Foreign Exchange Risk Management- INT.FIN-6

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Foreign Exchange Risk Management

We know corporates, whether operating domestically or internationally, are exposed to risks of adverse movements in their profits resulting from unexpected movements in exchange rates. Foreign exchange exposure results in foreign exchange risk due to the unanticipated variability in exchange rates. Variability of exchange rates gives rise to foreign exchange exposure and foreign exchange risk. Though these two terms are often used interchangeably, in reality they represent two different, yet closely related concepts. Let us first understand these two terms.

Foreign Exchange Exposure

Adler and Dumas define foreign exchange exposure as `the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates’.

To understand the concept of exposure, we need to analyze this definition in detail. The first important point is that both foreign and domestic assets and liabilities could be exposed to effects of exchange rate movements. E.g., if an Indian resident holds a dollar deposit and the dollar’s value vis-à-vis the rupee changes, the value of the deposit in terms of rupees changes automatically. This makes the dollar deposit exposed to exchange rate changes. On the other hand, if a person is holding a debenture in an Indian company, the value of the debenture may change due to an increase in general interest rates, which in turn may be the effect of a depreciating rupee. Thus, even though no conversion from one currency to another is involved, a domestic asset can be exposed to movements in the exchange rates, albeit indirectly.

The second important point is that not only assets and liabilities, but even operating incomes can be exposed to exchange rate movements. A very simple example would be of a firm exporting its products. Any change in the exchange rates is likely to result in a change in the firm’s revenue in domestic currency terms.

Thirdly, exposure measures the sensitivity of changes in real domestic-currency value of assets, liabilities and operating incomes. That is, it is the inflation adjusted values expressed in domestic currency terms that are relevant. Though this is theoretically a sound way of looking at exposure, practically it is very difficult to measure and incorporate inflation in the calculations. Hence, in reality, the nominal figures are taken into account, though it does not always present the true picture.

The last point to be noted is that exposure measures the responses only to the unexpected changes in the exchange rate as the expected changes are already discounted by the market.

What does this definition mean? In simple terms, it means that exposure is the amount of assets, liabilities and operating income that is at risk from unexpected changes in exchange rates. (We shall later see how this is different from foreign exchange risk.) The way it has been defined by Adler and Dumas helps us in measuring exposure. As we know, sensitivity can be measured by the slope of the regression equation between two variables. Here, the two variables are the unexpected changes in the exchange rates and the resultant change in the domestic-currency value of assets, liabilities and operating incomes.

Foreign Exchange Risk

Maurice D Levi describes foreign exchange risk as “the variance of the domestic-currency value of an asset, liability, or operating income that is attributable to unanticipated changes in exchange rates”.

According to this definition, foreign-exchange risk results when the domestic-currency value of assets, liabilities or operating incomes, becomes variable in response to unexpected changes in exchange rates. Hence, for exchange rate risk to be present, the presence of two factors is essential. One is the variability of exchange rates, and the second is exposure. If an asset, liability or operating income is not exposed to exchange rate changes, variability of exchange rate does not create any exchange rate risk. Similarly, variability of domestic-currency value of an asset, liability or operating income which is not linked to exchange rate movements, or where the changes in exchange rates are perfectly predictable, does not create any exchange rate risk.

Where exposure is measurable in terms of the slope of a regression equation between exchange rate movements and changes in the values of assets or liabilities, exchange rate risk can be expressed as a function of exposure and variance of exchange rate. The regression equation can be written as

This equation can be rewritten as:

var = var [a x ]

or,

var = a² x var

where

V = change in the domestic value of assets, liabilities and operating income

a = the slope of the regression line

DS^u = unexpected change in the exchange rate

var = exchange rate risk.

This is in conformity to our statement that exchange rate risk is dependent on both exposure and unexpected changes in exchange rates.

Effects of Exchange Rates on Exporters and Importers

Before we add to our discussion the complications of forward hedging and the invoicing of exports or imports in different currencies, we shall summarize what we have learned:

1. Even with no foreign assets or liabilities or foreign currency payables or receivables, changes in exchange rates will affect operations. This is called operating of residual exposure and is very difficult to avoid.

2. Devaluations raise export prices in home-currency terms and at the same time raise export sales. Therefore, home-currency revenue is increased by devaluations. The reverse is true for revaluations.

