Foreign Exchange Exposure
Welcome friends, to our course of International Business. As we have been discussing inthe last few lectures on foreign exchange and foreign exchange market, right. So, we alsodiscussed in the last lecture about the theories of foreign exchange, in which we talkedabout the purchasing power parity theory, interest rate parity theory and fisher effect,right.As you have understood by now that the importance of foreign exchange, right. Howimportant foreign exchange is, while making any transactions; international business orinternational transactions, right and change in foreign exchange the when the currencyvalue changes across against one another, a trader or a business person can makesubstantial gain or substantial losses, right.(Refer Slide Time: 01:09)So, today we will start with the Foreign Exchange Exposure. So; now, exposure as youfrom the word you can understand that when we are exposed to certain features; forexample, we are exposed to political situations; we are exposed to cultural problems; weare exposed to you know behavioral traits. So, similarly financial parameters. So, howwhat is foreign exchange exposure and how important it is? So, today we will bebasically discussing on this.So, as it is said, if you can see here, each firm is exposed, right to unforeseen changes.So, unforeseen changes could be like for example, there is a tension between a U.S andChina or there is a tension between Iran and US, when US bombarded Iran and one of itis leaders lost his life.So, there are unforeseen changes and the and every time there is a new political, theFedex, the federal reserve changes his policies, his interest rate. So, there is the changeon the, it has a significant impact on the currencies of all the different countries. So,unforeseen changes are there, a number of variables are affecting it, right. Thesevariables are called risk factor.So, example exchange rate fluctuation is one such risk factor we are talking about, rightand this exchange rate fluctuation will have a tremendous effect on every business, ok.Because, after all the businesses are done on the basis of the currencies, ok.It is a measure of the potential change for a firm’s profitability, net cash flow, andmarket value because of a change in the exchange rates. So, any company’s profitabilityor cash flow will change on base and the market value will change, because there is achange constant change in the exchange rates.So, for example, if we are talking about India and India as value rupee changes againstthe Yen or the Dollar or the Euro; accordingly, the profitability of a company who isexposed to different markets; for example, Tata is exposed to different countries where itis selling its products or it is importing certain items from other countries. So, all thistransaction needs those different kinds of currencies. So, as they are exposed to it, so itwill also affect its profitability in other factors.So, what exposure basically means? It says, it refers to the degree to which a company isaffected by exchange rate changes, simple, right. What is it saying? Exposure rate.Exposure refers to the degree to which a company or firm is affected by exchange ratechanges, right. Had all exchange rates were fixed in relation to one another, which is ahypothetical situation only, is not possible. There would be no foreign exchange risk,right.However, rates are not fixed, ok; because they are affected by the demand and supply.So, and it is not constant, it is cannot be fixed. So, since they are not fixed, the currencyvalue change frequently. So, since, we understand that the exchange rates cannot befixed, it is highly dynamic and they depend on the sub they majorly depend on the supplyand demand in the market, right.So, it is an open market mechanism, because this the measure of the sensitivity of afirm’s performance to fluctuations in the relevant risk factor, that is whether or not acertain risk factor effects a firm’s performance. So, what we are trying to study is; howmuch does the foreign exchange exposure of a of a company and the volatility in thecurrency currencies, how much are they going to affect the firm’s performance, ok.So, a measure of the potential for a firm’s foreign exchange exposure can be defined, asa measure of the potential for a firm’s profitability, net cash flow, and market value as Ihad said, and liabilities to change because of the change in the exchange rate. So, this iswhat is basically the thing that we are going to discuss. So, as a company, as most of theglobal companies, today they are into many inter you know, many countries, so they aretrading with several currencies.So, once they are trading with so many currencies, they have to keep track of themovement of these currencies, because a slight change in the movement of thesecurrencies can affect or have an impact on their profitability and other factors,.