Any multinational firm having exposure to international transactions and investments has to denominate the sales revenue and costs denominated in equivalent home currency. In that case, the firm is bound to be exposed to fluctuations in exchange rates. The calculation of the impact of the changes in the foreign exchange requires the measurement of the risks relating to the foreign exchange (Hakala and Wystup, 2002). The exposure to exchange rate risks may take the form of (a) translation exposure, (b) transaction exposure, and (c) operating exposure or economic exposure.
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Although there is a large volume of literature available on the management of foreign exchange risks and the risks of changing interest rates, only limited literature is available on the managing of the large multinational companies as well as on the comparison of the techniques of management of foreign exchange in different industries. Grant and Marshall (1997) and Mallin, Ow-Yong and Reynolds, (2001) have reported on the empirical results on the usage of derivatives by large companies in the UK. Belk and Glaum (1990) have identified through their empirical studies that the foreign exchange management by large companies has covered the management of specific exposures like transaction exposure and translation exposure. The following sections deal with the recognition of different forms of foreign exchange risks, which represent a major function of the foreign exchange management by the treasury department of a multinational corporation.
Transaction Exposure denotes the likelihood of any firm sustaining future benefits or losing money because of its action of settling a deal already contracted by it, which is specified in the currency of another country. “A firm transaction exposure consists of its foreign currency accounts receivables/payables, its long term foreign currency investments, and debt, as well as those of its foreign currency cash positions which are to be exchanged into other currencies. Until these positions are settled, their home currency value may be impaired by unfavorable parity changes” (Glaum, 1990). Earlier studies conducted by Belk and Edelshain (1997), Duangploy, Bakay and Belk (1997), and Aabo (1999), point out that managing transaction exposure is the essence of foreign exchange risk management.
Translation exposure covers the movements in the values of foreign assets and liabilities held by any firm. The translation exposure arises due to the conversion of a firm’s reported financial results from the functional currency of the firm to the currency of any other country. This may be done to incorporate the values of assets and liabilities of the subsidiary companies in the accounting reports of the companies owning the subsidiary companies. The purpose of such translation may be either informational or just comparison. Although translation exposure may not result in any actual cash inflow or outflow, it will for sure affect the consolidated financial statements of multinational firms. It is wise and is often being followed to dismiss the effect of translation exposure on the balance sheet items as illusory. However, the stated values of assets and liabilities do affect the financial ratios calculated based on the balance sheet figures. This may affect the borrowing powers of the firm when the loan covenants include the consideration of balance sheet ratios.
Kohn (1990) and Belk and Glaum (1990) are of the view that management of economic exposure is one of the major concepts which is relevant in foreign exchange management. Unlike the transaction and translation exposure, the economic exposure is not so precise and is difficult to measure and apply monitoring and control of this exposure. Shapiro (1992) states that economic exposure includes both transaction and translation exposure and in addition incorporates the competitive position of the firms. Economic exposure can be regarded as the relative sensitivity of the future cash flows of the firm, which may vary due to changes in the exchange rates and due to changes caused by the respective currency movements in the competitive environment in which the firms are operating.
The measurement of the economic exposure is complex and requires an in-depth knowledge of the firm’s operations and the impact of the movements of foreign currency rates on the expected cash inflows and outflows that may occur in the future.
According to Booth and Rotenberg (1990), the economic exposure of a firm largely depends on the nature of the international operations of the firm, the nature, and magnitude of the foreign competition, and the nature of the products or services the firm deals. Moles and Bradley (2002) state that the extent of sourcing, selling, financing, or manufacturing in foreign markets will act as the obvious determinants of the economic exposure of the firm.
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Measurement of Exchange Rate Risk
After analyzing the definition and nature of different types of exchange rate risk that a multinational firm is exposed to, the next crucial task in exchange risk management is to measure these risks. Measuring currency risk at least concerning translation and economic risk is a complex task (Van Deventer, Imai, and Mesler, 2004). The prominent model presently used is the Value-at-risk (VaR) model. VaR can be defined as the maximum loss for a specific exposure over a given time with a confidence level of z%.
The VaR methodology is the most common method used for measuring different types of risk, which enables firms in their efficient risk management. However, the method suffers from a shortcoming in that it does not define what happens to the exposure for the (100-z) confidence level implying that the method is silent on the worst-case scenario. Since the VaR model is unable to help the firms with the maximum loss of 100%, confidence firms often establish operational limits. These operational limits include nominal amounts or stop-loss orders in addition to VaR limits, to reach the maximum possible coverage (Papaioannou and Gatzonas, 2002).
For calculating the VaR different models can be used. The most common models are (i) historical simulation, (ii) variance-covariance model, and (iii) Monte Carlo simulation. The historical simulation assumes that currency returns in respect of the foreign exchange position of a firm will follow the same distribution as they did in the past. The assumption behind the variance-covariance model is that the currency returns in respect of the foreign exchange position of a firm would be normally distributed and the change in the foreign currency value has a linear dependency on all currency returns. Under Monte Carlo simulation, the assumption is that the future currency returns will follow a random distribution. Of all the three models, the historical simulation is the simplest one. However, the model suffers from the drawback that it requires a large database and needs intensive computations. Although the variance-covariance model makes quick calculations possible, the assumptions of this model are restrictive. While the Monte Carlo simulation can handle any underlying distribution, it also suffers from an intensive computational disadvantage.
