Risk Management

Exposure/Risk
• The corporations which are in import and export of
goods, services, plant, machinery, technology or which
have tapped the international sources of finance are
exposed to foreign exchange rate risk.
• Exposure' is a measure of sensitivity of the value of
financial items (assets, liabilities or cashflows) to change
in variables like exchange rates, interest rates, inflation
rates, relative prices etc.
• While risk is a measure of variability of the item, foreign
exchange exposure' is the sensitivity of the real value of
an undertaking's assets, liabilities or operating incomes
expressed in its functional currency to unanticipated
changes in exchange rates.
 Classification of Risk
• Transaction Risk
This risk will arise due to fluctuations in the exchange
rates when the normal trading transactions take place in
the normal course of international trade.
The transactions may be for export of goods and services
or import of goods and services
Transaction exposure occurs, when one currency must be
exchanged for another and when a change in foreign
exchange rate occurs between the time a transaction is
executed and the time it is settled.
• Translation Risk
• When the assets and liabilities of trading transactions are
denominated into foreign currencies, then there may be risk
of translation in such denomination into currencies. This
will also be due to fluctuations in the rates of different
currencies.
• Translation exposure has to do with how asset and liability
values appear when translated into the enterprise's domestic
reporting currency for inclusion in financial accounts.
• The translation risk is associated with the fact that a firm
that has assets in a foreign country whose currency
weakens against the firm's home currency suffers a
reduction in its wealth, as measured in the home currency.
• Economic Risk
• The exchange rate fluctuations may be due to the
conditions of economy of different countries which will
have impact on the currencies of respective countries.
• Economic exposure is the risk of a change in the rate
affecting the company's competitive position in the
market.
• Economic exposure is normally defined as the effect on
future cashflows of unpredicted future movements in
exchange rates. This affects a firm's competitive position
across the various markets and products and hence the
firm's real economic value.
 Foreign Exchange Risk
Management
• Foreign Exchange Risk Management (FERM) is also
known as 'exposure management copes with the
possibility of loss arising from uncovered (open) position
when the related exchange rate rises or falls or the
currency involved is devalued or revalued.
• key factors that would support FERM against rate
volatility are:
• (a) the large proportion of the corporate foreign
exchange earnings/expenses and cashflow,
• (b) the potential effect of cashflow volatility on the
corporate's ability to execute its strategic plan
• A firm which seeks to maximize profit in the foreign
exchange markets is termed an aggressive firm,
whereas if it aims to minimize potential losses resulting
from changed exchange rates is called a defensive
firm.
Benefits of Foreign Exchange Risk
Management
• (a) It gives comfort that the enterprise is controlled and
there would be no unwelcome surprises.
• (b) It defines an operating band within which the
enterprise is prepared to accept volatility its risk
appetite/risk aversion..
• (c) It helps in using that appetite/aversion in the
shareholder's interest, improving the quality of earnings
that the enterprise generates.
 Risk Management Strategies
• Passive Risk Management Strategy
• The corporate can choose to cover selectively and progressively on
its view of individual currency movements. Hence, the company
may leave some portion of their forex exposures open with the aim
of capitalising on certain anticipated market movements.
• However, the company could stand to lose should the market not
move in the anticipated direction.
• Active Risk Management Strategy
• In addition to the above risk management strategies, the
enterprise may also decide to trade in the currencies in which it
has underlying exposure and hence an existing need to manage
exchange risk.
• However, due to the exchange control restrictions active risk
management is permitted only against underlying transactions.
 Simple Hedging Techniques
• Doing Nothing:
• This method suggests that the firm should not involve
in a transaction which exposes the firm to risk or make
sure that the firm does not suffer if it necessitates to
enter into such transaction.
• The firm should take the advantage of favourable
situations to smooth out the adverse fluctuations.
• It is only unlikely events or those that would lead to a
major disaster for the firm that would be worth insuring
against.
• Pre-emptive Price Variation
• When there is expected variation in foreign exchange rate,
either party may ask for an adjustment of price variation in
the invoice amount or contract price.
• But in practice, this would possible only for the strong party
who is in a position to dictate terms to the other.
• Risk Sharing:
• It is a contractual arrangement between the buyer and seller
to share any fluctuations in foreign exchange rate movements.
This method suggests the establishment of long-term
relationship between the parties. If the fluctuations exceed the
desired levels, the parties may renegotiate for sharing.
• Maintaining a Foreign Currency Bank Account
• The exporting firms can maintain separate bank accounts for
each currency in which it transacts and delay the conversion
into home currency until favourable situation to take place.
• The major drawback of this method is that liquidity problems
arise if funds are kept for long time waiting for favourable
situation.
• International Forfaiting
• It is a method whereby the exporter sells the export bills
to the forfaiter and obtains cash. Money comes to the
exporters even before the collection of exporter's debts.
Forfaiter, after having made payments to exporters
become sole owners to collect the debts and assume full
risks. The bank guarantee provided by importer
obviates the need to make a thorough check on
creditworthiness of the importer.
 Selling and Buying in One's Own
Currency
• the company simply invoices all its supplies in its own
currency. The exchange rate risk is not eliminated in
this case, but transferred to the customer. This
technique may keep the firm competitive with local
industries.
• Matching Receipts and Payments: The foreign
exchange rate risk can be eliminated or reduced, if the
company which is having exposure to receipts and
payments in the same currency. The company can
offset its payments against its receipts if it can plan
properly.

• Leads and Lags: A firm having exposure to pay foreign

currency, can make payments in advance prior to due
date called leads to take the advantage of lesser rate of
foreign currency. In such cases, the firm should
consider the interest loss on opportunity to funds
elsewhere
 Netting
• In case of MNCs, parent company and its subsidiaries
periodically 'settling up the net amounts owned or
amount as a result of trade within the firm is called
'netting. The basic idea behind netting is to transfer
only net amounts, usually within a short period.
Instead of making each payment, incurring transaction
costs, the net position between the two companies can
be ascertained say, every three months and one
payment only to be made by the company which is in
the net debtor position.