Foreign Exchange Exposure

Foreign Exchange Exposure

Foreign exchange risk is related to the variability of the domestic currency values of assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at risk. Foreign currency exposures and the attendant risk arise whenever a company has an income or expenditure or an asset or liability in a currency other than that of the balance-sheet currency. Indeed exposures can arise even for companies with no income, expenditure, asset or liability in a currency different from the balance-sheet currency. When there is a condition prevalent where the exchange rates become extremely volatile the exchange rate movements destabilize the cash flows of a business significantly. Such destabilization of cash flows that affects the profitability of the business is the risk from foreign currency exposures.

Classification of Exposures

Financial economists distinguish between three types of currency exposures – transaction exposures, translation exposures, and economic exposures. All three affect the bottom- line of the business.

1. Transaction Exposure

Transaction exposure can be defined as “the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure is sometimes regarded as a short-term economic exposure. Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly.

Suppose that a company is exporting deutsche mark and while costing the transaction had reckoned on getting say Rs.24 per mark. By the time the exchange transaction materializes i.e. the export is affected and the mark sold for rupees, the exchange rate moved to say Rs.20 per mark.

The profitability of the export transaction can be completely wiped out by the movement in the exchange rate. Such transaction exposures arise whenever a business has foreign currency denominated receipt and payment. The risk is an adverse movement of the exchange rate from the time the transaction is budgeted till the time the exposure is extinguished by sale or purchase of the foreign currency against the domestic currency.  Furthermore, in view of the fact that firms are now more frequently entering into commercial and financial contracts denominated in foreign currencies, judicious management of transaction exposure has become an important function of international financial management.

Some strategy to manage transaction exposure

  • Hedging through invoice currency: While such financial hedging instruments as forward contract, swap, future and option contracts are well known, hedging through the choice of invoice currency, an operational technique, has not received much attention. The firm can shift, share or diversify exchange risk by appropriately choosing the currency of invoice. Firm can avoid exchange rate risk by invoicing in domestic currency, there by shifting exchange rate risk on buyer. As a practical matter, however, the firm may not be able to use risk shifting or sharing as much as it wishes to for fear of losing sales to competitors. Only an exporter with substantial market power can use this approach. Further, if the currencies of both the exporter and importer are not suitable for settling international trade, neither party can resort to risk shifting to deal with exchange exposure.
  • Hedging via lead and lag: Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. To “lead” means to pay or collect early, where as “lag” means to pay or collect late. The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively implement the Lead/Lag strategy, the transaction exposure the firm faces can be reduced.

2. Translation Exposure (Accounting Exposures)

Translation exposure is defined as the likely increase or decrease in the parent company’s net worth caused by a change in exchange rates since last translation. This arises when an asset or liability is valued at the current rate. No exposure arises in respect of assets/liabilities valued at historical rate, as they are not affected by exchange rate differences. Translation exposure is measured as the net of the foreign currency denominated assets and liabilities valued at current rates of exchange. If exposed assets exceed the exposed liabilities, the concern has a ‘positive’ or ‘long’ or ‘asset’ translation exposure, and exposure is equivalent to the net value. If the exposed liabilities exceed  the exposed assets and results in ‘negative’ or ‘short’ or ‘liabilities’ translation exposure to the extent of the net difference.

Translation exposure arises from the need to “translate” foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of translation exposure is the treatment of foreign currency borrowings. Consider that a company has borrowed dollars to finance the import of capital goods worth $10000. When the import materialized the exchange rate was say Rs 30 per dollar. The imported fixed asset was therefore capitalized in the books of the company for Rs 300000.

In the ordinary course and assuming no change in the exchange rate the company would have provided depreciation on the asset valued at Rs 300000 for finalizing its accounts for the year in which the asset was purchased. If at the time of finalization of the accounts the exchange rate has moved to say Rs 35 per dollar, the dollar loan has to be translated involving translation loss of Rs50000. The book value of the asset thus becomes 350000 and consequently higher depreciation has to be provided thus reducing the net profit.

Thus, Translation loss or gain is measured by the difference between the value of assets and liabilities at the historical rate and current rate. A company which has a positive exposure will have translation gains if the current rate for the foreign currency is higher than the historic rate. In the same situation, a company with negative exposure will post translation loss. The position will be reversed if the currency rate for foreign currency is lesser than its historic rate of exchange. The translation gain/loss is shown as a separate component of the shareholders’ equity in the balance-sheet. It does not affect the current earnings of the company.

3. Economic Exposure

Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. An economic exposure is more a managerial concept than a accounting concept. A company can have an economic exposure to say Yen: Rupee rates even if it does not have any transaction or translation exposure in the Japanese currency. This would be the case for example, when the company’s competitors are using Japanese imports. If the Yen weekends the company loses its competitiveness (vice-versa is also possible). The company’s competitor uses the cheap imports and can have competitive edge over the company in terms of his cost cutting. Therefore the company’s exposed to Japanese Yen in an indirect way.

