MIB 3.6 export financing

EXPORT financing

•Export FIANCING

Export Financing Exporters naturally want to get paid as quickly as

possible, while importers usually prefer to delay payment until they have received the goods. Because of the intense competition for export markets, being able to offer attractive payment terms customary in the trade is often necessary to make a sale. Exporters should be aware of the many financing options open to them so that they choose the most acceptable one to both the buyer and the seller.

Export credit can be broadly classified into• Pre-shipment finance and • post shipment finance. • Preshipment

finance refers to finance extended to purchase, processing or packing of goods meant for exports

• Financial assistance extended after the shipment of exports falls within the scope of post shipment finance

PACKING CREDIT• As loan or cash credit against pledge or hypothecation.• Verification of Exporter-Importer Code No. issued by

DGFT.• Party should not be in the RBI Caution

list or ECGC Special Approval List.• Export is not to a listed country• Verify order/LC• Up-to date knowledge of export policy• Commodity should not be in the negative list.• Commodity should have a good market• Terms of contract• No FEMA violation• Borrower should be credit worthy.

• Working capital may be defined as funds required to carry the required level of Current assets to enable the industry to carry on its operations at the expected levels uninterruptedly..

• The guidelines set by Nayak Committee for computation of WrkCptl finance quantum for village, tiny and other SSI industries to a minimum extent of 20% of Projected/ Accepted Turnover to continue Guidelines with regard to specific activities / industries / situations to continue (Sugar / tea industries, Rehabilitation cases, Export Financing etc.) Banks may consider Cash Flow approach of financing in order to close the gap between the sanctioned limits and the utilization levels …

Quantum of finance:• FOB value of goods minus profit and credit

margin Cost of production less margin (can be more if the domestic cost is more than the FOB value and the difference is accounted as incentives like duty draw-back etc. subject to export production finance guarantee of ECGC).

• In the case of exports on CIF value basis PC can be granted towards insurance and freight also

• Period of finance: to coincide with the date for shipment and normally up to 180 days

Clean Packing Credit• Granted to credit worthy parties where advance

payment is required to be made to the supplier. • Quantum determined based on the likely purchase

pattern of the exporter with their suppliers. • Period of CPC is determined based on the

facts of each case (but not later than the period of contract /LC.

• A higher margin of say 25% should be stipulated, collected each time and remitted along with PC to the supplier.

• CPC should be converted as PC or Bills

EXPORT FINANCE

• PRE SHIPMENT finance : Deals with the finance schemes available before the shipment has been made.• POST SHIPMENT finance : on the

contrary deals with credit available after the goods have shipped.

Both stages are crucial for the exporter

Pre-shipment finance

• PSF.. Offer liquidity to the exporter to produce raw materials, carry out processing, packing, transporting and warehousing of the goods to be exported.

• Pre-Export Finance: provision of funds to cover the period between signing of purchase orders and payment (short-term, working capital)

• –Pre-export finance typically covers:• Cost of inland transport to port• Purchase of raw materials for processing

• Cost of processing• Storage costs

Illustrative procedure (commodities)

• Exporter provides title to or pledges products to bank• –Products that have yet to be produced• –Products that have been produced (warehouse

receipt)• Bank provides credit facility• Payment• –Trader takes delivery• –Bank receives payment directly from buyer• »Escrow account• »Evidence account

Methods of Pre-Export Finance• Open Account: –Exporter ships goods without any guarantee of

payment, thereby financing importer–Risk of transaction dependent on relationship/importer integrity.

• Documentary letter of credit (see UCC Art. 5 and UCP 500): Letter from bank, addressed to exporter, in which bank promises to pay or accept drafts if exporter conforms 100% to conditions within the letter.

