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Foreign Exchange Risk Exposure, Types of Risk

Exchange rate fluctuations affect not only multinationals and large corporations, but also small and medium-sized enterprises. Therefore, understanding and managing exchange rate risk is an important subject for business owners and investors.

There are various kinds of exposure and related techniques for measuring the exposure. Of all the exposures, economic exposure is the most important one and it can be calculated statistically.

Companies resort to various strategies to contain economic exposure.

Types of Exposure

Companies are exposed to three types of risk caused by currency volatility −

  • Transaction exposure − Exchange rate fluctuations have an effect on a company’s obligations to make or receive payments denominated in foreign currency in future. Transaction exposure arises from this effect and it is short-term to medium-term in nature.
  • Translation exposure − Currency fluctuations have an effect on a company’s consolidated financial statements, particularly when it has foreign subsidiaries. Translation exposure arises due to this effect. It is medium-term to long-term in nature.
  • Economic (or operating) exposure − Economic exposure arises due to the effect of unpredicted currency rate fluctuations on the company’s future cash flows and market value. Unanticipated exchange rate fluctuations can have a huge effect on a company’s competitive position.

Note that economic exposure is impossible to predict, while transaction and translation exposure can be estimated.

Economic Exposure – An Example

Consider a big U.S. multinational with operations in numerous countries around the world. The company’s biggest export markets are Europe and Japan, which together offer 40% of the company’s annual revenues.

The company’s management had factored in an average slump of 3% for the dollar against the Euro and Japanese Yen for the running and the next two years. The management expected that the Dollar will be bearish due to the recurring U.S. budget deadlock, and growing fiscal and current account deficits, which they expected would affect the exchange rate.

However, the rapidly improving U.S. economy has triggered speculation that the Fed will tighten monetary policy very soon. The Dollar is rallying, and in the last few months, it has gained about 5% against the Euro and the Yen. The outlook suggests further gains, as the monetary policy in Japan is stimulative and the European economy is coming out of recession.

The U.S. company is now facing not just transaction exposure (as its large export sales) and translation exposure (as it has subsidiaries worldwide), but also economic exposure. The Dollar was expected to decline about 3% annually against the Euro and the Yen, but it has already gained 5% versus these currencies, which is a variance of 8 percentage points at hand. This will have a negative effect on sales and cash flows. The investors have already taken into account the currency fluctuations and the stock of the company fell 7%.

Calculating Economic Exposure

Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. We know from statistics that a regression analysis of the asset value (P) versus the spot exchange rate (S) will offer the following regression equation −

P = a + (b x S) + e

Where, a is the regression constant, b is the regression coefficient, and e is a random error term with a mean of zero. Here, b is a measure of economic exposure, and it measures the sensitivity of an asset’s dollar value to the exchange rate.

The regression coefficient is the ratio of the covariance between the asset value and the exchange rate, to the variance of the spot rate. It is expressed as −

b  =  

Cov (P,S)Var (S)

Economic Exposure – Numerical Example

A U.S. company (let us call it USX) has a 10% stake in a European company – say EuroStar. USX is concerned about a decline in the Euro, and as it wants to maximize the Dollar value of EuroStar. It would like to estimate its economic exposure.

USX thinks the probabilities of a stronger and/or weaker Euro is equal, i.e., 50–50. In the strong-Euro scenario, the Euro will be at 1.50 against the Dollar, which would have a negative impact on EuroStar (due to export loss). Then, EuroStar will have a market value of EUR 800 million, valuing USX’s 10% stake at EUR 80 million (or $120 million).

In the weak-Euro scenario, currency will be at 1.25; EuroStar would have a market value of EUR 1.2 billion, valuing USX’s 10% stake will be equal to $150 million.

If P represents the value of USX’s 10% stake in EuroStar in Dollar terms, and S represents the Euro spot rate, then the covariance of P and S is −

Cov (P,S) = –1.875

Var (S) = 0.015625

Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million

USX’s economic exposure is a negative EUR 120 million, which is equivalent to saying that the value of its stake in EuroStar decreases as the Euro gets stronger, and increases as the Euro weakens.

Determining Economic Exposure

The economic exposure is usually determined by two factors −

  • Whether the markets where the company inputs and sells its products are competitive or monopolistic? Economic exposure is more when either a firm’s input costs or goods’ prices are related to currency fluctuations. If both costs and prices are relative or secluded to currency fluctuations, the effects are cancelled by each other and it reduces the economic exposure.
  • Whether a firm can adjust to markets, its product mix, and the source of inputs in a reply to currency fluctuations? Flexibility would mean lesser operating exposure, while sternness would mean a greater operating exposure.

