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Updated on June 24, 2015

International Financial Risk Management

All firms are in some way influenced by three financial prices; Exchange Rate interest rates, and commodity prices. The management of these prices, these risks, is termed financial risk management. Interest rates have always received, deservedly, much of man-agreement's attention in business; it is only recently that many firms have chosen to ac-knowledge their financial health is also affected and commodity prices. the following analysis focuses on the Exchange Rat risks suffered by firms operating internationally.

Financial Price Risk And Firm Value

Risk is a word that deserves more respect than is commonly afforded it. Most diction-arise will refer to risk as the possibility of suffering harm or loss, danger; or a factor or element involving uncertain danger or hazards. These are negative definitions. yet in the field of finance, the word risk has a neutral definition; a value or result that is at present unknown. This means that risk can be either positive or negative in impact.

There are three categories of financial price risk; interest rate risk, Exchange Rat risk, and commodity prices risk. Each can have potentially positive or negative impacts on the profitability or value of the firm. If the dollar were to appreciate against other major currencies like the Japanese yen, Kodak's products would be more expensive to foreign buyers, and it may lose market share to foreign competitors.

But this same firm value sensitivity also exists for interest rates and commodity prices. Most firms are at least partially financed with short term floating rate debt. Therefore whenever interest rates rise, these firms suffer higher financing cots reducing the value of the firms.

Similarly an increase in the like oil or coal, which are inputs into the production processes of many firms, will also reduce the value of those firms. But it does vary across firms. For a company like Kidder Peabody which mines coal, will see rising profits and firm value when coal prices rise. Each firm is different. It simply depends on the markets and makeup of each company. Although the following sections will focus on the measurement and management of Exchange Rat risk , it is important to remember that other financial price risks, such as those of interest rates and commodity prices are fundamentally the same. They too can be measured and managed by firms.

Classification Of Foreign Currency Exposures

Companies today know the risks of international operations. They are aware of the substantial risks to balance sheet values and annual earnings that interest rates and Exchange Rat may inflict on any firm at any time. And as is the case with most potential risks or problems to the firm, senior management expects junior management to do something about it. Financial managers, international treasures, and financial of farces of all kinds are expected to protect the firm from these risks. But before you can manage a risk you must be able to measure it. There are three types of foreign currency exposures that firms have in varying degrees:

1. Transaction exposure

This is the risk associated with a contractual payment of foreign currency. For a U.S firm that export products to France will receive a guaranteed payment in French francs in the future. Firms that buy or sell internationally have transaction exposures if any of the cash flows are denominated in foreign currency.

2. Economic exposure

This is the risk to the firm that its long term cash flows will be affected, positively or negatively by unexpected future Exchange Rat changes. Although many firms that consider themselves to be purely domestic may not realize it all firms have some degree of economic exposure.

3. Translation exposure

This risk arises from the legal requirement that all firms consolidate their financial statements of all worldwide operations annually. Therefore any firm with operations outside its home country, operations that will be either earning foreign currency or valued in foreign currency has translation exposure.

Transaction exposure and economic exposure are true exposures in the financial sense. This means they both present potential threats to the value of a firm's cash flows over time. The third exposure translation is a problem that arises from accounting. Under the present accounting principles in practice across it once was. For the most part few real cash resources should be devoted to a purely accounting based event.

Transaction Exposure

Transaction exposure is the most commonly observed type of exchange rate risk. Only two conditions are necessary for a transaction exposure to exist:

(i) a cash flow that is denominated in a foreign currency.

(ii)and the cash flow to occur at a future date. Any contract agreement purchase or sale that is denominated in a foreign currency and will be settled in the future constitutes a transaction exposure10.

The risk of a transaction exposure is that the exchange rate might change between the present date and the settlement date. The change may be for the better or for the worse. For an American firm signs a contract to purchase heavy rolled-steel pipe from a South Korean steel producer for 21,000,000 Korean won. The payment is due in 30 days upon delivery. This 30 day account payable so typical of international trade and commerce, is a transaction exposure for the U.S. firm. If the spot exchange rate on the date the contract is signed is Won 700/$, the U.S. firm would expect to pay .

Won 21,000,000 =$30,000

Won 700/$

But the firm is not assured of what the exchange rate will be in 30 days. If the spot rate at the end of 30 days is Won 720$, the U.S. firm would actually pay less. The payment would then be $29, 167. If however the exchange rate changed in the opposite direction, for Won 650$, the payment could just as easily have increased to $32,308. This type of price risk, transaction exposure, is a major problem for international commerce.

Transaction-Exposure Management

Management of transaction exposure is usually accomplished by either natural hedging or contractual hedging. Natural hedging is the term used to describe how a firm might arrange to have foreign currency cash flows coming in and going out at roughly the same times and same amounts. This is referred to as natural hedging because the management or hedging of the exposure is accomplished by matching offsetting foreign currency cash flows and therefore does not require the firm to undertake unusual financial contracts or activities to manage the exposure. For a Canadian firm the generates a significant portion of its total in U.S. dollars may acquire U.S. dollar debt. The U.S. dollar earnings from sales could then be used to service the dollar debt as needed. In this way regardless of whether the C$/US$ exchange rate goes up or down, the firm would be naturally hedged against the movement. If the U.S dollar went up in value against the Canadian dollar the U.S dollars needed for debt service would be generated automatically by the export sales to the United States. U.S. dollar cash inflows would match U.S. dollar cash outflows.

