Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
Managing Foreign Exchange Exposure: Information
System Integration
Ernest E.N.N. Mudogo* and Sitalakshmi Venkatraman**
Huge growth in international foreign exchange market since 1986
and the increasing global business competition have resulted in the
need for firms to manage foreign exchange risk exposure through
better use of information systems. This paper considers managing
foreign exchange exposure through better integration of a firm’s
information system. Using historical cases, the paper first reviews
criticisms against using information that are derived from traditional
accounting models for exposure management, and adopts a 2X2
matrix presenting a holistic typology in two dimensions, that of time
and exposure-generating factors (Mudogo 2012). for discussing a
firm’s exposure management information integration. Information
integration based on a firm’s foreign exchange exposure database is
proposed to include factors that influence hedging decisions,
hedging methods and a firm’s multifaceted cash flow. Such an
integrated multifaceted approach would provide the right mechanism
for automated exposure tracking, trade management, as well as
improved processes within the firm for managing foreign currency
and currency derivative risks effectively.
1. Introduction
With the huge growth witnessed in international foreign exchange market since 1986
and the increasing global business competition, firms are under pressure to
manage foreign exchange exposure risks through better use of information systems
(Shapiro, 2006; Bartram, Brown, and Minton, 2010; Kenett and Raanan, 2010;
Mudogo, 2012). In this context, firms increasingly consider foreign exchange
exposure management as a critical component for increasing shareholder value.
While business operational efficiency can be enhanced through automation of the
corporate financial management processes, introducing improved processes into the
financial information system for foreign exchange exposure management would lead
to more corporate performance and sustainability (Rountree, Weston and
Allayannis, 2008; Zhang, 2009; Venkatraman and Nayak, 2010).
The first and foremost requirement is to arrive at reliable information of foreign
exchange (FX) exposures through formalized identification of the risk categories.
The next requirement is to integrate accurate data for analysis through a cohesive
risk management work flow within the corporate information system (Mudogo, 2012).
Such an approach would not only help to minimize the degree of uncertainty
surrounding FX exposures but would also provide reliable information for an
improved decision-making process.
*Dr. Ernest E.N.N. Mudogo, Department of Higher Education - Business, Northern Melbourne Institute of
TAFE, Australia. Email:ErnestMudogo@nmit.edu.au
**Dr. Sitalakshmi Venkatraman, Department of Higher Education - Business, Northern Melbourne Institute
of TAFE, Australia. Email:SitaVenkat@nmit.edu.au
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
This paper is an extension of previous work by Mudogo (2012). The following three
sections provide an enhancement of Mudogo’s classification of foreign exchange
exposure towards a more holistic typology of economic exposure categories. In
section 5, a new framework for integrating financial information system for FX
management is presented. firms. Section 6 consists of summary and conclusions.
2. Literature Review
Foreign exchange exposure affects businesses regardless of their size, as they are
each susceptible to significant profitability risk due to unanticipated changes in
currency exchange rates (Financial Accounting Standards Board, 1981; Economic
Monitoring Group Report No 6, 1986; Fosler and Winger, 2004; Pramborg, 2005).
Eiteman and Stonehill (1989) describe foreign exchange exposure as: “a measure of
the potential for a firm's profitability, net cash flow, and market value to change
because of a change in exchange rates”. Hence, any currency fluctuations could
impact cash inflows and outflows that are measured in home currency and are
associated with foreign operations. Similarly, costs, loans and settlement value of
contracts made in foreign currency could get adversely affected and accurate
knowledge about the currency risks are important (Loderer and Pichler, 2000).
Firms operating in an international environment are required to consider three
distinct types of foreign exchange exposures in their risk management process and
these are, translation exposure, operating exposure, and transaction exposure.
