UNIT 5 FOREIGN EXCHANGE MARKETS

5.0 Objectives
5.1 Introduction
5.2 Meaning
5.3 Functions
5.3.1 Playm
5.3.2 Cumncies Commonly Treded
5.3.3 Trading Hours
5.4 Foreign Exchange Rates
5.5 Foreign Exchanges Quotations
* 5.6 Types o f Foreign Exchange Transactions
5.6.1 Tlade Transactions
5.6.2 Interbank Transactions
c 5.6.3 Spot Transactions
5.6.4 Forward Transactions
5.7 Indian Foreign Exchange Market
5.8 Let Us Sum Up
5.9 Key Words
5.10 Answers to Check Your Progress
5. II Terminal QuestionsIExercises

OBJECTIVES
ARer studying this unit you should be able to :

explain meaning o f fonign exchange market

discuss various types o f exchange transactim quotations md rates prevailing in
f m i g n exchange markets
describe the functions o f the foreign exchange m a & %and the role o f its
perticipnnts
discuss the operations o f Indian foreign exchange market.

5.1 INTRODUCTION
International trade and investment cnate need for buying, selling borrowing and lending
e
f m i g n cumnciea Let us take an example, an expotter in Japan sells goods to a
customer in the U.K. The sale will be priced in Yen, Sterling or perhaps a third
currency such as U.S. dollar.

a) If the sak is priced in Yen, the U.K. customer will purchase Yen with Sterling
in order to m l e payment.

b) If the sale price is in Sterling, the Japanese supplier will nonnally wish to
convat the receipts into domestic currency yen^ to meet operating expenses in
Japan, and will sell Sterling in exchange for Yen.

c) If the sale price is in a third currency, such as US dollars, the customer will buy
dollars in exchange for Sterling to. make the payment and supplier will then sell
the dollars in exchange for Yen.
Sometimes, international trade transactions do not result in the sale or purchase o f
foreign currency because companies setsff foreign currency receipts against foreign
exchange payments. However. buying and selling, borrowing and lending foreign
currencies an common activities which support international trade and investment. These
activities an undertaken in the financial markets called foreign exchange markets. As
student o f International Business Operations, it is thus important for you to know the
terminology. operations and mechanisms o f foreign exchange markets. In this unit, you
5
Foreign 'Exchange Risk
Management
will learn about the meaning of foreign exchange market and its functions, types of
transactions made and the rates used in this market. You will also learn about the
operations and dynamics of Indian foreign exchange market. !
1

5.2 MEANING
1
Foreign exchange in short form is called Forex. The foreign exchange market or forex
market is the market where one currency is exchanged or traded for another currency.
Forex markets are also called foreign currency or just currency markets. There are
domestic and international foreign currency markets. Domestic foreign currency markets
serve the foreign currency buying, selling, borrowing and lending needs of residents
whereas international markets serve non-residents also. Much of the foreign currency
lending and borrowing take place in the Euromarkets.

Currencies are also traded in other forms as "derivative contracts" such as currency
swaps, options and futures. These are more sophisticated instruments for trading in
foreign currencies. You will study about them in the following units in this block.

5.3 FUNCTIONS

As you know in the past most of the financial markets had a physical centre or say
trading floor, where dealers met to transact their trade by "out cry" method. But things
have changed for many of the markets in many countries. Floor trading has been
replaced by screen trading, meaning trades are made through the network of teIephone
and computers from dealers' dealing rooms. Foreign exchange markets have led this
trend.

Despite its lack of a physical centre, the forex market is still a market, in the sense.that
it is a system for bringing buyers and sellers together and for supplying informations
about prices and trading activity to participants. 'The dealers responsible for setting
prices at which their banks will exchange currencies must have access to the latest
prices in the market. This information is provided constantly by computer networks and
brokers. Thus, forex market performs very useful functions.

The global foreign exchange market has established three principle (major) dealing
centres, each operating with a specific time zone : London, New York and Tokyo.
London is the main forex market centre.

5.3.1 Players
There are various participants in the foreign exchange market. The major participants
are commercial banks which act as a clearing house between users and earners of
foreign exchange. The banks also deal with foreign exchange brokers. These brokers act
as a middleman for a fee between banks. The investors, exporters, importers and tourists
also participate in the market. They are users and suppliers of foreign currencies.

Nation's central bank acts as the lender or buyer of last resort when the nation's total
foreign exchange earnings are not equal to expenditures. In that case the central bank
either draws down its foreign exchange reserves or adds to them.

Most foreign exchange trading is conducted between banks. Non-financial companies

wishing to make foreign currency transactions will either deal with a bank or within the
same group in case companies have internal procedures for inter-company currency

I
trading.

Major international banks trade in many currencies from offices in several countries.
Other banks specialise in certain currencies. A bank will want to be a major dealer in a
 Foreign Exchaege Markets
responsibility for fixing the exchange rates (price) at which the bank will buy or sell
the currency at any time. Trading profits represent the difference between selling (offer
.or ask) and buying (bid) prices. We will discuss more about bid-offer prices a little
later. Exchange rate movements occur because dealers must continuously adjust their
prices to match buying and selling pressures.

5.3.2 Currencies Commonly Traded

The US dollar is the most heavily traded currency in the international forex markets. It .
indicates : a) The role of the dollar as the favoured currency of major energy and
agricultural commodities b) The power of the US economy and its central role in the
. world economy and c) The dollar's status on the traditional reserve' currency and a safe

P heaven for investors in the times of world crises.

In recent years, world wide trading in Yen and Deutsche Mark has increased in volume
and these currencies have begun to challenge the supremacy of the dollar. Euro, the
currency of European Union or Euroland, is aimed to challenge the supremacy of US
dollar, though the experience till now does not bear any such sign. Every currency is
quoted against dollar and most currency transactions included the dollars as one of the
two constituent currencies.

Most non-dollars transactions are called 'cross currency' deals and involve two
transactions, a purchase and a sale transaction in exchange for dollars. An 1NWFrench
Franc exchange, for example, would be a cross-currency deal, involving the bank in two
transactions INWDollar and Dollar/French Franc.

Cross-Currency Deal

Sell Currency A
Buy Currency B

Effected by Sell Currency A Sell. US Dollars

Buy US Dollars Buy Currency B

If a bank wants to purchase of a large quantity of French francs in exchange for

Sterling, it would sell Sterling and purchase French francs for US dollars in two
separate transactions.

5.3.3 Trading Hours

The trading hours of the three major foreign exchange markets virtually span 24 hours,
expressed in local time, are

London 8.00 - 16.30

New York . 8.30 - 16.30
Tokyo 8.00 - 17.30

Allowing for the five-hours time lag between London and New York and nine hours
between Tokyo and London, the effective opening hours in UK time (GMT) are
virtually round the clock. As one major forex market closes for the day, trading will
switch to another centre,.For banks and other organisations, with heavy involvement in
the forex markets, buying and selling currencies can be done virtually round the clock.

5.4 FOREIGN EXCHANGE RATES

Foreign Exchange Risk currency against other major currencies. The exchange rate mechanism (ERM) of the
Management
European monetary system (EMS), intervention by central banks of different countries
from time-to-time, and the keenness with which board meetings of Federal Reserve (US
central bank) or Deutsche Bank (German central bank) and central banks of other G-7
'
countries are watched by forex market players highlight the importance and role of
regulation in the forex markets.

To a large extent, however, the main forex markets are now fairly free from controls
and exchange rates between the major currencies, most notably the US dollar, the Yen,
and the Deutsche mark, fluctuate fieely according to demand and supply. How exchange
rates are determined and forecasted, you will read more abopt it in unit 6.
- - - - - - - -

5.5 FOREIGN EXCHANGE QUOTATIONS

*
The foreign exchange quotations, meaning the way relative prices or rates are quoted
for trade between players in the foreign exchange markets, can be direct, indirect or
cross. w

Direct Quotation is the price of one unit of a foreign currency quoted in terms of the
home country's currency. In other words, it is the home currency that would cost you to
purchase one unit of the foreign currency. For instance, a quotation of Rs. 43.50 per
dollar in New Delhi is a direct quotation for rupee. This is also known as a quotation
in European terms.
- .
Indirect Quotation is just the reverse. It is the price of one unit of the home country's
currency quoted in terms of foreign currency. In other words, it is the amount of
foreign currency that you can buy using one unit of your own currency. For example, a
quotation of S.0435 per rupee is an indirect quotation for rupee. You will notice here
that the direct and indirect quotations are reciprocals of each other. In other words, the
direct quotation is equal to one divided by the indirect quotation. This is also known as
quotation in American terms.

Cross Rates

Although banks deal with non-bank customers in any convertible currency, for a French
franclltalian lira, Sterling/Spanish pesta, Swiss franc1French francs and so on, the inter
bank market normally quotes currencies against the US dollars. This avoids the trouble
of having to quote many individual rates between currencies. The exchange rate for any
non-dollar currencies is then calculated from their respective dollar exchange rates, to
derive a cross rate. For example, the Swiss FranctFrench franc exchange rate can be
derived from Swiss francldollar and dollar1French franc rates. Cross rates are are the
rates between two currencies where neither one is the US dollar. C

5.6 TYPES OF FOREIGN EXCHANGE TRANSACTIONS

A foreign exchange transaction is a contract to buy or sell a quantity of one currency in

exchange for another at a specified time for delivery and settlement and at a specified
price (exchange rate). These transactions take place ip foreign exchange markets. In
terms of counter parties and settlement dates, the forex transactions may be classified as
follows:

5.6.1 Trade Transactions

Trade transaction is a transaction between a bank and a non-bank customer, where the
customer wishes to buy or sell a quantity of currency to complete a business transaction
or (occasionally) specalates for profit by anticipating future changes in the exchange
rate.

8
 I
Foreign Exchange Markets
5.6.2 Interbank Transactions
Interbank transactions are where two banks trade currencies between themselves. Banks
buy and sell huge quantities of foreign currencies. They also accept currency deposits
and lend in foreign currency.

5.6.3 Spot Transactions

A spot transaction is a contract to buy or sell a quantity of a foreign currency for
immediate settlement. Immediate settlement as per convention of forex market means
two working days from the date of contract. The settlement date is also known as 'value
date'. The exchange rate for a spot transaction is known as the 'spot rate' and the
market where spot 'transactions are conducted is called spot market.

Value Date and Dealing Date for Spot Transactions

As noted above, spot transactions traditionally require two banking day's for settlement.
The date on which the spot transaction (agreement) is made is called 'dealing date' and
the exchange of currencies will occur two working days after the dealing date.
Settlement date is known as 'spot value date', this is the day when the exchanged
currencies are delivered with good value into the (bank) accounts of the counter-parties
to the transaction. This allows time for necessary paper work and cash transfers to be
, arranged. These arrangements consist of the verification of the transaction, through an
exchange of confirmation, between the counter parties detailing the terms of the deal,
the issue of settlement instructions by each counter party to its bank to pay the amount
on the appointed date and satisfying exchange control requirements, if any.

When one counter party is a bank, payment may be made by its own branches or by
another bank acting as an agent. The actual transfers of funds will be carried out on the
value date.

Working days do not include Saturdays, Sundays or bank holidays in either of the
r countries of the two currencies involved.
2
t
To take an example, a spot deal transacted on a Tuesday will be settled on the
Thursday of the same week and a deal agreed on a Friday will be settled on the
following Tuesday. But there are some exceptions. For example :

A transaction for US dollar against Canadian dollars is often for delivery on the next
working day. Forex market in the Middle East are closed on Fridays but open on
Saturdays. A transaction involving the exchange of US dollars and Saudi riyals could
t
1
therefore have a split settlement date, with US dollar delivered on the Friday and the
E riyals delivered on the Saturday.

There are over night (Om) contracts also available in forex markets.

Interbank Spot Rates

Interbank spot rates are the current selling and buying prices for spot transactions in a
currency. These are the benchmark rates for trade transactions. They are used for
foreign currency transactions above a certain size. They also provide the basis for an
exchange rate for transactions of smaller size.

For example, if a company wishes to buy US$ 5 million spot, its bank will quote the
current interbank spot rate for the transaction. However, if the company wished to buy
a smaller quantity of dollars; say $ 50,000, the bank would quote a rate less favourable
to the customer (although based on interbank rate) in order to obtain a reasonable profit
from a relatively small transaction.
F-. Exchange RI& Spot rates are quoted as one unit of base currency against a number of units of variable
Mmnagement currency. Quoted rates are therefore, the rates at which a bank will buy or sell the base
currency : e.g. Poudd E 1 = $1.4705 or $1 = Y 1.66.5 10. The spot rates are published in
daily newspapers. There are two spot rates isr a currency, namely, Bid Rate and Offer
(or Ask) Rate.

Bid and Offer Rates

As the bank and the customer are counter parties, they are on opposite sides of the
transaction. If a UK company is converting ~e proceeds of its sales in Japan by selling
Yen for Sterling, the bank is then buying Yen for Sterling.

There is a bid rate at which a bank will buy and the counter party sell the base
currency; and an offer rate at which the bank will sell and the counter party buy the .
base currency.

The terms 'bid' and 'offer' can be confusing and it is easy to mix them up. They
originate from interbank transactions which are normally against US dollars. The bid
rate is the rate at which the bank is willing to pay to buy dollars (and sell the non-
dollar currency) and offer rate is the rate at which the bank will offer to sell dollars
(buy non-dollar currency).

In quotes, the offer rate follows the bid rate. So in a quotation, Sterling / US $ 1.4957
- 1.4962; 1.4953 is bid rate and 1.4962 is the offer rate or ask rate. What it means that
the quoting bank is prepared to buy a sterling for 1.4957 US dollars and is prepared to
sell,a sterling for 1.4962 US dollars. Implicitly, a counterparly can buy a sterling from
this bank for US $ 1.4962 and sell sterling to it for US $ 1.4957. You notice that offer
rate is higher than the bid rate. That is the trading margin of this bank.

Remember as a ready to use rule that the bank will always buy and sell currency at the
more favourable of these two rates.' The difference between the two rates is known as
the spread (sometimes called the bid-offer spread in the UK and the bid-ask spread in
the US). .

5.6.4 Forward Transactions

Currency can be traded spot or forward. In a spot transaction, the purchase or sale of
currencies takes place for settlement two working days later. With a forward transaction,
the purchase or sale is agreed now but will take place at sometime in the future, there
by fixing the rate now for a future exchange of currencies. Forward transactions are --
forward exchange contracts ( or forward contract). The rate at which forward
transactions contracted in the present for future delivery of foreign currency is the
forward rate. The market where purchase and sales of currencies are contracted in the
present for receipt and delivery in future is called forward market.

Forward Quotation

As you know, the forward rate is the rate quoted by foreign-exchange traders for the
purchase or sale of foreign exchange in the future. There is a difference between the
spot rate and the forward rate known as the 'spread' or swap rate in the forward
market. In order to understand how spot and forward rates are determined, let us now
understand how to calculate the spread between the spot and forward rates. In the
example given below, we compute the points, or the difference between the spot and
forward rates, for a 3 months contract for the Canadian dollar and the Japanese ym
quoted in US terms.
&* ~
Canadian dollars Japanese yen

Spot. $0.8590 $0.00760

3 months forward 0.85 10 0.00762
Points
 The spread in Canadian dollars is 80 points; because the forward rate is less than 'the Foreign Exchange Markets
spot rate, the Canadian dollar is at a discount in the 3 months forward market. The
spread in Japanese yen is only 2 points, and since the forward rate is more than the
spot rate, the yen is at a premium in the forward market. Thus, we can say that a
foreign currency is at a forward discount if the forward rate is below the spot rate
whereas it is at forward premium if the forward rate is above the spot rate.

The premium or discount can also be quoted in terms of annualized per cent. The
following fonnula can be used to determine the annualized percentage.

Premium (discount) =
Fl - S, x
12
- x 100,
S, N
Where F, is the forward rate on the day the contract is entered into, S, is the spot rate
on that day, N is the number of months forward, and 100 is used to convert the
decimal to per cent amounts (e.g., 0.05 x 100 = 5%).

0.8510 - 0.8590 12
. . . Discount = x -x 100 = 3.725%
0.8590 3
I

i which means that the Canadian dollar is selling at a discount of 3.725 per cent under
the spot rate. Lets work out forward premium rate for yen, in our example :

Premium =
0.00760 - 0.00762
x-
12
x 100 = 1.05%
t 0.00760 3

Cheek Your Progress A

1. Assume that the following spot rates apply to each question.

Spot Rate Against Sterling

US Dollars 1.4957 - 1.4962

Deutsche Mark ' 2.6197 - 2.6221
Yen 167.728 - 167.859

a) UK Company has to make a payment of S 400,000 to a supplier. What price would

bank quote in Sterling for the dollars?

.....................................................................................................................................................
1

b) The UK company wishes to convert the DM 600,000 'it has just received from a
German Customer into Sterling. How much would the bank be willing to offer?

*
C) A UK importer of electronic goods from Japan must pay W5 million to a supplier.
At what price would the bank fix the foreign exchange transaction with this customer?
........................................ ................

2. Explain the following terms:

a) Bid and Offer Rate
................................................................................................................................
................................................................................................................................
Foreign Exchange Risk c) Forward rate
Management

d) Spread
................................................................................................................................

3. If $ : DM exchange rate is DM 1 = $0.36 and the DM : FF exchange rate is

FFI = DM 0.32. Find out the FF : $ exchange rate.

5.7 INDIAN FORIGN EXCHANGE MARKET

Indian forex market is still in the developmental stage. In Indian forex market not all
the currencies are bought or sold. The banks use London, New York or Singapore
market. for the currencies which are not frequently traded in Indian forex market. From
these rates, the cross rates are calculated.

The structure of forex market in lndia is three tier. The first part consists of
transactions between the Reserve Bank of lndia and the authorised dealers. These
dealers are usually the commercial banks. The second is the interbank market in which
the banks transact among themselves. The third is the retail part in which the authorised
dealer deal with their corporate clients and other retail customers. In the retail part
money changers also operate. These are licensed dealers in the currency market to cater
to the needs of retail customers. In the interbank market the quotes %ppear in swap
points. There are currency brokers also who match the buyers and sellers and they work
on commission basis.

The authorised dealers face two main types of transactions : (i) Clean instruments .
(known telegraphic transfers (TT), and (ii) Payment against collection (bill for
collection) of documents. The authorised dealers (ADS) have to provide more semices.
for the second category of transactions therefore the two rates are different. While fixing
the exchange rate for a transaction ADS must consider (a) is the transaction clean or
documentary? (b) is the bill under consideration a sjght or time draft or a usance bill?
(c) does the ADS have to fork out funds in rupees or in foreign exchange or the
reimbursement would be more or less immediate or after some time? After considering
these things, ADS quote the rates for the following types of instruments : (a) TT Clean
Buying Rate (b) TT Documentary Buying Rate (c) On Demand (OD) Bills Buying Rate
(d) Long Rates (e) Tel Quel Rate (f) DIA Bill Buying Rate

Let us now understand about them one by one:

TT clean buying rate is quoted for transaction of which the reimbursement is more or
1
less immediate. This rate also applies to remittances by mail transfers and bank drafts
provided the required conditions are met. It is the best rate a customer can get. TT
documentary buying rate will be lower than TT clean, because in this case certain
documents are to be collected, therefore handling charges are involved. On demand bill
buying rate is used for sight draft or demand bills that are negotiated or purchased by
authorised dealers. For discounting usance bills, long exchange rates are required. Since
different usance bills have different usance periods; therefore, various long terms
exchange rates are required. Thus there are several long terms rates. These quotations
are used for usance bills that are discounted by ADS. The applicable rate depends on
the usance period. In all the cases, the usance period will have run for some time
before the bill is presented to an authorised dealer for discounting. In such'cases, the
Tel Quel rates are quoted. These rates cover the unbroken period of usance. DIA stands
for documents against acceptance and all the DIA rates are long rates. Tel Quel rates
12
 and the D/A rates depend on the transit time involved. The time between the payment Foreign Exeha~~ge
Markets
made to the document holder and the reimbursement of the document from the issuing
agency is called the transit time. A traveller cheque is paid at sight, but it takes time to
realise these cheques from the issuing bank. Exports bills also involve transit time.
Foreign exchange dealers association of lndia (FEDAI) has prescribed transit periods
and interest factors. The e are taken into account and loaded onto the exchange rates.
!l
The main loading facto are : (a) handling charges, (b) expenses on postage, (c)
administrative charges, (d) stamp duties, (e) commission to the exchange brokers or to
correspondent banks, (g) exchange rate fluctuations, and (g) profit margins.