• Three parties: • –Issuer: the issuing bank• –Account party (importer)• –Beneficiary (exporter) • •Three agreements• –Trade contract between importer and exporter• –Documentary credit between bank and exporter• –Reimbursement agreement between bank and importer

Documentary Letter of creditRevocable/Irrevocable• –A revocable letter of credit can be cancelled or amended by the issuing

bank; the bank does not need the exporter/beneficiary’s consent.Confirmed/Unconfirmed• –Issuing bank forwards letter of credit to exporter’s bank• –Exporter’s bank promises to pay exporter (confirms l/c)• –In an unconfirmed transaction, the advising bank acts as the issuing

bank’s agent and bears no obligation to exporterBack-to-back• –Typically used by brokers, the letter of credit allows the beneficiary to

assign its rights in one letter of credit to the issuer of a second letter of credit

• –Both letters of credit must require identical documentsTransferable• –The original beneficiary can transfer the letter of credit to third parties

Documentary Letter of credit• Revolving• –Typically used in construction contracts• –Allows beneficiary to draw on the letter of credit, up to a certain

amount, usually without presentation of documents• –The account party replenishes the account“Red clause” letter of credit• –Exporter can use to obtain pre-shipment finance by providing either (i)

a statement of purpose or (ii) an undertaking to provide specified documents.

• –Issuing bank provides exporter with a percentage of the L/C amount• –Advising bank guarantees reimbursement“Green clause” letter of credit• –Similar to “red clause” letters of credit, but pre-shipment finance is

contingent upon the production of warehouse receipts…

Letter of credit SettlementSight payment (sight draft)• –Exporter presents documents and receives paymentDeferred payment (dated draft)• –Exporter presents documents and receives payment at some

specified future timeAcceptance (time draft)• –Exporter (i) presents documents and (ii) draws a usance draft• –Bank accepts bill of exchange for payment on a future date Negotiation• –Exporter may choose a bank and negotiate the payment of a

sight or usance draft• –Bank will either:• »Advance payment with recourse to the exporter• »Advance payment less a fee (discount)• »Pay exporter when issuing bank provides payment

Post shipment Finance

• Provides credit facility from the date shipment of the goods to the time export payment is realized ( expenses between period of shipment dispatch and payment realisation…

Export Finance –Post-Export-Post-Export Finance (medium/long-term)

Post-Export finance typically covers:• Account receivables• equipment• Other fixed assets

–Methods of Post-Export Finance• Revolving line of credit• Term loan • Finance accounts receivable

Methods of Post-Export FinanceFinance account receivables–Typically used in two instances• Undercapitalized company with permanent financing

need• Temporary insufficient cashflow–Banks provide loan secured by:• Assignment of receivables• Assignment of commodity inventory–Loan• Made on a revolving basis against a pool of receivables–Borrower• Responsible for collecting from customers• Responsible for 100% loan repayment despite inability to

collect from customers

Export Finance –Forms of Risk

Commercial risk•The risk that either party will not fulfill its obligationsTransportation risk•The risk that goods become damaged or destroyed

during transportExchange risk• The risk that currency fluctuations will affect the

value of the transactionPolitical risk• •The risk that government policy changes, wars,

embargoes, etc., will prevent the conclusion or affect the value of the transaction

Indian Case study ; RBI sources !• PRE-SHIPMENT EXPORT CREDIT, Definition:

…any loan or advance granted or any other credit provided by a bank to an exporter for financing the purchase, processing, manufacturing or packing of goods prior to shipment / working capital expenses towards rendering of services on the basis of letter of credit opened in his favour or in favour of some other person, by an overseas buyer or a confirmed and irrevocable order for the export of goods / services from India or any other evidence of an order for export from India having been placed on the exporter or some other person, unless lodgement of export orders or letter of credit with the bank has been waived.

Period of AdvanceThe period for which a packing credit advance may be

given by a bank will depend upon the circumstances of the individual case, such as the time required for procuring, manufacturing or processing (where necessary) and shipping the relative goods / rendering of services.

