University Business school

Transfer
Transfer
Risk
Risk

Macro-
Macro- Sovereign
Sovereign
economic
economic Risk
Risk
Risk
Risk

COUNTRY
COUNTRY
RISK
RISK

Indirect
Indirect Contagion
Contagion
Country
Country Risk
Risk
Risk
Risk

Currency
Currency
Risk
Risk
 Technical forecasting
 Fundamental forecasting
 Market based forecasting
 Mixed forecasting
 Whether as a business advisor or a litigation
manager, the value of in-house counsel is to
guide their company clients through a
multitude of legal obstacle courses, with the
primary purpose of managing the legal risk
while enabling the client to achieve its
business goals. Part and parcel of that value
is counsel’s ability to be proactive and
prepared for risk as it arises. In the context of
litigation, where risk can be realized in a very
public manner through court orders and
negative press, investing time to prepare
themselves and the company to proactively
 It is based on fundamental relationship
between economic variables and exchange
rates.
◦ e= f[ INF, INT, GC, EXT]
◦ e=% change in the spot rate
◦ INF= change in the differential between U.S.
inflation & the foreign country’s inflation
◦ INT= change in the differential between U.S.
interest rate & the foreign country’s interest rates
◦ INC= change in the differential between U.S.
income level & the foreign country’s income level
◦ GC= change in government controls
◦ EXT= change in expectations of future exchange
rates.
 Spot rate
 Forward rate
◦ F= s(1+p)
 Gains or losses from exchange rate
changes that occur as a result of
converting financial statements from one
currency to another in order to
consolidate them.
 Translation exposure= (exposed assets-
exposed liabilities) ( change in exchange
rate)
 This exposure refers to the extent to
which the future value of firm’s domestic
cash flow is affected by exchange rate
fluctuations.
 The risk of changes in the expected value
of a contract between its signing and its
execution as a result of unexpected
changes in foreign exchange rates.
 Whoever makes a contract denominated
in a foreign currency bears transaction
risk.
 Changes in competitive position as a result
of permanent changes in exchange rates.
 Every company buying or selling abroad or
even just competing with foreign companies
has economic risk.
 Translation
methods

Single rate Multiple rate

method method

Monetary/non-
Current rate Current/non- Temporal
monetary
method current method method
method
 Balance sheet: All current assets and current
liabilities are translated into the home
currency at the current exchange rate.
 Income statement/P&L a/c: translated at
average exchange rate for the period cover.
AER = Total ER/Number of years
 Revenue and expenses related to non-current
assets and long term borrowings at the
historical cost.
 Liabilities / Sources Assets/ Applications
Share Capital Fixed Assets
Reserve surplus Investment
Secured Loan Current Assets
t
Unsecured Loan Loan & Advances
Current Liabilities & Miscellaneous
t Provision Expenditure
Profit/Loss A/c

t= current rate
Rest of the balances are on historical cost

Net current assets= current asset- current liabilities

+ve NCA: CA>CL
-ve NCA: CA<CL
 Monetary items: are those that represent a
claim to receive or an obligation to pay a fixe
amount of foreign currency unit, e.g. cash,
accounts receivables, current liabilities,
account payable and long term debt.
 Non-monetary items: inventory, fixed assets,
long term investment.
 Monetary items: current rates
 Non-monetary items: historical rates
 P/L= AER except COGS, depreciation or those
related to non-monetary item.
 Modified version of monetary/non monetary
method.
 Inventory translated at current rate if shown
in the balance sheet at market value.
 All balance sheet and income statement items
are translated at current rate except equity.
 Equity = historical rate.
 COGS and Depreciation = Actual exchange
rate/weighted average exchange rate.
 Dividend paid = exchange rate on payment
date.
 Gains/loss reported separately in cumulative
translation adjustments.
Accounts Functional Current/n Monetary/ Temporal Current
currency on current non rate
monetary
Cash 100
Accounts 150
receivable
s
Inventory 200
Fixed 250
assets
Total 700
Current 100
liablities
Long- 300
term debt
Gains/loss
Accounts Functional Current/n Monetary/ Temporal Current
currency on current non rate
monetary
Cash 100 100 100 100 100
Accounts 150 150 150 150 150
receivable
s
Inventory 200 200 400 200 200
Fixed 250 500 500 500 250
assets
Total 700 950 1150 950 700
Current 100 100 100 100 100
liablities
Long- 300 600 300 300 300
term debt
Gains/loss -350 150 -50 300
 Net exposure in currency (i)- Net exposure in currency (i)
New spot Rate (i/r) old spot Rate (i/r)
r= reporting currency (U.S)
i= Euro
 New spot rate = 1.1786/$1.0

