Foreign Exchange Exposure

Foreign exchange exposure is very critical for the performance of companies dealing mainly in imports-
exports. Economic exposure is the extent to which a firm's market value, in any particular
currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value
of the firm’s operating cash flows, income statement, and competitive position, hence market share and
stock price, in short, the overall financial health of the company.

Exchange rates may affect a firm through a variety of channels:

1. a firm may produce at home for export sales

2. a firm may produce with imported components
3. a firm may produce a product plants abroad
4. a firm may offer a service abroad

Foreign exchange exposure or risk can be classified into three types: transaction, economic and
translation exposure.

1. Transaction exposure refers to the extent to which the future cash transactions of the firm may
be affected by any changes in the currency exchange rate.
2. Economic exposure measures the impact of changes in exchange rate on the firm&'s cash flows
and earnings.
3. Translation exposure refers to accounting exposure. It measures the impact of changes in
exchange rate on the financial statements of the group of company.

Most companies attempt to minimize the risk of fluctuating exchange rates by using hedging
instruments such as Forward Exchange Contracts, Money Market Hedge, Futures, Options and Swaps.

For example, a Malaysian trader who exports palm oil to India for future payments in Rupees is faced
with the risk of Rupees depreciating against the Ringgit when the payment is made. This is
because if Rupee depreciates, a lesser amount of Ringgit will be received when the Rupees are
exchanged for Ringgit. Therefore, what originally seemed a profitable venture could turn out to be a loss
due to exchange rate fluctuations. Such risks are quite common in international trade and finance. A
significant number of international investment, trade and finance dealings are shelved due to the
unwillingness of parties concerned to bear foreign exchange risk. Hence it is imperative for businesses to
manage this foreign exchange risk so that they may concentrate on what they are good at and eliminate
or minimize a risk that is not their trade.

Hedging with Options:

A currency option may be defined as a contract between two parties - a buyer and a seller - whereby the
buyer of the option has the right but not the obligation, to buy or sell a specified currency at a specified
exchange rate, at or before a specified date, from the seller of the option. While the buyer of option
enjoys a right but not obligation, the seller of the option nevertheless has an obligation in the event the
buyer exercises the given right.

There are two types of options:

• Call options – gives the buyer the right to buy a specified currency at a specified exchange rate, at or
before a specified date.

• Put options – gives the buyer the right to sell a specified currency at a specified exchange rate, at or
before a specified date.

Of course the seller of the option needs to be compensated for giving such a right. The compensation is
called the price or the premium of the option. Since the seller of the option is being compensated with
the premium for giving the right, the seller thus has an obligation in the event the right is exercised by
the buyer.

An Example:

Assume that it is July and a Malaysian construction company, Bumiways is hoping to win a contract to
build a stretch of road in India, to be decided in September. The contract is to be signed for 10,000,000
Rupees and would be paid for after the completion of the work. This amount is consistent with
Bumiways minimum revenue of RM1,000,000 at the exchange rate of RM0.10 per Rupee. However,
since the exchange rate could fluctuate and end with a possible depreciation of Rupees, the net returns
of Bumiways could vary.

Hedging:

Bumiways wants a minimum acceptable revenue of RM1,000,000 after hedging costs, but Bumiways
need to quote a bid price now. In this instance, Bumiways would only face the exchange rate risk
contingent upon winning the bid.

Assume that the following September Forex options quotes are available today:

RM0.10 call @ RM0.002

RM0.10 put @ RM0.001

where the size of each Rupee contract is 2,000,000 Rupees.

0.002 and 0.001 are the Option premiums. The option premium is primarily affected by the difference
between the stock price and the strike price, the time remaining for the option to be exercised, and the
volatility of the underlying stock.

The following is how Bumiways would make its hedging strategy:

 1. Buy puts or calls? Since Bumiways would receive Rupees in the future if it won the contract, its
risk is a depreciation of Rupees. Therefore, it should buy puts.

