FOREIGN

EXCHANGE RISK
MANAGEMENT
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GROUP 9
 FOREIGN EXCHANGE

Foreign Exchange (forex or FX)

is the trading of one currency
for another.
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 ”When comparing the price of
one currency to another, the
base currency is the unit of
currency that does not
fluctuate in amount, while the
quoted currency or price
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currency does fluctuate.”

 WHAT IS FOREIGN CURRENCY
EXCHANGE RISK?
When a customer is obligated to pay the company in
a foreign currency such as the dollar, the dollar
appreciates against the customer’s currency, then the
customer is paying with a reduced- value currency,
which causes the company to record a foreign
exchange loss once it is paid.
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 DATA COLLECTION FOR FOREIGN EXCHANGE
RISK MANAGEMENT
Obviously, those with an ERP
system have a significant advantage
in determining the amount of this
booked exposure. The resulting
forecasted exposure estimates the
most likely size of currency
transactions that will occur in the
near term and medium term, so
that hedging plans can be made to
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mitigate these exposures.
Booked exposure, especially when
derived from ERP information,
should be quite accurate. However,
forecasted exposure is only
moderately accurate in the near
term, and its accuracy declines
rapidly within a year. This reduced
accuracy strongly impacts the
amount of hedging that a company
may be willing to engage in.
 FOREIGN EXCHANGE HEDGING
STRATEGIES
There are a variety of foreign
exchange hedging strategies noted
in this section. The main strategy
groupings are:
• To not hedge the exposure
• To hedge the exposure through
business practices
• To hedge the exposure with a
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derivative
 ACCEPT THE RISK
“Not hedging the exposure is the
simplest strategy of all. A
company can accept the foreign
exchange risk, and record any
gains or losses on changes in the
spot rate as they occur.”
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 The following strategies are all
internal business practices that reduce currency
exposure:

Insist on Home Get Paid on Time Sourcing Changes

Current Payment
Foreign Currency Foreign Currency
Ciurrency Loans Account
Surchargers
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 STRATEGIES TO REDUCE CURRENCY EXPOSURE
INSIST ON GET
HOME CURRENCY PAID
CURRENCY SURCHARGES ON
PAYMENT TIME

It is possible to insist on being
paid in the company’s home
currency, so that the foreign
exchange risk shifts entirely
to the customer. This is a
likely strategy for a company
that is dominant in its
industry and can therefore
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If a customer will not pay When a company deals
in a company’s home with a counterparty in
currency, then a related another country, the
option is to bill the payment terms may be
customer a currency quite long, due to longer
surcharge if the company delivery schedules, border-
incurs a foreign exchange crossing delays, or simply
loss between the time of because of longer

impose terms on its billing and payment. customary payment

customers. intervals in the other
country
 STRATEGIES TO REDUCE CURRENCY EXPOSURE

FOREIGN FOREIGN
CURRENCY SOURCING CURRENCY
LOANS CHANGES ACCOUNT

It is possible to offset a If there is a large If a company regularly

foreign currency risk
exposure by creating a
counter liability, such as a
loan. To do so, a company can
borrow an amount of money
in the foreign currency that
matches the amount of the
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amount of foreign receives and pays out funds
currency cash flows in a particular foreign
coming from a specific currency, it may make
country, then one way sense to open a foreign
to hedge this risk is to exchange account, in which
start using suppliers it maintains a sufficient
located in the same currency balance to meet

receivable. country. its operational needs.

 3 WAYS TO REDUCE THE VOLUME OF THESE
TRANSACTIONS
BILATERAL MULTILATERAL
UNILATERAL SPREADSHEET CENTRALIZED
ANETTING
company can aggregate the
NETTING
If two companies located in NETTING
When there are multiple parties wishing to net
cash flows among its various transactions, it becomes much too complex to
different countries transact manage with a spreadsheet. Under a
subsidiaries, to determine if any
a great deal of business centralized netting system, each participant
foreign exchange payments enters its payables into a centralized database
with each other, then they
between the subsidiaries can be through an Internet browser or some other file
netted, with only the can track the payables upload system, after which the netting service
(presumably) smaller residual owed to each other and net converts each participant’s net cash flows to
an equivalent amount in each participant’s
balances being physically shifted. out the balances at the end base currency, and then uses actual traded
This reduces the volume of of each month, and one exchange rates to determine the final net
foreign exchange cash flows, and position of each participant. The exchange
party pays the other the operator then pays or receives each
therefore the associated foreign net remaining balance.
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participant’s net position, and uses the

exchange risk. proceeds to offset the required foreign
exchange trades.
 FOREIGN
EXCHANGE CONTRACTS

A forward exchange contract is the most

commonly used foreign exchange hedge
wherein a company agrees to purchase a fixed
amount of a foreign currency on a specific
date, and at a predetermined rate.
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 RULES IN COMPUTING INTEREST RATES DIFFERENTIAL

1. The currency of the

country having a 2. The currency of
higher interest rate the country having a
trades at a discount. lower interest rate
trades at a 100% Editable
premium.
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 FOREIGN CURRENCY
CONTRACTS

Requires delivery of, or the settlement of

which depends on the value of, a foreign
currency that is a currency in which
positions are also traded through regulated
futures contracts
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 CURRENCY FUTURES

Each contract has standardized size, expiry

date, and settlement rules. The primary
currency futures center with substantial
volume in Chicago Mercantile Exchange
(CME). The CME offers futures trading
between the major currencies, as well as some
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of the emerging market currencies.

