International business course at ESEC BCN. Bachelor 3. Lesson 6: Foreign exchange risk

1. International Business
Foreign exchange risk
Professor: Marc Arza
marc@futura.cat

2. 1. Foreign exchange risk
Foreign exchange exposure is one of the most
important risks of international business practice.
Business operations in between two countries with
a different currency will always represent a risk for
one or both of the players as the operation will
necessarily be in a different currency than the one
they usually operate with. Any exchange rate
fluctuation during their business operations will
change the money/value relation and obviously
impact results.
Sellers are favoured by a lower exchange rate as
buyers will prefer a higher exchange rate.
Financial operations, on the other hand, require
lower interest rates, linked with a currency lower
value (higher interest rates attract savings and
investments and so will tend to increase a
currency exchange rate).

3. 2. Foreign exchange reference (strong) currencies
Most international business transactions are conducted in a limited set of reference
currencies: dollars (USD - $), euros (EUR - €), brittish pounds (GBP - £) and japanese
yens (JPY - ¥). These strong currencies are convertible into almost any other world
currency and being used as a reference are reliable and more stable than other
currencies.
After the gold standard was abandoned in the seventies the exchange rate of world
currencies is fixed by the exchange market (supply/demand) and influenced by the
following criteria:
- Supply & demand (Central bank's role)
- Higher inflation = Lower value
- Higher interest rate = Higher value
- Economic performance

4. 3. Foreign exchange restrictions
Although most global currencies are freely floating
presently (subject to free market exchange rate
setting) some countries still use restrictions to control
the value of their exchange rate limitting the currency
conversion. The reason for this may be to prevent
capital flight or to keep an artifficial value because of
political/economic interests.
Some of this weak currencies echange policies
include:
- Exchange restrictions (forbidding exchange or
limitting it to certain transactions)
- Dual exchange rate (using different exchange rates
depending on the final use)
- Advanced import deposit (requiring a deposiit to
exchange currency to control the use)

5. 4. Foreign exchange exposure
Foreign exchange exposure is normally broken into: transaction exposure, translation
exposure, and economic exposure.
Transaction exposure is typically defined as the extent to which the income from
individual transactions is affected by fluctuations in foreign exchange values. Such
exposure includes obligations for the purchase or sale of goods and services at
previously agreed prices and the borrowing or lending of funds in foreign currencies.
Translation exposure is the impact of currency exchange rate changes on the reported
consolidated results and balance sheet of a company. Translation exposure is basically
concerned with the present measurement of past events. (Example: A US firm with a
subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the
dollar this would substantially reduce the dollar value of the Mexican subsidiary's equity.
This would reduce the total dollar value of the firm's equity reported in its consolidated
balance sheet raising the apparent leverage of the firm (its debt ratio), which could
increase the firm's cost of borrowing).
Economic exposure is the extent to which a firm's future international earning power is
affected by changes in exchange rates. Economic exposure is concerned with the long-
run effect of changes in exchange rates on future prices, sales, and costs. This is distinct
from transaction exposure.

6. 5. Reducing foreign exchange exposure
Reducing Transaction and Translation Exposure: A number of tactics can help firms
minimize their transaction and translation exposure. These tactics primarily protect short-
term cash flows from adverse changes in exchange rates.
Firms can minimize their foreign exchange exposure through leading and lagging
payables and receivables--that is, collecting and paying early or late depending on
expected exchange rate movements.
A lead strategy involves attempting to collect foreign currency receivables early when a
foreign currency is expected to depreciate and paying foreign currency payables before
they are due when a currency is expected to appreciate. A lag strategy involves delaying
collection of foreign currency receivables if that currency is expected to appreciate and
delaying payables if the currency is expected to depreciate. Leading and lagging involves
accelerating payments from weak-currency to strong-currency countries and delaying
inflows from strong-currency to weak-currency countries.

7. 5. Reducing foreign exchange exposure
Several other tactics can reduce transaction and translation exposure:
. Financial solutions: forwards, options and SWAP's
— Local debt financing can provide a hedge against foreign exchange risk. As will any
policy directed to link income and expenses currencies (being paid in the same
currency in which expenses are denominated).
— Transfer prices can be manipulated to move funds out of a country whose currency
is expected to depreciate.
— It may make sense to accelerate dividend payments from subsidiaries based in
countries with weak currencies.

