MANAGEMENT OF FOREIGN EXCHANGE

AND RISK MANGEMENT

INTRODUCTION
Business firm engaged in international business
experience foreign exchange exposure and risk. It may
be recalled that foreign exchange exposure is a
sensitivity of the value of assets , liabilities and cash
flow of a firm to change in exchange rate of currencies.
The variability in the value of assets , liabilities
and cash flows induced by such exposure is referred to
as foreign exchange risk. Business enterprise have to
design and implement proper risk management
system and methods to reduce or eliminate the risk
arising from foreign exchange exposure
MANAGEMENT OF TRANSACTION
RISK
Transaction risk refers to the variability in the home
currency value of cash flow arising from transactions
already completed and whose foreign currency values
are contractually fixed . The variability may be
significant or insignificant depending on the extent of
movement of exchange rates . It is possible to neutralize
the impact of exchange rate fluctuations on cash flows
and thus eliminate the variability by adopting certain
measure. This process of eliminating variability is known
as hedging and the measure used for achieving
objectives are known as hedging techniques
Management of foreign exchange risk
involves three important functions
1. Assessing the extent of variability and
identifying whether it is likely to be favorable or
adverse.
2. Deciding whether to hedge or not to hedge all
or part of the exposure.
3.Choosing the optimal hedging technique to suit
the situation
TECHNIQUE FOR HEDGING
TRANSACTION RISK
A hedge is an investment that is made with the
intention of reducing the risk of adverse price
movements in an asset. A company that decide
to hedge its transaction exposure may choose
any of the following
techniques:
 Foreword hedge
 Future hedge
 Money market hedge
 Currency option hedge
FOREWARD HEDGE
If you are going to owe foreign currency in
the future (import), agree to buy the foreign
currency now by entering into long position
(investor owned) in a forward contract.
If you are going to receive foreign currency in
the future (export), agree to sell the foreign
currency now by entering into short position
(investor owes) in a forward contract.
MONEY MARKET HEDGE
This is the same idea as covered interest
arbitrage. To hedge a foreign currency payable,
buy a bunch of that foreign currency today and sit
on it.
 It’s more efficient to buy the present value of
the foreign currency payable today.
 Invest that amount at the foreign rate.

At maturity your investment will have grown

enough to cover your foreign currency payable
OPTION MARKET HEDGE
Options provide a flexible hedge against the
downside, while preserving the upside potential.
To hedge a foreign currency payable, buy calls on
the currency.
Call Option
 A call option is a contract that gives the option
buyer the right to buy an underlying asset at a
specified price within a specific time period.
 If the currency appreciates, your call option lets
you buy the currency at the exercise price of the
call.
OPTION MARKET HEDGE
To hedge a foreign currency receivable, buy puts
on the currency.
Put Option
 Put options give investors the right to sell an
asset at a specified price within a
predetermined time frame.
 If the currency depreciates, your put option
lets you sell the currency for the exercise price.
FUTURE HEDGE
While the use of short and long hedges can reduce (or eliminate in
some cases - as below) both downside and upside risk. The reduction
of upside risk is certainly a limation of using futures to hedge.
Short Hedges
 A short hedge is one where a short position is taken on a futures
contract. It is typically appropriate for a hedger to use when an
asset is expected to be sold in the future. Alternatively, it can be
used by a speculator who anticipates that the price of a contract
will decrease
Long Hedges
 A long hedge is one where a long position is taken on a futures
contract. It is typically appropriate for a hedger to use when an
asset is expected to be bought in the future. Alternatively, it can
be used by a speculator who anticipates that the price of a
contract will increase
CROSS HEDGING
A risk management strategy used in limiting or
offsetting probability of loss from fluctuations in the
prices of commodities, currencies, or securities. In
effect, hedging is a transfer of risk without buying
insurance policies.
Hedging employs various techniques but,
basically, involves taking equal and opposite positions
in two different markets (such as cash and futures
markets). Hedging is used also in protecting one's
capital against effects of inflation through investing in
high-yield financial instruments (bonds, notes, shares),
real estate, or precious metals.
INTERNAL TECHNIQUES
Netting
 Netting implies offsetting exposures in one currency with exposure in the same or
another currency, where exchange rates are expected to move high in such a way
that losses or gains on the first exposed position should be offset by gains or
losses on the second currency exposure.
Matching
 The netting is typically used only for inter company flows arising out of groups
receipts and payments. As such, it is applicable only to the operations of a
multinational company rather than exporters or importers. In contrast, matching
applies to both third parties as well inter-company cash flows. It can be used by
the exporter/importer as well as the multinational company. It refers to the
process in which a company matches its currency inflows with its currency
outflows with respect to amount and timing. Receipts generated in a particular
currency are used to make payments in that currency and hence, it reduces the
need to hedge foreign exchange risk exposure
INTERNAL TECHNIQUES
Leading and Lagging
 It refers to the adjustment of intercompany credit terms, leading means a
prepayment of a trade obligation and lagging means a delayed payment. It is
basically intercompany technique whereas netting and matching are purely
defensive measures. Intercompany leading and lagging is a part of risk- minimizing
strategy or an aggressive strategy that maximizes expected exchange gains. Leading
and lagging requires a lot of discipline on the part of participating subsidiaries.
Multinational companies which make extensive use of leading and lagging may
either evaluate subsidiary performance in a pre-interest basis or include interest
charges and credits to overcome evaluation problem
Pricing Policy
 In order to manage foreign exchange risk exposure, there are two types of pricing
tactics: price variation and currency of invoicing policy. One way for companies to
protect themselves against exchange risk is to increase selling prices to offset the
adverse effects of exchange rate fluctuations. Selling price requires the analysis of
Competitive situation, Customer credibility, Price controls and Internal delays.
MANAGEMENT OF OPERATING RISK
The term Operational Risk Management
(ORM) is defined as a continual cyclic process
which includes risk assessment, risk decision
making, and implementation of risk controls,
which results in acceptance, mitigation, or
avoidance of risk. ORM is the oversight of
operational risk, including the risk of loss
resulting from inadequate or failed internal
processes and systems; human factors; or
external events
THREE LEVELS OF ORM
In Depth
In depth risk management is used before a project is implemented, when
there is plenty of time to plan and prepare. Examples of in depth methods
include training, drafting instructions and requirements, and acquiring
personal protective equipment.
Deliberate
Deliberate risk management is used at routine periods through the
implementation of a project or process. Examples include quality assurance,
on-the-job training, safety briefs, performance reviews, and safety checks.
Time Critical
Time critical risk management is used during operational exercises or
execution of tasks. It is defined as the effective use of all available resources
by individuals, crews, and teams to safely and effectively accomplish the
mission or task using risk management concepts when time and resources
are limited. Examples of tools used includes execution check-lists and
change management. This requires a high degree of situational awareness
BENEFITS OF ORM
1. Reduction of operational loss.
2. Lower compliance/auditing costs.
3. Early detection of unlawful activities.
4. Reduced exposure to future risks
MANAGING TRANSLATION
EXPOSURE
Translation or Accounting Exposure:
 Is the sensitivity of the real domestic currency value of assets and
liabilities, appearing in the financial statements to unanticipated
changes in exchange rates

Managers, analysts and investors need some idea about the importance
of the foreign business. Translated accounting data give an approximate
idea of this.

 Performance measurement for bonus plans, hiring, firing, and

promotion decisions.
 Accounting value serves as a benchmark to evaluate a discounted-
cash flow valuation.
 For income tax purposes.
 Legal requirement to consolidate financial statements