Risk definition
and
measurement
e c ange
CONTENTS
5EWîOM 1 Definition and valuation of customer risk
5EWîoM 2 Detertnin ati on customer positi on
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xchange rate risk arises from daily fluctuations market exchange rates. This is a
fact of life 1 company. However, the foreign exchange market is not only source of
danger; it is also a place where the treasurer can carry out various buying and
selling operations. It' a tool that offers numerous possibilities for action in the
company's cash management.
The introduction of the single European currency in 2002, although a major
change for the life of company, did not eliminate the exchange rate risk. The
monetary environment of the EuroJnne company has obviously 1 1'simplified
considerably. A single common currency is shared by t9 euroJn countries. Intraeurozone trade relations have become overnight examples of foreign exchange
risk. It is estimated that around two-thirds of each eurozone country's foreign
trade is with other euroJns. Conversely, this means that one third of the foreign
trade of the European countries of the Monetary Union is "outside the walls. This is
directed towards the United States, Japan or the United Kingdom, which are not
part of the euro zone. The proportion of imports and exports denominated in
dollars, yen and pounds sterling remains high in international trade outside the euro
zone, and with it the exchange rate risk.
We need to look beyond the currency in which international transactions are
denominated. Just an export 1 to the USA may have been denominated in euros,
the problem of competitiveness does not arise. In markets which, for certain
products, are totally globalized, what counts is the ex- position of Aux
Commercial 1 a dollar (or yen) risk at both international and domestic level.
Exchange-rate risk, broadened in this way, remains 1 part of day-to-day reality
European business.
Table 7. t shows euro's share of world trade. In euro zone countries, the euro
currency represents on average 50 1 60 No. of total Aux exports and imports.
Nonetheless, currencies outside the zone, and particularly the dollar, are also
used as a link in international trade, and therefore represent a foreign exchange
risk. The dollar accounts for between a quarter and a third of these Aux. We
know that exports/imports of certain products are traditionally denominated in
dollars. This is the case for @oil, raw materials and 1' aeronautics.
Beyond the euro zone Aux exports 1 to other countries are sometimes
denominated in euros, sometimes in other currencies. In Asia, in particularthe US
dollar continues to dominate.
For the corporate treasurer, this involves 1 defining and 1 measuring the
company's foreign exchange risk. This is 11 an essential preliminary internal
analysis stage, which is all too often neglected or set aside by operators who give
priority to 1 1' instruments over 1 1' defining the stakes or 1
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determining a policy. The second section of the chapter presents the concept of the
net foreign exchange position, which is at the heart of foreign exchange risk
management, both as a synthetic variable and as an objective.
Tables u T.1- Share of euro and dollar in international trade
t
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DEFINITION AND ENHANCEMENT OF RISOUE
FOR CHANGE
We will present the definition (or rather definitions) of foreign exchange risk, a
study of its origins and time horizon, followed by its valuation and accounting.
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Generally speaking, foreign exchange risk is the result of confronting an
external uncertainty 1 with a company's internal situation.
External uncertainty is the variation in exchange rates of currencies other the
currency used as a unit of account and to measure the companys results, the socalled reference currency. Daily exchange rate variations have become the norm
since introduction of a floating parity system.
The internal situation of a company that is affected by a movement is defined
as its general net foreign exchange risk position. This refers to all items whose
value, profit and income are likely to be affected by a movement. amount of
exposure, also known as the foreign exchange posi- tion, may be significant or
negligible, depending on the case. It can be positive or negative. A positive
currency position (also known as a long position) in any currency means that if the
currency appreciates, the company will make a gain (symmetrically, a loss if it
depreciates). A negative position (also known as a short position) means a loss if
the currency rises, and a gain if it falls.
The reference made above to the elements of the company that are sensitive 1
to exchange rate movements is asse z play. Three approaches to foreign exchange
position are dis- tinguished, even if the one traditionally favored is the first.
1' transactional approach, 1' patrimonial conversion approach, and 1' economic
approach.
1.1 Transactional foreign exchange risk
A company is exposed to foreign exchange risk 1 when carrying out a
commercial or financial transaction in a currency other than its reference currency.
There is a risk that the transaction will be settled in a currency other than the one
used for the foreign currency commitment. This is basically a risk on Aux in
progress or 1 in the future.
This risk is linked to 1 all the company's current international activities. It
concerns both positive Aux in foreign currencies (customer payments,
miscellaneous income, investment returns) and negative Aux in foreign
currencies (supplier payments, debt or interest payments).
Transactional foreign exchange risk is commercial in nature. Commercial imports
and exports are often invoiced in foreign currency. In the company's balance
sheet, there are corresponding accounts receivable and accounts payable which
are of a circulating nature, i.e. which will sooner or later give rise to a monetary
settlement. Foreign exchange gains or losses will then be
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and will weigh on the company's financial results. The commercial exchange
risk therefore concerns all operating receivables and payables arising from
commercial Aux, royalties linked to 1 Aux patents or licenses, commissions,
taxes 1 paid or 1 received.