In Indian forex market besides spot contract, an over night (OM) and tomorrow night
(TM) foreign exchange contract can also be done which means the delivery next
business day or on second business day. Before August 2, 1993, the quotes were
indirect. The quotations were made in the form of foreign currency hundred rupees.
But now-a-days, in the interbank market, the rates are quoted per unit or per hundred
units of foreign currency. Only authorised dealers trade in interbank market. The rates
quoted by ADS are merchant rates at which trading can take place. There are four types
of rates being quoted in the newspapers. These are TT-Bill Rate, Bill Rate, Currency
Notes and the Traveller Cheque Rate.

IT-Bill Rate for immediate payment : TT Bill Rate is a sight draft i.e. a draft to be
paid on seeing or a bill to be paid immediately. The buying and selling rates for such
payments are fixed as follows:

IT-Buying Rate = Base Rate - Exchange Margin

3 TT-Selling Rate = Base Rate + Exchange Margin

.3 The base rate is the interbank rate.

Example : Assume the interbank rate between rupees and dollars is Rs. 43.50 and the
exchange margin is 0.12% then TT Buying Rate is : = 43.50-43.50 x 0.12%
or = 43.50 (1 -0.0012) = 43.46
TT Selling = 43.50 + 43.50 x 0.12%
or = 43.50 (1+0.0012) = 43.55
t
Bill rate when the Bill is to be sent for collection : If some delay is involved in
Payments such as in the case of time draft (the draft to be paid after specified time) or
bill for collection another margin for lag in payment to the bank is added in the form
! of interest payment. This charge is called transit time charges.

Foreign Exchange Dealers Association of lndia fixes the exchange margins, transit time
and rules for charging interest. These involve discounting for immediate payment. If
some service is required the service charges are also to be added or subtracted to the
base rate, for example, banker's drafts issued by other banks or personal cheques then in
that case the clearance is involved, i.e, the bills are to be sent for collection overseas;
so in this case the bill buying and selling rates are fixed as follows:

Bill Buying Rate = Base rate ( 2 ) forward premium (discount) for transit time period
plus usance period rounded off to the higher (lower) month minus
exchange margin.

, Bill Selling Rate = Since it is the issuing of the bill to the importer only, therefore it
only involves a service, i.e., issuing and service the collection of
bills therefore its rate is formed as per TT-Selling Rate plus a
margin for the service rendered.

I Bill Selling Rate = TT Selling Rate + Service Margin

Foreign Exchange Rirk Forward buying rate = Spot rate ( 2 ) Forward Premium (Discount) for transit time
Yanugcmrnt period plus usance period plus forward period rounded off to
the higher (lower) rnonth minus Exchange Margin.

Spot rate is the spot bill buying rate. I

Forward Selling Rate = Interbank spot selling rate (9
Forward premium (discount) for forward period
+ Exchange Margin

Bill Selling Rate = Forward TT selling rate

+ Exchange Margin for Selling a Bill

In the case o f forward buying, the forward period, usance period and the transit period
are to be added together. Thus for 60 days bill bought 2 months forward, with transit s
period of I 5 days, the total comes to 60 + 60 + 15 = 135 days. If the currency is at a
discount the bank will charge the discount for IS0 days and if the currency i s at a
premium the bank will pay premium for four months.

In India national newspaper contains quotes on major currencies traded in India. They
provide exchange rates on major currencies and buying and selling rate for some
currencies. The TT rates given in the figure are the rates for telegraphic transfer. Apart
from the TT rates, the rates on travellers cheque and currency notes are also quoted in
the financial newspapers. All major banks provide currency buying and selling rates for
major trading currencies.

In case of forward rates the premiums and discounts on dollar contracts till six month
forward are quoted. However, one year forward transactions can be contracted. Month-
wise premium and discounts as well as annualised premium/discounts are quoted. These
quotes usually are tentative and are subject to change at the time of contract.

Some of the financial newspapers also provide expected exchange rate matrix (cross
currency matrix) for other forex markets. These are calculated on the basis o f inverse
and cross rate calculations.

The official rate is detennined by the RBI on the basis o f the multi-currency basket.
The official buying and selling rates are announced. The Foreign Exchange Dealers
Association announces indicative free market rate on every business day. The RBI has
the discretion to enter the market to stabilise the exchange rate. Every authorised dealer
has to maintain, at the close of the day a square or near square position in each foreign
currency, except for the limits o f open positions prescribed for each currency or total
currency value. Now a days the authorised dealers have much wider powers or
realising. foreign exchange for business travel abroad, medical treatment, the remittance
o f agency commissions and legal expenses. The banks payment, in those countries
where the bank does not have their branch, are done through a correspondent bank
account called nostro account. It literally means our account with you and& opposite
is called vostro account.

5.8 LET U$ SUM UP

-
The market where one currency is traded for anbther is called forex market. Its primary
function i s to facilitate international trade and investment. The market consists of the
interbank market in which major banks deal with each other and the retail market, in
which banks deal with their commercial customers. Foreign exchange market has two
segments; (a) spot market; and (b) forward market. In spot market, currencies are tradedf
for settlement two business days after. In the forward market contracts are made to buy
or sell currencies for future cyjvery. The foreign exchange quotation cc\? be in direct,
indirect or cross. They can also be expressed in European terms or American tenns.
The participants in the foreign ,exchange markets are commercial banks, brokers,
customers, MNCs and central banks. Indian forex market is in a developing stage. All
the currencies are not traded in the markets.
 Fordgo Exclumge Markeb
5.9 KEY WORDS
t
i
Foreign Exchange Market : The market in which currencies are brought and sold.
r Bid Rate : The rate at which themstomer is willing to buy quoted currency in
i exchange for base currency.
Offer Rate : The rate at which customer is willing to sell quoted currency in
exchanges for base currency.

'1 Exchange Rate : The price at which one currency is trade for another.

1 Direct Quotation : Rice of one unit of foreign currency-quoted in terms of home

country's currency.
b

Indirect Quotation : Rice of one unit of home country's currency quoted in tenns of
foreign currency.

Spot Transaction : A transaction in which the exchange of currencies occur two

business days later.

Forward Transaction : A transaction in which exchange of currencies take place in the

future at a rate which is fixed on a day when the transaction is entered into.

Interbank Market : The market is which major banks trade with one another.

Spot Market: The market where spot transactions are conducted.

$1 Forward Market : The market where forward'transactions are conducted.

5.10 ANSWERS TO CHECK YOUR PROGRESS

i

A.l a) The bank is selling dollars against sterling and the spot rate is therefore 1.4957.
The customer will have to pay E 267,433.31 (400,000 / 1.4957) for the dollars.
b) The bank is buying Deutsche Marks against Sterling and the Spot rate is
therefore 2.6221. The customer will obtain E 228,824.22 ( 600,000 / 2.6221) in
exchange for DM.
c) The bank is selling Yen against Sterling and the spot rate is therefore 167.728.
The customer will have to pay E 268,291.52 (45 million / 167.728) for the

I' 5.1 1,
Yen.

,3. FF: S exchange rate is FFI = S 0.115

I

TERMINAL QUESTIONS/EXERCISES
I. What are foreign exchange markets. What is their most important function?. How
is this function performed?

2. Explain the following terms

e) Spot transaction
b) Exchange rate
C) Direct quotes
d) Indirect quotes

3. Who arc the major participants in the fotex market?

4. The spot rate for the pound is S 1.1386 and 90 day forward me is $1.1352.
Whet is the forward premium or discount on the pound? 1S
Foreign Exchrnge Risk 5. If $ I=$, 2.4210 in US, $1 = FF 3.990 in France and FFI = $0.1098 in UK,
Management how will you take advantage of these rates?
6. A small investor wants to buy French francs spot at $0.1 180 and sells french
franc forward for 90 days at $ 0.1 186. What is the group rate on french francs
and the premium on 90 days French francs.
7. The spot rate for DM in US is $ 0.55 what should be the spot price for the US
$ in Gennany?
k
8. If the buying rate for DM spot in US is $ 0.45, what would be the price of US
dollar in Germany? If the dollar in Germany is DM 2.65, how will the market
react to it?
 UNIT 6 DETERMINATION AND FORECASTING
OF EXCHANGE RATES
&

Structure

Objectives
Introduction
Equilibrium Approach to Exchange Rates
Purchasing Power Parity
Interest Rate Parity
6.4.I The F~sherEffect
6.4.2 The International Fisher Effect
Inflation and its Impact on Financial Markets
Central Bank Intervention
Exchange Rate Forecasting
Let Us Sum Up
Key Words
Terminal Questions/Exercises

6.0 OBJECTIVES

;I ' ~ f t e rstudying this unit you should be able to :

describe how exchange rates are determined under freely floating exchange rate
regime
examine consequences of central bank intervention in foreign exchange markets.
explain how exchange rates are forecast.

6.1 INTRODUCTION

In unit 5 you learnt about foreign exchange market and its various operational aspects.
In this unit you will first learn about how exchange rates are determined in the free
market environment and then you will learn about forms and consequences of central
bank intervention in the foreign exchange market. You will also study methods of
i exchange rate forecasting.

6.2 EQUILIBRIUM APPROACH TO EXCHANGE RATES

We learnt in unit 5 that exchange rate is relative price of currencies in the foreign
exchange market. How is this price determined? There are various theories offered for
the same. Purchasing Power Parity Theory, Interest Parity Theory are quite popular. But
before we go into these theories, lets examine equilibrium approach or free market
approach to exchange rates.

Equilibrium approach to exchange rate determination essentially states that exchange rate
between any two currencies will be determined by demand and supply of the relevant *
currencies. Thus the exchange rates are influenced by various factors influencing
demand and supply for various currencies. Cross border transactions viz trade, services
and capital account, as explained in Bleck 1, Unit 4 on Balance of Payment , create
.
demand- supply forces in the market and in a free market, exchange rates are the
demand supply clearing prices.

The exchange rates in this environment are determined as part of the general real and
monetary equilibrium of the world economic system; there is no sense in which one
may assert that the exchange rate is an exclusively monetary phenomenon. Indeed an
equilibrium exchange rate can change without any accompanying change in money
SU~DIV or the real rnnnpTr+wand Such wnrrld for example, be the case if there were 1 7
Foreign Exchange Risk a change in the compos~iionof production between home goods and traded goods or
M a r agement improvements in domestic supply condition of a critical raw material or discovery of a
new source of energy. Besides, 'expectations' about future demand supply of a
currency play a critical role in determining exchange rates. Needless to say, the
exchange rate will be highly volatile in free market

Changes in exchange rates, as you can well imagine, would have radical impact on -
patterns of international trade and capital flows, and can profoundly influence the
economy of countries. The domestic economy of a country will be directly and
indirectly affected by foreign exchange developments. The immediate impact of
fluctuations in rates is felt at first by those who are directly involved in international !
trade or international finance. What complicates the problems of those affected is the
unpredictability of the markets. While trends can be forecast, timing is a sensitive issue.
The events of recent years have thrown up painful lessons .for institutions which deal in
and with foreign currencies. The advent of tloating rates has given rise to movements
which has made things extremely difficult. The importers who have to pay for their
purchases in foreign currency, investors who have purchased a foreign asset, or the
corporation which floats a foreign debt, are all facing foreign exchange risk. The
exporters are similarly placed. Every one would like to minimise his risks by trying to
quantify it to determine maximum exposure. It is some what easier to identify the
foreign exchange risk in a fixed rate environment - although the danger of parity
changes still exists - than in a floating rate environment. In the latter case, one can only
hope that profit taking or central bank intervention would stop complete panic when
markets are highly illiquid.

Devaluation and revaluation cover large fluctuations but have generally been in the
range of 20 per cent. The measures can give indication of short term foreign exchange
risk. Longer term' risk is greater and much more difficult to evaluate. Currencies can
undergo sharp fluctuations over a few years or even a few months. The South East
Asian crisis towards the end of the last century is a case in point, where currencies lost
70-80 per cent in short span of time. It may thus seem logical to establish parities
under equilibrium, but unfortunately nobody has ever been able to establish them and
nobody even knows all the factors that weigh at a given point of time on the behaviour
of currencies. We are reminded of a quote from a reputed foreign exchange consultant
when at the end of his lecture during a seminar one of the delegates asked him : Sir,
can you tell us what will be the exchange rate of Rupee tomorrow? He replied: Well,
my dear, it will depend on which side of my bed 1 get up tomorrow morning! Well, so
much-for the exchhge forecasts. But the world can not run its mill unless we find
some anchor in this highly unpredictable foreign exchange market. Purchasing power
parity and interest parity have been the two main anchors in this context. Let us
---
discuss them one by one in th&f:lllowing.

6.3 PURCHASING POWER PARITY

Purchasing Power Parity was firs: started in a rigorous manner by Swedish Economist
Gustar Cassel in 1918. It was suggested by him that this could be used for new set of
off~cialexchange rates at the end of World War I that would allow the resumption of
normal trade relations. Since then this has been widely used by central banks as a
, means to establish new par values for their currencies when they find the older rates
were' in disequilibrium.

Purchasing power parity in simple words means that the exchange rate between the two
currencies will be determined by the relative purchasing power of the two currencies.
To take an example, if a ' standard' pizza costs one dollar in US and p s 40 in India,
the dollar1 rupee exchange rate should be I$= Rs. 40. Thus, in absolute terms,
purchasing power parity means that exchange aajusted price levels should be the same
- all over the world. The assumption is that free trade between the countries should
equalise the prices of goods in all the countries expressed in local currencies. Suppose,
for a moment that the exchange rate 1$ = Rs 45. It will provide opportunity for
international arbitrage. How? As you can readily imagine, in this situation, an Indian ,
exporter would buy pizza in India for Rs. 40 and export it to US to sell for 1% and
 convert the sale prlce of I$ into Indian rupees at the rate of Rs. 45 for each dollar. , Detern~inationand
Forecasting of Exchange
Assuming the transportation costs to be zero, the lndian exporter can make neat profit Rates
of Rs. 5 for every pizza he sells in US. Because of this profit potential, forces are set
in motion to change the exchange rate and/or the prices of pizza. In our example,
pizzas will start moving from lndia to US. The reduced supply of pizzas in lndia will
raise the prices of pizzas in India and the increased supply of pizzas in US will lower
the prices of pizzas in US. In addition to moving pizzas around, the pizza exporters
would be busily converting dollars into Indian ruppes to buy more pizzas. This activity
increases the supply of dollar and simultaneously increases the demand for Indian rupee.
This means INR is getting more valuable, so it will take more dollars to buy INR.
Since the rate is quoted in INR, it will take lesser INR to buy dollar. The exchange
rate of INR will go up from Rs 45 towards Rs. 40. Thus, ~ntemationalarbitrage works
to keep exchange rates in line with purchasing power parity . This is the absolute
purchasing power parity theory. The absolute purchasing power parity does not take into
account the differences in prices that will arise due to transportation costs, tariffs, quotas
and other restrictions and product differentiation.

The relative version of purchasing power parity which is more commonly used states .
that the exchange rates between home currency and any foreign currency will adjust to
reflect chiinges in the price levels of the two countries. For example, if inflation is 5%
in the United States and 7 % in India, then in order to equalise dollar price of goods in
the two countries, the dollar value of lndian rupee must fall by about 2%.

If ih and if are the periodic price level increases (rate of inflation) for the home'
currency and foreign currency respectively, eo is the home currency value of one unit
of foreign currency at the beginning of the period and et is the spot exchange rate in
period t then :
et - (l+ih)'
eo (Itif)'

Take an example, if the United States and India are running annual inflation rates of '
5% and 7%, respectively, and the initial exchange rate was 1$ = Rs 40; then according
I to relative purchasing power parity, the value of the dollar in three years should be :

Purchasing power parity bears an important message. Just as the price of goods in one
year cannot be meaningfully compared to the price of goods in another year without
adjusting to interim inflation, so exchange rate change may indicate nothing more than
the reality that countries have different inflation rates. In fact, according to purchasing
power parity, exchange rate movements should cancel out changes in foreign price level
relative to the domestic price level. The offsetting movements should have no effects
on the relative competitive positions of domestic firm and foreign competitors. Thus
'
changes in the nominal exchange rate may be of little significance in determining the
true effects of currency changes on a firm and nation. In terms of currency changes
affecting relative competitiveness, therefore, the focus must be not on nominal exchange
rate changes but instead on changes in real purchasing power of one currency related to
another. That is the exchange rate change during a period should equal the inflation
differential for the same time period. In one word, purchasing power parity says that
currencies with high rates of inflation should devalue relating to currencies with lower
rates of inflation.

6.4 INTEREST RATE PARITY

Besides purchasing power parity theory, another theory which is quite popular is the
interest rate parity theory. According to interest rate panty theory, the currency of one
country with a lower interest rate should be at forward premium in terms of the
I currency of a country with a higher rate. More specifically in an efficient market with
no transaction costs, the interest differential should be equal to the forward differential. ,
When this condition is met, the forward rate is said t c ~be at interest parity and
equilibrium prevails in the money market. This theory is based on interest rate
Foreign Exchange Risk behaviour, commonly known as Fisher Effect and International Fisher Effect. Lets us
Management discuss these in the following.

6.4.1 The Fisher Effect

The financial news papers generally give interest rates for currencies which are mostly
nominal. That is, they are expressed as the rate of exchange between current and future
rupees. For example, a nominal interest rate of 8% p.a. on one year loan means that
Rs.1.08 must be repaid in one year for Rs.1 .OO loaned today. But what really matters to
both parties to a loan agreement is the real interest rate, the rate at which current goods
are being converted into future goods.

In a sense, the real rate of interest is the net increase in wealth that people expect to
achieve when they save and invest current income. Alternatively, it can be viewed as
the added future consumption promised by a corporate borrower to a lender in return
for the latter's deferring current consumption. From the company's standpoint, this
exchange is worth while as long as it can find suitably productive investments.
However, because virtually all financial rates are stated in nominal terms, the nominal
interest rate must be adjusted to reflect expected inflation. The Fisher Effect states that
the nominal interest rate is made of two components (I) a real required rate of return,
a, and (2) an inflation premium equal to the exvected amount of inflation, i. Formally
the Fisher Effect is :

1 + nominal rate = (I + real rate) (I+expected inflation rate)

l+r = (l+a) (1+ i ) or r = a + i + ai

The Fisher equation says that if the required real return is 4% and expected inflation is
lo%, then the nominal interest rate will be 14.4% = I+ r = (1 + .04) ( 1+ .lo).

6.4.2 The International Fisher Effect

The key to understanding the impact of relative changes in nominal interest rates among
I
countries on the foreign exchange value of a nation's currency is to recall the
implications of purchasing power parity (PPP) and the generalised Fisher effect.
Purchasing power parity implies that exchange rates will move to offset changes in
inflation rate differentials. Thus a rise in lndian inflation rates relative to those of other
countries will be associated with a fall in the rupees' value. It will also be associated
with a rise in lndian interest rate relative to foreign interest rates. Combine these two
conditions and the result is the International Fisher Effect.

