Companies trading outside of their domestic borders find themselves facing foreign exchange risk. This is the risk that movements in currency rates will create gains/losses when transactions are entered into for which payment (or receipts) is at a future date.
There are various ways in which companies facing this risk can protect themselves.
Hedging Foreign Exchange risk
Internal Hedging Techniques
Invoicing home currency
Nota:
This has the advantage of eliminating forex risk but it passes the risk to the customer making the company less competitive and introducing the risk that customers will move on to other suppliers able to deal in their currency
Leading and Lagging
Nota:
Acceleration or delay of receipts and payments in anticipation of exchange rate movements. Some degree of confidence will be needed in the exchange rate forecast
Netting
Nota:
Setting of debtors and creditors of all companies in a group so that only the net amount is paid
Bilateral
Nota:
Only two companies are involved
Multilateral
Nota:
More than two companies are involved. The company's own treasury can arrange this or alternatively, the bank may be able to help.
Steps to follow:
Convert all balances to the common currency.
Draw up a matrix with payments and receipts as the columns or rows and compute total balances.
Use these balances to establish a net position i.e payments less receipts
Matching
Nota:
Match payments in a forex with receipts by way of a foreign exchange bank account
External Hedging Techniques
Foward Contracts
Money Market Hedge
Futures Contracts
Options
Swaps
Transaction Risk
Nota:
The risk a company is exposed to when they enter into a transaction for which payment or receipt is in a foreign currency at a future date. In the period between the transaction date and the payment/receipt date, the exchange rate may change leading to a gain or loss.
There is a cashflow effect
Translation Risk
Nota:
Companies with subsidiaries in foreign countries will need to prepare consolidated accounts. To this end, any accounts in foreign currency must be translated to the presentation currency giving rise to a gain or loss.
Economic Risk
Nota:
Also referred to as Economic, Operational or Strategic exposure, it arises due to the changes in the present value of a company due to changes in the future value of cashflows as a result of foreign exchange movement. For example a company that relies on foreign import of raw materials may find that the cost of these is affected by an appreciation of the foreign currency against it's local currency, put simply, they will need to pay more to achieve the planned level of production directly affecting the net cashflows of their operations
Terminology
Variable and Base Currency
Nota:
The base currency is the currency expressed as one and the variable is the currency expressed in the base currency terms e.g £/$ 1:1.6
Bid, Offer, Spread
Nota:
Bid = buying rate
Offer = Selling Rate
Spread = Offer less Bid and is the compensation for the dealer for holding risky foreign currency
Spot and Forward Rates
Nota:
Spot = bid and offer rates today
Forward = Price quoted today for delivery at a future date of a specified currency at a specified amount
Quotations
Nota:
Outright = price to all its decimal places e.g 1.6878
Point = number of points away from outright quotation either as a premium (subtract from outright) or as a discount (add to outright) e.g if given at a discount: bid 65 and offer 68 this means add 0.0065 to the bid spot rate and 0.0068 to the offer spot rate to arrive at the foward rate
Cross Rates
Nota:
Allows you to calculate a rate given exchange rates for different currencies (with one in commone) e.g
1 Yen = $0.6
£1 = $1.56
Cross multiplying
1.56 Yen=£0.6
dividing both sides by 0.6
1.56/0.6 Yen = £1
2.6 Yen = £1