It is primarily for the banks to decide the period for which a packing credit advance may be given, having regard to the various relevant factors so that the period is sufficient to enable the exporter to ship the goods / render the services

• If pre-shipment advances are not adjusted by submission of export documents within 360 days from the date of advance, the advances will cease to qualify for concessive rate of interest to the exporter ab initio.

• RBI would provide refinance only for a period not exceeding 180 days.

Disbursement of Packing CreditBanks may also maintain different

accounts at various stages of processing, manufacturing, etc. depending on the types of goods / services to be exported, e.g. hypothecation, pledge, etc., accounts and may ensure that the outstanding balance in accounts are adjusted by transfer from one account to the other and finally by proceeds of relative export documents on purchase, discount, etc.

Banks should continue to keep a close watch on the end-use of the funds and ensure that credit at lower rates of interest is used for genuine requirements of exports. Banks should also monitor the progress made by the exporters in timely fulfillment of export orders.

Liquidation of Packing CreditThe packing credit / pre-shipment credit granted

to an exporter may be liquidated out of proceeds of bills drawn for the exported commodities on its purchase, discount etc., thereby converting pre-shipment credit into post-shipment credit. Further, subject to mutual agreement between the exporter and the banker it can also be repaid / prepaid out of balances in Exchange Earners Foreign Currency Account ( EEFC A/c ) as also from rupee resources of the exporter to the extent exports have actually taken place.

What is an EEFC Account and what are its benefits?

Exchange Earners' Foreign Currency Account (EEFC) is an account maintained in foreign currency with an Authorised Dealer i.e. a bank dealing in foreign exchange. It is a facility provided to the foreign exchange earners, including exporters, to credit 50 per cent of their foreign exchange earnings to the account, so that the account holders do not have to convert foreign exchange into Rupees and vice versa, thereby minimizing the transaction costs.

Thanks to RBI

Running Account' FacilityIn many cases, the exporters have to procure raw

material, manufacture the export product and keep the same ready for shipment, in anticipation of receipt of letters of credit / firm export orders from the overseas buyers. Having regard to difficulties being faced by the exporters in availing of adequate pre-shipment credit in such cases, banks have been authorized to extend Pre-shipment Credit ‘Running Account’ facility in respect of any commodity, without insisting on prior lodgment of letters of credit / firm export orders, depending on the bank’s judgment regarding the need to extend such a facility and subject to the following conditions:

a) Banks may extend the ‘Running Account’ facility only to those exporters whose track record has been good as also to Export Oriented Units (EOUs) / Units in Free Trade Zones / Export Processing Zones (EPZs) and Special Economic Zones (SEZs)

(b) In all cases where Pre-shipment Credit ‘Running Account’ facility has been extended, letters of credit / firm orders should be produced within a reasonable period of time to be decided by the banks.

(c) Banks should mark off individual export bills, as and when they are received for negotiation / collection, against the earliest outstanding pre-shipment credit on 'First In First Out' (FIFO) basis. Needless to add that, while marking off the preshipment credit in the manner indicated above, banks should ensure that concessive credit available in respect of individual pre-shipment credit does not go beyond the period of sanction or 360 days from the date of advance, whichever is earlier.

(d) Packing credit can also be marked-off with proceeds of export documents against which no packing credit has been drawn by the exporter.

Export Credit against Proceeds of Cheques, Drafts, etc. Representing Advance/ Payment for Exports

Where exporters receive direct remittances from abroad by means of cheques, drafts, etc. in payment for exports, banks may grant export credit at concessive interest rate to exporters of good track record till the realization of proceeds of the cheque, draft etc. received from abroad, after satisfying themselves that it is against an export order, is as per trade practices in respect of the goods in question and is an approved method of realization of export proceeds as per extant rules.

Rupee Export Packing Credit to Manufacturer Suppliers for Exports Routed through STC/MMTC/Other Export Houses, Agencies, etc.

Banks may grant export packing credit to manufacturer suppliers who do not have export orders/letters of credit in their own name, and goods are exported through the State Trading Corporation/Minerals and Metal Trading Corporation or other export houses, agencies, etc.

