Foreign Exchange and Trade Risk

Foreign exchange (FX, forex) risk is the risk of a change in value due to variation in exchange rates be it resulting in a cash flow or recorded value difference. There are several exposures possible:

\- transaction exposure comes from cash flow changes in relation to contractual obligations.

\- translation exposure (aka accounting exposure) comes from translations of foreign accounts into home currency for a group account

\- economic exposure (aka operating, strategy exposure) comes from changes in exchange rates having an effect on sales and/or costs and hence company value. Nokia had a growth in sold phones for example but not a very good growth in sales, if any, due to the decline of the USD.

Transaction exposure can be in both product price, invoice and realised profit or loss at conversion.

You create a product -> build stocks -> fix the foreign price [potential transaction exposure] -> receive order -> Invoice [actual transaction exposure] -> receive foreign funds -> exchange into local currency [gain or loss due to exchange rate movements]

Translation exposure arrises from assets and liabilities available in more than one currency. It is an account concept and results in adjustments to the balance sheet reserves of the parent company. In most countries there is an account standard abou which exchange rates to take in your books and in general you should stick to the true and fair idea, meaning that you shouldn’t change the way you pick exchange rates without a real reason.

Economic exposure is very wide and far ranging, direct or indirect.

To measure your foreign exchange exposure you can for example use spreadsheets including the revenues and costs over several months into the future and the potential changes in linked exchange rates. Economic exposure is harder to pin down, as it can be made up of quantifiable data and less precise information. A strategic DCF model and/or scenario analysis with the help of e.g. Porter’s five forces would help here.

Market for foreign exchange

The forex market is very complicated but the book will not try to make a forex trader but to be able to understand one. The market is a framework for buying and selling currencies, with this being possible in many markets world-wide, allowing for around the clock trading. There are two markets, namely the interbank (wholesale) and the client (retail) market. A major market for any currency is the home market and international interbank markets are only found in London, New York and Tokyo.

In Aprial 1998 the estimated net turnover in the global forex market wsa USD1,490 billion per working day. In relation to that, the International Monetary Fund released numbers for 1994 statingthat the total volume of goods sold world wide was USD4,314.9 billion. 58% of all forex trading happens in London, New York and Tokyo. 83% of the trading in London was interbank.

A speculator’s purpose is to take risks on market prices for profit while an arbitrageur is trying to optian risk free profits due to price differences in different markets.

The mechanics of foreign exchange

When currencies are bought or sold for immediate delivery (settlement in two working days) they are called spot (exchange) rates. There are two prices, one for buying and one for selling. The direct quote gives you the amount of local currency to buy one unit of foreign currency. In New York, it would be quoted as EUR1 = USD0,9055. The indirect quote gives you the number of units of foreign currency bought with one unit of home currency, e.g. USD1 = EUR1,1523

The spread between the rates for buying and selling currency (bid and offer spread) represents the dealer’s margin. The foreign exchange dealer is the market maker and posting the rates, while the market user takes the rates as given. Bid price is the rate at which the bank buys and the offer rate at which it sells.

When there isn’t liquid market from one currency to another, it might be worthwhile to look at cross rates, meaning that you exchange not directly but via another currency like the USD. You can use simple math to get the next exchange rate. e.g.: EUR/USD * USD/GBP = EUR/GBP.

Another thing are forward exchange contracts, an agreement to deliver a specified amount of one currency for a specified amount of another currency at some future date. This is a forward (exchange) rate. This agreement is binding. If a currency is trading at a discount, the currency is weaker in the forward market, otherwise it would be trading at a premium. Forward rates are either quoted forward outright rate or forward margin: forward outright = Spot + Forward margin

All transactiona are booked at the start of the deal, but the settlement of a forward deal is done at the end of the period, but to a price that has been locked in and booked at the beginning. This brings us to an interesthing concept: interest rate parity. This means that the forward rate will reflect the different in interest rates in the two currencies.

Forward Margin (FM) = [(Period in days) (Spot rate) (Foreign currency interest — Local currency interest)] / [360 + {Period in days x Local currency interest}]

This 360 days is just an old habit.

Remember that risk-free gains normally do not arise as arbitrageurs will put them back inline swiftly. There is also risk attached to forwards, e.g. due to the potential default (credit risk) of one of the parties during the deal, meaning you will have to do a new deal to replace the old one. Or the settlement risk when you hold your side but the other party doesn’t pay their share. To get arround this risk, banks will reduce your borrowing limit by 5–15% of the forward value. Remember: banks do not charge fees but make their money through the bid-offer spread.

Here are some advantages in relation to forwards:

\- fix currency prices

\- eliminate risk

\- colculate exact domestic currency value

Premium of the foreign currency means:

\- corrency string in foreign market

\- exporter will receive more of his local currency in the future

\- importer will pay more

In case of a discount

\- currency weaker in foreign market

\- exporter will receive less local currency

\- importer will pay less local currency.

