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