Managing Economic Exposure

The economic exposure risks can be removed through operational strategies or currency risk mitigation strategies.

Operational strategies

  • Diversifying production facilities and markets for products − Diversification mitigates the risk related with production facilities or sales being concentrated in one or two markets. However, the drawback is the company may lose economies of scale.
  • Sourcing flexibility − Having sourcing flexibilities for key inputs makes strategic sense, as exchange rate moves may make inputs too expensive from one region.
  • Diversifying financing − Having different capital markets gives a company the flexibility to raise capital in the market with the cheapest cost.

Currency risk mitigation strategies

The most common strategies are −

  • Matching currency flows − Here, foreign currency inflows and outflows are matched. For example, if a U.S. company having inflows in Euros is looking to raise debt, it must borrow in Euros.
  • Currency risk-sharing agreements − It is a sales or purchase contract of two parties where they agree to share the currency fluctuation risk. Price adjustment is made in this, so that the base price of the transaction is adjusted.
  • Back-to-back loans − Also called as credit swap, in this arrangement, two companies of two nations borrow each other’s currency for a defined period. The back-to-back loan stays as both an asset and a liability on their balance sheets.
  • Currency swaps − It is similar to a back-to-back loan, but it does not appear on the balance sheet. Here, two firms borrow in the markets and currencies so that each can have the best rates, and then they swap the proceeds.

1. Transaction Exposure

Financial Techniques to Manage Transaction Exposure

The main feature of a transaction exposure is the ease of identifying its size. Additionally, it has a well-defined time interval associated with it that makes it extremely suitable for hedging with financial instruments.

The most common methods for hedging transaction exposures are −

  • Forward Contracts If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value.
  • Futures Contracts These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure.
  • Money Market Hedge Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies’ riskless returns. It is also a form of financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks.
  • Options A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period.

Note − The major difference between an option and the hedging techniques mentioned above is that an option usually has a nonlinear payoff profile. They permit the removal of downside risk without having to cut off the profit from upside risk.

The decision of choosing one among these different financial techniques should be based on the costs and the penultimate domestic currency cash flows (which is appropriately adjusted for the time value) based upon the prices available to the firm.

Transaction Hedging Under Uncertainty

Uncertainty about either the timing or the existence of an exposure does not provide a valid argument against hedging.

Uncertainty about transaction date

Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-currency cash flow. The key reason is that, even if they are sure that a foreign currency transaction will occur, they are not quite sure what the exact date of the transaction will be. There may be a possible mismatch of maturities of transaction and hedge. Using the mechanism of rolling or early unwinding, financial contracts create the probability of adjusting the maturity on a future date, when appropriate information becomes available.

Uncertainty about existence of exposure

Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids with prices fixed in foreign currency for future contracts. The firm will pay or receive foreign currency when a bid is accepted, which will have denominated cash flows. It is a kind of contingent transaction exposure. In these cases, an option is ideally suited.

Under this kind of uncertainty, there are four possible outcomes. The following table provides a summary of the effective proceeds to the firm per unit of option contract which is equal to the net cash flows of the assignment.

State Bid Accepted Bid Rejected
Spot price better than exercise price : let option expire Spot Price 0
Spot price worse than exercise price: exercise option Exercise Price Exercise Price – Spot Price

Operational Techniques for Managing Transaction Exposure

Operational strategies having the virtue of offsetting existing foreign currency exposure can also mitigate transaction exposure. These strategies include −

  • Risk Shifting The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, it is not possible in all cases.
  • Currency risk sharing The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero sum game, one party loses and the other party gains%
  • Leading and Lagging It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging.
  • Reinvoicing Centers A reinvoicing center is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the transaction exposure.

Reinvoicing centers have three main advantages −

  • The centralized management gains of transaction exposures remain within company sales.
  • Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting processes and improve intra affiliate cash flows, as intra-company accounts use domestic currency.
  • Reinvoicing centers (offshore, third country) qualify for local non-resident status and gain from the offered tax and currency market benefits.

2. Translation Exposure

Translation exposure, also known accounting exposure, refers to a kind of effect occurring for an unanticipated change in exchange rates. It can affect the consolidated financial reports of an MNC.

From a firm’s point of view, when exchange rates change, the probable value of a foreign subsidiary’s assets and liabilities expressed in a foreign currency will also change.

There are mechanical means for managing the consolidation process for firms that have to deal with exchange rate changes. These are the management techniques for translation exposure.

We have discussed transaction exposure and the ways to manage it. It is interesting to note that some items that create transaction exposure are also responsible for creating translation exposure.

