Details of Foreign Exchange Exposure Best fitted for Bachelor Students

1. 
Foreign exchange
risk and exposure
Kanchan Kandel
BBA 8th

2. Risk and exposure
 Business firms, whether operating domestically or
internationally, are exposed to risks of adverse
movements in their profits resulting from unexpected
movements in exchange rates.
 Movement of exchange rates gives rise to foreign
exchange exposure and foreign exchange risk.
 Though these two terms are often used interchangeably,
in reality they represent two different, yet closely
related, concepts. Let us first understand these two
terms. 2

3. Foreign Exchange Risk
Management
 Exposure refers to the degree(sensitivity) to which a company
is affected by exchange rate changes.
 It is calculated by regression.
 Exchange rate risk is defined as the variability of a firm’s
value due to uncertain changes in the rate of exchange.
 It is calculated by variance or standard deviation.
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4. Cont…
 Thus as the foreign exchange exposure is the sensitivity of values of
assets, liabilities and operating income to the unexpected change in
the exchange rate, we can relate this relationship to a regression
equation which is as mentioned below:
ΔV($) = β ΔS($/£) + µ ------ Eq.(I)
 Here, β (exposure) =regression coefficient which explains the
systematic relation between ΔV and ΔS($/£).
 ΔV=change in value of foreign assets denominated in domestic
currency
 ΔS=change in exchange rate (Direct quote)
 µ = random error (regression error).
 If we assume there is no random error then
exposure (β) = ΔV($) / ΔS($/£)
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5. Types of Exposures
 Transaction Exposure
 Translation Exposure (Accounting Exposure)
 Operating Exposure (Economic Exposure)
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6. Transaction Exposure
 Transaction Exposure: Results from a firm taking on “fixed”
cash flow foreign currency denominated contractual agreements.
 Examples of transation exposure:
 An Account Receivable denominate in a foreign currency.
 A maturing financial asset (e.g., a bond) denominated in a foreign
currency.
 An Account Payable denominate in a foreign currency.
 A maturing financial liability (e.g., a loan) denominated in a foreign
currency.
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7. Cont…
 For instance, if a firm has entered into a contact
to sell computers to a foreign customer at a fixed
price denominated in foreign currency, then the
firm would be exposed to exchange rate
movements till it receives the payment and
converts the receipts into the domestic currency.

8. Cont…
 In contractual assets, the exposure value is equal to euro deposits
(Face value).
 Exposure is positive magnitude i.e. change in exchange rate and
dollar value of the investment move same direction.
 If investor gain when the spot value of foreign currency increase
and loss when it decrease is known as long position in foreign
currency
 In contractual liabilities exposure is negative magnitude i.e. change
in exchange rate and dollar value of the investment move opposite
direction.
 If investor gain when the spot value of foreign currency decrease,
loss when it increase is known as short position in foreign currency

9. Translation exposure
 Translation exposure, (also called accounting exposure),
results from the need to restate foreign subsidiaries’
financial statements, usually stated in foreign currency,
into the parent’s reporting currency when preparing the
consolidated financial statements.
 While translation exposure may not affect a firm's cash
flows, it could have a significant impact on a firm's
reported earnings and therefore its stock price
 Restating financial statements may lead to changes in the
parent’s net worth or net income.
 If exchange rates have changed since the previous reporting period,
translation/restatement of those assets/liabilities, revenues/expenses
that are denominated in foreign currencies will result in foreign
exchange gains or losses

10. Cont…
 When converting financial statement items (transactions)
denominated in currencies other than the parent currency,
two choices of exchange rate are possible:
 The historical rate, the exchange rate prevailing at the time
of the transaction.
 ²The current rate, the exchange rate prevailing at the
balance sheet date or during the income statement period.
 There are two method of adjusting Translation exposure:
 Temporal Method
 Current Rate method

11. Management of transaction
exposure
 Forward contract hedge
 Option hedge
 Money market hedge (borrowing or investing in local market)

12. Overview of Options Contracts
 Important advantage:
 Options provide the investor which the potential to take
advantage of a favorable change in the spot exchange rate.
 Recall that this is not possible with a forward contract.
 Important disadvantage:
 Options can be costly:
 Firm must pay an upfront non-refundable option premium which it
loses if it does not exercise the option.
 Recall there are no upfront fees with a forward contract.
 This fee must be considered in calculating the home currency
equivalent of the foreign currency.
 This cost can be especially relevant for smaller firms and/or those
firms with liquidity issues.

13. Leading and lagging
 To “lead” means to pay or collect early, whereas to
“lag” means to pay or collect late.
 If there is payable and you expect that foreign
currency will appreciate in near future but before
credit period, it may attempts to expedite the payment
to exporter before the foreign currency appreciation.
As we know if foreign currency appreciate you have
to pay more. This is the leading strategy.
 As second scenario, assume that you expect the
foreign currency will depreciate in near future but
before credit period, it may attempts to stall its
payment until the after the foreign currency
depreciate. Deprecation of pound gives lower
payments. This is the lagging strategy

14. Manager hedge vs. Shareholder hedge
 There is always question of who should hedge corporate
risk? It should hedge by corporate manager or individual
shareholder. Following are some of the strong reason to
hedge corporate risk by manager not by shareholder.
 Progressive tax rate: Volatile EBT
 Cost of hedging: Economic of scale
 Operating cost: Volatile income
 Debt repayment: If organization loan mature when their
income is low
 Strategic planning: Difficult to collect information
 Instrument availability: Specialization

15. Exposure and purchase power parity
 Relative theory of PPP suggests that the exchange between
two countries should change as difference of inflation rate
of these two countries
 If relative purchasing power is hold then there will be no
exposure. Exposure arise due to change in exchange rate
and when change in exchange rate is offset by inflation
change there is no question about arising exposure.
 Suppose euro depreciate from 1.500/€ to 1.3500/€ during
the year. American MNC has building worth €1,000,000 in
Europe. In same year America experience 0% inflation and
Europe 11.1111% inflation. new price of building after
inflation will be €1000,000*1.111111=€1,111,111.