Any business unit faces foreign
exchange risk in three ways—transaction risk, translation risk and economic
risk. Contrary to the common notion, economic exposure has a significant impact
not just on companies with foreign exchange exposures but on all companies in
general. With the ripple effect of economic changes in one part of the world
being widely felt in another part, economic risk has become a focus of
discussion in today’s globalized world. It is highly essential that risk
managers take-up adequate steps to identify and insulate against economic risks
if the companies’ operations are not to be adversely affected. What role does
economic exposure actually play in forex risk?
Charles Tschampion, Managing Director
of the $ 50 bn General Motors pension fund, once remarked that the real
challenge for any company is not to take more risk than needed to generate the
return that is offered. It is an iconic statement—pregnant with a high degree
of philosophical and mathematical sophistication. But the question is how to
know beforehand, how much risk one is taking.
Secondly, if one has to manage risk, one should also know what items and
amounts of a firm are exposed to risk. This problem gets compounded if one’s
business is exposed to foreign exchange rate risk that too, when markets are
witnessing frequent bouts of excessive volatility. Indeed it is not uncommon
among the business men to exasperate about their helplessness in the fight to
control the associated risks that arise when exporting or importing goods and
services, etc.
Forex-risk
In a financial context, ‘risk’ refers to the probability of
loss. In basic arithmetic terms, a company makes loss whenever its income is
less than the expenditure incurred for generating that income. So long, as one
records income and expenses in rupee terms, working out profit or loss is no
big a task. But if a business is having receipts and payments in two different
currencies, profit or loss calculation gets complicated. One way of overcoming
this problem is to convert foreign currency receipts into rupees so that
revenues can be compared with the rupee cost of production and profit/loss can
be arrived at. The other alternative is to convert the rupee cost into foreign
currency, compare it with the receipts in foreign currency, and workout the
profit. In either of the cases the
exchange rate of rupee against the foreign currency at which such conversions are done, becomes a key variable in determining the
profit or loss.
Theoretically
one can therefore, say that changes in exchange rate can convert a business
unit’s profit to loss and vice versa. Interestingly, these losses are
not the outcome of operational inefficiencies or management’s bad practices.
These have purely emanated out of change in exchange rates. It is the
sensitivity of the real value of a firm’s assets/ liabilities/operating
income, expressed in its functional currency, to unanticipated changes
in exchange rates that causes the loss. Future cash flow projections, profitability,
competitiveness and the ability to service debt can all be impacted by foreign
exchange volatility when paying or receiving foreign currency. This probability
of a business incurring loss on account of changes in foreign exchange rates
is, what is known as foreign exchange rate risk.
Forex exposure
vs. risk
This discussion also makes it evident that there are two
conditions precedent for a business to suffer from foreign exchange risk. One,
it needs to have foreign currency exposure in its books and two, the exchange
rate should move adversely. Here by foreign currency exposure we mean,
possession of assets/liabilities/cash flows that are denominated in foreign
currency. To understand a company’s exchange rate exposure it is necessary to
consider how it generates its cash flows. The export/import volumes, the nature
of markets from which it sources inputs and the extent and structure of its
foreign operations affect exposure to exchange rate changes. Any company having
any sort of currency exposure in its books faces the risk of loss due to
adverse exchange rate movements. Currency exposure or position could be long
position— holding assets, receivables denominated in foreign currency or short
position—holding liabilities or payables in foreign currency.
However, it is not necessary that all currency exposures will
always result in loss and hence to be avoided. There could be occasions where
such foreign exchange exposures result in a gain too. Presume, a shrimp farmer
exported shrimps to Japan
on May 1, and drew the bill in US
dollars due for payment on June 15, 2002. Presume that in the intervening period, the Rupee depreciated and by the
due date of the bill it fell to US $1= Rs. 50.12 from Rs. 49.80 because of which,
the unit realized more units of domestic
currency, resulting in increased
profit. This leads us to appreciate that when every thing else remains same, a
depreciation of a domestic currency lowers the relative price of a country’s
exports and raises the relative price of its imports. In the process an
exposure is potential enough to generate a profit or loss.
Exchange risk is thus not a one-way street. Every exposure
need not necessarily end-up as a risk. It would therefore be not prudent to
avoid all currency exposures. Instead one should give more weightage to other
relevant commercial factors that have a bearing on cost efficiencies.
Financial reforms
vs. forex risk
In the wake of liberalization of
exchange control and trade control regimes, the number of business units having
currency exposure and the magnitude of exposures has gone up. Even the
perceptions of the role of foreign trade
in growth have changed dramatically in the last five decades. Trade liberalization,
no doubt, could contribute to economic growth by facilitating technology
transmission, international integration of production and the associated
possibility for reaping scale economies, reduction in price distortions and
increase in efficiency. In imperfectly competitive markets, increased
competition through trade could bring about welfare gains by reducing the
deadweight losses stemming from monopolies and oligopolies. Nevertheless it has
a flip-side too—it can inflict losses even on companies that were once
considered as efficient merely because, under a changing market scenario, the
overseas manufactures gain a price-advantage over the domestic manufacturers.