Requirements (a) Banks should obtain from the export house a letter

setting out the details of the export order and the portion thereof to be executed by the supplier and also certifying that the export house has not obtained and will not ask for packing credit in respect of such portion of the order as is to be executed by the supplier.

(b) Banks should, after mutual consultations and taking into account the export requirements of the two parties, apportion between the two i.e. the Export House and the Supplier, the period of packing credit for which the concessionary rate of interest is to be charged. The concessionary rates of interest on the pre-shipment credit will be available up to the stipulated periods in respect of the export house/agency and the supplier put together.

The export house should open inland L/Cs in favour of the supplier giving relevant particulars of the export L/Cs or orders and the outstandings in the packing credit account should be extinguished by negotiation of bills under such inland L/Cs. If it is inconvenient for the export house to open such inland L/Cs in favour of the supplier, the latter should draw bills on the export house in respect of the goods supplied for export and adjust packing credit advances from the proceeds of such bills. In case the bills drawn under such arrangement are not accompanied by bills of lading or other export documents, the bank should obtain through the supplier a certificate from the export house at the end of every quarter that the goods supplied under this arrangement have in fact been exported. The certificate should give particulars of the relative bills such as date, amount and the name of the bank through which the bills have been negotiated.

Export of Services

In view of the large number of categories of service exports with varied nature of business as well as in the environment of progressive deregulation where the matters with regard to micromanagement are left to be decided by the individual financing banks, the banks may formulate their own parameters to finance the service exporters.

Exporters of services qualify for working capital export credit (pre and post shipment) for consumables, wages, supplies etc.

• The proposal is a genuine case of export of services.• The item of service export is covered under

Appendix – 36 of the Hand Book (Vol.1)• The exporter is registered with the Export

Promotion Council for services • There is an Export Contract for the export of the

Service• There is a time lag between the outlay of working

capital expense and actual receipt of payment from the service consumer or his principal abroad.

• There is a valid Working Capital gap i.e. service is provided first while the payment is received some time after an invoice is raised.

• Banks should ensure that there is no double financing/excess financing.

• The export credit granted does not exceed the foreign exchange earned less the

• margins if any required, advance payment/credit received.

• Invoices are raised• Inward remittance is received in Foreign

Exchange.• Company will raise the invoice as per the

contract where payment is received from overseas party, the service exporter would utilize the funds to repay the export credit availed of from the bank.

India: POST-SHIPMENT EXPORT CREDIT

Post-shipment Credit' means any loan or advance granted or any other credit provided by a bank to an exporter of goods / services from India from the date of extending credit after shipment of goods / rendering of services to the date of realization of export proceeds and includes any loan or advance granted to an exporter, in consideration of, or on the security of any duty drawback allowed by the Government from time to time.

Types of Post-shipment Credits:(i)Export bills purchased/

discounted/ negotiated.

(ii) Advances against bills for collection.

(iii) Advances against duty drawback receivable from Government

Liquidation of Post-shipment Credit:Post-shipment credit is to be liquidated by the

proceeds of export bills received from abroad in respect of goods exported / services rendered. Further, subject to mutual agreement between the exporter and the banker it can also be repaid / prepaid out of balances in Exchange Earners Foreign Currency Account (EEFC A/C) as also from proceeds of any other unfinanced (collection) bills. Such adjusted export bills should however continue to be followed up for realization of the export proceeds and will continue to be reported in the XOS statement.

Rupee Post-shipment Export Credit• the case of demand bills, the period of advance shall be the

Normal Transit Period (NTP) as specified by FEDAI.• In case of usance bills, credit can be granted for a maximum

duration of 365 days from date of shipment inclusive of Normal Transit Period (NTP) and grace period, if any. However, banks should closely monitor the need for extending post shipment credit up to the permissible period of 365 days and they should influence the exporters to realize the export proceeds within a shorter period.

