Foreign Exchange Risk Management

What is Foreign Exchange Risk? Any company that buys or sells in foreign markets will have to deal in multiple currencies. As price of those currencies in terms of home currency varies, the company has a foreign exchange exposure. Foreign exchange risk means exchange exposure can move adversely or favourably for the company. However, exchange rate exposure is not limited to those who buy or sell abroad. Even a purely domestic company with no sales abroad will be affected if it has foreign competitors.

Specifically exchange rate risk is viewed as the possibility that currency fluctuations can alter the expected amounts or variability of firms future cash flows.

Factors that help identify Exchange Risk to companies Where is the company selling? Domestic versus foreign sales breakdown If the company has sales mainly in the domestic market i.e. sells where it produces than exchange risk is minimal. Conversely if the company is a big exporter of goods and services than fluctuations in exchange rates will affect companys sales.

Who are the companys key competitors? Domestic versus foreign companies If the companys main competitors are domestic than the industry will have similar cost and sales structure vis a vis exchange rate changes. But if there are foreign competitors, the company will have

Foreign Exchange Risk Management economic exposure even though there will be no accounting exposure. For example, if the Yen depreciates against rupee than Japanese companies can lower rupee prices of their products without sacrificing Yen revenues. So Indian companies will be forced to match those price cuts or else cede market share.

How sensitive demand is to price? Price elasticity of demand The company can partially offset the effect of its appreciating currency if it exports goods to affluent consumers. The company can then hike prices without corresponding fall in demand. Conversely if it sells in the mass market, a home currency appreciation will leave it in a dilemma. If it cuts prices, revenues (and hence profits) will fall. Otherwise it will be priced out of the market by competition.

Where is the company producing? Domestic production versus foreign production The company can produce goods at home and export or it can manufacture them where it sells. In former case, company will be affected by exchange movements while in later it will have both costs and sales in foreign currency. However decisions to shift production plants abroad require huge investments and are irreversible in nature. So apart from exchange rates, hosts of other factors such as tax, labour supply, political stability etc need to be considered.

Foreign Exchange Risk Management Where the companys are inputs coming form? Domestic inputs versus foreign inputs If the company has very high import contents in its products then currency changes will affect its cost of production. For instance, Toyota uses steel, copper (priced in $) in its cars. A strong yen will lower their import costs so cost of production will decline. Thus for such companies, selling at home and abroad, both costs and revenues are subjected to exchange risks.

How are companys inputs or outputs priced? Currency of determination versus Currency of denomination If the company sells products in domestic market but whose prices are fixed globally then exchange risks arise. An example is oil. An Indian oil company sells crude oil domestically but because oil prices are fixed in dollars, the rupee price of oil will fluctuate with dollar/rupee rate. Hence although rupee is the currency of denomination, dollar is the currency of determination. Similar scenario arises if a company buys inputs whose prices are fixed globally.

Foreign Exchange Risk Management Based on the nature of exposure, they can be classified in two broad categories

Accounting Exposure

Economic Exposure

Accounting (or Translation) Exposure: It arises from the need, for purpose of consolidation and reporting, to convert financial statements of foreign subsidiaries in local currency (LC) to home currency (HC). If exchange rates have changed since previous reporting period, this translation or restatement of those assets, liabilities, revenues, expenses etc that are denominated in foreign currencies will result in foreign exchange gains or losses.

An accounting definition of exposure basically divides balance sheets assets and liabilities into those accounts that will be affected by exchange rate changes and those that will not. Losses or gains from translation exposure are notional in nature, as they do not involve any cash outflows or inflows. Four principle translation methods are available: the current/non-current method, the monetary/nonmonetary method, the temporal method and the current rate method. Current/Non Current method With this method, all the foreign subsidiarys current assets and liabilities are translated into home currency at the current exchange rate. Each non-current asset or liability is translated at its historical exchange rate that is, at the rate in effect at the time the asset was acquired or the liability incurred.

Foreign Exchange Risk Management The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with non-current assets or liabilities. The latter items such as depreciation expense are translated at the same rates as the corresponding balance sheet items. Monetary/Non monetary method This method differentiates between monetary assets and liabilities- that is those items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units- and, non monetary, or physical, assets or liabilities. Monetary items such as cash, accounts payable, receivable, and long-term debt are translated at the current rate, non-monetary items like inventory, fixed assets, are translated at historical rates. Temporal method This method is similar to a modified version of monetary/non monetary method. The only difference is that inventory is normally translated at historical rate, but it can be translated at the current rate if inventory is shown on the balance sheet at market values. Current Rate method It is the simplest method; all balance sheet and income items are translated at the current rate. One variation is to translate all assets and liabilities except net fixed assets at the current rate.

Foreign Exchange Risk Management Economic Exposure: While accounting exposure is mainly concerned with changes in balance sheet figures, economic exposure focuses on impact of an exchange rate change on future cash flows, i.e. it is based on the extent to which the value of firm-as measured by present value of expected future cash flows-will change when exchange rate changes. Economic exposure can be divided into two components Transaction Exposure Transaction Exposure arises from exchange gains or losses on foreign currency denominated contractual obligations i.e. transactions that require settlement in a foreign currency. For instance if IBM sells a mainframe computer to, say, Indian Oil, then IBM will be normally paid at a later date. If that sale is priced in dollars then Indian Oil has a dollar transaction exposure. Other examples include cross border trade, borrowing and lending in foreign currencies and local purchasing and sales activities of foreign subsidiaries. Some of these such as loans and receivables will be on the firms balance sheet. But a transaction exposure also arises from future sales and purchases, lease payments, forward contracts and other contractual or anticipated foreign currency receipts and payments.

Operating Exposure In terms of measuring economic exposure, a transaction exposure report no matter how detailed has a basic flaw: that local currency costs and revenue streams remain constant following an exchange rate change. operating exposure arises because currency fluctuations can alter a firms future revenues and costs-that is its operating cash flows. Consequently measuring or even identifying a firms operating exposure requires a long-term perspective, viewing the firm as an going concern whose cost and price competitiveness can be affected by exchange rate changes.

Foreign Exchange Risk Management Thus the firm faces operating exposure the moment it invests in servicing a market subject to foreign competition or in sourcing goods or inputs abroad. This investment includes new product development, a distribution network, foreign supply contracts, or production facilities. Transaction Exposure arises later on, and only if the companys commitments lead it to engage in foreign currency denominated sales or purchases. The time pattern of economic exposure is shown below. The measurement of economic exposure is made particularly difficult, as it is impossible to assess the effects of exchange rate change without simultaneously considering the impact on cash flows of the underlying relative inflation rates associated with each currency. Hence the concept of real exchange rate and exchange risk is briefly discussed below.