Translation exposure, also called accounting exposure is associated with firms with
a physical presence in a foreign country and having on-going foreign operations. In
translation exposure measurement, there is a point-in-time valuation when foreign
currency denominated assets and liabilities are translated into a common currency
for reporting purposes. This could also be of concern due to the sensitivity of net
income to the variation in the exchange rate with the need to report foreign
subsidiaries’ financial statements into the parent’s reporting currency. These
situations give rise to dealing with translation adjustments whenever translations are
made at a different exchange rate from that at which the assets or liabilities were
previously recorded. On the other hand, operating exposure or economic exposure
is concerned with the effect of an exchange rate change on the future cash flows
resulting from foreign operations. The impact could be due to a firm’s long term
involvement in a particular foreign market where uncertainty is involved with future
and unknown transactions in the foreign currency. The third exposure type, namely
transaction exposure arises when firms are currently engaged in transactions
involving foreign currencies. It could also be due to foreign currency fluctuations
during the commencement and settlement period of trade transactions (imports and
exports or short-term capital items such as loans, interests, and dividend payments).
While some types of foreign exchange exposures are easier to be determined and
analysed, others could be complex and less deterministic. For example, in transaction
exposure type with a fixed contractual obligation in a foreign currency, the foreign
exchange exposure is known and analysis is quite straightforward. In cases of
operating exposure, there is greater uncertainty
and the analysis of foreign
exchange exposure could be quite complex (Dufey . and Srinivasulu, 1983; Dhanani,
2004). In any case, global firms are faced with a need to analyse and streamline the
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
risk management process of foreign exchange exposures for a better decision making
and to maintain profitability.
In today's increasingly uncertain climate of foreign exposure rate fluctuations, firms are
faced with challenges to manage the impact of such changes on their net cash flow.
Typically, the operations of incurring costs and generating revenues reside in different
functional areas of the firm, such as purchasing, marketing, sales and finance. Hence,
through a multi-functional coordination and information integration, a comprehensive
foreign exchange exposure management could be achieved.
3. Need for the Study
There are criticisms reported in literature with regard to traditional methods adopted
for FX exposure measurements. Walker (1978) suggests that translation exposure
gives only an arbitrary indication of the real effects of currency fluctuations on a
company's on-going foreign operations and the methods using the accounting
information leads to an inaccurate measurement of exposure (Walker 1978). Aliber
and Stickney (1975) view that the methodology adopted for translating foreign
currency denominated financial statements to be “logically inconsistent” and
“empirically unjustifiable.” In addition, literature reports that contradictory policy
decisions are reached through such traditional accounting approaches (Dufey 1972,
Rudiger 1980, Shapiro 2006).
The arbitrariness of translation exposure figures is a result of the fact that more than
one method of measuring exposure can be used. The parent company may choose
from a varied array of translation methods. The main translation methods used for
consolidating a foreign subsidiary's accounts are: (a)Current/non-current
method,
where the current assets or current liabilities are translated at the exchange rates
ruling when accounts are consolidated, and non-current assets and liabilities are
translated using historical rates of exchange leading to unfavorable accounting
exposure if it has net current assets; (b) Closing rate method, which prescribes the use
of the rate of exchange ruling at the time of translating the foreign currency
denominated assets and liabilities for all balance sheet items assuming equal risks,
with the accounting exposure inherent in a foreign subsidiary relating to the net equity
of the subsidiary; (c) Monetary/non-monetary method, where the translation of all
foreign currency denominated monetary assets uses the closing rate of exchange, and
foreign currency denominated non-monetary assets and liabilities are translated at
historical exchange rates, resulting in the accounting exposure inherent in a foreign
subsidiary to attach to its net monetary assets; and (d) Temporal method that uses the
closing rate for all items stated at current cost, and historic rate for all items stated at
historic cost leading to the translation of foreign currency denominated assets/liabilities
to observe the measurement basis used in the foreign subsidiary's original accounts.
