1. Foreign Risk & Management
Dr. Sunita Sukhija
Assistant Professor in Commerce
Govt. National College, Sirsa(HRY)
2. Introduction
• Foreign exchange risk is the exposure of an institution to
the potential impact of movements in foreign exchange
rates. The risk is that adverse fluctuations in exchange rates
may result in a loss in British pound terms to the
institution.
• Foreign currency exchange risk is the additional riskiness
or perhaps varience of the firm’s cash flows which may be
attributed to money fluctuations. Normally, foreign
currency risk exists in three forms; translation, deal and
economical exposures. Foreign currency risk management
entails taking decisions which aim minimizing or
eliminating the negative effects of currency variances on
balance sheet and profits statement ideals, a firm’s receipts
and payments arising out of current deals, and on long-
term future funds flows of a firm.
3. Types of Risk/ Exposure
• These exposures may be classified into three
different categories:
• Translation exposure
• Transaction exposure
• Economic exposure
4. • Translation Exposure; It refers to the profit or loss associated
with converting foreign currency denominated
assets/liabilities, income/expenses into reporting currency. It
is also referred as ‘Translation exposure’. In essence,
translation risk can be defined as the effect of exchange rates
on the figures shown on the parent company’s consolidated
balance sheet. Although this exposure does not affect the
shareholder’s equity, it does influence the investors due to the
changing values of the assets or liabilities.
• Transaction Exposure; it is a risk associated with a transaction
that has already been contracted. It is as a result of unexpected
changes in foreign exchange rates affecting future cash flows
which the MNC has already committed itself to. It refers to the
effect of exchange rate movement associated with the time gap
between the date of the transaction and the date on which the
consideration is settled. It is also referred as ‘Transaction
exposure’.
5. • Economic Exposure; this is the most complex risk as it
not only involves the known cash flows but also future
unknown cash flows, hence also termed as a hidden risk.
It is a comprehensive measure of a company’s foreign
exchange exposure and therefore sometimes termed as a
combination of translation and transaction exposure. It
is an unanticipated change in exchange rate, which has
an impact on the potential of an organization to perform.
It is also referred as ‘Economic exposure’.
• Political Exposure: It refers to the effects that political
activities in a country may have on the forex transactions
of an entity. For example, compulsory acquisition of
business by Government, tax related controls,
discrimination against foreign goods.
6. Foreign Exchange Risk Management
• Foreign exchange risk management is a process which involves identifying
areas in the operations of the MNC which may be subject to foreign
exchange exposure, studying and analysing the exposure and finally
selecting the most appropriate technique to eliminate the affects of these
exposures to the final performance of the company.
• Risks involving short term transactions can be dealt with using financial
instruments but long term risks often require changes in the operations of
the company.
• The management of transaction exposures may either involve hedging
using special techniques or applying pro-active policies. The pro-active
policies commonly used include:
• Matching currency cash flow
• Risk sharing agreements
• Back to back loans
• Currency swaps
• Lead and Lag payments
• Use of re-invoicing centres
7. • 1. Home Currency Invoicing:
• The business entity simply prices everything in home currency. For
example, an Indian exporter would invoice his bills in INR and Indian
importer would insist his supplier to invoice in INR.
• This method of managing exchange risk is most effective when the product
line is unique and not price driven, like Pharmaceuticals, etc. Home
currency invoicing should be continuously monitored because it invites
competition from countries with weaker currencies.
• 2. Foreign Currency Accounts/EEFC Account:
• An entity which engages into both import and export can maintain account
in the currency of trade, through which all transactions are routed. Since
exports can pay for imports, he is exposed to exchange risk only for the net
balance. In India, the Exchange Earners Foreign Currency (EEFC) account
scheme exists for those who earn foreign exchange for the country.
Exchange Earners’ Foreign Currency (EEFC) Account is an account
maintained in foreign currency with an authorized dealer i.e. a bank dealing
in foreign exchange.
8. • 3. Leads and Lags:
• Importers and exporters try to advance or delay their payments or
receipts according to their estimation of movement of exchange rate. If
the importer expects devaluation of the domestic currency, he will
hurry to pay his foreign currency obligation (if he waits, then he need
more of local currency to buy the foreign currency).
• This is called as ‘Lead’ the payments. In the same situation, an exporter
would delay in converting the foreign currency receipts into domestic
currency (if he waits, then he will receive more of local currency after
selling foreign currency). This is called as ‘Lag’ the receipts. In case of
appreciation of the domestic currency, the importer would ‘Lag’ his
payments and exporter would ‘Lead’ his receipts.
• 4. Netting:
• A process that enables business firms, dealing in foreign transactions,
to settle only their net positions with one another at the end of the day,
in a single transaction, not trade by trade. In this process, debit
balances are netted off against credit balances, so that only the net
amounts remain due to be paid in actual currency flows. For such kind
of transactions, the dates of settlement should match and the foreign
currency involved should be the same for receipts and payments that
are due.
9. • 5. Money Market Hedge:
• Money market is a market for short term instruments. In this market,
borrowing and lending transactions are carried out with foreign
currencies so that home currency value is established at a specific level,
in a forex transaction.
• 6. Forward Exchange Rate Contracts:
• An entity can enter into currency forward contracts with banks. It is a
negotiated agreement between two parties to exchange specific
amounts of currency at a set rate on a particular date in future. The
forward rate is decided based on the current exchange rate and other
factors like inflation and interest rate differential.
• 7. Futures Contract:
• Futures currency contract are similar to forward contracts. The futures
contracts are traded on organized exchanges like, Chicago Mercantile
Exchange (CME), or London International Financial Futures Exchange
(LIFFE). Futures contract are not tailor made like forward contracts.
They are standard in terms of expiration time and lot sizes.
10. • 8. Currency Option:
• A currency option gives the holder the right, but not the obligation, to
sell or buy a face amount of currency at a set price, on or before a
given date. A currency option has a strike price — the amount for
which the currency can be bought or sold — and an expiration date.
U.S. options can be exercised at any time up to and including the
expiration date, whereas European options can only be exercised on
the expiration date.
• There are two types of options:
• i. Call options give the holder the right to buy a given amount of a
currency at the strike price.
• ii. Put options give the holder the right to sell a given amount of
currency at the strike price.
• 9. Currency Swap:
• A Currency Swap involves exchange of principal and/or interest
payments on a loan or on an asset in one currency for principal
and/or interest payments on an equivalent loan or on an asset in
another currency, with a predetermined prevailing
spot/predetermined forward rate (for forward start swaps) as agreed
on the date the transaction is entered into.