Time Pattern of Economic Exposure

Noncontractual

Quasi-contractual

Contractual

Investment in new Product development, Distribution facilities, Brand name, mktg, Foreign production capacity Foreign supplier relationships Quote/receive foreign currency price Ship product/bill customers in foreign currency, receive bill for supplies in foreign currency (FC) Collect FC receivables, pay FC liabilities

Foreign Exchange Risk Management Real Exchange Rate and its Importance A Real Exchange Rate is defined as the nominal exchange rate (say no. of rupees per $) adjusted for changes in the relative purchasing power of each currency since some common base period. Specifically if e t is the nominal exchange rate ( HC per unit of FC) at time period t, i h and if are home and foreign currency inflation rates w.r.t some common base period and e t is the real exchange rate then assuming Purchasing Power Parity (PPP) holds true, we have

e t = e t (1+ if ) t/ (1+ ih ) t A distinction between real and nominal exchange rates is crucial because of their different implications for exchange risk. A dramatic change in nominal exchange rate followed by an equal change in relative price level should have no effects on the relative competitive positions of domestic firms and their foreign counterparts. This therefore will not alter real cash flows. Alternatively if real exchange rate changes, it will cause relative price changes-changes in ratio of domestic goods prices to prices of foreign goods. In terms of currency changes affecting relative competitiveness, therefore focus should be on real exchange rate changes and not nominal ones.

Inflation and Exchange Risk Above point implies that without relative price changes, a multinational company faces no real operating exchange risk. As long as it avoids contracts fixed in foreign currency terms its foreign cash flows will vary with the foreign rate of inflation. Now, according to PPP, the exchange rate changes also depend on the relative difference between foreign and domestic rates of inflation. So movement of the exchange rate approximately cancels out the change in foreign price level leaving real home currency cash flows unaffected.

Foreign Exchange Risk Management The above conclusion does not hold if the firm enters into contracts fixed in foreign currency terms. Examples of such terms are foreign currency denominated debt with fixed interest rates, long-term leases, labour contracts and rent. If the real exchange rate remains constant, the risk introduced by entering into such contracts is not exchange risk but inflation risk as foreign cash flows remain constant but foreign inflation rate varies. The solution to inflation risk is to avoid writing contracts fixed in nominal terms in currencies, which experience high or unpredictable inflation.

Real Exchange Rate Changes and Exchange Risk In general, a decline in the real value of a nations currency makes its exports and domestic goods (competing against imports) more competitive. Conversely an appreciation in domestic currency will hurt its exporters and producers competing against imports.

Consider the Swiss and American exporters dilemmas in 1970s and 80s During the late 1970s, worldwide demand for Swiss franc denominated assets (equities, real estate, bonds) caused the Swiss franc to appreciate in real terms relative to other currencies. As a result Swiss watchmakers selling in United States were squeezed from both sides. Because of competition from Japanese companies, Swiss firms could not raise dollar prices of watches sold in US. Yet the dollar cost of Swiss labour and materials rose as the franc was appreciating against the dollar.

Foreign Exchange Risk Management Between 1980 and 1985, American exporters such as Kodak and Boeing faced similar problems. As dollar appreciated in real terms relative to other currencies, this left them with two harsh choices. They could either raise the foreign currency price of exports to preserve dollar revenues and margins but lose market share, or they had to accept lower dollar revenues (and margins) to protect market share. In either case, production costs were in dollars, which remained the same or rose in line with US inflation. Similarly US producers competing against imports found their dollar revenues and margins declining. They either had to match the price cuts by foreign firms or lose market share.

From above we can conclude that the economic impact of a currency change on a firm depends on whether the exchange rate change is fully offset by the difference in inflation rates or whether (due to price controls, a shift in monetary policy etc) the real exchange rate and , hence , relative price change. It is these relative price changes that ultimately determine a firms long run exposure

Fixed Nominal Exchange Rates and Exchange Risks A less obvious point is that a firm may face more exchange risk if the nominal exchange rates do not change. For instance, the Chinese (Remnibi) and Malaysian (Ringitt) currencies are pegged to the dollar. The risks faced by firms in such countries are better understood by a numerical example.

Consider a country like Brazil that has typically high inflation rates. Suppose a Brazilian shoe manufacturer exports shoes to US.

The Brazilian firm sells shoes in US for $10. Shoes cost $4 to the firm giving it a profit margin of $6 or Cruzerio$300 at current exchange rate of Cr$1=$0.02

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Foreign Exchange Risk Management

Assume price levels in US and Brazil at beginning of year are 100 each. At the end of year the price level in US remains same while that in Brazil double to 200. Now if nominal Cruzerio exchange rate remains constant then the real rate at the end of year will be Cr$1=0.02(2/1) = $0.04 The profit in Cr$ will decline to Cr$ (500-400) = Cr$100. In dollar terms, profit=$(10-400*0.02) =$2

So dollar profits have declined from $6 to $2 due to the fixed nominal exchange rate and rise in domestic inflation. The nominal exchange rate should change to reflect higher inflation in Brazil i.e. The new rate should be Cr$1=0.02(1/2) =$0.01. With this nominal rate, the real exchange rate at the end of year remains at Cr$1=$0.02 and profit margins revert to $6 (or Cr$ 600).

Another example of unfortunate effects of fixed nominal rates coupled with high domestic inflation rate was observed in Chile in 1980s. In order to tackle high inflation the Chilean government in the middle of 1979 fixed the exchange rate at 39 pesos to US dollar. (Ps 1=$ 0.02564). Over the next two and half years the Chilean inflation rose by 60% while that of US rose by 30%. So by 1982, the real exchange rate of peso was Ps 1= 0.02564(1.6/1.3) =$0.03156 even as the nominal rate was fixed. This implied a real peso appreciation of 23% over 3 years.

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Foreign Exchange Risk Management An 18% corrective devaluation was enacted in June 1982 but the artificially high Peso had done its damage. There was loss of export markets, loss of domestic markets to imports, massive unemployment, numerous bankruptcies and bank failures.

The Chile example illustrates a crucial point. An increase in the real value of a currency acts as a tax on exports and subsidy on imports

An Operational measure of Exchange Risk This approach is based on the following operational definition of exchange risk faced by a parent firm or one of its foreign affiliates . A company faces exchange rate risk to the extent that variations in the home currency (HC) value of the units cash flows are correlated with variations in the nominal exchange rate. This correlation can be established by regression analysis. The trick is to regress actual cash flows from past periods, converted into their HC values, on the average exchange rate during the corresponding period. This involves the following regression.

CF t = a + EXCH t + u

Where CF t = the HC value of total affiliate (parent) cash flows in period t EXCH t = the average nominal exchange rate (HC value per unit of FC)during period t u = a random error term with mean 0 The output from such a regression includes three key parameters 1. The foreign exchange beta () coefficient, which measures the sensitivity of HC cash flows to exchange rate changes.

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Foreign Exchange Risk Management 2. The t-statistic, which measures the statistical significance of the beta coefficient, and 3. The R2 which measures the fraction of cash flow variability explained by variation in the exchange rate The higher the beta coefficient, greater the impact of a given exchange rate on HC value of cash flows. Conversely lower the beta coefficient, less expose is the firm to exchange rate changes. A larger tstatistic means a higher level of confidence in the value of beta coefficient. However, even if a firm has a large and statistically significant beta coefficient and thus faces real exchange risk, this situation does not necessarily mean that currency fluctuations are an important determination of overall firm risk. What matters is the percentage of total corporate cash flow variability that is due to these currency fluctuations. So the most important parameter, in terms of its impact on firms exposure management policy, is the regressions R2.. For example, if exchange rate explains only 1% of total cash flow variability, the firm should not devote much time to foreign exchange risk management, even if beta is large and statistically significant.

