exchange rate risk
TRANSCRIPT
Exchange rate risk and exposure
Exchange rate risk of an MNC
Transaction exposure Consolidation exposure Economic exposure
Transaction exposure
Trade transaction with foreign countries when billing is done in foreign currencies (export/import).
Banking and financial transactions done in foreign currencies like lending and borrowing or equity participation.
Consolidation (Translation) exposure
Due to direct/indirect investments in Foreign countries.
It depends on Existing exchange rate Accounting practices of the countries
Economic exposure
It rises due to Economic factors like inflation, deflation
in the country Value of the currency
Evaluation of Transaction exposure
Currency Indian Rupees
US dollar in Rs.
Pound Sterlings in Rs.
Japanese yen in Rs.
Total exchange exposure
Receivables
200,000 100,000 50,000 70,000 +220,000
Total exchange exposure position is Rs 220,000 (100,000+50,000+70,000)
MNC in export business
MNC in import business
Currency Indian Rupees
US dollar in Rs.
Pound Sterlings in Rs.
Deutschmarks in Rs.
French francs in Rs.
Total exchange exposure
Suppliers -125,000 -50,000 -60,000 -100,000 -30,000 -240,000
Rs.240,000 is a debt on the company
Post Indian Rupees
US dollar in Rs.
Pound Sterlings
in Rs.
Deutschmarks in
Rs.
French francs in
Rs.
Total exchange exposure
Amount receivables
from debtors
10,000 45,000 50,000 - 10,000 105,000
Forward sale of foreign currency
- - -15,000 -20,000 - -35,000
Orders received
50,000 25,000 10,000 - 10,000 45,000
Amount payable to creditors
-60,000 - -46,000 -16,000 - -62,000
Forward purchase of
foreign currency
- 20,000 24,000 - 11,000 55,000
Orders placed for purchase
- -10,000 - -35,000 -25,000 -70,000
Net exposure position
80,000 23,000 -71,000 6,000 38,000
Evaluation of translation Exposure
Assets LiabilitiesFixed assets 200,000 Equity 140,000Stocks 50,000 Long-term debt 80,000Receivables 30,000 Short-term debt 70,000Cash 10,000Total 290,000 290,000
(In India rupees)
Translation exposure
Assets LiabilitiesFixed assets 200,000/35 =5,714 Equity 140,000/35=4,000Stocks 50,000/35= 1,429 Long-term debt 80,000/35= 2,285Receivables 30,000/35= 857 Short-term debt 70,000/35= 2,000Cash 10,000/35= 285Total 8,285 8,285
(In US dollar)
Balance sheet is presented in terms of US dollars, using a conversion rate of Rs. 35 = US$1
Closing rate method: All assets and liabilities, except the owner’s equity, are converted on the basis of the prevailing exchange rate.
Assets LiabilitiesFixed assets 200,000/36 =5,556 Equity 140,000/35=4,000Stocks 50,000/36=1,388 Long-term debt 80,000/36=2,222Receivables 30,000/36=833 Short-term debt 70,000/36=1,944Cash 10,000/36=277Total 8,054 8,166
Balance sheet is presented in terms of US dollars, using a conversion rate of Rs. 36 = US$1
(In US dollar)
Monetary/Non-monetary method: the monetary items (cash, receivables, debt) are translated at the closing rate while rest (fixed assets, stocks, equity) are retained at historic rates.
Assets LiabilitiesFixed assets 200,000/35=5,714 Equity 140,000/35=4,000Stocks 50,000/35=1,428 Long-term debt 80,000/36=2,222Receivables 30,000/36=833 Short-term debt 70,000/36=1,944Cash 10,000/36=277Total 8,252 8,166
In this method there is a gain of US$ 86. It is used in Latin American Countries
Current/Non-current method: The current assets and liabilities are translated at the closing rate while the rest are retained at historic costs.
Assets LiabilitiesFixed assets 200,000/35=5,714 Equity 140,000/35=4,000Stocks 50,000/36=1,389 Long-term debt 80,000/35=2,286Receivables 30,000/36=833 Short-term debt 70,000/36=1,944Cash 10,000/36=277Total 8,213 8,230
In this method there is a loss of US$ 17.
Evaluation of economic exposure
An appreciation of local currency results into a reduction of cash inflows as well as outflows.
If local currency depreciates the cash flows are affected in opposite direction.