3. Devaluations raise an exporter's profits. The gains are reduced by using tradable inputs and may be in any case removed in the long run by free entry of new firms or by general inflation brought about by devaluation.

4. Foreign-owned companies or companies with foreign-currency debts care about receipts and payments in units of foreign currency. Devaluation lowers prices in foreign currency units (while raising prices in units of the devalued currency) and raises an exporter's sales. Total revenues increase because the percentage sales increase exceeds the price reduction. This follows because firms sell where demand is elastic. Production costs also increase, but it can be shown mathematically that if profits are being made, an exporter's total revenues will rise more than total costs, and so profits will increase.

5. Import prices rise in units of the devalued currency and fall in units of foreign currency. The quantity of imports will fall from devaluation. The importer's sales revenues will fall in terms of the devalued currency because price increases are smaller than quantity reductions. Total costs also fall, but if profits are being made, not by as much as total revenues. The profits of importers therefore decline from devaluation. This is true whether we measure in terms of the local currency or in terms of foreign currency.

Types of Exposure

Exposure can be classified into three kinds on the basis of the nature of item that is exposed, measurability of the exposure and the timing of estimation of exposure. These are

· Transaction exposure

· Translation exposure

· Operating exposure

Transaction Exposure

Transaction exposure is the exposure that arises from foreign currency denominated transactions which an entity is committed to complete. In other words, it arises from contractual, foreign currency, future cash flows. For example, if a firm has entered into a contract to sell computers to a foreign customer at a fixed price denominated in a foreign currency, the firm would be exposed to exchange rate movements till it receives the payment and converts the receipts into the domestic currency. The exposure of a company in a particular currency is measured in net terms, i.e. after netting off potential cash inflows with outflows.

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Translation Exposure

Translation exposure is the exposure that arises from the need to convert values of assets and liabilities denominated in a foreign currency, into the domestic currency. For example, a company having a foreign currency deposit would need to translate its value into its domestic currency for the purpose of reporting at the time of preparation of its financial statements. Any exposure arising out of exchange rate movement and the resultant change in the domestic-currency value of the deposit would classify as translation exposure. It needs to be noted that this exposure is mostly notional, as there is no real gain or loss due to exchange rate movements since the asset or liability does not stand liquidated at the time of reporting. Hence, it is also referred to as accounting exposure. This fact makes the measurement of translation exposure dependent on the accounting policies followed for the purpose of converting the foreign-currency values of assets and liabilities into the domestic currency.

At the time of the initial transaction, an asset or liability is recorded at a particular rate in accordance with company policy. At a later date, when the need to translate the value of the asset or liability arises, it may be translated either at the historical rate (which was the rate used at the time of the initial transaction) or at some other rate, which would again depend either on company policy, or on accounting standards, or on both. We know that for an asset to be considered as exposed there needs to be a change in its domestic currency value in response to a change in the exchange rate. Hence, those assets whose values are translated at a historical exchange rate do not result in translation exposure. Only the assets whose values are translated at the current (or post-event) exchange rate contribute to translation exposure. Again, like transaction exposure, translation exposure is measured as the difference between exposed assets and exposed liabilities.

Operating Exposure

Operating exposure is defined by Alan Shapiro as “the extent to which the value of a firm stands exposed to exchange rate movements, the firm’s value being measured by the present value of its expected cash flows”. Operating exposure is a result of economic consequences (rather than accounting consequences, as in the case of transaction and translation exposure) of exchange rate movements on the value of a firm, and hence, is also known as economic exposure. In an earlier section, we had discussed the exposure faced by an export firm on account of changes in exchange rates. That is one example of economic exposure.

As we saw in the preceding sections, transaction and translation exposure cover the risk of the current profits of the firm being affected by a movement in exchange rates. On the other hand, operating exposure describes the risk of future cash flows of a firm changing due to a change in the exchange rate.

The exposure arising out of contractually fixed cash flows can be managed using various techniques, but where the exposure arises out of cash flows that are not fixed contractually, or where the change in the domestic-currency value as a result of exchange rate movements cannot be predicted exactly, these techniques become ineffective. Due to this difficulty in managing such exposure with the traditional techniques, it is also referred to as the residual exposure.