Translation Exposure – An Exhibit

The following exhibit shows the transaction exposure report for Cornellia Corporation and its two affiliates. Items that produce transaction exposure are the receivables or payables. These items are expressed in a foreign currency.

Affiliate Amount Account Translation Exposure
Parent CD 200,000 Cash Yes
Parent Ps 3,000,000 Accounts receivable No
Spanish SF 375,000 Notes payable Yes

From the exhibit, it can be easily understood that the parent firm has mainly two sources of a probable transaction exposure. One is the Canadian Dollar (CD) 200,000 deposit that the firm has in a Canadian bank. Obviously, when the Canadian dollar depreciates, the deposit’s value will go down for Cornellia Corporation when changed to US dollars.

It can be noted that this deposit is also a translation exposure. It is a translation exposure for the same reason for which it is a transaction exposure. The given (Peso) Ps 3,000,000 accounts receivable is not a translation exposure due to the netting of intra-company payables and receivables. The (Swiss Franc) SF 375,000 notes for the Spanish affiliate is both a transaction and a translation exposure.

Cornellia Corporation and its affiliates can follow the steps given below to reduce its transaction exposure and translation exposure.

  • Firstly, the parent company can convert its Canadian dollars into U.S. dollar deposits.
  • Secondly, the parent organization can also request for payment of the Ps 3,000,000 the Mexican affiliate owes to it.
  • Thirdly, the Spanish affiliate can pay off, with cash, the SF 375,000 loan to the Swiss bank.

These three steps can eliminate all transaction exposure. Moreover, translation exposure will be diminished as well.

Translation Exposure Report for Cornellia Corporation and its Mexican and Spanish Affiliates (in 000 Currency Units) −

  Canadian Dollar Mexican Peso Euro Swiss Frank
Assets
Cash CD0 Ps 3,000 Eu 550 SF0
A/c receivable 0 9,000 1,045 0
Inventory 0 15,000 1,650 0
Net Fixed Assets 0 46,000 4,400 0
Exposed Assets CD0 Ps 73,000 Eu 7,645 SF0
Liabilities
A/c payable CD0 Ps 7,000 Eu 1,364 SF0
Notes payable 0 17,000 935 0
Long term debt 0 27,000 3,520 3,520
Exposed liabilities CD0 Ps51,000 Eu 5,819 SF0
Net exposure CD0 Ps22,000 Eu 1,826 SF0

The report shows that no translation exposure is associated with the Canadian dollar or the Swiss franc.

Hedging Translation Exposure

The above exhibit indicates that there is still enough translation exposure with changes in the exchange rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major methods for controlling this remaining exposure. These methods are: balance sheet hedge and derivatives hedge.

Balance Sheet Hedge

Translation exposure is not purely entity specific; rather, it is only currency specific. A mismatch of net assets and net liabilities creates it. A balance sheet hedge will eliminate this mismatch.

Using the currency Euro as an example, the above exhibit presents the fact that there are €1,826,000 more net exposed assets than liabilities. Now, if the Spanish affiliate, or more probably, the parent firm or the Mexican affiliate, pays €1,826,000 as more liabilities, or reduced assets, in Euros, there would be no translation exposure with respect to the Euro.

A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar (€/$) exchange rate would not have any effect on the consolidated balance sheet, as the change in value of the assets would completely offset the change in value of the liabilities.

Derivatives Hedge

According to the corrected translation exposure report shown above, depreciation from €1.1000/$1.00 to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which was more when the transaction exposure was not taken into account.

A derivative product, such as a forward contract, can now be used to attempt to hedge this loss. The word “attempt” is used because using a derivatives hedge, in fact, involves speculation about the forex rate changes.

3. Economic Exposure

Economic exposure is the toughest to manage because it requires ascertaining future exchange rates. However, economists and investors can take the help of statistical regression equations to hedge against economic exposure. There are various techniques that companies can use to hedge against economic exposure. Five such techniques have been discussed in this chapter.

It is difficult to measure economic exposure. The company must accurately estimate cash flows and the exchange rates, as transaction exposure has the power to alter future cash flows while fluctuation of the currency exchange rates occur. When a foreign subsidiary gets positive cash flows after it corrects for the currency exchange rates, the subsidiary’s net transaction exposure is low.

Note − It is easier to estimate economic exposure when currency exchange rates display a trend, and the future cash flows are known.

Regression Equation

Analysts can measure economic exposure by using a simple regression equation, shown in Equation 1.

P = α + β.S + ε (1)

Suppose, the United States is the home country and Europe is the foreign country. In the equation, the price, P, is the price of the foreign asset in dollars while S is spot exchange rate, expressed as Dollars per Euro.