(1 + rh It - =t
- - 1.1
(1 + rf eo

Where et is the expected exchange rate in period t. The single period analogue to
equation 1.1 is
1 + rh
- -
- - 1
1.2
1 + rf eo
Note the relation here to interest rate parity. If the forward rate is an unbiased predictor
of the future spot rate - that is fl = el then equation 1.2 becomes interest parity
condition
- -- -
+ '-11 f,
1.3
I + rf eo
b
According,to both equations 1.2 and 1.3 the expected return from investing at home,

I
4 + rh should equal 'the expected return in home currency from investing abroad,
(1+ r f ) el/eo or (I + rf ) fifeo . However despite the intuitive appeal of equal expected
retum, domestic and foreign expected returns might not equilibrate if the element of
currency risk restrained the process of international arbitrage.
 Using the International Fisher Effect as discussed above, let us forecast US dollar and Determination and
Forecasting of Elrehaage
Swiss Franc rates. In January, the onesyear interest rate is 4% on Swiss francs and 7 % Ra tts
on US dollars.

3) If the current exchange rate is SF1 = $ 63, what is the expected future exchange
rate in one year? ,

According to International Fisher Effect, the spot exchange rate expected in one year
equals 0.63 x 1,0711.04 = $0.6482.

In this case, international arbitrage works to keep exchange rates in line with interest
dZfferentials.Suppose, for a moment, that one year forward rate equals $ 0. 65 instead
of $ 0.6482. Does this offer an arbitrage opportunity? The answer is yes! Do you see
how? In this situation, an American resident has two options. He can either invest his
1 dollar for one year at the rate of 7% per annum and obtain 1.07 dollar at the end of
one year . Or, alternatively he may convert 1 dollar into SF at the spot rate of $0.63,
I
invest that money in the Swiss market at the rate of 4% per annum and simultaneously
execute a forward contract to convert SF back into dollar at the end of one year. The
necessary steps will be as follows:

1) Convert 1 dollar into 1.5873 SF at the spot rate of 1SF = $0.63

2) Invest 1.5873 SF at 4% to obtain SF L6508 = SF 1.5873 x I+ .04
a 3) Convert SF 1.6508 into dollar 1SF = $0.65, as per forward contract executed, to
get $ 1.0730
Do you notice, under the second alternative, the US resident will get $ 1.0730 instead
of $ 1.07 under the first option. Clearly, it is an opportunity to make neat profit of
.003%. This opportunity will move market forces to convert US $ into SF and make
neat profit which will soon get corrected as we had seen under the case of international
arbitrage under absolute PPP above. Only difference is that instead of Indian pizzas,
now more dollars will like to flow to Swiss, increasing demand for dollars and thereby
strengthening dollar; with exchange rate moving from 1SF = $0.65 towards $0. 6482.

b) If a change in expectations regarding future inflation rate causes the expected

future spot rate rise to $0.68 what would happen to U.S. Interest rate?
If r US is the unknown US interest rate and Swiss interest rate stayed at 4%
then according to the lnternational Fisher Effect
0.6810.63 = (1 + r US) / 1.04
={(0.68 1 0.63) ( 1.04) ) - 1 = r US
= 12.25%.

The International Fisher Effect is also known as Interest parity as foreign exchange
rates tend to adjust for interest differential between two countries. You must have
noticed the role of inflation both under purchasing power parity and interest parity
theories. Lets elaborate on the role of inflation in financial markets in the following.

6.5 INFLATION AND ITS IMPACT ON FINANCIAL

MARKETS
Exchange rate movements have become the single most important factor affecting the
value of investments particularly on an international level. They are crucial to business
sales and profits forecasts and to investment plans and their outcome. They can turn
what was in one year a thriving industry into a loss making industry in two years time
- whether the products were intended for the export or the home market. The much
favoured "discounted cash flow" approach to investment analysis is useless without
taking into account exchange rate assumptions. With the growth of investments across
international boundaries and a shrinking world in tenns of communications, the domestic
cost of food, fuel, clothes or travel are now substantially influenced by international
markets and subject to the exchange rate movements.

In the present day floating exchange rate system, the currency of any individual country
is only wonh what you can buy with it, or what you can exchange it for at any
particular time.
Foreign Exchange Risk A country whose rate of inflation is consistently higher than that of its competitors will
Management experience faster increase in its production costs and its exports will become more
expensive than those of its lower inflation competitors. This invariably leads to a
reduction in level of exports, a rising level of imports and a growing trade and current
account deficit. This will ultimately result in weakening of/the value of its currency
against its competitors.

Over a long term an historic record of high inflation is often thought of as an indicator
of weak currency. A country's inflation rate is determined mainly by a combination of
government economic policies and the political climate in the country. Like in India,
with state 'populism', rate of inflation has invariably been on the rise. Coinsequence!
rupee consistently depreciating against all major currencies. The financial markets are
seriously affected by the inflationary pressures. The U.S. economy has protected itself
from violent exchange rate fluctuations of dollar because of a regime of low inflation
and interest rates over a number of years.

Thus, from the long term perspective, factors which determine the competitiveness of a
particular economy and, in turn, strength and weakness of its currency are relative
inflation rates which further, in turn, are impacted by money supply growth , budget
deficits, economic growth rates, employment rate, etc.

6.6 CENTRAL BANK INTERVENTION

Central banks do participate in foreign exchange markets in their role as agents to their
governments or banker of the banks. Thus they always maintain some form of presence
in the markets. Their most publicised form of involvement however is when they enter
the markets on their own or under orders from their governments to stabilise exchange
rates. Such operations are often termed as central bank intervention.

The primary purpose of intervention is to alter the liquidity of the markets by providing
either supply or demand for home currency in the foreign exchange market. The reasons
could be deep seated or temporary; in any case they will seldom be stated publicly. If
we want to know the success of intervention compared to goals, such goals would not
normally be defined precisely.

When central bank authorities state publicly that a certain level is "unrealistic" and that
they are trying to modify it, they have in fact committed to a support level, and the
user of the market can act accordingly. If they fail to maintain that level, they lose
face. It is then that we witness the cat and mouse game between central bank and the
markets, which former seldom wins. However, over the years central banks have
developed their understanding of markets and developed better intervention methods and
therefore they intervene in the market by using minimum funds with maximum impact.

The most obvious form of intervention takes place in spot markets. A central bank can
intervene openly or under cover. Public intervention consists in calling one or several
banks in the market and either asking for prices and dealing, or making prices. Under
cover intervention consists in giving an order to one bank or a limited number of
banks, like RBI using State Bank of India as agent. The choice and size of such
intervention is determined by the goal that the central bank wishes to achieve.

The intervention of the central bank is not limi!ed to its own market and it can request
other central banks to act as its intervening agent in their markets. Such intei-dentions
/ are however, resorted to under exceptional circumstances and run in large figures.

Spot interventions result in the acquisition of foreign currency, if the central bank is
selling its own currency in the markets, or in acquisition of domestic currency, if the
central bank is a buyer. In the first case the central bank is increasing its reserves of
foreign currency and in the process creates extra domestic money to accommodate
markets. In the second case it is depleting its foreign currency reserves and is
ti&tening the money supply by taking its own currency.
 If a central bafik no longer has foreign currency reserves, it may borrow them from Detc:rmlnrHon and
other central banks or get accommodation from world financing agencies like IMF, Forccrsti~tgof Exchange
Rates
World Bank. Excessive foreign currency reserves may be lent in the markets. What this
means is that spot interventions always lead to other money market operations with
clear interest rate implications. Therefore, central banks, in order to intervene effectively
in spot markets undertake forward swap transactions in sizeable amounts in their
domestic market. However, there are very clear cut lessons which the central banks
have learnt :

I 1)
2)
It is difficult to fight a market trend unless the trend is about to shift;
Acting in a manner that the market is anticipating is futile and self defeating;

3) It is only by keeping the markets guessing that some degree of success can be
achieved;

4) You can put on others the blame for loss of confidence in your currency.

The intervention by a central bank is important because the government considers that
their currency in the international market is vital to their economic and financial well
being. High economic growth with low inflation is the common agenda of all
governments and their central banks. Central bank intervention in foreign exchange
markets is therefore common. In the process, said or unsaid, free floating exchange rate
regime turns into managed exchange rate regime. Intervention by central banks ,
particularly because of the lesson number (3) above, have further added to array of
factors which determine exchange rates. Forecasting is nothing but projecting
explanatory factors into the future. By now you must have realised why that foreign
exchange consultant, quoted above, said that the tomorrow's exchange rate will depend
on which side of the bed he gets up next morning. Foreign exchange rate forecasting is
thus quite challenging.

6.7 EXCHANGE RATE FORECASTING

Forecasting of exchange rate can be classified as being short term (e.g., upto one year)
medium term (between one to three years) or long term (three to five years). The
assessment of currency or interest rate in the future cannot be an exact science.
Fundamental analysis can, however, provide a reliabb guide to likely changes in major
trends for individual currencies, although the timings and extent of such changes are
difficult to anticipate precisely. For timing, technical analysis may help. All technical
analysts use historical data as a basis for their conclusions. The patterns of
behaviour that emerge through the study of this data are the basis .for projeak?uture ,

trends. Although technical analysis has become prevalent and accepted, many banks
have also developed their own systems. But technical analysis has considerable
limitations , chief among which is that it does not concern itself with factors such as
upcoming news which can change the market.

The methodology used in forecasting is sometimes guessing, but with a more systematic
and methodical approach. Further , forecasts are again to be seen from the point of
view of the user. Spot dealer could not care less what the currency will be doing in a
year's time. However, corporates who have to develop long-term strategies are interested
in long-term c~rrenc~linte~est
rate forecasts.

short-tbrm Factors

News expected, or unexpectkd may have an impact on the markets. The unpredictability
of political developments in the modern world and the speed with which they are
reported always adds elements of instability. What further aggravates the problem is that
the full impact of a particular development is not always clear. The developments that
affect the markets cuts across all geographical boundaries. There is a great difference
between'the theoretical, "should be", response of the markets to certain developments, to
what "'actually" takes place.
Foreign Exchange Risk The other factor which affect ,the market on a day-to-day basis is reaction to liquidity.
Management Liquidity is the relationship between supply and demand from all market participants.
Liquidity of the markets is initially the result of existing positions.in the interbank
market combined with arising supply and demand.

Let us take an hypothetical situation where the interbank market is highly short in
dollars. If during the day further demand for non-dollar currencies arises, the banks can
easily accommodate this demand by reducing their short positions. This does not
necessarily mean that dollar will stabilise because the banks may wish to re-establish
their original positions. However, if a sudden need for dollars arises, we may have a
situation where banks already over-extended may have to buy large quantities of dollars
that nobody has for sale. This would create a sharp if temporary - dis-equilibrium.

Under the same situation where the market is short in dollars let us assume two news
items appear within a space of one hour. 'The first is very bearish to dollar. Market
participants who wish to sell more dollars, will find buyers - perhaps not easily if
nobody wants to hold them; but at a price somebody will be willing to take them. The
second news item is very bullish. This can suddenly create a demand for dollars that
nobody has. The result can easily be guessed. This rather simple example illustrates
what can happen in a one-sided market when demand shifts abruptly.

The gross liquidity of the market -the total supply and demand - is commonly
referred to as the depth of the market. The greater the depth, the more efficient the
markets are, especially when supply and demand come close to being matched.

The main characteristic of the market depth is the smooth large deals. When a sizeable
deal does not move the market by more than 0.2 or 0.3 per cent or when any move is
only temporary the markets can be said to have depth. On the other hand, if a relatively
small deal, such as a $20 million transaction moves the market by 0.5 per cent or
more, creates a temporary trend, the markets lack depth.

Another important aspect of depth is stability. In the first example above, a purchase
of $200 million instead of $ 20 million in a market heavily selling dollars may not
have a great influence on the trend but $25 million sale may create a further drop. In
this case the market shows reserves only on one side. A truly efficient market will be
one where transactions, no matter how large, are more or less matched - an infrequent
occurrence in foreign exchange markets. Thus, in one word, in the short term, market
liquidity and demand-supply pressure are to be foreseen for exchange rate forecasting.

Long-term Strategies

Long-term strategies focus more on what are perceived as underlying trends. This type
of strategy tends to be more of a manger's prerogative. Such basic positions are
usually taken with a certain goal in mind; perhaps the view that certain parities will
change drastically within a time span, or devaluation or revaluation will occur.
Usually the parameters of such positions are established in advance and dealers are
given specific instructions on how to handle the positions. The one added element on
long-term strategies as opposed to short-term strategies is the financing of basic
positions. Short-term positions are in or out and are settled within a day or two, The
financing is minimal. In the management of long-term positions the financing is
extremely important.

The basic 'qbestidns to.consider when mapping out long-term strategy are : what is the
goal? what is.the time span for achieving that goal? is the financing costly, or does it
create added profit potential? is it better to stay in spot, or should it be changed into a
forward ?

The exchange rate forecasting may be undertaken in-house or bought out. Banks and
large players normally have in- house forecasting team. Forecasting service is to provide
an added tool of analysis for the purpose of predicting market trends. No serious
service can ever claim to be always right. Even if it did, nobody would believe it.
Dealers have therefore, mixed feelings about this as they feel those who forecast have '

no stake as they do not operate in the market.

I 6.8 LET US SUM UP
Delermination and
Forecasti~mgof Exchange
Rater

In the absence of government intervention, exchange rate respond to the forces of

supply and demand that in turn are dependent on inflation rate, interest rates and GNP
growth rates. In a healthier economy, the currency is likely to be strong. Exchange rates
are affected to a large extent by expectations of future exchange rates changes, which
depend on forecasts of future economic and political conditions. .

In order to achieve certain economic and political objectives, governments often

intervene in the currency markets to affect exchange rate. Although the mechanics of
such intervention vary, the general purpose of each variant is basically the same, to
affect market liquidity.

Where people are unsure of what to expect, any new piece of information can alter
their beliefs. Thus if the underlying domestic policies are unstable, exchange rates will
be volatile as traders react to new information.

-6.9 KEY WORDS

Equilibrium Exchange Rate : The rate at which demand and supply of a currency
become equal.
Monetary Equilibrium : Equilibrium between demand and supply of a currency
achieved through monetary forces.
Real Equilibrium : It refers to equilibrium in the commodity market.
Purchasing power parity : It states prices of a similar products of two different
countries should be equal when measured in common currency.
Interest Rate Parity : The forward discount or premium is approximately equal to the
interest differential between' currencies.
Arbitrage : Purchase of securities or commodities on one market for immediate resale

'1 on another to earn profit from price discrepency.

6.10 TERMINAL QCTESTIONSIEXERCISES

I. Suppose prices start rising in the United States relative to prices in India. What
would you expect happen to the dollar - rupee rate? Explain.
2. If a foreigner purchases Indian short term security, what happens to the supply
and demand for rupees?
3. Under each of the following scenario , whether the value of rupees relative to
Japanese yen will appreciate, depreciate or remain the same? Assume that
exchange rates are free to vary and that other factors remain constant.

a) Growth rate of external income is higher in lndia than in Japan.

b) Inflation is higher in lndia than in Japan.

c) Prices in Japan and India are rising at the same rate.

d) Real interest rates are higher in lndia than in Japan.

e) India imposes new restrictions on the ability to buy lndian companies and
real estate,
UNIT 7 CURRENCY RISK MANAGEMENT'
Structure
Objectives
Introduction
Meaning of Currency Risk and Exposure
Types of Currency Risks
7.3.1 Translation Risk
7.3.2 Transaction Risk
7.3.3 Economic Risk
7.3.4 Political Risk
7.3.5 Interest Rate Risk
Why manage Currency Risk?
Managing Currency Risk with Derivatives
Derivative Instruments
7.6.1 Forward Contracts and Forward Rate Agreements
7.6.2 Future Contracts
7.6.3 Currency Options
7.6.4 Currency Swaps
7.6.5 Interest Rate Swaps
Derivatives Market in India
Let Us Sum Up
Key Words
Terminal Questions/Exercises

7.0 OBJECTIVES

After studying this unit you should be able to:

explain the meaning of currency risk and exposure
highlight need for currency risk management
discuss methods of currency risk management
describe and illustrate instruments of currency risk management, namely,
forwards, futures, options and swaps
discuss derivatives market in India.

7.1 INTRODUCTION

In unit 6, you noted that exchange rates change, and change frequently. And you were
also explained the reasons for the fluctuations in exchange rates and the methods of
exchange rate forecasting . In this unit you will study the nature of various products
available to the risk manager for management of risk arising out of exchange
fluctuations. However, it is necessary for such a manager to take a view on the
direction in which the exchange rates are likely to move at the time of paymentlreceipt
of foreign currency. For this he requires to know reasons for exchange rate movements,
which were discussed in unit 6. In this unit you will learn about the meaning of
currency risk and exposure and types of currency risks faced by business. You will also
learn about how is currency risk managed with derivatives, different types of derivative
instruments and derivatives market in India.

7.2 MEANING
- OF CURRENCY RISK AND EXPOSURE
Risk , in common parlance, is the other naine of possibility of loss. This in finance
literature is called downside risk. In finance, risk means the variability from the most
likely happening. Statistically, standard deviation is taken as the measure of risk. You
 Currency Risk Management
kr~owthat standard deviation is nothing but dispersion or variability, both, upside and
downside from mean; and mean is the most representative or most likely observation.
Standard deviation is thus a measure of total risk, including upside and downside risk.

In practice, a busines's will find that at the time of payments, or receipts in cross border
dteals viz imports, exports, borrowing, lending, investments, the exchange rates are not
necessarily as predicted, despite the use of the best andlor all of the methods for
fixecasting of exchange rates. Businesses therefore, always have an uncertainty, arising
out of exchange rate fluctuations, as to the quantum of cash inflows and outflows in a
given period. Ibis uncertainty is called the currency risk. Another risk to which cross
t~orderdeals (i.e. foreign trade) are exposed is country/political risk. This arises out of
the possible imposition of restriction on the movement of currencies by the government
. of the.country in which the counterpart is located or even that of the business's own
country. This can result in the payment or receipt of funds being affected, as well as,
at a later date, if restrictions on them are removed. Therefore, business or even a
(country may wish to fix the quantum of inflow or outflow of funds in order to increase
its chances of a gain or in other words restrict its chances of a loss for overall
profitability. Besides currency and political risks there are other more common risks
such as the interest rate risk that is the bane of any business enterprise. Interest rate
risk is embedded in any foreign currency borrowjng, lending and investment
transactions. It may be noted that country and interest rate risks are broader terms than
used in the context of currency risk; nevertheless they do belong to currency risk.

In the context of foreign currency dealings, risk arises out of exchange rate fluctuations
i.e, unanticipated 6hanges in the value of the currency itself (e.g. in January 1998 the
exchange rate was 1 USD = 42.50 INR and in June 1998 1 USD = 43.10 INR). The
anticipated changes get reflected in the exchange rate as in the case of the forward
rates, which are ant~cipatedspot rates of the future. As against currency risk which is
system wide or say that would affect all the businesses in an industqr / country,
currency exposure means the degree of variability of profits or cash flow, arising out
of exchange rate fluctuations, faced by an individual firm. As you can imagine, the
currency exposure of a firm will depend on specific revenue and / or cash flow
characteristics of individual firm ; and would differ from each other. So while the
currency risk is broad and common to all, currency exposure is specific to an individual
firm. In conimon parlance, the terms 'currency risk' and 'currency exposure' are
interchangeably used. We will , in this block, use these terms interchangeably; though
the difference should be well recognised from the real world point of view.

7.3 TYPES OF CURRENCY RISKS

Management of currency risks involves dealing with diverse risks, namely, translation
risk, transaction risk, economic risk, political risk, interest rate risk. Mgasurement and
management of transaction, translation and economic risks will be discussed at length in
Units 8 and 9. We may briefly introduce them here.

7.3.1 Translation Risk

Translation risk arises when the functional currency used in various transactions, e.g. US
Dollar (USD) or Great Britain Pound (GBP) or Japanese Yen (JPY), is different from
the reporting currency, which in the Indian context is the Indian rupee (INR). Each
currency may move in different directions vis-a-vis the reporting currency (the one in
which the company's balance sheet is pyepared). The former may appreciate or
depreciate against the reporting currency. Thus, the reported profit or loss and statement
of assets and liabilities may be affected by cgrrency movements.

