the current situation and past data records of a particular currency of interest to the business. This method analyses the riskiness of a company’s foreign exchange position arising from its activities over a certain period of time (Van Deventer & Imai, 2004). It depends on three parameters: The holding period in which the foreign exchange position is planned to be held. This is usually one day The confidence level at which the estimate is planned to be made usually (95-99) % The unit of the currency to be used for the denomination of the VaR According to Holton (2003), there are a variety of models used in calculating VaR. most common methods are The historical simulation- it assumes that the foreign exchange of a firm will have the same distribution as they had in the past The variance-covariance model- it assumes that the currency returns on a firms total foreign exchange position are always normally distributed and tat the change in the value of the foreign exchange position is linearly dependent on all currency returns The montecarlo simulation- it assumes that future currency returns will be randomly distributed 2. Table of projected foreign currency cash flows technique In the case where the business pays and receives payment in terms of foreign currency, it is important ton measure the net surplus and the net deficit of the currency. It is done by projecting the foreign currency cash flow. It indicates the position of the business in terms of having a surplus or a deficit in the foreign currency reserves. It also indicates the timing of the currency flows (CPA Australia, 2009). This is a simple yet effective method that can be adopted by a non-financial services business. 3. Sensitivity analysis This is simply the measurement of the effect of an adverse movement in exchange rates to a business. It can be done by basing the exchange rate on history or by choosing arbitrary movements in exchange rates (Engel & West, 2005). A matrix is usually the tool of choice to simulate the possibilities of a combined result of a currency and commodity movement in cases where commodities are involved. 4. Register of foreign currency exposure It is the simplest of the above methods. It entails maintaining a register of exposures and their associated foreign exchange mitigation (hedging) practices. The emphasis is on recording the details of each hedge against its relevant exposure and relating it to future possibilities (Dagfinn, Sarno & Sojli, 2010). Conclusion Analyzing and understanding the risks exposure of a business in the fluctuations of currency on the foreign exchange markets is vital in protecting the revenue flow as well as the perpetuity of a business concern. The risks are especially real for a firm that is directly involved in the importation and exportation business. However the risks are also a concern for other business indirectly due to the interrelationship factor of economies. To counter this risks business have developed techniques in analyzing and hedging against the effects of currency fluctuations. The techniques range from the simplest to the most complex depending on the level of exposure and capacity of operation. All in all the fact is that it is becoming more important to understand foreign exchange risks as countries increase trade amongst each other in the wake of the information age that has seen the internet make the world a small interrelated global village. References *Papaioannou. M.G, (2006) Exchange rate risk measurement and management: issues and approaches for the firms, South- East Europe Journal of Economics [PDF] available online from http://www.asecu.gr/Seeje/issue07/papaioannou.pdf [accessed on 30 Nov 2012] *CPA Australia, (2009) A guide to managing foreign exchange risks [PDF] available online from http://www.cpaaustralia.com.au/cps/rde/xbcr/cpa-site/Guide_to_managing_foreign_exchange_risk_.pdf [accessed on 30 Nov 2012] *Popov.V, Stutzmann.Y, (2003) How is foreign exchange risk managed? An empirical study applied to two swiss companies [PDF] available online from http://bbs.cenet.org.cn/UploadImages/200582215562754075.pdf [accessed on 30 Nov 2012] *Allayannis,G., Brown, G., Klapper, L., (2002) Capital structure and financial risk: Evidence from foereign debt use in East Asia, world Bank *Allan,S, (2003) Finaancial risk management : A practitioners guide to managing market and credit risk, john Wiley and Sons *Hakala , J Wystup, U, (2002) Foreign exchange risk: Models, Instruments and strategies, Risk publications *Marrison, c, (2002) The fundamentals of risk management, McGraw hill *Van Deventer, D.R., Imai, K., (2004) Advanced financial Risk Management: tools and Techniques for Integrated Credit Risk and Interest Rate Management, John Wiley and Sons *Holton, G.A., (2003) Value at risk: Theory and Practice, Academic Press *Engel, c., West.K., (2005) Exchange rates and fundamentals, Journal of political economy, #113, pp 485-517 *Dagfinn, R., Sarno,L., Sojli,E., (2010) Exchange rate forecasting, order flow and macroeconomic information, Joournal of international economics, #80, pp 72-88 *Crabb.P., (2001) Multinational corporations and hedging exchange rate exposure, International Review of Economics and Finance, Vol.11, #3 *Ihrig,J., (2001) Exchange Rate Exposure of Multinationals : focusing on exchange rate issues, international finance discussion paper *Neely,C., Weller.P., (2011) Technical Analysis in/the Foreign Exchange Market, working paper, Federal Reserve Bank of St. Louis *Dominguez,K., TesarL., (2001) A Re-Examination of exchange rate exposure, American economic review, Vol.91, #2, pp 396-399 Read More