Module-5

Foreign Exchange Exposure or Risk / Types

of Exchange Rate Risk
• A firm dealing with foreign exchange may be exposed to foreign
currency exposures. The exposure is the result of possession of assets
and liabilities and transactions denominated 'in foreign currency.
When exchange rate fluctuates, assets, liabilities, revenues, expenses
that have been expressed in foreign currency will result in either
foreign exchange gain or loss. A firm dealing with foreign exchange
may be exposed to the following types of risks:
Transaction Exposure
• A firm may have some contractually fixed payments and receipts in
foreign currency, such as, import payables, export receivables,
interest payable on foreign currency loans etc. All such items are to be
settled in a foreign currency. Unexpected fluctuation in exchange rate
will have favorable or adverse impact on its cash flows. Such
exposures are termed as transactions exposures.
Translation Exposure:
• The translation exposure is also called accounting exposure or balance
sheet exposure. It is basically the exposure on the assets and liabilities
shown in the balance sheet and which are not going to be liquidated
in the near future. It refers to the probability of loss that the firm may
have to face because of decrease in value of assets due to devaluation
of a foreign currency despite the fact that there was no foreign
exchange transaction during the year.
Economic Exposure:
• Economic exposure measures the probability that fluctuations in
foreign exchange rate will affect the value of the firm. The intrinsic
value of a firm is calculated by discounting the expected future cash
flows with appropriate discounting rate. The risk involved in economic
exposure requires measurement of the effect of fluctuations in
exchange rate on different future cash flows.
• Q-1
• M/s Omega Electronics Ltd. exports air conditioners to Germany by
importing all the components from Singapore. The company is
exporting 2,400 units at a price of Euro 500 per unit. The cost of
imported components is S$ 800 per unit. The fixed cost and other
variables cost per unit are Rs. 1,000 and Rs. 1,500 respectively. The
cash flows in Foreign currencies are due in six months. The current
exchange rates are as follows:
The techniques designed to hedge Transaction
exposure may be broadly divided into two –
Invoicing
• – Invoicing as an internal hedging technique involves drawing the
invoice in home currency. Thus, if the terms of the trade permit, an
Indian importer / exporter should have the invoice drawn in INR.
Normally, invoice is drawn in the seller’s currency. However, if the
bargaining power of the buyer is high, it could be otherwise. Invoicing
may be in a third currency or there may be a case of dual invoicing i.e.
invoicing partly in the seller’s currency & partly in the buyer’s
currency.
Leading and Lagging
• Q-2
• Kamat Ltd is importing a special equipment from US for an amount
$50,000, payable in 3 months. The current spot rate US $ 1 =
Rs.45.35. It is expected that the dollar will strengthen against rupee in
3 months and the spot rate at the end of 3 moths would be Rs.46.50.
The borrowing cost is 8% p.a. Calculate the cash flow of transaction.
• Q-3
• D Ltd is supplying goods worth $1,00,000 to US importer and the
amount is payable after 4 months time. The current spot rate US $ 1 =
Rs.45.36. It is expected that the Rs. will strengthen against $ in 4
months and the spot rate at the end of 4 moths would be Rs.44.50.
The importer accepts to pay immediately if 2% cash discount is
offered by D Ltd. The current borrowing rate is 8%.
Netting
• Q-4
• Following are the details of cash inflows and outflows in foreign currency
denominations of MNP Co. an Indian export firm, which have no foreign subsidiaries:
• Q-5
• A UK Company has its subsidiaries in three countries- India, USA and South Africa. At
the end of the year the inter- Company balances were as follows:
Hedging of Foreign Exchange receivable/
Payable through Option
• In Forex, hedging is done in following ways:
• If LHC is to be sold in future, then we should buy Put option for
hedging of sale price of LHC at given strike rate.
• If LHC is to be purchased in future, then we should buy Call option for
hedging of purchase price of LHC at given strike rate.
• Q-6
• Q-7 A Ltd of U K has imported some chemical worth of USD 3,64,897 from one of the US suppliers. The
amount is payable in six months time. The relevant spot and forward rates are:
• Spot Rate USD 1.5617 – 1.5673
• 6 months Forward Rate USD 1.5455 – 1.5609
• The borrowing rates in UK and US are 7% and 6% respectively and the deposit rates are 5.5% and 4.5%
respectively.
• Currency options are available under which one option contract is for GBP 12,500. The option premium for
GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096 (put option) for 6 months
period.
• The company has three choices:
• (i) Forward Cover [Ans: GBP 236102.89]
• (ii) Money Market Cover; and [Ans: GBP 236510.10]
• (iii) Currency Option [Ans: GBP 227923.00]
• Which of the alternatives is preferable by the company?
Translation/Accounting exposure
Methods of Translation
• Q-8
Q-9