7.3.2 Transaction Risk

The other aspect of currency risk IS the transaction risk. The associated risk-depends
on the nature of the transaction e.g. whether the company is primarily an importer or an
exporter or both. If the transaction currency is an appreciating one as against the
reporting currency, an importer will find his input costs rising. On the other hand an
Foreign Exchaagc Risk exporter would receive a higher income without having to raise prices.
Mamagenrent Such exposure also affects a company's financial results by virtue of its effect on its
foreign currency investment and borrowing transactions.
I
7.3.3 Economic Risk
Another aspect of currency risk is the impact of exchange rates on future cash flows of
the company. It is based on the extent to which the value of the firm as measured by
the present value of its expected future cash flow willl change when exchange rates .
fluctuate unexpectedly. Such risk is said to arise out of the company's business
transactions vis-a-vis competitors. In an open economy, competitors would include both
domestic and international competitors.

7.3.4 Political Risk

Besides transaction, translation and economic risks as described above, companies also
face political risk, also referred to as country risk. A company transacting in a foreign
country may find its assets in that country frozen or even confiscated or it may find
that the country has prohibited its currency from being convertible. Such an eventuality
will prohibit the asset from being taken out of that country. Similarly a country could
increase the taxes that businesses are required to pay, thereby reducing the amount
repatriable to home country. Another aspect of country risk is the legal iurisdiction to
which business transactions are subjected.

7.3.5 Interest Rate Risk

Although interest rate risk affects all businesses, including dealing solely in the home
currency, foreign currency borrowers and lenders are exposed to the effects of changes
in interest rates on foreign currencies which in turn add to currency risk as the amount
of interest payable / receivable in foreign currency fluctuates with currency movements.

7.4 WHY MANAGE CURRENCY RISK?

Any uncertainty, especially one where the likelihood of an adverse outcome looms high
1
is generally required to be controlled and managed to reduce or altogether nullify its
impact. At times the impact may threaten the very viability of a company. A return - .
on investment is only meaningful if one knows the probability of achieving it. Risk
requires to be managed for reducing the fear of an adverse price, for locking in costs
and revenues and also to be able to forecast cash flows better.

Businesses adopt various systems and procedures to minimise risk. The market offers
various products and services to reduce losses likely to arise out of currency and
interest rate risks. Although risk may be due to reasons other than monetary viz risk
of fire, generally its management translates into financial compensation packages e.g.
possibility of lossfdamage to goods is addressed by the purchase of an insurance policy
that provides monetary compensation as against replacement of goods. There are
therefore, whole systems and organization that are in the business of trading in risk.
Whenever a risk is perceived there is always a financial entrepreneur who will work out
a product such that both the financial entrepreneur and those who are affected adversely,
by the risk stand to gain. They have on offer various products, priced differently.
Purchase of these products entails a cost as opposed to a financial loss. Steps taken to
purchase such products is called hedging and the product i.e. the contract itself
constitutes a hedging instrument and -it has the features of a contract. The consideration,
analysis and endeavor to reduce risk constitute risk management..

The favourable outcome of managing risk can be (1) reduced cost of borrowing, (2)
planning of a better business strategy, (3) better forecast of cash flows and reduction in
its volatility.
 - Currency Risk Management
7.5 MANAGING CURRENCY RISK WITH
DERIVATIVES
Currency risk is managed by the use of financial derivatives. Derivative is a general
telm and is nothing but the derivation of one variable from another. The term
orrginates from mathematics. Derivatives are used to manage systemic or market risk.
Financial derivatives are financial instruments whose prices are derived from the prices
of other financial instruments. They are traded in almost any market where trading takes
place. Derivative trading is linked to the underlying cash or spot market. In this unit
we shall confine ourselves to the currency markets.

Tlne action of managing risk is called hedging. Hedging is the technique by which an
exposure to risk is covered or dealt with in a manner so as to remove and reduce
uncertainties or even to look upon the uncertainty as an opportunity for gain as opposed
tct the occurrence of a possible loss.
d
It is like being in the state of defence preparedness in the event of an enemy attack or
an insurance against future loss or limiting future loss.

Here it is important to observe the distinction between hedging and speculation. The
average person looks upon speculation as a distasteful activity. Yet without speculators
there can only be limited scope for hedging and hedgers. Some persons and companies
a.re in the business of taking risks and making money, for which they use their own
ciapita1 or those of their clients.,. Speculation involves the acceptance of certain risks in
order to receive high returns and does not involve the existence of an underlying
transaction. Whereas in hedging there is an underlying transaction with a certain risk
attached which is being covered through hedging.

Major instruments of currency risk management are forward contracts and forward rate '
irgreements, currency futures, currency options and currency swaps and interest rate
,swaps. Lets explain them in the following.

Check Your Progress A

1. Distinguish with example currency risk and exposure.

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2. Why are derivatives called derivatives?

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3. What is country risk?
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7.6 DERIVATIVE INSTRUMENTS
7.6.1 Forward Contracts and Forward Rate Agreements
The forward contract .is an instrument wherein the price of the forward currency is the
future spot rate for that maturity as expected by the market. Forward contract may be
an outright contract. An outright forwardcontract is an agreement to eychange
currencies at a future date at an agreed price.
 Foreign Exchange Risk
Management
The forward exchange market is an unregulated market and contract specifications-
largely depend on convention and may be changed by mutual consent of the parties to
the contract. Although theoretically it is possible to enter into a forward contract for
any maturity of 3 days and beyond, in practice it is diflicult for maturities of over one
year. In India it is dificult to obtain it for maturities beyond 6 months although the
market is now developing for longer maturities.

A forward rate agreement (FRA) is a contract in which an amount of currency is

borrowed notionally at a certain fixed rate of interest as against a floating rate of
interest or vice versa over a specific, single period of time. It is an over-the counter
transaction in which financial institutions, such as banks act as intermediaries. So
whereas a forward contract is a hedge against exchange rate fluctuations, the FRA is a
hedge against interest rate fluctuations. I

I
The underlying transaction for a FRA would be an investment or debt involving receipt
or payment of interest. However, in the FRA, which is a separate transaction, there is
no exchange of any principal amount. The rate of interest considered is generally the
LIBOR (London Inter bank offered Rate). There is no payment of fee, other than
transaction costs. The payer of the fixed rate is the buyer of the hedge. The receiver
of the fixed rate is the seller of the hedge and the bank or financial institution that
arranges the transaction is the intermediary.

To take an example, assume that the buyer of the hedge, a company, has decided on
day 'A' to borrow a certain sum 'X' at LIBOR for a one-month period beginning from
future date 'B'. The one-month LlBOR on day 'B' is an unknown quantity today i.e.
'A'; giving rise to buy an FRA at a fixed rate for settlement on day 'B'.

As per the mechanics of a FRA, on day 'B' the company has to notionally pay the
fixed rate of interest on sum 'X' for one-month to the intermediary. So also the
intermediary has to pay the company one-month LIBOR on the same sum 'X' on day
'B' when the one-month LIBOR becomes known. In effect, neither the sum 'X'
exchanges hands nor the interest amount due on the sum; but the net of the two interest
amounts is payable by the party, which has to pay the higher of the two interest rates,
to the party which has to pay the lower of the two interest rates ,e.g. if the fixed rate is
5% and the one-month LlBOR on day 'B' is 4%, the company will pay 1% to the
intermediary. On the other hand if the fixed rate is agreed as 6% the intermediary will
pay 1% to the company. The transactions can be represented as below:

LIBOR (4%) 1%
Lender 4 Company Intermediary

LIBOR (6%) 1%
Lender t Company 4 lntennedi!!ry

The cash flows will be such that on Day 'B' the company receives LlBOR and pays it
to lender on Day C i.e. the datk of maturity. Thus the company in effect has paid the
net fixed rate of interest on the sum 'X'. In this manner it converts its floating interest
rate exposure to a fixed rate.

The intermediary on the other hand converts its LlBOR exposure on Day 'B' to a fixed
rate one by selling an FRA to another company, which wishes to buy an FRA to hedge
against its own fixed rate exposure. Such a company will pay, on Day 'B', the
applicable LlBOR to the intermediary and receive a fixed rate interest.

7.6.2 Future Contracts

Most derivatives are futures or options. Some have both features.

Futures are contracts conveying

a) an agreement, b) to buy or sell, c) a specific amount, d) of a financial instrument, e)

 ~ l t h o u ~futures
h are similar to forward contracts they differ in respect of the following: Currency NIsk Management

a futures contract whereas a forward contract

- Standardises the quantity of the has a designated quantity of the
underlying asset to be delivered underlying asset to be delivered
per contract. per contract.
- has an underlying financial has an underlying financial exposure
instrument or index
- is regulated by exchange concerned is self regulating
- has the minimum price has a mutually agreed upon price
movement for the contract for the contract.
- has the period of the contract has a designated future date for
delivery
- is an exchange traded instrument is not an exchange traded instrument
- transaction is not directly between is a transaction directly between
wunter parties but through the counter parties
~ntermediationof the exchange
- does not consider must consider creditworthiness
creditworthiness of the opposite of the counter party.
party very relevant.

, From the above it is clear that a currency &re is a contract that trades in a futures
exchange where long positions (orders to buy) are matched with short positions (orders
to sell) by brokers and members. The exchange guarantees both sides of the contract.
Currency futures were first traded in 1972 in the International Money Market of the
Chicago Mercantile Exchange. One of the biggest futures exchanges is the London
International Financial Futures Exchange (LIFFE).

Futures prices are generally quoted in USD equivalents of one unit of another currency;
however in the case of Japanese Yen (JPY) the price are quoted as USD equivalent of
JPY100. Contract sizes for some currencies are JPY 12.5 million, GBP 62,500; SFr

Members are required to maintain a margin with the exchange. The margin requirement
would generally be directly proportionate to the volatility of the market. When margin
requirement is low, cost of capital required for trading is reduced. But low margins
increase default risk of the exchange-clearing house. Exchanges generally permit
trading over an eight-hour period. Although this is a restrictive practice, exchanges
enter into mutual offset agreements which permit opening of positions on one exchange
and closing on the other. They may also permit expanded trading hours.

7.6.3 Currency Options

Options are different from forwards and futures contracts which gives one the option to
deliver or not, on the designated date. In the forward contract both parties are obliged
to deliver the designated currencies regardless of the actual exchange rate on the date of
delivery. In the options contract one may compare the actual exchange rate on the
designated date with the contracted rate and opt to deliver or otherwise the designated
currency. As the seller of the option , also called a writer of the option such as a
bank, is exposed to the unlimited risk of non-delivery, the seller is entitled to receive
compensation at the time of the sale or contract upfront. This compensation is called

Depending on whether the option buyer has contracted to buy the asset or sell it, the
option is called 'call' or 'put' respectively. A currency option is the right to exchange
two currencies, which means it is a simultaneous right to buy and sell a certain
currency. The price at which it is agreed to purchase or sell the asset is called the
31
Foreign Exchange Risk In an European option, the option can be exercised only on the date of expiry whereas
Management in an American option it can be exercised any day prior to or on the date of expiry.
Options are traded at the exchange as also over-the-counter.

A 3-month USD lmillion call/INR put European option contract having a strike price
44.25 and premium 2.5% will be executed by the payment of 2.5% by the option .
purchaser to the seller on the date of the contract. At the end of the 3- month period
the buyer will see the spot rate on that day and decide whether to utilise the option or
not. If the spot rate is higher than INR. 44.25 the option buyer will exercise the option
and take delivery of the option contract at INR 44.25 two days after the expiry date.
In this situation, the option is said to be in the money. If the spot rate on the date of
expiry is lower than the strike price the option is said to be out-of-the money and the
buyer will not utilise the contract, as it would be cheaper for the buyer to buy spot in
the market. The buyer of any currency is considered to have assumed a long position
in that currency and the seller to assume a short position.

The simple call or put option as described above is referred to as plain vanilla or
standard derivative. The non- standard option is said to be 'exotic'. Actually it would
be a mix of options with other contracts , for example with swaps, called swaption.

7.6.4 Currency Swaps

A swap is an agreement to buy and sell a currency at agreed rates of exchange and
where the buy and sell trayactions are at different times. A swap is therefore really a
combination of the outright contracts, one of which is a spot transaction and the other
an opposite and forward transaction. However, both legs of the swap can be forward in
which case it is known as a forward-forward swap. When both legs of the swap are
separated by one day, it is known as a rollover swap.

A swap-in INR is a spot purchase of INR against another currency with a forward sale
of INR against the same currency. On the other hand, a swap-out INR is a spot sale
of INR against a certain currency with a forward purchase of INR against the same
currency.

A currency swap is undertaken when a party has a liability into another currency, in
order to take advantage of favorable interest rate or interest rate movement, whereas a
counter party has a liability in the latter currency, which it wishes to convert into
liability in the former currency. The party and counter party can be in two different
countries and need not know each other. A bank or financial institution can act as

currency for a principal and fixed rate interest payment on an equivalent loan in another
'
currency. For example, assume company 'A' may have to pay USD at 5 % whereas
Company 'B' may be in a position to borrow GBP at 8.0%. Similarly, Company 'A'
may be in a position to borrow GBP at 9 % whereas Company B may be able to do so
in USD at 6 %. To make a swap, at the beginning the principal amounts are exchanged
notionally in the original currencies. Thereafter each year the two companies pay
interest on the currencies received by them to the intermediary and the intermediary in
turn pays them interest on their original currencies. In the process all there entities
gain. Let us take an example:

Company 'A' can borrow USD at 5 %

Company B can borrow GBP at 8 %

Intermediary receives 5.5 % from B,and pays 5 % to A in USD and gains .5 %; also
it receives 8.5% from A and pays 8 % to B in GBP and gains .5 % , making a net
gain of 1 %.

-
Thus, Company 'A' has a net gain of 0.5% [ 9 % 8.5%], Company B has a gain of
-
0.5% [ 6% 5.5% ] and the intermediary makes a gain of 1%.

32
 - -

At the end of the swap the two companies would notionally return the currency Currency Risk nIanagement
received at the beginning of the swap and notionally receive their original principal
amounts.

7.6.5 Interest Rate Swaps

An interest rate swap on the other hand is useful to parties, which have interest
liabilities. Consider for example a situation in which Company 'A' has a fixed rate
liability e.g. a three-year bond issue at 8% p.a., which it wants to convert into a
floating rate liability, based on LIBOR, which it expects will go down in the near
future. Assume, this company is able to borrow at LIBOR+O.S%. On the. other hand
Company 'B' may have borrowed the same amount of currency as the bond issue size
of Company 'A' and for the same period at a floating interest rate of LIBOR +1%
payable every six months. Company 'B' may wish to lock into a fixed interest rate of
say 9% p.a. as its treasurer finds it is a nightmare managing the net of interest cash
flows of the Company.

Companies 'A' and 'B' can enter into an interest rate swap through the intermediation
of a financial institution in the following manner.

Company 'A' is required to pay LIBOR + 0.5% to company B at the end of six month.
LIBOR prevailing at the beginning of the 6-month period in question is taken into
account. Company 'B' will pay 9% to Company 'A' at the end of the same 6-month
period. Company 'A' then pays 8% to its bondholders and Company 'B' pays LIBOR
+I% to its lenders. Company 'A' at the end of 6 months thus receives 9% and pays

a +05%. Company 'B' at the end of 6 months receives LIBOR + 0.5% and pays (LIBOR
+I%) + 9% i.e. has a net position (LIBOR +0.5%) - (9% - (LIBOR +I%)} = 9.5%.

Here again neither the principal amount nor the interest are exchanged but the net
mount of the interest is exchanged through the intermediary, which earns a profit by
adding its margin to the interest rates payable by both companies. The intermediary
enters into separate contracts with both companies who may not know each other.

7,7 DERIVATIVES MARKET IN INDIA

Currency markets, spot and forward, are very active markets in India. The forward and
spot currency markets are relatively well developed in India as opposed to the futures
and options markets.

The Reserve Bank of India is nudging banks to deal with derivatives but unless
currency markets are fully developed with large volumes (the minimum units for
-
currency futures in international markets are Deutsche Marks (DEM) and Swiss Francs
(SFr): 125,000; for GBP: 62,500 and for JPY: 12,500,000) and unless for hedging in
international futures markets, rupee becomes fully convertible, the fbtures markets will
not be available to Indian corporates to cover all types of risks.

The disoussion in this unit has therefore limitations in that examples.provided are of
overseas futures markets, which may not appear altogether realistic in Indian conditions.

In the US and European countries, banks act as intermediaries and advice corporate
-about futures and options and undertake the hedginglfutures transactions to cover the
currency risks. In India, unless Indian banks are themselves able to obtain cover for
' futures, Indian banks may not negotiate to undertake the business.

In India, the futures and options currency markets are yet to catch on. The Reserve
Bank of India has permitted it in a limited way at a time when neither bankers nor
customers fully understand the usefulness and mechanism of the instruments. In this
state of general ignorance, news of the losses of Proctor and Gamble Inc. and Orage
County in the U.S.A. only compounds the fear and the parties hesitate to tread into this
area. Nevertheless, it is hoped to pick up very fast with opening up of the economy.
33
Foreign Exchange Risk Check Your Progress B
Management
1. What is a currency call option?
5

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2%
-d.' .."" .."...."................PP.....................................................................................................
"

2. What is a currency put option?

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3. What is currency swaps?

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7.8 LET US SUM UP

Risk is the variability from the most likely happening. One of the most common risk
faced by international business firms is called currency risk.
Currency risk arises from the currency fluctuations. The major types of currency risks
are namely transaction risk, translation risk and economic risk. Besides these risks there
are interest rate risk and country risk. Risk should be managed for reducing profit and
cash flow variability. A firm can use various financial instruments like currency
options, currency futures, currency swaps to hedge currency risk. The derivative market
in India is not fully developed. It is hoped to pick up fast with opening up of economy.

7.9 KEY W O ~ S

Currency Risk : The risk arising from currency fluctuations.

Currency Swap : A transaction to exchange a liability in one currency for liability in
another.
Currency Option : Buyer has the right but not the obligation to take delivery of the
designated currency.
Call Option : An option to buy a stated number of units of a foreign currency at a
specific price per unit during a specific period of time.
Put Option : An option to sell a stated number of units of a foreign currency at a
specified price per unit during a specified period of time.
Option Premium : The price of an option paid by the option buyer to the option seller
at the beginning when they first enter into option contract.

7.10 TERMINAL QUESTIONSIEXERCISES

1. What tire the different types of currency risks?
2. What are the basic differences between forward and future contracts?
3. Distinguish, with examples, between currency swaps and interest rate swaps.
4. What is an option? How-is it different from other derivative?
5. Write a brief note on currency derivatives market in India.
UNIT 8 MEASURING AND MANAGING
TRANSACTION EXPOSURE
Structure

8.0 Objectives
8.1 Introduction
8.2 Concept and Measurement of Transaction Exposure
8.3 Techniques of Transaction Exposure Management
8.3.1 Forward Market Hedge
8.3.2 Money Market Hedge
8.3.3 Exposure Netting
8.3.4 Currency Risk Sharing
8.3.5 Leading and Lagging
8.3.6 Currency Options
8.3.7 Currency Futures
8.3.8 Currency Swaps
8.4 Let Us Sum Up
8.5 Key Words
8.6 Terminal Questions/Exercises

8.0 OBJECTIVES

After studying this unit you should be able to :

explain the concept of transaction exposure

describe various techniques of transaction'exposure management
compare and contrast different hedging techniques.

8.1 INTRODUCTION
Exposure is a word commonly used in day-to-day life. You may have referred to your
fiiend getting exposed to business ethics in his or her corporate career. Your joining
this course itself is getting you exposed to the world of international finance. However,
the word exposure may also carry a negative connotation especially when some degree
of uncertainty of outcome is involved. Our specific reference is to the outcome of
changes in foreign exchange rates on corporate profitability or the overall position of a
company. Foreign currency exposures arise whenever a business has an income or
expenditure, or an asset or liability in a currency other than the balance sheet currency.
In unit 7 you learnt about the different types of currency risks. In this unit, you will
learn about the concept and measurement of transaction exposure and main techniques
of transaction exposure management.

