Tài chính kế toán - Chapter 17: Foreign exchange: risk identification and management

Chapter 17Foreign exchange: riskidentification andmanagementLearning objectivesRecognise FX transaction, translation, operational and economic riskFormulate an FX policy documentOutline methods to identify a company’s FX exposuresDescribe the implementation of market-based hedging techniquesExplain internal non-market-based techniques for managing FX riskChapter organisation17.1 FX risk policy formation17.2 Measuring transaction exposure17.3 Risk management: market-based hedging techniques17.4 Risk management: internal hedging techniques17.5 Summary17.1 FX risk policy formationForeign exchange risk exposures can be classified in terms of their impact on a firm’s cash flows, balance sheet, competitive position and valueTransaction exposureTranslation or accounting exposureOperational exposureEconomic exposure(cont.)17.1 FX risk policy formation (cont.)Transaction exposureThe risk that future foreign currency denominated cash flows will vary on account of exchange rate movementsE.g. a contract to import goods from the US denominated in USD(cont.)17.1 FX risk policy formation (cont.)Translation or accounting exposureThe risk that conversion and consolidation of foreign currency assets or liabilities will impact adversely on the balance sheetE.g. a firm accumulates assets and liabilities overseas and at a future date translates their value onto its consolidated balance sheet(cont.)17.1 FX risk policy formation (cont.)Operational exposureThe risk that day-to-day operating revenues and expenses will be affected by FX movementsE.g. foreign subsidiary operating expenses paid in the currency of the foreign country but sourced in another country such as the parent company(cont.)17.1 FX risk policy formation (cont.)Economic exposureThe effect of exchange rate movements on the ongoing business operations of a firm (i.e. the net present value of its future cash flows)It includes both transaction exposures and operating FX exposures and extends further to recognise the impact of FX risk on the value of a firm(cont.)17.1 FX risk policy formation (cont.)A company’s board of directors should document and circulate specific policies on FX risk management (i.e. policy document) including:FX objectivesManagement structureAuthorisationsExposure reporting systemsCommunicationsPerformance evaluationAudit and review procedures(cont.)17.1 FX risk policy formation (cont.)FX objectivesConsideration of what the company intends to achieve and how it will do so, by specifying the following:The products and services that can be used to manage FX risk exposures; e.g. forward exchange contracts and currency swapsThe style of risk managementActive—hedging techniques continuously adjusted in response to forecast changes in the exchange rateDefensive—a defined percentage of identified risk exposure is automatically hedged(cont.)17.1 FX risk policy formation (cont.)Management structureEnsure appropriate organisational controls and reporting systems, skilled personnel and sufficient funding are in placeE.g. a company with a treasury division requires an FX dealing room, back office support, technical support and administrationThe FX operation of a company may be:centralised—a single FX function in one location from which all policy is developed and transactions occurdecentralised—policy and trading is divested to each regional office(cont.)17.1 FX risk policy formation (cont.)AuthorisationsA description of who, within the organisation, has the authority to do what, ensuring task segregationLimits can relate to:single transactionsexposure to a particular clienteach currencyFX products used by the organisationeach individual FX dealermaximum overnight exposures(cont.)17.1 FX risk policy formation (cont.)Exposure reporting systemsDetermine which reports are required, how frequently they are required and who is responsible for acting on themE.g. exception reports—automatic computer-generated report when an FX authority is breached(cont.)17.1 FX risk policy formation (cont.)CommunicationsHow communication should occur both horizontally and vertically within the treasury division and the overall organisationE.g. Treasury must be advised of an import transaction so that it may arrange the payment of FXDaily strategy meetingPolicy document should also outline communication system to apply in the event of a disaster; e.g. fire in the treasury and FX operations area (cont.)17.1 FX risk policy formation (cont.)Performance evaluationEvaluation of the performance of the FX operations, given the FX objectivesSMART—specific, measurable, achievable, realistic and timelyAudit and review proceduresA regular and structured process of carrying