Contractual hedging is when the firm uses financial contracts to hedge the transaction exposure. The most common foreign currency contractual hedge is the forward contract although other financial instruments and derivatives such as currency futures and options, are also used. The forward contract would allow the firm to be assured a fixed rate of exchange between the desired two currencies at the precise future date. The forward contract would also be for the exact amount of the exposure.

Economic Exposure

Economic exposure also called operating exposure is the change in the value of a firm arising from unexpected changes in exchange rates. Economic exposure emphasizes that there is a limit to firm's ability to predict either directly or indirectly have economic exposure.

It is customary to think of only firms that actively trade internationally as having any type of currency exposure . But actually all firms that operate in economies affected by international financial events such as exchange rate changes are affected by these events. A barber in Ottumwa, low a, seemingly isolated from exchange rate chaos, is still affected when the dollar rises as it did in the early 1987s. U.S. products become increasingly expensive to foreign buyers, American manufactures like John Deere & Co. in low a are forced to cut back production and lay off workers, and businesses of all types decline. Even the business of barbers. The impacts are real and they affect all firms domestic and international alike.

Impact Of Economic Exposure

The impacts of economic exposure are as diverse as are firms in their international structure. Take the case of a U.S. corporation with a successful British subsidiary. The British subsidiary manufactured and then distributed the firm's products in Great Britain, Germany and France. The profits of the British subsidiary are paid out annually to the American parent corporation. What would be the impact on the profitability of the British subsidiary and the entire U.S. firm if the British pound suddenly fell in value against all other major currencies .

If the British firm had been facing competition in Germany France and its own home market from firms those other two continental countries, it would now be more competitive. If the British pound is cheaper so are the products sold internationally by British based firms. The British subsidiary of the American firm would in all likelihood, see rising profits from increased sales.

But what of the value of the British subsidiary to the U.S. parent corporation? The same fall in the British pound that allowed the British subsidiary to gain profits would also result in substantially fewer U.S. dollars when the British pound earnings are converted to U.S. dollar at the end of the year. It seems that it is nearly impossible to win in this situation. Actually from the perspective of economic exposure management the suit of the exchange rate change is desirable. Sound financial management assumes that a firm will profit and bear risk in its line of business not in the process of settling payments on business already completed.

Economic-Exposure Management

Management of economic exposure is being prepared for the unexpected. A firm such as Eastman Kodak (U.S) which is highly dependent on its ability to remain costs competitive in markets both at home and abroad may choose to take actions no that would allow it to passively withstand any sudden unexpected rise of the dollar. This could be accomplished through diversification diversification of operations and diversification of financing.

Diversification of operations would the firm to be desensitized to the impacts of any one pair of exchange rate change. For many multinational firms such as Hewlett Packard produce the same products in manufacturing facilities in Singapore the United States, Puerto Rico and Europe. If a sudden and prolonged rise in the dollar made production in the United States prohibitively expensive and uncompetitive, they are already positioned to shift production t a relatively cheaper currency environment. Although firms rarely diversify production location for the sole purpose of currency diversification it is a substantial additional benefit from such global expansion.

Diversification of financing serves in hedging economic exposure much in the same way as it did with transaction exposures. A firm with debt denominated in many different currencies is sensitive to many different interest rates. If one country or currency experiences rapidly rising inflation rates and interest rates a firm with diversifies debt will not be subject to the full impact of such movements. Purely domestic firms however are actually somewhat captive to these local conditions and are unable to ride out such interest rate storms as easily.

In both cases diversification is a passive solution to the exposure problem. This means that without knowing when or where or what the problem may be the firm simply spreads its operations and financial structure out over a variety of countries and currencies to be prepared.

Translation Exposure

Translation or accounting exposure result from the conversion or translation of foreign currency denominated financial statements of foreign subsidiaries and affiliates into the home currency f the parent. This is necessary to prepare consolidated financial statements for all firms as country law requires. The purpose is to have all operations worldwide stated in the same currency tars for comparison purposes. Management often uses these translated statements to judge the performance of foreign affiliates and their personnel on the same currency terms as the parent itself.

The problem however arises from the translation of balance sheets in foreign currencies into the domestic currency. Which assets and liabilities are to be translated current exchange rates versus historical rates . Or should all assets and liabilities be translated at the same rate.? The answer is somewhere in between and the process of translation is dictated by financial accounting standards.

Translation-Exposure Management

At present in the United States the proper method for translating foreign financial statements is given in Financial Accounting Standards Board statement According to FASB 52, if foreign subsidiary is operating in a foreign currency functional environment11, most assets liabilities and income statement rate in effect on the foliates are translated using current exchange rates. For this reason, it is often referred to as the current rate method.

Translation exposure under FASB 52 result in no cash flow impacts under normal circumstances. Although consolidated accounting does result in cumulative translation adjustment (CTA) losses or gains on the parent's consolidated balance sheet, these accounting entries are not ordinarily realized. Unless liquidation or sale of the subsidiary is anticipated neither the subsidiary nor the parent firm should expend real resources on the management of an accounting convention. In the event that the realization of the CTA translation gain or loss is imminent traditional currency hedging instruments can be used.

    Domestic firms that specialize in performing global business services as commission representatives as distributors are known as export management companies (EMCs).
  • The Role Of Management
    The type and quality of its management are the keys to whether or not a firm will enter the international marketplace. Researchers have found that management commit-mint is crucial in the first steps towards international operations.2


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    • Verlin Gradney profile image

      Verlin Gradney 

      23 months ago

      Verlin Gradney: Great overview article of currency markets and effects on business decisions. A good read in today's changing economic climate.


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