Many companies have also raised foreign currency loans from abroad through
borrowings/equity placements. More than any thing else, it is the tariff
reductions that would generate stiff competition from global players in the
domestic market, which is potential enough to adversely impact the local firm’s
sales/cash flows. All this implies that many Indian companies today face risk
of loss from adverse movement in exchange rates than in the past.
Position Rupee Depreciates
Rupee appreciates
Long in Forex position Profit Loss
Short in Forex position Loss Profit
Forex Risk vs. Business valuations
Exchange rate changes do influence the market value of an
organization. As a company’s market value is related to the expected future
cash flows, analysts estimate the impact of exchange rate movements on current
and expected future cash flows of firms.
Investors therefore change the company’s current market value by an
estimate of the change in the present value of its future cash flows resulting
from the change in the exchange rate. Estimates of the impact of exchange rate
movements on an organization’s value may be more difficult to predict if the
company participates in activities with off-setting exposures.
Research indicates that there is a lag structure involved in
the response of a firm value to an exchange rate change. It otherwise suggests
that an economically significant proportion of the impact of exchange rate
changes on the firm value is not immediately incorporated into value. This affect is however likely to become
larger and more extensive as economies become more and more open and companies
become more globally oriented.
Different types of forex risk
Generally, a business unit suffers
foreign exchange risk in three ways indicating that some categories are to be
actively managed by the firm while some others need not be paid so much
attention by the corporate treasury.
Transaction risk arises from individual trade transactions that are
initiated today but extinguished at a later date because of which any adverse
movement in exchange rate in the intervening period alters the net realized
amount in terms of domestic currency of the exporter. It arises when currency has to be converted
from domestic to foreign or vice versa in order to make or receive
payment for goods or to repay a loan or make an interest payment or currency
has to be converted to make a dividend payment.
It is purely a cash
flow exposure. To better appreciate the impact of transaction exposure on
business profit, consider Indian exporters who would have invoiced their
shipments in Euro during 1999 looking at its initial quote of 1Euro = Rs. 50.
All those who had invoiced their exporters in Euro would have suffered a loss
of 12 percent in their cash flows as Euro depreciated by around 12 percent by
the year-end.
Translation risk arises out of conversion of assets/liabilities owned
in foreign currency and translated into domestic currency for reporting in the
balance sheet of the parent company. It is therefore known as accounting
exposure. It arises as a result of the process of consolidation of foreign
currency items into group financial statements denominated in the currency of
the parent company. It has however no direct effect on the firm’s cash flows.
Translation exposure is dependent on: the degree of involvement by foreign subsidiary in the firm’s
business, the location of foreign subsidiaries and the accounting methods used.
Different translation methods may have different impacts upon a firm’s reported
earnings per share. But theoretically,
the accounting methods of reporting used to record the overseas subsidiaries
should not; on their own have any impact upon its valuation. Therefore,
corporates may safely ignore pure translation exposures by allowing them to
remain uncovered.
Economic risk is nothing but the sensitivity of future cash flows
and profits of a firm to unanticipated exchange rate changes. It arises because
the present value of a stream of expected future operating cashflows
denominated in the home currency or in a foreign currency may vary due to
changed exchange rates.
Amongst the three, it’s the economic risk, which is all
pervasive. It affects the future value of every business. It is commonly,
though wrongly perceived that companies, which have no exposure to foreign
currency, are protected from exchange rate risk. But, this is not always true.
If competitors with-in or out-side the country derive a profit opportunity on
account of movement of exchange rate, it is bound to have an influence on the
Indian company’s cashflows irrespective of the fact of not having a forex
exposure.
True, exchange rates can move both ways and thus it can lead
to profit as often as to losses. It is also true that the extent of profit or
loss owing to exchange rate movement should average out over a period of time.
But the danger with forex risk is it could result in large-enough loss to
wipe-out the business in one stroke, resulting which the company may not have a
second opportunity to wait for the probability of making an equally large
profit.
The economic
risk is increasingly becoming significant in the globalized economy, where the
ripple effects of economic changes in one corner of the globe are being felt
everywhere else. Yet, its management is failing to draw the attention of
corporate mandarins to the extent desired. One plausible explanation to this
shortsightedness could be that unlike transaction or translation risk, it is
not distinctly visible.
Economic exposure
Local currency appreciation
In view of the appreciation of domestic currency, a firm’s
local sales are likely to decrease as customers could buy foreign substitute
products cheaply, of course depending on the trade regulations allowing their
supply, with their strengthened currencies. During 1998 and ’99 the Indian TV market witnessed a similar
situation when noted domestic TV brands like BPL, Onida etc. recorded steep
fall in sales vis-à-vis imported
Asian brands like Akai, Samsung, LG etc., for the simple reason that the prices
of their brands became cheaper owing to
depreciation of their local currencies by 30-50 percent against the US $ while
the Indian rupee remained stable. In fact as a sequel to their currencies’
steep depreciation, goods from East Asian countries simply swamped the Indian
electronic/white-goods market. With the result, cash flows of many well-known
Indian companies were affected though they did
not have any currency exposure in their books.