The future cash flows of a firm are dependent not only on the exchange rate movements, but also on the relative rates of inflation prevailing in different countries. The interplay of these two forces determines the future cash flows and their variability, and hence, the operating exposure faced by a firm. If the change in the exchange rates is matched by an equal change in the price levels, i.e. Relative PPP is maintained (or in other words, the real exchange rate remains unchanged), the relative competitive positions of domestic and foreign firms will not change, and hence, there will be no change in the cash flows of the domestic firm due to exchange rates. Hence, there will be no economic exposure. On the other hand, in case of a change in the real exchange rate, the relative prices (i.e. the ratio of the domestic goods’ prices to the prices of foreign goods) will change, resulting in a change in the domestic firm’s cash flows. Hence, it follows that in case Relative PPP holds good, even a widely fluctuating and unpredictable exchange rate will not result in operating exposure. On the other hand, even a relative stable exchange rate can result in operating exposure if it is not matched by appropriate changes in the price levels. The hidden dangers of a fixed or stable exchange rate become clear from the above discussion. Hence, we can say that a real appreciation of a currency harms the domestic exporting and import-competing industries, while a real depreciation has the opposite effect.

A change in the real exchange rate getting translated into a change in a firm’s cash flow is dependent upon the price flexibility enjoyed by it. When the domestic currency experiences a real appreciation, for an export-oriented firm the flexibility gets reflected in whether it can increase its foreign-currency prices proportionately, and in case of a firm competing with imported goods, it gets reflected in whether the company can maintain its domestic prices at the existing level in face of the lower price of the imported goods without losing sales.

The price flexibility enjoyed by a firm is largely a factor of the price elasticity of demand. Price flexibility is negatively correlated to price elasticity, i.e. the more price elastic the demand, the less flexibility the firm enjoys to change the foreign-currency price (or keep the domestic price unchanged, in case of a firm facing competition from imported goods) of its product. The price elasticity of demand, in turn, is dependent on a number of factors. These are

· Degree of competition

· Location of competitors

· Degree of product differentiation.

Degree of Competition

A large number of competitors restrict the flexibility of prices enjoyed by a firm. This is so because with a large number of suppliers, it will be very easy for the consumers to change from one product to another. Hence, lower the competition faced by a firm, higher the price flexibility.

Location of Competitors

If most of the competitors are located in the same country as the exporting firm, all of them will face the same changes in costs and pressures on profits as a result of a change in the real exchange rate. This will enable them to change the foreign-currency price of their product collectively, without having any effect on their competitiveness.

Degree of Product Differentiation

A firm’s product being unique and different in some way from its competitors’ products, helps it charge a premium on it. The higher the product differentiation, the more price flexibility the firm enjoys.

A firm’s exposure is also a factor of the flexibility it enjoys to shift its production centers and the sources of its raw materials. An MNC having production centers in different countries is less exposed to exchange rate movements as it can increase the production in a country whose currency has depreciated and decrease production where the currency has appreciated. Also, having a production center in the country where the goods are to be sold reduces the exposure by matching the currency of costs and revenue.

Management of Transaction and Translation Exposure

Transaction exposure introduces variability in a firm’s profits. For example, the price received in rupee terms by an Indian exporter for goods exported by him will not be known till he actually converts the foreign currency receipts into rupees. This price varies with changes in the exchange rate. While transaction exposure arises out of the day-to-day activities of a firm, translation exposure arises due to the need to translate the foreign currency values of assets and liabilities into the domestic currency.

These differences in the two types of exposures result in some basic differences in the way they are required to be managed. Management of transaction exposure is essentially a day-to-day operation carried out by the treasurer. It involves continuous monitoring of exchange rates and the firm’s exposure, along with an evaluation of the effectiveness of the hedging techniques employed. On the other hand, management of translation exposure is a periodic affair, coming into the picture at the time of preparation of financial statements. This makes the management of translation exposure more of a policy decision, rather than a day-to-day issue to be handled by the treasurer.

Management of exposure essentially means reduction or elimination of exchange rate risk through hedging. It involves taking a position in the forex/and or the money market, which cancels, out the outstanding position. Though the frequency at which the need to manage transaction and translation exposure arises, differs, the basic instruments that can be used are the same. These instruments can broadly be classified as internal and external instruments. Internal instruments are those, which are a part of the day-to-day operations of a company, while external instruments are the ones, which are not a part of the day-to-day activities and are especially undertaken for the purpose of hedging exchange rate risk. Here, it needs to be noted that the term internal does not denote that no external party is involved. It only denotes that it is a normal activity for the company.

