mitigating fx risk in corporate portfolio

05/02/20231

Mitigating FX Risk in Corporate Portfolio

BY :- RAHUL MAGAN

CHIEF EXECUTIVE OFFICER - TREASURY CONSULTING LLPCOUNTRY DIRECTOR – INTERNATIONAL INSTITUTE OF CERTIFIED FORENSICS INVESTIGATION PROFESSIONALS, INC.

COUNTRY DIRECTOR – ASSOCIATION OF CERTIFIED FORENSICS INVESTIGATION PROFESSIONALS (ACFAP)

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Managing FX Risk in Corporate Portfolio:- Foreign Exchange Risk is turning out to be a biggest risk for all Corporates across the world as majority of the Corporates are getting Globalized in nature. As more and more Corporates are getting Globalized in nature hence forth more the exposure towards Foreign Exchange Risk…

Foreign Exchange Risk Exposures :- Foreign Exchange Exposure is the sensitivity of the real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates

Mitigating FX Risk in Corporate Portfolio

Foreign Exchange Exposure

Balance Sheet Impact P&L Impact

Goes in OCI & impacts Equity

Goes in P&L and impacts EPS

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UNDERSTANDING THE EXCHANGE RISK MANAGEMENT PROBLEM

Value of hedging Goals Nature of the business

MEASUREMENT OF EXPOSURE

ACCOUNTING TRANSACTION ECONOMIC

NATURE OF THE CASH FLOW EXPOSURE: One-shot? Linear? Contingent on exchange rates? Contingent on other events?

HEDGING METHODS

OPERATIONAL FINANCIAL

Linear Forwards Futures Debt Currency swaps

Exchange-rate contingent Options Debt with option

features

Contingent onother events Event options Probability-based

hedging

Examples: Sourcing flexibility Pricing strategy Market

diversification

A Corporate Foreign Exchange Roadmap

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The Exposure Triangle – Corporates Balance Sheet

TransactionsExposure

TranslationExposure

EconomicExposure

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• Three types of Exposure:

- Translation or Accounting Exposure

- Transaction or Contractual Exposure

- Operating or Economic Exposure

FOREIGN EXCHANGE RISKS EXPOSURE – TYPES - I

Foreign Exchange Exposure

Translation Exposures

Transaction Exposure

Economic Exposure

Goes in B/S in OCI Goes in P&L Goes in P&L

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• Translation or Accounting Exposure:

Is the sensitivity of the real domestic currency value of Assets and Liabilities, appearing in the financial statements to unanticipated changes in exchange rates. The impact of Translation Gains/(Losses) goes in Balance Sheet in Other Comprehensive Income (OCI)

FOREIGN EXCHANGE RISKS EXPOSURE - Types - II

• Transaction or Contractual Exposure:Is the sensitivity of the real domestic currency value of Assets and Liabilities, when

assets and liabilities are liquidated with respect to unanticipated changes in exchange rates for exporting, importing, or import-substituting firms. The impact or Transaction exposure goes in P&L at revaluation rate.

• Economic or Operating Exposure:

Is the sensitivity of the real domestic currency value of Assets and Liabilities, or future operating incomes to unanticipated changes in exchange rates. The impact of Economic exposure goes in P&L at revaluation rate.

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1. Current/Non-Current Method: All current assets and current liabilities are translated at current exchange rate

2. Monetary/ Non-Monetary Method: All monetary assets and liabilities are translated at current exchange rate

3. Temporal Method: Same as Monetary/Non-Monetary method BUT inventory may be translated at current exchange rate IF it is shown at market value

4. Current Rate Method: All balance sheet and income statement items are translated at current exchange rate

FOREIGN EXCHANGE EXPOSURES – ACCOUNTING TREATMENT

Monetary / Non Monetary Temporal

Accounting Exposures

Current/Non Current Current Rate

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Foreign Exchange Transaction Exposure

Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date

Example: If Intel invoices a German company in Deutsche marks for a semiconductor shipment then the firm has German mark exposure and can hedge this by borrowing marks.