8. 5. Reducing exposure (financial tools)
Spot rate: The current exchange rate at the moment of a transaction.
Forward contract: A forward exchange contract is a non-standardized contract
between two parties to buy or sell currency at a specified future time at
a price agreed today. A tool to fix the value of a future exchange rate.
The forward price of such a contract is commonly contrasted with the
spot price. The difference between the spot and the forward price is the
forward premium or forward discount, generally considered in the form
of a profit, or loss, by the purchasing party.
Option contract: Is a derivative financial instrument where the owner has the right but not
the obligation to exchange money denominated in one currency into
another currency at a pre-agreed exchange rate on a specified date.
SWAP: Using a spot & a forward contract at the same time (or two forwards for
different currencies) to cover against possible exchange rate variations.

9. 5. Reducing foreign exchange exposure
Reducing Economic Exposure: Reducing economic exposure requires strategic
choices that go beyond the realm of financial management. The key to reducing economic
exposure is to distribute the firm's productive assets to various locations so the firm's
long-term financial well- being is not severely affected by adverse changes in exchange
rates.
The post1985 trend by Japanese automakers to establish productive capacity in North
America and Western Europe can partly be seen as a strategy for reducing economic
exposure (it is also a strategy for reducing trade tensions). Before 1985, most Japanese
automobile companies concentrated their productive assets in Japan. However, the rise in
the value of the yen on the foreign exchange market has transformed Japan from a
lowcost to a high-cost manufacturing location over the past 10 years. In response,
Japanese auto firms have moved many of their productive assets overseas to ensure
their car prices will not be unduly affected by further rises in the value of the yen. In
general, reducing economic exposure necessitates that the firm ensure its assets are not
too concentrated in countries where likely rises in currency values will lead to damaging
increases in the foreign prices of the goods and services they produce.

10. 5. Reducign foreign exchange exposure
The firm needs to develop a mechanism for ensuring it maintains an appropriate mix of
tactics and strategies for minimizing its foreign exchange exposure.
- Central control of exposure is needed to protect resources efficiently and ensure that
each subunit adopts the correct mix of tactics and strategies. Many companies have set
up in-house foreign exchange centers to set guidelines for subsidiaries to follow.
- Firms should distinguish between, on one hand, transaction and translation exposure
and, on the other, economic exposure.
- The need to forecast future exchange rate movements cannot be overstated, though.
The best that can be said is that in the short run, forward exchange rates provide
reasonable predictions of exchange rate movements, and in the long run, fundamental
economic factors--particularly relative inflation rates--should be watched because they
influence exchange rate movements.
- Firms need to establish good reporting systems so the central finance function (or in-
house foreign exchange center) can regularly monitor the firm's exposure positions.
Such reporting systems should enable the firm to identify any exposed accounts, the
exposed position by currency of each account, and the time periods covered.Tthe firm
should produce monthly foreign exchange exposure reports.

11. 6. FOREX case: The small Irish company Lily O'Briens
A wooden spoon and a saucepan were Mary Ann O'Brien's start-up tools 12 years ago
when, with a recipe for honeycomb crisp hearts, she launched a small venture making
Irish handcrafted chocolates for local shops. Today as managing director of Lily O'Briens -
which is named after her daughter - she has a factory in Newbridge, Co Kildare, employs
100 people and makes 500 tons of luxury chocolates a year.
The company is heavily reliant on Britain as an export market and British Airways is one
of her biggest customers. So Gordon Brown's decision to keep sterling out of the
eurozone means the accountants at Lily O'Briens must remain busy watching exchange
rate fluctuations with Ireland's nearest neighbour for some time to come."I'm a chocolate
manufacturer, not a currency trader," Mrs O'Brien says. "But I have to study the rates
every day, and I have been preparing for the day when we have parity.
(...)

12. FOREX case: The small Irish company Lily O'Briens
(...)
The euro weakness against sterling has been great for our profits for the past few years
but the euro has strengthened so we have to factor that in now. And ultimately, for a small
or medium-sized company, exchange rate volatility could wipe you out."
Since Ireland abandoned the punt in 1999 with the launch of the euro, Mrs O'Brien has
ensured the company sources all its ingredients, and its boxes, ribbons and packaging, in
the eurozone. "We have to try not to buy in sterling." Despite yesterday's decision, Britain
will remain a crucial export market for cultural and gastronomic reasons,although the
company now exports to the United States, Australia and New Zealand. "The euro area is
flooded with chocolate, and tastes are different. The British tend not to eat as much dark
chocolate as the French, Belgians or Swiss."
Mrs O'Brien would rather concentrate on innovation by designing new centres and fillings
so that she can compete with her Belgian rivals than check the foreign exchange rates.
But the Chancellor's announcement came as little surprise. "The currency risk has been
part of the business since we started. So we just manage it, and we're used to it."