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Exchange Rate Risk

Exchange Rate Risk. International Finance and Development . Outline. Meaning of Exchange Rate Risk Types of Exchange Rate Risks Transaction Exposure Translation Exposure Economic Exposure Measurement of Exchange Rate Risk Management of Exchange Rate Risk

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Exchange Rate Risk

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  1. Exchange Rate Risk International Finance and Development

  2. Outline • Meaning of Exchange Rate Risk • Types of Exchange Rate Risks • Transaction Exposure • Translation Exposure • Economic Exposure • Measurement of Exchange Rate Risk • Management of Exchange Rate Risk • Management of Transaction Exposure • Management of Economic Exposure

  3. Meaning of Exchange Rate Risk • Risk of fluctuating value of a currency over time • If the time and size of cash inflows in one currency does not match the time and size of cash outflows in the same currency, we face exchange rate risk • Impacts dollar value of foreign currency cash inflows and foreign currency cash outflows • If we have foreign currency cash inflows, we face risk of foreign currency depreciating against domestic currency • If we have foreign currency cash outflows, we face risk of foreign currency appreciating against domestic currency

  4. Types of Exchange Rate Exposures • Transaction Exposure • Only companies engaged in global business and doing transactions in foreign currency face this risk • Arises due foreign currency transactions of a firm • Arises from the possibility of incurring future exchange gains/losses on transactions already entered into and denominated in a foreign currency.

  5. Measuring Transaction Exposure • Determine the projected net amount of inflows or outflows in each foreign currency • Determine the overall risk of exposure to these currencies

  6. Measuring Transaction Exposure • To determine the amount of transaction exposure, keep in mind the following: • The net exposure of all subsidiaries combined • Range of possible exchange rates • Range of cash inflows and outflows • Standard Deviation of currencies • Correlations among currencies

  7. Translation Exposure • The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations • If the assets/liabilities are translated at something other than the historical exchange rates, the Balance Sheet will be affected by fluctuations in currency values over time

  8. Economic Exposure • The extent to which the economic value of a company can decline because of exchange rate changes • Decline can be due to a decline in the level of expected cash flows or an increase in the riskiness of these cash flows • Overall effect of exchange rate changes in competitive relationships between alternative foreign locations • Extent of exposure depends on • structure of markets for a firm’s product • Price elasticity of demand for the product • Availability of close substitutes for the product • Even pure domestic firms may face economic exposure

  9. Management of Transaction Exposure • Foreign currency cash outflows • Risk: Foreign currency may become more expensive/appreciate against domestic currency • Strategy: Buy foreign currency futures, forwards, or call options • Foreign currency cash inflows • Risk: Foreign currency may become more cheap/depreciate against domestic currency • Strategy: Sell foreign currency futures, forwards, or buy put options

  10. Management of Economic Exposure • Marketing Initiatives • Market Selection • Pricing Strategy • Product Strategy • Promotion Strategy • Production Initiatives • Product sourcing and input mix • Plant location • Raise Productivity • Financial Initiatives

  11. Marketing Initiatives • Shall we pull out of a market that has been rendered unprofitable due to competition or shall we differentiate the product and concentrate on specific customers only? • Shall we emphasize market share or profit margin in response to weak domestic currency? • Shall we add/drop a product to our product line in response to exchange rate changes? • Where to advertise?

  12. Production Initiatives • Outsource your inputs/raw materials/components in response to strong domestic currency • Change input mix to reduce cost in response to strong domestic currency • Shift production to weak currency area in response to strong domestic currency • Raise productivity by cutting costs—produce the same number of units at a lower cost or produce more units at the same cost

  13. Financial Initiatives • Equate the sensitivity of costs and revenues to exchange rate changes

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