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THE NEED FOR FOREIGN EXCHANGE MANAGEMENT 1.

____________________________________________________________ _ Module F P17: INTERNATIONAL FINANCE ____________________________________________________________ _ FOREIGN EXCHANGE RISK MANAGEMENT

-------------------------------------------------------------------------CPA REVIEW PROGRAMME

Exporting companies might invoice their customers in a foreign currency. For example, a UK exporter might invoice a customer in Belgium in US dollars, Deutsche marks or Belgian francs Similarly, suppliers might invoice importing companies in a foreign currency With international trade, either the exporter or the importer must be trading in a foreign currency. Quite often, they both are, with the deal in a third currency, such as US dollars.

2.

Foreign exchange management has much greater significance for many companies, however, because of the volatile nature of exchange rates. The exchange rates between currencies are continually changing, and this lack of stability creates uncertainty about what foreign exchange income will be worth when it is received, or what foreign exchange payments will cost when they have to be made. Foreign exchange rate movements create the risk of unforeseen losses for a company, and so foreign exchange risk management can be a crucial element of a corporate treasure's functions. 2. ACCOUNTING EXPOSURE 2.1.1 MEASURING ACCOUNTING EXPOSURE

Alternative Currency Translation Methods Companies with international operations will have foreign-currency-denominated assets and liabilities, revenues, and expenses. However, because home-country investors and the entire financial community are interested in home-currency values, the foreign currency balance-sheet accounts and income statement must be assigned HC values. In particular, the financial statements of an MNC'S overseas subsidiaries must be translated from local currency to home currency prior to consolidation with the parents, financial statements. If currency values change, foreign exchange translation gains or losses may result. Assets and liabilities that are translated at the current (post-change) exchange rate are considered to be exposed; those translated at a historical (pre-change) exchange rate will maintain their historic HC values and, hence, are regarded as not exposed. Translation exposure is simply the difference between exposed assets and exposed liabilities.

2 Four principal translation methods are available: the current/non-current method, the monetary /nonmonetary method, the temporal method, and the current rate method. in practice, there are also variations of each method. Current / Non-Current Method

With this method, all the foreign subsidiary's current assets and liabilities are translated into home currency at the current exchange rate. Each non-current asset or liability is translated at its historical exchange rate that is at the rate in effect at the time the asset was acquired or the liability incurred. Hence, a foreign subsidiary with positive local-currency working capital will give rise to a translation loss (gain) from devaluation (revaluation) with the current/non-current method, and vice versa if working capital is negative. The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with non-current assets or liabilities. The latter items, such as depreciation expense, are translated at the same rates as the corresponding balance-sheet items. Thus it is possible to see different revenue and expense items with similar maturities being translated at different rates. Monetary / Non-Monetary Method

The monetary/non-monetary method differentiates between monetary assets and liabilities-that is, those items that represent a claim to receive or an obligation to pay, a fixed amount of foreign currency units- and non-monetary, or physical, assets and liabilities. Monetary items (for example, cash, accounts payable and receivable, and long-term debt) are translated at the current rate; non-monetary items (fore example, inventory, fixed assets, and long-term investments) are translated at historical rates. Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to non-monetary assets and liabilities. The latter items, primarily depreciation expense and cost of goods sold, are translated at the same rate as the corresponding balance-sheet items. As a result, the cost of goods sold may be translated at a rate different from that used to translate sales. Temporal Method

This method appears to be a modified version of the monetary/non-monetary method. The only difference is that under the monetary/non-monetary method, inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, but it can be translated at the current rate if the inventory is shown on the balance sheet at market values. Despite the similarities, however, the theoretical basis of each method is different. The choice of exchange rate for translation id based on the type of asset or liability in the monetary/non-monetary method; in the temporal method, it is based on the underlying approach to evaluating cost (historical versus market). Income statement items are normally translated at an average rate for the reporting period. However, cost of goods sold and depreciation and amortization charges related to balance-sheet items carried at past prices are translated at historical rates. Current Rate Method The current rate method is the simplest' all balance-sheet and income items are translated at the current rate. Under this method, if a firm's foreign-currency-denominated assets exceed its foreign-currencydenominated liabilities, a devaluation must result in a loss and a revaluation, in a gain. One variation is to translate all assets and liabilities except net fixed assets at the current rate. 2.2 MANAGING ACCONTING EXPOSURE The general concept of exposure refers to the degree to which a company is affected by exchange rate changes. Accounting exposure arises from the need, for purposes of reporting and consolidation, to convert