Calculation of VaR
VaR calculations enable a multinational firm to estimate the riskiness of a foreign exchange position that results from the activities of a firm. This includes the foreign exchange position of its treasury. The calculations about a specific period under normal circumstances (Holton, 2003). There are three basic parameters, which determine the VaR calculations. They are (i) the holding period, which implies the length of time during which the firm plans to hold the foreign exchange exposure (ii) the confidence level at which the firm would like to plan the estimation (the confidence levels, which are usually adopted are 99% and 95%) and (iii) the unit of foreign currency, which the firm would like to use for denominating the VaR.
With an assumed holding period of x days with a confidence level assumed at y%, calculation of VaR enables the firm to arrive at the maximum expected loss likely to occur in the form of reduction in the market value of foreign exchange in the possession of the firm. This loss is calculated for the holding period of x days if the holding period is not one exceeding the confidence level period that is worst under normal circumstances.
“Thus, if the foreign exchange position has a 1-day VaR of $10 million at the 99% confidence level, the firm should expect that, with a probability of 99%, the value of this position will decrease by no more than $10 million during 1 day, provided that usual conditions will prevail over that 1 day. In other words, the firm should expect that the value of its foreign exchange rate position will decrease by no more than $10 million on 99 out of 100 usual trading days, or by more than $10 million on 1 out of every 100 usual trading days” (Papaioannou, 2006).
Managing the Exchange Rate Risk
Hedging against translation exposure has been subjected to several debates and discussions as to the necessity of doing it. The major argument against hedging is that the gains or losses arising from the translation exposure are unreal as the translation exposure itself is uneconomic since it relies on the historic book values arrived at in the past and does not have any long-term implication whatsoever in the changes of the exchange rates and also on the competitive edge of the firm. The hedging of translation exposure does not create any shareholder value, as it does not result in a reduction of the expected cost of financial distress or other financial implications of incidence of taxes or issues relating to underinvestment. It is also important to note that gains or losses out of translation exposures are not strong determinants of real changes in the value of the firms and therefore hedging such exposure may not also help in reducing the share price exposure.
Managing the economic exposure may take the form of operational or financing approaches. At best, the firms may use a combination of both approaches to mitigate the economic exposure risks (Soenen and Madura 1991). The financial hedging approach requires a strategic reorientation of operating policies regarding pricing, sourcing, location of production, and financing. ‘Natural hedging’ is considered as one of the ways of managing economic exposure risks by the use of production, financial, and marketing decisions taken to manage such risks (Moffet and Karlsen 1994).
The other form of managing the economic exposure is to diversify the financing across different currencies, which can be used as an operational strategy of hedging the economic exposure. The operation of this strategy takes the form of structuring the liabilities of the firm in such a way that the fluctuations in the value of foreign assets due to the economic exposure is compensated by the relative changes in the debt service by the firm in the same currency as the assets are held by it. This implies that the firm will acquire debts in the same currency in which the firm is expected to receive cash inflows that are subjected to economic exposure risks.
Forward contracts, Futures Contracts, Options, and Swaps are some of the forms of derivative instruments, which are being managed by the companies to manage their risk exposures to foreign exchange. The manners in which these derivatives are used differ from company to company on the size and nature of their foreign exchange transactions. Several studies have been conducted on assessing the effectiveness of the usage of the instruments, especially forward contracts and currency futures.
A forward contract is an arrangement whereby a certain amount of foreign exchange in any denominated currency is bought or sold, at a particular price. The transaction is to take place on a certain date during a period after the transaction. The predetermined price is known as the forward exchange rate. Under this system, no money needs to be paid at the time of the initiation of the contract. Where the exposures are having certain timings and range from short to medium term, the currency contact becomes particularly useful. Since the forward contracts have several risks associated with them, it requires considerable caution on the part of the treasury managers before dealing in forwarding contracts.
A futures contract is another technique used by companies to reduce the risks in foreign exchange exposure. Mostly the futures contract are similar in all respects with the forward contract except for the point that in the forward contract the gains and losses are realized and transferred at the maturity of the contract, while in the case of futures contract the gains and losses on them are realized and settled every day. Futures contracts are one of the ways to hedge against risky assets. When a company takes a long-term hedge, the company is protected against an increase in the rise in foreign exchange value, and when the company enters into a short-term futures contract, any fall in the foreign exchange rate is protected.
Options contracts are different from the forward contracts in that, an option usually provides the holder of an option holds the right to sell or buy a certain quantum of any specified asset at a particular price until or on a specified date. However, the contract does not place any obligation on the holder to buy or sell the asset. Currency options are being increasingly used as a hedging technique because of the distinct advantage of protecting the company from any unfavorable movements in the foreign exchange rates. At the same, time when there are favorable movements; option contracts help the firms to realize the gains from such transactions. While Call options are used to protect the hedging firms against any increase in the price of the foreign currency, Put options protect the firms against a fall in foreign exchange rates.
A currency swap represents a contract under which two parties agree to exchange the cash flows arising out of principal and interest payments over a specified period at a pre-fixed exchange rate. A currency swap is often used by the firms which need to operate by borrowing in another currency and it is usually found cost-effective to borrow funds in the own currency of the company that is borrowing as the receipt of funds upfront and repayment of the principal as well as settlement of interests are being made in the same currency.
Measuring and managing foreign exchange risks is an important part of the functions of a treasury manager in a multinational firm. To efficiently manage their exchange rate risks, firms need to adopt certain best practices. These include identification of the exchange rate risk and measurement of them, development of an appropriate exchange management strategy, creation of a centralized entity in the treasury for dealing with hedging transactions, development of controls for monitoring the exchange rate risk, and establishment of a risk oversight committee. Since there are ample chances for the vulnerabilities in the exchange rate movements to arise because of the involvement of a multinational firm in international operations and investments, it is for the firm to adopt the best practices and strategies for effective management of foreign exchange risks.
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