out internal and external audits of FX operations, including current objectives, policies and procedures, with appropriate lines of reporting(cont.)17.1 FX risk policy formation (cont.)The importance of FX risk policy has been highlighted within many Australian firms since 2008The strength of the Australian dollar has negatively impacted upon the competitiveness of Australian firms competing in international marketsThe manufacturing sector has been particularly affected and the government has taken steps to assist some firms and industriesChapter organisation17.1 FX risk policy formation17.2 Measuring transaction exposure17.3 Risk management: market-based hedging techniques17.4 Risk management: internal hedging techniques17.5 Summary17.2 Measuring transaction exposureTransaction exposureThe risk faced by Australian firms that the AUD will change between the time an order is placed and the time of its paymentThis risk is caused by uncertainty as to the exact value of the transaction(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure risk has two directional components1. Downside exposureAmount received (paid) in the future is less (more) than the current projected amount2. Upside exposureAmount received (paid) in the future is more (less) than the current projected amount(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure has two elements1. Net cash flowsCollate all receivables and payables in each currency to determine net exposure2. Risk associated with transaction exposureCurrency variabilityCurrency correlations(cont.)17.2 Measuring transaction exposure (cont.)Net cash flowsCollate all receivables and payables in each foreign currency rather than considering each individual transactionIt is evident from Table 17.1 that the:company has a natural hedgei.e. matching transactions have been used to offset a potential risk exposurenet FX exposure is zerocompany had a perfect hedge because its receivables and payables were identical in size, currency and time(cont.)17.2 Measuring transaction exposure (cont.)(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposures: currency variabilityHaving determined the net FX exposure in each currency, the next step is to assess the extent of the risk (variability) of each exposure Currency variability relates to the probability of the spot rate changing between contract date and payment date(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposures: currency variability (cont.)Often measured by standard deviationMay need to examine trend in currency standard deviation over time as in Table 17.2, which illustrates that:standard deviations vary between currencies in the same periodstandard deviations vary over time(cont.)17.2 Measuring transaction exposure (cont.)(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure: currency correlationsIn considering whether to hedge an FX exposure, the correlations between the currencies should also be consideredCorrelation measures the degree to which two currencies move in relation to each otherCorrelation ranges from + 1 (perfectly positively correlated) to – 1 (perfectly negatively correlated)(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure: currency correlations (cont.)Figure 17.2 indicates that:currencies A and B are highly positively correlatedcurrency C is highly negatively correlated with both currencies A and B(cont.)17.2 Measuring transaction exposure (cont.)(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure: currency correlations (cont.)Table 17.3 demonstrates the use of correlation coefficients in assessing whether an FX exposure requires hedgingDate t+6A change in the AUD will result in a similar change in both inflows and outflows, which offset each otherA natural hedge exists(cont.)17.2 Measuring transaction exposure (cont.)(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure: currency correlations (cont.)Date t+8A change in the AUD will result in either a gain or a loss on both flowsThe exposure should be hedgedDate t+9A change in the AUD will result in either a gain or a loss on both flowsThe exposure should be hedged(cont.)17.2 Measuring transaction exposure (cont.)Transaction exposure: currency correlations (cont.)Date t+11A change in the AUD will result in a similar change in both inflows and outflows, which offset each otherA natural hedge existsChapter organisation17.1 FX risk policy formation17.2 Measuring transaction exposure17.3 Risk management: market-based hedging techniques17.4 Risk management: internal hedging techniques17.5 Summary17.3 Risk management: market-based hedging techniquesA firm may attempt to minimise FX risk (particularly downside exposure) through the use of hedging techniques/instrumentsHedging instruments include:forward exchange contractsmoney-market hedgefutures, options and swaps (discussed in Part 6 of text)(cont.)17.3 Risk management: market-based hedging techniques (cont.)Forward exchange contractsLock in an exchange rate today for delivery or receipt of a foreign currency at a specified future dateFigure 17.3 provides an example of the use of a forward exchange contract to hedge a USD1 million receivable in six months’ time(cont.)17.3 Risk management: market-based hedging techniques (cont.)