Foreign
Exchange Risk Management
Many firms are exposed to foreign exchange risk - i.e. their
wealth is affected by movements in exchange rates - and will seek to manage
their risk exposure.
This page looks at the different types of foreign exchange risk and introduces
methods for hedging that risk
Types of foreign
exchange risk
·
Transaction
risk
This is the risk of an exchange rate changing
between the transaction date and the subsequent settlement date, i.e. it is the
gain or loss arising on conversion.
This type of risk is primarily associated with imports and
exports. If a company exports goods on credit then it has a figure for debtors
in its accounts. The amount it will finally receive depends on the foreign
exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of
a company, most companies choose to hedge against such exposure. Measuring and
monitoring transaction risk is normally an important component of treasury risk
management.
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash
flows occurs.
(c) The anticipated volatility of the exchange rates during the
hedge period.
The corporate risk management policy
should state what degree of exposure is acceptable. This will probably be
dependent on whether the Treasury Department is been established as a cost or
profit centre.
·
Economic
risk
Transaction exposure focuses on relatively short-term cash flows
effects; economic exposure encompasses these plus the longer-term affects of
changes in exchange rates on the market value of a company. Basically this
means a change in the present value of
the future after tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic
risk.
Directly: If your firm's home currency strengthens then foreign
competitors are able to gain sales at your expense because your products have
become more expensive (or you have reduced your margins) in the eyes of
customers both abroad and at home.
If
your firm's home currency strengthens then foreign competitors are able to gain
sales at your expense because your products have become more expensive (or you
have reduced your margins) in the eyes of customers both abroad and at home.
Indirectly: Even if your home currency does not move vis-a -vis your
customer's currency you may lose competitive position. For example suppose a
South African firm is selling into Hong Kong and its main competitor is a New
Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar
the South African firm has lost some competitive position.
Even
if your home currency does not move vis-a -vis your customer's currency you may
lose competitive position. For example suppose a South African firm is selling
into Hong Kong and its main competitor is a New Zealand firm. If the New
Zealand dollar weakens against the Hong Kong dollar the South African firm has
lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy
to manage it is to diversify internationally, in terms of sales, location of
production facilities, raw materials and financing. Such diversification is
likely to significantly reduce the impact of economic exposure relative to a
purely domestic company, and provide much greater flexibility to react to real
exchange rate changes.
·
Translation
risk
The financial statements of overseas subsidiaries are usually
translated into the home currency in order that they can be consolidated into
the group's financial statements. Note that this is purely a paper-based
exercise - it is the translation not the conversion of real money from one
currency to another.
The reported performance of an overseas subsidiary in home-based
currency terms can be severely distorted if there has been a significant
foreign exchange movement.
If initially the exchange rate is given by $/£1.00 and an
American subsidiary is worth $500,000, then the UK parent company will
anticipate a balance sheet value of £500,000 for the subsidiary. A depreciation
of the US dollar to $/£2.00 would result in only £250,000 being translated.
Unless managers believe that the company's share price will fall
as a result of showing a translation exposure loss in the company's accounts,
translation exposure will not normally be hedged. The company's share price, in
an efficient market, should only react to exposure that is likely to have an
impact on cash flows.
Hedging transaction
risk - the internal techniques
Internal techniques to manage/reduce forex exposure should
always be considered before external methods on cost grounds. Internal
techniques include the following:
Invoice in home currency
One easy way is to insist that all foreign customers pay in your
home currency and that your company pays for all imports in your home currency.
However the exchange-rate risk has not gone away, it has just
been passed onto the customer. Your customer may not be too happy with your
strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a
competitive environment this is an unrealistic approach.
Leading and lagging
If an importer (payment) expects that the currency it is due to
pay will depreciate, it may attempt to delay payment. This may be achieved by
agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to
receive will depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for immediate payment.
The problem lies in guessing which way the exchange rate will
move.
Matching
When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against each other.
It is then only necessary to deal on the forex markets for the
unmatched portion of the total transactions.
An extension of the matching idea is setting up a foreign
currency bank account.
Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off
to leave a similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in
transaction costs.
Hedging transaction
risk - the external techniques
Transaction risk can also be hedged using a range of financial
products. These are introduced below with links to more detailed pages.
Forward contracts
The forward market is where you can buy and sell a currency, at
a fixed future date for a predetermined rate, i.e. the forward rate of
exchange. This effectively fixes the future rate.
Money market hedges
The basic idea is to avoid future exchange rate uncertainty by
making the exchange at today's spot rate instead. This is achieved by
depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur. This effectively fixes the future rate.
Futures contracts
Futures contracts are standard sized, traded hedging
instruments.
The aim of a currency futures contract is to fix an exchange
rate at some future date, subject to basis risk.
Options
A currency option is a right, but not an obligation,
to buy or sell a currency at an exercise price on a future date. If there is a
favourable movement in rates the company will allow the option to lapse, to
take advantage of the favourable movement. The right will only be exercised to
protect against an adverse movement, i.e. the worst-case scenario.
A call option gives the holder the right to buy the underlying
currency.
A put option gives the holder the right to sell the underlying
currency.
Options are more expensive than the forward contracts and
futures but result in an asymmetric risk exposure.
Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of
currency for a period and then re-swap them at the end of the period at an
agreed swap rate. The swap rate and amount of currency is agreed between the
parties in advance. Thus it is called a fixed rate/fixed rate swap.
The main objectives of a forex swap are:
To hedge against forex risk, possibly for a longer period than
is possible on the forward market.
Access to capital markets, in which it may be impossible to
borrow directly.
Forex swaps are especially useful when dealing with countries
that have exchange controls and/or volatile exchange rates.
Currency swaps
A currency swap allows the two counter parties to swap interest
rate commitments on borrowings in different currencies.
In effect a currency swap has two elements:
An exchange of principal in different currencies, which are
swapped back at the original spot rate - just like a forex swap.
An exchange of interest rates - the timing of these depends on
the individual contract.
The swap of interest rates could be fixed for fixed or fixed for
variable.
No comments:
Post a Comment