In addition, there is a transactional exchange risk linked to financial
operations in foreign currencies. Any company may need to borrow or lend in
foreign currencies. This financial foreign exchange risk arises a decision taken
within company, often by the treasurer himself. Foreign currency debts and
receivables may be part of long-term financing decisions (bond issues in foreign
currency, loan to a subsidiary, etc.) or short-term decisions (advances in
foreign currency, investments in euro-currency, dividends to be received, etc.);
In the latter case, the choice of the exchange rate used to initiate the financial
transaction is a matter for the treasurer. Insofar as the treasurer originates or is
associated with 1 these financial transactions, the resulting exchange rate risk is
a choice that does not necessarily imply a systematic hedging decision. On the
other hand, the foreign exchange risk associated with commercial transactions
is 1 beyond the treasurer's control. Here, the choice a reference parity will play a
role in commercial negotiations. The hedging of Aux commerciaux is often more
systematic. This may be the reason why some people (1 wrongly) limit
transactional foreign exchange risk to commercial risk.
1.z Asset conversion risk e
Unlike transactional risk, which has a certain maturity, currency risk is an
exposure resulting a permanent or quasi-permanent asset. Multinational
companies thus 1 long-term assets (subsidiaries, equity investmentsabroad, the
countervalue of which is fixed in the balance sheet. For the parent company, the
risk 1 corresponds to a long-term position with a
ë indeterminate. Oil companies also provide an example of a permanent long i
dollar position due to regulations requiring them to maintain i
a stock of oil
corresponding to 1 a certain number of months' consumption.
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Asset currency risk is a conversion risk. It is linked to 1 the revaluation
luation, at the balance sheet date, of permanent assets in foreign currencies. This
risk Ï remains potential, since it does not correspond to a foreseeable actual cash Aux.
Only dividends repatriated by the parent company create a real cash surplus. They
are covered by the financial transaction risk described above. Variations in net
worth resulting from rate movements, for example between two different
currencies, are not taken into account.
* are not, however, neutral, as they are subject to a series of processing
* accounting and tax systems, which are not the same in all countries.
At group level, and not just at parent company level, the risk of foreign
exchange on assets and liabilities 1 the source of a foreign exchange
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consolidation position.
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This only takes into account the currency risk outside the Group's Lornes.
Foreign exchange differences may arise at the local level each of the Group's
entities. However, a difference in the opposite direction may be identified at the
level of another entity, the counterparty of the first. This is particularly true of
intra-group transactions, the impact of which must be cancelled out on
consolidation. These transactions may generate exchange gains or losses with tax
implications. In such cases, we need to take into account the tax differential
between the company generating foreign exchange losses in country A and the
one generating foreign exchange profits in country B.
Such an analysis is not easy to implement in practice when preparing the
financial statements. However, it is important to stress the importance of precise
knowledge the part of the parent company of the consequences of the exchange
rate risk associated with intra-group transactions at the level of the subsidiaries'
income statements. In the absence of a precise analysis, subsidiaries losses on
intercompany transactions could be demotivated, while those generating gains
could be wrongly linked to their results.
1.3 Economic currency risk
Economic exchange rate risk corresponds to the impact of exchange rate
movements on the value of the company.
In fact, it expresses the companys strategic foreign exchange position. The
company needs to understand the impact of unanticipated exchange rate
variations on its position in relation to 1 foreign competitors. This applies not
only to large companies with highly developed international activities, but also to
medium-sized companies subject to strong international competition, whether on
the export or domestic market.
Economic exchange-rate risk is therefore a competitiveness risk. A rise in the
reference currency makes exports more difficult and favors imports. In a
competitive situation, this results in a lasting weakening of the company's
margins. This competitive pressure weighs heavily on exports, whether or not
they are invoiced in local currency. Even in the absence of foreign competitors,
the economic exchange-rate risk also manifests itself on the domestic market,
through the costs of imported materials and products incorporated into the
production process. A leash on the dollar is thus likely to favor, via the cost of
oil, hydrocarbon-consuming companies, which will thus be able to offer more
competitive prices.
The economic exchange rate risk leads to 1 an analysis in terms of pricecompetitiveness and the fragility of the competitive position, which is the
responsibility of the company's General Management. The impact of currency
variations will depend on
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These include market structures, competitor organization, purchasing policies,
production process integration, export and foreign location , currency invoicing
policies, etc. The study of economic risk gives rise to complex simulations
involving both quantitative and qualitative elements. The economic exchange risk
is not easily quantifiable and does not give rise to 1 accounting treatment, unlike
the previous ones. For all these reasons, it does not fall within the direct sphere
of action of the corporate treasurer.
2.1 Role of types operation: regular activity or projects
Foreign exchange risk does not arise at the time of invoicing 1 of a foreign
currency transaction. It originates long before the accounting documents are
received or issued by the company, and the receivables or payables are booked. A
distinction must be made here according to the process followed by the
commercial transactions. A distinction is made according to whether the
company manages a portfolio activities or a portfolio of projects.
A company with foreign business portfolio manages a set of recurring and
repetitive commercial transactions linked, for example, to the holding a market
share. It carries out a large number of transactions at regular intervals, even if in
some cases there may be seasonal fluctuations. The most important date is the
order.
