Exchange Rate Risk

1
Exchange Rate Risk

• International Finance and Development

2
Outline

• Meaning of Exchange Rate Risk
• Types of Exchange Rate Risks
• Transaction Exposure
• Translation Exposure
• Economic Exposure
• Measurement of Exchange Rate Risk
• Management of Exchange Rate Risk
• Management of Transaction Exposure
• Management of Economic Exposure

3
Meaning of Exchange Rate Risk

• Risk of fluctuating value of a currency over time
• If 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 risk
• Impacts dollar value of foreign currency cash
  inflows and foreign currency cash outflows
• If we have foreign currency cash inflows, we face
  risk of foreign currency depreciating against
  domestic currency
• If we have foreign currency cash outflows, we
  face risk of foreign currency appreciating
  against domestic currency

4
Types of Exchange Rate Exposures

• Transaction Exposure
• Only companies engaged in global business and
  doing transactions in foreign currency face this
  risk
• Arises due foreign currency transactions of a
  firm
• Arises from the possibility of incurring future
  exchange gains/losses on transactions already
  entered into and denominated in a foreign
  currency.

5
Measuring Transaction Exposure

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

6
Measuring Transaction Exposure

• To determine the amount of transaction exposure,
  keep in mind the following
• The net exposure of all subsidiaries combined
• Range of possible exchange rates
• Range of cash inflows and outflows
• Standard Deviation of currencies
• Correlations among currencies

7
Translation Exposure

• The exposure of the MNCs consolidated financial
  statements to exchange rate fluctuations
• If 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

8
Economic Exposure

• The extent to which the economic value of a
  company can decline because of exchange rate
  changes
• Decline can be due to a decline in the level of
  expected cash flows or an increase in the
  riskiness of these cash flows
• Overall effect of exchange rate changes in
  competitive relationships between alternative
  foreign locations
• Extent of exposure depends on
• structure of markets for a firms product
• Price elasticity of demand for the product
• Availability of close substitutes for the product
• Even pure domestic firms may face economic
  exposure

9
Management of Transaction Exposure

• Foreign currency cash outflows
• Risk Foreign currency may become more
  expensive/appreciate against domestic currency
• Strategy Buy foreign currency futures, forwards,
  or call options
• Foreign currency cash inflows
• Risk Foreign currency may become more
  cheap/depreciate against domestic currency
• Strategy Sell foreign currency futures,
  forwards, or buy put options

10
Management of Economic Exposure

• Marketing Initiatives
• Market Selection
• Pricing Strategy
• Product Strategy
• Promotion Strategy
• Production Initiatives
• Product sourcing and input mix
• Plant location
• Raise Productivity
• Financial Initiatives

11
Marketing Initiatives

• Shall 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?

12
Production Initiatives

• Outsource your inputs/raw materials/components in
  response to strong domestic currency
• Change input mix to reduce cost in response to
  strong domestic currency
• Shift production to weak currency area in
  response to strong domestic currency
• Raise productivity by cutting costsproduce the
  same number of units at a lower cost or produce
  more units at the same cost

13
Financial Initiatives

• Equate the sensitivity of costs and revenues to
  exchange rate changes