March 2006
MANAGEMENT

BY Sujit Mundul

The purpose of a long term foreign exchange management is not just to cover a given foreign exchange exposure through dealings on the forward markets but also to minimise and, if possible, eliminate such exposures before they become critical and costly to cover eventually. Long term approaches differ from conventional approaches in three important respects:

Longer time horizon

Sujit Mundul

The accepted current methods of covering foreign exchange risks normally use a time horizon of three to six months. However, because of production and investment commitments, foreign exchange risks may actually arise as much as five years before they are reflected in the accounting system. With a three to six month time horizon, therefore, coverage operations will often come too late. Once a currency is under serious pressure, the forward coverage costs become exorbitant, frequently exceeding the probable foreign exchange loss.

For example, an Italian auto manufacturer produces a car in January for export to the US and sells it in April for $5,000 which it will collect three months later in July. This company’s accounting system would identify a foreign exchange exposure only during the three months when the figure of $5,000 in accounts receivables would appear on its books. Losses due to a devaluation of the dollar between January and April would, for accounting purposes, be defined as losses on regular transactions, not as foreign exchange losses.

To have risked the loss of its US markets by stopping its exports or to have raised its final selling price in line with the devaluation would not have been realistic options for the Italian manufacturer. In effect, the company was locked into the exposure at least from the time the car came off the assembly line.

The company actually incurred exchange risks considerably earlier—from the point at which it invested in production facilities to supply foreign markets. In fact, domestic facilities that supply foreign markets commonly entail a much greater risk than do foreign facilities, since material and labour cannot be paid for in the same currency for which the products are sold. The point seems obvious, yet few companies even consider covering such risks when they invest at home.

Thus, the first key characteristic of a longer term approach to foreign exchange management is that it does not rely on the accounting system. Risks are “managed” from the time the investments are made until the final receipts from sales of the product are received.

Dynamic orientation

To identify foreign exchange exposure, it is not enough, as some companies have recognised, simply to compare foreign assets and liabilities on a particular date—whether by the current or non-current method or the monetary or non-monetary method. Rather, the flows of foreign currencies arising from transactions affecting these assets and liabilities over an appropriate period of time must be considered.

Many assets and liabilities translate into currency flows over time, and it is the difference between inflows and outflows that define a company’s exposure at any given period. Thus, the dynamic of time is a second vital characteristic of proper foreign exchange management.

Preservation of earnings

Under the new approach, the Financial Controller’s objective concerning foreign exchange management is very different. Rather than seeking to minimise reported foreign exchange losses he would endeavour to preserve the earning power of the company as a whole through exchange rate fluctuations. For example, suppose a US company has to repay a loan of 10 million French francs in 1980 and expects export sales to France of 10 million French francs during the same year. Only the liability, not the expected income, will be shown on the books. Assuming that the export estimates are reliable, it should not be necessary to cover that loan, since the export receipts can be used to repay it. In other words, there is no foreign exchange risk if the export sales are realised i.e. through self-pledging.

Yet from an accounting point of view, the financial controller is still in an awkward position. If the franc should revalue by 10 per cent, his liabilities will result in an accounting loss of 1 mio francs, while the increased dollar value of the French sales receipts will be identified not as foreign exchange gains, but as additional profit on regular transactions.

If, therefore, the financial controller merely wants to safeguard the interest of his own department, he will make sure to cover the 10 mio franc liability, even if his expected export receipts from France are 10 mio francs or considerably more. If he is to protect the earning power of the company as a whole, however, he needs to take a more systematic approach, which can only be implemented with fuller understanding and support on the part of top management.

In recent times most of the large companies have successfully put into practice this more fundamental approach to foreign exchange management. While their programmes differ in detail, they all include the same three basic steps:

Estimate net exposures

Net exposure is the difference between estimated inflow and outflows of foreign currency over a specified period or periods—not only those already known or contracted (from maturing receivable and payables, loan repayments, and interest and dividend payments), but also those that are expected or can reasonably be foreseen on the basis of the company’s short and long term plans (from forecasted export sales, material purchases from abroad, planned investments in other countries, capital issues in other currencies, and equity increases in foreign subsidiaries).

To arrive at the overall net exposure, the parent and each subsidiary estimate their expected inflows and outflows of each currency for a specified period as appropriate to the company. Rather than allowing each subsidiary to cover its risks on its own, with attendant high coverage costs, management then consolidate all these estimates for the corporation as a whole. Instead of imposing this step as a requirement, companies with partially decentralised financial management have found it possible to achieve central control of foreign exchange exposure by giving subsidiaries concrete incentives to cover their risks only with the parent.

Since inflows and outflows of any given currency could be subject to significant uncertainties, it would also be helpful to consider the probable upper and lower limits of variation from the projected values in estimating net exposures. The object is to develop an approximate picture of net exposure positions in the major currencies involved, so that the company can move earlier on to reduce its exposure through decisions on currency denominations, maturities of loans, repayment schedules, and the like.

Logically, then, the impact a given decision (for example, on a plant investment or a long term purchase contract) will have on the company’s net exposure becomes an important input to that decision. Currently, foreign exchange risks associated with investment projects are specific—if at all—only for the individual projects, but what is important is the extent to which each investment will increase or decrease the overall net exposure of the company.

For example, in analysing alternative production site for one of its major components, one American company discovered that building a plant in West Germany instead of in the US would substantially reduce its overall net exposure over the next five years. The DM inflow from the company’s present exports of finished products to Germany would in fact then be offset by the DM payments for investment outlays in Germany and the subsequent purchase of components by the US plants. Had the project been evaluated by itself, building the plant in Germany would have appeared, on the basis of foreign exchange risk, much less desirable than building it in the US.