 Old spot rate = 1.1000/$1.0

300 - 300
1.1786/1.00 1.1000/1.00

-$18.2
 Balance sheet hedge: it is never entity specific. It basically
arises on account mismatch of assets and liabilities
denominated in same currency.
 A balance sheet hedge requires an equal amount of exposed
foreign currency assets and liabilities on a firm’s consolidated
balance sheet.
 These hedges are a compromise in which the denomination
of balance sheet accounts is altered, perhaps at a cost in
terms of interest expense or operating efficiency, to achieve
some degree of foreign exchange protection.

 Example: Assets 7645

Liabilities 5819
◦ 1826 (difference)
 Derivative Hedge: how much forward we need
to hedge exposure of -$18.2. for this they
are making forward sell.
 Forward contract position in functional
currency= Potential translation loss
f (r/i)-expected spot (r/i)
r= reporting currency U.S
i= Euro
18.2 = $140
1/1.393-1/1.1786
So we need to forward sell $140 to hedge
 Inaccurate earning forecasts
 Inadequate forward contracts for some
currencies
 Accounting distortions
 Increased transaction exposure
 Reporting currency: it is currency which
enterprise use to present financial
statements.
 Foreign currency: currency other than
reporting currency.
 Foreign operation: any subsidiary associate of
a reporting enterprise.
 India is adopting at temporal rate.
 This exposure refers to the extent to which the
future value of firm’s domestic cash flow is
affected by exchange rate fluctuations.
 The risk of changes in the expected value of a
contract between its signing and its execution as a
result of unexpected changes in foreign exchange
rates.
 Whoever makes a contract denominated in a
foreign currency bears transaction risk.
 Determine the projected net amount of currency
inflows or outflows in each foreign currency
 Determine the overall exposure to those
currencies.
 Transaction exposure arises from:
 Purchasing or selling on credit goods or
services whose prices are stated in
foreign currencies.
 Borrowing or lending funds when
repayment is to be made in a foreign
currency.
 Being a party to an unperformed foreign
exchange forward contract.
 Otherwise acquiring assets or incurring
liabilities denominated in foreign
currencies
 Suppose a U.S. firm, IBM, sells merchandise
on account to a Belgian buyer for:
 €2,00,000 payment to be made in 60 days.
 S0 = $0.9000/€
 The U.S. seller expects to exchange the
€2,000,000 for €1,800,000 when payment is
received.
 Transaction exposure arises because of the
risk that the U.S. seller will receive
something other than $1,800,000.
 If the euro weakens to $0.8500/€, then
Trident will receive $1,700,000
 If the euro strengthens to $0.9600/€,
then Trident will receive $1,920,000

 Thus, exposure is the chance of either a

loss or a gain.
 Hedging is the taking of a position, either
acquiring a cash flow or an asset or a contract
(including a forward contract) that will rise (fall) in
value to offset a fall (rise) in value of an existing
position.

 Hedging, therefore, protects the owner of the

existing asset from loss (but it also eliminates any
gain resulting from changes in exchange rates on
the value of the exposure).
 Future Hedge Alternative Hedging
 Forward Hedge Techniques
 Money market hedge Leading and lagging
 Currency option hedge Cross-hedging
Hedging Long-term Currency
transaction exposure diversification
 Long-term forward
contracts
 Currency swap