The decision is led by the policy towards risk. Also, if you calculate the forward rate, and believe that the real rate at the time will be different, then there is a reason to go for such a deal. If you are in a high turnover business, with a small net margin, there is also a good reason to take out a forward cover since your margin might become negative by fluctuations in exchange rates alone. I remember one company with a very low margin business where the finance department actually made a good profit for the books due to good exploitation of the financial markets and hedging.

Forecasting foreign exchange rates

Unless you want to hedge all your currency exposure, you need to think about how to decide when to do it. There are four concepts that are said to explain international exchange rates, forming the four-way equivalence model together.

The _purchasing power parity_ (PPP) is based on the idea that something should cost the same everywhere. Higher inflation will lead to adjustments in the exchange rates so that things cost the same again. In the short term, there are too many market imperfections for PPP to hold, but it does seem to work for the long term.

The _fisher effect_ can be put into a formula:

1 + Nominal rate = (1+Real rate)(1+Expected inflation rate)

The real rates are thought to be the same worldwide, meaning that differences in nominal rates have to come from differences in the expected inflation rate.

The fisher effect together with PPP makes up the International Fisher effect, saying that interest rate differentials will be reflected in forward exchange rates. This means that on top of a devaluaton of the home currency in case of higher inflation, there will also be an increase in home interest rate relative to the foreign market.

The _interest rate parity theory_ (IRP) is about the idea that the difference between interest rates should be equal to the difference between forward and spot rates of exchange. The arbitrage relationship is key to this parity condition.

_Expectations theory_ is linked to the EMH, meaning all relevant information is reflected in market rates. So the forward rate of exchange reflects what the spot rate in the future will be. All these four theories together give the four-way equivalence model, meaning that they all come to the same conclusion. (Forward — Spot rates = interest rates difference)

There is actually a Big Mac index, linked to PPP, which actually allows some prediction on future movements. Yes, that’s the price of Big Macs in different countries.

To forecast future exchange rates, some look at movements in a country’s capital account (movements in financial investments) and current account (movements of import and export). e.g. if the current account goes into a deficit, there will be a bigger demand for foreign currency to pay for those imports and that will put pressure on the exchange rate.

The monetarist approach is about looking at the money supply.

Technical analysis is rather about a long term study of the market over time, with the chartists using graphics of prices and trading volumes. They believe the market takes long to reflect new information, while fundamental analysts state that the EMH would not allow for such a thing to take place. The EMH might not hold on the currency markets though as some countries might support a set currency over the long term.

If you have different estimates you can combine them in currency histograms, weighting them by their perceived reliability.

Forex risk management within the organisation

This depends on how risk averse you are.

Very -> Finance in local currency or hedge

Less -> Potential loss and gain is believed to be minimal or to cancel each other out

Assymetrical -> hedge when interest costs preferable to exchange losses

Aggressive Speculator -> exchange as potential for profit

Multi-divisional organisations needs to decide on (de)centralisation. Departments need to decide on their exposure to currency risks in relation to foreign production or invoicing in foreign currency or how to make capital available. You choice will be between the foreward rate achieved through hedging and the forecast that exists now. The currency hedging for your company depends on the type of business and the size and makeup of the corporation.

Techniques for exposure management

1. Exposure netting: Two companies in the same group net off the currency accounts that they owe to each other.

2. Matching: Similar to netting just that here you are matching receipts and payments in a sense.

3. Pricing adjustments: You adjust prices to match revenue and costs, establishing them in one currency only. Then of course you have exposure in your profits if you use the foreign currency.

Transfer pricing within a company can of course be set fairly liberaly.

1. Exchange risk guarantees: If there is a benefit for exporting then government might give guarantees.

2. Long-term borrowing in foreign currencies: Mainly used for reducing economic exposure. you simply finance in USD if your fixed asset are in the US. You also limit transaction exposure for the loan if sales are in the local market. Swaps have a potential here.

3. Financial instruments: trading in spot, forwards, futures or options.

Credit risk and settlement risk

They are normally lumped together as trade risk. The come from the same route and have a low probability but danger of total loss. You need a cash management system takes care that the security of your cash is protected and it is not lying around more than needed. Most problems of loosing money inside a company are inadvertent mistakes rather than deliberate fraud. Banks record phone calls not due to mistrust but for security and to easily settle disputes.

Trade creditors are normally ranked along with other unsecured creditors. Normally we expect to be paid normally. As current liability creditors we should look at our customer’s current assets as they are our source of payments. You can also request a credit report, which should not be seen as a substiture for your own analysis.

Letters of credit allow for reduction of credit risk by interposing one or more banks between the transactions. They are sometimes called documentary credits and there are lots of variants. There are some choices you need to make. Should it be revocable (cancelable before products shipped) or irrevocable. Does the LC remove the recepient from going directly to the customer? LCs can be confirmed (guarantee of both issuing country bank and local one) or advised. It is also most common for the supplier to fund the shipping period and then be paid. Sometimes LCs are used instead of allowing credits.

A letter of guarantee is about a bank guaranteeing a certain amount in relation to certain events.