Exchange Rate Risk PDF

Topic 4 Foreign Exchange Risk Additional Reading: Chapter 13 Kaplan Publishing (2024) ACCA Financial Management (FM) Study Text 2 Upon completion of Topic 4 you will be able to: 1. Define Exchange Rate Risk 2. Explain the mean...

Topic 4 Foreign Exchange Risk Additional Reading: Chapter 13 Kaplan Publishing (2024) ACCA Financial Management (FM) Study Text 2 Upon completion of Topic 4 you will be able to: 1. Define Exchange Rate Risk 2. Explain the meaning and cause of Economic, Transaction and Translation Rate Risk 3 The Message! Foreign exchange shifts can have profound implications for: o Jobs o Competitiveness o National economic growth o Firms long-term survival Managers need to be aware of this risk Managers need to be capable of protecting the firm from such risk 4 Foreign Exchange Risk Is the sensitivity of real domestic currency values of assets, liabilities and operating income, to unanticipated changes in exchange rates Companies may become exposed to foreign exchange risk through: 1. Importing goods or services 2. Exporting goods or services 3. Having overseas subsidiaries 4. Being the subsidiary of an overseas company 5. Transactions in overseas capital or money markets 5 Risk Management: Describes the Policies Which a Firm May Adopt and the Techniques It May Use to Manage the Risks It Faces Pooling of Risks: Diversification Through a Portfolio of Investments Hedging of Risks: An Action Which Reduces/eliminates an Exposure Position 6 Foreign Exchange (FX) Exposure: FX exposure can be classified into THREE types of risk: 1. Economic Exposure 2. Transaction Exposure 3. Translation Exposure 7 Economic Rate Risk Economic Rate Risk is the risk that exchange rate movements might reduce the international competitiveness of a company. It is the risk that the present value of the company’s future cash flows might be reduced by adverse exchange rate movements It is long-term in nature Strategic or competitive exposure The impact can be substantial It affects a firms ability to compete in the domestic and international market place. It can affect a company’s competitive position, even if it does not operate or sell overseas 8 Economic Rate Risk For an export company, it could occur because: The home currency strengthens against the currency in which it trades A competitors home currency weakens against the currency in which it trades It impacts all firms; but some more than others The level of exposure is determined by: The industry / firms position within that industry Level of product differentiation, competition within a market, switching costs It is difficult to predict, quantify and avoid It is challenging to hedge, as it cannot be hedged using financial instruments 9 Managing Economic Risk: Strategy! Marketing Strategy: Production/Operations Strategy: FINANCIAL Strategy: MARKET SELECTION o PRODUCT SOURCING o Match revenue with cost; o Niche segment v’s mass market? o Raw Material Supply – one supplier finance debt in currency of o Pull out if market uncompetitive? or diversified sources? revenue o Develop market at expense of foreign o Produce in-house or subcontract o Finance debt to off-set rivals? components? competitive risk; hedge v’s major competition PRODUCT STRATEGY o PLANT LOCATION o What products to produce/range? o Introduce new/drop old line/range? o Where in world to locate? o Invest in R&D? o Invest in Flexible Manufacturing o Innovate, differentiate, upgrade, modify? Facilities? PRICING STRATEGY o RAISING PRODUCTIVITY o Fixed Price Contracts? o Cut costs, Preserve Cash? o Frequent Price Changes? o Emphasis Market Share or Profit? o Reduce Non-added-value? o Price Skimming or Market Penetration? o Increase Operational Efficiency? o Wage Cut-backs, Redundancy PROMOTIONAL STRATEGY Programme? o Training, Personal Selling? o Seek Government Intervention; o Marketing, Advertising Budgets? Quotas & Import Restrictions? 10 1970’s Laker Airlines 1970’s company doing well Existing fleet of aircraft couldn’t handle the volume of British vacationers Company bought 5 new DC10’s financing them in US$ Problem: o Revenues primarily in STG£ o Expenses and liabilities primarily in US$; paid for new aircraft in USD$ o Laker Airlines had a mismatch between revenues and expenses o $ strengthened in 1981: o Revenues declined o Liabilities increased o Company went bankrupt! 11 Impact of strong STG on UK firms Early 2000’s Corus (British Steel) cuts thousands of jobs, and forced its UK suppliers to cut their prices Dyson (2000) announced that it was setting up production facilities in East Asia, as a result of strong STG£ Japanese car makers (Toyota, Honda & Nissan) that set up manufacturing plants in the UK and were badly hit o They had to reduce their selling prices to compete against cheaper imported cars o But they were also contractually committed to buying 70% of its raw material components from UK Suppliers o Japanese imports and European competitors had 30-40% price advantage due to strong £ pound 12 Irish Companies and strong Euro CRH (international buildings material group) o Every 1c movement in favour of the € will reduce EPS by 0.8c o 60% of operating profit sourced in the US Fyffes (fruit importer) o Significant winner from weak $ o Imports bananas; priced in $ o Every 1c move can add €1-2m in operating profit Ryanair is one of the most exposed Dublin-listed companies to Brexit Ryanair estimates that every 1 pence decline against the Euro is wiping approx. €7m off its earnings 22% of its revenue, in the year to March 2019, came from its UK operations 13 Tutorial Task for Monday 6th November Self-directed Learning Exercise: I have uploaded some pre-2022 newspaper articles, describing strategies used by firms to manage currency risk and other business risks caused for example by Brexit, Covid-19 etc. During your next tutorial hour (Monday 6th Nov), you are required to complete the following: 1. Find 4 x 2022-2023 online newspaper articles, that show how firms (Irish or UK preferably) are impacted by currency and/or other business risks such as Brexit and Covid19 etc. 2. You must write a short paragraph on each article, explaining the strategies used by these firms to manage the risks identified. 