8.2 CONCEPT AND MEASUREMENT OF

TRANSACTION EXPOSURE
All of us know that foreign exchange rates are highly volatile. In a free market,
changes occur practically every second. The movement in foreign exchange rates
occurs as a result of genuine trade transactions in the case of highly regulated markets
like the Indian market where speculation is strictly prohibited. Thus, export and
import transactions or borrowings and lending in foreign currency move foreign
exchange rates in India. The intra-day trends may be more predictable than slightly
longer-term trends; but the uncertainty does exist. And where there is a substantial time
gap between the date of the contract and its maturity, the uncertainty can be quite
fearsome. The time gap will depend on the credit period permissible for such
transactions. At present, the Reserve Bank of India permits a credit period of up to six
-
months actually 180 days to be precise, for export and import transactions. Now,
Foreign Exchange Risk
Management
surely, 180 days is a long enough period for forecasts of movements in foreign
exchange rates to be rendered imprecise. Hence, there arises a transaction exposure
which needs to be measured and managed well in order to minimise its negative effect
on corporate profitability or wealth. The treasury departments managing foreign
exchange fluctuations are sometimes looked upon as profit centres - whereby, the main
objective becomes that of making a profit out of foreign exchange movements. Yet, the
primary aim remains that of avoiding the uncertainty relating to the hture exchange rate
that will prevail on the date the contract matures. A company's transaction exposure is
measured currency by currelicy and equals the difference between contractually fixed
future cash inflows and outflows in each currency. How does one avoid uncertainty of
the future exchange rate or say manage exposure? Let us discuss the main techniques of
transaction exposure management in the following section.

8.3 TECHNIQUES OF TRANSACTION EXPOSWRE

MANAGEMENT
8.3.1 Forward Market Hedge
You may note that there are various techniques available to avoid uncertainty of the
future foreign exchange rates. Forward market hedge is one such technique. The term
hedging refers to mean a transaction undertaken specifically to offset some exposure out
of the firm's usual operations. A forward market hedge refers to a transaction
specifically undertaken in the forward market. The transaction is normally a forward
contract with an authorised dealer, i.e., one authorised to deal in foreign currency - that
is, sell or purchase foreign currency. Most commercial banks have been authorised to
deal in foreign currency by the Reserve Bank of India. And so, a fin-n which is
expecting a receivable or a payable sometime in the near future can enter into a
forward contract with an authorised commercial bank to fix the rupee rate vis-a-vis the
foreign currency in hich the receivable or the payable will materialise. This
I
effectively avoid the ncertainty of the future exchange rate; for whatever the rate
prevailing at that time, the firm has locked in a rate for itself. There are a few things
you should note about forward contracts.

Firstly, a forward contract cannot be entered into for an unlimited period. The
maximum period was earlier directly related to the maximum credit period permissible,
i.e., six months. Under the new RBI guidelines, the maximum period has now been
extended to one year. A firm may, therefore, enter into a one-year forward contract or
of any shorter duration. Now, you will wonder as to what will happen if the firm's
transaction for which a forward hedge is desired extends beyond a period of one year.
It is typical in case of foreign curre'ncy loans wherein not only the principal amount but
also the series of interest payments is likely to extend beyond a period of one year. In
such a case, there is the facility of roll-over contracts. A roll-over contract is rolled
over for the next desired period every time the maturity date arrives. Let us take the
example of a foreign currency loan which involved hedging through a forward contract
for the principal amount as well as the interest series. Let us say, the table of
repayments [US$]runs as follows:

Time Period (t) Interest Principal Repayment Loan Outstendlng

0 5,00,000
1 25,000 1,00,000 4,00,000
2 20,000 1,00,000 3,00,000
3 15,000 1,00,000 2,00,000
4 10,000 1,00,000 1,00,000
5 5,000 1,00,000

The firm receives the loan of US$ 500,000 at time-0 and converts it into rupees at the
spot rate. At the same time, it obtains a forward cover for $500,000 to cover the
principal amount and $25,000 to cover the interest instalment. At t-1, it must take
36
delivery of $5,25,000 at the contracted forward rate, but since it requires only Measuring rind Managing
$1,25,000, it will sell $400,000 at the spot rate prevailing then and again buy forward Transaelion Exposure
the same amount along with $20,000 of interest payment. On $400,040, we would say
that the f m has done a swap - sold spot and bought forward. For buying $400,000
forward, the swap rate will apply and for buying $20,000 forward, the outright forward
rate will apply. Corporates generally gain in the swap market as the turnover there is
much larger than in the outright forward market. Swaps are common in the interbank
market which explains their huge turnover. The swap rate, for example, may be Rs
32.501$1 as against the outright forward rate of Rs 32.701$1. At t=2, once again, the
firm will take delivery of $420,000 ; sell $300,000 spot and again purchase it forward
along with the needed interest amount of $ 15,000. The series continues until the entire
principal amount along with interest is paid off.

Next is the question of whether a forward contract must necessarily be for a fixed
period. An option in the period of the contract may be desired when there is some
uncertainty as regards the exact date of a receivable or payable. For example, the best
-
a fm may know is that shipment will arrive anytime between the third and the sixth
'
month of the date of the contract. Accordingly, payment is also due within the third
and the sixth month. The f m , obviously, cannot enter into an outright forward
contract for a fixed period. The firm, in such a case, can enter into a option forward
conh'act. However, it must be remembered that an option forward contract proves to be
quite expensive for the firm, as the authorised dealer will take the maximum benefit of
the premium or discount for itself. Let us take an example to understand it.

Let us say that a firm's payables are denominated in DM. As you are aware, there are
no direct quorCs available of DM vs. rupee or for that matter for any non-dollar
currency against the rupee. The rate vis-a-vis the rupee in such cases is calculated via
two Steps: step 1 is obtaining the DM/$ rate and step 2 involves obtaining the $/Rs.
rate. A simple multiplication of the two rates (recall cross rate)will give the DMlrupee
rate. For the purpose of illustrating an option forward contract, let us say that the
authorised'dealer deals only with the rate vis-a-vis the US dollar. Let us further say
that on a particular day, the following rates are ruling in the market:

DM/% spot : 1.620011.6210

DM/$ 3 month forward : 1.5950/1.5970
DM/$ 6 month forward : 1.570011.5730 .

Clearly, the DM is at a premium for both the 3 month and the 6 month maturity. If
the customer wanted to buy DM (sell $), the bank will charge the largest possible
premium for the purchase of dollars over the option period. The 3 month forward rate
is DM 1.59501%and the 6 month forward rate is DM 1.57001$. As is obvious, the six
month forward rate of DM 1.5700/$ is more favourable for the bank as it has to give
fewer DM for every dollar it purchases from the customer firm. That is, the bank
charges the six month premium when it sells DM (buys $). But, if the firm wanted to
sell DM (buy $), the bank will charge the 3 month premium for the sale of dollars.
The two rates applicable are DM 1.59701%and DM 1.57301%- the bank will choose
DM 1.59701$ as it gets more DM for every dollar it sells.

This was the case when DM was at a premium to the dollar. Now, let us take the case
of the DM being quoted at a discount. Let us say the rates are as follows:

DM/$ 3 month forward: 1.644011.6460

DM/$ 6 month forward: 1.668011.6710

For the sale of DM (purchase of $) to the customer in this case, the bank will quote
-
the rate 1.64401%as it has to give fewer DM fbr every dollar it purchases that is, it
gives the least possible discount to the customer. For the purchase of DM from the
customer (sale of $), it will quote the rate 1.67101$ as it gets maximum DM for every
-
dollar sold that is, it takes the maximum possible discount from the customer.

3-
Foreign Exchange Risk One must remember that in all cases, the amount of the forward cover cannot exceed
Management the value of the underlying commercial transaction. That is because no speculation is
permissible under Indian laws. Another aspect relating to forward contracts is that
although it does not offer any flexibility to the customer in terms of the rate (the
contract with the authorised dealer must be honoured at the fixed rate), it offers the
facility of cancellation and rebooking of forward contracts. Forward contracts can be
cancelled at or before maturity depending on the view taken by the corporate on the
fbture prevailing rates or due to some genuine Feason, for example, delayed shipment of
goods. For a forward sale by the customer to the bank, cancellation on due date is
deemed as purchase by the bank at the contracted forward rate and a simultaneous sale
at the then ruling spot rate. If the currency has appreciated beyond the forward rate,
the difference is recovered from the customer; conversely, the gain, if any, is paid to
the customer. The bank charges a flat fee every time the contract is cancelled. Let us
now take up other method of hedging.

8.3.2 Money Market Hedge

As opposed to the forward market, one may use the money market for the purpose of
hedging transaction exposures. But for that, one has to have access to international
money markets for short-term borrowings as well as investments. Essentially, money
market hedge involves arbitrage between the Euro deposit market and the spot and
forward foreign exchange market. As you would agree, an investor in choosing
between assets denominated in different currencies looks for the highest possible return
adjusted for exchange rate changes. And, since there is a great deal of uncertainty
regarding exchange rates, arbitrageurs will arbitrage between various assets using
forward contracts to take care of the exchange risk. This kind of arbitrage provides a
link between foreign exchange markets and securities markets in different currencies and .
is called the covered interest arbitrage. Covered interest arbitrage links the forward
premia and discounts directly with interest rate differentials between currencies. This
will happen only in a free market where there is no exchange control or restrictions on
the movement of funds. Let us assume, the following rates prevail in a free market:

US dollar interest rate :

Rupee interest rate : 10%

In this market condition, anybody would like to borrow US dollars, convert into rupees
and avail of the higher interest rate on rupees. The clear profit-making opportunity will
surely increase demand for US dollars as more players enter the market for making a
profit. As a result, the dollar will begin to be quoted at a premium to the rupee while
interest rate on dollars will move up and on rupees will fall. Ultimately, equilibrium
will settle at a premium which will be exactly equal to the interest rate differential
between the dollar and the rupee. What this means is that it should not matter to an
investor in which currency he invests as higher interest rate yielding currencies are
bound to be quoted at a discount in a free market. Thus, in efficient markets, covered
investment in any currency would give the same returns. There are no riskless arbitrage
profits to be had. This is the famous covered interest parity theorem. However,
departures from this theorem exist because of transaction costs, political risks,
withholding taxes on interest, government restrictions, etc. Because of such restrictions,
significant difference may occur between the forward premia / discounts and Euro
market interest differentials between two currencies. Such an imperfection will present
opportunities for cost savings.

So, what really happens in a money mvket hedge? A firm with planned receivables in
a currency can hedge by borrowing in that currency .a that the outflows on accowit of
interest and repayments can be set off against the receivables. Conversely, the firm
could obtain a forward cover and if the covered interest theorem prevailed, the forward
discount/premium would be exactly equal to the interest differential between the two
currencies. But, due to the departures from the covered interest theorem, there may be a
cost saving using the money market hedge. Let us take an example:

38
 Measuring and Managing
1. Borrow DG in the Euro DG market for 90 days. Transactior~Exposure
2. Convert DG spot into DM.
3. Use DM in its operations, e.g., to pay off a short-term bank loan or finance

4. When the receivable is settled, use it to pay off the DG loan.

Suppose, the rates are as follows:

DG/DM spot: 1.lo25135 90 day forward: 1.1045165

Euro DG interest rates: 5.2515.50
Euro DM interest rates: 4.7515.00

A comparison between the spot and the forward rate clearly shows that the DG is at a
discount to @e DM. But the covered interest parity does not hold.

Let us now compare forward cover against the money market cover.

With forward cover, each DG sold will give 90 days later an inflow of:

DM(111.1065) = DM 0.9038

The present value of this (at 4.75% p.a) is:

0.90381(1+(0.047514)) = DM 0.893 1

To cover using the money market, for each DG of receivable, the fm will borrow DG
equivalent to : 11(1+(0.05514)) = DG 0.9864. Next, the fm sells these DG spot to
get DM equivalent to (0.986411.1035) = DM 0.8939. The fm will then pay off the
M3 loan when the receivable matures.

Thus, with the money market cover, there is a net gain of DM 0.0008 [DM 0.8939 -
DM 0.89311 per DG of receivable or DM 8,000 for the 10 million guilder receivable.

8.3.3 Exposure Netting

From forward market hedging and money market hedging, let us now go on to yet
another method of transaction exposure management. Exposure netting, as the name
implies, involves adding up two or more exposures to arrive at the net exposure. The
net exposure may be smaller than any single exposure if some exposures automatically
get cancelled out due to their opposite impacts. Exposure netting, thus, implies that
each transaction need not be looked upon independently for the purpose of hedging; the
whole corporate picture must be obtained before any hedging technique is applied. This
is known as the portfolio approach to hedging - it recognises that the total variability
or risk of a currency exposure portfolio should be less than the sum of the individual
variabilities of each currency exposure considered in isolation.

For example, it is easy to see that a DM 1 million receivable and DM 1 million

payable cancel each other out, with no net exposure. However, such exposure netting
I can also be accomplished by using positions in different currencies, where exchange
rates are expected to move in such a way that losses (gains) on the first exposed
position would be offset by gains (losses) on the second exposed position.

In practice, exposure netting involves one of the following three possibilities:

1. A fm can offset a long position in a currency with a short position in the same
currency.
2. If the exchange rate movements of two currencies are positively correlated, then
Foreign Exchange Risk 3. If the currency movements are negatively correlated, then short (or long)
Management positions can be used to offset each other.

Netting assumes importance in the context of cash management in a multinational

corporation with a number of subsidiaries and extensive intra-company transactions.
Netting not only reduces the amount of exposures to be covered company-wide but also
minirnises company payments. To be able to use netting effectively, the company must
have continuously updated information on inter-subsidiary payments position as well as
payables and receivables to outsiders. One way of ensuring efficient information
gathering is to centralise cash management. We will deal with it a little later.

8.3.4 Currency Risk Sharing

Currency risk sharing as an exposure management technique is directly related to the
strategy of risk shifting which corporates follow by invoicing transactions in their home
currency. Hence, if a German firm is exporting to Great Britain and is invoicing its
goods in DM, it obviously does not face any currency risk. Currency risk has been
shifted to the British firm which will have to convert Pounds into DM at the agreed
date in order to pay for the goods it is importing. But, there is one thing you must
note. Although the German firm may be benefitting on the exchange rate front, it may
be losing out on the price front. The British firm may have already planned for the
maximum Pounds it is willing to pay for the goods it needs to purchase from the
German fum. Depending on the DMlPound forward rate, the British firm will quote
a price which may not work to the benefit of the German firm. Hence, it is not
possible to gain from risk-shifting if one is dealing with informed customers or
suppliers.

Currency risk sharing is implemented by developing a customised hedge contract

embedded in the underlying trade transaction. This hedge contract typically takes the
form of a price adjustment clause whereby a base price is adjusted to reflect certain
exchange rate changes. For example, a base price could be set at DM 25 million, but
the parties would share the currency risk beyond a neutral zone. The neutral zone
represents the currency range in whish risk is not shared. Suppose, the neutral zone is
specified as a band of exchange rates: $0.39-0.41 : 1 DM, with a base rate of DM 1
= $0.40. This means that the exchange rate can fall as far as $0.39: 1 DM or rise as
high as $0.41: 1DM without reopening the contract. But, if the DM depreciates from
$0.40 to, let us say, $0.35, the actual rate will have moved $0.04 beyond the lower
boundary of the neutral zone ($0.39: 1 DM). This amount is shared equally. Thus, the
exchange rate actually used in settling the transaction would be $0.38: IDM ($0.40-
0.0412). In currency risk-sharing, therefore, a firm shares both its loss and its profit
with its partner. Thus, if the DM appreciates beyond the upper limit to say $0.45, the
American firm will not get the full benefit of the DM'S rise in value. Instead, the new
exchange rate becomes $0.42 (0.40+0.04/2).

8.3.5 Leading and Lagging

Leading and lagging is another internal hedging technique for managing transaction
exposures. Leading refers to advancing and lagging to delaying receivables or payables
as part of managing a firm's potential transaction exposure. This strategy is used
particularly by multinational corporations. The general rule is lead, i.e., advance
payables and lag, i.e., postpone receivables in strong currencies and, conversely, lead
receivables and lag payables in weak currencies. However, shifting the exposure in
time is not enough; it has to be combined with .a borrowingllending transaction or a
forward transaction to complete the hedge. Essentially, leading and lagging are a
response to market imperfections. Thus, suppose an American firm has a 3 month DM
payable and the firm (and everyone else) is almost sure that the DM is going to s h q l y
appreciate against the dollar. The firm can offer to settle the payment immediately, i.e.,
forgo the usual 90 day credit and demand a discount for cash payment. On the other
hand, suppose it has a receivable in a weak currency such as the Mexican peso, it can
offer a discount to the Mexican buyer for immediate payment.

Just like we saw in the case of the money market hedge, if the covered interest parity
holds, a firm woyld be indifferent between a forward market hedge and using the
40 leadingllagging technique. Let us take an example:
A French firm has a 180 day payable of SFr 3,50,000 to a SWISS supplier. The spot Measuring and Managing
Transactio~tExposure
rate is FFr .3.2500/SFr. The 180 dollar forward is 3.3312 , i.e., the SFr is at a
forward premium by 2.5%. The Swiss supplier is prepared to give a discount of 2.5%
for cash payment. The French firm can borrow at 10% p.a. The net cost of leading
the payment would, thus, be 2.5% [ 5% for 180days minus 2.5% cash discount] which
is equal to the 180 day premium on the SFr. The interest differential, as you can see,
is exactly captured in the forward premium and, hence, leading and forward hedge are
equivalent. If some imperfections drive a significant wedge between Euro interest rates
and domestic interest rates, then leading or lagging an exposure may turn out to be
cheaper than a forward hedge.

Let us illustrate with the help of an example:

Suppose, an American firm has a 180 day payable of A$1,000,000 to an Australian

supplier. The market rates are: A$/US$ Spot: 1.3475 180 day forward: 1.3347

Euro US$ 180 day interest rate : 10% p.a

Euro A$ 180 day interest rate : 8% p.a

Let us say, the Australian authorities have imposed a restriction on Australian firms
which prevents them from borrowing in the Euro A$ market. Similarly, non-residents
cannot make money market investments in Australia. As a consequence, the domestic
180 day interest rate in Australia is 9.5% p.a. The American firm may consider the
following four alternative hedging strategies:

a) Buy A$ 1,000,000 180 day forward. (Forward contract)

b) Borrow US$, convert spot to A$, invest in a Euro A$ deposit, settle the deposit
with the deposit proceeds. (Money Market Hedge)
c) Borrow US$ for 180 days, convert spot to A$, lead the payable, get a discount.

d) Borrow A$ in the Euro market, settle the payable, buy A$ 180 day forward to
pay off the loan (Lead with a forward).

Leads and lags in combination with netting form an important cash management strategy
for multinationals with extensive intra-company payments.

8.3.6 Currency Options

Let us recall forward contracts discussed under 8.3.1. A major limitation of forward
contracts is their lack of flexibility. The contracted rate and period have to be adhered
to; otherwise a cancellation fee is payable besides compensation for any loss suffered by
the authorised dealer. Currency options are designed to overcome this rigidity of
forward contracts. A currency option provides an option to the buyer of the contract to
move out of the contract, in case the currency in question moves to his disadvantage.
You can well imagine the risk that the option seller exposes himself to. That is why,
he has to be compensated by a front-end payment, i.e., payment in advance, which is
called the 'option premium'. The option premium is payable by the buyer of the
option. As you have read in unit 7 there are essentially two kinds of options that a firm
-
can purchase an option to purchase a currency and an option to sell a currency. The
former is called a call option and the latter a put option. The price specified in the
option contract at which the option buyer can purchase or sell the currency is called the
strike price or the exercise price.

