Some terms and concepts related to foreign exchange market

1 & 2. Exposure and Risk:

Exposure is a measure of the sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the relevant risk factor while risk is a measure of variability of the value of the item attributable to the risk factor. Let us understand this distinction clearly. April 1993 to about July 1995 the exchange rate between rupee and US dollar was almost rock steady. Consider a firm whose business involved both exports to and imports from the US. During this period the firm would have readily agreed that its operating cash flows were very sensitive to the rupee-dollar exchange rate, i.e.; it had significant exposure to this exchange rate; at the same time it would have said that it didn’t perceive significant risk on this account because given the stability of the rupee-dollar fluctuations would have been perceived to be minimal. Thus, the magnitude of the risk is determined by the magnitude of the exposure and the degree of variability in the relevant risk factor.

3. Hedging:

Hedging means a transaction undertaken specifically to offset some exposure arising out of the firm’s usual operations. In other words, a transaction that reduces the price risk of an underlying security or commodity position by making the appropriate offsetting derivative transaction.

In hedging a firm tries to reduce the uncertainty of cash flows arising out of the exchange rate fluctuations. With the help of this a firm makes its cash flows certain by using the derivative markets.

4. Speculation:

Speculation means a deliberate creation of a position for the express purpose of generating a profit from fluctuation in that particular market, accepting the added risk. A decision not to hedge an exposure arising out of operations is also equivalent to speculation.

Opposite to hedging, in speculation a firm does not take two opposite  positions in the any of the markets. They keep their positions open.

5. Call Option:

A call option gives the buyer the right, but not the obligation, to buy the underlying instrument. Selling a call means that you have sold the right, but not the obligation, to someone to buy something from you.

6. Put Option:

A put option gives the buyer the right, but not the obligation, to sell the underlying instrument. Selling a put means that you have sold the right, but not the obligation, to someone to sell something to you.

7. Strike Price:

The predetermined price upon which the buyer and the seller of an option have agreed is the strike price, also called the ‘exercise price’ or the striking price. Each option on an underlying instrument shall have multiple strike prices.

8. Currency Swaps:

In a currency swap, the two payment streams being exchanged are denominated in two different currencies. Usually, an exchange of principal amount at the beginning and a re-exchange at termination are also a feature of a currency swap.

A typical fixed-to-fixed currency swaps work as follows. One party raises a fixed rate liability in currency X say US dollars while the other raises fixed rate funding in currency Y say DEM. The principal amounts are equivalent at the current market rate of exchange. At the initiation of the swap contract, the principal amounts are exchanged with the first party getting DEM and the second party getting dollars. Subsequently, the first party makes periodic DEM payments to the second, computed as interest at a fixed rate on the DEM principal while it receives from the second party payment in dollars again computed as interest on the dollar principal.  At maturity, the dollar and DEM principals are re-exchanged.

A floating-to-floating currency swap will have both payments at floating rate but in different currencies. Contracts without the exchange and re-exchange do exist. In most cases, an intermediary- a swap bank- structures the deal and routes the payments from one party to another.

A fixed-to-floating currency swap is a combination of a fixed-to-fixed currency swaps and a fixed-to-floating interest rate swap. Here, one payment stream is at a fixed rate in currency X while the other is at a floating rate in currency Y.

9. Futures

Futures are exchanged traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/commodity in a designated future month at a price agreed upon by the buyer and seller. The contracts have certain standardized specification.

10. Transaction Exposure

This is a measure of the sensitivity of the home currency value of the assets and liabilities, which are denominated, in the foreign currency, to unanticipated changes in the exchange rates, when the assets or liabilities are liquidated. The foreign currency values of these items are contractually fixed, i.e.; do not vary with exchange rate. It is also known as contractual exposure.

Some typical situations, which give rise to transactions exposure, are:

(a)  A currency has to be converted in order to make or receive payment for goods and services;

(b)  A currency has to be converted to repay a loan or make an interest payment; or

(c)  A currency has to be converted to make a dividend payment, royalty payment, etc.

Note that in each case, the foreign value of the item is fixed; the uncertainty pertains to the home currency value. The important points to be noted are (1) transaction exposures usually have short time horizons and (2) operating cash flows are affected.