Limitations The validity of this method clearly depends on the sensitivity of future cash flows to exchange rate changes being similar to their historical sensitivity. Also if the firm has entered into a large purchase or sales contract fixed in terms of foreign currency, it might decide to consider the resulting transaction exposure apart from its operating exposure.

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Foreign Exchange Risk Management A Further Look at Operating Exposure A real exchange rate change affects a number of aspects of the firms operations. When home currency (HC) appreciates, the key issue for a domestic firm is its pricing flexibility. Can the firm maintain its HC margins on domestic sales in the face of lower priced imports? In case of foreign sales can it raise the foreign currency selling price sufficiently to preserve its HC margins? The answers to these questions depend on the price elasticity of demand. Lesser the price elasticity of demand, easier it will be for a firm to change prices in response to exchange rate changes. Price elasticity in turn depends on the degree of competition and location of key competitors. The more differentiated a firms products are, lesser competition it will face both at home and abroad. Examples here are IBM mainframe computers and Mercedes Benz cars. Similarly if most competitors are based in same country then all will face a similar change in cost structure due a HC appreciation and all can raise their foreign currency prices without putting any of them at a competitive disadvantage relative to their domestic competitors. Conversely, less distinct a firms products are and more internationally diversified its competitors are, greater will be the price elasticity of demand for its products and less pricing power it will have. Such companies face the greatest exchange risk. A good example is the low/economic end of auto industry in US. Between 1980 and 85, dollar appreciated relative to yen and other European currencies. With US carmakers offering similar products and a weak home currency, low cost Korean, Japanese and European exporters gained market share as US carmakers suffered because of ensuing price war. Another important determinant of a companys susceptibility to exchange risk is its ability to shift production and the sourcing of inputs among countries. The greater a companys flexibility to substitute between home-country and foreign-country inputs or production, less exchange risk it will face. Other things being equal, firms with worldwide production plants and sourcing can cope better with currency

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Foreign Exchange Risk Management changes by increasing production in a country whose currency has devalued in real terms and decreasing production where the currency has revalued in real terms. For instance, Toyota with worldwide production plants can cope better with exchange rate fluctuations then, say, Boeing, which manufactures planes only in US but sells them worldwide. Thus a major conclusion is that operating exposure to a firm depends greatly on the sector of the economy it operates (export, import-competing or purely domestic), the sources of firms inputs (imports, domestic traded, nontraded goods), price elasticity of demand for its products and fluctuations in the real exchange rates. These factors help identify a firms true economic exposure than any accounting definition can.

Hedging Managing accounting exposure centers on the concept of Hedging. Hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency position is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Regardless of what happens to the future exchange rate, hedging locks in a fixed home currency value for the currency exposure. Thus hedging can protect a firm from unforeseen currency movements. A variety of hedging techniques are available, but before a firm uses them it must decide on which exposures to manage. Once the firm has determined the exposure position it intends to manage, it has to decide as to how it should manage that position. Also the firm has to decide which exposure reducing technique(s) should it employ. Exchange rate considerations need to be incorporated into operating decisions that will affect the firms exchange risk exposure.

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Foreign Exchange Risk Management Management of Transaction Exposure As said above, a transaction exposure arises whenever a company is committed to a foreign currencydenominated transaction. Since the transaction will result in a cash outflow or inflow, any change in exchange rate between the time transaction is entered into and the time it is settled in cash will lead to change in home currency amount of the cash inflow or outflow. There are various techniques-financial and non financial-to guard against such transaction exposures. However, eliminating transaction exposure risk does not eliminate all foreign exchange risks. The firm is still subject to exchange risk on its future revenues and costs-its operating cash flows. We will now look at some hedging techniques by examining General Electrics euro () exposure. Suppose on January 1 2005, GE is awarded a contract to supply turbine blades to Germanys Lufthansa. On December 31, GE will receive a payment of 25 million for these blades from Lufthansa. GE can convert these euros on December 31 at the then prevailing dollar/euro exchange rate. Alternatively, it can convert euros into dollar now and avoid any loss if dollar appreciates at the time of receipts. One way to do this is sell a 25 million contract one year forward. Otherwise, GE can use a money market hedge (explained below). If interest rate parity holds, both methods will yield same results. Forward market Hedge In a forward market hedge, a company that is long a foreign currency (foreign currency receivable) will sell the foreign currency forward; whereas a company that is short a foreign currency (foreign currency payable) will buy that currency forward. In this way, the company can fix its home currency value of foreign currency cash flow. Thus by selling forward proceeds from its sale of turbine blades, GE can effectively transform its euro denominated receivables into dollars. This will eliminate all currency risk on the sale. Suppose the current spot rate for euro is 1=$1.31 and one year forward rate is 1=$1.28. Then a forward sale of 25 million for delivery in one year will yield GE $32 million (25 *1.28).

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Foreign Exchange Risk Management Possible outcomes of forward market hedge as on December 31 2005 Spot exchange rate Value of original receivable (1) 1=1.31 1=1.28 1=1.26 1=1.34 $32.75 million $32 million $31.5 million $33.5 million Gain (loss) on forward contract (2) $(0.75) million 0 $0.5 million $(1.5) million Total cash flow (1) + (2) $32 million $32 million $32 million $32 million

Above exhibit shows four possible exchange rate scenarios on December 31. Regardless of what happens to future spot rate, GE will receive $32 million on its turbine sale. Any exchange rate gain or loss on the forward contract will be offset by a corresponding exchange loss or gain on the receivable. Without hedging, GE will have a 25 million asset whose value will change with exchange rate fluctuations. The forward contract creates an equal 25 million liability, offset by an asset worth $32 million. The euro asset and liability cancel each other out, and GE is left with a $32 million asset. True cost of Hedging The above exhibit shows that true cost of hedging cannot be calculated in advance because it depends on future spot rate, which is unknown at the time the forward contract is entered into. In the above example, the cost of hedging varies from $0.5 million to a loss of $1.5 million. This is the traditional method to calculate true cost of hedging as against the correct method, which measures its opportunity cost. Specifically, the cost of a forward contract is usually measured as its forward discount or premium: (e0-f1 / e0)

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Foreign Exchange Risk Management Where e0 is the current spot rate (home currency) of the foreign currency and f1 is the forward rate. In GEs case, this cost would be 2.3%. However, this approach is wrong because relevant comparison must be between the home currency (here dollar) per unit of foreign currency (euros) received with hedging, f1, and the dollars received in the absence of hedging, e1. Here e1 is the future (unknown) spot rate on the date of settlement. This means that the real cost of hedging is an opportunity cost. In particular, in absence of hedging, the future value of each unit of foreign currency would have been e1 dollars. Thus, the true home currency (HC) cost of the forward contract per HC worth of foreign currency sold forward equals (e1- f1)/ e0 In fact, in an efficient market, the expected cost (value) of a forward contract must be zero. Otherwise, there would be arbitrage opportunity.

