ForeignExchangeRateRiskEC320212021/6/7ForeignExchangeRateExposure Foreignexchangeexposureisameasureofthepotentialforafirmsprofitability,netcashflow,andmarketvaluetochangebecauseofachangeinexchangerates.Animportanttaskofthefinancialmanageristomeasureforeignexchangeexposureandtomanageitsoastomaximizetheprofitability,netcashflowandmarketvalueofthefirm.22021/6/7TypesofForeignExchangeRateExposure TransactionExposure TranslationExposure OperatingExposure32021/6/7TransactionExposure TransactionExposuremeasureschangesinthevalueofoutstandingfinancialobligationsincurredpriortoachangeinexchangeratesbutnotduetobesettleduntilaftertheexchangerateschange.Therefore,itdealswithchangesincashflowsthatresultfromexistingcontractualobligations. Forexample:42021/6/7TranslationExposure Translationexposureisthepotentialforaccounting-derivedchangesinownersequitytooccurbecauseoftheneedto“translate”foreigncurrencyfinancialstatementsofforeignsubsidiariesintoasinglereportingcurrencytoprepareworldwideconsolidatedfinancialstatements. Forexample:52021/6/7OperatingExposure Operatingexposure,alsocalledeconomicexposure,competitiveexposureorstrategicexposure,measuresthechangeinthepresentvalueofthefirmresultingfromanychangeinfutureoperatingcashflowsofthefirmcausedbyanunexpectedchangeinexchangerates.Thechangeinvaluedependsontheeffectoftheexchangeratechangeonfuturesalesvolume,pricesandcosts. Forexample:62021/6/7 Transactionexposureandoperatingexposureexistbecauseofunexpectedchangesinfuturecashflows.Thedifferencebetweenthetwoisthattransactionexposureisconcernedwithfuturecashflowsalreadycontractedfor,whileoperatingexposurefocusesonexpected(notyetcontractedfor)futurecashflowsthatmightchangebecauseachangeinexchangerateshasalteredinternationalcompetitiveness.72021/6/7StepsinMeasuringandManagingExchangeRateRisk Identifytheexposure Quantifytherisk Formulateriskmanagementpolicy Assessavailableriskmanagementtechniques Monitorandevaluatetheriskmanagementprocess82021/6/7ManagementofForeignExchangeExposure Foreignexchangeriskmanagementtechniquescanbedividedintointernalandexternaltechniques. Internaltechniquesaremainlyusedaspartofacompanysriskmanagementstrategywhichaimstominimizethecompaniesexposuretoexchangeraterisk.92021/6/7InternalRiskManagement Netting Matching LeadingandLagging Invoicinginthehomecurrency Currencydiversification Mark-ups Counter-tradeandcurrencyoffsets102021/6/7Netting Nettingistheoffsetofintra-grouppaymentsandreceiptsinthesameordifferentcurrencies. Bilateralnettingoccursbetweentwopartieswithinthesamefirmoracrosssubsidaries.Thesemayexistindifferentcurrencyzones.Thenetamountoutstandingistransferred.112021/6/7Netting Multilateralnettinginvolvesmanypartiesorsubsidiariesandinvolvesacentralnettingfacility.122021/6/7Matching Matchingisamechanismwherebyacompanymatchesitsforeigncurrencyinflowswithitsforeigncurrencyoutflowsinrespectofamountandapproximatetiming.Receiptsinaparticularcurrencyareusedtomakepaymentsinthatcurrencytherebyreducingtheneedforagroupofcompaniestogothroughtheforeignexchangemarketstotheunmatchedportionofforeigncurrencycashflows.132021/6/7LeadingandLagging Leadingmeanspayinganobligationinadvanceoftheduedate.Laggingmeansdelayingpaymentofanobligationbeyonditsduedate.Thisisadjustingthetimingofreceiptspaymentscyclessoastofacilitatenetting.142021/6/7Invoicinginthehomecurrency ByinvoicinginthehomecurrencythisavoidstheFXexposure.Theresultisallforeignexchangeriskistransferredtotheotherpartyinthebusinesstransaction.Howevertheotherpartymaychargeahigherpricetocompensatefortheextrariskundertaken.152021/6/7Currencydiversification Spreadtransactionsoveralargenumberofcurrencies,thisshouldlimittheimpactofanadversechangeinexchangerates.Anadvantageofthismethodofinternalforeignexchangeriskmanagementisthattheprobabilityofadversemovementsinlargenumberofcurrenciesisverysmall.Thegreatestdiversificationisachievedwherethecurrenciesareperfectlynegativelycorrelated.162021/6/7Mark-ups Increasingpricesonexportsorimportstocoverworst-casescenariochangesinanexchangerate e.g.exportermarks-upexportpriceofgoodssold e.g.importermarks-upthedomesticpriceofimportedgoods Competitionisaconstrainttothisstrategy172021/6/7Counter-tradeandcurrencyoffsets Theexchangeofproductforproduct,ratherthencurrency-basedbuyorsellcontracts.Limitedtocompanieswishingtoexchangeproductsofequalvalueandatthesametime.Currencyoffsets.Recognitionofthetimingandamountofcashinflowsandoutflowsinthesamecurrency.ApplicabletobothinternalcashflowsofafirmandFXcashflowsbetweendifferentfirms182021/6/7ExternalRiskManagement Theexternaltechniquesareusedtohedgeagainstpossibleexchangerateexposure,whichinternalmeasureshavenotbeenabletoeliminate. Externaltechniquesareusedbybothexportersandimportersaswellasbymultinationalcompanies.Thecostsoftheexternalexposuremanagementmethodsarefixedandpredetermined.192021/6/7ExternalRiskManagement Themainexternalexposuremanagementtechniquesare: ForwardExchangeContracts CurrencyFutures CurrencySwaps CurrencyOptions202021/6/7ForwardExchangeContracts Forwardexchangecontractsrefert