When are options useful for currency hedging? Options are particularly useful for
hedging uncertain cash flows, i.e., cash flows that are contingent on other events.
Typical situations are:

1. International Tenders: Foreign exchange inflows will materialise only if the bid
is successful. If execution of the contract also involves purchase of materials,
equipment, etc. from third countries, there are contingent foreign currency
outflows too.
41
Foreign Exchange Risk 2. Foreign currency receivables with substantial default risk o r political risk,
Management
e.g., the host government of a foreign subsidiary might suddenly impose
restrictions on dividend repatriation.
3. Risky Portfolio Investment: A funds manager, say in UK, might hold a
portfolio of foreign stockslbonds currently worth say DM 50 million which he is
planning to liquidate in six months' time. If he sells-DM 50 million forward,
and the portfolio declines in value because of a falling German stock market and
rising interest rates, he will find himself to be overinsured and short in DM.

Currency options can also be used to hedge exposure to shifts in a competitor's

currency. Companies competing with firms from other nations may find their products
at a price disadvantage if a major competitor's currency weakens, allowing the
competitor to reduce its prices. Thus, the company will be exposed to fluctuations in
the competitor's currency even if it has no sales in that currency. For example, a Swiss
engine manufacturer selling in Germany will be placed at a competitive disadvantage if
dollar depreciation allows its principal competitor located in the United States, to sell
at a lower price in Germany. The Swiss firm can purchase options on the dollar to
reduce its disadvantage. Let us illustrate how:

The Swiss firm can purchase put options - why? Because it is expecting depreciation of
the dollar vis-a-vis the DM. Further, if the firm purchases out of the money put option
- strike price less favourable than the market price - the firm may make a neat profit.
After the depreciation of the dollar, the out of the money put option contract is likely
to become in the money put option contract - strike price more favourable than the
market price. The Swiss firm can then profitably sell these options at a profit enabling
it to partly compensate for its lost competitiveness.

8.3.7 Currency Futures

Currency futures are yet another technique to remove the rigidity associated with
forward contracts. In principle, the idea is very simple. If a corporation has an asset,
e.g., a receivable in a currency , let us say, US$ which it would like to hedge, it
should take a futures position such that futures generate a positive cash flow whenever
the asset declines in value. In this case, since the firm is long in the underlying asset,
it should go short in futures, i.e., it should sell futures contract in US dollars. A direct
hedge is available for most of the convertible currencies; otherwise, a firm must choose
a futures contract on an underlying currency that is highly positively correlated with the
currency exposure being hedged. Even when a direct hedge is available, it is alreost
always impossible to achieve a perfect hedge. This is due to two reasons. One is the
fact that futures contracts are for standardised amounts and only rarely will the exposure
to be hedged equal the value of an integral number of futures. For example, an
American firm with a receivable of DM 5,50,000 cannot hedge this amount exactly by
selling DM futures. Four DM futures will cover DM 5,00,000 while five contracts will
be worth DM 6,25,000. The second and more important reason is that the correlation
between spot and futures prices is less than perfect. Essentially, the difficulty is that
the change in spot price does not, in general, equal the change in futures price. This is
known as the basis risk. On March 1, the dollar/Pound spot rate is 1.6750 while June
futures are trading at 1.6680. The basis is 0.0070 or 70 ticks. Suppose, an American
firm has a three month sterling receivable of 1,00,000 Pounds and hedges it by selling
two sterling futures. By June 1, the spot sterling has depreciated to 1.6620 while June
futures are trading at 1.6590. The basis has, thus, shrunk to 30 basis ticks. The loss
on the receivable is :
$100,000 (1.6750- 1.6620) =%1,300
Y
while the gain on futures is : $(1,25,000(1.6680-1.6590)) = $ 1,125. Hence, even the
two sterling futures do not give a perfect hedge to the sterling receivable.

8.3.8 Currency Swaps

Currency swaps are increasingly becoming popular as a transaction exposure
management technique.. In a currency swap, the two payment streams being exchanged
are denominated in two different currencies. There are essentially three kinds of swaps:
 fixed to fixed currency swap, a floating to floating currency swap, and a fixed to Measuring and Managing
Transaction Exposure

In fixed to fixed currency swap, one party raises a fixed rate liability in say US dollars
and the other party raises fixed rate funding iri another currency, say DM. The
principal amounts are equivalent at the current market rate of exchange. At the
initiation of the swap contract, the principal amounts are exchanged, the first party
"getting DM and the second party getting US dollars. Subsequently, the first party
makes periodic DM payments to the second, computed as interest at a fixed rate on the
DM principal while it receives from the second party payments in dollars again
computed as interest on the dollar principal. On the maturity date, the principal
amounts are once again exchanged. It may be noted, however, that the exchange of
principals, both at the beginning and at the end is notional - not real. What is real is
the cash flows resulting from interest payments. Whether or not the parties to the swap
contract benefit from the swaps will depend on how the underlying currencies and
interest rates move during the contract period, which is normally for three to five years.

.A floating to floating currency swap will have both payments at floating rate but in
different currencies. In most cases, an intermediary -a swap bank structures the deal
and routes the payment from one party to another.

A fixed to floating currency swap is a combination of a fixed to fixed currency swap

and a fixed to floating interest rate swap, i.e., one payment stream is at a fixed rate,
while the other is at a floating rate.

There is a growing market for swaps for which many explanations have been advanced.
Most of these hypotheses rely either on a capital market imperfection or factors like
differences in investor attitudes, informational asymmetries, differing financial norms,
peculiarities of national regulatory and tax structures, etc. You will agree that
borrowers and investors differ in their preferences and market access. For instance, a
manufacturing firm or a utility might prefer fixed rate funding to 'finance long gestation
physical investment projects but finds that fixed rate investors do not view it very
kindly while it is able to borrow relatively easily in the floating market. On the other
side, is a large international financial institution such as a money centre bank which can
borrow on excellent terms in the fixed market but prefers floating rate funding because
it has a large portfolio of floating rate loans.

Swaps help borrowers and investors overcome the difficulties posed by market access
andlot provide opportunities for arbitraging some market imperfection. Swaps, thus,
bec.ome a good way of managing transaction exposures in any particular currency.

Check Your Progress A

1. What is transaction exposure?

...........................................................................................................................................
..........................................................................................................................................
...........................................................................................................................................
2. List the various techniques of hedging?
...........................................................................................................................................
...........................................................................................................................................
.............................................................................................................................................
3. When should a firm consider purchasing a call optionfput option.
........._......................................................................................................................*........2.
...........................................................................................................................................
I
Foreign Exchange Risk
Management 8.4 LET US . UM UP
Transaction exposure occurs whenever a company is committed to a foreign currency
denominated transaction. Since the transaction will result in a future foreign currency
cash inflow or outflow, any change in the exchange rate between the time the
transaction is entered into and the time it is settled in cash will lead to a change in the
amount of cash inflow or outflow in local currency. Protective measures to guard
against transaction exposure involve entering into foreign currency transactions whose
cash flows exactly offset the cash flows of the business transaction. These protective
measures include using forward market hedge, money market hedge, exposure netting,
currency risk sharing, leading and lagging, currency options, futures and swaps. It may
be noted that if interest parity holds, the firm would be indifferent between a forward
market hedge and money market hedge as well as between a forward market hedge and
leadingllagging. Alternatively, a firm could try to invoice all transactions in local
currency to avoid transaction exposure entirely. However, it may have to compromise
on price front. lt may be mentioned that eliminating transaction exposure doesn't
eliminate all foreign exchange risk. The firm is still subject to economic exposure or
exchange risk on its future revenues and costs - i.e., its operating cash flows. We will
discuss translation and economic exposure management in the next unit.

8.5 KEY WORDS

Transaction Exposure: Transaction exposure arises when a company is committed to a
foreign currency denominated transaction, In other words, on transactions that a firm
has already entered into and that are denommated in a foreign currency, the firm could
incur future gains or losses owing to unanticipated exchange rate fluctuations.

Forward Market Hedge: A forward market hedge involves a company that is long in
a foreign currency selling the foreign currency forward and a company that is short in a
foreign currency buying the foreign currency forward.

Roll-Over Contracts: Roll-over forward contract is one that can be rolled over at the
initial forward rate agreed upon subject to a roll-over charge. This is particularly useful
for large importers in countries with constantly depreciating currencies.

Option Forward Contract: Option forwards are contracts in which the rate of
exchange between two currencies is fixed at the time the contract is entered into as in
a standard forward (outright forward contract) but the delivery date is not a fixed date.
One of the parties (usually a corporate customer) can, at its option, take or make
delivery on any day between two fixed dates. The interval between these two dates is
the option period.

Money Market Hedge: A money market hedge involves simultaneous borrowing and
lending activities in two different currencies to lock in the local currency value of a
future foreign currency cash flow.

Covered Interest Arbitrage: According to the covered interest arbitrage theory, the
currency of the country with a lower interest rate should be at a forward premium in
terms of the currency of the country with the higher interest rate. More specifically, in
an efficient market with no transaction costs, the interest differential should be equal to
the forward differential. When this condition is met, the forward rate is said to be at
interest parity, and equilibrium prevails in the money markets.

Exposure Netting: Exposure netting is a method used mainly by MNCs to reduce the
number of foreign exchange transactions needed to settle inter-unit transactions. The
basic idea is to chart out all the payments that units have to make to one another and
work out a solution that minimises the number of transactions needed.

Currency Risk Sharing: Currency risk sharing is different from a traditional hedge in
the sense that the parties agree to share the risks associated with currency rate
fluctuations. Typically, a hedge contract, in the form of a price adjustment clause, is
44
imbedded in the underlying trade transaction. Exchange rate changes are reflected in Measuring snd Managing
Transaction Exposure
adjustments to base price. The base price representsethe currency range in which risk is
not shared.

Leading and Lagging: Leading and lagging shift the timing of transaction exposures.
The general rule followed is lead, i.e., advance payables and lag, i.e., postpone
receivables in strong currencies and, conversely, lead receivables and lag payables in
weak currencies.
Out of the money option: An option contract wherein the strike price is less
favourable than the market price.

In the money option: An option contract wherein the strike price is more favourable
than the market price.

Tick Value: Tick value is a measure commonly used by traders in currency futures.
In futures parlance, the tick value is 0.01 cents per unit of foreign currency.

Swaps : Swaps involve exchange of a series of periodic payments between two parties,
usually through an intermediary which is a large financial institution. The two payment
streams are estimated to have identical present values at the outset when discounted at
the respective cost of funds in the relevant primary financial markets. The two major
types are interest rate swaps and currency swaps. The two are combined to give a
cross-currency interest rate swap. A number of variations are possible within each type:
Swaps also refer to the simultaneous purchase (sale) of a currency in the spot or the
forward market coupled with forward sale (purchase) of that currency. In case both
transactions are in the forward market, the forward periods differ with respect to their
maturities.

8.6 TERMINAL QUESTIONSIEXERCISES

1. What you do mean by transaction exposure? Describe various techniques
available to manage transaction exposure both in the short term as well as the
long term.
2. "Interest rate parity and leadingtlagging are related to forward contracts" Discuss
and illustrate.
3. Illustrate with the help of an example how futures may be a good hedging
technique. Also explain why futures may not be a perfect hedge sometimes.
4. Contrast the forward market hedge and money market hedge.
 UNIT 9 MEASURING AND MANAGING
TRANSLATION AND ECONOMIC
EXPOSURES
---.__
Structure

9.0 Objectives
9.1 Introduction
9.2 Translation Exposure Defined
9.2.1 Distinction between Transaction and Translation Exposure
9.3 Currency Translation Methods
9.4 ~inancialAccounting Standards No. 8 and 52
9.5 Designing a Hedging Strategy
9.5.1 Funds Flow Adjustment
9.5.2 Forward Contracts
9.5.3 Exposure Netting
9.6 Centralisation vs. Decentralisation of Exchange Risk Management
9.7 Economic Exposure Defined
9.7.1 Measuring Economic Exposure
9.8 Managing Economic Exposure
9.8.1 Marketing Initiatives
9.8.2 Production lnitiatives
9.8.3 Financial Initiatives
9.9 Let Us Sum Up
9.10 Key Words
9.1 1 Terminal Questions/Exercises

9.0 OBJECTIVES
After studying this unit you should be able to :

explain the concepts of translation and economic exposures

discuss their impact on corporates
discuss various ways of hedging these exposures
compare and contrast various hedging techniques.

9.1 INTRODUCTION
In unit 8 you learnt about the concept, measurement and techniques of managing
transaction exposure. In this unit you will learn about two other forms of exposure
facing international business firms, namely translation (or accounting) and economic
exposure. You will also learn about their concepts and various hedging techniques and
the impact of these exposures on corporates.

9.2 TRANSLATION EXPOSURE DEFINED

Translation exposure refers to the amount of risk facing the firm as a result of the
need to translate financial statements prepared in onL currency into statements in another
currency. This is particularly true for multinational firms which must consolidate their
financial results at the end of the year. The accounting framework is the legally
required form in which companies must report operating results and financial condition
to shareholders. The financial statements contain information of interest to various other
parties viz lenders, debtors, regulators. Thus , the translation of subsidiary accounts for
consolidation into parent accounts faces translation exposure and may pose serious
implications for the parent company. ,

46
 Measuring and Managing
9.2.1 Distinction between Transaction and Translation Exposure Translation and Economic
Exppsures
The addition of the word 'risk' after 'transaction' or 'translation' tends to convey that
transaction risk and translation risk are two different risks, i.e., different external threats.
Indeed, they may be more appropriately viewed as different ways of looking at and
managing the same (or at least largely overlapping) external threats. An accounting
model of receipts and payments is implicit when reference is made to translation risk,
and a cash flow model of receipts and payments is implicit when reference is made to
transaction risk.

Translation risks are commonly restricted by experts to contractually committed receipts

and payments. Uncommitted ones may never appear on financial statements at all.
Clearly, this category of contractually committed receipts and payments overlaps with a
considerable proportion of those included in transaction risks. In fact, some writers
would treat transaction and translation risks as co-terminus, whereas others would wish
to extend transaction risk to include a number of uncommitted future transactions.
What is common to all of them, however, is that the distinction is not between different
external threats, i.e., different mismatches. Transaction and translation mismatches arise
largely froni the same transactions: both threats are from the effect of adverse
movements in the same nominal exchange rates on the outcomes of largely the same
transactions, The distinction is effectively between two models of the business used by
managers, the accounting model and the future cash flows model. The contrast
concerns the values (current market or balance sheet values) and the time horizon which
the durrency manager has in mind when managing the risks. The distinction is
subjective in that it turns on manager's perceptions: if he is concerned with accounting
values and with losses or gains arising in financial reporting periods, then he is
managing the translation or accounting risk; if he is concerned with the amount of the
future cash receipt or payment on its expected date, then he is managing transaction
risk. The clistinction between translation and transaction risk is, therefore, between
management perceptions, not between external threats or risks. This is, however,
important to recognise and provide for.

Translation (position) risk can be measured either aggressively for gain or defensively to
avoid loss. Some companies prefer the objective of leaving the impact of currency
movements unchanged between successive reporting periods. They prefer to smooth
rather than sptimise or minimise the effect of currency movements. Defensive
management approach involves adjustment of each position to zero. Aggressive
management of freely floating currencies is for those who either have reason to know
they can beat market expectations of fiture exchange rates, or have special tax position
which load the dice in their favour after tax. Aggressive management is more likely to
be successfbl with controlled or managed currencies or over very short periods.
Aggressive position risk management is difficult, but not wrong in principle, as long as
it is a calculated and adequately controlled and the relevant policy disclosed to and
understood by investors.

9.3 CURRENCY TRANSLATION METHODS

Companies with international operations will have foreign currency denominated assets
and liabilities, revenues and expenses. However, because home country investors would
be interested in home currency values, the foreign currency balance sheet accounts and
income statements must be assigned home currency 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 parent's 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 home currency values and hence, are regarded as not exposed. Translation
exposure is simply the difference between exposed assets and exposed tiabilities. The
difference of opinion among accountants centre around (1) which assets and liabilities
are exposed and (2) when accounting-derived foreign exchange gains and losses should
be recognised (reported on the income statement). A crucial point to see these
Foreign Exchange Risk
Management differences of opinion in perspective is that such gains and losses are of an accounting
nature - that is, no corresponding cash flows are involved. The four most common
methods of translation are, the currenvnon-current method, the monetarylnon-monetary
method, the temporal method, and'the current rate method. Let us briefly discuss these
in the following:

CurrentINon-Current Method

At one time, the current/non-current method, whose underlying theoretical basis is

maturity, was used by almost all US multinationals. Under 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 a devaluation (revaluation) with the current/
non-current method, and vice versa if working capital is negative. The income
statement is translated at the average exch'ange rate of the period, except for those
revenue and expense items associated with noncurrent 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.

MonetaryINon-monetary Method

The monetarylnon-monetary method differentiates between monetary assets and liabilitie!

- 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 payables and receivables and long-term
debt) are translated at the current rate; non-monetary items (for 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 nonmonetary 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 monetarylnon-monetary method.

The only difference is that under the monetarylnon-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 these two methods is different. The choice of
exchange rate for translation is 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 valuation viz historical cost versus market value. lncome statement items are
normally translated at an average rate for the reporting period. However, cost of goods
sold and depreciation and amortisation charges related to balance sheet iiems carried at
past prices are translated at historical rates.

Current Rate Method

The current rate method is the simplest. Under this method, all balance-sheet and
income items are translated at the current rate. Thus, if a firm's foreign currency
denominated assets exceed its foreign currency denominated liabilities, a devaluation
must result in a loss and a revaluation in a gain. One variation of this method is to
translate all assets and liabilities except net fixed assets at the current rate.
 Measuring ancl Managing
9.4 FINANCIAL ACCOUNTING STANDARDS Translat'on and Economic
Exposures
NO. 8 AND 52

From our discussion above of various methods of translation available, you may easily
expect wide variation in the results reported under different methods of translation. This
precisely led the Financial Accounting Standards Board (FASB) of the US to issue
accounting standard number 8 to establish uniform standard of translating foreign
currency denominated financial statements. FASB 8, which was based on the temporal
method, became effective on January 1, 1976. Its principal virtue was its consistency
with generally accepted accounting practice that requires balance sheet items to be
valued (translated) according to their underlying measurement basis (that is, current or
historical). Almost immediately upon its adoption, controversy ensued over FASB 8. A
major source of corporate dissatisfaction with FASB 8 was the ruling that all reserves
for foreign currency losses be disallowed. Before FASB 8, many companies established
a reserve and were able to defer unrealised gains and losses by adding them to, or
chzrging them against the reserve. In that way, corporations generally were able to
cushion the impact of sharp changes in currency values on reported earnings. With
F A S B ' ~ ,however, fluctuating values of foreign currencies often had more impact on
profit and loss statements than did the sales and profit margins of multinational
manufacturers' product lines.

In 1981, widespread dissatisfaction by corporate executives over FASB 8 led to a new

-
translation standard FASB 52. According to FASB 52, firms must use the current rate
method to translate foreign currency denominated assets and liabilities into home
currency. All foreign currency revenue and expense items on the income statement
must be translated at either the exchange rate in effect on the date these items are
recognised or at an appropriately weighted average exchange rate for the period. The
most important aspect of 'the new standard was that unlike the case with FASB 8, most
FASB 52 translation gains and losses bypass the income statement and are accumulated
in a separate equity account on the parent's balance sheet. FASB 52 also, for the first
time, differentiated between the functional currency and the reporting currency. An
affiliate's functional currency is the currency of the primary economic environment in
which the affiliate generates and expends cash. If the enterprise's operations are
relatively self-contained and integrated within a particular country, the functional
currency would generally be the currency of that country. It is also possible that the
functional currency is neither the local currency nor the home currency, but rather is a
third currency. This especially happens in high inflation countries. The reporting
currency, on the other hand, is the currency in which the parent firm prepares its own
financial statements. FASB 52 requires that the financial statements of a foreign unit
first be stated in the functional currency, using generally accepted accounting principles.
At each balance sheet date, any assets and liabilities denominated in a currency other
than the functional currency, or from settling such items, generally must appear on the
foreign unit's income statement. That is, if the functional currency is identical to the
local currency, translation gains and losses must appear in the balance sheet as a
separate item called cumulative translation adjustment under the shareholder's equity
account. If the functional currency is other than the local currency, then all financial
statements prepared in local currency must first be translated into the functional
currency. This translation is done according to the temporal method previously required
by FASB 8, and therefore, the resulting translation gains and losses must be reported in
the income statemeht.