(Refer Slide Time: 05:47)Some examples for you. Starbucks in 2004, its revenue increased almost 32 percent,because of the weakening US dollar. It was not due to any other reason, rather because ofthe US dollar weakened, right; against the Canadian dollar and the British pound. So,that resulted in 32 percent growth in revenue for Starbucks.Similarly, in 2000, because of the weak euro, the British pound and Australian dollar hada negative impact upon the McDonalds results; so, financial results, which showed anegative effect.Similarly, in 2017, general motors reported that fourth-quarter net income declined by500 million due to only foreign currency losses. So, you can understand, that anycompany or firm which is transacting in several countries they are highly affected by thecurrency fluctuations. So, the companies have to take guard and to safe guard themselvesfrom this factors.(Refer Slide Time: 06:53)So, what are the types of exposure? Basically, the exposure can be explained in threeways. One called the translation exposure; second called the transaction exposure; thirdcalled the economic or operating exposure, right.So, in some of the you know, this views sometimes change also, people explain try toexplain these two as economic, but to my understanding, since this is a transactionexposure and this is operating exposure or economic exposure can be, are the samethings basically.(Refer Slide Time: 07:25)So, let us start with Translation exposure. So, what is it saying? The translation exposureis also called as accounting exposure. Why it is called an accounting exposure I will justexplain you. Or balance sheet exposure.So, it measures the impact of changes in foreign currency exchange rate on the value ofthe assets and liabilities. So, why, what is important here? Now, it is important forMNC’s with a physical presence in a foreign country. Suppose, MNC is there, who is inmany countries, so the value of it is assets and liabilities are constantly changing on thatbooks of accounts; on their books of accounts, right.So, actually they are not finally, they are they have not been liquidated, nothing has beensold off, but on the books of accounts the values would constantly change. So, this iscalled translational translation exposure. It arises because financial statements of foreignsubsidiaries; which are stated in foreign currency, right; must be restated in the parentsreporting currency for the firm to prepare consolidated financial statement.Suppose, for example, a UK a firm or an Indian firm for that, is in let us say, in U.K andCanada also; now, when we are doing the financial balance sheet for the year end, right;consolidated financial statements we are making, at that time we have to make aconsolidated balance sheet. And that time when we are doing that, so the currencyvalues, according to the change in the value of the currency, the Canadian dollar or theUS dollar or the you know, British pound wherever we are there.Accordingly, the value of that asset or the liabilities also changing. So, that is only beingreported in our balance sheet.It is concerned with the present measurement of the past events. It has no direct impacton the cash flows; obviously, it will no direct impact, because it is only for the books.Because assets and liabilities appearing in the balance sheet are not going to beliquidated in the foreseeable future. Since they are not going to be sold off or they are notgoing to be liquidated, so why should there be any loss? But it is the only a change in theaccounts, right; as because of the change in the value of the currencies.The key difference between the transaction exposure, which I will come to, I have notexplained. I will explain in the next. First let me explain this then I will come back, ok.(Refer Slide Time: 09:51)Just to understand. Let us see the example, of a translation exposure, then I will comeback to that difference. This is an translation exposure. I have taken it from one of thebooks of international business.A Mexican subsidiary reports cash in the bank of 9,00,000 pesos at a time when 9.5pesos will buy 1 U.S dollar. So, how much? 9.5 peso is equal to 1 U.S dollar, right; thus,it is U.S parent translates the net in pesos into U.S. So, how much when it translates, howmuch it becomes?Now, 9,00,000 you see, U.S company bank account in Mexico. How much it has got?The 9,00,000 pesos, right. Initial exchange rate is 9.5 pesos per dollar, right. So, initialbank account worth is how much? The 9,00,000 divided by 9.5 which comes to 94,737.This is the value, right.Subsequently, the exchange rate changes as you can see here. When the exchange ratechanges; however, and 10 pesos are required to buy 1 U.S dollar. So, because subsequentexchange rate what happens? The bank worth is now on basis of this 10 pesos, so 909,00,000 divided by 10, so that makes 90,000. So, this is the change, right.So, it has now the bank worth, which was earlier 94,737 has now become 90,000, right.So, in a translation exposure, although we have not liquidated, we have not sold, butwhen you show it on the books of accounts you have to show the changes, right.(Refer Slide Time: 11:30)Now, let me explain first the transaction; this is the another example for translation Ihave said. Assume that a company has a wholly owned subsidiary in USA; an Indiancompany. The exposed assets of the subsidiary are 200 million and its exposed liabilitiesare 100 million, right. How much are the assets? 