Foreign Exchange Risks Nov Nov (1)

8/4/2019 Foreign Exchange Risks Nov Nov (1)

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Foreign Exchange

Risk Management


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Foreign Exchange Risks

Transaction Risk

Translation Risk

Economic Risk


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Transaction Risk

The risk of changes in the expected value of acontract between its signing and its execution as aresult of unexpected changes in foreign exchange

rates. Whoever makes a contract denominated in a

foreign currency bears transaction risk.

Ocean Drilling has transaction risk if it borrows

money in French francs or Japanese yen, andHintz-Kessels-Kohl has transaction risk if it agreesto accept future payments for its vehicles in U.S.dollars.


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Translation Risk Gains or losses from exchange rate changes that

occur as a result of converting financial statementsfrom one currency to another in order toconsolidate them.

Every company having at least one subsidiaryusing a different functional currency bearstranslation risk.

MSDI has translation risk from having asubsidiary, MSDI Alcala de Henares, whosefinancial statements are kept in Spanish pesetasand not in U.S. dollars.


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Economic Risk

Changes in competitive position as a result of

permanent changes in exchange rates.

Every company buying or selling abroad or evenjust competing with foreign companies has

economic risk.

Maybach has economic risk from manufacturing

its automobiles in Germany for export to the

United States, where it competes with Rolls

Royces manufactured in England.


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Transaction Risk


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Passive Transaction Risk

Management Denominate all contracts in domestic

currency. This is a possible strategy for

companies with market power.

Do nothing about transaction risk. This is a

possible strategy for companies with a large

number of small contracts in a large numberof currencies.


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Natural Transaction Risk Hedging

Centralize cash management to net all

offsetting transactions, transactions which

are long and short the same currency.

Time, lead and lag, offsetting business

transactions in the same currency.

Create offsetting business transactions inthe same currency.


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Hedging

Insuring against transaction risk to reduce or

eliminate the effects ofunexpectedchanges in

exchange rates. You can hedge only at market rates. The effects

ofexpectedchanges in exchange rates are

incorporated in these market rates.

Hedging is insurance. The purpose of hedging

is to reduce or eliminate risks, not to make

profits.


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Market Transaction Risk

Hedging Forward Markets

Futures Markets Money Markets

Options Markets


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Translation Risk


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Example of Translation Risk

RUCHI INDUSTRIES intends to set up a marketingsubsidiary in the United States.

It loans this subsidiary 125,000 RUPEES whenthe exchange rate is 45 RUPEES/USD.

The USD 2777 (125,000/45) is deposited in anaccount at a U.S. bank.

RUCHI INDUSTRIES credits cash and debits a newasset, loan to subsidiary, for 125,000 RUPEES .

The subsidiary debits cash and credits a newliability, loan from parent, for 2777 USD.


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Financial Statement

Consolidation No other transactions have occurred, and the cash

remains in the account at the U.S. bank.

The tolar has strengthened, and the exchange rateis now 48 RUPEES/USD.

The financial statements ofRUCHI INDUSTRIES

and its subsidiary must be consolidated for

financial reporting at the end of the fiscal year.


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Convert at Current Rate

The cash is worth 133296 RUPEES (2777 x 48).

On the subsidiary statements, the loan from parent

is also worth 133296 RUPEES (2777 x 200). The subsidiary balance sheet balances.

But on the RUCHI INDUSTRIES statements, theloan to subsidiary is still 125,000 RUPEES

The loan to subsidiary and the loan from parentno longer offset each other.


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Is the Loss Real?

Yes. RUCHI INDUSTRIES has lost in tolar value as aresult of transaction risk; that is, making a loandenominated in a foreign currency. Had they kept that

money in Slovenia, they could be doing more with it now. No. RUCHI INDUSTRIES has lost nothing in dollar value.

The ability of the subsidiary to perform its economicfunction has not changed as a result of the exchange ratechange. Had the subsidiary belonged to a U.S. company,

the exchange rate change would have been completelyirrelevant. RUCHI intended the subsidiary to besuccessful and did not intend to get the cash back. It cannot

lose what it never intended to have.


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Market Transaction Risk

Hedging Forward Markets

Futures Markets

Money Markets

Options Markets


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Forward and Futures Markets

Any currency, any amount,any maturity

Illiquid

Self-regulated OTC market

Contract with dealer

Requires credit-worthiness

Cash flow only at maturity

Settled by executing contract

Hedge by buying forward theshort currency or sellingforward the long currency

Selected currencies, standardcontracts, standard maturities

Liquid

Government-regulated

exchange-based market Contract with exchange

Requires margin account

Marked to market daily

Settled by offsetting trade

Hedge by making a transactionwhose gains or losses offsetthose of the underlying

position


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Forward and Money Markets

Money markets can always be used to synthesizeforward markets.

Money market rates are used to set forward marketrates.

Money market transactions are likely to be morecostly than forward market transactions, since

three transactions having their own bid-askspreads are required to duplicate one forwardmarket transaction with one bid-ask spread.

Money market transactions appear on the balance

sheet; forward market transactions do not.


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THANK YOU..AKHIL DHAMIJA

FIB1003

Foreign Exchange Risks Nov Nov (1)

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