Extensive surveys have reported that different countries use different translation
methods, and this has an influence on the size of accounting exposure (Price
Waterhouse International,1976; Shapiro, 2006) and the results of translating the
same accounting data could vary sharply with the translation method applied. An
exclusive focus on the balance sheet effects of currency fluctuations ignoring the more
important effects on future cash flows is one of the major mistakes in practice. It is
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
reported that management's concern with translation exposure is due to the desire to
have a consistent and stable level of reported earnings, and a fear that violent
fluctuations in reported earnings might affect share prices (Srinivasulu, 1983).
Companies have also incurred a cash-flow loss due to sudden currency change when
they attempt to hedge their translation loss (Hutson and Stevenson, 2010). In contrast
to economic exposure, translation exposure is based on a static and historically
oriented framework rather being based on expectation about the future. It is a
point-in-time valuation that contrasts with the economic concept of value. According to
the future oriented economic concept, the value of a foreign asset, such as a foreign
subsidiary, is the discounted future cash-flow arising from the ownership of that asset.
In order to be consistent with the economic value concept of the firm, exposure
measurement and management must focus on the impact of possible changes in the
value of the firm following an exchange rate change. There are instances where
different policies were adopted at the same economic event with the parent company
planning a reduction of investments based on the potential paper loss alone, while the
subsidiary opting for greater investment to boost sales. Such contradictory responses
highlight a fundamental flaw in the accounting information system, and a focus solely
on accounting exposure is inadequate.
Firms require a more systemic, and integrated accounting information systems, in
identifying and managing the impact of foreign exchange rate changes on corporate
cash flow and competitiveness (Aliber and Stickney 1975). The logical inconsistency is
inherent in the use of the monetary/non-monetary method of translation. This method
prescribes the use of the current rate of exchange for translating monetary items
(thereby deemed exposed) and the historic rate of exchange for translating
non-monetary items such as property and plant (which are therefore deemed
unexposed). This mistakenly assumes that only monetary items are exposed to
exchange rate changes. Foreign exchange exposure for non-monetary items are
ignored since accounting practice advocates that foreign exchange differences
between countries are offset by inflation differences, following the purchasing power
parity theory. According to Fisher effect theory, market-based model of exposure on
monetary items are ignored with the assumption that interest rates and inflation
differences between countries get offset with each other. Aliber and Stickney (1975)
have also demonstrated empirically that more than considering assets and liabilities as
monetary/ non-monetary or current/non-current categories, the planning horizon plays
an important role. Thus, if one focuses on value, the exposure dimensions can be
re-categorized in terms of whether they relate to translation effects or they relate to
cash flow effects. Consistent with the concept of value, it is suggested that the
exposure consequences on cash flows should be the main focus of information
systems for a firm’s exposure management.
4. Typology of Foreign Exchange Exposure problem
Foreign exchange cash flow exposure requires a multifaceted approach (Soenen
and Madura, 1991; Nguyen and Faff 2003; Muller and Verschoor, 2006). Exchange
rate fluctuations can be analysed under three levels, depending on whether one is
concerned with transaction cash flows, contingent cash flow, or future operating cash
flow. Using this categorization leads to informed input regarding whether to hedge or
not to hedge (RBA, 2002).
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
A first step is to analyse cash flow exposure with regard to exchange rate fluctuations
in the context of the three levels, namely transaction cash flow, contingent cash flow
and operating cash flow. Transaction cash flow exposure affects most import/export
businesses. The consequences of a floating dollar on currency transactions not only
challenge corporate financial planning for managers, but also have detrimental effects
with wider economic implications. For instance in 1986, many smaller businesses
complained that the uncertainty created by these parity changes regarding the final
value of their exports in New Zealand dollar flowed through into production decisions,
and export margins declined as the New Zealand dollar strengthened against the
Australian and US currencies from which the company derived its main export income
(Marshall, 2000; Briggs, 2004; Becker, Debelle and Fabbro, 2005). On the other
hand, contingent cash flow exposure that relates to conditional transactions, such as
tenders, where the transaction does not become valid until the outcome of the tender
process is known. Hence, when a large sum of cash inflows or outflows is involved in
a tender such as in construction or technology industries, between the dates of
submitting the bid and winning the tender, adverse currency changes could turn a
profitable project into a loss situation and could have a devastating effect on the
business.