Suppose for instance, the GE management believes that despite a forward rate of $1.28, the euro will be worth about $1.30 on December 31. Then GE can profit by buying (rather than selling) euros forward for one year at $1.28, and on December 31, complete the contract by selling euros in spot market at $1.30. If GE is correct, it will earn $0.02 (1.30-1.28) per euro sold forward. On a 25 million forward contract, this would amount to a whopping $0.5 million. Unfortunately, no such free lunches are likely to exist for long in the highly liquid international currency markets where speculators and hedge funds can quickly spot such inefficiencies. So unless, GE or any other company has some special information about the future spot rate that they feel is not adequately reflected in the forward rate, it should accept the forward rates predictive ability for hedging purposes and abstain from speculative activities. In hindsight, the actual cost of forward

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Foreign Exchange Risk Management contract can turn out to be positive or negative (unless the future spot rate equals the forward rate) but nobody can predict the sign in advance.

Money market Hedge A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency value of future foreign currency cash flow. For instance, suppose euro and dollar one year interest rates are 10% and 7.5% respectively. The hedge will be carried out as follows. GE will borrow 25/1.1 million = 22.72 million for one year, convert it into $29.76 million in the spot market and invest the $29.76 million for one year. On December 31, GE will receive 1.075*$29.79 million=$32 million. GE can use these dollars to pay back the 1.1*22.72 million= 25 million it owes in principal and interest. The equality of the net cash flows from the forward market and money market hedges is not incidental. If there are no capital account restrictions, interest rate parity holds so that domestic interest rates are aligned with exchange rates. Otherwise, covered interest arbitrage opportunity would exist.

Risk Shifting A firm can avoid transaction exposure altogether if the counterparty is willing to pay in the exporters currency. For instance, GE can avoid currency risk if Lufthansa has allowed it to price the sale of turbine blades in dollars. Dollar invoicing, however, does not eliminate currency risk; it simply shifts that risk from GE to Lufthansa (which now has dollar exposure).Lufthansa may or may not be better able, or willing, to bear the risk. Despite this form of risk shifting being a zero sum game, it is common in international business. Firms typically attempt to invoice exports in strong currencies (low inflation) and imports in weak currencies. This strategy assumes firms have some bargaining power with their trading

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Foreign Exchange Risk Management partners. (Say, the only supplier of a product) In other cases, where bargaining power is less pronounced, shifting risk in this manner may require concessions equal to or greater than the currency risk, and the effort may not be worthwhile. Exposure Netting Exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses (or gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. For example, a dollar receivable can be used to offset against a dollar payable. In practice, exposure netting involves one of three possibilities.

A firm can offset a long position in a currency with a short position in that same currency If the exchange rate movements of two currencies are positively correlated (for example, Taiwan $ and South Korean won), then the firm can offset a long position in one currency with a short position in the other.

If the currency movements are negatively correlated, then short (or long) positions can be used to offset each other.

Currency Risk Sharing In addition to a forward hedge, companies can engage in currency risk sharing which can be implemented by developing a customized hedge contract imbedded in the underlying trade transaction. This hedge contract typically takes place the form of a price adjustment clause whereby abase price is adjusted to reflect certain exchange rate changes. As an example, in the GE-Lufthansa deal, the base price could be set at 25 million, but the parties would share the currency risk beyond a neutral zone. The neutral zone represents the currency range where risks will not be shared.

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Foreign Exchange Risk Management Suppose the neutral zone is specified as a band of exchange rates: 1: $1.30-1.32 with a base rate of 1=$1.31. This means that within this band, Lufthansa will pay GE the dollar equivalent of 25 million at the rate of 1=$1.31, or $32.75 million. Thus, Lufthansa costs can vary from 25.19 million to 24.8 million. However, if the euro depreciates to, say, $1.26 then the actual rate has moved by $0.04 beyond the lower boundary of $1.30. This amount is shared equally. Thus the exchange rate used to settle transaction is 1=$1.29 ($ 1.31-0.04/2). The new price of turbine blades becomes 25 * 1.29=$32.25 million. Lufthansas costs rises to 25.6 million ($32.25 million/1.26). In absence of risk sharing agreement, GE would have received $31.25 million (25*1.29 million). Alternatively, if the euro appreciates by $0.04 beyond its upper bound of $1.32, then GE does not get the full benefit of the euros rise. Instead the new exchange rate becomes 1=$1.33 (1.31+0.04/2). GE receives 25 million*1.33=$33.25 million, and Lufthansas pays a price of 24.4 million. Thus in the neutral zone, the dollar value of GEs contract under the risk-sharing agreement stays at $32.75 million. Beyond the neutral zone, he contracts dollar value rises or falls only half as much under the risk-sharing agreement as under the no-hedge alternative. The value of the hedged contract remains the same irrespective of the exchange rate.

Currency Futures Currency futures, like forwards can be used to hedge a foreign currency exposure and are similar to forward contracts except for some key differences. They are entered into and traded on an organized exchange unlike forwards, which are not exchange based. Currency futures have standard contract sizes and risk of default is minimal as the exchange acts as counterparty to every transaction. In addition, they are settled only on specific dates (say, last Thursday of every month) and available in only the major currencies. Another distinguishing feature is the maintenance of a margin account with the exchange. An

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Foreign Exchange Risk Management initial sum is paid and then depending on the price difference between the contract price and daily settlement price, a cash inflow or outflow occurs in the margin account between the futures contract user and the exchange.

Foreign Currency Options Thus far, we have examined how firms can hedge known foreign currency exposures. Yet, in many situations, the firm is uncertain whether the hedged foreign currency outflow or inflow will materialize. For instance, suppose in above example, GEs bid for the contract was placed on January 1 and the outcome of bidding would be known only three months later. Therefore, from January 1 to April 1, GE does not know whether it will receive a payment of 25 million on December 31 or not. GE would like to remove this uncertainty and guarantee that the exchange rate does not move against it between the time it bids and the time it is paid for the contract, should it win the contract. The risk of not hedging is that its bid will be selected and the euro will decline against dollar, possibly wiping out its anticipated profit margins. If it hedges using forward contracts, it may have to suffer losses. For example, if the forward rate on April 1 for delivery on December 31 falls to 1=$1.26, the value of contract drops from $32 million to $31.5 million. The apparent solution for GE is to sell anticipated 25 million receivable forward on January 1 itself. However, if GE does that and loses bid on the contract, it still has to sell the euros-which it will have to buy from the open market, possibly at a big loss. This foreign exchange risk dilemma faced every company that bid on a foreign currency contract and was not assured of its success. The arrival of foreign currency options has resolved that dilemma, albeit at a small cost (option premium) to user companies. Two options are available to manage foreign exchange risk. A put option gives the option buyer the right, but not the obligation, to sell a specified number of foreign currency units to the option seller

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Foreign Exchange Risk Management (called the option writer) at a fixed price, called the strike price, up to the option expiration date.. Alternatively, a call option is the right, but not the obligation, to buy the foreign currency at a specified price, up to the option expiry date. Specifically, the solution in this case, therefore, is for GE, at the time of its bid, to purchase an option to sell (put option) 25 million on December 31. For example, suppose that on January 1, GE can buy for $100,000 (this represents option premium) the right to sell Citibank (the option writer) 25 million on December 31 at a price of $1.28 per euro. If it enters into this option contract with Citibank, GE will guarantee itself a minimum price of $32 million should its bid be selected, while simultaneously ensuring that if its bid failed, its loss will be limited to the price paid for the option contract (the premium of $100,000). Moreover, on December 31 if the spot price of euro exceeds $1.28, GE can let the option expire and convert the 25 million at the prevailing spot rate. Above example illustrates a crucial point on use of options. For example, when a firm has offered to buy a foreign asset, such as another firm or an oilfield, at a fixed foreign currency price, but is uncertain whether its bid will be accepted. By buying a call option on the foreign currency, the firm can lock in the maximum home currency price for its tender offer, while limiting its downside risk to the call premium in case its bid is rejected. The general rule for selection between forwards contracts and options contracts for hedging purposes are summarized below.