• Normal transit period' means the average period normally involved from the date of negotiation / purchase / discount till the receipt of bill proceeds in the Nostro account of the bank concerned, as prescribed by FEDAI from time to time. It is not to be confused with the time taken for the arrival of goods at overseas destination.

Post-shipment Advances against Duty Drawback Entitlements• Banks may grant post-shipment advances to exporters

against their duty drawback entitlements as provisionally certified by Customs Authorities pending final sanction and payment.

• The advance against duty drawback receivables can also be made available to exporters against export promotion copy of the shipping bill containing the EGM Number issued by the Customs Department. Where necessary, the financing bank may have its lien noted with the designated bank and arrangements may be made with the designated bank to transfer funds to the financing bank as and when duty drawback is credited by the Customs

ECGC Whole Turnover Post-shipment Guarantee Scheme

The Whole Turnover Post-shipment Guarantee Scheme of the Export Credit Guarantee Corporation of India Ltd. (ECGC) provides protection to banks against non-payment of post-shipment credit by exporters. Banks may, in the interest of export promotion, consider opting for the Whole Turnover Post-shipment Policy. The salient features of the scheme may be obtained from ECGC.

DEEMED EXPORTS - CONCESSIVE RUPEE EXPORT CREDIT

Banks are permitted to extend rupee pre-shipment and post-supply rupee export credit at concessional rate of interest to parties against orders for supplies in respect of projects aided/financed by bilateral or multilateral agencies/funds (including World Bank, IBRD, IDA), as notified from time to time by Department of Economic Affairs, Ministry of Finance under the Chapter "Deemed Exports" in Foreign Trade Policy, which are eligible for grant of normal export benefits by Government of India.

INTEREST ON EXPORT CREDIT• A ceiling rate has been prescribed for rupee export credit

linked to Benchmark Prime Lending Rates (BPLRs) of individual banks available to their domestic borrowers. Banks have, therefore, freedom to decide the actual rates to be charged within the specified ceilings. Further, the ceiling interest rates for different time buckets under any category of export credit should be on the basis of the BPLR relevant for the entire tenor of export credit.

• ECNOS: ECNOS means Export Credit Not Otherwise Specified in the Interest Rate structure for which banks are free to decide the rate of interest keeping in view the BPLR and spread guidelines. Banks should not charge penal interest in respect of ECNOS.

Interest Rate Structure• Pre-shipment Credit (from the date of advance) : (a) Up to 180

days / (b)Against incentives receivable from Government covered by ECGC Guarantee up to 90 days.

• Post-shipment Credit (from the date of advance) : a) On demand bills for transit period (as specified by FEDAI) (b) Usance bills (for total period comprising usance period of export bills, transit period as specified by FEDAI, and grace period, wherever applicable)

Up to 90 days Up to 365 days for exporters under the Gold Card Scheme.(c) Against incentives receivable from Govt. (covered by ECGC

Guarantee) up to 90 days(d) Against undrawn balances (up to 90 days)(e) Against retention money (for supplies portion only) payable

within one year from the date of shipment (up to 90 days)

EXPORT CREDIT IN FOREIGN CURRENCY• Pre-shipment Credit in Foreign Currency (PCFC): The

scheme is an additional window for providing pre-shipment credit to Indian exporters at internationally competitive rates of interest. It will be applicable to only cash exports. The instructions with regard to Rupee Export Credit apply to export credit in foreign currency also mutatis mutandis, unless otherwise specified.

Source of Funds for Banks• The foreign currency balances available with the bank in

Exchange Earners Foreign Currency (EEFC) Accounts, Resident Foreign Currency Accounts RFC(D) and Foreign Currency (Non-Resident) Accounts (Banks) Scheme could be utilized for financing the pre-shipment credit in foreign currency.

• Banks are also permitted to utilise the foreign currency balances available under Escrow Accounts and Exporters Foreign Currency Accounts for the purpose, subject to ensuring that the requirements of funds by the account holders for permissible transactions are met and the limit prescribed for maintaining maximum balance in the account under broad based facility is not exceeded.