In India, Institute of Chartered Accountant of India has issued AS-1 1, which is based
on IAS-21 prescribed by International Accounting Association in this regard.

49
Foreign Exchange Risk
Management 9.5 DESIGNING A HEDGING STRATEGY
14s you can see, translation exposures are serious enough to merit specially designed
hedging strategies. Firms have three available methods for managing their translation
exposure: (1) adjusting fund flows; (2) entering into forward contracts; and (3)
exposure netting. The general rule followed is as follows:

Basic Stratenv for Hed~inpTranslation Exmsure

Hard Currencies
(likely to appreciate) Increase Decrease

Weak Currencies
(likely to depreciate)

The strategy shown above essentially involves increasing hard currency (likely to
appreciate) and decreasing weak currency (likely to depreciate) assets, while
simultaneously decreasing hard currency liabilities and increasing weak 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 receivables, increase local currency borrowing, delay accounts payable, and sell
the weak currency forward. Despite their prevalence among firms, however, these
hedging activities are not automatically valuable. If the market already recognises the
likelihood of currency appreciation or depreciation, this recognition will be reflected in
the costs of the various hedging techniques. Only if the firm's anticipation differs from
the market' and is also superior to the market, can hedging lead to reduced costs.
Otherwise, the principal value of hedging would be to protect a fum from unforeseen
currency fluctuations.

9.5.1 Funds Flow Adjustment

Most techniques for hedging an impending local currency devaluation reduce local
currency assets or increase local currency liabilities, thereby generating local currency
cash. If accounting exposure is to be reduced, these funds must be converted into hard
currency assets. For example, a company will reduce its translation loss if, before local
currency devaluation, it converts some of its local currency cash holdings to the home
currency. Th$ conversion can be accomplished, either directly or indirectly, by means
of various funds adjustment techniques.
G
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 a local currency devaluation is anticipated, direct
finds-adjustment methods include pricing exports in hard currencies and imports in the
local currency, investing in hard currency securities, and replacing hard currency
borrowings with local currency loans. The indirect methods include adjusting transfer
prices on the sale of goods between affiliates, speeding up the payment of dividends,
fees and royalties, and adjusting the leads and lags of inter subsidiary accounts. The
latter method, which is the one most frequently used by multinationals, involves
speeding up the payment of inter subsidiary accounts payables and delaying the
collection of inter subsidiary accounts receivables. These hedging procedures would be
reversed for an appreciation of the local currency. Some of these techniques or tools
- -
may require considerable lead time and as is the case with a transfer price once they
are introduced, they cannot be easily changed. In addition, techniques such as transfer
price, fee and royalty, and dividend flow adjustments fall into the realm of corporate
policy and are not usually under the treasurer's control. It is, therefore, incumbent on
the treasurer to educate other decision makers about the impaqt of these tools on the
costs and management of corporate exposure. For those countries in which a formal
50
 Measuring and Managing
market in local currency forward contracts does not exist, leading and lagging and local Translation and I:cosomic
currency borrowing are the most important techniques. The bulk of international Exposures
business, however, is conducted in those few currencies for which forward markets do
exist. A summary of the fund flow adjustment hedging actions under currency
depreciation / appreciation scenarios may be given as follows:

Currencv Deoreciation Currency Aooreciation

Sell local cwrency forward Buy local currency forward

Reduce levels of local currency Increase levels of local currency cash

cash and marketable securities and marketable securities

Tighten credit (reduce local Relax local currency credit terms

currency receivables)
Speed up collection of weak currency
receivables
Increase imports of hard currency Reduce imports of soft currency goods

Borrow locally Reduce local borrowings

Delay payment of accounts payables Speed up payment of accounts payables
Speed up dividend and fee remittances Delay dividend and fee remittances to
to parent and other subsidiaries parent and other subsidiaries
Speed up payment of inter subsidiary Delay payment of inter subsidiary
accounts payables accounts payables
Delay collection of inter subsidiary Speed up collection of inter subsidiary
accounts receivables- accounts receivables
Invoice exports in foreign currency and Invoice exports in local currency and
imports in local currency imports in foreign currency

9.5.2 Forward Contracts

You have already studied in unit 8, how forward contracts can reduce a fum's
transaction exposure. Forward contract can also be used to hedge translation exposure
by creating an offsetting asset or liability in a foreign currency. For example, suppose
that IBM U.K has translation exposure of 40 million pounds (that is, sterling assets
exceed sterling liabilities by that amount). IBM U.K can eliminate its entire translation
exposure by selling 40 million pounds forward. Any loss (gain) on its translation
exposure will then be offset by a corresponding gain (loss) on its forward contract.
However, it is to be noted that the gain (or loss) on the forward contract is of a cash
flow nature and is netted against an unrealised translation loss (or gain).

9.5.3 Exposure Netting

Exposure netting is another hedging technique that can be used by a multinational

firms with positions in more than one foreign currency or with offsetting positions in
the same currency. As explained in unit 8, this technique involves offsetting exposures
in one currency with exposures in the same or another currency such that gains and
losses on the two currency positions will offset each other.

Selecting convenient (less risky) currencies for invoicing exports and imports and

51
Foreign Exchange Risk
Management 9.6 CENTRALISATION VS. DECENTRALISATION OF
EXCHANGE RISK MANAGEMENT
Centralisation or decentralisation is a particularly important issue in exchange risk
management. The choice depends not only on the company's management style, but
also on the nature of its business. In any case, the logistics of management influence
the handling of currency risk in a variety of ways. In the area of foreign exchange risk
management, there are good arguments both for and against centralisation. Favouring
centralisation is the reasonable assumption that local treasurers want to optimise their
own financial and exposure positions regardless of the overall corporate situation. Many
companies take the view that their group's commercial success requires strong local
control. Local here refers to any profit centre, be it geographical, product or a market
segment. It is hard for such a structure to be effective if there are any unnecessary
restrictions on the local manager's power to take decisions which influence profit
centre's commercial success. Many currency risk decisions are highly germane to
'
commercial success. Secondly, the local currency manager is closer to the transactions
of the local unit, and also to the local banking system and foreign exchange market.
This is espkcially important if the local currency market is insulated by controls from
the world banking market in which the parent deals.

There is much diversity in the extent to which companies centralise currency dealing,
currency invoicing decisions, and risk management and hedging decisions. Practice in
multinational groups can vary from total centralisation, where all dealing is done by the
parent, to a high degree of freedom for every world-wide profit centre to manage its
own currency risks by its own criteria. The variety of practice is likely to owe much
to differences between the products, market positions and international spread of each
group of companies. Few companies stand at the extreme ends of the spectrum. Most
international companies, as a minimum:

issue guidelines stating the corporate objectives in managing currency risks;

require prompt and accurate information about currency positions, so that
the corporate can then at the centre adjust the consolidated position of the
group to the desired level; and
monitor and take central action to manage the group position.

On the other hand, very few groups centralise:

currency dealing for all their foreign subsidiaries, or

decisions about the currencies in which units sell, or
decisions about the exchange rates used to calculate export selling prices.

Many give guidance and advice, but few directly interfere in the affairs of overseas
subsidiaries. Domestic subsidiaries are another matter, for the prevailing practice is to
have only one currency dealing centre per country.

Total centralisation of currency dealing may be appropriate in a very monolithic single

product group. However, there are diseconomies of dealing from a distance besides '
possibility of demotivation of local managers. A decentralised group that wishes to
manage currency risk for gain may, therefore, ask its overseas subsidizfries to adopt a
defensive, hedge only policy, leaving the corporate centre to deal aggressively for gain.
It might seem as the way to get the best of both worlds. However, there are some other
ways also. A devolved structure may be adopted which permits all profit centres to
make their own currency risk management decisions, but requires them to deal
exclusively with the group centre as their in-house banker. The group centre then, at
their request, gives the profit centre spot or forward deals, swaps, or options, quoting
the best market prices that they could have obtained by dealing direct. It then makes its
own decisions about dealings with the outside world. The group centre is then in
complete control of the group position, free to pursue its own policies; yet, the
operating units are equally free to run their affairs as they choose.
52
 Where currency expertise is for one reason or another centralised as an exception to an Measuring a ad Managing
Translation and Economic
otherwise decentralised management structure, there are two implications. First, the Exposures
need for team work is paramount. Secondly, the central currency management function
should, as far as possible, play a detached part, relying as much as possible on
'guidelines, routine advice on exchange rates and currencies, and as little as possible on
an imposed right to be consulted on day-to-day decisions. This helps to reinforce the
motivation of line managers to run their businesses successfully. The corporate centre
needs a clear view of what exposures are too small and fragmented to be worth
managing, and to issue carefully defined authority limits. Units are free to manage
exposures below those limits as they think fit. All currency positions must, however, be
reported to the centre so that the group exposure can be monitored. The ultimate
constraints on delegation are:

the integral nature of the group's standing in its financial markets; and
the threshhold of tolerable risk.

The process of delegation needs so much care because currency exposures have a way
of being correlated and of being cumulative, both in time and across the spectrum of a
group's sub-units. However, few groups' inflows and outflows are so naturally
balanced that a policy of laissez-faire is safe. Small individual exposures, instead of
cancelling out, have a way of accumulating to major gains or losses for the group. The
most effective place for the head office to manage this is in the parent company,
leaving the profit centres to watch their own solvency criteria. An effective
decentralised structure should be impeded as little as possible. Currency risk
management should achieve its central objectives as unobtrusively as possible.

The dimensions in which currency risk management can be either centralised or

decentralised are:

1. where and by whom currency dealing is done;

2. where and by whom exposures can be authorised and hedging decisions taken;
3. where and by whom it is decided in what currencies to quote prices; and
4. in what currencies intragroup sales are invoiced.

The extreme form of centralisation is where the group centre does all dealing and takes
all decisions. However, a complete absence of central guidelines and authority limits is
rare. The first reason for it is that a group of companies cannot decentralise its credit
rating and investment status in its financial markets. If the parent IS listed, it will have
its stock market quotation on a stock exchange. The stock market treats such a group
as a single financial entity with an integral investment and credit status. Similarly,
banks tend to regard subsidiaries as extensions of the parent, even if the parent will not
formally guarantee them. The parent alone, therefore, has the critical interface with the
fmancial markets. Partly owned subsidiaries may be an exception to this rule. It
follows that only the corporate centre is sensitive to the effect of currency exposures on
the group's financial standing and cost of capital. Managers outside the corporate
centre may take decisions which are either imperfectly targeted or convey unhelpful
signals to the financial markets.

Secondly, because only the centre has the key interface with the financial markets,
wholly owned subsidiaries tend to need less experts for dealing with those markets than
the parent. They may, therefore, lack some of the technical sophistication and
experience needed to handle currency risk in volatile markets. Currency risk is not easy
to handle; few groups can afford expertise in all their subsidiaries or other sub-units.
Where the skills are concentrated at the centre, there is a strong case for letting the
central experts take the critical decisions.

Thirdly, it is often contended that there are economies, particularly in dealing costs, if
transactions are minimised, netted and then centrally handled. On the whole, centralised
exchange risk management seems better option.

53
Foreign E:change Risk Check Your Progress A
Management

1. Define translation exposure.

...........................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................
2. What was the rationale behind introduction of FASB-8 and FASB-52?
...........................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................

9.7 ECONOMIC EXPOSURE DEFINED

Economic exposure relates to 'cash flow' risks. The term cash flow has been defined in
different ways. Cash flow means (1) the total net dividends and liquidation proceeds
available to the owners over future years, (2) the free cash flow, that is earnings before
depreciation minus capital expenditure minus increases in working capital, (3) the future
earnings of the company defined in such a way as to reflect cash earnings rather than
earnings computed on the accrual concept of accounting. The following distinguishing
- . features apply to cash flow risk:

One, the threat is to the competitiveness of costs; it affects the ability of the business to
compete, to obtain sales at a remunerative margin of profit over cost.

Two, the threat is from movements of the real, not the nominal exchange rate. A rise in
the real rate of exchange erodes either margins or sales volume or a mixture of both.
Rise and fall in the real exchange rate of selling currencies tend to affect all
competitors, and are part of the wider phenomenon of macroeconomic uncertainty which
every business must manage. It is thus not primarily a currency risk. This is a trading
risk. All businesses have to watch the forces which affect demand and supply of what
they are offering. This is a wider macroeconomic risk and not just a currency risk.
Currencies are an important part, but not the whole of the relevant economic
environment. Consequently, if there are only two competing suppliers, one with French
avd one with Geman costs, and if the bulk of sales are in the USA or in US dollars, a
fall in the real exchange rate of the dollar would not cause economic or competitiveness
risk. What could cause it is a change in the real FFrIDM exchange rate.

competitiveness risk. In these cases, management task is concerned with nominal, 'not
real exchange rates. Competitiveness risk, thus, excludes all potential sales for which
the business has quoted prices, as well as actual sales, regardless of whether they have
reached the balance sheet as receivables or payables.

Four, the threat is to the competitive position of a business. Strictly, it is to a business

in one or more of its commercial markets, where it incurs appreciable costs in a
currency which may become less competitive.

In sum, economic (competitiveness) risk is concerned with threats from changes in real
exchange rates to the competitiveness of costs.The seriousness of the risk depends on
how hard it is t o shift costs between currencies. For example, the value added by the
contractor for a petrochemical process plant is largely design and management, the
hardware is all procured from manufacturers. The largest item, the compressor, can be
ordered from manufacturers in a number of countries, and if a high real exchange rate
makes the British compressor maker uncompetitive, then the contractor has little
difficulty in switching this major cost item to a supplier with costs in a more
competitive currency. Procurement costs are seldom locked into a particular currency,
- 4
 +
c.

Measuring and Managing

whereas la&& and capital costs are. not easily or rapidly switched. So, contractors are Translation and Economic
better placed than manufacturers to switch costs by switching subcontracts. If the main Exposures
contractor had been a British compressor manufacturer, it would have found it much
harder to purchase the compressor from its Swiss competitor, leaving its own British
workforce to face redundancies.

The sensitivity of a business to competitiveness risk depends on its elasticity of demand.

A competitive strategy of differentiation aims precisely at a more steeply sloping
demand curve. The less price-sensitive customers are, the less damaging is a
deterioration in cost competitiveness.

Competitiveness risk is a long term problem. Trends in real exchange rates can
sometimes be assessed for a few years ahead. Companies can profit from this either by
switching costs to currencies likely to become more competitive or by competitive
strategies which modify sensitivity to cost differentials. The essence of this risk is its
effect on the competitive position, and responses should concentrate on commercial
rather than financial action.

Economic or competitiveness risk is not restricted to businesses which trade with other
countries. If, for example, the business is a single hotel, and the home currency
becomes uncompetitive, less tourists will come and the hotel will lose business. Some
authors like Adler and Dumas (1984) and Wihlborg (1987) treat currency risk as one
element of the wider concept of macroeconomic threats to real (inflation-adjusted) cash
flows. One diffictilty with this is that it ignores the difference between threats caused
by nominal, as op#osed to real exchange rate movements. At a more fundamental
level, however, exchange rates are themselves correlated with, and caused by
macroeconomic phenomena which affect business profitability directly, as well as
indirectly via currency movements. It is thus suggested that a sharp distinction should
be made between external influences on (a) costs; and (b) selling prices. Real
exchange rates tend to have a much more dramatic impact on the competitive costs of a
given competitor than on the market price of what he is offering. This is because only
in conditions of absolute or near monopoly, will the individual competitor set market

9.7.1 Measuring Economic Exposure

Determining a f m ' s true economic exposure is a daunting task, requiring a singular

ability to forecast the amounts and exchange rate sensitivities of future cash flows.
Most f m s that follow the economic approach to managing exposure, therefore, must
settle for a measure of economic exposure and their resulting exchange risk which is
nothing more than intuition. A workable approach may be to use historical data from
the firm's actual operations or, in the case of a new venture, data from a comparable
business. This approach is based on definition of the exchange risk faced by a parent
or one of its foreign affiliates as follows:

A company faces an exchange risk to the extent that variations in the dollar value of
the unit's cash flows are correlated with variations in the nominal exchange rate. This
correlation is precisely what a regression analysis seeks to establish. Specifically, this
involves running the following regression equation:

[CFt = a+ bEXCHt +ut

CFt = the dollar value of total affiliate (parent) cash flows in period t
EXCHt = the average exchange rate during ptriod t
u = a random error term with mean 0

The output from such a regression analysis includes three key parameters: (1) the
fofeign exchange beta 'b' coefficient, which measures the change in cash flow
corresponding to one unit change in exchange rate; (2) the 't' statistic which measures
55
Foreign Exchange Risk the statistical significance of the beta coefficient, and (3) the R square [R~] which
Management
measures the fraction of cash flow variability explained by variation in the exchange
rate. The higher the beta coefficient, the greater the impact of a given exchange rate
change on the home currency value of cash flows. Conversely, the lower the beta
coefficient, the less exposed the firm is to exchange rate changes. A larger 't' statistic
means a higher level of confidence in the value of the beta coefficient. However, even,
if a firm has a large and statistically significant beta coefficient and, thus, faces real
exchange risk, this situation does not necessarily mean that currency fluctuations are an
important determinant of the overall firm risk. What really matters is the percentage of
total corporate cash flow variability that is due to these currency fluctuations. Thus, the
most important parameter in terms of its impact on the firm's exposure management
policy is the regression's R2. For example, if exchange rate changes explain only 1%
of total cash flow variability, the firm should not devote much in the way of resources
to foreign exchange risk management, even if the beta coefficient is large and
statistically significant. The validity of this method is clearly dependent on the
sensitivity of future cash flows to exchange rate changes being similar to their historical
sensitivity. In the absence of additional information, this assumption seems to be
reasonable. But the firm may have reason to modify the implementation of this
method. For example, the nominal foreign currency tax shield provided by a foreign
affiliate's depreciation is fully exposed to the effects of currency fluctuations. If the
amount of depreciation in the future is expected to differ significantly from its historical
values, then the depreciation tax shield should be removed from the cash flows used in
the regression analysis and treated separately. Similarly, if the firm has recently entered
into a large purchase or sales contract fixed in terms of the foreign currency, it might .
decide to consider the resulting transaction exposure apart from its economic exposure.

9.8 MANAGING ECONOMIC EXPOSURE

A manager whose costs become uncompetitive must either get out of that particular
product in its present form, or seek to make his costs competitive. He can only use a
hedge against his costs becoming uncompetitive if he treats the effect of that hedge as
part of the cost structure. In other words, if the hedge does its job, i.e., provides a
financial gain which offsets his costs, he must look at his costs as reduced by the gain
from the hedge. Conversely, however, if his own currency of cost falls in real terms,
he must treat the loss from the hedge as an extra cost which denies him the benefit of
the improvement in the competitiveness of his own currency. It is not easjl to see
many managers readily accepting that. It would obviously be dangerous commercial
policy where the company has a local competitor in its own country. With a falling
real exchange rate, it would lose market share to that competitor unless that competitor
had adopted an identical hedging policy. Otherwise, the competitor would be free to
reduce prices or collect higher margins. Generally speaking, no manager will handicap
his company when its economic environment is favourable.

