Dr. Prakash Apte, a distinguished Professor of Economics and Finance, was a faculty member at Indian Institute of Management, Bengaluru from1997 till 2012 during which period he was also the Director of the Institute from 2002 to 2007. A Mechanical Engineer from IIT Delhi, a PGDM from IIM Calcutta and a PhD in Economics from Columbia University, he is currently an Adjunct Professor at National Institute of Bank Management (NIBM), Pune. Besides being a Visiting Faculty at K.U. Leuven, EDHEC Lille, France; Gothenberg University, Sweden and AESE Lisbon, he was also the former Chairperson of SEBI's Secondary Markets Advisory Committee and a Member of the Planning Commission's Expert Committee chaired by Dr. Abhijit Sen, to examine the impact of futures trading on commodity prices. He has authored four books in the area of International Finance and Economics and several papers in refereed professional journals.
Exchange rate fluctuations and its uncertainties affect all firms in the economy, with the extent and nature of impact crucially depending on the nature of a firm's business. The fluctuations affect net importers and net exporters quite differently. They also affect purely domestic firms, those without exports or imports, due to its impact on the firm's suppliers and customers.
Though often used interchangeably, the terms exposure and risk are not identical. Exposure is a measure of the sensitivity of the value of an item (asset, liability or cash flow) to changes in exchange rate, while risk is a measure of the variability of the value of the financial item attributable to the risk factor. A firm may have a large exposure to currency fluctuations because of large imports or exports, but, if the exchange rate is highly stable the risk is quite small.
Between April 1993 and July 1995, the exchange rate between Rupee and the US dollar was almost rock steady.
- A firm trading with the US would have readily agreed that its operating cash flows were very sensitive to the rupee-dollar exchange rates, if it had significant exposure to the dollar. At the same time, it would have said that it did not perceive any significant risk, given the stability of the exchange rate during that period.
- Exposure to contractually fixed payments and receipts in foreign currency, such as export receivables, import payables, interest payable on foreign currency loans and so forth are known as transactions exposures. This is a measure of the sensitivity of the home currency value of assets and liabilities, which are denominated in foreign currency, to unanticipated changes in exchange rates, when the assets or liabilities are liquidated.
Another kind of short-term exposure is translation exposure, also called Accounting Exposure. A multinational firm may have the assets and liabilities of a foreign subsidiary denominated in a foreign currency, which are not going to be liquidated in the foreseeable future. However, the governing accounting standards could require that at the end of the fiscal year, they would have to be translated into the home currency of the parent company and reported in the parent company's balance sheet, thus creating the translation exposure. Translation risk is the related measure of variability in the translation.
The second group, classified as long-term exposures, consists of operating exposure and strategic exposures. The principal focus here is on items which could impact the future cash flows, which could have a serious impact on the firm's competitive status forcing it to restructure its business and redefine its long-term strategy. In the long run, an exchange rate change could affect both future revenues, operating costs and operating income, forcing firms to restructure its business, change its markets, sources of raw materials and even the location of its production facilities.
The currency risk management function consists of three major tasks. First is the selection of a target performance variable which should normally be cash flows.
The second task is assessing and, if possible, quantifying the impact of exchange rate fluctuations on the target performance variable. The third aspect is the choice of an appropriate mechanism or instrument to eliminate, reduce or shift the risk.
It is up to the top management to lay out the risk management policy. The major considerations are:
1. Whether the risk management posture is to be conservative or aggressive?
2.The time horizon to be adopted in making risk management decisions.
3. Who should get involved in the establishment and implementation of the policy?
4. Performance measurement and control systems.
2.The time horizon to be adopted in making risk management decisions.
3. Who should get involved in the establishment and implementation of the policy?
4. Performance measurement and control systems.
For multinational corporations with world-wide operations, a critical issue is whether to centralize exposure management or leave it to the individual units in different countries.
A large variety of financial products are available for managing transactions exposure, which arises out of contractually fixed payables or receivables in foreign currency. The simplest and most conservative way to hedge a foreign currency payable or receivable is through a forward contract.
A large variety of financial products are available for managing transactions exposure, which arises out of contractually fixed payables or receivables in foreign currency. The simplest and most conservative way to hedge a foreign currency payable or receivable is through a forward contract.
- In a forward contract, the firm agrees to buy or sell a specified amount of a foreign currency on a specified future date, at an exchange rate agreed upon on the date of the contract. This rate is the “forward rate”. The counterparty to the contract is a commercial bank, which specifies the forward rate. On the expiry date of the contract, the two parties must conclude the transaction at the agreed rate irrespective of the prevailing spot exchange rate. If a company has entered into a forward contract to buy one million dollars three months later at the rate of `60/- per dollar, it must buy and the counterparty – the bank – must sell that amount at that rate irrespective of the prevailing market rate.
