Example
A U.S. company buys textiles from England with payment of 1 million pound
due in 90 days. Thus, the importer is short pounds.
Suppose the spot price of the pound is $ 1.71.
During the next 90days, the pound might rise against dollar, raising the
dollar cost of textiles.
The importer can guard against this exchange risk by immediately
negotiating a 90 day forward contract with a bank at a price of say, 1pound =
1.72 $.
According to the forward contract,
* In 90 days, the bank will give the importer 1 million pound which it will
use to pay its textile order.
* The importer will give the bank $ 1.72 million, which is the dollar
equivalent of 1 million pound at the forward rate of 1.72 $.
example
Gives textiles in 90 days
U.S. company England (Exporter)
(Importer) 1 million pound
ENTERS INTO A FORWARD CONTRACT
BANK
spot price of the pound is $ 1.71
Enters into a forward contract with bank at 1pound = 1.72 $.
Transaction exposure
It refers to the extent to which the future value of firms domestic
cash flows is affected by exchange rate fluctuations. It arises from
the possibility of incurring foreign exchange gains or losses on
transaction already entered into and denominated in a foreign
currency.
Foreign exchange risk
It is the possibility of a gain or loss to a firm that occurs due to
unanticipated changes in exchange rate.
For ex: if an Indian firm imports goods and pays in foreign currency
(say dollar) , its outflow is in dollars, thus it is exposed to foreign
exchange risk. If the value of currency rises($ appreciates) the
Indian firm has to pay more domestic currency to get the required
amount of foreign currency.
It relates to the possibility of changes in the value.
Foreign exchange exposure
It relates to the total value of assets, liabilities or cash flows of an
enterprises denominated in foreign currency
It relates to the absolute value of an asset and liabilities involved.
Types of exposure
Translation exposure
Transaction exposure
Economic exposure
Translation exposure
MNCs may wish to translate financial statement of foreign affiliates into
their home currency in order to prepare consolidated financial statements
or to compare financial results.
Assets and liabilities that are translated at the current exchange rate or
historical exchange rate are considered to be exposed overtime
Translation exposure= exposed assets- exposed liabilities
example
A US parent co has a single wholly owned subsidiary in France. This
subsidiary has monetary assets of 200 million francs and monetary
liabilities of 100 million francs. The exchange rate declines from FFr 4 per
dollar to FFr 5 per dollar
The loss=
Monetary assets = FFr 200 millions
Monetary liabilities = FFr 100 million
Net exposure =FFr 100 million
Pre devaluation rate =$25 million
Post devaluation rate =$ 20 million
Potential exchange loss =$5 million
Translation method
The current rate method
The monetary/ non monetary method
The temporal method
The current/ non current method
Comparison of four methods
Balance sheet current monetary temporal current or
non current
Cash C C C C
Receivables C C C C
Payables C C C C
Inventory C C C or H C
Fixed assets H H H C
Long term debt H C C C
Net worth H H H H
Economic exposure
It measures the impact of an actual conversion on the expected
future cash flows as a result of an unexpected change in exchange
rates. A MNC may have established its subsidiary in a country with
price stability, favorable balance of payment, low rates of taxation
and readily available funds. However if the economic situation of
the country were to deteriorate, these positive aspects may get
reduced over time and the local currency will depreciates.
example
A French subsidiary of an American firm is expected to earn FFr
45 million after taxes and its depreciation charge is estimated at
FFr 5 million. The excahnge rate is expected to decrease from FFr
4=1$ to FFr 5=1$ for the next year
Profit after taxes =FFr 50 million
Pre devaluation rate =$12.5 million
Post devaluation rate =$10 million
Potential exchange loss= $2.5 million
Managing economic exposure
Marketing initiatives
a) Market selection
b) Product strategy
c) Pricing strategy
d) Promotional strategy
Production initiatives
a) Product sourcing
b) Input mix
c) Plant location
d) Raising productivity
