Foreign exchange risk can be neutralized or hedged by a change in the asset and liability position in the foreign currency. How? This post shows 6 proven ways to control and neutralize the foreign exchange risk with case example followed by step-by-step that you can follow through. But before that, let’s discuss some basic foreign exchange related terms first [i.e. foreign currency-based transaction exposure; when a foreign currency transaction happened, long vs short position and assessing your own monetary position]. Read on…
Foreign Currency-Based Transaction Exposure
Foreign currency transactions may result in receivables or payables fixed in terms of the amount of foreign currency to be received or paid. Transaction gains and losses are reported in the income statement. Foreign currency transactions are those transactions whose terms are denominated in a currency other than the entity’s functional currency.
Foreign currency transactions take place when a business:
- Buys or sells on credit goods or services the prices of which are denominated in foreign currencies
- Borrows or lends funds, and the amounts payable or receivable are denominated in a foreign currency
- Is a party to an unperformed forward exchange contract
- Acquires or disposes of assets, or incurs or settles liabilities denominated in foreign currencies
Transaction losses differ from translation losses, which do not influence taxable income.
Long Vs. Short Monetary Position
When a devaluation of the dollar takes place, foreign assets and income in strong-currency countries are worth more dollars as long as foreign liabilities do not offset this beneficial effect. Foreign exchange risk can be analyzed by examining expected receipts or obligations in foreign currency units.
A company expecting receipts in foreign currency units (‘‘long’’ position in the foreign currency units) has the risk that the value of the foreign currency units will drop. This results in devaluing the foreign currency relative to the dollar. If a company is expecting to have obligations in foreign currency units (‘‘short’’ position in the foreign currency units), there is risk that the value of the foreign currency will rise and it will need to buy the currency at a higher price.
If net claims are greater than liabilities in a foreign currency, the company has a long position since it will benefit if the value of the foreign currency rises. If net liabilities exceed claims with respect to foreign currencies, the company is in a short position because it will gain if the foreign currency drops in value.
Assessing Your Monetary Position
Monetary balance is avoiding either a net receivable or a net payable position. Monetary assets and liabilities do not change in value with devaluation or revaluation in foreign currencies.
- A company with a long position in a foreign currency will be receiving more funds in the foreign currency. It will have a net monetary asset position (monetary assets exceed monetary liabilities) in that currency.
- A company with net receipts is a net monetary creditor. Its foreign exchange rate risk exposure has a net receipts position in a foreign currency that is susceptible to a drop in value.
- A company with a future net obligation in foreign currency has a net monetary debtor position. It faces a foreign exchange risk of the possibility of an increase in the value of the foreign currency.
How to Control and Neutralize Foreign Exchange Risk
Foreign exchange risk can be neutralized or hedged by a change in the asset and liability position in the foreign currency. Here are six ways to control and neutralize exchange risk.
Way-1st. Entering a Money-market Hedge
Here the exposed position in a foreign currency is offset by borrowing or lending in the money market.
Money Market Hedging Example
LIE DHARMA PUTRA COMPANY, an American importer, enters into a contract with a British supplier to buy merchandise for 4,000 pounds. The amount is payable on the delivery of the good, 30 days from today. The company knows the exact amount of its pound liability in 30 days. However, it does not know the payable in dollars. Assume that the 30-day money-market rates for both lending and borrowing in the United States and United Kingdom are 0.5 percent and 1 percent, respectively. Assume further that today’s foreign exchange rate is $1.50 per pound.
In a money-market hedge, LIE DHARMA PUTRA COMPANY can take these steps:
Step 1. Buy a one-month U.K. money market security worth 4,000/(1 + 0.005) = 3, 980 pounds. This investment will compound to exactly 4,000 pounds in one month.
Step 2. Exchange dollars on today’s spot (cash) market to obtain the 3,980 pounds. The dollar amount needed today is 3,980 pounds × $1.7350 per pound = $6,905.30.