 CURRENCY
OPTIONS
A foreign currency option requires
the payment of a premium in
exchange for a right to use one
currency to buy another currency at
a specified price on or before a
specified date. A call option permits
the buyer to buy the underlying
currency at the strike price, while a
put option allows the buyer to sell the
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underlying currency at the strike
price.
CURRENCY
SWAPS
A currency swap is a spot transaction
on the over-the-counter market that is
executed at the same time as a
forward transaction, with currencies
being exchanged at both the spot date
and the forward date. One currency
is bought at the spot rate and date,
while the transaction is reversed at
the forward date and rate.
 SUMMARY OF STRATEGIES
FORWARD CURRENCY
EXCHANGE CURRENCY
OPTIONS
CONTRACTS FUTURES
are the most heavily used They are more easily entered right to buy or sell a futures
form of hedging, for two into and sold off, since they contract of a foreign currency
are standardized products that at any time for a specified
reasons. First, they are very
trade through a formal period.
inexpensive, having a exchange system.
modest transactional cost.
Second, they are an over -
the - counter product, and so
can be precisely tailored to a
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company ’ s individual
needs.
 HEDGE ACCOUNTING

There are complex hedging rules that permit

a company to elect to obtain special
accounting treatment relative to foreign
currency risks. These rules include the
establishment, at inception, of criteria for
measuring hedge effectiveness and
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ineffectiveness.
 CHANGE IN VALUE IN FORWARD CONTRACT

To record present value

(at 0.5 percent monthly rate) of
change in value of forward
contract )
= change in forward rate
(1.46 − 1.44)
× à 4,000,000 = $80,000
to be received in three months,
discounted
Forward currency
at 6 percent contract
per annum]

(80,000) (90/365days)
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Gain on forward contract 78,818

 CHANGE IN AMOUNT CHANGE IN VALUE
OF FIRM OF FORWARD
COMMITMENT CONTRACT

To record present value (at 0.5 To record change in value of

percent monthly rate) of forward contract
change in amount of firm {[= (1.48 − 1.44) × à 4,000,000
commitment = $160,000] − gain previously
[= change in spot rate (1.45 − recognized ($78,818)}
1.40) ×à 4,000,000 = $200,000
to be paid in three months,
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discounted at 6% per annum]

 FORWARD EXCHANGE
CONTRACT ACCOUNTING

Foreign currency transaction gains and losses on

assets and liabilities that are denominated in a
currency other than the home currency can be
hedged if a U.S. company enters into a forward
exchange contract.
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 10/1/08 (forward rate for
4/30/09 E 1 = $1.57)
(1.57*6M)
Forward contract
Receivable 9,420,000
12/31/08
(forward rate
for 4/30/09
Á 1 = $1.589)
Forward contract
Receivable 114,000
Net increase in fair value of the
forward contract = (1.589 − 1.57 = .
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019 × Q 6,000,000 = $114,000).

 3/1/09 (forward rate for
4/30/09 Q1 = $1.585)

Loss on hedge Activity 24,000

[1.585 − 1.589 = (.004) ×

Q 6,000,000 = ($24,000)]

4/30/09 (spot rate Q 1 = $1.60)

Forward contract
Receivable 90,000

change in the forward to

the spot rate from 3/1/09 to
4/30/09 [Q 6,000,000 × ($1.60 − $1.585)
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=$90,000]
 4/30/09 Transaction Loss

The transaction loss related to the

accounts
payable reflects only the change in
the spot rates and ignores the
accrual of
interest.
[ Q 6,000,000 × ($1.60 −$1.58)
= $120,000]
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 FOREIGN CURRENCY
INVESTMENT HEDGE
ACCOUNTING
A company can invest in a subsidiary
located in another country, and issue a
loan to act as a hedge against the
investment in the subsidiary
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SLIDESMANIA.CO
 FOREIGN EXCHANGE
HEDGE CONTROLS
There are a variety of controls that the treasury
department can implement in order to reduce
the risk profile of its hedging activities. These
controls are divided into ones related to hedging
authorizations, contracts, hedge accounting, and
risk assessment
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 Contractual General Risk
Authorization Hedge
Controls Assessment
Controls Accounting Controls Controls

● Define dealing ● Verify contract ● Include in the ● Determine

responsibilities terms and hedging counterparty
● Issue an updated signatory procedure a credit
signatory list to requirement for worthiness.
counterparties full ● Full-risk
at least once a documentation modeling.
year of each hedge ● Audit
● Centralize spreadsheet
foreign exchange calculations and
trading contents.
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operations
 POLICY DESCRIPTION
The determination of hedge effectiveness shall always
ACCOUNTING
use the same method for similar types of hedges. GAAP
CONSISTENCY
allows one to use different assessment techniques in
POLICIES
determining whether a hedge is highly effective.

This staggered benchmark hedging policy gives the

DEAL BOUNDARIES
treasury staff firm guidance regarding the amount of
hedging activity to engage in.

AUTHORIZATION Authorization to deal in foreign exchange hedging

POLICIES transactions shall be issued solely by the board of
directors.
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 THANK
YOU!
GROUP 9
ORCAJADA, HANNAH
PACAL, KAYE
OGAYON, PRINCESS
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