Exchange Rate Risk

International Finance and Development

OutlineMeaning of Exchange Rate RiskTypes of Exchange Rate Risks

Transaction ExposureTranslation ExposureEconomic Exposure

Measurement of Exchange Rate RiskManagement of Exchange Rate Risk

Management of Transaction ExposureManagement of Economic Exposure

Meaning of Exchange Rate RiskRisk of fluctuating value of a currency over timeIf the time and size of cash inflows in one currency does not match the time and size of cash outflows in the same currency, we face exchange rate riskImpacts dollar value of foreign currency cash inflows and foreign currency cash outflowsIf we have foreign currency cash inflows, we face risk of foreign currency depreciating against domestic currencyIf we have foreign currency cash outflows, we face risk of foreign currency appreciating against domestic currency

Types of Exchange Rate Exposures

Transaction ExposureOnly companies engaged in global business and doing transactions in foreign currency face this riskArises due foreign currency transactions of a firmArises from the possibility of incurring future exchange gains/losses on transactions already entered into and denominated in a foreign currency.

Measuring Transaction Exposure

Determine the projected net amount of inflows or outflows in each foreign currencyDetermine the overall risk of exposure to these currencies

Measuring Transaction Exposure

To determine the amount of transaction exposure, keep in mind the following:

The net exposure of all subsidiaries combinedRange of possible exchange ratesRange of cash inflows and outflowsStandard Deviation of currenciesCorrelations among currencies

Translation Exposure

The exposure of the MNC’s consolidated financial statements to exchange rate fluctuationsIf the assets/liabilities are translated at something other than the historical exchange rates, the Balance Sheet will be affected by fluctuations in currency values over time

Economic ExposureThe extent to which the economic value of a company can decline because of exchange rate changesDecline can be due to a decline in the level of expected cash flows or an increase in the riskiness of these cash flowsOverall effect of exchange rate changes in competitive relationships between alternative foreign locationsExtent of exposure depends on

structure of markets for a firm’s productPrice elasticity of demand for the productAvailability of close substitutes for the product

Even pure domestic firms may face economic exposure

Management of Transaction Exposure

Foreign currency cash outflowsRisk: Foreign currency may become more expensive/appreciate against domestic currencyStrategy: Buy foreign currency futures, forwards, or call optionsForeign currency cash inflowsRisk: Foreign currency may become more cheap/depreciate against domestic currencyStrategy: Sell foreign currency futures, forwards, or buy put options

Management of Economic Exposure

Marketing InitiativesMarket SelectionPricing StrategyProduct StrategyPromotion Strategy

Production InitiativesProduct sourcing and input mixPlant locationRaise Productivity

Financial Initiatives

Marketing InitiativesShall we pull out of a market that has been rendered unprofitable due to competition or shall we differentiate the product and concentrate on specific customers only?Shall we emphasize market share or profit margin in response to weak domestic currency?Shall we add/drop a product to our product line in response to exchange rate changes?Where to advertise?

Production InitiativesOutsource your inputs/raw materials/components in response to strong domestic currencyChange input mix to reduce cost in response to strong domestic currencyShift production to weak currency area in response to strong domestic currencyRaise productivity by cutting costs—produce the same number of units at a lower cost or produce more units at the same cost

Financial Initiatives

Equate the sensitivity of costs and revenues to exchange rate changes