Session 13 Exchange Rate Risk Programme : Executive Diploma in Accounting, Business & Strategy (EDABS 2017) Course : Corporate Financial Management (EDABS 202) Lecturer : Mr. Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA Contact : asanka.ranasinghe11@yahoo.com
Introduction FX, can impact on various aspects of a firm s activities: Income to be received from abroad The amount actually paid for imports at some future date The valuation of foreign assets and liabilities The long-term viability of foreign operations The acceptability, or otherwise, of an overseas investment project 2
Buyers and Sellers of Fx Exporters/importers Tourists or investors (e.g. in property or shares) needing to pay in foreign currency Fund managers (pensions, insurance companies, etc.) Governments (for example, to pay for activities abroad) Central banks (smoothing out fluctuations) Speculators or arbitrageurs taking advantage of perceived FX pricing anomalies Banks Dealers trading and acting as market makers in a currency (usually the big banks) Brokers, buying and selling currencies on behalf of a client, e.g. a client bank or commercial firm 3
Exchange Rates An exchange rate is the price of one currency (the base currency) expressed in terms of another (the secondary, counter or quote currency) The spot market : Transactions take place which are to be settled quickly. Immediate delivery, but this usually takes place two business days after the deal is struck The forward market : In the forward market a deal is arranged to exchange currencies at some future date at a price agreed now 4
Exchange Rates Answer the following questions on the basis that the euro/us$ exchange rate is 1.1168 1.1173, that is, 1.1168/US$ or 1.1173/US$ depending on whether you are buying or selling euros. 1 What is the cost of buying 200,000? 2 How much would it cost to purchase US$4m? 3 How many dollars would be received from selling 800,000? 4 How many euros would be received from selling US$240,000? 5
Exchange Rates Suppose that on 7 December 2011 a UK exporter sells goods to a customer in France invoiced at 5,000,000. Payment is due three months later. With the spot rate of exchange at 1.1706/ 1. If sterling strengthens against the euro, and the rate is then 1.40/ 2. If sterling weakens against the euro, and the rate is then 1.00/ 3. The forward rate available on 7 December is 1.1689/ 6
Foreign Exchange Risk Transaction risk : Transaction risk is the risk that transactions already entered into, or for which the firm is likely to have a commitment in a foreign currency, will have a variable value in the home currency because of exchange-rate movements Translation risk : Translation risk arises because financial data denominated in one currency are then expressed in terms of another currency The balance sheet effect Assets and liabilities denominated in a foreign currency can fluctuate in value in home-currency terms with forex-market changes The profit and loss account effect Currency changes can have an adverse impact on the group s profits because of the translation of foreign subsidiaries profits 7
Foreign Exchange Risk Economic risk : A company s economic value may decline as a result of forex movements causing a loss in competitive strength Directly If your firm s home currency strengthens then foreign competitors are able to gain sales and profits at your expense because your products are more expensive Indirectly Even if your home currency does not move adversely vis-à-vis your customer s currency you can lose competitive position 8
Transaction Risk Strategies Invoice the customer in the home currency Do nothing Netting if a UK parent owned a subsidiary in Canada and sold C$2.2m of goods to the subsidiary on credit while the Canadian subsidiary is owed C$1.5m by the UK company, instead of transferring a total of C$3.7m the intra-group transfer is the net amount of C$700,000 9
Transaction Risk Strategies Matching The Canadian importer is not a group company and the UK firm also imported a raw material from another Canadian company to the value of C$2m it is necessary only to hedge the balance of C$200,000 Leading and lagging : Leading is the bringing forward from the original due date of the payment of a debt. Lagging is the postponement of a payment beyond the due date 10
Transaction Risk Strategies Forward Market Hedge If the three-month forward rate is C$2.25/ the UK exporter could lock in the receipt of 977,778 in three months by selling forward C$2.2m Money Market Hedge The exporter could, at the time of the export, borrow in Canadian dollars on the money markets for a three month period. The amount borrowed, plus three months interest, will be equal to the amount to be received from the importer (C$2.2m). Interest rate charged over three months is 2 per cent Futures Hedge Currency Option 11
Translation Risk Strategies Graft plc has decided to go ahead with a US$190m project in the USA. One way of financing this is to borrow 100m and exchange this for dollars at the current exchange rate of US$1.9/. Over the course of the next year the dollar depreciates against sterling to US$2.30/ 12
Translation Risk Strategies Alternatively Graft plc could finance its dollar assets by obtaining a dollar loan. Thus, when the dollar depreciates, both the asset value and the liability value in translated sterling terms becomes less. 13
Economic Risk Strategies Economic exposure is concerned with the long-term effects of forex movements on the firm s ability to compete, and add value. These effects are very difficult to estimate in advance, given their long-term nature The main method of insulating the firm from economic risk is to position the company in such a way as to maintain maximum flexibility to be able to react to changes in forex rates which may be causing damage to the firm. Firms which are internationally diversified may have a greater degree of flexibility than those based in one or two markets. Example : Production facilities in numerous countries Maintaining flexibility in sourcing supplies a firm could achieve a competitive advantage by deliberately planning its affairs so that can switch suppliers quickly and cheaply it 14
Purchasing Power Parity (PPP) Suppose we had a product that cost the same in the UK and the US: Price in UK : 200 Price in US : $ 280 Exchange rate : Inflation in UK is 5% and inflation in US is 8% 15
Interest Rate Parity (IRP) Suppose we have 100,000 to invest for one year period UK interest rate is 3% US interest rate is 4% Exchange rate : 1=$1.4 If we invest in UK : If we invest in US : 16
Asanka Ranasinghe BBA (Finance), ACMA, CGMA 17