When the quantity of a foreign currency cash outflow is known, buy the foreign currency forward; when the quantity is unknown, buy a call option on the currency

When the quantity of a foreign currency cash inflow is known, sell the foreign currency forward; when the quantity is unknown, buy a put option on the currency

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Foreign Exchange Risk Management

When the quantity of a foreign currency cash flow is partially known and partially uncertain, use a forward contract to hedge the known portion and an option to hedge the maximum value of the uncertain reminder.

Managing Translation Exposure The basic hedging strategy for reducing translation exposure is shown below Assets Hard currencies (likely to appreciate) Soft currencies (likely to depreciate) Increase Decrease Liabilities Decrease Increase

Essentially, the strategy involves increasing hard-currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets, while simultaneously decreasing hard currency liabilities and increasing soft currency ones. For example, if a devaluation appears likely, the basic hedging strategy would be executed as follows: Reduce the level of cash, tighten credit terms to decrease accounts receivable, increase local currency (LC) borrowing, delay accounts payable and sell the weak currency forward. Despite their prevalence among firms, these techniques may not be automatically valuable. For if the market expects a currency appreciation or depreciation, this recognition will be reflected in the costs of the various hedging techniques. Only if the firms view is different from that of the markets and is superior to the markets can hedging lead to reduced costs. Otherwise main purpose of hedging is to protect the firm value from unforeseen currency movements.

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Foreign Exchange Risk Management Firms have three available methods for managing their translation exposure. These are briefly discussed below Funds Flow Adjustment Most techniques for hedging an impending LC devaluation reduce LC assets or increase LC liabilities, thereby generating LC cash. If accounting exposure is to be reduced, these funds must be converted into hard-currency assets. For example, a company will reduce its translation loss if, before an LC devaluation, it converts some of its LC cash holdings into home currency. This conversion can be done, either directly or indirectly, by means of various funds adjustment techniques. Funds adjustments involves altering either the amounts or the currencies (or both) of the planned cash flows of the parent and/or its subsidiaries to reduce the firms local currency accounting exposure. If an LC devaluation is anticipated, direct funds-adjustment methods include:

Pricing exports in hard currencies and imports in the local currency, Investing in hard-currency securities and Replacing hard-currency borrowings with local currency loans

The indirect methods include

Adjusting transfer prices on the sales of goods between affiliates, Speeding up the payment of dividends, fees, and royalties and Adjusting the leads and lags of inter subsidiary accounts receivable.

The latter method, which is the most frequent one used by multinationals, involves speeding up the payment of inter subsidiary accounts payable and delaying the collection of inter subsidiary accounts receivable. Above hedging procedures for devaluation would be reversed for revaluation.

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Foreign Exchange Risk Management

Basic Hedging Techniques Depreciation of LC Sell local currency forward Reduce levels of LC cash and marketable securities Reduce LC receivables Delay collection of hard currency receivables Borrow locally Increase imports of hard currency goods Delay payments of accounts payable Speed up dividend and fee remittances to Parent and other subsidiaries Delay collection of inter subsidiaries accounts receivables Invoice exports in foreign currency and imports in local currency Appreciation of LC Buy local currency forward Increase levels of LC cash and marketable securities Relax LC credit terms Speed up collection of soft currency receivables Reduce local currency borrowing Reduce imports of soft currency goods Speed up payments of accounts payable Delay dividend and fee remittances to parent and other subsidiaries Speed up collection of inter subsidiary accounts receivable Invoice exports in local currency and imports in foreign currency.

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Foreign Exchange Risk Management Forward Contracts Forward contracts, as explained above, along with leading and lagging of payables and receivables, is the most popular coverage technique. For those countries in which a formal market for local currency (LC) forwards does not exist, leading and lagging and LC borrowing are the most important techniques. However, most of international business is done in those major currencies for which forward markets do exist. Selecting convenient (less-risky or low inflation) currencies for invoicing exports and imports and adjusting transfer prices are two other techniques less frequently used because of certain constraints. For instance, it is often difficult to make a customer or supplier accept billing in a particular currency. Exposure Netting This additional exchange management technique is available to firms with positions in more than one foreign currency or with offsetting positions in the same currency. As defined earlier, this technique involves offsetting exposures in one currency with exposures in the same or another currency such that gains or losses on the two currency positions will offset each other.

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Centralization versus Decentralization In the area of foreign exchange risk management, there are arguments both for and against centralization. Favouring centralization is the reasonable assumption that local treasurers want to optimize their own financial and exposure positions, regardless of the overall corporate position. Through lack of knowledge or incentive individual subsidiaries may undertake hedging actions that increase rather than decrease overall corporate exposure in a given currency. If subsidiary A sells to subsidiary B in sterling, then from a firm perspective, these sterling exposures net out on a consolidated translation basis. If A and/or B hedge their sterling positions, however, unnecessary hedging takes place or a zero sterling exposure turns into a positive or negative position. Furthermore, in their dealings with external customers, some affiliates may end up with a positive exposure and others with a negative exposure in the same currency. Once the firm has decided on the maximum currency exposure it is willing to tolerate, it can then select the cheapest option(s) worldwide to hedge its remaining exposure. Tax effects can be crucial at this stage, both in computing the amounts to hedge and the costs involved, but only headquarters will have the global perspective. Against the benefits must be weighed the loss of local knowledge and the lack of incentive for local managers to take advantage of particular situations that only they may be familiar with. Companies that decentralize the hedging decisions may allow local units to manage their own exposures by engaging in forward contracts with a central unit at negotiated rates. The central unit, in turn, may or may not lay off these contracts in the marketplace.

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Management of Operating Exposure Firms can easily hedge exposures based on projected foreign currency cash flows, but competitive exposures-those arising from competition with firms based in other currencies-are longer term, harder to quantify and cannot be solely dealt through financial hedging techniques. For any currency depreciation or appreciation to significantly affect the firms value, it must lead to changes in the relative prices of either of the firms inputs or the products bought or sold in various countries. To the extent that exchange rate changes do bring about relative price changes, the firms competitive position will be altered. The appropriate response to an anticipated or actual real exchange rate change depends crucially on the length of time the real change is expected to persist. For example, following a real home currency appreciation, the exporter has to decide if, and how much to raise its foreign currency prices. If the change were expected to be temporary and regaining market share were expensive, the exporter will prefer to keep FC prices constant and accept lower profitability. A longer lasting change in real exchange rate will probably lead the firm to increase its FC prices, at the expense of losing some export sales. Assuming a still more permanent shift, the firm might choose to build production facilities abroad. Alternatively, if the cost of regaining market share is sufficiently great, the firm can hold foreign currency prices constant and count on shifting production prices to preserve longer-term profitability. Marketing Management of Exchange Risk The design of a firms marketing strategy under conditions of home currency (HC) fluctuation presents considerable opportunity for gaining competitive advantage. Thus one of the international marketing managers tasks should be to identify the likely effects of a currency change and act on them by adjusting pricing and product policies.