Post-shipment Export Credit in Foreign Currency

• Banks may utilise the foreign exchange resources available with them in Exchange Earners Foreign Currency Accounts (EEFC), Resident Foreign Currency Accounts (RFC), Foreign Currency (Non-Resident) Accounts (Banks) Scheme, to discount usance bills and retain them in their portfolio without resorting to rediscounting. Banks are also allowed to rediscount export bills abroad at rates linked to international interest rates at post-shipment stage.

International Trade finance/ glance

Private sources : commercial banks, export finance companies, factoring houses, forfeit houses, international leasing companies, in-house finance companies and private insurance companies.

A BANK GUARENTEE : is a financial instrument that guarantees specified sum payment to either the exporter or importer. Apart from regular bank guarantees, there are three other types of guarantees:-

1. The loan guarantee, in which a loan is granted conditional on security provided by the borrower.

2. A distraint guarantee, which helps s debtor to recover his seized assets; and

3. A bill of lading Guarantee, which ensures that the carrier will hand over the goods to the consignee when individual bills of lading lost.

A Bank line of credit >>Is a sum of money allocated to an

exporter by a bank to finance its export business. This could also be meant to finance a specific export transaction from the foreign customer’s side, and allows the exporter to extend competitive credit terms to foreign customers.

Buyer Credit >>>> refers to credit extended by one or more

financial institutions in the exporter’s country. This form of finance is mostly used to finance capital equipment purchases, but other goods with payment terms of up to one year can also be financed by buyer credits. Buyer credits are normally arranged under an export credit insurance programme.

Export factoring EF is particularly suited for small and medium sized

exporters as it enables them to be more competitive by selling on open account rather than using more costly methods such as L/C s. It involves the sale of export accounts receivables to a third party that assumes the credit risk. This technique proceeds through factoring houses that not only provide financing but also perform credit investigations, guarantees commercial and political risks ,,,, and …/// how about commission ?? // widely used in USA …

Forfaiting/// Transaction In which exporter transfers

responsibility of commercial and political risks for the collection of a trade –related debt to a forfaiter ( often financial institutions), and in turn receives immediate cash after the deduction of its interest charge( the discount) //// Two segments : 1. primary Mkt: consists of Banks and forfait houses that buy properly executed and documented debt obligations directly from exporters. 2. The secondary Mkt : consists of trading these forfait debt obligations among themselves. //// widely used in EUROPE//

BANKER’S ACCEPTANCE • Is a time draft drawn on and accepted by one

bank to another // interbank financing methods// 30 /60/ 90 to 180 days after sight or date ///

• CORPORATE GUARENTEE : is a method of finance where on company undertake to pay the principal debts of another corporate house. The method is used when creditors ask the corporate or parent company to guarantee an obligation of one or more its overseas subsidiaries////

Government sourcesExport import Bank financing: Many countries have

put in place EXIM financing programmes to provide finance for exports, imports and overseas investments. The loans are low cost for a medium –to- long term period arranged in collaboration with larger commercial banks throughout the world. Eg . South korea’s EXIM bank offers such services as direct lending to both suppliers and sellers, re-lending facilities to foreign financial institutions, and the issuance of guarentee and export insurance .///

FOREIGN credit INSURANCE • USA: Insurance programmes are offered by both

EXIM bank and FCI Association. • CANADA: Export Credit Insurance Corporation• Japans’s International Trade Bureau • HONG KON: Export Insurance Credit corporation • INDIA: Export Credit Guarantee Corporation Ltd • Taiwans ‘ Central Trust of China programmes. • Latin America: Compania Argentina de seguros

de Credito a la exportation in argentina.• Brazil: Instituto de Resserguros do Brazil///

FOREX risk and Exposure • FOREX RISK: Concerns the variance or

change in domestic currency value of an asset, liability or operating income that takes place due to unanticipated changes in exchange rates.• FOREX EXPOSURE: Refers to the sensitivity

of changes in the real domestic-currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.