3 the financial statements of foreign operations from the local currencies (LC involved to the home currency (HC). If exchange rates have changed since the previous reporting period, this translation, or restatement, of those assets, liabilities, revenues, expenses, gains, and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains or losses is measure by the translation exposure figures. Management of accounting exposure centers along the concept of Hedging. a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Regardless of what happens to the future exchange rate, therefore, hedging locks in a dollar (home currency) value for the currency exposure. In this way, hedging can protect a firm form unforeseen currency movements. A variety of hedging techniques are available, but before a firm uses them it must decide on which exposures to manage. 2.2.1 MANAGING TRANSLATION EXPOSURE

Firms have three available methods for managing their translation exposure: (i) Adjusting fund flows (ii) Entering into forward contracts, and (iii) Exposure netting methods. Essentially the strategy involves increasing hard-currency (likely to appreciate)assets and decreasing softcurrency (likely to depreciate) assets, while simultaneously decreasing hard-currency liabilities and increasing soft-currency liabilities. For example, if a devaluation appears likely, the basic hedging strategy would be executed as follows: Reduce the level of cash, tighten credit terms to decrease accounts payable, and sell the weak currency forward. Funds Adjustment Most techniques for hedging an impending local currency (LC) devaluation reduce LC assets or increase LC liabilities, thereby generating LC cash. If accounting exposure is to be reduced, these funds must be converted into hard currency assets. For example, company will reduce its translation loss if, before an LC devaluation, it converts some of its LC cash holdings to the home currency. This conversion can be accomplished, either directly or indirectly, by means of various funds adjustment techniques. Funds adjustment involves altering either the amounts or the currencies (or both) of the planned cash flows of the parent and/or its subsidiaries to reduce the firm's local currency accounting exposure. If an LC devaluation is anticipated, direct funds-adjustment methods include pricing exports in hard currencies and imports in the local currency, investing in hard-currency securities, and replacing hardcurrency borrowings with local currency loans. Exposure Netting Exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way ht losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. This portfolio approach to hedging recognizes that the total variability or risk of a currency exposure portfolio should e less than the sum of the individual variability of each currency exposure considered in isolation. The assumption underlying exposure netting is that the net gain or loss on the entire currency exposure portfolio is what matters, rather than the gain or loss on any individual monetary units

2.2.2. MANAGING TRANSACTION EXPOSURE A transaction exposure arises whenever a company is committed to a foreign currency denominated transaction. Will result in a future foreign currency cash inflow or outflow, any change in the exchange rate

4 between the time the transaction is entered into and the time it is settled in cash will lead to a charge in the dollar (HC) amount of the cash inflow or outflow. Protective measures to guard against transaction exposure involve entering into foreign currency transaction exposure. These protective measures include using forward contracts, price adjustment clauses, currency options, and borrowing or lending in the foreign currency. Alternatively, the company could try to invoice all transactions in dollars and to avoid transaction exposure entirely. However, eliminating transaction exposure entirely. However, eliminating transaction exposure doesn't eliminate all foreign exchange risk. The firm is still subject to exchange risk on its future revenue and costs its operating cash flows. An international company that decides to hedge part or all of its transaction exposure may select from the following hedging Forward Contract Hedge Futures Contract hedge Money Market Hedge Currency Option hedge Forward Contract Hedge Forward contracts are commonly used by large firms that desire to hedge. A forward contract is an immediately firm binding contract between a bank and its customer for the purchase or sale of a specified quantity of a stated foreign currency at a specified rate of exchange. the exchange rate is fixed at the time the contract is made and the delivery of the currency and the payment for it at a future time which is also agreed upon when making the contract. this future time will be either a specific date, or any time between two specified dates. In a forward market hedge, a company that is long a foreign currency will sell the foreign currency forward, whereas a company that is short a foreign currency will buy the currency forward. In this way, the company can fix the dollar value of future foreign currency cash flow. The Cost of a Forward Contract Specifically, the cost of forward contract is usually measured as its forward discount of premium:

eo f t eo
Where eo is the current spot rate (dollar price) of the foreign currency and f1 is the forward rate. In GE's cash is cost would equal 4.3%. However, this approach is wrong because the relevant comparison must be between the dollars per unit of foreign currency received with hedging ft, and the dollars received in the absence of hedging, e1 is the future (unknown) spot rate on the date of settlement. that is, the real cost of hedging is an opportunity cost. In particular, if the forward contract had not been entered into, the future value of each unit of foreign currency would have been e1 dollars. Thus, the true dollar cost of the forward contract per dollar's worth of foreign currency sold forward equals.

e f ft eo
The Money Market hedge An alternative to a forward market hedge is to use a money market hedge. A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash-flow.