In simple words, economic exposure to an exchange rate is the risk that a change in the rate affects the company’s competitive position in the market and hence, indirectly the bottom-line. Broadly speaking, economic exposure affects the profitability over a longer time span than transaction and even translation exposure. Under the Indian exchange control, while translation and transaction exposures can be hedged, economic exposure cannot be hedged.

Economic exposure consists of mainly two types of exposures.

  • Asset exposure
  • Operating exposure

Exposure to currency risk can be properly measured by the sensitivities of (1) the future home currency values of the firm’s assets (and liabilities) (2) the firm’s operating cash flows to random changes in exchange rates.

Asset exposure: Let us discuss the case of asset exposure. For convenience, assume that dollar inflation is non random. Then, from the perspective of the U.S. firm that owns an asset in Britain, the exposure can be measured by the coefficient ‘b’ in regressing the dollar value ‘P’ of the British asset on the dollar/pound exchange rate ‘S’.

P = a + b * S + e

Where ‘a’ is the regression constant and ‘e’ is the random error term with mean zero, P = SP*, where P* is the local currency (pound) price of asset. It is obvious from the above equation that the regression coefficient ‘b’ measures the sensitivity of the dollar value of asset (P) to the exchange rate (S). If the regression coefficient is zero, the dollar value of the asset is independent of exchange rate movement, implying no exposure. On the basis of above analysis, one can say that exposure is the regression coefficient. Statistically, the exposure coefficient, ‘b’, is defined as follows:

b = Cov (P,S)/ Var (S)

Where Cov (P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var (S) is the variance of the exchange rate.

Next, we show how to apply the exposure measurement technique using numerical examples. Suppose that a U.S. firm has an asset in Britain whose local currency price is random. For simplicity, let us assume that there are three states of the world, with each state equally likely to occur. The future local currency price of this British asset as well as the future exchange rate will be determined, depending on the realized state of the world.

Operating exposure: Operating exposure can be defined as “the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates”. Operating exposure may affect in two different ways to the firm, viz., competitive effect and conversion effect. Adverse exchange rate change increase cost of import which makes firm’s product costly thus firm’s position becomes less competitive, which is competitive effect. Adverse exchange rate change may reduce value of receivable to the exporting firm which is called conversion effect.

Some strategy to manage operating exposure

  • Selecting low cost production sites: When the domestic currency is strong or expected to become strong, eroding the competitive position of the firm, it can choose to locate production facilities in a foreign country where costs are low due to either the undervalued currency or under priced factors of production. Recently, Japanese car makers, including Nissan and Toyota, have been increasingly shifting production to U.S. manufacturing facilities in order to mitigate the negative effect of the strong yen on U.S. sales. German car makers such as Daimler Benz and BMW also decided to establish manufacturing facilities in the U.S. for the same reason. Also, the firm can choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes. Consider Nissan, which has manufacturing facilities in the U.S. and Mexico, as well as in Japan. Multiple manufacturing sites provide Nissan with great deal of flexibility regarding where to produce, given the prevailing exchange rates. When the yen appreciated substantially against the dollar, the Mexican peso depreciated against the dollar in recent years. Under this sort of exchange rate development, Nissan may choose to increase production in the U.S. and especially in Mexico, in order to serve the U.S. market. This is, in fact, how Nissan has reacted to the rising yen in recent years. Maintaining multiple manufacturing sites, however, may prevent the firm from taking advantage of economies of scale, raising its cost of production. The resultant higher cost can partially offset the advantages of maintaining multiple production sites.
  • Flexible sourcing policy: Even if the firm manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes by sourcing from where input costs are low. Facing the strong yen in recent years, many Japanese firms are adopting the same practice. It is well known that Japanese manufacturers, especially in the car and consumer electronics industries, depend heavily on parts and intermediate products from such low cost countries as Thailand, Malaysia, and China. Flexible sourcing need not be confined just to materials and parts. Firms can also hire low cost guest workers from foreign countries instead of high cost domestic workers in order to be competitive.
  • Diversification of the market: Another way of dealing with exchange exposure is to diversify the market for the firm’s products as much as possible. Suppose that GE is selling power generators in Mexico as well as Germany. Reduced sales in Mexico due to the dollar appreciation against the peso can be compensated by increased sales in Germany due to dollar depreciation against the euro. As a result, GE’s overall cash flows will be much more stable than would be the case if GE sold only in one foreign market, either Mexico or Germany. As long as exchange rates do not always move in the same direction, the firm can stabilize its operating cash flow by diversifying its export market.
  • R&D efforts and product differentiation: Investment in R&D activities can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements. Successful R&D efforts allow the firm to cut costs and enhance productivity. In addition, R&D efforts can lead to the introduction of new and unique products for which competitors offer no close substitutes. Since the demand for unique products tend to be highly inelastic, the firm would be less exposed to exchange risk. At the same time, the firm can strive to create a perception among consumers that its product is indeed different from those offered by competitors. This helps firm to pass-through any adverse effect of exchange rate on to the customers.
  • Financial hedging: While not a substitute for the long-term, financial hedging can be used to stabilize the firm’s cash flow. For example, the firm can lend or borrow foreign currencies as a long term basis. Or, the firm can use currency forward of options contracts and roll them over if necessary.
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