The Main Sources of Foreign Currency Risk Confronting an International Firm - Essay Example

Identify the main sources of foreign currency risk confronting an international firm and evaluate different techniques that you think may be most appropriate in managing them. A thorough knowledge of international risk exposures and the relevant techniques for avoiding them is very important for multinational firms. International Currency risk is one of the risks most international firms face in connection with foreign exchange rates.1The problem arises when future payments or remunerations payable in a foreign currency depreciate in value before the foreign currency payment is received and is exchanged into the local currency of the firm. It is not that an unexpected increase or decrease in the foreign currency may not be profitable and will always cause a loss. But this entire uncertainty hampers businesses and overall economic growth. There are two kinds of markets within the foreign exchange market: Spot market: this involves forex delivered with in two or three days as the rates are quoted in line with the exchange rate prevalent at the time of the transaction.2 Forward or future market concerns the delivery of exchange rate to be delivered with in 3 days or more. Here the banks will use the forex rate on which they are willing to buy or sell the currency with in a month or more after the transaction.3 It can be seen that due to the volatile and unpredictable nature of the forex markets during times of political or economic crisis both these markets carry a considerable risk for the multinational firms. The preceding discussion will assess the types of strategies which can be used to avoid these risks and their feasibility in the short and long term. The strategies to combat the foreign exchange risks and transaction exposure Transferring exposure This involves the transfer of the transaction exposure to another company through the technique asking them to pay for a product in your currency so that they have to bear the transaction exposure resulting from forex uncertainty on their own. Another technique would be to price the export in the local currency of the other firm and demand payment immediately in which case the current spot rate will determine the value in your own currency of the export.4 Netting transaction exposure A second way of minimising transaction risk is "netting out", and this technique is very helpful for foreign multinationals with large business concerns who do frequent and sizeable amounts of foreign currency transactions. In this way unexpected exchange rate charges will essentially "net out" over many different transactions. This is mainly because when payments and receipts are in many different currencies as this will spread the risks and there might even be a chance of profit.. Although transaction exposure cannot be completely netted away ,the company is better off making a small in one area of trade that a large loss overall if it literally "puts all its eggs in one basket". Compared to hedging this may even be a safer way of avoiding forex risks. Hedging strategies (aimed at reducing short-term transaction exposures of roughly less than a year.5) Forward Contracts This is probably one of the most direct methods of handling hedging risks. The obvious advantage of this is to prevent the company from suffering any loss through a depreciating or appreciating currency because the payment has already been made to a bank. The problem however is that small businesses are often discouraged by banks in this option because of the increased risk that the banks in collecting back the money Futures contracts Another option of hedging transaction exposure is with futures market hedge which is a lot similar to the above method .The difference begins when a short sale of a future contract puts the business in a position opposed to that of a business owning the futures contract. This happens because an increase in the value of the contract causes a loss to the company. 6When the futures contract decreases in value, it gains that amount. Another problem is that any losses in such contracts have to be made in liquidity on a daily basis and the company will have to wait for the resulting gain until the transaction actually takes place or is processed. This has been known to create severe liquidity crises with in small multinationals. There is also an added disadvantage of the sole usability of standardized amounts and maturities in these contracts. This way there is an added danger of losing profits due to a slightly mishandled timeframe.7 Hedges Using the Money Market There is an alternative way of using a money market hedge incase forward market hedging becomes too expensive.In this strategy through the short term borrowing or lending an international firm will be able to make the required exchange of currencies at the current spot rate.The cost of the money market hedge thus becomes the difference between the borrowing and the lending interest rates. Even