Money Market Hedge on Receivables Hedging receivables using this technique involves three steps 1. Borrow the currency denominating the receivables 2. Convert the money borrowed to the local currency 3. Pay off the loan with cash inflows from the receivables Money Market hedge on Payable A money market hedge on payables involves the immediate acquisition of the foreign currency and investment in a security dominated in that currency. The acquisition may be done using excess cash (when available) or a loan (borrowing). The foreign currency investment proceeds will then be used to cover the payable position. Future Market Hedge Closely related to the use of a forward contract is a futures contract. Futures contracts are standardized contracts that trade on organized futures market. Contract sizes are standardized according to the amount of foreign currency, for instance US$ 200,000, C$100,000, SFr 125,000. Future Contract hedge on payables To hedge payments on future payables in a foreign currency, the firm purchases a currency futures contract representing the currency it will need in the near future. A firm that buys a currency futures is entitled to receive a specified amount of a specified currency for a stated price on a specified date. By holding this contract, it locks the amount of its home currency needed to make payment on the payables. Future Contract in Receivables To hedge the home currency value of future receivables in a foreign currency, a firm sells a currency futures contract representing the currency it shall be receiving. this way the firm knows how much of its home currency it will receive after converting the foreign currency receivables into its home currency. By locking in the exchange rage at which it will be able to exchange the foreign currency, it insulates the value of its future receivables from the fluctuations in the foreign currency spot rate over time. Currency Option hedging Forward hedge and money market hedge can backfire when a payable currency depreciates or a receivable currency appreciates over the hedge period. In these situations case un-hedged would likely to outperform the forward market or the money market. The ideal type of hedge would insulate the firm against adverse exchange rate movements but allow the firm to benefit from favourable exchange rate movements. Hedging Payables will currency Call Options A currency call option provides the right to buy a specified amount at a particular currency at a specified price (the exercise price) within a given period of time. Unlike a futures or forward contract, the currency call option does not obligate its owner to buy the currency at that price. Consider a Tanzania-based firm that has payables in British pounds. If the spot rate remains lower than the exercise price throughout the life of the option, the firm could let the option expire and simply purchase them at the existing spot rate. On the other hand, if the spot rate of the pound appreciates over time, the call option allows the firm to purchase pounds at the exercise price. That is, the Tanzania firm owning the call option has locked in a maximum price the (exercise price) to pay for the currency. it also has the flexibility to let the option expire and obtain the currency at the existing spot rate when the currency is to be sent for payment. Hedging Receivables with Currency Put Options A currency put option provides the right to sell a specified amount of a particular currency at a specified price (the exercise price) within a given period of time. A Currency put option could be used by firms to hedge future receivables in foreign currencies since it guarantees a certain price at which the future

6 receivables can be sold. The currency put option does not obligate its owner to sell the currency at the specified price. If the existing spot rate of the foreign currency is above the exercise price when the firm receives the foreign currency, the firm can sell the currency received at the spot rate and let the put option expire. Hedging Long Term Transaction Exposure The hedging techniques used to hedge short-term transaction exposure may have limited effectiveness for the long-term. International firms that are certain of having cash flows denominated in foreign currency for several years could use long term hedging. For firms that can accurately forecast foreign exchange payables or receivables that will occur several years from now, there large two commonly used techniques to hedge such long-term transaction exposure. Long term Forward Contract Currency Swap

Long Term Forward Contract Hedge Long-term forward contracts are specially useful to firms that have set up fixed price exporting or importing contracts over a long period of time and want to protect their cash flows from exchange rate fluctuations. Large international banks quote forward rates or terms up to five years for British pounds, Canadian dollars, US dollars, German marks, and Swiss francs. Long term forward contracts can be tailored to specific needs of the firm. The mechanics of hedging in this case resemble those of short-term forward contract. Currency Swaps The second, most commonly technique of hedging long term transaction exposure is a currency swap. Currency swaps may take several forms. A common type of currency swaps accommodates two firms that have different long-term needs. 3. 3.1 ECONOMIC EXPOSURE MEASURING ECONOMIC EXPOSURE The most important aspect of foreign exchange risk management is to incorporate currency change expectations into all basic corporate decisions. In performing this task, the firm must know what is at risk. However, there is a major discrepancy between accounting practice and economic reality in terms of measuring exposure, which is the degree to which a company is affected by exchange rate changes. MANAGING ECONOMIC EXPOSURE

3.2

3.2.1.1 Marketing Management of Exchange Risk The design of a firm's marketing strategy under conditions of home currency (HC) fluctuation presents considerable opportunity for gaining competitive leverage. Thus one of the international marketing manager's tasks should be to identify the likely effects of a currency change and then act on them by adjusting pricing and product policies. Market Selection Major strategic considerations for an exporter are the markets in which to sell-that is, market selection-and the relative marketing support to devote to each market. Frequency of Price Adjustments Firms in international competition differ in their ability and willingness to adjust prices in response to exchange rate changes. Some firms constantly adjust their prices for exchange rate changes.