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Foreign Exchange Risk Management Market Selection Major strategic considerations for an exporter are the markets in which to sell-that is, market selectionand the relative marketing support to devote to each market. it is also necessary to consider the issue of market segmentation within individual countries. A firm that sells differentiated products to more affluent customers may not be harmed as much by a foreign currency devaluation as a company that sells to the mass market. On the other hand, following a depreciation of home currency, a firm that sells primarily to upper-income groups may find it easy to penetrate mass markets abroad with lower prices. Market selection and market segmentation provide the basic parameters within which a firm may adjust its marketing mix over time. In the short, however, neither of these two basic strategies can be altered in response to actual or anticipated currency changes. Instead the firm must select certain tactical responses such as adjustments of pricing, promotional and credit policies. In the long run, if real exchange rate change persists, the firm will have to revise its marketing strategy. Pricing Strategy Two key issues must be addressed when developing a pricing strategy in face of exchange rate volatility. One is whether to emphasize market share or profit margin and how frequently to adjust foreign currency prices. Market share or Profit Margins? In the wake of a rising rupee, consider the dilemma of an Indian exporter (selling in, say, US market) or a domestic firm competing against imports. The exporter can keep dollar prices constant in US market but suffer a decline in rupee revenues (and hence profit margins) or it can increase dollar prices to preserve rupee margins but lose market share. Conversely, if the rupee weakens against dollar, the exporter can either reduce dollar prices to regain lost market share or keep prices same and recoup losses suffered due to a strong rupee.

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Foreign Exchange Risk Management The above dilemma needs a little analysis. To start with, an Indian firm selling in US market should follow the standard economic proposition of setting the price that maximizes its rupee profits. In making this determination, however, dollar profits should be translated using the forward exchange rate that reflects the true expected rupee value of the receipts upon collection. Following appreciation of rupee, which is equivalent to dollar depreciation, the firm selling in US should consider opportunities to increase dollar prices of its products. However, local producers will have a competitive cost advantage, limiting exporters ability to raise dollar prices. At best, therefore the Indian firm will be able to raise its prices by the extent of the dollar devaluation. For example, suppose ITC sells cigarettes in US priced at $2 when the exchange rate is $1=Rup. 43.00. This gives ITC revenues of Rs. 86 per unit. Now if dollar weakens to $1=Rup.42.00 then ITCs revenues fall to Rs. 84 per unit unless it can raise prices to $2.05. At worst, in an extremely competitive market, ITC will be forced to absorb a reduction in rupee revenues equal to the percentage decline in dollar i.e. if ITC cannot raise its dollar price then the new price of Rs. 84 represents a 2.33 % decline in revenues, the same as the drop in value of Dollar [(42-43)/43] =2.33% In the most likely case, foreign currency prices can be raised somewhat, and the exporter will make up the difference through a lower profit margin on foreign sales. Under the conditions of rupee depreciation, the exporter will gain a price advantage in foreign market. An exporter now has the option of increasing unit profitability- that is, price skimming- or expanding his market share-penetration pricing. Other factors such as whether this change is likely to persist, economies of scale, the cost structure of expanding output, consumer price sensitivity and the likelihood of attracting competitors if unit profitability is unusually high also need to be considered. The greater the price elasticity of demand, the greater the incentive to hold down the price and thereby expand sales. Similarly, if economies of scale exist, it is worthwhile to hold price, expand demand and

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Foreign Exchange Risk Management thereby lower unit production costs. The reverse is true if price elasticity is low or economies of scale do not exist. In deciding whether to raise prices following home currency appreciation, firms must consider not just sales lost today but also the likelihood that sales will be lost in future. For instance, following weak yen and pound, Japanese and European automakers lowered their car prices in US. However, even with a weak dollar in late 1980s, US carmakers did not substantially gain market share as foreign competition was firmly entrenched. Frequency of Price Adjustments Firms in international competition differ in their ability and willingness to adjust prices in response to exchange rate changes. Price adjustments also depend on the nature of goods sold and to whom. For example, customers who buy machinery and equipment from the selling firm would value a contract that is fixed in price and quantity. A devaluation of home currency, say rupee, will be an advantage for Indian firms competing against imports. They can either lower prices and gain market share or raise their prices in line with increase by foreign firms. Promotional Strategy Promotional strategy should take into account expected exchange rate changes. A key issue in any marketing program is the size of promotional budget for advertising, personal selling and merchandising. Promotional decisions should explicitly build in exchange rates, especially in allocation of budgets among different markets. An Indian exporter, after a domestic devaluation will find that return per rupee expenditure on advertising or selling has increased due to products lower price abroad. On the other hand, a domestic revaluation is likely to reduce the return on marketing expenditures and may require a fundamental shift in product strategy.

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Foreign Exchange Risk Management Product Strategy In the long term, companies respond to exchange risks by altering their product strategy. This can be done through new-product introduction, product line decisions and product innovation. The company can change the timing of introduction of new products. For instance, the period following domestic devaluation may be the ideal time to develop a brand in foreign markets. Exchange rate fluctuations also affect product line decisions. Following home currency devaluation, a firm can expand its consumer base both at home and abroad. Conversely, a revaluation will force the firm to focus on high income consumers where quality and style rather than price are key factors. This strategy was adopted by Volkswagen, as it became a big exporter of small economy class cars. However, the rise of Deutsche mark in early 1970s effectively ended Volkswagens ability to compete on basis of price alone. To compete in long run, Volkswagen was forced to revise its product line and sell relatively higher priced cars to middle-income consumers who focused more on style then on price.

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Production Management of Exchange Risk The marketing strategies discussed so far to counter a real exchange rate change involve attempts to alter the home currency value of foreign currency revenues. However, sometimes exchange rate moves so much that pricing or other marketing strategies cannot save their product. This was the case for US firms in early 1980s and for Japanese firms in late 1980s when the dollar and Yen were relentlessly appreciating. In fact between 1980 and 1985, the dollar appreciated so much against other currencies that the Group of Seven (G-7) industrialized nations finance ministers actually met in a New York hotel to collectively bring dollar down through Central Bank intervention (known famously as the Plaza Accord after the hotel where they met). Firms who face such situations must either drop uncompetitive products or cut costs. Product sourcing and plant location are the principal variables that companies manipulate to manage competitive risks that cannot be dealt with through marketing changes alone. Input Mix Outright additions to existing facilities overseas naturally accomplish a manufacturing shift. A more flexible solution is to purchase more components overseas. This is sensible, as a stronger home currency will make it easier to buy components from overseas low cost producers rather than make them inhouse. Consider the Japanese Automakers response to a rising yen In late 1980s, an appreciating yen dragged down the US earnings of Japanese carmakers like Toyota, Honda as a falling dollar made their cars relatively costly . Estimating the yen rise to be of a permanent nature, Japanese carmakers began to cut costs to remain competitive in US markets. They purchased a significant percentage of intermediate components from independent suppliers. This practice, called outsourcing, gave them the flexibility to shift the purchase of intermediate inputs towards suppliers with costs least affected by exchange rate changes. Some of these suppliers were from South Korea and

