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Study On Various Types Of Foreign Exchange Risk Finance Essay

In simple words Probability of loss occurring from an adverse movement in foreign exchange rates .i.e. the risk that the exchange rate on a foreign currency will move against the position held by an investor such that the value of the investment is reduced. For example, a Malaysian exporter who exports palm oil to India, for future payments in rupees is faced with the risk of rupee depreciating against the ringgit when the payment is made. This is because if rupee depreciates, a lesser amount of ringgit will be received when the rupee are exchange for ringgit. Therefore, what originally seemed a profitable situation could turn out to be a loss due to exchange rate fluctuation. Also called exchange rate risk.

An asset, liability, profit or expected future cash flow stream (whether certain or not) is said to be exposed to exchange risk when a currency movement would change, for better or worse, its home currency value. The term exposure used in the context of foreign exchange means that a a firm has assets, liabilities, profits or expected future cash flow streams such that the home currency value of assets, liabilities, profits or the present value in the home currency terms of expected future cash flow changes as exchange rate changes. Risk arises because currency movements may alter home currency values.

But some expected future cash flows denominated in home currency may also be exposed. For example a UK company selling in its home market may be competing with firms based in the Netherlands. In such circumstances changes in the sterling/guilder exchange rate will almost certainly effect the present value of the UK companys expected cash flows by strengthening or weakening its competitive positions against its Dutch rivals.

Foreign exchange exposure is usually classified according to whether it falls into one or more categories:

1. Transaction exposures;

2. Translational exposure;

3. Economic exposure

Transaction Exposure

Transaction exposure arises because the cost or proceeds (in home currency) of settlement of a future payment or receipt denominated in a currency other than the home currency may vary because of changes in exchange rates. �For example, suppose that a company borrows 2 million French francs when the exchange rate is FF4/�1. The company records the liability on its book at the pound equivalent of the amount borrowed, �500000. If the loan is repaid as an exchange rate of FFf3/�1 the company must spend �666, 67 to acquire the �2 million French francs necessary to liquidate the debt. The additional �166, 67 necessary to repay the loan is a exchange loss in that complete transaction.� Clearly transactional exposure is a cash flow exposure. It may be associated with the trading flows (such as foreign-currency-denominated in trade debtors and trade creditors), dividend flows or capital flows (such as foreign-currency-denominated dividends or loan repayments). It can be thought of as a short-term component of economic exposure. Transaction exposure measures the effect of currency value change specifically on the operating performance of the firm.

Translational Exposure

Translational exposure is the risk of net worth of a company changes because of the fluctuating home valuation of assets and liabilities denominated in foreign currencies.it arises on the consolidation of foreign-currency-denominated assets and liabilities in the process of preparing consolidated accounts. This may include foreign currency loans and investment.

Translation exposure may be segmented into two distinct parts:

1. Profit translation exposure � The exposure resulting from the translation of earnings in a foreign currency of a company�s account. It impacts on the profit and loss account of the year.

2. Balance sheet translation exposure � The fluctuation in the home country value of foreign assets and liabilities due to movements in exchange rate.

The concept of translation exposure

Translation exposure is measured by taking the difference between a firm�s exposed currency assets and liabilities. An excess of exposed assets over exposed liabilities (i.e. those foreign currency items translated at current exchange rates) give rise to a net exposed asset position , referred to as a �positive exposure�. Devaluation of the foreign currency relative to the home currency produces a translation loss as the domestic currency equivalence of the currency net assets is less after devaluation than before. Revaluation of the foreign currency would produce a translation gain. Conversely a company experiences a net exposed liability position or negative exposure whenever exposed liabilities exceeds exposed assets. In this instance devaluation of the foreign currency gives rise to a translation gain as the home currency equivalence of the net foreign currency liabilities decreases following the devaluation. Revaluation of the foreign currency gives rise to a translation loss. Transactional exposure can be managed by fully, matching assets and liabilities in the overseas currency, whenever possible, but this may result in loosing control of consolidated gearing. There is a also a problem of trying to match assets to liabilities in countries where there are no sophisticate capital markets or in other case a perfect match is not necessary desirable. Companies have attempted to get round this by either using grouping currencies together or using a proxy currency or a basket currency.

Economic exposure

Economic exposure is concerned with the present value of future operating cash flows to be generated by company�s activities and how this present value , expressed in parent currency changes following exchange rate movement. The concept of economic exposure is most frequently applied to a company�s expected future operating cash flows (unhedged) from sales in foreign currency and from foreign operations. but it can equally well applied to a firm�s home territory operations and extent to which the present value of those operations alter resultant upon changed exchange rates.

