Foreign Exchange Risk &

Exposure
Kameshwar Rao
WHAT IS RISK?
Conceptually, RISK for an ENTITY, arises
because it has an EXISTING or POTENTIAL
SENSITIVITY to a FACTOR.
This FACTOR changes in a random
manner, and its movement is neither
predictable nor controllable by the
ENTITY.
Generally, if this SENSITIVITY results into
a LOSS, it is reckoned as RISK.
WHAT IS EXPOSURE?
The SENSITIVITY of an ENTITY to a
FACTOR is known as EXPOSURE.
Like I run the risk of skin cancer, if
my skin is EXPOSED to the
HARMFUL radiations of SUN.
Hence, it is the EXPOSURE which
causes RISK.
RISK is not EXPOSURE.

What is Foreign Exchange
(Forex) Exposure?
It is the sensitivity of a firm to
UNEXPECTED exchange rate movements.
When we say a firm, it is the sensitivity of
PROFITS/ITS VALUE (measured in
domestic currency), to movements in
exchange rates.
When we say PROFITS/VALUE, it is the
sensitivity of future (foreign currency
denominated) REVENUES, EXPENSES, and
values of existing(foreign currency
denominated) ASSETS, LIABILITIES, and
OWNERS FUND.
What is Forex Risk?
It is the variability of the Profits and Value
of the firm, due to unexpected exchange
rate movements.
Forex Risk necessarily arises due to forex
exposure, but requires the following
additional reasons
a) Exchange Rate neither fixed nor
predictable
b) Compulsion for Conversion into
domestic currency
Example of Exposure & Risk
Changes in US $ 1000 item
FOR.CUR E/R DOM.CU
R
G / (L)
1000 46 46000 1000
1000 45.50 45500 500
1000 45 45000 0
1000 44.5 44500 (500)
1000 44 44000 (1000)
Example Contd
The US $ 1000 is the Forex Exposure of
the firm. So for any given change in the
exchange rate, the gain or loss will be
1000 times, the change in the exchange
rate. So the firm is sensitive 1000 times.
The Standard Deviation of the given range
of (5) domestic currency values of this
exposure, is the Forex Risk.
Exposure & Risk
Exposure is measured in Foreign
Currency
Risk is measured in Domestic
Currency
Risk may not be there eventhough
there is Exposure
Certain Exposures can be avoided

Types of Forex Exposure
Forex Exposure is the sensitivity of the
firms foreign currency denominated
Receivables, Payables, Assets, Liabilities,
and Operating cashflows, to unanticipated
changes in exchange rates.
Firms can experience broadly three types
of exposure, namely TRANSACTION,
TRANSLATION and ECONOMIC
TRANSACTION EXPOSURE
It is the exposure of a firms foreign
currency denominated receivables and
payables, to unanticipated exchange rate
movements.
It results into cash losses or gains, at the
time of settlement of the receivables or
payables.
It is born on the day when an agreement
to receive or pay in foreign currency is
entered into.

Transaction Exposure Contd..
It expires on the day the receivable or
payable is settled.
The value of exposure does not change
during the life of the item, as it is
contractually fixed.
It is prevalent in firms, which transact
with the rest of the world in foreign
currency.
Typical examples: Exports receivables,
Import payables, Inter Company
Transfers, Dividend/Interest Payments,
repayment of loans and receipts of loans.
Transaction Exposure Contd..
The term of the exposure is known.
There is a desired exchange rate
which the firm would like protect in
the receivable or payable.
It is short-term in nature.


Managing Transaction Exposure
Either we try to reduce the exposure or
getting the desired exchange rate.
Methods involving reducing the exposure
are NETTING, MATCHING, OFFSETTING,
CURRENCY RISK SHARING, INVOICING,
LEADING, LAGGING ETC.
The desired exchange rate can be
protected by hedging with the help of
derivatives, like FORWARD, FUTURES AND
OPTION CONTRACTS.

Translation Exposure
It is the exposure of firms foreign
currency denominated assets and
liabilities to unanticipated changes in
exchange rates.
It results into book gains or losses at the
time of translating the foreign currency
values into domestic currency, on the date
of closing of accounts.
It exists as long as the asset or liability
exists on the date of balance sheet.
Translation Exposure Contd..
The gains or losses arising out of
translation depend on the accounting
standards and method of translation.
MNCs with and firms with foreign
subsidiaries, experience this exposure,
when consolidating their accounting
statements, for reporting.
Eg: Foreign Currency Loans, Subsidiary
Assets, Investments in Financial assets
abroad.


Translation Exposure Contd..
The term of the exposure is as long
as the accounting item appears in
the balance sheet.
There is no desired exchange rate
which the firm would like to protect
in such an exposure.
It is medium to long-term in nature.
Managing Translation Exposure
The focus of managing translation
exposure is reducing the exposure,
as there is no desired exchange rate
to protect.
Methods like BALANCE SHEET
HEDGING, LEADING, LAGGING, &
CREATING DERIVATIVES POSITIONS
may be adopted.
Economic Exposure
It is the sensitivity of the firms future
operating cashflows, to unanticipated
exchange rate movements.
It results in loss of sales realisation, loss
of markets, increases in costs due to
unfavourable movements in the exchange
rate involving domestic currency or the
currency of any other competitor country.


Economic Exposure Contd..
Firms not having any transactions
with the rest of the world also
experience this exposure if they are
operating in an open economy
The gains or losses are due to two
affects, COMPETITIVE EFFECT and
CONVERSION EFFECT.

Economic Exposure Contd...
The exposure is long-term in nature
and affects the survival of the firm.
It exists as long as the firm
continues to operate in the
respective sector, or in an open
economy.



Economic Exposure Contd..
Cases where economic exposure exists.
a) Domestic Firms output exported
b) Domestic Firm having imported inputs
c) A firm faces global competition, and operates
in an open economy
d) Domestic Firm produces and sells import
substitutes
e) Firm does not posses the flexibility for price
adjustment.
Managing Economic Exposure
Exposure reduction and Locking the desired
rate, cant effectively manage economic
exposure.
Requires strategic cross functional approach to
manage it, like the following
(a) Pricing (b) Product Innovation
(c) Market Selection (d) Outsourcing
(e) Relocation of Production Units
(f) Raising Productivity (g) Changing sources of
inputs