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Taiwan-nations whose currencies are closely linked to dollar. Thus even if the intermediate goods were not priced in dollars their yen-equivalent costs would decline with a falling dollar and thereby lessen the impact of falling dollar on the cost of Japanese cars sold in US. Shifting Production among Plants Multinational firms with worldwide production systems can allocate production among their several plants in line with the changing home currency costs of production-increasing production in a nation whose currency has devalued and, decreasing production in a country where there has been a revaluation. Multinationals firms would therefore be subjected to less exchange rate risk then an exporter because their ability to shift production (and marketing) operations in line with changing relative production costs. A strategy of production shifting requires that the MNC has already created a portfolio of plants worldwide. However, multiple plants create manufacturing redundancies and impede cost cutting. The cost of multiple plants is especially great when economies of scale would dictate having only one or two plants serve the global market. Moreover, MNC firms may not be able to move production so easily across countries due to government restrictions, local labour unions and other factors. The case the auto industry illustrates the potential value of maintaining a globally balanced distribution of production facilities in the face of fluctuating exchange rates. For instance, consider Swedish carmakers like SAAB and Volvo. They have most of manufacturing plants at home but sell cars worldwide so there is always the threat of reduced overseas earnings due to stronger home currency. By contrast, Ford and General Motors of US have plants worldwide and are better adapted to handle any exchange rate risks by reallocating various stages of production among their several plants in line with relative production and transportation costs.

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Plant Location A firm without foreign facilities that is exporting to a competitive market whose currency has devalued may find that sourcing components abroad may be insufficient to maintain unit profitability. Therefore, it may have to build new production plants abroad. Before committing any investments abroad, the firm must attempt to assess the length of time a particular country will retain its cost advantage. If the devaluation was due to inflationary conditions that are likely persist, a countrys apparent cost advantage may soon reverse itself. In Mexico, for example, the wholesale price index rose 18% relative to US prices between January 1969 and May 1976. This led to a 20% peso devaluation in September 1976. Within one month, though, the Mexican government allowed the organized labour to raise its wages by 35-40%. As a result, the peso devaluations effectiveness was nullified, and the government was forced to devalue the peso again in less than two months. The government, once again, fixed nominal exchange rate of peso while inflation persisted at a high level-a policy with disastrous effect as was seen in case of Chile. Yet, shifting production abroad when home currency rises may not always be the best approach. If the firm can produce components in high volume in efficient domestic factories then it is better to raise productivity of domestic plants then to shift them overseas. This is particularly true in case of technology intensive industries like chip design and manufacturing, electronics etc where protecting proprietary know how are also important. Producing at home also improves coordination between design and manufacturing and avoids problems of quality control. For instance in 2004, Canon, a Japanese maker of high quality digital cameras has decided to bring back its outsourced components business back to Japan for precisely the above-mentioned reasons.

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Raising Productivity As mentioned above, shifting factories abroad in response to a persistently appreciating home currency may not always be necessary. Domestic firms can achieve the desired savings by improving productivity-closing inefficient plants, automating heavily, negotiating wage and benefit cutbacks and work-rule concessions with unions. Firms can also improve productivity and product quality through employee motivation programs.

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Financial Management of Exchange Risk The one attribute that all strategic marketing and production adjustments have in common is that they take time to accomplish in a cost effective manner. The role of financial management in this process is to structure the firms liabilities in such a way that during the strategic operational adjustments are underway, the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities. One possibility is to finance the portion of a firms assets that are used to create profits from foreign sales so that any shortfall or loss in operating cash flow due to an adverse exchange rate change is offset by a reduction in debt servicing expenses. For example, a firm, which has developed a sizable export market, should hold a portion of its liabilities in that countrys currency. This ensures that if the firms home currency appreciates against that currency then any loss on export sales will be offset by a reduction in liabilities in home currency value. Obviously, the portion to be held in foreign currency depends on the size of the loss in profitability associated with a currency change.

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Is it necessary to Hedge? In the above discussions on types of foreign exchange exposures and ways to minimize them, one critical question remains unanswered. Is it necessary to hedge? The company managements objectives will largely determine its decision about the specific hedging tactics and strategy to pursue. The view taken here is that the basic purpose of hedging is to reduce exchange risk, where exchange risk is defined as that element of cash flow variability that is due to currency fluctuations. Underlying the selection of above definition of exchange risk based on market value is the assumption that managements primary objective is to maximize the value of the firm. Hence, the focus is on the cash-flow effects of currency changes. In operational terms, hedging to reduce the variance of cash flow translates into the following exposure management goal: to arrange a firms financial affairs in such a way that however the exchange rate may move in future, the effects on home currency (say, rupee) are minimized. Not all firms subscribe to above view. Instead, many firms follow a selective hedging policy designed to protect against anticipated currency movements. However, if financial markets are efficient, firms cannot hedge against expected exchange rate changes. Domestic interest rates, forward rates and sales contract prices should already reflect the currency changes that are anticipated, thereby offsetting the loss-reducing benefits of hedging with corresponding higher costs. Other techniques for hedging against anticipated currency changes were summarized in above exhibits. These techniques, however, are vastly overrated. For instance, if devaluation is imminent, the cost of using these techniques (say, cost of local borrowing) rises to reflect the anticipated devaluation. For example, the one-year forward discount rate in the futures market was close to 100% just before the Mexican peso was floated in 1982. Just prior to

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Foreign Exchange Risk Management the August 1982 peso devaluation, for instance, every company in Mexico was trying to delay peso payments. Of course, this technique cannot produce a net gain, as one companys receivable is another companys payable. A company can profit from hedging techniques only to the extent that it can estimate the probability and timing of devaluation more accurately then the general market can. However in doing so, the firm must remember that it will be competing against banks and other sophisticated investors where professionals are paid to forecast such events. Moreover, attempting to profit from foreign exchange forecasting is speculation rather than hedging. To summarize, hedging exchange risks costs money and should be viewed as a purchase of insurance. The conclusion is that a firm can protect itself only against unexpected currency changes; however, by definition these changes are unpredictable and, consequently, impossible to profit from.

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The Risk Management Process Management of currency risk and exposure is vital for multinational firms and the effectiveness with which it is performed can have serious implications for companys survival. The main issues are
The

companys strategic business posture towards risk and its tolerance design required to implement a coherent policy

Attitude

Organization Monitoring

and control mechanisms for performance evaluation

Implications Possible

conflict of interest between a parent company and its global subsidiaries.