 Parallel loan
 Purchasing Currency Futures: A firm that buys
a currency futures contract is entitled to
receive a specified amount in a specified
currency for a stated price on a specified
date. E.g. for future payables.
 Selling currency futures: A firm that sells a
currency futures contract is entitled to Sell a
specified amount in a specified currency for a
stated price on a specified date. E.g. for
future receivables.
 A forward contract hedge is very similar to a
future contract hedge, except that forwards
contracts are commonly used for large
transactions, whereas future contract tend to
be used for smaller amounts.
 It involves taking a money market position to
cover a future payables or receivables
position. ()
 Money market hedge on payables
 Money market hedge on receivables.
 Hedging payables with currency call options-
A currency call option provides the right to
buy a specified amount of a particular
currency at a specified price within a given
period of time.
 Hedging receivables with currency put
options.
 Hedging of Receivables  Hedging of Payables

 Sell futures or forward  Buy futures or forward

 Money market hedge

 Money market hedge
 borrow foreign  borrow home
currency to be currency
received  convert to foreign
 convert to domestic currency
currency  invest for future
 invest for future use use
 Buy Put Option
 Buy Call Option
 Long-term forward contract
 Currency swap ()
 Parallel loan/back-to-back loan
 Alternative hedging techniques
 Leading& lagging()
 Cross- hedging
 Currency diversification
 Limitations of hedging an uncertain amount
 Limitations of repeated short-term hedging.
 It can be defined as the extent to which the value
of the firm would be affected by unanticipated
change in exchange rates.
 Change in expected cash flow arising because of an
unexpected change in exchange rates.
 Changes in competitive position as a result of
permanent changes in exchange rates.
Transaction exposure
Contact specific
Cash flow losses due to an exchange
rate change are easy to compute.
Simple financial accounting
techniques can be used to compute
losses due to transaction exposure
Firms generally have some policies to Firms generally do not have policies
cope with transaction exposure
Avoidance sometimes requires third-
party cooperation
The duration of exposure is the same
as the time period of contract
Relates to nominal contracts whose
value is fixed in foreign currency
terms
Economic exposure
General relates to the entire
investment
Opportunity losses caused by an
exchange rate change are difficult to
compute. A good variance accounting
is needed to isolate the effect of
exchange rate change on sales
volume, costs & profit margin
to cope with transaction exposure
Avoidance require good strategic
planning
The duration of exposure is the time
required for the restructuring of
operations through such means as
changing product, markets, sources
& technology
Relates to cash flow effects through
changes in cost, price and volume
relationships.
 Transaction exposure: is an uncertain
domestic currency value of a cash flow which
is known and fixed in foreign currency terms.
 Economic exposure: is an uncertain domestic
currency value of a cash flow whose value is
uncertain even in foreign currency terms. E.g.
cash flow from a foreign subsidiary.
 Exposure to currency risk can be properly
measure by the Sensitivities of
1. The future home currency values of the
firm’s assets/liabilities
2. The firm’s operating cash flow to random
changes in exchange rates.
P= a+b*S+e
A= constant
E= random error
P= local currency price of asset
B= sensitivity of the dollar value of asset (p) to
exchange rate. Cov( p,s)/ Var (s)
 Marketing initiatives
◦ Market selection
◦ Product strategy
◦ Pricing strategy
◦ Promotional strategy
 Production initiatives
◦ Product sourcing
◦ Input mix
◦ Plant location
◦ Raising productivity
 Market selection: market to sell, market
segmentation.
 Pricing strategy: std economic proposition of
setting the price that max dollar profits
 Promotional strategy
 Product strategy: product line decisions,
product innovations.
 Input mix: outsourcing
 Shifting production among plants
 Plant location
 Raising productivity
 Fluctuations in interest rate affect a firm’s
cash flow by affecting interest income on
financial assets and interest expenses on
liabilities. To put it another way, the market
values of a firm’s portfolio of financial assets
and liabilities fluctuates with interest rates.
1. Net interest income: interest income on
assets minus interest exposure on liabilities.
Monitoring of this account will reveal the
sensitivity of firm’s profitability to changes
in interest rates.
2. Net equity exposure: sensitivity of the firm’
s net worth to interest rates.
 Forward rate agreements
 Interest rate options
 Interest rate caps, floors and collars
 Options on interest rate futures.