International Financial

Management

Foreign Exchange Risk Management

Part I

1
 Exchange Rate Exposure

• Exposure refers to the degree to which a

multinational company is affected by exchange
rate changes.

• Foreign exchange exposure is the risk

associated with activities that involve a global
firm in currencies other than its home currency.

2
 Exchange Rate Exposure

• Exchange rate movements may negatively

impact to the company.

• Therefore company should assess and manage

their exchange rate exposure.

3
Exchange Rate Movements

4
 Exchange Rate Exposure

Three types of exposures

Translation/Accounting Exposure

Transaction Exposure

Economic Exposure

5
 Translation Exposure

• Translation exposure arises from the need, to

convert the financial statements of foreign
operations from the local currencies involved to
the home currency/reporting currency.

6
 Translation Exposure

• If exchange rates have changed since the

previous reporting period, this translation of
those assets, liabilities, revenues, expenses,
gains and losses are dominated in foreign
currencies will result in foreign exchange gains
or losses

7
 Translation Exposure

• Companies with international operations will

have foreign currency dominated assets,
liabilities, revenues, and expenses.

• Home country investors are interested in home-

currency values.

8
 Translation Exposure

• Assets and liabilities that are translated at the

current (post change) exchange rate are
considered to be exposed.

• Those are translated at a historical (pre change)

exchange rate are considered to be not
exposed.

9
 Translation Exposure

• Translation Exposure is simply the difference

between exposed assets and liabilities.

• Gain/loss in accounting nature, no cash flows

are necessarily involved.

10
 Translation Methods
• Current/non current method

• Monetary/non monetary method

• The temporal method

• The current rate method

11
 Current/ Non current method
• In this method theoretical basis is maturity.

• Current assets/liabilities are translated into

home currency at the current exchange rate.

• Non current assets/liabilities are translated into

home currency at its historical exchange rate

12
 Current/ Non current method
E.g. Foreign subsidiary with positive local currency
working capital will give rise to translation loss
from currency depreciation.

13
 Current/ Non current method
• E.g. Foreign subsidiary with positive local
currency working capital will give rise to
translation profit from currency appreciation.

14
 Current/ Non current method
• Income statement is translated at the average
exchange rate, except for those revenues and
expenses items associated with non current
assets or liabilities.

15
 Monetary/ Non monetary method
• Monetary assets/liabilities- those items that
represent a claim to receive, or an obligation to
pay, a fixed amount of foreign currency units.

• Eg. Cash, debtors

• Translated at current rate

16
 Monetary/ Non monetary method
• Non-monetary – physical assets and liabilities

• e.g inventory, fixed assets, long term

investments

• Translated at historical rate.

17
 Monetary/ Non monetary method
• Income statement items are translated at the
average exchange rate during the period, except
for those revenues and expenses items
associated with non monetary items.

18
 Temporal method
• This is a modified version of monetary/non
monetary method

• Only difference is, inventory. Normally it is

translated at historical rate, but it can be
translated at the current rate if the inventory is
shown on the balance sheet at market values.

19
 Current Rate Method
• This is the simplest method

• All balance sheet and income items are

translated at the current rate.

20
 Transaction exposure

This is occurs from the possibility of incurring

future exchange gains or losses on
transactions already entered into and
dominated in foreign currency.

21
 Transaction exposure

• Some of these unsettled transaction are

already listed on the balance sheet (foreign
currency dominated debt and accounts
receivables)
• Other obligations not listed on the balance
sheet such as contracts for future sales or
purchases

22
 Managing transaction exposure

• Whenever a company is committed to a

foreign currency dominated transaction there
will be a transaction exposure.
• Because this will result in a future foreign
currency cash inflow or outflow.

23
 Managing transaction exposure

• Suppose we have purchased some goods

worth of 50$ at Rs 100/$ in credit terms and
to be settled in one month.
• At the settlement date exchange rate can be
changed.

24
 Managing transaction exposure

• Proactive measures to guard against

transaction exposure involve entering into
foreign currency transactions whose cash
flows exactly off set the cash flows of the
transaction exposure

25
 Managing transaction exposure

• Proactive measures
Forward contracts
Futures Contracts
Currency options
Money Market hedge.

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