This kind of exposure is readily hedgable using forwards, futures or debt

Transactions exposure arises when a company must pay or receive a foreign currency at an unknown future exchange rate

It is contractual It affects the income statement It can often be hedged directly using forwards, futures or currency

options

Cash Flow Hedging

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Recognition of Exchange Gains & Losses

Exchange Gain/Loss

Transaction Gain/Loss Translation Gain/Loss

Trans-actionDate

FinancialStatement

Date

Settlementdate

FinancialStatement

Date

FinancialSatement

date

Translation

Transaction

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Foreign Exchange Fair Value Exposure

Fair value exposure (accounting exposure) results from the way accounting conventions dictate that a company’s foreign assets and liabilities should be booked.

Example: If Intel’s assets in Ireland are regarded as denominated in Irish punts, then the subsidiary’s accounting value is exposed to the punt and the firm may wish to hedge this exposure by financing in punts.

Hedging of Fair Value Exposures

Onshore Markets

Offshore Markets

Onshore & Offshore Markets

Singapore, NY, HK, Australia Markets Domestic Markets

Fair Value Hedging

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Currency Risks: Economic Exposure

Change in the economic value of the firm resulting from unanticipated exchange rate changes.

Booked vs. anticipated transactions Expected vs. unexpected changes; the "cost of

hedging" Exposure and the parity assumptions: "We are not

exposed in the long run" Currency of denomination vs currency of

determination; competition, elasticity's, etc.

Economic Exposure – Hedging & Impact

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Economic Exposure

Economic exposure is how the firm’s revenues and costs will respond to exchange rate changes. Example: Even though Intel invoices German customers in

marks, its future revenues may be unaffected by fluctuations in the mark if the currency of determination of prices in the semiconductor business is the dollar or even the yen.

The currency of determination is the currency in which most of the competition prices similar products. Example: General Electric’s Yen Payables

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Translation vs Economic Exposure

Accounting exposure Exposure = "Exposed" assets - "exposed" liabilitiesEconomic exposure Exposure = How will an unanticipated exchange

rate change affect the cash flows of the firm? Domestic sales Exports Domestic costs Import costs

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A Realistic Approach

Banks versus corporations: To the extent that the firm is like a bank, do bank-style hedging. Match financial assets with liabilities of the same kind.

Seek to identify economic exposure using product cost-and-market analysis, industry competitive analysis, or statistical analysis on the sensitivity of the company’s value to exchange rate changes.

Hedge economic exposure using debt/swaps for long term exposure, short term instruments for uncertain exposure, and options for disaster insurance

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Developing a Hedging Program

Hedging Program:- With the rising Globalization almost all organizations are having Foreign Exchange exposures lying in their books which in turn impacts their Balance Sheet as well as Profit & Loss A/c. There are three types of exposures lying in Corporate Balance sheets.

Types of Hedging Program

Cash Flow Hedging

Fair Value Hedging

Net Investment Hedges

Protecting Cash Flow exposures via approved derivatives instruments in Onshore & Offshore markets

Protecting Fair value exposures via approved derivatives instruments in Onshore & Offshore markets

Protecting Net Investments done by one Group company in other Group company in Foreign Currency.

To protect Exports / fair value & Net Investments

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Developing a Hedging Program – Cash Flow Hedges

Cash Flow Hedging Program:- Cash Flow Hedges are taken to protect either near term or long term cash flows from the volatility in exchange rates. The same can be done via taking FX hedges not only in Onshore Treasury markets & Offshore Treasury markets using Derivatives contracts like Plain vanilla forwards contracts, Options , Swaps , Interest Rate Hedging , FRA and respective others.

Cash Flow Hedging

Onshore Derivatives Offshore Derivatives

Local Treasury markets

Plain Vanilla Derivatives,Options Contracts

SwapsInterest rate Hedging

FRARespective others..

Offshore Treasury Markets – Australia , London, Singapore, NY, Dubai

To protect Exports , Imports or VCF

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Developing a Hedging Program – Fair Value Hedges

Fair Value Hedging Program:- Fair value hedging program is devised to protect the fair value of the foreign currency assets & liabilities in books. All MNC having various subsidiaries across the world hence forth all subsidiaries are having various foreign currency assets & liabilities which needs to be revalue at the end of the month hence forth concept of fair value hedging is required.