Step 3. If LIE DHARMA PUTRA COMPANY does not have this amount, it can borrow it from the U.S. money market at the going rate of 1 percent. In 30 days, LIE DHARMA PUTRA COMPANY will need to repay $6, 905.30 × (1 + 0.1) = $7, 595.83.
LIE DHARMA PUTRA COMPANY need not wait for the future exchange rate to be available. On today’s date, the future dollar amount of the contract is known with certainty. The British supplier will receive 4,000 pounds, and the cost of LIE DHARMA PUTRA COMPANY to make the payment is $7,595.83.
Way-2nd. Hedging by Purchasing Forward (or futures) Exchange Contracts
The forward exchange contract is a commitment to buy or sell, at a specified future date, one currency for a specified amount of another currency (at a specified exchange rate). This can be a hedge against changes in exchange rates during a period of contract or exposure to risk from such changes.
More specifically, you: (1) buy foreign exchange forward contracts to cover payables denominated in a foreign currency and (2) sell foreign exchange forward contracts to cover receivables denominated in a foreign currency. This way, any gain or loss on the foreign receivables or payables due to changes in exchange rates is offset by the gain or loss on the forward exchange contract.
Forward Exchange Contract Example
In the previous example, assume that the 30-day forward exchange rate is $1.7272. LIE DHARMA PUTRA COMPANY may take the following steps to cover its payable:
Step 1. Buy a forward contract today to purchase 4,000 pounds in 30 days.
Step 2. On the 30th day pay the foreign exchange dealer 4,000 pounds × $1.7272 per pound = $6,908.80 and collect 4,000 pounds. Pay this amount to the British supplier.
Using the forward contract, LIE DHARMA PUTRA COMPANY knows the exact worth of the future payment in dollars ($6,908.80).
The basic difference between futures contracts and forward contracts is that futures contracts are for specified amounts and maturities, whereas forward contracts are for any size and maturity desired.
Way-3rd. Hedging by Foreign Currency Options
Foreign currency options can be purchased or sold in three different types of markets: (1) options on the physical currency, purchased on the over-the-counter (interbank) market; (2) options on the physical currency on organized exchanges, such as the Philadelphia Stock Exchange and the Chicago Mercantile Exchange; and (3) options on futures contracts, purchased on the International Monetary Market (IMM) of the Chicago Mercantile Exchange.
The difference between using a futures contract and using an option on a futures contract is that with a futures contract, the company must deliver one currency against another, or reverse the contract on the exchange, while with an option the company may abandon the option and use the spot (cash) market if that is more advantageous.
Way-4th. Repositioning cash by leading and lagging the time at which an MNC makes operational or financial payments.
Often, money- and forward-market hedges are not available to eliminate exchange risk. Under such circumstances, leading (accelerating) and lagging (decelerating) can be used to reduce risk.
A net asset position (i.e., assets minus liabilities) is not desirable in a weak or potentially depreciating currency. In this case, you should expedite the disposal of the asset.
Way-5th. Maintaining a balance between receivables and payables denominated in a foreign currency.
MNCs typically set up multilateral netting centers as special departments to settle the outstanding balances of affiliates of a MNC with each other on a net basis. It is the development of a clearinghouse for payments by the firm’s affiliates. If there are amounts due among affiliates, they are offset insofar as possible. The net amount would be paid in the currency of the transaction. The total amounts owed need not be paid in the currency of the transaction; thus, a much lower quantity of the currency must be acquired.
The major advantage of the system is a reduction of the costs associated with a large number of separate foreign exchange transactions.
Way-6th. Positioning of Funds Through Transfer Pricing
A transfer price is the price at which an MNC sells goods and services to its foreign affiliates or, alternatively, the price at which an affiliate sells to the parent. For example, a parent that wishes to transfer funds from an affiliate in a depreciating-currency country may charge a higher price on the goods and services sold to this affiliate by the parent or by affiliates from strong-currency countries. Transfer pricing affects not only transfer of funds from one entity to another but also the income taxes paid by both entities.