The various internal hedging techniques are:

· Exposure netting,

· Leading and lagging,

· Choosing the currency of invoice, and

· Sourcing.

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Exposure Netting

Exposure netting involves creating exposures in the normal course of business which offset the existing exposures. The exposures so created may be in the same currency as the existing exposures, or in any other currency, but the effect should be that any movement in exchange rates that results in a loss on the original exposure should result in a gain on the new exposure. This may be achieved by creating an opposite exposure in the same currency or a currency, which moves in tandem with the currency of the original exposure. It may also be achieved by creating a similar exposure in a currency which moves in the opposite direction to the currency of the original exposure.

Leading and Lagging

Leading and lagging can also be used to hedge exposures. Leading involves advancing a payment, i.e. making a payment before it is due. Lagging, on the other hand, refers to postponing a payment. A company can lead payments required to be made in a currency that is likely to appreciate, and lag the payments that it needs to make in a currency that is likely to depreciate.

Hedging by Choosing the Currency of Invoicing

One very simple way of eliminating transaction and translation exposure is to invoice all receivables and payables in the domestic currency. However, only one of the parties involved can hedge itself in this manner. It will still leave the other party exposed as it will be dealing in a foreign currency. Also, as the other party needs to cover its exposure, it is likely to build in the cost of doing so in the price it quotes/it is willing to accept.

Another way of using the choice of invoicing currency as a hedging tool relates to the outlook of a firm about various currencies. This involves invoicing exports in a hard currency and imports in a soft currency. The currency so chosen may not be the domestic currency for either of the parties involved, and may be selected because of its stability (like the dollar, which serves as an international currency).

Another way the parties involved in international transactions may hedge exposures is by sharing the risk. This may be achieved by denominating the transaction partly in each of the domestic currencies of the parties involved. This way, the exposure for both the parties gets reduced.

Hedging through Sourcing

Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in the same currency in which it sells its products. This results in netting of the exposure, at least to some extent. This technique has its own disadvantages. A company may have to buy raw material which is costlier or of lower quality than it can otherwise buy, if it restricts the possible sources in this manner. Due to this, this technique is not used very extensively by firms.

The various external hedging techniques are:

· Forwards

· Futures,

· Options, and

· Money markets.

Hedging though the Forward Market

In order to hedge its transaction exposure, a company having a long position in a currency (having a receivable) will sell the currency forward, i.e., go short in the forward market, and a company having a short position in a currency (having a payable) will buy the currency forward, i.e. go long in the forward market.

The idea behind buying or selling a currency in the forward market is to lock the rate at which the foreign currency transaction takes place, and hence, the costs or profits. For example, if an Indian firm is importing computers from the USA and needs to pay $1,00,000 after 3 months to the exporter, it can book a 3-month forward contract to buy $1,00,000. If the 3-month forward rate is Rs.42.50/$, the cost to the Indian firm will be locked at Rs.42,50,000. Whatever be the actual spot price at the end of three months, the firm needs to pay only the forward rate. Thus, a forward contract eliminates transaction exposure completely.

Most of the times, when the transaction exposure is hedged, the translation exposure gets automatically hedged. In the above example, the translation exposure gets automatically hedged as any loss/gain on the outstanding payable gets set-off by the gain/loss on the forward contract. But there may be situations where the translation exposure may need to be hedged, either because the underlying transaction exposure has not been hedged or because the translation exposure arises due to the company holding some long-term asset or liability. In such situations also, forward contracts may be used to hedge the exposure. The firm would need to determine its net exposure in a currency and then book an opposite forward contract, thus nullifying its exposure. For example, if a firm has a net positive exposure of $1,00,000, it will sell $1,00,000 forward so that any loss by exchange rate movements on account of the main exposure will be canceled off by the gain on the forward contract, and vice versa. However, the gain/loss on the underlying exposure will be notional while the loss/gain on the forward contract will be real and involve cash outlay.

