Exposure to foreign exchange involves the situation where the cash flow activities of a firm become sensitive to exchange rate changes. The exposure to foreign exchange is carried out in three different forms namely translation, economic as well as transaction exposures. This exposure has been experiencing continuous challenges within global markets caused by high levels of instability in the rates of foreign exchange. The increasing intensity of competition in financial markets also contributes to the uncertainty of these rates. This has called for the implementation of efficient management skills to maintain profitable exposure to foreign exchange. Soenen (2008 p.27)
Forms of Exposure
There are three different types through which exposure to foreign exchange takes place among them being translation exposure. This involves changes that occur to an accounting of financial statements resulting from changes in exchange rates. This takes place to match the figures presented in financial statements with the existing exchange rates. Another type of exposure is transaction exposure which involves changes in exchange rates taking place during the transaction period.
This is particularly from the initial time that a transaction agreement is made to the time when transaction processes are completed and payments made. Transaction exposure has a considerable effect on how cash flows due to the differences in exchange rates existing at the start and end of transactions. The third type of exposure is economic exposure which involves a reflection of changes that are expected to occur to cash flows of a firm in the future when compared to the existing value.
Expected changes in the value of cash flow are normally caused by unexpected changes occurring in rates of exchange. Foreign exchange in the different types of exposure has registered a high level of instability globally, which calls for a frequent adjustment in the strategies through which these exposures take place within various firms. This adjustment is part of the management process that is undertaken to cope with exchange rate changes. Soenen (2008 p.28)
Management Process
Firms are normally exposed to risky situations due to movements that take place in the three exposures. In such cases, exposure managers are burdened with the task of ensuring that the entire financial operations of a firm are in line with existing changes. The exposure management process starts with exposure analysis. In this particular case, exposure is considered as an expected and /or unexpected flow of cash with an unknown magnitude.
The magnitude of cash flow is normally dependent on foreign exchange as well as interest rates. A company or firm is supposed to determine its exposures to foreign exchange which are then analyzed accordingly. The determination of specific exposures of individual firms involves a consideration of cash flows which assists during exposure management. The various cash flows, as well as transaction types that are put into consideration, include foreign currency that is contracted where part of the exposure takes place in revenue while the other part takes place in form of capital. Another category of cash flow involved in the determination process is interest rates with interest payments as the exposure.
The consideration of cash flow that is expected involves revenue exposures while actual implementation transaction consideration of cash flows takes place in form of hedge transactions. An exposure manager also ensures that he/she receives information concerning large amounts of cash flows once they have been estimated and/or predicted. This is supposed to come from all sections of the entire firm so that he/she can conduct their regulation accordingly.
Determination of cash flow in its various exposures is followed by analysis performance which involves a study of the gap between the time during which transactions are started and their time of completion. Another area of study during cash flow analysis is the gap between cash outflow and cash inflow as well as the certainty of cash flow in terms of dates and amounts. Schedules in which cash flows take place are also studied to compare them with existing ratings. Levi (2005 pp.49-51)
Other constituent steps that should be followed during exposure management include;
Market Forecasts
Exposures analysis is followed by consideration of the future direction of a firm’s financial operations. This is known as forecasting which is undertaken for a fixed period, for instance, six months. This particular period is chosen because; it gives reliable results which are provided by predictions of what would take place after six months. During market forecasting, exposure managers are supposed to focus on trends of exchange rates, where the direction is given in terms of either increase or decrease. Another area that should be focused on during forecasting financial markets is the likelihood in which a forecast can give correct results.
The higher the probability of a forecast, the more effective results it will provide since exposure managers will be able to fix reasonable figures for future transactions. Underlying assumptions of the predictions that are made are also focused on since they have a likelihood of giving the expected results of implementing a particular forecast. The final area of focus during market forecast is the extent to which the prediction is likely to be applied which is guided by the existing exchange rates trends. (Siegel 2007pp 16-19)
Risk Appraisal
Market forecasting is followed by risk appraisal which involves the determination of the situation of a firm’s exposures in the market forecasts that have been predicted. A variety of possible risks are put into consideration among them being the risk that might affect a particular exposure’s value. This involves the determination of the amount by which a particular forecast affects a firm’s cash flows. The actual value that is affected by a given forecast is calculated using forecasted exchange rates which may result in a loss or profit.
Another consideration of risk appraisal is forecast risk which involves the determination of the probability of the exchange rates shifting as well as the probability of the forecasted rates being incorrect. Risks associated with transactions and the market form a third risk appraisal consideration, where all the risks to which a market is susceptible are determined and chances of a particular transaction experiencing operation difficulty.
For instance, Rupee is found to encounter sudden changes which may make its predictability quite difficult, whereas Deutschemark’s shifts are regular hence predictable. Systems risk is also part of the risk appraisal’s considerations where risks that are likely to occur due to the existence of weaknesses in the system of exposure management otherwise known as gaps are determined.