Three Kinds of Exposures>>

>>may lead to risk

1.Transaction Exposure

2.Economic( or operating) exposure

3.Translation exposure

Types of Foreign Exchange Exposure

Changes in exchange rates can effect firm value through:

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Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.

Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation.

The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currency-denominated statements.

Translation Exposure

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Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide:– The current rate method– The temporal method

Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).

Translation Methods

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The current rate method is the most prevalent in the world today.

– Assets and liabilities are translated at the current rate of exchange.

– Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period.

– The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).

Current Rate Method

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Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s creation.

This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value.

Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).

Temporal Method

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If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/non-monetary method of translation.– Monetary assets and liabilities are translated at current exchange

rates.

– Non-monetary assets and liabilities are translated at historical rates.

– Income statement items are translated at the average exchange rate for the period.

– Dividends (distributions) are translated at the exchange rate on the date of payment.

– Equity items are translated at historical rates.

Monetary / Non-monetary Method

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The main technique to minimize translation exposure is called a balance sheet hedge.

A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.

If this can be achieved for each foreign currency, net translation exposure will be zero.

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.

Managing Translation Exposure

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Transaction Exposure

Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.

Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations.

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Sources of Transaction Exposure 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.

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Real Life Example

In 1971, Great Britain’s Beecham Group borrowed SF100 million (equivalent to £10.13 million).

When the loan came due five years later, the cost of repayment of principal was £22.73 million – more than double the amount borrowed!

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To Hedge or not?

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).

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Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide.

Operating Exposure

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Operating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure.

Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon.

Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production.

Operating Exposure

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An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value.

From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firm’s market value.

Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

Operating Exposure

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Recognising Operating Exposure Where is the company selling? [domestic

v. foreign] Who are the key competitors? [domestic

v. foreign] How sensitive is demand to price? Where is the company producing?

[domestic v. foreign] Where are the company’s inputs coming

from? [domestic v. foreign]

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Recognising Operating Exposure

Volvo produces most of its cars in Sweden, but buys most of its inputs from Germany.

The U.S. is an important export market for Volvo. Volvo management believed that a depreciating Swedish krona

versus the $ and an appreciating Swedish krona versus the DM would be beneficial to Volvo.

But researchers found that statistically:

A depreciating krona relative to the Deutschemark improved Volvo’s cash flow!

These results reflect the fact that Volvo’s major competitors are the German firms BMW, Mercedes and Audi.

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Recognising Operating Exposure

Aspen Skiing Company owns and operates ski resorts in Colorado

• Uses only American labor and materials

• Nonetheless, hurt by a strong dollar that made American skiers opt for the French Alps or the Canadian Rockies, and foreign skiers stay at home.

So, even a domestic firm with zero transaction exposure to exchange rates can be vulnerable to exchange rate risk.

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Managing Operating Exposure

Pass Through – can the company pass the price increase on to the customer?

This depends on the product and the level of competition in the market.

For low-quality goods, price competition is usually intense, so no one company can change prices.

For high-quality goods, there may be room to increase prices and not effect demand.

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Managing Operating Exposure

Use of Marketing Strategies Market Selection Pricing Strategy/Product Strategy Promotional Strategy

Use of Production Management Input mix Plant Location & Shifting production among plants Raising Productivity (i.e. lowering costs)

Financial Hedging techniques may also be used

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Example

Matsushita exports TVs to the US. Suppose the yen is expected to move from ¥130/$ to ¥110/$ over the next few years. What can Matsushita do about its currency risk?

As yen appreciates, Matsushita becomes less competitive. Can it increase prices in the US? Probably not as TV market is competitive.

It can keep US$ prices constant to retain market share but this will hurt profits. Can it cut costs and become more efficient?

Matsushita could move production to US or low-cost US$ zone. Move to high-end TVs or other products with less price

competition. Hedge using currency derivatives. Stop selling in US markets.

•Good bye for the day