Unit IV: Foreign Exchange Exposure in International Financial Systems
Types of Foreign Exchange Exposure
Foreign Exchange Exposure = Risk that a firm’s financial performance may change due to exchange rate movements.
There are three major types:
A. Transaction Exposure
Exposure arising from actual foreign currency transactions that are already contracted but not yet settled.
Examples
- An Indian importer has to pay USD after 3 months.
- An exporter expects EUR payment next month.
- A firm has borrowed money in foreign currency.
Risk
If the foreign currency strengthens → payment becomes costlier.
B. Translation Exposure (Accounting Exposure)
Exposure arising when financial statements of foreign subsidiaries are converted into the parent company’s currency.
Where it appears?
- Consolidation of balance sheets
- Reporting foreign assets/liabilities in home currency
Example
An Indian MNC has assets in UK (in GBP).
If GBP depreciates, the value of assets decreases when converted to INR.
C. Economic Exposure (Operating Exposure)
Long-term impact of exchange rate changes on a firm’s future cash flows and competitiveness.
Key Idea
Affects:
- Sales,
- Costs,
- Pricing strategies,
- Market competitiveness.
Example
If Japanese Yen depreciates → Japanese products become cheaper globally → Indian firms face tougher competition.
Managing Transaction Exposure
A. Internal Hedging Techniques
1. Leading and Lagging
- Lead (pay early) if foreign currency is expected to appreciate.
- Lag (delay payment) if foreign currency is expected to depreciate.
2. Netting
Offset receivables and payables in the same currency between subsidiaries.
3. Invoicing in Home Currency
Asking the buyer/supplier to invoice in INR instead of foreign currency.
4. Matching
Match foreign currency inflows with outflows.
B. External Hedging Techniques (Financial Hedging)
1. Forward Contracts- Lock the exchange rate for a future date.
- Best for exporters/importers.
2. Futures Contracts
Standardized contracts traded on exchanges.
3. Options
- Right (not obligation) to buy or sell currency at a specified rate.
- Call option: Buy foreign currency
- Put option: Sell foreign currency
4. Swaps
Exchange of principal and interest in one currency for another.
Managing Translation Exposure
A. Balance Sheet Hedging
Match foreign-denominated assets with foreign-denominated liabilities.
B. Forward Cover
Use forward contracts for future translation dates.
C. Currency Borrowing
Borrow in the currency where exposure exists.
D. Adjusting Accounting Methods
- Adjust depreciation rates
- Revaluation techniques
- Use temporal or current rate method
Measuring and Managing Economic Exposure
Economic exposure is broad and long-term → harder to calculate.
A. Measuring Economic Exposure
- Regression Analysis - Measure relation between exchange rate changes and cash flows.
- Sensitivity Analysis - Check how profits change when exchange rates move by ±5%, ±10%, etc.
- Scenario Analysis - Build best-case and worst-case exchange rate scenarios.
- Operating Cash Flow Forecasting - Estimate future sales and costs under different exchange rates.
B. Managing Economic Exposure
- Product Diversification - Sell in multiple markets to reduce dependence on one currency.
- Market Diversification - Expand operations globally to balance exchange risk.
- Sourcing Flexibility - Buy materials from multiple countries to shift sourcing when rates change.
- Operational Hedging - Adjust production facilities, pricing, cost structure.
- Financial Hedging (Selective) -Use long-term currency swaps, Long-term forwards (where available)
Quick Summary Table
| Type of Exposure | Meaning | Example | Hedge |
|---|---|---|---|
| Transaction Exposure | Risk from future currency settlements | Export/import payments | Forward, Options, Money market hedge |
| Translation Exposure | Accounting conversion risk | Consolidating subsidiary accounts | Balance sheet hedge, Forward cover |
| Economic Exposure | Long-term competitive risk | Yen depreciation affects Indian firms | Diversification, operational hedging |
Multinational Financial System (MNFS)
A Multinational Financial System is the financial structure used by multinational corporations (MNCs) to manage money flows, investments, risks, and operations across countries.
A. Role of Multinational Financial System in Global Business
1. Optimal Use of Global Funds
MNCs raise funds from the cheapest markets and invest in the most profitable ones.
2. Better Risk Management
Manage:
- Foreign exchange risk
- Interest rate risk
- Political risk
- Credit risk
3. Access to Global Capital Markets
Companies can raise cheaper and larger funds through:
- ADRs
- GDRs
- Eurobonds
4. Efficient Cash Management
Move capital across subsidiaries to minimize idle cash and maximize returns.