(cont.)17.3 Risk management: market-based hedging techniques (cont.)Money-market hedging to cover FX riskAlso called ‘BSI hedge’—borrow, spot, investExample:A company has USD1 million receivable in six months’ timeMoney market hedging involves:Step I: Borrow USD today Step II: Spot convert USD to AUDStep III: Invest the AUD today(cont.)17.3 Risk management: market-based hedging techniques (cont.)Chapter organisation17.1 FX risk policy formation17.2 Measuring transaction exposure17.3 Risk management: market-based hedging techniques17.4 Risk management: internal hedging techniques17.5 Summary17.4 Risk management: internal hedging techniquesInternal hedging minimises FX exposures and the need to use market-based hedging techniquesMain internal hedging techniquesInvoicing in the home currencyCreating a natural hedgeCurrency diversificationLeading and lagging FX transactionsMark-upsCounter-trades and currency offsets(cont.)17.4 Risk management: internal hedging techniques (cont.)Invoicing in the home currencyAvoids FX exposureEffectively transfers all FX risk to the other party in the business transactionThe other party may charge a higher price to compensate for the extra risk(cont.)17.4 Risk management: internal hedging techniques (cont.)Creating a natural hedgeMatch foreign currency receivables and payables in terms of currency, timing and magnitudeDifficulties with this approachUnlikely that an exact hedge can be achievedCosts of hedge-motivated transactionsExtra costs associated with borrowing in markets where the business may not be well knownAre imported inputs or lease agreements superior in quality or price to another supplier in a non-matching currency?(cont.)17.4 Risk management: internal hedging techniques (cont.)Currency diversificationLimit impact of adverse exchange rate movements by spreading transactions over a large number of currenciesChance of adverse movements in a large number of currencies is very smallGreatest diversification achieved where currencies are perfectly negatively correlated(cont.)17.4 Risk management: internal hedging techniques (cont.)Leading and lagging FX transactionsLeadingChanging the timing of a cash flow so that it takes place prior to the originally agreed date E.g. pay a USD payable before an expected AUD depreciationLaggingDelaying the timing of an existing FX cash flowE.g. delay a USD payable to coincide with a USD receivableNeed to assess costs/impact of strategies; e.g. unpredictable payment behaviour(cont.)17.4 Risk management: internal hedging techniques (cont.)Mark-upsIncreasing prices on exports or imports to cover worst case scenario changes in an exchange rateE.g. exporter marks up export price of goods soldE.g. importer marks up the domestic price of imported goodsCompetition is a constraint to this strategy(cont.)17.4 Risk management: internal hedging techniques (cont.)Counter-trade and currency offsetsCounter-tradeThe exchange of product for product, rather then currency-based buy or sell contractsLimited to companies wishing to exchange products of equal value and at the same timeCurrency offsetsRecognition of the timing and amount of cash inflows and outflows in the same currencyApplicable to both internal cash flows of a firm and FX cash flows between different firmsChapter organisation17.1 FX risk policy formation17.2 Measuring transaction exposure17.3 Risk management: market-based hedging techniques17.4 Risk management: internal hedging techniques17.5 Summary17.5 SummaryForeign exchange risk exposures can be classified as:transaction exposuretranslation or accounting exposureoperational exposureeconomic exposureFX risk policy formulation involves a number of aspects necessary to measure and manage FX risk, including:FX objectives, authorisations, exposure reporting systems, communications, performance evaluation, and audit and review procedures(cont.)17.5 Summary (cont.)Transaction exposures can be measured by:net cash flowscurrency variabilitycurrency correlationsRisk management techniques include:market-based hedging—forward exchange contracts and money market hedginginternal hedging—invoicing in home currency, natural hedge, currency diversification, leading and lagging FX transactions, mark-ups, counter-trade and currency offsets