The Regression equation estimates the connection between price and the exchange rate. The random error term (ε) equals zero when there is a constant variance while (α) and (β) are the estimated parameters. Now, we can say that this equation will give a straight line between P and S with an intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex Beta or Exposure Coefficient. β indicates the level of exposure.

We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset’s price to the exchange rate, while the variance measures the variation of the exchange rate. We see that two factors influence (β): one is the fluctuations in the exchange rate and the second is the sensitivity of the asset’s price to changes in the exchange rate.

β =  Covariance (P,S)Variance (S)

(2) Economic Exposure – A Practical Example

Suppose you own and rent out a condominium in Europe. A property manager recruited by you can vary the rent, making sure that someone always rents and occupies the property.

Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in Table 1. Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability. The forecasted exchange rate for each state, which is S has also been estimated. We can now calculate the asset’s price, P, in U.S. dollars by multiplying that state’s rent by the exchange rate.

Table 1 – Renting out your Condo for Case 1

State Probability Rent (Euro) Exchange Rate (S) Rent (P)
1 1/3 €1,800 $1/1.00 E $1,800
2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E
3 1/3 €2,200 $1.50/1.00 E $3,300

In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the fluctuating exchange rate, and there is a potential economic exposure.

A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A forward contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against the exchange rate risk.

In Table 2, (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the forward contract and it is the spot exchange rate for a state.

Suppose we bought a forward contract with a price of $1.25 per euro.

  • If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into Dollars, we gain $200, and we compute it in the Yield column in Table 2.
  • If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose anything.
  • State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the forward contract. We know that each state is equally likely to occur, so we, on average, break even by purchasing the forward contract.

Table 2 – The Beta is the Correct Hedge for Case 1

State Forward Price Exchange rate Yield
1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$
2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0
3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $
Total     $ 0

The rents have changed in Table 3. In Case 2, you could now get € 1,667.67, € 2,000, or € 2,500 per month in cash, and all rents are equally likely. Although your rent fluctuates greatly, the exchange moves in the opposite direction of the rent.

Table 3 – Renting out your Condo for Case 2

State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,500 $1/1E $2,500
2 1/3 2,000 $1.25/1E $2,500
3 1/3 1,666.67 $1.50/1E $2,500

Now, do you notice that when you calculate the rent in dollars, the rent amounts become $2,500 in all cases, and (β) equals –1,666.66? A negative (β) indicates that the exchange rate fluctuations cancel the fluctuations in rent. Moreover, you do not need a forward contract because you do not have any economic exposure.

We finally examine the last case in Table 4. The same rent, € 2000, is charged for Case 3 without considering the exchange rate changes. As the rent is calculated in U.S. dollars, the exchange rate and the rent amount move in the same direction.

Table 4 – Renting out your Condo for Case 3

State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,000 $1/1E $2,000
2 1/3 2,000 $1.25/1E $2,500
3 1/3 2,000 $1.50/1E $3,000

However, the (β) equals 0 in this case, as rents in Euros do not vary. So, now, it can be hedged against the exchange rate risk by buying a forward for €2000 and not the amount for the (β). By deciding to charge the same rent, you can use a forward to protect this amount.

Techniques to Reduce Economic Exposure

International firms can use five techniques to reduce their economic exposure −

  • Technique 1 A company can reduce its manufacturing costs by taking its production facilities to low-cost countries. For example, the Honda Motor Company produces automobiles in factories located in many countries. If the Japanese Yen appreciates and raises Honda’s production costs, Honda can shift its production to its other facilities, scattered across the world.
  • Technique 2 A company can outsource its production or apply low-cost labor. Foxconn, a Taiwanese company, is the largest electronics company in the world, and it produces electronic devices for some of the world’s largest corporations.
  • Technique 3 A company can diversify its products and services and sell them to clients from around the world. For example, many U.S. corporations produce and market fast food, snack food, and sodas in many countries. The depreciating U.S. dollar reduces profits inside the United States, but their foreign operations offset this.
  • Technique 4 A company can continually invest in research and development. Subsequently, it can offer innovative products at a higher price. For instance, Apple Inc. set the standard for high-quality smartphones. When dollar depreciates, it increases the price.
  • Technique 5 A company can use derivatives and hedge against exchange rate changes. For example, Porsche completely manufactures its cars within the European Union and exports between 40% to 45% of its cars to the United States. Porsche financial managers hedged or shorted against the U.S. dollar when the U.S. dollar depreciated. Some analysts estimated that about 50% of Porsche’s profits arose from hedging activities.

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