- A forward contract at the market rate has zero value at the time it is entered into. However, it develops a positive or negative value as the markets move. It can be cancelled before expiry. Depending upon how the market has moved, one of the two parties has to pay the other.
Currency futures are like forward contracts in the sense, that the two parties to the contract agree to exchange a given amount of currency 'A' against currency 'B' on a future date, at a rate agreed upon on the date of the contract.
There are a few differences between forwards and futures. Forward contracts are tailor-made to the specifications of one of the two parties. The firm can specify the exact amount of the currency it wishes to buy or sell, the maturity date of the contract and the mode of delivery and that it is an OTC product. In a futures contract, the amount of the currency to be delivered, the date of expiry and the mode of settlement are specified by the Exchange on which the contract is traded. Also, the Clearing House guarantees the performance of the contract, so that the two parties do not have to be concerned about credit risk. Unlike a forward contract, changes in the value of the contract are settled on a daily basis. With expiry dates and contract sizes being fixed, futures are regarded as unsuitable for managing currency risk.
Forwards and Futures completely eliminate the uncertainty about the price at which the deal has to be done. However, if you are locked in a forward deal you cannot benefit from favorable movement in the exchange rate. Thus, if a firm has entered into a forward contract to sell a three month dollar receivable at a price of sixty rupees per dollar, it has eliminated the uncertainty pertaining to the rupee value of its dollar receivable. But three months later, if the dollar has risen to sixty two rupees, it cannot benefit from that favorable movement.
Currency options are more flexible for managing currency risk. The buyer of an option acquires the right to buy or sell a specific amount of foreign currency at a specific rate, with no obligation to carry out the transaction. Thus a firm with a six month Euro payable can buy a six month call option on Euro which gives it the right to buy Euros at a specific price, but with no obligation to do so. The strike price specified in the contract is the rate at which it can buy Euros, if it chooses to do so. Thus, if it has a call option with strike price of ` 75, on the expiry date it has the right to buy Euros at a rate of ` 75 but with no obligation. If the Euro is below ` 75 it can buy it at the ruling market rate; if it is above ` 75 it can exercise its option and the option seller must provide Euros at a rate of ` 75. For a foreign currency receivable it can buy a put option which gives it the right to sell the foreign currency at a specific price without the obligation to do so. The option buyer has to pay an up-front fee known as option premium to the option seller.
There are a few differences between forwards and futures. Forward contracts are tailor-made to the specifications of one of the two parties. The firm can specify the exact amount of the currency it wishes to buy or sell, the maturity date of the contract and the mode of delivery and that it is an OTC product. In a futures contract, the amount of the currency to be delivered, the date of expiry and the mode of settlement are specified by the Exchange on which the contract is traded. Also, the Clearing House guarantees the performance of the contract, so that the two parties do not have to be concerned about credit risk. Unlike a forward contract, changes in the value of the contract are settled on a daily basis. With expiry dates and contract sizes being fixed, futures are regarded as unsuitable for managing currency risk.
Forwards and Futures completely eliminate the uncertainty about the price at which the deal has to be done. However, if you are locked in a forward deal you cannot benefit from favorable movement in the exchange rate. Thus, if a firm has entered into a forward contract to sell a three month dollar receivable at a price of sixty rupees per dollar, it has eliminated the uncertainty pertaining to the rupee value of its dollar receivable. But three months later, if the dollar has risen to sixty two rupees, it cannot benefit from that favorable movement.
Currency options are more flexible for managing currency risk. The buyer of an option acquires the right to buy or sell a specific amount of foreign currency at a specific rate, with no obligation to carry out the transaction. Thus a firm with a six month Euro payable can buy a six month call option on Euro which gives it the right to buy Euros at a specific price, but with no obligation to do so. The strike price specified in the contract is the rate at which it can buy Euros, if it chooses to do so. Thus, if it has a call option with strike price of ` 75, on the expiry date it has the right to buy Euros at a rate of ` 75 but with no obligation. If the Euro is below ` 75 it can buy it at the ruling market rate; if it is above ` 75 it can exercise its option and the option seller must provide Euros at a rate of ` 75. For a foreign currency receivable it can buy a put option which gives it the right to sell the foreign currency at a specific price without the obligation to do so. The option buyer has to pay an up-front fee known as option premium to the option seller.
No comments:
Post a Comment