Economic exposure is also a cash flow exposure like transaction exposure although a transaction exposure is one that is readily identifiable in the currency in which it arises. Transaction exposure is a subset of economic exposure. However economic exposure is taking place on continuing basis, it has no time limit, nor a defined direction of movement. The term Economic exposure may be used to describe any exposure which is forecast to become a transaction exposure in due course-although if the forecast can be made fairly, accurately, this would regarded rather as a transaction exposure. Once the exposure is uncertain, or not genuinely in the currency in which transaction is setteled.it is most subtle and insidious of all the type of exposure, and has a potential to ruin a company, but to do it in a very surreptitious manner. The simplest example is when a forecast transaction (expected sale) does not occur. �For example we expected �500 million and the actual sale is only �300 million, so the balance �200 will be the exposure which we expected but never occur.� Another example is where the currency underlying the economics of goods and services is not the same as currency of payment. Suppose �for example if a company is paying for fuel in French Francs but the price of the fuel in the medium term is linked to the US dollar- because that is the currency in which oil is traded internationally. The fuel purchase which has already been invoiced but not paid clearly represents a French franc risk � a transaction exposure. But future purchases represent a US dollar risk � an economic exposure.� If the dollar strengths, the cost will rise, so that the company must buy dollars if it wishes to hedge against the risk.

Economic exposures relates directly to the competitive position for a firm within the ever, more global trading community. For example, both jaguar and Porshe sell cars to the US markets where they compete at the luxury end. Both clearly have an economic exposure to the level of the US dollar against their home currencies. They also have because of the cost base in their manufacturing territories, an economic exposure to the �/DM rate.

We have studied above all the espousers that a company has to face now it will be more clear in the following example of a big company:-

Duni is a leader in Europe in the design, production and marketing of high-quality table covers, napkins, candles and other table setting products. Duni also offers packaging and packaging systems to the growing take-away market. The Duni brand is sold in over 40 markets and enjoys a number one position in Central and Northern Europe. We have about 2,000 employees in 17 countries. Our headquarters are in Malm� and our production units are in Sweden, Germany and Poland. The company is listed on the NASDAQ OMX Stockholm. The largest markets are in Central and Northern Europe, but globally more than 40 markets are covered in Europe, the Middle East, Africa and Asia.

Duni operates internationally and is exposed to currency risks which arise from various currency exposures. The Group's exposure to changes in exchange rates may be described as translation exposure and transaction exposure.

Duni manages its translation exposure and transaction exposure by concentrating the exposure to a small number of group companies and through a finance policy adopted by the Board of Directors.

Translation exposure

Items included in each individual subsidiary's annual report are calculated based on the currency of the country in which the subsidiary has its primary financial and/or legal domicile (functional currency). The Parent Company's annual report is presented in Swedish kronor (SEK), which is the Group's presentation currency. Translation from each company's functional currency to SEK does not give rise to any cash flow and thus this exposure is not hedged. The Group is, however, exposed to another type of translation exposure which occurs in the balance sheets of the individual group companies due to the fact that such balance sheets may include items in a currency other than such group company's functional currency. Revaluation of these items to the closing day rate is included in the Group's result. The financial borrowing and lending in the individual group companies is primarily internal through the Parent Company and in the respective group company's functional currency. In this manner, currency exposure regarding these items has been centralized on the Parent Company. In the Parent Company, 100% of the financial borrowing and lending is hedged in accordance with the Group's policy, and thus a change in exchange rates has no effect on the result.

Transaction exposure

The transaction exposure is minimized primarily through external commercial transactions essentially being carried out in the functional currency of the group companies. Purchases by group companies, primarily internal, may however take place in currencies other than the company's own functional currency, and thus these purchases are exposed to a currency risk. By also directing the internal flows to as great an extent as possible to the functional currency of the recipient group company, the currency risk is concentrated to a small number of group companies. The Group's external flows are primarily in SEK as well as PLN, while external inward flows are primarily in DKK, NOK, CHF and EUR.

Are currency options useful in hedging these risks?

In many instances a company is uncertain as to whether the foreign exchange rate will increase or decrease. Rather than being tied to a forward contract with a fixed exchange rate, currency options have been devised which permit the company to protect itself against adverse foreign exchange rate movements, while also offering the opportunity to benefit from favourable exchange movements. This is apparently one of the advantages that currency options have over the forward and future contract. A currency option provides the right but not the obligation, to buy (call) or sell (put) a specific currency at specific price at any time prior to specified date. At the same time, the maximum to the buyer of an option is the actual up from premium cost of option. Currency option is designed as a new distinctive financial vehicle that offers significant opportunities and advantages to those seeking either protection or profits from changes in exchange rates.

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