Foreign exchange exposure is one fact that no company involved in international business or trade can completely avoid. This article is a continuation of international financial risk management. If you got to this page through search engine, it will be wise for you to start reading from there so that you will the full picture of risk that faces multinational businesses and how to manage them properly. The mere fact that a company is involved in international business or is a multinational corporation is enough to give the entity foreign exchange exposure.
WHAT IS FOREIGN EXCHANGE EXPOSURE?
The phrase ‘Foreign exchange exposure’ is used to describe the degree at which the potential/ future profitability, net cash flow and perceived market value of a firms value changes as a result of a change in exchange rate. That is to say that it is a company’s probability of making either a loss or profit as a result of movements in exchange rate.
One of the most important task of a financial manager in today’s ever dynamic business environment is to identify, measure and control foreign exchange exposure so as to ensure that a company’s future: net cash flows, profitability, and market value are maximised.
THREE TYPES OF FOREIGN EXCHANGE EXPOSURES
Movement in foreign exchange can affect a company in several ways. The three most common effects of a change in currency exchange are:
This is a non economic and non cash flow movement in the balance sheet (statement of financial position) value of a company resulting from translating the financial statements of one subsidiary into the currency of the parent. This is also known as accounting exposure. When purchasing power parity (PPP) holds, financial managers need not worry themselves over this kind of exposure as it does not have any economic significance to the real value of the company. However, there are few occasions when managers may be compelled to take action in other to ameliorate the effect of translation exposure. Under such conditions, any of the following exposure risk management techniques can be used: Asset shifting, borrowing locally, and using a forward contract. Note that the use of forward contract has some cash flow implications.
Transaction exposure arises in situation where companies in different countries have to in business deal that requires settlement to be made in future date. In other words, both parties have either exchanged values or agreed to exchange value without making any monetary consideration, but legally bound to make same when due. Most of the techniques used to manage transaction exposure are also used to manage operating exposure and will therefore be discussed together.
Operating exposure (also known as; strategic exposure, economic exposure or edge exposure) measures those changes in present value that a multinational experience as a result of changes in future cash flows which in turn were caused by change in exchange rates.
The first thing that a company does is to assess the effect of movement in exchange rates (over the nearest future) and on its competitive advantage relative to other corporations. Care is taken to classify operating exposure into:
(1) Those that affect the operating cash flow and (2) those that affects the financing cash flows. The traditional strategic style of managing operations-related cash flow exposures like, receivables, royalties, etc is to (a) diversify sales channel, (b) operate from different distribution channels, and (c) obtain raw materials from different sources. For those that affect the financing aspects of the business, all that needs to be done is to raise fund from different countries and in difference currencies.
Generalised way of managing transaction and operating exposure
Generally, operating exposures can be managed in the five following ways:
(i) Parallel or back to back borrowing and lending: this is an over the counter (OTC) arrangement between individuals whereby they agree to exchange the equivalent of currencies. This is like the barter system. For example, a U.S firm that needs £5,000.00 could arrange with a British firm that equally needed the dollar equivalent of £5,000.00 and exchange same with the firm.
(ii) Currency swaps: this is a contractual agreement whereby parties agree to exchange cash flows. Notice that this is a legally binding contract, meaning that the parties involved cannot back out once the contract is signed, sealed and delivered. The only way around it is to enter into what is called swaption (a hybrid form of swap and options).
(iii) Matching and netting: this can also be seen as a natural way of hedging against currency risk. This in other words is the arrangement to lend and borrow in local currency.
(iv) Leading and lagging: this is simply the acceleration or deceleration of the timing of receipt and payment that a company is to receive or make. There are two kinds of leading and lagging, namely, inter-firm or intra-firm leads and lags. An inter-firm leading and lagging is an arrangement between independent firms that encourages the preference of one firm to be imposed on the other. Intra-firm is an agreement between related companies with common goal. This is usually seen as a mutual agreement whereby both parties benefit from the transaction.
(v) Risk sharing and shifting: the most popular techniques used here is for the parties to the transaction to mutually agree upon a sort of risk sharing clause that will be included in the facility agreement. When both parties involved agree that one of the partners solely bear the risk, it is known as risk shifting.
In addition to managing the above exchange rate exposures, international financial management will not be complete if interest rate movement is not considered. Hence,
INTEREST RATE RISK AND HOW TO MANAGE IT
Interest rate risks are faced by all kinds of company- domestic, transnational or multinational. This is the risk that a company’s activity might be sensitive to movements in interest rate. There are two basic types of interest rate risks: basis risk and gap risk. Interest rate risk management is a broad topic that needs to be discussed in a dedicated article. Follow the link above for more on it.
One thing that you should always bear in mind is that foreign exchange risk management is not a static process; it is a dynamic process that requires the thinking capability of a financial manager to effectively handle.