The cost of a forward hedge can be measured by the opportunity cost, which depends on the expected spot rate at which the currency needs to be bought or sold in the absence of the forward contract. Hence, the cost of a forward hedge is measured as the difference between the forward rate and the expected spot rate for the relevant maturity. In an efficient market, as mentioned earlier, the forward rate is an unbiased predictor of the future spot rate. The process equating these two requires the speculators to be risk-neutral. Hence, when the markets are efficient and the speculators are risk-averse, the cost of hedging through the forward market will be nil.

Hedging through Futures

The second way to hedge exposure is through futures. The rule is the same as in the forward market, i.e. go short in futures if you are long in the currency and vice versa. Hence, if an importer needs to pay $2,50,000 after four months, he can buy dollar futures for the required sum and maturity. Futures can be similarly used for hedging translation exposure. Hedging through futures has an effect similar to hedging through forward contracts. As the gain/loss on the futures contract gets canceled by the loss/gain on the underlying transaction, the exposure gets almost eliminated. Here it is assumed that basis remains constant. Only a small part of the exposure is left due to the mark-to-market risk on the futures contract. The main difference between hedging through forwards and through futures is that while under a forward contract the whole receipt/payment takes place at the time of maturity of the contract, in case of futures, there has to be an initial payment of margin money, and further payments/receipts during the tenure of the contract on the basis of market movements.

Hedging through Options

Options can prove to be a useful and flexible tool for hedging transaction and translation exposure. A firm having a foreign currency receivable can buy a put option on the currency, having the same maturity as the receivable. Conversely, a firm having a foreign currency payable can buy a call option on the currency with the same maturity.

Hedging through options has an advantage over hedging through forwards or futures. While the latter fixes the price at which the currency will be bought or sold, options limit the downside loss without limiting the upside potential. That is, since the firm has the right to buy or sell the foreign currency but not the obligation, it can let the option expire by not exercising its right in case the exchange rates move in its favor, thereby making the profits it would not have made had it hedged through forwards or futures. But this advantage does not come free. Because of this feature, options generally cost more than the other tools of hedging.

Another advantage offered by options is flexibility. There is only one exchange rate at which a currency can be bought or sold under a forward or a futures contract. On the other hand, options are available at different exchange rates. Depending on the firm’s outlook about the future and its risk-taking capacity, it can buy a suitable contract.

Hedging through the Money Market

Money markets can also be used for hedging foreign currency receivables or payables. Let us say, a firm has a dollar payable after three months. It can borrow in the domestic currency now, convert it at the spot rate into dollars, invest those dollars in the money markets, and use the proceeds to pay the payable after three months. This process locks the exchange rate at which the firm needs to buy dollars. At the same time, it knows its total cost in advance in the form of the principal and interest it needs to repay in the domestic markets.

Illustration

An Indian firm exports jeans to America. Currently it sells 20,000 pieces at $30 per piece. Its cost per piece of jeans is Rs.300. In addition, it needs to import certain raw material which costs $10 per piece. The fixed costs of the company are Rs.2,000,000. The current spot rate is Rs.44.00/$. Suppose that the rupee appreciates to Rs.40/$. By how many units should the company’s sales increase for its profits to remain unchanged?

Guest

The company’s existing profits can be calculated as follows:

		(in Rs.)
Sales (20,000 x 30 x 44)		26,400,000
Variable costs:
300 x 20,000 = 6,000,000
10 x 44 x 20,000 = 8,800,000
	14,800,000
Fixed costs	2,000,000
		16,800,000
Profit		9,600,000

After the rupee appreciation, the company’s profits will be

		(in Rs.)
Sales (20,000 x 30 x 40)		24,000,000
Variable costs:
300 x 20,000 = 6,000,000
10 x 40 x 20,000 = 8,000,000
	14,000,000
Fixed costs	2,000,000
		16,000,000
Profit		8,000,000

As a result of the appreciation of the domestic currency, the profits of the company have come down despite it selling the same number of units at the same dollar price, as existed before the appreciation. Let the number of units that need to be sold for keeping the profits at the pre-appreciation level be ‘X’. Here, we are assuming that the company can sell unlimited quantity at the existing dollar price. Then,

9,600,000 = (40 x 30 x X) – [(300 x X) + (10 x 40 x X) + 2,000,000]

9,600,000 = 1,200 X – 700 X – 2,000,000

11,600,000 = 500 X

X = 11,600,000 / 500 = 23,200 units.