Lastly, the operating cash flow exposure which relates to sales and costs would
impact the on-going international business operations as the basis of expected future
cash-flows from operations would be affected with uncertain exchange rate
fluctuations. Most project appraisal techniques such as net present value and internal
rate of return use the expected future cash-flow to measure the value of a project, and
sudden changes make it difficult to plan for these activities. The cash-flow effect on
product sales price, sales volume, and cost of inputs due to an exchange rate change
requires close monitoring, which is possible with an integrated financial information
system and foreign exchange monitoring tool that can globally harmonise operational
functions; such as production, marketing, purchasing, and financing. Powers (1988)
noted that interrelationships between a foreign exchange management department
and other organizational departments are traditionally unsatisfactory, and
recommended more interrelationships between the different functions of an
organization.. Other studies also support such a view (Waters 1979; Weston 1986;
Stone, Wheatley and Wilkinson 2005; Shapiro 2006), and recommend firms'
management to be pro-active to include all relevant functions of an organization so
that the exposure problem is well-internalized.
The foregoing cash flow exposures can be identified with dimensions and factors
influencing the foreign exchange exposure problem. Apart from time dimension, a
distinction between currency and meta-currency dimensions also play an important
role in recognising the full range of exposure types for a holistic method of dealing with
the exposure problem. Hence, the different dimensions of currency exchange problem
can be analyzed in terms of two critical perspectives: (a) the time dimensions
dichotomized between the "present" (actualized transactions), and the "future" (events
yet to unfold); and (b) the exposure-generating factors again dichotomized between
those factors which are directly determined by foreign "currency" rate changes, and
those largely determined by other environmental factors termed as "meta-currency".
Meta-currency represents factors such as economic and socio-political changes,
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
technological changes, consumer pattern changes, that are considered either
individually, or in combination to form the fundamental source or causative origin of
the exposure problem. In addition, another type of exposure, exposure due to shocks
and crashes, which is quite different from the other three types of exposure discussed
previously, as it occurs instantaneously, unexpected, and with severity of catastrophic
proportions. Hence, we include shocks and crashes exposure as a new exposure
category along with transaction (or contractual), contingent and operating exposures.
Figure 1 shows the time dimensions of present and future mapped to the types of
economic exposures that influence the exposure generating factors under currency
and non-currency categories.
For an integrated financial information system, the exposure categories in Figure 1
form an underpinning framework useful for effective foreign exchange exposure
management. In decisions relating to a firm's normal operations, it is the case that the
magnitudes of a stream of future cash flows, expected changes in discount rates (time
value of money) and in inflation rates are forecasted notwithstanding uncertainties
about future states of nature pertaining to these variables. We opine that forecasting
expected foreign exchange rate changes is likely to be the ultimate determinant of real
cash flows in terms of receivables and payables. It is from this argument that the
significance of operating exposure in Cell E (2, 2) of the 2 x 2 matrix in Figure 1
should be appreciated. Hence, we emphasise the need for exposure forecasting, and
summarise the distinctive factors associated with the various categories of exposure
risks below:
(a)
(b)
(c)
(d)
Exposure Forecastability (EF)
Magnitude of Exposure (ME)
Crystallization of Exposure Generating Events (CE)
Direction of Rate of Changes (DR)
Figure 1: Dimensions and types of economic exposure
TIME
EXPOSURE-GENERATING FACTORS
DIMENSION
PRESENT
FUTURE
CURRENCY FACTORS
Transaction
Exposure
CELL E(1,1)
Contingent Exposure
CELL E(2,1)
META-CURRENCY FACTORS
Shocks And Crashes
Exposure
CELL E(1,2)
Operating Exposure
CELL E(2,2)
Figure 2 presents the defining characteristics of the exposure categories based on the
four exposure factors.
