International financial

management
HARISHA.B.V.
AIP(FINANCE AND CONTROL)
IIM BANGALORE

MODULE 3

FOREIGN EXCHANGE RISK

MANAGEMENT
Measuring accounting exposure
transaction exposure
translation exposure
Managing accounting exposure
Hedging
Measuring and Managing economic exposure
Managing interest rate exposure.

Exchange rate risks

Transaction exposure
Translation exposure / consolidation
exposure
Economic Exposure

Risk
Risk is the measure of deviation from the
expected value .
The risk that cannot be removed is called as
Systematic risk or Un-diversifiable risk.
Systematic risk includes shortage in money
supply, economic policy followed by the
country etc.
However, a part of risk that can be removed
is called as Unsystematic risk or Diversifiable
risk.. An investor can reduce such risk by
holding currencies of various countries.

Transaction exposure

The following situations give rise to

transaction exposure.
1. Trade transactions with foreign countries
when billing is done in foreign currencies.
2. Banking and financial transactions done in
foreign currencies like lending and
borrowing or equity participation .

Consolidation /Translation
Exposure
When balance sheets are consolidated ,the
value of assets and liabilities expressed in
the national currency varies as a function of
the variation of the currency of the country
where investment was made.

Economic Exposure
The economic exposure refers to the change in
expected cash flows as a result of an unexpected
change in exchange rates.
If US company in French reduces the French
prices for the products can increase the market
share , conversely if French franc weakens against
dollar then French company will have more
competitiveness than US company.

Techniques of Hedging
Internal hedging
External hedging

Internal techniques

Choosing a particular currency for invoice.

Leads and lags
Indexation clauses in contracts
Netting
Shifting the manufacturing base
Center of re invoicing
Swaps
Discount.

External hedging

Covering risk in the forward /future market

Covering in the money market
Covering in the option market
Covering through swaps.

Translation exposure

1.
2.
3.
4.

The different methods of translation vary

from one country to another, each method
has its own advantages and disadvantages.
Methods
Current rate method
Current /Non current method
Monetary /non monetary method
Temporal method

Current rate method

It is also called as closing rate method.
All items of the income statement and
balance sheet are translated at current rate .
This method is preferred in those countries
the currencies are periodically adjusted to
inflation.
The net worth of the company will be
maintained on the historical rate only.

Current / Non current method

Current assets and current liabilities of the
subsidiary are translated at current rate .
The fixed assets and liabilities are translated
at historical rate.

Monetary /Non monetary method

Items that represent a claim or receive .
All liabilities and current assets are shown
under current rate .(except inventory)
All fixed assets , inventory and net worth
under historical rate

Temporal method
Historical rate for those which are stated at
historical rate.
Current rate for those which are stated at
replacement cost or realizable value.
Similar to monetary/non monetary method
but even stock will be shown under current
rate.

Balance sheet

Assets
Fixed assets
Stocks
Receivables
Cash

Rs
200000
50000
30000
10000

liabilities
Rs
equity
140000
long term
80000
short term
70000

The historical rate is 45Rs/$ and spot is 46

problem
Suppose a French firm has an Indian subsidiary
.The total translation exposure is estimated to be
Indian Rs 1 million .the exchange rates are as
follows.
Spot Rs 6.00
12 months forward Rs 6.0600
The French company anticipates a depreciation of
6% of the Indian Rupee.
If company wants to avoid the potential loss what
amount of Indian Rs it has sell forward.

Loss = x( 1 / forward - 1/ anticipated spot)