Practical opportunities to manage competitiveness risk occur in two types of

circumstances. The first is whenever plans are made. A business can seek to improve
its competitive position by arranging, as far as practicable, to incur its costs in
currencies expected to be relatively competitive during the critical period. '
Competitiveness risk and the real exchange rate should be taken into account in all
investment and other planning decisions. How decisive a role this consideration will
play will depend on the circumstances of each case. Often, it will play only a minor
role. In.any event, the planning process will be better informed if t r d s in the real
exchange rate and its effect on costs over the planning period are taken into account.
The second set of circumstances is whenever a deterioration in trading performance is
being analysed, or where other evidence comes to hand that the currency of major costs
is becoming less competitive. Where trading performance has deteriorated, a rising real
exchange rate is, of course, only one of many possible explanations. However,
whenever other explanations have been eliminated and yet market share is being lost to
foreign competitors, there must be a strong chance that the real exchange rate has done
the damage. Again, the opportunity to manage such situation will depend on whether
some of the following courses of action are available to the management:
.One, shift costs into a more competitive currency, or Measuring r~ndManaging
Translation r~ndEconomic
Two, increase the degree of differentiation of the company's competitive offering, so as Exposures
to make it less price-sensitive.

The first can be used aggressively, the second is defensive in the context of the real
exchange rate. It can, of course, be used as an aggressive competitive strategy.
However, neither of these remedies is always promptly available. Competitiveness risk
has to be managed opportunistically. Where there are opportunities, they must be
seized. Where they do not exist, they can sometimes be created. In any case, it is
difficult to believe in effective countermeasures outside the commercial markets.
-Financial hedges can at best be a temporary palliative, at worst a millstone around the
company's own neck.

A cost portfolio may also be considered. The more balanced the production is a h m g
different currencies of cost, the less the risk of the total portfolio. Two-pronged
benefits result from this approach. The portfolio may by itself bring reduction of risk;
and a portfolio of underutilised capacity could be exploited to switch production from
less to more competitive currencies when real exchange rates move. However, this
concept can be contemplated only by multinationals. The deliberate creation of spare
capacity may not be economic. Labour relations might be difficult if work is shifted as
an explicit act of policy rather than as a last resort after a site has become manifestly
uneconomic. Besides, a commercial response to a rise in the real exchange rate
requires strong evidence of the rise in the real exchange rate. Any minor change in the
real exchange rate is unlikely to justify action.

The focus on the real (economic) effects of currency changes and how to cope with the
associated risks suggests that a sensible strategy for exchange risk management is one
that is designed to protect the home currency earning power of the company as a
whole. But whereas firms can easily hedge exposures based on projected foreign
currency cash flows, competitive exposures - those arising from competition with firms
based in other currencies - are longer-term, harder to quantify, and cannot be dealt with
solely through financ,ial hedging techniques. Rather, they require making longer-term
operating adjustments such as the following:

9.8.1 Marketing Initiatives

To the extent that exchange rate changes do bring about relative price changes, the
firm's competitive situation will be altered. As a result, management may wish to
adjust its marketing m k o r its production process to accommodate the new set of
relative prices. Market selection, market segmentation, product strategy, pricing strategy
and promotional strategy may all form part of marketing initiatives.

Market Selection and Segmentation

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. It is
also necessary to consider the issue of market segmentation within individual countries.
A firm that sells differentiated products to more affluent customers may not be harmed
as much by a foreign currency devaluation as will a mass marketer. On the other hand,
%llowing a depreciation of the home currency, a firm that sells primarily to upper
income groups may find it is now able to penetrate mass markets abroad. Market
selection and segmentation provide the basic parameters within which a company may
adjust its marketing mix over time. In the short term, however, neither of these two
basic strategic choices can be altered in reaction to actual or anticipated currency
changes. Instead, the firm must select certain tactical responses such as adjustments of
pricing, promotional and credit policies. In the long run, if the real exchange rate
change persists, the firm will have to revise its marketing strategy.

Pricing Strategy

Two key issues that must be addressed when developing a pricing strategy in the face
of cl1rrencv volatility are whether to emphasise market share or profit margin and how
Foreign Exchange Risk frequently to adjust prices. To begin the analysis, a firm selling overseas should follow
Management the standard economic proposition of setting the price that maximises profits in home
currency. In making this determination, however, profits should be translated using the
forward exchange rate that reflects the true expected home currency value of the
receipts upon collection. Following appreciation of the home currency, which is
equivalent to a foreign currency depreciation, a firm selling overseas should consider
opportunities to increase the foreign currency prices of its products. The problem, of
course, is that local producers will now have a competitive advantage, limiting an
exporter's ability to recoup home currency profits by raising foreign currency selling
prices. At best, therefore, an exporter will be able to raise its product prices by the
extent of the foreign currency devaluation. In the most likely case, foreign currency
prices can be raised somewhat, and the exporter will make up the difference through a
lower profit margin on its foreign sales.

Under conditions of home currency depreciation, it follows that exporters will gain a
competitive advantage on the world markets. An exporter now has the option of
-
increasing unit profitability that is, by price skimming or expanding its market share
by penetration pricing . 'The decision is influenced by such factors as (1) whether this
change is likely to persist, (2) economies of scale, (3) the cost structure of expanding
output, (4) consumer price sensitivity, and (5) the likelihood of attracting competition if
-
high unit profitability is obvious. The greater the price elasticity of demand the
-
change in demand for a given change in price the greater the incentive to hold down
price and thereby expand sales and revenues. Similarly, if significant economies of
scale exist, it will generally be worthwhile to hold down price, expand demand, and
thereby, lower unit production costs. The reverse is true if economies of scale are
nonexistent or if price elasticity is low.

As regards 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. However, other
companies feel that stable prices are a key ingredient in maintaining their customer
base. It is also important not to neglect the effect of frequent price changes on the
exporters' distributors who must constantly adjust their margins to conform to the prices
they pay. A number of firms now have different list prices for domestic and foreign
customers in order to shield their foreign customers - especially those who sell through
-
catalogues from continual revisions of overseas prices.

In .respect of domestic price after devaluation, a domestic firm facing strong import
competition may have much greater latitude in pricing. It then has the choice of
potentially raising prices consistent with import price increases or of holding prices
constant in order to improve market share. Again, the strategy depends on such
variables as economies of scale and consumer price sensitivity.

Promotional Strategy

Promotional strategy should similarly take into account anticipated exthange rate
changes. A key issue in any marketing programme 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. A firm exporting its products after a domestic devaluation may well find that
the return per rupee expenditure on advertising or selling is increased because of the .
product's improved price positioning. Foreign currency devaluation, on the other hand,
is likely to reduce the return on marketing expenditures and may require a more
fundamental shift in the firm's product policy.

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. For example, the period after a home currency
depreciation, because of the competitive price advantage, may be the ideal time to
develop a brand franchise. Exchange rate fluctuations also affect product line decisions.
Following home currency devaluation, a firm will potentially be able to expand its Measuring and Managing
Translation and Economic
product line and cover a wider spectr~mof consumers.both at home and abroad. Exposures
Conversely, following appreciation of the home currency, a firm may have to reorient
its product line and target it to a higher-income, more quality conscious, less price
sensitive constituency. The equivalent strategy for firms selling to the industrial rather
than the consumer market and confronting a strong home currency is product innovation
financed by an expanded research and development budget.

9.8.2 Production Initiatives

The adjustments discussed above involve attempts to alter the home currency value o f
foreign currency revenues. But, sometimes exchange rates move so much that pricing
or other marketing strategies cannot save the product. Product sourcing and plant
location are the principal variables that companies manipulate to manage competitive
risks that cannot be dealt with through marketing changes alone. Consider, for
example, the possible responses of Indian firms to a strong rupee. The basic strategy
would involve shifting the firm's manufacturing base overseas which can be
accomplished in more than one way as discussed below:

Outright additions to facilities overseas naturally acconiplish a manufacturing shift. A

more flexible solution is to purchase more components overseas. For a firm already
manufacturing overseas, the cost savings associated with using a higher proportion of
domestically produced goods and services, following local currency depreciation, will
depend on subsequent price behaviour. Goods and services used in international trade,
or with a high import content, will exhibit greater home currency price increases than
those with a low import content or with little involvement in international trade. For
the longer term, while increasing production capacity, the firm should consider the
option of designing new facilities that provide added flexibility in making substitutions
among various sources of goods. The advantages of being able to respond to relative
price differences among domestic and imported inputs must be weighed, of course,
against the extra design and construction costs.

Shifting Production among Plants

Multinational firms with worldwide production systems can allocate production among
their 'several plants in line with the changing costs of production; increasing production
in a country whose currency has devalued, and decreasing production in a country
whose currency has revalued. Multinational firms may well thus be subject to less
exchange risk than an exporter, given the MNC's greater ability to adjust its production
(and marketing) operations on a global basis, in line with changing relative production
costs. Of course, the theoretical ability to shift production is more limited in reality.
The limitations depend on many factors, not the least of which is the power of the local
labour unions involved. However, the innovative nature of the typical MNC means a
continued generation of new products. The sourcing of those new products from among
the firm's various plants can certainly be done with an eye to the costs involved. A
strategy of production shifting presupposes that the MNC has already created a portfolio
of plants worldwide. Multiple sources allow a company to offer the best economies of
production, given exchange rates at any moment. But multiple plants also create
manufacturing redundancies and impede cost cutting. The cost of multiple sourcing is
especially excessive where there are economies of scale that would ordinarily dictate the
establishment of only one or two plants to service the global market. But most firms
have found that in a world of uncertainty, significant benefits may be derived from
production diversification. Hence, despite the higher costs associated with smaller
plants, currency risk may provide one more reason for the use of multiple production

Plant Location

An exporter, without foreign production facilities, may find that sourcing components
abroad is not sufficient to maintain unit profitability in the fact; of currency devaluation
of its importer. Despite its previous hesitancy, the firm may now locate new plants
59
; Foreign Exchange Risk abroad. Third country plant locations are also a viable alternative in many cases,
Management
dependin,wspecially on the labour intensity of production or the projections for fbther
monetary realignments. Many Japanese firms, for example, have shifted production
offshore - to Taiwan, South Korea, Singapore and other developing nations, as well as
to the United States - in order to cope with the high yen. Before making such a major
commitment of its resources, management should attempt to assess the length of time a
particular country will retain its cost advantage. Yet, shifting production abroad when
the home currency rises is not always the best approach. Production at home improves
coordination between design and manufacturing and avoids problems of quality control.
For firms that rely heavily on such coordination and closeness to suppliers, raising .
domestic productivity is preferable to producing abroad.

Raising/F'roductivity
/
Ma y companies assaulted by foreign competition make prodigious efforts to improve
-
P("
t eir productivity closing inefficient plants, automating heavily, and negotiating wage
and benefit cut-backs and work-rule concessions with unions. Many also begin
programmes to heighten productivity and improve product quality through employee
motivation. Others, however, seek import restrictions from the government.

The marketing and production strategies advocated thus far assume knowledge of
exchange rate changes. Even if currency changes are unpredictable, however,
contingency plans can be made. This planning involves developing several plausible
currency scenarios, analysing the effects of each scenario on the firm's competitive
position, and deciding on strategies to deal with these possibilities. When a currency
change actually occurs, the firm is able to quickly adjust its marketing and production
strategies in line with the plan. Given the substantial costs of gathering and processing
information, a firm should focus on scenarios that have a high probability of occurrence
and that would also strongly impact it. The ability to plan for volatile exchange rates
has fundamental implications for exchange risk management because there is no such
thing as the 'natural' or 'equilibrium' rate. Rather, there is a sequence of equilibrium
rates, each of which has its own implications for corporate strategy. Success in such
an environment depends on a company's ability to react to change within a shorter time
horizon than ever before. To cope, companies must develop competitive options - such
as outsourcing, flexible manufacturing systems, a global network of production facilities
and shorter product cycles. In a volatile world, these investments in flexibility are
likely to yield h~!zll returns. For example, flexible manufacturing systems permit faster
production respurlse times to shifting market demand. Similarly, foreign facilities, even
if they are uneconomical at the moment, can pay off by enabling companies to shift
production in response to changing exchange rates or other relative cost shocks.

The greatest boost to competitiveness comes from compressing the time it takes to bring
new and improved products to market. The edge a company gets from shorter product
cycles is dramatic. Not only can it charge a premium price for its exclusive products,
but it can also incorporate more up-to-date technology in its goods and respond faster to
emerging market niches and changes in taste.

9.8.3 Financial Initiatives

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 drving 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 that portion of a firm's assets used to create
export profits in such a way that any shortfall in operating cash flows due to an
exchange rate change is offset by a 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. The implementation of a hedging policy is likely to be quite
difficult in practice, if only because the specific cash'flow effects of a given currency
change are hard to predict. Trained personnel are required to implement and monitor Measuring and Managing
Translation and Ecornomic
an active hedging programme. Consequently, hedging should be undertaken only when Exposures
the effects of anticipated exchange rate changes are expected to be significant. The
approach, of course, concentrates exclusively on risk reduction rather than on cost
re~luction. Where financial market imperfections are significant, a firm might consider
exposing itself to more exchange risk in order to lower its expected financing costs.

Currency risk affects all facets of a company's operations; therefore, it should not be
the concern of financial managers alone. Operating managers, in practice, should
d~:velop marketing and production initiatives that help to ensure profitability over the
long run. They should also devise anticipatory or proactive, rather than reactive
slrategic alternatives in order to gain competitive leverage internationall- The key to
effective exposure management is to integrate currency considerations into the general
management process. One approach used by a number of MNCs is to develop the
r~ecessarycoordination among executives responsible for different aspects of exchange
risk management by constituting committee for managing foreign exchange exposures.
13esides financial executives, such committees should - and often do - include senior
officers of the company such as the vice president - international, top marketing and
.production executives, the director of corporate planning, and the chief executive officer.
This arrangement is desirable as top executives are exposed to the problems of
exchange risk management and they can then incorporate currency expectations into
their- own decisions. In this kind of integrated exchange risk management programme,
the role of the financial executive is fourfold: (1) to provide local operating
management with forecasts of inflation and exchange rates, (2) to identifL and highlight
the risks of competitive exposure, (3) to .structure evaluation criteria such that operating
managers are not rewarded or penalised for the' effects of unanticipated currency
changes, and (4) to estimate and hedge whatever operating exposure remains after the
appropriate marketing and production strategies have been put in place.

Check Your Progress B

1. What is economic exposure?

............................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................
2. Among three exposures which is difficult to manage and why?
...........................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................
3. Distinguish between transaction and economic exposure.
...........................................................................................................................................
...........................................................................................................................................
...........................................................................................................................................

9.9 LET US SUM UP

Exposure is the amount at risk. Exposures to foreign exchange rate fluctuations can be
defined either in accounting terms or in future cash inflow and outflow terms. While the
fonner is generally referred to as translation exposure,, the latter is more appropriately
called the economic exposure. Economic exposure indudes all those hture sales,
purchases and other transactions which are either uncommitted or commercially
uncertain. Many of these like uninvoiced postnatal trading risks, will not be included
in an accounting balance sheet. The position is measured in the yardstick currency in
which the company monitors its performance and net worth. Economic exposure leads
to competitiveness risk - the threat to the competitiveness of a company's costs from
rise in real terms of the currency in which those costs a, .: incurred. The cause of the 61
Foreign Exchange Risk risk is the interaction between commercial and currency markets, in which prices move
Managenlent
at very different speeds. Competitiveness risk is not a short tcrm phenomenon. It
cannot be managed day by day. It takes longer periods to recognise shifts in real
exchange rates, and the management actions to deal with the risk are strategic rather
than tactical, and can only be taken infrequently. The risk affects companies in their
commercial rather than in their financial markets . The action can be on the demand
side, by repositioning commercial offerings in less competitive submarkets or segments,
or on the supply side by shifting costs into a more competitive currency. This last
action is possible because real exchange rates are slower to move and more predictable
than nominal rates. Financial market hedges are unlikely to provide suitable answers to
problems in the commercia! markets. Thus, although exchange risk is conceptually
easy to identify, it is difficult in practice to determine what the actual economic impact
of a currency change will be. For a given firm, this impact depends on a large number
of variables including the location of its major markets and competitors, supply and
demand elasticities, substitutability of inputs, and offsett~nginflation. Regression
techniques may be applied, of course with the assumption that the past is representative
of the future.

The parent needs to control the group's currency gains and losses over the short and
long periods for which it plans. This is important because group currency gains and
losses have a direct impact on the reported group results, net worth and gearing, which
are the focus of attention in financial markets. Even if the group does not wish to
hedge its accounting exposure, it may still wish to watch it. For this task, the parent
needs to know all non-parent currency positions. The parent can then restore zero risk
by taking a mirror-image position to the rest of the group's net total in each currency.
It can do this, for example, by the use of spot or forward hedges or currency swaps.
The biggest problem is often to get accurate up-to-date information on the net non-
parent positions. The most extreme form of centralistion is to make not only risk
management, but also dealing, the sole prerogative of the corporate centre; currency
management in that case simply bypasses the subsidiaries and other profit centres.

9.10 KEY WORDS

Accounting Exposure: Accounting exposure arises from the need to convert the
financial statements of foreign operations from foreign currencies to home currency; the
restatement of assets, liabilities, revenues and expenses at prevailing exchange rates will
result in exchange gains and losses.

Economic Exposure: Economic exposure is based on the extent to which the value of
the company - as measured by the present value of its expected future cash flows - will
change when exchange rates change.

CurrenUNon-Current Method: Under this method of translation of financial statements,

current assets and liabilities of a foreign subsidiary are translated at the current rate and
non-current assets and liabilities are translated at the historical rate. Depreciation is
similarly translated at the historical rate. The other items of the income statement are
translated at the average exchange rate prevailing during the given period.

MonetaryINon-Monetary Method: Under this method of translation of financial

statements, all monetary items like cash, accounts payablestreceivables, short-termllong-
term debt, etc. of a foreign subsidiary are translated at the current rate and all non-
monetary, i.e., physical assets are translated at the historical rate.

Temporal Method: This method resembles the monetarylnon-monetary method in all

respects, except that inventory under this method may be translated at the current rate if
it is shown at market value in the balance sheet.

Current Method: This method is the simplest of all in the sense that all items of
income statement and balance sheet are translated at the current rate.

FASB 8: This was an accounting standard issued by the US FASB under which all
gains and losses arising as a result of foreign exchange rate fluctuations were required
62
 to tle shown in the income statement. No reserve was allowed to be maintained in the Measuring and Managing
Translation and Economic
balance sheet. Expofiures

FASB 52: This accounting standard reversed the earlier FASB 8. A reserve capturing
foreign exchange gains and losses was, thereby, permitted to be maintained under this
i standard. This method also distinguished between functional and local currency.
Foreign subsidiaries must prepare their accounting statements in functional currency if
the local currency is one affected by high inflation.

Funds Adjustment: This method of managing translation exposure involves altering

. either the amounts or the currencies (or both) of the planned cash flows of the parent
at~dlorits subsidiaries to reduce the firm's local currency accounting exposure.

Marketing Initiatives: The design of a firm's marketing strategy under conditions of

home currency fluctuation presents considerable opportunity for gaining competitive
Izverage. 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 selecting appropriate
markets, and adjusting pricing and product policies which may involve changing the
foreign currency price andlor introduction of new products.

Production It~itiatives: Multinational firms with worldwide production systems use this
method of exchange risk management effectively as they are able to allocate production
among their several plants, locating new plants overseas and improving productivity
through employee motivation, automation, etc.

Financial Initiatives: This involves managing cash flows in such a way that any
sl~ortfallin operating cash flows due to an exchange rate change is offset by a
reduction in debt servicing expenses. The approach, of course, concentrates exclusively
on risk' reduction rather than on cost reduction.

9 . 1 TERMINAL QUESTIONSIEXERCISES
1. Distinguish between translation and transaction exposure?
2. Discuss various translation methods in vogue?
3. What hedging strategies would you employ in order to manage translation and
economic exposures? How do these strategies differ from those usually
employed to manage transaction exposures?
4. What are the factors determining centralisationldecentralisation of exchange risk
management? Which policy would you advocate for Indian multinationals?

63
Foreign Excbangc Risk
Manmcmcnt SOME USEFUL BOOKS 1
Dombusch, Adler, 'Currency Risk Management', Oxwell Publishing House, London,
1991 I