if forward and futures contracts are available this is the least risky alternative to avoiding the problems of a forex market.8 Options Currency options give one party the right, to buy or sell a specific amount of currency at a specified exchange rate on or before an agreed-upon date. This means that if the exchange rate moves in favour of the option holder, holder will not suffer from financial loss.It is not always a great situation though,mainly because once this option is exercised the company will suffer from the burden of the option premium and commission costs. Cross Hedging9 For small developing countries cross hedging is an effective way of preventing forex loss.This entails using the local currency in conjunction with a currency which is highly influenced by it in the sale and purchase of business assets.However the success of this method will largely depend upon the extent to which the stronger currency changes in value along with the minor currency. Long term strategies In the long term there are a host of other strategies available 10 like Back-to-Back Loans which allow Multinationals to reduce their risks by entering into bilateral arrangements which are outside the scope of the foreign exchange markets. This will essentially protect both the companies from losses . Furthermore Currency and Credit Swaps are like a series of forward contracts 11and can be successfully used to avoid the credits related to parallel borrowing.Here two parties agree to exchange specified amounts of currency at present and to reverse the exchange at some point in the future.12 The only risk inherent in this very safe method is that the forex exchange has to be carried out at a new rate in the future. Much worthy of mention here are also the interest parity conditions which prevent the risk of arbitrage in an economy. According to this formula the returns from borrowing (in Currency A), exchange of that currency for Currency B if added to the investment required for this exchange and investing in interest-bearing instruments of Currency B, while at the same time purchasing futures contracts to convert that currency back when the investment period ends should be the equivalent of purchasing and holding similar interest-bearing instruments of the first currency.13 The imbalance is actually favorable for foreign investors because when these returns are different there is a chance that investors can commit "arbitrage or make risk-free returns".14 In practice there are some very interesting ways in which various corporations have dealt with and suffered the burnt of foreign currency transaction risk in the past. Millman(1990,1995) gives some interesting examples in his research work. One example he gives is of Lufthansa,the German airline which when contracted with Boeing to purchase aircrafts in the 1980's ,the value of the dollar was rising. The price of the aircrafts were set in dollars. Lufthansa feared that the dollar would strengthen and the cost in . Deutsche marks would increase the cost of the planes. Therefore it entered into forward contracts for the dollars required to pay for the planes.Contray to expectations the dollar weakened. Due to its wrong speculation forward contracts cost Lufthansa $140 to $160 million more for the aircrafts that they would have if they had bought the dollars on the spot market(Millman 1990). In conclusion there is really no reliable way to counter forex risk in foreign markets. Back to Back loans definitely provide more certainty than hedging which causes unexpected risks especially in financially volatile markets much affected by political repercussions and unpredictable events. _____________________________________________________________________ Bibliography 1. Anomalies: Foreign Exchange," K. Froot and R. Thaler, Journal of Economic Perspectives, Summer 1990, 179-192, American Economic Association. 2. "Is Currency Trading Profitable Exploiting Deviations from Uncovered Interest Parity," P. Green, Financial Analysts Journal, July-August, 1992, 82-86, Financial Analysts Federation. 3. "Currency Swaps," T. O'Brien, Global Financial Management, 1996, Chapter 6, 157-183, John Wiley & Sons. 4. "Currency Swaps," J. Evans, International Finance: A Markets Approach, 1992, 521-531, Dryden Press. , 5. "Lessons for International Asset Allocation," P. Odier and B. Solnik, Financial Analysts Journal, 1993, 63-77, Financial Analysts Federation. 6. "The Emerging Markets Phenomenon," D. Beim and C. Calomiris, Chapter 1 in Emerging Financial Markets (2001), pages 2-37, McGraw-Hill Irwin. 7. The Floating Battlefield: Corporate Strategies in the Currency Wars Gregory J. Millman, (New York, AMACOM, 1990). 8. The Vandals' Crown: How Rebel Currency Traders Overthrew the World's Central Banks, Gregory J. Millman (New York, The Free Press, 1995). 9. Using Currency Futures to Hedge Currency Risk,By Sayee Srinivasan & Steven Youngren,Product Research & Development, 10. Foreign Currency Risk: Minimizing,Transaction Exposure,by Michael P. Kelley Read More