200. Liabilities are 100. The exchangerate changes from 0.020 per rupee, which is you can count to 0.021, so this is 50 rupeesand this will almost change to little less than that.So, potential foreign exchange gain or loss to the company will be calculated as follows:-In this case, the net exposure is; exposed assets 200 million, liabilities 100 million. So,what is the net exposed? Difference is 100 million, right.So, pre devaluation rate which is 0.020, right. So, that is equal to 100 million divided by0.020, that is equal to 5,000 million rupees. Now, if you divide 100 million, thisdifference net difference divided by the 0.020, this is the value we are talking about. So,it comes to 5,000 million Indian rupees.But post devaluation what is happening? It is 0.021 is equal to rupees 1. So, dollar 0.021is equal to rupees 1, this is what we have considered, right. So; that means, how manyrupees? It must, if you count it you will you can find out, how many rupees would be 1dollar.So, 100 million divided by 0.021 is equal to 4,762. So, the potential loss now, for this ishow much? 5,000 minus 4,762 is 238 million. So, in terms of the account books, whenyou are showing in the account books, although you have not liquidated, but you there isa loss of 238 million which is to be shown, right.If the rate, post-devaluation rate would be have become 19, let us say, then what wouldhave happened? The company would have gained, you see. Now, by dividing 100million with this value, it is becoming 5,263 million, right Indian rupees. So, there is apotential gain.So, neither this gain is actual nor this loss is actual. It is only to be reflected in the booksof accounts, right. So, this is for that books of accounts purpose, so this is called thetranslation exposure. Now, we will move into the next; which is transaction exposure andthen I will come back to that difference which I have shown it.(Refer Slide Time: 14:01)So, transaction exposure says, it measures the changes in the value of the outstandingfinancial obligation. Now, what is it? Let us see, a transaction exposure arises due tofluctuation in exchange rate between the time. Now, this is very important.The fluctuation in exchange rate between the time at which the contract is concluded inforeign currency and the time at which the settlement is actually made. So, when yousuppose get into a business and you have made a contract; that contract could be, let ussay, it for one month; for two months; for three months; for any some time period, right.Usually, it is one to three months.So, when the contact is made and the contract is concluded; in that time period maybethe currency has changed, right. So, what effect will that have on our profit and loss, thatwhat is actually explained in the transaction exposure. So, this is short term in nature,less than a year. Here, you see it is an actual gain or loss, right. In the translation it wasnot an actual loss or gain, it is only in the books of accounts.The credit purchase and sales, borrowing and lending denominated in foreign currenciesetcetera, are examples of transaction exposure. It has a direct impact on cash flow. Thatdid not have any direct impact, right.So, let us see this example. So, this is a contract being made on 1st of January, right. So,an equipment order has been placed which is cost let us say, 1,00,000 euro, right. Now,the value exchange rate of 1 euro versus the dollar is 1.1, ok. So, it is 1.1.So, that is dollar equivalent is equal to how much? Now 1,10,000 dollars, right. Now, 1stApril when actually the invoice comes and the payment has to be made, the cost whichis 1,00,000 euros; now, the exchange rate has changed from 1.1 to 1.2, right.So, now the company has to pay how much? Now 1,20,000, right. So, 1,00,000 into 1.1here 1,00,000 into 1.2. So, 1,20,000. So, now, because of this time difference and in thechange of the currency during this time difference, there has been a negative impact, ofhow much? 1,20,000 minus 1,10,000 that is 10,000 of loss to this company, right.So, transaction exposure is something which happens perennially, when [FL] firm isbuying or selling a good, right. When he is a he has to pay or he has even receive, boththe conditions. It is getting affected, because the currency has fluctuated in between.Now, let us see the difference, which I was saying. So, the key difference is that thetransaction exposure impacts the cash flow of the firm whereas; translation has no effecton the direct cash flows. It is only to be shown, but it does not have any actual effect, buttransaction you have made you have to pay or you have to receive whatever it is. So, youare actually making a loss or a gain out there. So, let us see this example of transactionexposure.