Page 172 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 10: Management of Operating/Economic Exposure

approach are that yields and costs of the transaction are known and there is little risk of cash Notes
flow destabilisation. Again, this option doesn’t require any investment of management time or
effort. The negative side is that automatic hedging at whatever rates are available is hardly
likely to result into optimum costs. At least some managements seem to prefer this strategy on
the grounds that an active management of exposures is not really their business. In the floating
rate era, currencies outside their home countries, i.e., in terms of their exchange rate, have
assumed the characteristics of commodities. And business whose costs depend significantly on
commodity prices can hardly afford not to take views on the price of the commodity. Hence this
does not seem to be an optimum strategy.

Low Risk: Reasonable Reward

This strategy requires selective hedging of exposures whenever forward rates are attractive but
keeping exposures open whenever they are not. Successful pursuit of this strategy requires
quantification of expectations about the future: and the rewards would depend upon the accuracy
of the prediction. This option is similar to an investment strategy of a combination of bonds and
equities with the proportion of the two components depending on the attractiveness of prices. In
forex exposure terms, hedged positions are similar to bonds (known costs or yields) and unhedged
ones to equities (uncertain returns).

High Risk: Low Reward

Perhaps the worst strategy is to leave all exposures unhedged. The risk of destabilisation of cash
flows is very high. The merit is zero investment of managerial time or effort.

High Risk: High Reward

This strategy involves active trading in the currency market through continuous cancellations
and re-bookings of forward contracts. With exchange controls relaxed in India in recent times,
a few of the larger companies are adopting this strategy. In effect, this requires the trading
function to become a profit centre. This strategy, if it is to be adopted, should be done in full
consciousness of the risks.

Caselet Economic Exposure

K Inc is a US based MNC that conducts a part of its business in Malaysia. Its US
sales are denominated in US dollars while its Malaysian sales are denominated
Min Malaysian dollars. Its proforma income statement for the next year is shown
below. Show how the costs, revenue and earnings items would be affected by three possible
exchange rate scenarios for the Malaysian dollar:
1. $ 1.45,

2. $ 1.50 and
3. $ 1.60.
Assume US sales will be unaffected by the exchange rate. Also assume that Malaysian
dollar earnings will be remitted to the US at the end of the period.
Revenue and costs estimates: (MK Inc. in millions of US dollars and Malaysian dollar)
Contd...

LOVELY PROFESSIONAL UNIVERSITY 167