Hence, the firm needs to increase its sales by 3,200 units to maintain its pre-appreciation profits.

Management of Economic Exposure

As was mentioned previously, economic exposure cannot be managed by the traditional hedging techniques due to the unpredictability of the changes in the cash flows. Rather, it requires various marketing, production and financial management strategies to cope with the risks.

Changes in real exchange rate may either bring about losses, or create an opportunity to increase the profits for an exposed firm, by changing the relative prices, and hence, the competitiveness of the firm. Depending on the duration for which the change in the exchange rate is expected to last, an appropriate strategy can be adopted. For example, if an appreciation of the domestic currency is not expected to last long, the firm may decide not to increase the foreign-currency price of its product if it considers the cost of regaining the lost market share to be too high. On the other hand, if the exchange rate change is likely to last for a longer period, the cost of regaining the market share may become lower than the profit that would be lost if the price is not increased. This may persuade the firm to increase the foreign-currency price even at the cost of losing market share (again, depending on the volume of market share that will be lost, which will be dependent on the price elasticity of demand). If the change is expected to last for a very long time, the firm may even consider shifting its production capacities to a country whose currency has depreciated.

Marketing Strategies

The marketing manager needs to analyze the effect of a change in the exchange rate and evaluate the strategy required to manage the exposure. The four strategies available to him are:

· Market selection,

· Pricing strategy,

· Promotional strategy, and

· Product strategy.

Market Selection

This strategy is useful when the actual or anticipated change in the real exchange rate is likely to persist for a long time. It involves selection of the markets in which the firm wishes to market its products and providing relevant services to provide the firm an edge in these markets. This may translate into pulling out of the markets which have become unprofitable due to the depreciation of the currency of that market, or entering those markets that have become attractive as a result of currency appreciation in that market.

Knowledge about market segmentation is a very important input for the decision about market selection. Before pulling out of a market, the effect of the change in the exchange rate on the cash flows of the firm needs to be analyzed. The cash flows of a firm selling a highly differentiated product to high-income customers may not be affected by the exchange rate movement, hence not requiring the firm to pull out of the market. Similarly, a company that does not aim at the low-price mass market, may be able to access that market as a result of a depreciation of the domestic currency. In both the cases, the decision about market selection gets affected by market segmentation.

Pricing Strategy

There are two main issues involved in developing a pricing strategy – the choice between market share and profits, and the frequency of price adjustments.

Market share vs. profit margin: When the domestic currency appreciates, a firm can either reduce its domestic currency prices, thus maintaining the foreign currency prices at the pre-appreciation level, or maintain the domestic currency prices, which would result in an increase in the foreign currency price. While the former would result in the profit margins coming down, the latter may result in a fall in the market share, which would again affect the profits of the firm. On the other hand, a firm facing a depreciation of the domestic currency may either increase the domestic currency price which would result in the profit margin going up (called price skimming), or maintain them at the pre-depreciation level, thus reducing the foreign currency price to increase its market share (called penetration pricing).

A company facing competition from imported goods faces a similar dilemma. In the face of a domestic currency appreciation, it can either let the price of its product remain unchanged, thus risking a reduction in the market share, and hence, overall profits, or it can reduce the price, thus reducing the profit margin.

As mentioned earlier, the final decision would depend on the price elasticity of demand. The greater the price elasticity, the higher the incentive to take a hit on profit margins rather than on market shares. An important point that needs to be kept in mind while taking the decision is that it may not always be possible to regain lost market share subsequently. Even if it is possible, the cost may be prohibitive. This brings the expected duration of the change in the exchange rate into the picture. Longer the expected duration, lesser the importance of lost sales.

Another factor that needs to be considered is economies of scale faced by the company. In case of large economies of scale, it may make more sense to forego larger profit margins and to try to make up the lost profit through higher volumes. Lower the economies of scale, more important defending the profit margins becomes.

Frequency of price adjustments: While a firm may decide to change the price of its products with a change in the exchange rates, it would still need to decide upon the frequency of such price changes. As we know, exchange rates move even on a minute-to-minute basis. A firm’s sales may get affected by frequent price changes, because of the resultant risk faced by its consumers. On the other hand, a firm may lose on account of unfavorable exchange rate movements if it delays the change in the price of its product. Finally, a balance between the two needs to be arrived at, based on the level of uncertainty the firm’s customers are ready to face, the duration for which the exchange rate movement is likely to persist and the loss expected to be incurred by not changing the prices.