3. Include a bibliography listing the sources used. 4. Upload your work to Brightspace, under the assignments tab, before 5pm, Monday 6th November. I will be in the virtual classroom (link for joining will be emailed separately). Please feel free to drop into from 12-2pm, if you have any questions on that require clarification. 14 Transaction Rate Risk Transaction Rate Risk is the risk of an exchange rate changing between the transaction date and the subsequent settlement date i.e. it is a gain or loss arising on conversion This type of exposure is more short-term than economic exposure The exposure measures the cash flow lost by a company in settling a financial obligation (transaction) denominated in a foreign currency Transaction exposure normally arises in the settlement of foreign currency assets and liabilities, for example: FX Debtors FX Creditors FX Loans or Deposits 15 Example: Transaction Rate Risk On 1st July An Irish company sells $5,000,000 worth of golf equipment to the organisers of the US Open Golf Championship at Winged Foot Golf Course, USA Payment due 30th September FX rates were as follows: 1 July: $1.12 : €1 30 Sept: $1.18 : €1 Required: Calculate the transaction rate exposure. 16 Transaction Rate Risk The main distinction between transaction and economic rate risk is: The ease with which a firm can identify the size/amount of the exposure The well defined time interval associated There are numerous ways in which a company can hedge against transaction rate risk; both internal and external methods are available One Way To Avoid - Invoice In Home Currency! 17 Transaction Rate Risk: Hedging Techniques Various techniques can be used by a company to eliminate transaction risk or to reduce it to an acceptable level. These include: Internal Hedging Techniques: Net Inter-company debts Match receipts and payments in the same currency Leading and lagging payments Adjust contract prices to forward rates Alter currency of invoicing External Hedging Techniques: Forward contracts Money market hedges Currency options Currency futures Swaps 18 Translation Rate Risk Translation rate risk is the risk that the firm will make exchange losses when it translates the value of its foreign assets and or liabilities into domestic (reporting currency) values at the closing rate applicable at the year end (i.e. year end reporting date) Foreign currency assets and liabilities may take the form of: Property assets - investment properties, factories, land, buildings Financial assets or liabilities - cash deposits, investments, medium or long term borrowings Subsidiary companies or businesses The reported values of such assets and liabilities may suffer a diminution in value between successive year ends, purely due to adverse exchange rate movements between the year end dates. The translation affects book values and not cash flows 19 Translation Rate Risk: Multinational Firms Translation rate risk occurs where the reported performance of an overseas subsidiary in home-currency terms is distorted in the consolidated financial statements, because of a change in exchange rates Multinational firms (with foreign subsidiaries) must prepare consolidated financial statements for reporting purposes The financial statements (accounting results) of overseas subsidiaries are translated into home currency The risk is that exchange rate changes can result in translation losses This is an accounting loss, rather than a cash-based one Translation rate risk should not need to be hedged. A legitimate hedging scenario - directors may consider hedging this risk if the company is near its debt limits, as translation losses may cause a breach of a loan agreement and could send the company into default. 20  Directors may consider hedging this risk! Irish company has a US subsidiary, and is structured as follows: Asset Euro - €100m Financed by €100m Equity Asset US - $100m Financed by $100m Debt Year-end 1 Exchange Rate: $1.00:€1 Year-end 2 Exchange Rate: $0.95:€1 The company has a loan covenants where the max gearing ratio allowed is 1:1 The gearing ratio is calculated, based on the consolidated financial statements As the € weakens against $; this company will have a problem with gearing ratio! The directors may legitimately decided to hedge the balance sheet, against translation rate risk, as the company is nearing its debt limits, and any translation losses, at the year-end, may cause a breach of its loan agreement and could potentially send the company into default. Balance Sheet Exchange Rate $1:€1 Assets Euro €100 Dollar($100m) €100 Total €200 Financed By: Equity €100 Debt ($100m) €100 Total €200 Gearing Ratio: 1:1 Balance Sheet Exchange Rate $1:€1 $0.95:€1 Assets Euro €100 €100 Dollar($100m) €100 €105 Total €200 €205 Financed By: Equity €100 €100 Debt ($100m) €100 €105 Total €200 €205 Gearing Ratio: 1:1 1.05:1