Measuring and Managing

Foreign Exchange
Exposures
Prof. Kapil Bhopatkar

 On 1st January Bombay Fashions US Subsidiary

showed the followed accounts situation
Current Assets 1000000$
Current Liabilities 300000$
Total Assets 2500000$
Total Liabilities 900000$
Exchange rate as on Jan 1 1$= 48
Exchange Rate as on 31 Dec 31 1$=45
Calculate Translation Exposure

 Translation Exposure measures the

effect of an exchange rate change on
published financial statements of the
firm. I
It arises out of foreign operations
from the foreign currency to the
home currency.
They are just paper exchange gains
or losses.
They are retrospective and short

Solution
All Assets and Liabilities are to be converted at
the Current Rate
Calculation of Equity= 2500000$900000$=1600000$
At the Beginning of the Year= 1600000x48=
At the End of the Year= 1600000 x45=

Calculate Transaction Exposure

M/S Omega Electronics Ltd exports air conditioners to
Germany by importing all the components from
Singapore. The Company is exporting 2400 units at a
price of Euro 500 per Unit. The Cost of Imported
Components is $ 800 per unit. The Fixed Cost and
other variable costs are Rs 1000 and 1500 respectively.
The Cash flows in foreign Currencies are due in 6
months. Then Current Exchange Rates are as follows:
Rs /Euro 51.50/55
Rs/SGD 27.20/25
After 6 months the exchange rates turns out as follows
Rs/Euro 52.00/52.05 Rs/SGD 27.70/75

Solution
Profit
based

On
today's

Current
Exchange
rate

Profit
based

Revenu
e
Units
Unit Price

On
Rate after
xchange 6 months
Revenu
e

Amount

Units

Amount

500 GBP

Unit Price

500 GBP

1200000
GBP

Exports
2400
Recievabl
es

1200000G
BP

Exchange
Rate

Rs 51.50

Exchang
e Rate

Rs 52.00

Exports
Receivabl
es

61800000

Exports
Receivabl
es

62400000

Exports
Recievabl
es

2400

Import Cost
per Unit
Import
Payments

SGD
800
2400

Import Cost
per Unit

192000 Import
0
Payments
Exchange
Rate

SGD 800
2400 1920000

Exchange
Rate

Rs
27.25

Rs 27.75

Total Import
Cost

523200 Total Import

00
Cost

5328000
0

Fixed Cost@
1000

2400

240000 Fixed Cost@

0
1000

2400000

Variable
Cost@1500

2400

360000 Variable
0
Cost@1500

3600000

Total Cost

583200 Total Cost

00

5928000
0

Profit

348000 Profit
0

3120000

Economic Exposure
It measures the impact of an
exchange rate change on the net
present value of expected cash flows
from foreign investment project

 Economic Exposure Management must cover

the entire life of the foreign investment project.
EEM must cover all aspects of business
operations such as factors market product
market and finance market.
Risk Management can be done by diversified
production diversified marketing and diversified
financing.
The biggest problem of diversification strategy
is loss on economies of scale.

Transaction Exposure V Operating

Exposure
Both Deal with changes in Expected Cash Flows
Transaction Exposure deals with changes in near
term cash flows that have already been
contracted for.(foreign currency accounts
receivable, accounts payable and other debts)
Operating Exposure deals with changes in long
term Cash flows that have not been contracted
for but would be expected in normal course of
Future business.
It can be termed as anticipated future
transaction exposure.

 Operating exposure is a much broader

concept as the exposure might be through
sales Volume or operating cost changes.
The Cash flow impact of transaction
exposure can be measured precisely
whereas the cash flow impact of operating
exposure remains a conjecture about the
future.

Operating Exposure
Currency fluctuations x Changes in Price
level
Change in price of the inputs or change in
the quantities of outputs.
Unexpected changes in Exchange Rates
causing unanticipated changes in sales
Volume Sales Price or Operating Costs.

Two Effects of Operating Exposure

Conversion effect: The impact on operating
Cash flows owing to change in domestic
currency proceeds arising out of changes in
foreign currency Selling Price(p) and number
of units sold (Q) remaining the same.
Competitive Effect: The changes in
competitive position that may arise because
changes in prices of output done by firm to
cover the increase in input costs which ahs
arisen because foreign currency has changed.

Quant's
Using additional data in Omega Electronics
if the contracted price of the air
conditioners is Rs 25000 and the current
exchange rate is
Rs/Euro 51.75/80
Rs/SGD 27.10/15
Given that the price elasticity of demand is
estimated to be 1.5 and payments and
receipts are to be settled at the end of 6
months.

Unit Price

Euro

Solution

500

Exports Receivable

2400

1200000

Exchange Rate

Rs

51.75

Exports
Receivables

Rs

62100000

COST
Import Cost per
Unit

SGD

800

Total Import
payments

2400

1920000

Exchange Rate

27.15

Total Import Cost

52128000

Fixed Cost+
Variable Cost

6000000

Total Cost

58128000

Unit Cost

24220

Decrease in Profit due to

transaction exposure

1872000-720000=1152000

Price in terms of Euro Current

exchange rate

25000/51.75=483.09

Price in terms of Euro post 6

months each unit

25000/52.00=480.77

Reduction In
Price=2.32=0.48%
Price elasticity of Demand
given 1.5
Increase in Demand due to
price

0.48 x 1.5=0.72%

Increase in demand due to

decrease in price

2400 x (1+0.0072)=2417

Increase Profit after 6 months

2417 x (25000-24700)= Rs
725100

 ABC a UK subsidiary of US MNC, manufactures

and sells electronic equipments in the UK market.
ABC buys chips from the US as an imported input.
Currently the spot rate is GBP=1.60$. Assume
that the company also buys locally sourced inputs
to manufacture the equipment. Before pricing the
product, the company also takes into account the
other fixed /variable costs and the necessary
mark up .
If it is given that $ is set to appreciate then
Explain Conversion and Competitive effect.

 Conversion Effect would impact on

operating cash flows without any
changes at all in selling price or
number of units sold owing to pure
change in the value of dollar per
pound. Obviously the cash flows will
be lower both in Pounds and Dollars
as the price of the imported input is
higher

 Competitive Effect would mean

change in the firms competitive
position which would worsen as the
company would resort to raising
prices to cover the higher pound
costs of imported input. The result
might lead to loss of some customers
and ultimately the profits might be
impacted.

SESSION 1 ENDS