Promotional Strategy

The promotional strategy deciding the amount that the firm desires to spend in various markets in promoting its products needs to take the exchange rate movements into consideration. A change in the exchange rate would change the domestic-currency cost of overseas promotion. The effect of exchange rate movements on promotional costs is also in the form of the expected revenues that can be generated per unit of expenditure on promotion. For example, a devaluation of the domestic currency may improve the competitive position of an exporting firm, thus increasing the expected revenue per unit of promotional cost. This may persuade the firm to increase the promotional expenditure in those markets. When the promotional strategy takes these factors into consideration on a pro-active basis rather than on a reactive basis, the benefits are expected to be more.

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Product Strategy

A firm can use product strategy to respond to exchange rate movements. It may involve timing of introduction of new products, making product-line decisions and product innovations. The best time for a company to introduce a new product would be when it has a price advantage (for example, in case of an exporting firm, when the domestic currency has depreciated). The firm may need to hold back the products from the market when the conditions are not favorable. It is easier to establish a new product in international markets with a favorable pricing scenario, than with an unfavorable one. Product-line decisions refer to the company having to change its products in accordance with the exchange rate movements. As outlined in market selection, it involves according preference to producing high-end products at the time of an appreciation in the domestic currency, and producing mass products at the time of a depreciation. It may even involve an effort to improve the quality of the product by using new technology or through more R&D. While market selection refers to marketing the right product in the right market, product-line decisions involve changing the product-mix. The third component of this strategy is product innovations. In the face of an appreciating domestic currency and extremely competitive conditions in the international market, the firm may be able to protect its cash flows by regularly coming up with innovative products. Thus, by offering differentiated product to its customers, the firm may be able to protect its foreign currency price, and hence, its profits.

Production Strategies

Sometimes, exchange rate movements are too large and long lasting to be handled by marketing strategies. In these situations, the production manager may need to step in, to take long-term decisions to protect the firm from harmful effects of an unfavorable exchange rate movement, or to help it take advantage of favorable movements. The following strategies would be available to the production manager:

· Input mix,

· Product sourcing,

· Plant location, and

· Raising productivity.

Input Mix

The pressures on the profits of an exporting firm caused by an appreciating domestic currency can be countered by buying more inputs in the international markets than in the domestic market. This would reduce the costs at the time of reducing revenues, thus protecting the profits, at least to a certain extent. Another way of achieving the same objective is to outsource the intermediated inputs, either from producers in the country where the firm is selling its final product, or from producers of a country whose currency is closely linked to that of the country in which it markets its products. At the same time, it would create pressure on the domestic producers of the intermediate inputs and force them to become more competitive, thus proving advantageous to the exporting firm.

Inversely, a firm, which has production capacities in other countries, can benefit from a depreciating domestic currency by sourcing more of its inputs from the domestic market. However, while taking such a decision, the firm would need to observe the price behavior of the domestically produced inputs. In the wake of domestic currency depreciation, the domestic prices of tradable goods, or those using imported inputs are likely to go up, reducing the price advantage of sourcing the inputs from the domestic market. On the other hand, the prices of non-tradable goods and goods using little imported inputs are likely to remain stable.

To enable these changes, the technology used by the firm for production should be flexible and capable of adjusting to inputs sourced from different producers. This requires making a comparison between the costs of making the technology flexible, and the expected reduction in profits in case the input mix is not changed. The final decision has to be based on comparative costs.

Product Sourcing

One of the ways of countering exposure is to shift production among different production centers. This strategy presupposes the presence of production facilities in more than one country. As a response to exchange rate movements, the firm can reallocate production to increase the quantity produced in the country whose currency has depreciated, and reducing production in countries whose currency has appreciated. Due to this flexibility, an MNC faces less economic exposure than a company having production facilities in only one country.

Practically, there may be a number of problems coming in the way of such adjustments. For example, availability of an important raw material in a particular country, protest by labor unions to shifting of production (as it is likely to result in redundancies), etc. It may not always be possible to overcome such problems.