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
Figure 2: Defining Characteristics of Economic Exposure Categories
TIME
EXPOSURE-GENERATING FACTORS
DIMENSION
CURRENCY
META-CURRENCY
FACTORS
FACTORS
EF: YES
EF: NO
PRESENT
ME: YES
ME: NO
CE: YES
CE: NO
DR: NO
DR: NO
CELL E(1,1)
CELL E(1,2)
EF: YES
EF: YES
FUTURE
ME: YES
ME: NO
CE: NO
CE: NO
DR: NO
DR: NO
CELL E(2,1)
CELL E(2.2)
KEY:
EF = Exposure Forecastability
ME = Magnitude of Exposure
CE = Crystallization of Exposure Generating Events
DR = Direction of Rate Changes
From Figure 2, it is evident that for Contractual Cash flow Exposure cell E(1, 1) only
DR is problematic; and in Contingent Cash flow Exposure, cell E(2, 1) two factors CE
and DR are problematic. More importantly, in Operating Exposure cell E(2, 2) three
factors, ME, CE, and DR are problematic, while in Shocks and Crashes Exposure cell
E(1, 2) all distinctive factors, EF, ME, CE, and DR are problematic.
The difference between currency and meta-currency factors is better understood by
distinguishing between fundamental sources and their consequential effects, and from
Figure 2 we can see that Transaction Exposure is characterized by the intersection of
the problem of effects and the likely direction the exchange rate might take. In the
case of Contingent exposure the problem was one between effects of the
crystallization of exposure generating events, and the direction of exchange rate
change. In the case of Operating Exposure, the nature of the problem became
different: an intersection between the fundamental source of exposure risks, are
considered on one hand, and on the other hand, the magnitude of exposure, the
crystallization of exposure generating events, and the direction of exchange rate
change. But in the case of Shocks and Crashes Exposure the picture became
uniquely different. Here, the fundamental sources of exposure problem and their
effects became coterminous, thereby collapsing the time lag between sources and
effects, and in consequence causing what can only be described as catastrophic
Shocks and Crashes. Thus, the situation in cell E(1, 2) presents maximum
intractability with regard to exposure forecastability, ascertaining the magnitude of
exposure, the likelihood of occurrence of the exposure, and the direction the exposure
might take. This step now leads us to the next level of using hedging to deal with
exposures as it has predominantly influenced the real world of practice.
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
The use of hedging, where a global firm has two opposite foreign exchange
positions that cancel each other is considered as a mechanism to deal with
exposures (Taleb 1997; Allayannis, George and Ofek, 2001). For instance, a firm
with a long position, receiving foreign currency in future, would establish a situation
opposite with a short position, paying in future in that currency, and vice versa.
Literature reports that most of the multinational firms except those involved in
currency-trading prefer to hedge their foreign exchange exposures. The firm needs
to consider the influencing factors to decide whether to hedge or not to hedge
(Brown, Crabb and Haushalter, 2006). An assessment of the future strength or
weakness of the foreign currency it is exposed in would involve forecasting, and
determining the firm's position on profitability, sales growth and other factors that
could vary from one company to another. Global firms adopt different hedging
techniques. Some adopt operational techniques such as geographically spreading
the risk as a method to hedge, while others could use common financial contracting
methods to hedge, such as forward contract, forward rate agreement, futures
contract, swap contract, options contract, etc. (Kim, Mathur and Nam, 2006). We
suggest that integrating the proposed economic exposure categories and
hedging strategies mentioned above within the global financial information
systems is an important step for dealing with the foreign exchange exposure
problem effectively. This is explained in the next section.