7 Promotional Strategy Promotional strategy should similarly take into account anticipated exchange rate changes. A key issue in any marketing program is the size of the promotional budget for advertising, personal selling, and merchandising. Promotional decisions should explicitly build in exchange rates, especially in allocating budgets among countries. 3.2.2. Production Management of Exchange Risk The adjustments discussed so far involve attempts to alter the dollar value of foreign currency revenues. But sometimes exchange rates move so much that pricing or other marketing strategies can't save the product. Firms facing this situation must either drop uncompetitive products or cut their costs. Product sourcing and plant location is the principal variables that companies manipulate to manage competitive risks that can't be dealt with through marketing changes alone. The basic strategy would involve shifting the firm's manufacturing base overseas, but this can be accomplished more than one way. Shifting Production Amount Plants Multinational firms with worldwide production systems can allocation production among their several plants in line with the changing dollar costs of production, increasing production in a nation whose currency has devalued, and decreasing production in a country where there has been a revaluation. Plant Location A firm without foreign facilities that is exporting to a competitive market whose currency has devalued may find that sourcing components abroad is insufficient to maintain unit probability. Despite its previous hesitancy, the firm may have to locate new plants abroad. Product Strategy Companies often respond to exchange risk by altering their product strategy, which deals with such areas as new-product introduction, product line decisions, and product innovation. One way to cope with exchange rate fluctuations is to change the timing of the introduction of new products. 3.2.2 Financial Management of Exchange Risk The one attribute that all the strategic marketing and production adjustments have in common is that they take time to accomplish in a cost-effective manner. the role of financial management in this process is to structure the firm's liabilities in such a way that during the time the strategic operational adjustments are underway, the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities. One possibility is to finance the portion of a firm's assets used to create export profits so that any shortfall in operating cash flows due to an exchange rate change is offset by reduction in debt servicing expenses. For example, a firm that has developed a sizable export market should hold a portion of its liabilities in that country's currency. The portion to be held in the foreign currency depends on the size of the loss in profitability associated with a given currency change. No more definite recommendations are possible because the currency effects will vary from one company to another. Basic hedging Techniques
Depreciation Sell local currency forward Reduce levels of local-currency cash and marketable securities Appreciation Buy local currency forward Increase levels of local-currency cash and marketable securities

Tighten credit (reduce local-currency receivables) Delay collection of hard-currency receivables Increase imports of hard-currency goods Borrow locally Delay payment of accounts payable Speed up dividend and fee remittances to parent and other subsidiaries Speed up payment of inter-subsidiary accounts payable delay collection of inter-subsidiary accounts receivable Invoice exports in foreign currency and imports in local currency

Relax local-currency credit terms Speed up collection of soft-currency receivables Reduce imports of soft-currency goods Reduce local borrowing Speed up payment of accounts payable Delay dividend and fee remittances to parent and other subsidiaries Delay payment of inter-subsidiary accounts payable Speed up collection of inter-subsidiary accounts receivable Invoice exports in local currency and imports in foreign currency

Cost of the Basic hedging Techniques Depreciation Sell local currency forward Reduce levels of local-currency cash and marketable securities Tighten credit (reduce local receivables) Delay collection of hard-currency receivable Increase imports of hard-currency goods Borrow locally Delay payment of accounts payable speed up dividend and fee remittances to parent and other subsidiaries Speed up payment of inter-subsidiary accounts payable Delay collection of inter-subsidiary accounts receivable Invoice exports in foreign currency and imports in local currency Costs Transaction costs; difference between forward and future spot rates Operational problems; opportunity cost (loss of higher interest rates on LC Securities) Lost sales and profits Cost of financing additional receivables Financing and holding costs Higher interest rates Harm to credit reputation Borrowing cost if funds not available or loss of higher interest rates if LC securities must be sold Opportunity cost of money Opportunity cost of money

Lost exports sales or lower price; premium price for imports.

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