Another problem is that establishment of multiple production facilities may result in economies of scale not being utilized resulting in higher per unit cost, excess capacities, and higher fixed costs in times of low production requirements. These costs have to be weighed against the benefits of production flexibility provided by the presence of multiple production facilities. These additional costs can be seen as the cost of an option to produce goods at an alternative location, whose value increases with an increase in exchange rate volatility.

Plant Location

Companies, which do not have multiple production facilities, may be forced to set up such facilities abroad as a response to exchange rate movements, which change the relative cost advantages of countries. Firms may even decide to set up production facilities in third-world countries for labor-intensive products due to the low labor cost there, without there being any specific advantage due to exchange rate movements.

Such decisions have to be taken after giving due consideration to the duration for which such production facilities are likely to enjoy cost advantages. Since these commitments are long-term in nature, the benefits should be expected to continue for a substantially long period, for such investment to be justified. The underlying economic factors of the country where the setting up of production facilities is being contemplated need to be evaluated thoroughly before the decision is made. Sometimes the root cause of the depreciation of that currency (which gives the country its cost advantage) may be such as to make the cost advantage last only for a short-term (e.g. inflation). In such cases it may be advisable not to make the investment.

The advantages accruing from the setting up of these facilities also need to be weighed against factors like the loss over quality control, distance from suppliers of crucial inputs, the political environment in that country resulting in additional risks. The decision should be taken after all these relevant factors have been duly considered.

Raising Productivity

An appreciation of the domestic currency results in increasing the costs of an exporting firm in terms of the foreign currency, thus making the product uncompetitive in the international market, forcing the firm either to bear a cut in the profit margin or to lose market share. This problem may be resolved by the firm making an effort to reduce the domestic currency cost of its product in the wake of a domestic currency appreciation. While this may happen automatically in case imported raw materials or intermediate inputs being used. When this is not the case the firm may have to resort to other measures like attempting to increase the productivity of the various factors of production. It may entail modernizing the machinery and the technology, renegotiating wage agreements, closing inefficient plants, pruning the product line, etc.

Financial Management Strategies

The production and marketing strategies detailed above generally take some time to be implemented. The focus of the financial management strategies is to control the damage caused by unfavorable exchange rate movements while the above strategies are being implemented. The major financial management strategy is to create liabilities in the currency to which the firm’s earnings are exposed to a large extent, thus creating a natural hedge. Any loss of operating profits caused due to exchange rate movements would then be made up at least partially by reduction of debt-servicing costs.

It has to be kept in mind that while this strategy can be used for managing large exposures in currencies, it can neither be used to hedge exposures perfectly, nor for managing exposures in all the currencies. A comparative analysis of the exposures in various currencies needs to be done before deciding on the final strategy.

Exposure and risk

Foreign exchange exposure as the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates.

To understand the concept of exposure, we need to analyze this definition in detail. The first important point is that both foreign and domestic assets and liabilities could be exposed to effects of exchange rate movements. E.g., if an Indian resident holds a dollar deposit and the dollar's value vis-à-vis the rupee changes, the value of the deposit in terms of rupees changes automatically. This makes the dollar deposit exposed to exchange rate changes. On the other hand, if a person is holding a debenture in an Indian company, the value of the debenture may change due to an increase in general interest rates, which in turn may be the effect of a depreciating rupee. Thus, even though no conversion from one currency to another is involved, a domestic asset can be exposed to movements in the exchange rates, albeit indirectly.

Guest

Product Strategy

Production Strategies

· Input mix,

· Product sourcing,

· Plant location, and

· Raising productivity.

Input Mix

Product Sourcing

Plant Location

Raising Productivity

Financial Management Strategies

Exposure and risk

Foreign exchange exposure as the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates.

To understand the concept of exposure, we need to analyze this definition in detail. The first important point is that both foreign and domestic assets and liabilities could be exposed to effects of exchange rate movements. E.g., if an Indian resident holds a dollar deposit and the dollar's value vis-à-vis the rupee changes, the value of the deposit in terms of rupees changes automatically. This makes the dollar deposit exposed to exchange rate changes. On the other hand, if a person is holding a debenture in an Indian company, the value of the debenture may change due to an increase in general interest rates, which in turn may be the effect of a depreciating rupee. Thus, even though no conversion from one currency to another is involved, a domestic asset can be exposed to movements in the exchange rates, albeit indirectly.