Lecture 4 Nature and Measurement of Exposure and Risk 1

Lecture 4 Nature and Measurement of Exposure and Risk 1

Concept of Exposure Foreign Exchange Exposure occurs because of unanticipated change in the exchange rate For example the difference in the spot rate & one month forward rate is 0.30 rupee per USD and after one month rupee depreciates by 30 paisa there would be no FE exposure but if actual depreciation is more, then exposure would be said to exist 2

Classification of Foreign Exchange Exposure Accounting Exposure or Translation Exposure: derived from the consolidated financial statements of the parent company and it does not influence the cash flow Economic Exposure: results from altered cash flow of a company, further divided into transaction exposure and real operating exposure Transaction exposure refers to FE loss or gain on transaction already entered into & denominated in a foreign currency. It is connected with changes in the present cash flows Real operating exposure relates to changes in future cash flows- impact of inflation on the cost & revenue structure in addition to change in FE rate 3

Translation Exposure Emerges on a/c of consolidation of financial statements of foreign subsidiaries by the parent company With changes in exchange rate b/w host country & home country, picture of consolidated statement changes. This change represents the size of translation exposure Accounting exposure also explained in terms of net worth exposure where changes in exchange rate affect market value of assets & liabilities 4

Transaction Exposure Difference between expected cash flow & actual cash flow on a/c of exchange rate changes emerges: - owing to foreign trade in open account - borrowing or lending in foreign currency - intra firm cash flows In case of MNCs the consolidated net figure of cash flows determines the size of transaction exposure5 I 5

Real Operating Exposure Varies if the cost and revenue streams differ under different market conditions Cost & revenue streams under different market conditions are estimated and brought to the present value and then compared with the expected cash flow in absence of any change in exchange rate Estimated also by regression analysis 6

Management of FE Exposure: Hedging Decision PPP Theory- movement in exchange rate offsets the changes in price level Secondly, gains & losses of exchange rate change do tend to average out over a period of time Shareholders minimise currency risk through diversification of investment portfolio Hedging uses up scarce resource and may thus lower the value of the firm Debate seems to be academic, in practice firms do involve in various kind of hedging 7

Hedging Techniques for Transaction Exposure Contractual hedges and Natural hedges Contractual hedge include forward market hedge, money market hedge, future market hedge and options market hedge Money market hedge involve borrowing in local currency, convert the same into the currency of payables and then investing it for matching period (for imports). For hedging exports, the exporter first borrows in foreign currency and then converts in local currency before investment If the firm has sufficient cash from business operations to fund for this, it is called covered hedge otherwise an uncovered money market hedge Firm adopts a particular technique where cost is smallest or gain is largest 8

Natural Hedging Natural hedging is resorted to when contractual hedging fails to give results In the absence of a forward market in the currency in which the firm is exposed a perfect contractual hedge is not available Leads and lags: lead means accelerating or advancing the timing of receipt or of payment of foreign currency. Lag is just the reverse. Practiced for transactions between weak currency to hard currency areas or vice versa 9

Natural Hedging (2) Cross hedging: adopted when desired currency cannot be hedged. Firm has to first identify a currency that can be hedged and volatility of which is highly correlated with desired currency Currency diversification: diversifying operations in a larger no. of currencies as a hedging tool Risk sharing: contractual arrangement where buyer an seller agree to share the risk if variation crosses an accepted neutral zone 10