Lecture 4
Nature and Measurement of
Exposure and Risk
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Concept of Exposure
• Foreign Exchange Exposure occurs because of
unanticipated change in the exchange rate
• For example the difference in the spot rate &
one month forward rate is 0.30 rupee per USD
and after one month rupee depreciates by 30
paisa there would be no FE exposure but if
actual depreciation is more, then exposure
would be said to exist
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Classification of
Foreign Exchange Exposure
• Accounting Exposure or Translation Exposure: derived
from the consolidated financial statements of the parent
company and it does not influence the cash flow
• Economic Exposure: results from altered cash flow of a
company, further divided into transaction exposure and
real operating exposure
• Transaction exposure refers to FE loss or gain on
transaction already entered into & denominated in a
foreign currency. It is connected with changes in the
present cash flows
• Real operating exposure relates to changes in future
cash flows- impact of inflation on the cost & revenue
structure in addition to change in FE rate
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Translation Exposure
• Emerges on a/c of consolidation of financial
statements of foreign subsidiaries by the parent
company
• With changes in exchange rate b/w host country
& home country, picture of consolidated
statement changes. This change represents the
size of translation exposure
• Accounting exposure also explained in terms of
net worth exposure where changes in exchange
rate affect market value of assets & liabilities
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Transaction Exposure
• Difference between expected cash flow & actual
cash flow on a/c of exchange rate changes
emerges:
- owing to foreign trade in open account
- borrowing or lending in foreign currency
- intra firm cash flows
In case of MNCs the consolidated net figure of
cash flows determines the size of transaction
exposure5
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Real Operating Exposure
• Varies if the cost and revenue streams
differ under different market conditions
• Cost & revenue streams under different
market conditions are estimated and
brought to the present value and then
compared with the expected cash flow in
absence of any change in exchange rate
• Estimated also by regression analysis
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Management of FE Exposure:
Hedging Decision
• PPP Theory- movement in exchange rate offsets
the changes in price level
• Secondly, gains & losses of exchange rate
change do tend to average out over a period of
time
• Shareholders minimise currency risk through
diversification of investment portfolio
• Hedging uses up scarce resource and may thus
lower the value of the firm
• Debate seems to be academic, in practice firms
do involve in various kind of hedging
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Hedging Techniques for
Transaction Exposure
• Contractual hedges and Natural hedges
• Contractual hedge include forward market hedge, money market
hedge, future market hedge and options market hedge
• Money market hedge involve borrowing in local currency, convert
the same into the currency of payables and then investing it for
matching period (for imports). For hedging exports, the exporter first
borrows in foreign currency and then converts in local currency
before investment
• If the firm has sufficient cash from business operations to fund for
this, it is called covered hedge otherwise an uncovered money
market hedge
• Firm adopts a particular technique where cost is smallest or gain is
largest
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Natural Hedging
• Natural hedging is resorted to when contractual
hedging fails to give results
• In the absence of a forward market in the
currency in which the firm is exposed a perfect
contractual hedge is not available
• Leads and lags: lead means accelerating or
advancing the timing of receipt or of payment of
foreign currency. Lag is just the reverse.
Practiced for transactions between weak
currency to hard currency areas or vice versa
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Natural Hedging (2)
• Cross hedging: adopted when desired currency
cannot be hedged. Firm has to first identify a
currency that can be hedged and volatility of
which is highly correlated with desired currency
• Currency diversification: diversifying operations
in a larger no. of currencies as a hedging tool
• Risk sharing: contractual arrangement where
buyer an seller agree to share the risk if
variation crosses an accepted neutral zone
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