Consequently, top management must get intimately involved in the process of designing the risk management policy and ensure the participation of all employees concerned. Exposure management policy and its implementation cannot be divorced from the particular set of conditions, which affect a firms decision-making and daily operations. Therefore, it is not possible to frame policies that have universal applicability. However, there are certain tasks or steps involved in any risk management process. Choose an appropriate performance measure. Operating cash flows is the most likely measure for nonfinancial companies. Identify key risk factors and assess the sensitivity of the performance measure to each of them. Some exposures, like transaction exposures, are easy to identify and measure. Others, such as operating exposures are very difficult to quantify and require detailed understanding of price elasticity and industry cost structures. Macroeconomic risk factors like exchange rates, interest rates and commodity

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prices and government policies regarding taxation, foreign trade etc will also affect the competitive structure of an industry and hence operating exposure. Estimate the risk profile of the performance measure. The idea is to pin down those risk factors that appear to give rise to excessive fluctuations in the performance measure. Risk profiles can be expressed in terms of variance of target variable or the possible range of variation under reasonable assumption. Exposure is defined as the sensitivity of the performance variable to the underlying risk factors and risk is a measure of the extent of variation attributed to the particular risk factor. In this step, we are estimating risk while in above step we assessed exposure. Determine the desired risk profile. This is a crucial step. It requires an explicit statement of the firms risk-return trade off. Some firms may wish to entirely remove or shift exposure risk. Others may be willing to take some downside risk i.e. tolerate a limited loss in the hope of benefiting from favourable movements in the risk factors. Still others are bolder enough and may wish to leave certain exposures unmanaged. This is, however, passive speculation as firms have taken open positions with the expectations of benefiting from favourable future exchange rate changes. Determination of the desired risk profile in such cases must be based on the firms market view i.e. its forecasts of risk factors and the degree of confidence with which such beliefs are held. As a rule, risk reduction has a cost in terms of transaction costs and premium demanded by those who are willing to borne the risk. In many cases, a firm has natural hedges and does not need to execute a hedge transaction. For instance, a receivable in euro and a payable in Swiss franc, both maturing at the same time, may offset each other since movements in these two currencies tend to be strongly correlated. A firms dominant position may

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Foreign Exchange Risk Management allow it to pass on to customers any cost increases due to exchange rate changes. This and other in-built hedges must be fully explored before deciding to choose an explicit hedging contract.

After the risk-return trade off is decided, risk reduction mechanisms are selected. The menu available to choose from is very wide. From relatively simple methods like forwards, futures, options etc to complicated structures like commodity linked bonds, debt with embedded options etc. the option chosen depends on the risk-return tradeoff preferred by the firm. Execute the selected hedging transaction Monitor the performance of the selected risk reduction mechanism. In case of forwards and options hedges, the effectiveness and risk characteristics change with the underlying spot market prices and time. Therefore, the hedge may have to be regularly adjusted to achieve the desired performance. It is evident that some of these steps, for example, selecting the appropriate performance measure and specifying the desired risk profile call for top management involvement. Some, such as assessing the exposure and estimating the risk profile, will require inputs from managers in marketing, purchasing and production departments. Others such as execution and monitoring the hedge performance will be left to the treasury department. Selection of Performance Variable In recent years, financial institutions and banks have used a concept called Value at Risk (VAR) as a target variable to quantify the risk of their portfolios. It is a single statistical measure of possible loss in the value of a portfolio due to normal market movements in underlying risk factors over a given time period. It is a limit on the loss of value, which will be exceeded only with a small pre-specified probability. Thus, to say that for a particular portfolio of assets and liabilities, the VAR is X (dollars or rupees etc) with 95% confidence level is to assert that the probability of loss in value of

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the portfolio exceeding X is 5%. Quantifying risk in this manner requires sophisticated analytical modeling simulation exercises.

For industrial firms, a concept called cash flow at risk (CFAR) can be used as the performance variable. It links operating cash flows to the macro risk factors like exchange rates, interest rates and commodity prices. The idea is to build a business model for the entire firm which links key items such as sales quantity, revenues, cost of goods sold, interest expenses to above macro factors. We then generate simulations for macro factors and use the model to compute cash flows under each scenario. Objectives of Hedging Policy The task of managing foreign exchange risks must be guided by clearly defined objectives. The treasury staff that is responsible for selection of risk reduction mechanisms and monitoring the performance must have a clear understanding of following aspects. Whether the risk management posture is to be conservative or aggressive Risk management can be very conservative or can actively seek to profit from financial market fluctuations. If total risk removal is the objective, then risk management can be a purely passive response to financial fluctuations. Each exposure should be fully hedged every time. Alternatively, a firm may believe that it has superior forecasting ability and financial expertise and treat risk management as a profit centre. In such a case, the treasury people are expected to generate profits by outguessing financial markets, such profits have nothing to do with the firms core business. If such an active posture is adopted, the firm must be willing to tolerate some risks, which may occasionally lead to substantial cash losses.

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Foreign Exchange Risk Management In addition, an aggressive risk management policy requires that considerable resource be devoted for the purpose in terms of trained work force, sophisticated communications and equipment, access to database etc. The appropriate performance measure in terms of which efficacy of risk management will be evaluated. This has been already discussed and we suggest operating cash flows is the appropriate performance variable in most situations The time horizon to be adopted in making risk management decisions If the time horizon is limited to the upcoming financial year and the focus is on minimizing cash losses, hedging transactions exposure is the critical task. If, in addition the firm were concerned about the exhibits that will be reported in financial statements, translation exposure would also become relevant. On the other hand, if the time horizon is longer, operating exposure is crucial. In practice both short and long-term viability are important. Nevertheless, very often, since operating exposure is difficult to assess and defense against it requires structural adjustments, the treasury staff tend to focus on transactions and translation exposures. It is here the duty of top management to ensure that the longer-term effects of exchange rates trends are constantly analyzed and necessary adjustments are carried out in timely fashion. To summarize, the risk management policy must spell out the risk-return trade off, the target performance indicator(s), the relevant time horizon and quality of resources the firm is willing to commit to the risk management function.

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Organizational Issues in Risk Management For manufacturing and non-financial firms, a large part of financial exposures and risks arise out of their core business operations and the manner in which such risks are managed has implications for their operations. Consequently, design and implementation of risk management policy cannot be left solely to treasury. Senior executives in other functional departments must be involved at various stages. An effective risk management policy is based upon the existence of structures and systems, which facilitate information flows, allocation of responsibility and authority and performance evaluation. Three main considerations are briefly addressed below

Who should get involved in the establishment and implementation of risk management policy?

What are roles and responsibilities of various participants? Performance measure and control systems

On the first and second issues, it is clear that the primary responsibility for executing the policy must rest with the treasury managers and market dealers. Because of their intimate knowledge of financial markets, instruments and operational constraints, they can also help in evolving the policy and provide strategic perspective. Executives from marketing, sales, production, purchase can provide insights into how various exposures arise, their time profile and impact on their operations if they are managed in a particular way. For instance, using leads and lags to manage currency exposure may affect supplier and customer relationships. They should also play an important role in the management of operating exposure as they have a more detailed knowledge of competitive pressures in their product markets, demand elasticities, alternative sources of supply of imported materials, raw material prices and so on.

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Foreign Exchange Risk Management Finally, performance appraisal of risk management centers is relatively difficult since the local management cannot be penalized for decisions taken by centralized risk management teams. Moreover, measurement of hedging performance is a complex issue. Unless if a firm is completely risk averse and wishes to eliminate all possible exchange risks, it is always a question of risk-return trade off which are rarely, if ever, made explicit. Statistically the hedging performance can be measured by comparing the mean and variance of the operating cash flows attained with the chosen strategy with the mean and variance that would have been obtained by using an alternative benchmark strategy. Although the choice of a satisfactory benchmark is never easy, the strategy of forward hedging all the exposures all the time can be used as the benchmark for transaction exposures.

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