There are many other factors a company has to consider besides foreign exchange risks when it makes its final investment decisions.

Estimate range of exchange rates

As William D Serfass pointed out, the pursuit of speculative profits on the foreign exchange markets is a pastime about as rewarding as Russian roulette for corporate money managers. Informed guesses of the likely range (not necessarily direction) of long term future exchange rate movements do, however, serve a vital purpose: that of providing a rough idea of the range of possible gains or losses that may result, given a particular net exposure.

To take an obvious example, a US company ought to be less concerned about its exposure in Canadian dollars than, say, half the same exposure in English pounds. By computing the upper and lower limits of the probable gains or losses, the financial controller can predict and possibly forestall threats to company’s financial health arising from excessive exposure in volatile currencies.

Over the shorter term (three to six months), these same estimates provide a necessary basis for weighing the cost of forward coverage against the risks of leaving the net exposure uncovered. Note that it may at times be preferable to accept these risks. Since the costs of coverage are primarily determined by the differences in short term interest rates among countries, rather than by expectations concerning exchange rate movements, coverage may be attractive at some times, yet prohibitively costly at others.

Of course, specific exchange rate movements are difficult if not impossible to predict, but a company can at least reduce its undesirable net exposure positions well in advance, decreasing its vulnerability to exchange rate swings.

Cover risks

Having highlighted its principal future foreign exchange risks, the company can now devise means of coverage. Basically these are reduced to two techniques:

1. Buying or selling particular currencies on the forward market to cover estimated net exposures in those currencies at particular future periods.

2. Influencing individual components of expected currency inflows or outflows so as to reduce or eliminate estimated net exposures. This may mean changing the company’s financial plan, such as by substitution a loan in another currency for a local loan, or its operating plans, such as by reducing exports to a certain country, purchasing more material from abroad, or expanding or curtailing capital investment in a particular country.

Since the forward market is essentially confined to short term (up to 12 months) contracts, longer term foreign exchange risks can usually be reduced only by changing the net exposure – and this frequently has the advantage of enabling the company to avoid undertaking large scale coverage operations in the forward market.

The Chief Financial Executive would wish to explore the choices available to him for altering the net exposure without affecting basic strategic or operating decisions. Should it appear that serious imbalances in net exposures will persist after available financial measures have been exhausted, top management might even consider revising its operating plans accordingly.

Though the ability of the financial controller to influence operating plans is generally limited, it is one of his major responsibilities to identify and highlight the foreign exchange risks associated with executing operating plans, so that these risks are properly entered into the overall evaluation of alternative strategies and plans.

Management system

Systems embodying the concept of foreign exchange management inevitably differ from company to company in terms of organisation and nature of business. Their principal elements can, however, be summarised as follows:-

Long term financial plans:

Based on the operating plans of the divisions, the parent and subsidiaries develop long term financial plans for five years. As part of the cash flow projection, the subsidiaries also submit their estimates of major foreign currency flows above a certain level, which is deliberately set high because of the enormous uncertainty involved. This confines the planning work to significant flows and avoids burdening the smaller subsidiaries with unnecessary paperwork.

Those in corporate finance consolidate all currency flows of the subsidiaries and the parent company, netting out the intercompany flows to derive the net exposure in each major currency for the total corporation.

Analysis of capital, tax and regulatory outlook

With the support of the larger foreign subsidiaries, the corporate finance staff analyses trends of major capital and foreign exchange markets to identify interest rate differentials between various capital markets, and estimates the upper and lower limits of possible exchange rate movements. For many currencies the estimated ranges will be very wide, signaling high risk if significant difference between currency inflows and outflows are anticipated.

Since financing and coverage decisions are subject to tax and legal regulations and constraints on capital and profit transfers, such constraints are carefully analysed for each country while taking possible changes into account.

Sensitivity analysis

A sensitivity analysis model is used to calculate the effects of different rates of devaluation or revaluation on the profitability of the corporation and to test the impact of uncertainties in the estimates of each component of the net exposure. This model also shows the balance sheet and P&L statements for the total corporation, the parent, and each subsidiary for five years, highlighting the change in earnings after taxes due to exchange rate movements as well as foreign exchange losses or gains as defined by the accounting system. Corporate management can quickly see which subsidiaries are highly vulnerable to foreign exchange risks and how taxes and the degree of self-financing will be affected in each subsidiary if no specific counter measures are taken.

Coverage decisions

Having identified the major areas of foreign exchange risk, the corporate finance staff proceeds to develop measures to reduce the net exposure in particular currencies and years. Because they are highly interdependent, coverage and financing measures have to be worked out simultaneously and integrated into the financial plans of the corporation. All measures are thoroughly discussed with the subsidiaries affected and checked against legal and tax regulations or restrictions.

Adjustments of financial plans

The individual measures are then integrated into the financial plans of the parent and the subsidiaries. Adjustments are calculated with a financial planning model in local currencies and discussed with local management.

Currency conversion and group consolidation

The financial plans of the individual subsidiaries are converted from local currency into the home currency of the parent, using a currency conversion model. The plans are then consolidated on the basis of standard accounting rules for the total corporation with the aid of a group consolidation model. At the same time, the net exposure is recalculated for all major currencies to reflect the changes due to the coverage decisions. If the net exposure turns out to be still too high in certain currencies or periods, another round of adjustments is necessary.