5. Tax Optimization
MNCs place funds in countries with:
- Low tax rates
- Investment allowances
- Double taxation relief
6. Support Global Operations
Ensures smooth working capital for all global branches and subsidiaries.
Value of Multinational Financial System
1. Cost Efficiency
Access to lower-cost loans and foreign capital.
2. Economies of Scale
Large companies get better negotiation terms and lower transaction costs.
3. Financial Flexibility
Subsidiaries support each other:
- Internal borrowing
- Intragroup lending
- Cash pooling
4. Competitive Advantage
Better financing reduces product prices and increases market share.
Designing Global Remittance Policies
Global remittance policies guide the transfer of funds (cash, dividends, royalties, management fees) between subsidiaries and the parent company.
Key Elements:
1. Tax Efficiency
Send funds through countries with:
- Lower withholding tax
- Double Taxation Avoidance Agreements (DTAA)
2. Currency Risk Control
Time remittances based on expected exchange rate movements.
3. Legal Compliance
Follow:
- Host country rules
- FEMA (India)
- OECD guidelines
- Transfer pricing laws
4. Working Capital Needs
Subsidiaries must keep minimum cash to run operations.
5. Methods of Remittance
- Dividends
- Royalty payments
- Management fees
- Intercompany loans
- Transfer pricing adjustments
Transfer Pricing and Tax Evasion Issues
A. Transfer Pricing
Pricing of goods/services exchanged between MNC subsidiaries located in different countries.
Example - Google India pays Google USA for software licensing → the amount is transfer pricing.
B. Objectives of Transfer Pricing
- Allocate profits among countries
- Reduce global tax liability
- Manage performance of subsidiaries
- Optimize cash flows
C. Transfer Pricing and Tax Evasion
Some MNCs misuse transfer pricing to shift profits to low-tax (tax haven) countries.
Methods of Abuse
- Artificially high transfer prices → Move profits to low-tax subsidiary
- Artificially low transfer prices → Reduce profits in high-tax country
- Intra-group loans with high interest
- Manipulated service fees or royalties
Regulation
- OECD’s BEPS (Base Erosion and Profit Shifting)
- Arm’s Length Principle
- Tax audits and documentation
International Securities
International securities allow companies to raise funds outside their home country.
A. American Depository Receipts (ADR)
A negotiable certificate issued by a U.S. bank representing shares of a foreign company.
Where traded?
US stock exchanges (NYSE, NASDAQ).
Example
Infosys ADRs, Wipro ADRs.
Benefits
- Access to US investors
- Higher liquidity
- Better valuation
B. Global Depository Receipts (GDR)
A certificate issued by international banks representing shares of a company, traded in Europe or other global markets.
Where traded?
London Stock Exchange, Luxembourg Exchange.
Benefits
- Global investor base
- Easier regulations compared to US market
Difference: ADR vs GDR
| Feature | ADR | GDR |
|---|---|---|
| Market | US | Europe/World |
| Regulation | Strict (SEC) | Less strict |
| Cost | High | Lower |
| Investor Base | US investors | Global |
C. Eurobonds
Bonds issued in a country not in the currency of that country.
Examples
- A bond issued in London and denominated in USD.
- A Japanese company issuing bonds in Europe in USD.
Benefits
- Lower interest rates
- Large investor base
- Flexible regulations
D. Foreign Bonds
Bonds issued in a foreign country denominated in the currency of that country.
Types
- Yankee bonds → Foreign company issuing bonds in the USA (USD)
- Samurai bonds → Issued in Japan (JPY)
- Bulldog bonds → Issued in the UK (GBP)
Advantages
- Access to domestic investors of that country
- Strong liquidity
Summary Table
| Concept | Meaning | Importance |
|---|---|---|
| MNFS | Manage global finance of MNCs | Risk management, cost efficiency |
| Remittance Policies | Rules for money flow between subsidiaries | Tax optimization, currency risk control |
| Transfer Pricing | Pricing of intra-group transactions | Profit allocation, tax issues |
| ADR | Shares traded in US | Access to US capital |
| GDR | Shares traded globally | Easier international fundraising |
| Eurobond | Bond issued outside the currency’s country | Lower cost |
| Foreign Bond | Bond issued in foreign market & currency | Local investor access |