(Refer Slide Time: 17:18)If a US company denominates it is sales in dollars, right; it has no transaction exposure.If it denominates the sale in British pounds that the sale the dollar value of the receivablerises or falls as the exchange rate changes. Let us see this.So, total price of merchandise on the exporter books. So, the exporter is exporting it isitems, and the price of the merchandise is how much? 5,00,000 dollars, right. So, theUSA party is exporting and who is the importer? The U.K, the British one is importing,right.Initial exchange rate is 1.9 dollar to a pound. So, 1 pound is equal to 1.9 dollars. So, thisvalue of sale is how much in terms of pound if I say? Now, 5,00,000 upon 1.9, so thatcomes 2,63,158 pounds,. So; that means, the Britisher has to pay this much, right.Now, amount received by the exporter is 2,63,158, correct. But subsequently theexchange rate again changes. Now, what has been the change? Now, it is now, become1.88. So, 1 pound is now equal to 1.88. So; that means what?The value has now shifted. So, subsequent payment value of collected receivable is nowhow much? 2,63,158 which was on basis of 1.9 into 1.88, right. So, that gives. So, theoriginal 5,00,000 now has become how much? 4,94,737.So, this is the you know, thing. Now, what is the exporters gain or loss? Now, theexporter would have received actually, when it was 1.9 he would have received 5,00,000,but now, because of the change, now how much is he getting? Thus, he is getting anegative. So, calculation if you see; so, the loss to the exporter is 5,263. Because now heis receiving, because of the change of to 1.88, the loss to the exporter is 5,263 dollars.So, this is because, during the transaction the value has changed. So, the dollar hasstrengthened against the pound. Now, I am getting to the third case. Before that let ustalk about how to reduce the translation and transaction exposure, ok.(Refer Slide Time: 19:46)So basically, we talk it as a lead or a lag strategy. What is it lead or lag strategy? It says;a lead strategy involves attempting to collecting foreign currency receivables, right. So,payments which you are receiving early when a foreign currency is expected todepreciate. Or for the exporter to charge only this much. case B, or the exporter would charge onlythis much value, right; which he will be coming out of the calculation, which wouldallow the importer to pay the same amount in British pounds as before the exchange ratechange and still be able to keep the price in the same in the United Kingdom, right, andkeep the profit margin as before.So, let us see what is happening. So, initially the total price of merchandise on theexporter books, was how much? 5,00,000. What is the initial exchange rate? 1.9 dollarsto a pound, ok.So, what is the sale value in terms of pounds? 2,63,158. So, this is what the British firmwill have to pay. So, how did it come? This way, right. Now; so, this much he has paid,now he will charge a ten percent markup. So, additional 10 percent. So, if you do it soyou can simply calculated by 1.1.(Refer Slide Time: 29:29)So, amount charged by importer after 10 percent markup, is how much? So, 2,63,158into 1.1, 10 percent, right. So, that is equal to this much 2,89,474. So, this is the newvalue coming.The exchange rate, but now has again changed. So, what has been the change? Now, ithas become 1.88 instead of 1.9 across for against a pound. So, now if I take this5,00,000; original value and divide by the 1.88 the new exchange rate, so what is thevalue coming? 2,65,957, right. So, this is the value. So, subsequent underlying sale valueof sale is equal to this much, right. So, if you take the new exchange rate.Now, amount charged by importer after 10 percent markup, so you multiply this with 10percent, right, so into 1.1. So, you will get a value of 2,92,553 pounds, ok. Now,difference in sale price before and after the rate change; so, before the rate change, howmuch it was? 2,89,474; after the rate change and the 10 percent, how much it is?2,92,553.So, the difference between this and this; so, this value and this value is the subsequentdifference in sale price before and after rate change, right. 3,079. So; that means, what?There is a difference to this two prices because of only the currency fluctuation, right.Now, profit to importer, if importer charges a higher price. What if the importer chargesa higher price, right? So, 2,92,553 minus 2,65,957 now, this is equal to 26,596. So, hesays the profit to the importer, if importer charges higher price is equal to this much,right. How did it come? Through this way.Profit to the importer if importer absorbs the cost increase, he does not increase anythinghe absorbs the you know, increase in price. So, that is equal to 23,517. How much? Howdid it come? Now, on basis of this price, so 2,89,474 the original, right, before theexchange rate has changed to 1.88. So, this value minus the this 10, you know the valueafter it has changed, right. So, this value, right. So, this comes how much? 23,517pounds. So, the price charged by the exporter for constant cost to the importer, is howmuch? 2,63,158 which you got here; this one, right, into 1.88494737.So, if you can see. So, whenever a firm gets into a long term transaction, right and inbetween he is trying to price his product accordingly or place his product accordingly inthe market and there is in between a change in price so his pricing value also wouldchange. And this is what is reflected in this problem, right.