Some companies work differently, in that their sales price in foreign currency is
fixed in advance. This is particularly true of companies that sell abroad by
catalog. Here, the risk appears even before the order is taken.
_ since the company guarantees a certain amount of time (the catalog's lifespan) for a specific
product.
â sales price in foreign currency to potential customers. The currency risk is therefore
* on the basis of budgeted foreign sales 1 as an estimate of future orders.
at
The budget approach is defined as part of the company's overall budget
procedure. Most often defined on an annual basis, the foreign currency sales
budget is a contractual objective that the company enters into with itself at the
beginning of the year. Its
-internal recognition is an implicit commitment.
The approach in terms of recurring orders cannot applied to 1 companies that
commercially manage a portfolio of projects. These include, of course, companies
that operate abroad in the field industrial projects (buildings, public works,
transport, aeronautics, large-scale equipment, defense equipment, etc.), but also
those that make proposals for new projects.
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business in the form of service contracts. This also applies to companies involved
in major 1 asset transactions (industrial investments, external growth,
divestments). In these cases, the event generating the exchange rate risk is not
the order, but the 1 bidding for contracts, the submission of offers, the commercial
proposal or the date 1 on which the asset transaction is decided.
The foreign exchange risk horizon is simple and unique, whatever the type of
transaction. It is the date (or dates, in the case of Aux fæctionnés) of collection
of the receivable or settlement of the debt.
The "business portfolio" company adopts a (pre-)transactional approach to
foreign exchange risk, insofar as it arises from 1 the drawing up of the budget or 1
the receipt of the order. The latter corresponds to the creation of a reciprocal
commitment, usually confirmed in writing (signature of a contract, e-mail, fax or
letter of confirmation). The order received is immediately 1 the origin of an i
ndustrial act, as the company either de-stocks or starts manufacturing the goods to
be delivered. In , the order also entails the implementation of the logistical
requirements 1 for future delivery (transport, packaging, insurance).
The order, with its dual character of commitment to a third party and launch
an industrial process, is the preferred date for companies to manage their
transactional foreign exchange risk. The risk is almost certain 1 this date because,
even the order is cancelled, the goods produced will very probably another buyer.
Foreign exchange risk can even arise before an order is received. This is
preceded a phase commercial negotiation, during which the company's sales
staff make offers or present quotations to the potential customer. Negotiations may
last some time, and may lead to the revision of certain terms of the commercial
proposal (price, quantities, payment terms, etc.). The company is unilaterally
committed when it presents an offer to a prospect. In this case, the exchange rate
risk is not certain, since it depends on the likelihood of the offer being accepted
and translated into an actual order.
z.2 The pre-transactional or transactional approach
At expoAtion
In the case of regular customers, we can estimate the probability that they will
place an order for a given amount. We can therefore calculate a probabilized
transac- tional exchange rate risk as soon as a commercial proposal is up. This
kind of upstream defi- nition of the origin of transactional risk is not commonly
used, even if it is well-founded in principle. It require a
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The treasurer needs to know the counter-value of all foreign currency proposals
issued by all the company's sales departments, along with an estimate of
probability of each proposal being converted into an actual order. This is why it's
easier to date the exchange rate risk 1 the order: all you need to do is collect the
orders actually received. This is no mean feat when the company's sales
departments are located both in France and abroad.
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Once the order has been received, the manufacturing period begins, ending with
delivery of the goods or provision of the service. In this case, the foreign
exchange risk must be recorded in the off-balance sheet accounts "Goods or
services 1 delivered in foreign currencies". Hedging this risk, if decided, su
pprimes it almost entirely, but not totally, the amount or maturity may still be
modified or simply adjusted. The delivery date coincides with the invoice issue date.
The customer credit period runs from invoicing 1 to the contractual payment . In
this case, the foreign exchange risk becomes totally certain. The is shown in a
customer account on the balance sheet. All uncertainty is removed; the hedge can
be perfectly adjusted, to within ' uncertainty, between the contractual due date
and the date on which the funds to be collected are actually available. The latter
period corresponds to the time required to collect the funds. The risk here is
twofold: on the one hand, the customer may default, and the other, the banking
circuit used by the customer (or the direct debit used by the supplier) may default.
The first case is not specific to transactions
-with foreign countries. The second case is marginal and rare: the counterparty risk.
r banking party through which the funds must pass. rarely mentioned, this risk is not
non-existent in some countries. Once funds have been collected, the customer
account is cleared in the accounts by debiting the "Bank" account of
at
.
g
In of fi nancial stakes, these are not very high during the g
manufacturingstocking period. Cancellation of the order (or failure to carry it over to another order) will
result in a build-up of stock, and therefore an increase in capital requirements. This
increase will be more or less neutral, since it corresponds to an unrealized increase in the
"Customers item, which would have been
1 sale. However, there is an initial financial surcharge, insofar as the duration of
the working capital requirement 1 will be longer overall. It's reasonable to assume
that the product will be sold sooner or later, but the
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