Fair Value Hedging







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Developing a Hedging Program – Net Investment Hedges

Net Investment Hedging Program:- Net Investment hedges are taken when a Group company has given a loan in the form of net investments in other Group company. The same would happen when parent company invested in Group company which is not the functional currency of the subsidiary hence forth hedging is required.

Net Investment Hedging







To protect Net Investments in Group Companies

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Hedging Instruments

Hedging Instruments:- Well with the rising complexities of derivatives instruments & exporting models there is a dire need for Corporate Treasurers to not only hedge their receivables but also payables having correct derivatives in place.

Types of Derivatives Contracts


Plain Vanilla Derivatives, Options Contracts, Swaps, Interest rate Hedging

FRA, Respective others..

Types of Hedging Instruments

Offshore markets offers another biggest derivatives instruments known as NDF ( Non Deliverable Forwards Contracts ) , NDO ( Non Deliverable Options) & NDS ( Non Deliverable Swaps )

where in there is nothing to deliver however settlement of net Gain/(loss) would happen.

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Biggest Risks covered via Derivatives

Liquidity Risk

Funding Risk

Interest Rate Risk

Foreign Exchange Risk

Commodity Price Risk

Credit Risk

Business & Operating Risk

Low Severity Treasury Risks

High Severity Treasury Risks

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Derivatives - Robust Risk Management Framework

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Derivatives - Risk Management Process

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Interest Rate Risks – Types of Interest Rate Swaps (IRS)

Interest Rate Risks :- Treasury Interest rate risks are divided into various parts like Principal Only Swaps (POS), Coupon Only Swaps (COS), Interest Rate Swaps (IRS) , Overnight Index Swaps (OIS) and MIFOR Swaps

Interest Rate Risks

Coupon Only

Swaps(COS)Principal Only Swaps (POS)

Interest Rate Swaps (IRS)

Overnight Index Swaps(OIS)

Principal Only Swaps are those swaps where in company hedges only principal part and keep coupon open while Coupon Only Swaps are those swaps where in coupons are getting hedged while principal remains open.

Interest Rate Swaps are those swaps where in there is only exchange of interest where as OIS are those which are subject to daily Interest rate movements in MIBOR or OIS however they are settled at an periodic dates.

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Offshore Treasury Markets

FX

Interest Rates

hedging

Commodities

Credit Risk

Equities

Structured Debt

Asian (including NDF) and G7 Currencies Vanilla / Exotic Options Cross Asset / Dual Factor Options

Asian and G7 rates Vanilla and Exotics Interest Rate Derivatives

Asian fixed income (USD, SGD, HKD, CNH, IDR, AUD)Total Return Swaps / Repo

Vanilla / Exotic Equity Options( US, Europe & Asia)Equity Monetization

Secured Financing / Receivables Securitization Total Return / Loan participation Notes Debt restructuring

Metals, Energy, Agriculture & Freight Hedging & Investments

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Offshore Treasury Markets – Coverage

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Offshore Treasury Markets – Treasury & Markets

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Offshore Treasury Markets – Treasury & Markets

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Currency & Interest Rate Curve Volatility

USD/INR Currency Volatility

USD/INR OIS Curve

USD/PHP Currency Volatility

USD/AUD Currency Volatility

USD/CNY Currency Volatility

USD/CAD Currency Volatility

USD/JPY Currency Volatility

GBP/EUR Currency Volatility

Volatility in Asian &

Commodities

Currencies

Volatility in Asian

Interest Rate

Indexes

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USD/INR Currency Volatility – Year 2010 – YTD 2014

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USD/PHP Currency Volatility – Year 2010 – YTD 2014

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USD/INR OIS Curve –YTD 2014

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USD/AUD Currency Volatility –Year 2010 - YTD 2014

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USD/CNY Currency Volatility –Year 2013 -YTD 2014

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USD/CAD Currency Volatility –Year 2013 -YTD 2014

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USD/JPY Currency Volatility –Year 2013 -YTD 2014

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GBP/EUR Currency Volatility –Year 2013 -YTD 2014

mitigating fx risk in corporate portfolio

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