5. Integrating a Firm’s Financial Information System
The first and foremost aspect for integrating global financial information system is to
incorporate a vital management strategy for the assessment and diagnosis of the
firm's strengths and weaknesses in order to proactively deal with the external threat
of foreign exchange exposure. Today's financial information systems should provide
the necessary tools for managers to understand a firm’s operational and financing
flexibility that could determine the extent to which a firm can holistically adjust the
multi-functional arenas of pricing, cost of production, source and mix of financing,
market conditions, the company's business climate. Figure 3 provides a top-level
framework for integrating global financial information system of a multinational firm
using a streamlined corporate database and business intelligence system. Apart
from analysing the foreign exchange exposure generating factors and identifying
their types and categories as well as the hedging decisions to be made, the
importance of this step is to integrate the financial information that are gained from
both local and foreign exchange climate and analyse their impact. Such a holistic
and multifaceted approach is critical to a company’s ability to effectively monitor and
manage FX risk.
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
Figure 3: A framework for integrating financial information system for global
firms
It is well-known that the manner in which an exchange rate fluctuation affects a
firm's cost of production will depend on a variety of circumstances relating to the
price effect of a change in exchange rate, cost of production effect, effect on source
and mix of financing, and conditions in the input (factor) and output (product)
markets will directly affect the price and quantity of the product sold, and this in turn
will affect the operating cash-flow of its foreign subsidiary. Integrating with the
exposure effects on a foreign subsidiary's product price and input costs would
provide the context of the subsidiary's business economy as well. For instance,
Dufey (1972) provided a conceptual framework for the economic analysis of the
effects of a devaluation of a subsidiary's host currency, where an export-oriented
subsidiary would tend to increase its revenue receipts by the devaluation percentage if
the product price remains unchanged. Alternatively, the subsidiary may opt to increase
revenue receipts by lowering the foreign currency price of the product and presumably
increasing the sales volume. Overall, a devaluation will affect the profitability of firms
differently, and the differences will depend on the varied characteristics of the firms
and their products (Korth, 1971). For the parent company of the subsidiary in the
devaluing economy, the gain or loss due to the change in exchange rate will depend
on whether the loss arising from the new rate exceeds, equals, or is less than the
change in the net local currency cash-flow. Hence, the outlook for some subsidiaries
will actually improve after devaluation, for some it will deteriorate, while for others the
net change will be close to zero (Dufey, 1972). Therefore, devaluation can have
opposite effects, and this calls for the need for an integrated global financial
Proceedings of 23rd International Business Research Conference
18 - 20 November, 2013, Marriott Hotel, Melbourne, Australia, ISBN: 978-1-922069-36-8
information system to analyze both foreign exchange exposure and possible
responses within a specific market climate, as current accounting models fail to
address the reality of the cash flow impact.
As depicted in Figure 3, an integrated global financial information system not only
recognises the foreign exchange exposures in a timely and accurate manner, but also
facilitates in managing the risk effectively by employing appropriate tools for
forecasting the trends, risk estimation and benchmarking. The information system
would go through the steps to identify, measure, monitor. report, review and act
continuously to manage exposure risks effectively.
6. Conclusions and Future Work
This paper has considered the complex problem of managing foreign exchange
exposure and identifies the issues and challenges faced by firms in this global
economy. The paper reviews current practices in dealing with foreign exchange
currency fluctuations and presents the need for a new mechanism to manage the
associated financial risks through a multifaceted integrated approach of financial
information system. Criticisms against using information derived from existing
accounting models for exposure management were reviewed and a 2X 2 matrix
presenting a holistic typology in two dimensions, that of time and exposuregenerating factors were adopted for discussing information system integration. The
concept of information integration based on a global firm’s financial database and
business intelligence for managing foreign exchange exposure was considered to
include factors influencing hedging decisions, hedging methods and a firm’s
multifaceted cash flow from both local and global business climatic conditions.
Future work would investigate and implement appropriate business intelligence
techniques for mining the financial data combined with FX fluctuation inputs through
web services to automatically provide foreign exchange monitoring tools. This would
include dynamic reporting facilities such as dashboards displaying trend analysis for
the management to proactively act and review their financial risks due to foreign
exchange exposure using our proposed integrated multifaceted cash flow approach.
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