UNIT II

Currency Risk & Its Management

Currency Risk (Exposure) or
Foreign Exchange Risk
 Exchange Rate between currencies changes
frequently

 Such change influences the value of

multinational firms – their
 Assets,
 Liabilities,
 Present and future cash flows

 In other words, they faces CURRENCY RISK

Currency Risk
Types

Types of Currency Risk

Economic Risk Accounting or

(Effects Cash Flows) Translation Risk
(Do not effect Cash Flows)

Transaction Risk
(Current Cash Flows)

Operating Risk
(Future Cash Flows)
Currency Risk
1. Transaction Risk
 Concerned with the impact of changes in
exchange rate on Current Cash Flows.

 Mainly because of following:

 Export & Import

 Borrowing & Lending in Foreign Currency

 Intra-Firm flow in an Multinational Company

Currency Risk
2. Operating Risk
 Concerned with the impact of changes in
exchange rate on Future Cash Flows.

 Which is related to Costs and Revenues of firm

 Mainly because of following:

 Increase in Cost of imported Raw-Material
 If domestic currency depreciates
 Decrease in Export Revenue
 If domestic currency appreciates
 Increase in other factors cost
Currency Risk
3. Translation Risk
 Also known as Accounting Risk
 Emerges on account of consolidation of
financial statements (P&L, BS) of multinationals
 It is done by converting financial statements of
subsidiaries denominated in different currencies
into the domestic currency of parent company
 Any change in exchange rate effects the
consolidated statements
Currency Risk
3. Translation Risk
 One Thought – It is irrelevant, as does not
effects the cash flows
 Other Thought – Relevant, as it effects the net
worth (share prices) of firm
 This risk is also depends on no. of countries in
which multinational works
 If no. of countries is high, so will depreciate and
other will appreciate neutralizing the effect
Translation Risk
Methods of Translation
 Current Rate Method
 All items at current rate
 In case of fixed assets against historical concept

 Current / Non-Current Method

 CurrentAssets/Liabilities at Current Rate
 Fixed Assets / Long Term Liabilities at Historical Rate
 Income Statement at average rate
Translation Risk
Methods of Translation
 Monetary / Non-Monetary Method
 AllLiabilities & Current Assets except stock at current
 Inventory & Fixed Assets at Historical rate
 Income statement (except) depreciation at average
rate

 Temporal Method
 All liabilities and current assets (including inventory if
shown at MP) at current rate
 All Fixed assets and Inventory (if shown at CP) at
historical rate.
 Income Statement (except Dep.) at average
Management of Currency Risk
 Reducing the currency risk, through different
types of hedging, to eliminate the result in loss,
is known as Management of Currency Risk.

 We can see different strategies of different type

of Risks:
 Hedging of Transaction Risk
 Hedging of Operating Risk
 Hedging of Translation Risk
Management of Currency Risk
Hedging of Transaction Risk
 Contractual Hedges
 Natural Hedges
 Leads and Lags
 Cross-Hedging
 Currency Diversification
 Risk-Sharing
 Pricing of Transaction
 Parallel Loans
 Matching of Cash Flows
Management of Currency Risk
Hedging of Operating Risk
 Marketing Strategies
 New Markets
 Product Differentiation
 New Pricing

 Production Strategies
 New Source of Raw-Material
 New Substitutes via Research
Management of Currency Risk
Hedging of Translation Risk

 Selecting Appropriate Method

International Trade Theories

Why does Nations Trade?