Page 96 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 6: Economic Fundamentals and Foreign Exchange Risk Exposure

rates. The market perceived those interest rates as artificially high and, therefore, aggressively Notes
sold the respective currencies.
Finally, traders deal on the perceived importance of a change in the interest rate differential.

Political Events and Crises: Political events generally take place over a period of time, but
political crises strike suddenly. They are almost always, by definition, unexpected.
Currency traders have a knack for responding to crises. Speed is essential; shooting from the hip
is the only fighting option. The traders’ reflexes take over. Without fast action, traders can be left
out in the cold. There is no time for analysis, and only a split second, at best, to act. As volume
drops dramatically, trading is hindered by a crisis. Prices dry out quickly, and sometimes the
spreads between bid and offer jump from 5 pips to 100 pips.

6.3 Foreign Exchange Risk Exposure

The foreign exchange market consists of the spot market and the forward or futures market. The
spot market deals with foreign exchange delivered within 2 business days or less. Transactions
in the spot market quote rates of exchange prevalent at the time the transactional took place.
Typically, a bank will quote a rate at which it is willing to buy the currency (bid rate) and a rate
at which it will sell a currency (offer rate) for delivery of the particular currency. The forward
market is for foreign exchange to be delivered in 3 days or more. In quoting the forward rate of
currency, a bank will quote a bid and offer rate for delivery typically one, two, three or six
months after the transaction date.
Exchange rates are considered by MNCs as a crucially important factor affecting their profitability.
This is because exchange rate fluctuations directly impact the sales revenue of firms exporting
goods and services. Future payments in a foreign currency carry the risk that the foreign currency
will depreciate in value before the foreign currency payment is received and is exchanged into
Indian rupees.

Thus, exchange risk is the effect that unexpected exchange rate changes have on the value of the
firm. Foreign exchange risks therefore pose one of the greatest challenge to MNCs. The present
unit deals with the management of foreign exchange risk and based on the nature of the exposure
and the firm’s ability to forecast currencies, what hedging or exchange risk management strategy
should the firm employ.

6.3.1 Exchange Risk

Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to unanticipated
changes in exchange rate. For example, if an Indian firm imports goods and pays in foreign
currency (say dollars), its outflow is in dollars, thus it is exposed to foreign exchange risk. If the
value of the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay more
domestic currency to get the required amount of foreign currency.
The advent of the floating exchange rate regime, since the early 1970s, has heightened the
interest of MNCs in developing techniques and strategies for foreign exchange exposure
management. The primary goal is to protect corporate profits from the negative impact of
exchange rate fluctuations. However, the goals and techniques of management vary depending
on whether the focus is on accounting exposure or economic exposure.
Foreign exchange risks, therefore, pose one of the greatest challenges to a multinational company.
These risks arise because multinational corporations operate in multiple currencies. In fact,
many times firms who have a diversified portfolio find that the negative effect of exchange rate
changes on one currency are offset by gains in others i.e. – exchange risk is diversifiable.

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