(Refer Slide Time: 32:45)So, this is the case of BMW which I was saying, BMW; owner of the BMW, Mini Roycebrands has been based in Munich since it is founding in 1916. But by 2011 only 17percent of the cars were brought in Germany, right. Because Munich is in Germany so itis a Germany based.In recent years, China has become the BMWs fastest-growing market, accounting for 14percent of BMWs global sales volume in 2011. Three major markets are India, Russiaand eastern Europe.So, despite the sales volume, rising sales volume BMW was conscious that its profitswere often severely eroded by negative effect of exchange rates, which total to 2.4billion. So, instead of in-spite of growing market, everything been good, still thecompany was losing about 2.4 billion Euros between 2005 and 2009.BMW did not want to pass on it is exchange rate to the customers, right. They couldhave done it, because another company; its rival Porsche had done it, but that helpedonly in reducing it is entire sales. So, BMW did not want to pass on the you know, extracost to the customers, right.(Refer Slide Time: 34:01)So, what did BMW do? BMW took a two step approach, right. One was to use a naturalhedge, right. Meaning it would develop ways to spend money in the same currency aswhere sales were taking place. Meaning, revenues would also be in the local currency.However, not all exposure could be offset this way.So, what is it is saying? So, instead of getting into you know, getting affected by thechange in transactions, what they could do it, they could do the business in the localcurrency. For that what did they do? BMW decided to use formal financial hedges. Toachieve this the setup regionals treasury centres in the us UK and Singapore.So, two things that BMW did; first, it involved establishing factories in the marketswhere it sold it is products, so that they could do the transaction in the local currency.The second involved making more purchases in the currencies of it is main markets.BMW in the currencies of it is main markets, right.(Refer Slide Time: 35:03)So, what happened? BMW now has production facilities for cars and components in 13countries. So, this is the advantage they took. In 2000, its overseas production volumeaccounted for 20 percent of the total. So, the production volume in 2000 was 20 percentof the total from the overseas market. By 2011 it grew to 44 percent. So, 2005 to 2009they have made loss, right. So, from 2009 onwards, you see there has been significantchange from 20 to 44 percent.In 90’s BMW had become one of the first premium carmakers from overseas to set up aplant in the US, because it was from Germany, in South Carolina. In 2008, it announcedit was investing 750 million to expand it is one of it is plant, right. So, to create thismuch of jobs, right; and while cutting 8,100 jobs in the Germany.This had this had the effect of shortening the supply chain between Germany and the USmarket. So, what by the changing the you know, the production facility they shortenedthe supply chain. Unnecessary there was no transportation, right.The company boosted it is purchasing in US dollars generally, especially in the NorthAmerican Free Trade Agreement Region, right. It is office in Mexico made 615 milliondollars of purchases of Mexican auto parts; local purchase in 2009, expected to risesignificantly in the following years.(Refer Slide Time: 36:34)A joint venture with Brilliance China Automotive was set up in Shenyang, China, wherehalf the BMW cars for sale in the country are now manufactured. So, China has becomeanother major hubs for BMW. The carmaker also set up a local office to help it is grouppurchasing department to select competitive suppliers in China. So, they did everythinglocal they, they localized in China. They tried to be they were a global company there,but they try to be as local as possible in China. By the end of 2009 there was 6 billionworth of purchases were from local suppliers, right.So, this is the Chinese you know, new currency, right. Again this had the effect ofshortening supply chains and improving customer service. Because they were close tothe customer, they were also making their supply chain, their purchases and all in thelocal currency. So, they were aware of the local conditions very clearly.At the end of 2010, BMW announced it would invest another 1.8 billion rupees in it isproduction plant in Chennai in India, and increase the production capacity from 6,000 to10,000 units, right. They are also planning for expansion in Russia.Meanwhile, the overseas regional treasury centres, the regional treasury centres, whichwas the second strategy; were instructed to review the exchange rate exposure in theirregions on a weekly basis. They wanted it to be checked on a weekly basis, and report itto the group treasurer, part of the group finance operation in Germany. So, the grouptreasurer team then consolidates the risk figures globally and recommends actions tomitigate the foreign exchange risk.(Refer Slide Time: 38:16).So, this is what was the basic inference from this study. By moving production to theforeign markets the company not only reduces it is foreign exchange exposure, but alsobenefits from being closed to it is customers. In addition, sourcing parts overseas, andtherefore closer to it is foreign markets also helps to diversify the supply chain risk.So, this is what BMW did in order to mitigate it is risk and reduce it is losses. And it wasit is a classic case of you know in foreign exchange exposure, and how this companydealt with this condition where everything was in spite of being good there were stillmaking losses. Now, this was there was a radical change and the company saw a greatpositive movement, right. So, this is all we have for the day.Thank you very much.