11. Translation Exposure

Also called Balance Sheet Exposure, it is the exposure on assets and liabilities appearing in the balance sheet but which is not going to be liquidated in the foreseeable future. Translation risk is the related measure of variability.

The key difference is the transaction and the translation exposure is that the former has impact on cash flows while the later has no direct effect on cash flows. (This is true only if there are no tax effects arising out of translation gains and losses.)

Translation exposure typically arises when a parent multinational company is required to consolidate a foreign subsidiary’s statements from its functional currency into the parent’s home currency. Thus suppose an Indian company has a UK subsidiary. At the beginning of the parent’s financial year the subsidiary has real estate, inventories and cash valued at, 1000000, 200000 and 150000 pound respectively. The spot rate is Rs. 52 per pound sterling by the close of the financial year these have changed to 950000 pounds, 205000 pounds and 160000 pounds respectively. However during the year there has been a drastic depreciation of pound to Rs. 47. If the parent is required to translate the subsidiary’s balance sheet from pound sterling to Rupees at the current exchange rate, it has suffered a translation loss. The translation value of its assets has declined from Rs. 70200000 to Rs. 61805000. Note that no cash movement is involved since the subsidiary is not to be liquidated. Also note that there must have been a translation gain on subsidiary’s liabilities, ex. Debt denominated pound sterling.

12. Contingent Exposure

The principle focus is on the items which will have the impact on the cash flows of the firm and whose values are not contractually fixed in foreign currency terms. Contingent exposure has a much shorter time horizon. Typical situation giving rises to such exposures are

  1. An export and import deal is being negotiated and quantities and prices are yet not to be finalized. Fluctuations in the exchange rate will probably influence both and then it will be converted into transactions exposure.
  2. The firm has submitted a tender bid on an equipment supply contract. If the contract is awarded, transactions exposure will arise.
  3. A firm imports a product from abroad and sells it in the domestic market. Supplies from abroad are received continuously but for marketing reasons the firm publishes a home currency price list which holds good for six months while home currency revenues may be more or less certain, costs measured in home currency are exposed to currency fluctuations.

In all the cases currency movements will affect future cash flows.

13. Competitive exposure

Competitive exposure is the most crucial dimensions of the currency exposure. Its time horizon is longer than of transactional exposure – say around three years and the focus is on the future cash flows and hence on long run survival and value of the firm. Consider a firm, which is involved in producing goods for exports and /or imports substitutes. It may also import a part of its raw materials, components etc. a change in exchange rate gives rise to no. of concerns for such a firm, example,

  1. What will be the effect on sales volumes if prices are maintained? If prices are changed? Should prices be changed? For instance a firm exporting to a foreign market might benefit from reducing its foreign currency priced to foreign customers. Following an appreciation of foreign currency, a firm, which produces import substitutes, may contemplate in its domestic currency price to its domestic customers without hurting its sales. A firm supplying inputs to its customers who in turn are exporters will find that the demand for its product is sensitive to exchange rates.
  2. Since a part of inputs are imported material cost will increase following a depreciation of the home currency. Even if all inputs are locally purchased, if their production requires imported inputs the firms material cost will be affected following a change in exchange rate.
  3. Labour cost may also increase if cost of living increases and the wages have to be raised.
  4. Interest cost on working capital may rise if in response to depreciation the authorities resort to monetary tightening.
  5. Exchange rate changes are usually accompanied by if not caused by difference in inflation across countries. Domestic inflation will increase the firm’s material and labour cost quite independently of exchange rate changes. This will affect its competitiveness in all the markets but particularly so in markets where it is competing with firms of other countries
  6. Real exchange rate changes also alter income distribution across countries. The real appreciation of the US dollar vis-à-vis deutsche mark implies and increases in real incomes of US residents and a fall in real incomes of Germans. For an American firm, which sells both at home, exports to Germany, the net impact depends upon the relative income elasticities in addition to any effect to relative price changes.

Thus, the total impact of a real exchange rate change on a firm’s sales, costs and margins depends upon the response of consumers, suppliers, competitors and the government to this macroeconomic shock.

In general, an exchange rate change will effect both future revenues as well as operating costs and hence exchange rates changes, relative inflation rates at home and abroad, extent of competition in the product and input markets, currency composition of the firm’s costs as compared to its competitors’ costs, price elasticities of export and import demand and supply and so forth.

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