2. What should be the bid amount? To answer this question we need to compute the effective
exchange rate after incorporating the premium, i.e. RM0.10 minus RM0.001 which equals
RM0.099. Now the bid amount is computed as RM1,000,000/RM0.099, which equals 10,101,010
Rupees.

3. How many put contracts should it buy to protect against the depreciation in Rupees? To answer
this, just take the bid amount and divide by the contract size, i.e. 10,101,010/2,000,000 equals
5.05.
Since fractions of contracts are not allowed and we don’t overhedge, 5 contracts are sufficient
with some portion being unhedged.
However, to guarantee a minimum revenue of RM1,000,000 we cannot tolerate imperfections
in hedging. Therefore in this example we should go for 6 contracts.

4. What is the cost of hedging? Cost of hedging is computed as follows: 6 contracts x 2,000,000 per
contract x RM0.001 equals RM12,000. This cost of hedging is the maximum loss possible with
options.

In September, Bumiways would have known the outcome of the bid. By then also the
Rupee might have appreciated or depreciated. Lets assume the Rupees either appreciates to RM0.20 or
depreciates to RM0.05 per Rupee. The following are the four outcomes possible and their cash flow
implications:

Case Rupee depreciates to 0.05 Rupee appreciates to 0.20

Rupees earned = 10,101,010 Rupees earned = 10,101,010

@RM0.05 = RM505,050.50 @RM0.20 = RM2,020,202

Profit from options Puts options not worth exercising,

6 x 2,000,000 x (RM0.10-RM0.05) therefore let them just expire!
= RM600,000
Bid Won Cost of hedging = RM12,000
Cost of hedging = RM12,000
Net Cash flow = RM2,008,202
Net Cash flow = RM1,093,050

(which guarantees the minimum (In this case the option allows
revenue of RM1,000,000) Bumiways to enjoy a favourable
movement)
 In this case Bumiways would not receive the This is the worst case that can happen.
bid amount. But however it could still Bid lost and also the put option
exercise its rights and realize its profit position ends up being not profitable.
from puts.
Bumiways loses the premium paid
Bid Lost Profit from options 6 x 2,000,000 x RM0.05 = RM12,000
= RM600,000
This is the maximum loss possible.
Cost of hedging = RM12,000

Net Cash flow = RM578,000

The above example illustrates how options can be used to guarantee a minimum cash flow on
contingent claims. In case the bid is won, a minimum cash flow of RM1,000,000 is guaranteed while
allowing one to still enjoy a favourable movement if it does take place. If the bid is lost, the maximum
loss possible is the premium paid.

Advantages of Hedging using Options:

1. Flexibility: Options can be used in a wide variety of strategies, from conservative to high-risk,
and can be tailored to more expectations than simply "the stock will go up" or "the stock will go
down."

2. Leverage: An investor can gain leverage in a stock without committing to a trade.

3. Limited Risk: Risk is limited to the option premium (except when writing options for a security
that is not already owned).

4. Protection: Options allow investors to protect their positions against price fluctuations when it is
not desirable to alter the underlying position. The advantages of options over forwards and
futures are basically the limited downside risk.

Disadvantages of Hedging using Options:

1. Costs: The costs of trading options (including both commissions and the bid/ask spread) is
significantly higher on a percentage basis than trading the underlying, and these costs can
drastically eat into any profits.

2. Liquidity: With the vast array of different strike prices available, some will suffer from very low
liquidity making trading difficult.

3. Complexity: Options are very complex and require a great deal of observation and maintenance.
 4. Time decay: The time-sensitive nature of options leads to the result that most options expire
worthless.

Conclusion:

Foreign exchange rate is, thus, one of the key factors that effects the certainties of cash flows, mostly for
companies which have economic interests in various countries and whose revenues depends on other
than domestic currencies. We saw that by using financial derivative instruments, like options, such a
company can ensure a minimum possible inflow and a maximum possible outflow of money and thus,
hedge itself against drastic changes in foreign exchange rates.