Depreciation of local currency results into an increase of operating revenues as well as expenses.
There is no specific method for calculating the quantum of exposure.
It depends on forecasting and anticipatory survey.
Internal techniques of Hedging
To reduce exchange rate risk: Choosing a particular currency for invoice Leads and lags Indexation clauses in contacts Netting Shifting the manufacturing base Centre of reinvoicing Swaps
Choice of the currency of Invoicing
To avoid exchange rate risk companies invoice their exports in the national currency and pay their suppliers in the national currency.
In the countries of European Union, the use of European Currency Unit (ECU) is gaining popularity.
Leads and Lags
This technique consists of accelerating or delaying receipt or payment in foreign exchange as warranted by the position/expected position of the exchange rate.
In case of depreciation of national currency, importing enterprises like to clear their dues in
foreign currencies Exporting enterprises prefer to delay the receipt
from their debtors abroad.
Indexation clauses in contracts
A contract may contain a clause whereby prices are adjusted in such a manner that fluctuations of exchange rate are absorbed without any visible impact.
If the currency of the exporting country appreciates, the price of exports is increased to the same extent or vice-versa.
Netting (Internal compensation)
An enterprise may reduce its exchange risk by making and receiving payments in the same currency.
It can be bilateral or multilateral.
Bilateral Netting
When two companies have trade relations and do buying and selling reciprocally.
Parent Co. Subsidiary Co.
Parent Co. Subsidiary Co.
$80,000
$100,000
$20,000
Funds movement without netting
Funds movement with netting
Multilateral Netting
Subsidiary AParent Co.
Subsidiary B Subsidiary C
Subsidiary D
816
12 1016
20
2015910
5040
Funds movement without Netting
Multilateral netting
Parent Co. Subsidiary A
Subsidiary B Subsidiary C
Subsidiary D
10
5
1012
81
4
Parent Co. Subsidiary A
Subsidiary B Subsidiary C
Subsidiary D
9
6
2
4
8
Funds movement with Partial Netting
Funds movement with Netting
Switching the base of the manufacture
Switching the base of the manufacture may be useful so that costs and revenues are in the same currency.
Japanese car manufacturers have opened factories in Europe.
Reinvoicing Centre A reinvoicing centre of a multinational group
does billing in respective national currencies of subsidiary companies and receives the invoices made in foreign currency from each one of them.
Clients (Debtor)
Reinvoicing Centre
Supplier(Creditor)
Subsidiary A,B…
Pay in foreign
currency
Pay in foreign
currency
Pay in local currency
Pay in Local currency
Receipts and payments through Reinvoicing Centre
Swaps in Foreign Currencies
Swap is an agreement reached between two parties which exchange a predetermined sum of foreign currencies with a condition to surrender that sum on a pre-decided date.
Various types of Swaps: Cross-credit swaps Back-to-back credit swaps Export swaps
Cross credit swaps
American parent Co. Indian Bank
SubsidiaryA…
Indian rupee loan
There is an exchange of foreign currencies between a parent company and a bank in a foreign country.
US dollar loan
Reimbursement in US dollar
Reimbursement in Indian rupees
Back-to-back credit Swaps Two companies located in two different countries may
agree to exchange loans in their respective currencies for a fixed period.
Kodak USA
Fuji USA
Fuji Japan
Kodak Japan
in US $ to
in Japan yen
toLends Lends
Basic hedging techniques
If depreciation in anticipated
Sell local currency forward Reduce levels of local currency
cash and marketable securities
Delay collection of hard currency receivables
Accelerate imports of hard currency goods before depreciation of local currency
Borrow locally
If appreciation is anticipated
Buy local currency forward Increase levels of local
currency cash and marketable securities
Speed up collection of hard currency receivables
Reduce imports of soft currency goods
Borrow locally
Basic hedging techniques
If depreciation in anticipated
Delay payments of local accounts payable
Speed up remittance of dividend to the parent company
Speed up payments of intersubsidiary accounts payable
Delay collection of intersubsidiary accounts receivable
If appreciation is anticipated
Speed up payments of accounts payable
Delay remittance of dividend to the parent company
Delay payments of intersubsidiary accounts payable
Speed up collection of intersubsidiary accounts receivable
Text Book
International Financial Management by Jain,Peyrad &Yadav,Publisher-Macmillan