Examples of gaps that may occur include reporting gap which involves delays in the particular reporting exposures and the implementation gap, which involves a gap existing between decisions made and the actual implementation of those decisions. In this particular case, decisions are the objectives of a firm concerning ways in which exposures to foreign exchange are to be carried out. Horcher (2005 pp.11-15)
Benchmarking
Benchmarking during exposure management involves the determination of the terms in which a firm prefers its exposures to operate. Practices of a firm’s exposure management are determined and it is accompanied by the period attached to each practice which is six months. Among the considerations reflected by the benchmark include management objectives, stating whether exposure management is expected to be run on either cost or profit basis.
A practical argument suggests that cost-based operation is the best for those companies that are not financially stable since it involves lower risks which are featured in the account of profit and loss during actual exchange operations. On the other hand, profit-based operations are best for those companies which are strongly financially founded where exposures are run on a long-term basis and are not accountable to daily risks of the exchange business.
Another is the actual statement of the expected probability of already determined forecasts. Risks that had been previously determined during risk appraisal are also restated in a firm’s benchmark as well as the allowance to encounter errors in policy implementation. Outcomes of a benchmark should be realistic enough to assist in the achievement of a firm’s objectives. Hudson (2000 pp.30-34)
Hedging
Hedging is taken to be the most practical part of exposure management since it involves the actual implementation of a firm’s objectives that had been previously stated in its benchmark. In this case, a trader is expected to strictly follow the benchmark’s directions to achieve the forecasted objectives of a firm. During hedging, an exposure system is accorded the freedom to run its daily operations but concerning benchmarks directions. However, hedging cannot be carried out before the determination of loss and profit levels which gives allowances of adjustments that should be put in place to incorporate losses as well as profits undertaken in the course of hedging.
A firm is expected to apply all the available techniques of hedging by benchmark requirements which involve securing authorization to use currency options, Rupee contracts, currency swaps as well as the various options of interest rate. It is suggested that those companies operating in regions where currencies are susceptible to sudden fluctuations like Rupee should protect themselves from irregularities that may result from such fluctuations by changing their implementation currency to a more reliable one. However, these replacements should be dependent on forecasted trends to make correct choices that are not subject to similar fluctuations in the future. Bragg (2007 p.22)
Stop Loss
This is a very important policy in the implementation of exposure management and it is based on the principle that human beings are bound to making errors, but these errors can be corrected before they cause big losses. This policy also reflects ways in which hope is replaced by reality, where traders encounter practical instances related to exposure management together with their difficulties. Since various forecasts are attached to all the available exposures, the policy of stop-loss incorporates reverse decisions that should be implemented in cases where forecasts are incorrect.
It is suggested that this policy should be put in place when operation rates get to critical levels that prove a previous forecast as well as its assumptions wrong. However, this policy should not guide exposure managers to wrong directions that violate a firm’s benchmark requirements. Also, exposure managers should not use stop-loss allowances to justify their incompetence during management processes. Bragg (2007 p.23-24)
This is where exposure managers prepare reports showing details of the actual undertakings monitored in the course of the actual hedging process. It is during reporting that, a manager can determine whether the different exposures are operating as intended. The reports should reflect results of hedging operations periodically that is; on a daily, fortnight as well as monthly basis. Reporting should be followed by reviewing where reported issues are reviewed to make adjustments if necessary. During the review, the firm’s objectives as portrayed in benchmarks are reexamined to find possible reasons as to why irregularities may be occurring which is followed by corrective measures. Shapiro (2002p.43)
The discussed constituents of exposure to foreign exchange as well as its management clearly show the importance of exposure management, which is expected to be carried out with objectivity, where personal issues are put aside. However, exposure management should not be considered as a reason to make exposure managers afraid of keeping exposure operations under control but should be considered with the same objectivity as applied in production processes.
Exposure managers are expected to observe patience while undertaking exposure management as the process takes time and is also subjected to various difficulties before the realization of presentable results. They should also have in mind that, to come up with a working system, requires great effort especially during benchmark determination where various difficulties are encountered. Constituent exposures should be appropriately determined as well as terms in which they should be carried out to come up with a realistic benchmark that hedging is based on. Therefore, firms should always be committed to this process of exposure management since it is a very important activity of companies undertaking exposures to foreign exchange which should not be ignored. Shapiro (2002p.44-46)
References
Bragg S. The new CFO Financial Leadership Manual: John Wiley & Sons, 2007 pp 22-24.
Horcher K. Essentials of financial risk management: John Wiley and Sons, 2005 pp 11-15.
Hudson R. The capital markets & financial management in banking: Lessons Professional Publishing, 2000 pp 30-34.
Levi M. International Finance: Routledge, 2005 pp 49-51.
Shapiro A. Multinational Financial management: Taylor & Francis, 2002 pp 43-46.
Siegel J. Outline of financial Management: McGraw-Hill Professional, 2007 pp 16-19.
Soenen L. Foreign exchange exposure management: University of California, 2008, pp 27-28.