Theoretically
speaking, the demand for local firm’s product in international markets would
not change unless it is invoiced in the local currency. As against this, imports will become cheaper
and thus any cash out-flows would be reduced. Similarly, interest/principal
out-payments would require less of local currency.
Local currency depreciation
In the event of a firm’s local currency depreciation, the
converse of what has been observed under currency appreciation holds good. Local sales will increase, as foreign goods
will become costlier in terms of domestic currency and thereby reduce foreign
competition. The firm’s exports denominated in local currency will become
cheaper to overseas importers and thus they would grow. Similarly, exports
denominated in foreign currency result in increased cashflows as local currency
depreciates. In case of cash out flows the reverse happens: interest/principal
payments, payment under imports denominated in foreign currency will cost more
in terms of local currency. In a
nutshell, depreciation of local currency increases both cash inflows and out
flows of a firm. In view of this, a firm whose cash inflows are out of exports
while outflows towards cost of production, and payment of interest etc., are in
domestic currency is likely to be benefited from depreciation of domestic
currency.
To better appreciate this phenomenon, let us look at what
happened in Korea.
During the late 1997, Korean growth abruptly ground to a halt when the country
found it-self cut-off by foreign creditors and was on the verge of national
bankruptcy. As a result of the Asian currency crisis, the won depreciated
sharply in the Forex market. In the summer of 1998, the won was trading at
around 1,400 to the dollar as against 900 per dollar in the previous summer.
This brought in an immediate and dramatic rise in its net exports to the US.
Resultantly, its current account surplus reached to a level of 16 percent of
its GDP. The won’s sharp depreciation
against the dollar in1997, coupled with a precipitous fall in domestic income
in Korea led to an immediate
surge in its trade surplus with the USA. Infact access to American
export markets was a critical ingredient of economic recovery for all the Asian
countries that experienced the crisis in 1997 followed by the recession in
1998.
Domestic firms
Firms, which are operating purely in domestic markets, are
also exposed to economic risk. For example, Essar steel, a company locally engaged in steel
manufacturing, purchases all its inputs
from the domestic market and sells the output locally. Since all its
transactions are carried out locally, technically, it should not have any
exposure to transaction risk. However, this need not always be true since,
presence of a foreign competitor selling steel in the local market can subject
the local firm to economic exposure. Imagine for a while that the foreign
competitor’s currency has depreciated against the local currency—Indian rupee,
then the steel purchasers are likely to shift their purchases towards the
foreign competitor. Added to this, if there is any reduction in import tariffs,
the price would fall further. This automatically reduces the sales of the local
producer and in turn cashflows. In fact this is what has happened in the Indian
steel market during the early phase of the financial reforms.
How to measure?
Generally, the degree of economic exposure to exchange rate
fluctuations will be more for a firm engaged in international trade than to a
company, which is purely a domestic player. Even among the firms engaged
heavily in exports, the affect varies from unit to unit depending on the
characteristics of their exports such as the currencies in which they invoice
their shipments and how their competitors
react to the exchange rate movements.
The impact of exchange rate movement on a firm operating purely in the
domestic market depends on the level of competition that it faces from foreign
players. In either of the cases, economic exposure can impact the effected
companies either favorably or unfavorably.
In view of this, businesses have to measure their exposure
and determine if it warrants insulation. The situation becomes complex if a
firm has cash flows in a numbers of currencies for the impact varies from
currency to currency. One way of assessing the impact of economic exposure on
local sales is to collect historical data on how local sales have been affected
by exchange rate changes in the past and make use of it to simulate future
sales under different exchange rate scenarios.
Alternatively, a firm can assess its
economic exposure to exchange rate movements by applying regression analysis on
historical cashflows and exchange rate data.
Conclusion
Having said that, let us see how one can predict the exchange
rate movements and estimte its likely impact on a firm’s cashflows. But the sad
truth is that no theory of exchange as yet is in a position to explain why
exchange rates have behaved so in the past, leaving aside the question of
forecasting the future rates with any degree of accuracy. Gone are the days when international trade
was thought to be the dominant factor in
determining exchange rates. In today’s world free-floats, monetary variables,
capital flows, rational expectations and portfolio balances are all found to
have an impact on exchange rates. As Jeffery Frankel observed in his review of
research on exchange rates, the proportion of exchange rate changes that are
predictable in any manner— by the forward discount, interest rate differential,
survey data, or models based on macroeconomic fundamentals— appears to be
almost zero.
To risk or not to risk—that seems to be the question that is
haunting every firm. And its intensity is getting sharpened with the globalized
economy. There is no escape from it except to face it and handle it on a continuous
footing. Firms have to balance the sensitivity of revenues and expenses to
exchange rate fluctuations and how deftly it is handled is what ultimately
defines ones’ success.
grk
(Written sometime back and so examples may appear outdated but concepts remain valid even now)
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