Republic of the Philippines

CAPIZ STATE UNIVERSITY

BURIAS CAMPUS
Burias, Mambusao, Capiz

COLLEGE OF MANAGEMENT

JOSE MARS D. LUBRIQUE JR. JIMMY A. LOJA JR.

AGNES D. DELFIN Course Facilitator
REMBELL P. LAGUING
CAREN MAY N. CORNELIO
JONNA MAE V. ZAMENIO
BSBA IV FM Students / Reporters

FE 103 – TREASURY MANAGEMENT

Foreign Exchange Exposure Management

I.LEARNING OBJECTIVES
The general objective is to provide students with a comprehensive understanding of
Foreign Exchange Exposure Management
At the end of the lesson, they will have developed and/or enhanced the following
skills/outcomes. The students will:

1. Understand the basics foreign exchange exposure.

2. Identify the types of foreign exchange exposure.
3. Explore techniques for managing foreign exchange risk.
4. Evaluate the cost and benefits of different hedging strategies.
5. Develop a basic foreign exchange risk management plan.

II. INTRODUCTION

In today's interconnected global economy, businesses are increasingly exposed to foreign

exchange (FX) risk, which arises from fluctuations in currency exchange rates. This risk can
significantly affect companies engaged in international trade, investment, or any cross-border
transactions. Currency values can fluctuate due to various factors, including changes in interest
rates, inflation rates, and geopolitical events. As a result, understanding and managing FX risk
has become crucial for businesses striving to maintain financial stability and competitive
advantage.

The impact of FX risk can manifest in multiple ways, including transaction risk,
translation risk, and economic risk. Transaction risk pertains to the potential for losses due to
exchange rate movements between the time a transaction is initiated and settled. Translation risk
affects the reported financial results of foreign subsidiaries when their financial statements are
converted into the parent company's currency. Economic risk, on the other hand, reflects the
long-term impact of currency fluctuations on a company's market value and competitive position.

1 of 8 / Prepared by: Group 7

 FE 103 – Treasury Management

With these risks in mind, organizations must develop robust strategies to protect their financial
interests.

Hedging strategies and techniques are essential tools for mitigating the adverse effects of
currency fluctuations. By employing a variety of financial instruments, businesses can safeguard
their cash flows and stabilize their financial performance. Common hedging techniques include
forward contracts, futures contracts, options contracts, and currency swaps. Each of these
instruments offers unique benefits and drawbacks, allowing companies to tailor their hedging
strategies to their specific needs and risk appetites.

As businesses navigate the complexities of foreign exchange risk, the choice of the right
hedging strategy becomes paramount. Factors such as exposure levels, market conditions, and
organizational risk tolerance play crucial roles in determining the most effective approach.
Additionally, real-world applications and case studies of successful and unsuccessful hedging
practices can provide valuable insights into best practices. As the global financial landscape
continues to evolve, emerging trends and technological advancements in FX hedging will further
shape how organizations manage currency risk in the future.

III. CONTENT

i. Understanding Foreign Exchange.

 What Is Foreign Exchange Risk?

Foreign exchange risk refers to the losses that a business conducting international
transactions can incur due to fluctuations in currency rates. Changes in the relative value of the
currencies involved can change the real costs of goods ordered from abroad or delivered to a
foreign customer, or increase the cost of a planned expansion in a foreign country. Investments
in foreign companies can suffer losses due entirely to exchange rate changes.

7 Factors affecting exchange rates

1. Interest and inflation rates

Inflation is the rate at which the cost of goods and services rises over time.
Interest rates indicate the amount charged by banks for borrowing money. These two are
linked by the fact that people tend to borrow and spend more when the interest rates are
low, which results in an increase in costs. These rates are direct indicators of the current
and future economic performance of a country and can influence the decisions of forex
investors and traders throughout the globe. An increase in interest rate is usually followed
by a rise in the value of the local currency.

2. Terms of trade

2 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

Terms of trade are the ratio of the export prices of a country to its import prices.
When the export prices of a country rise at a greater rate than its import prices, its terms
of trade improve. This in turn results in higher revenue, higher demand for the country’s
currency, and an increase in the value of the currency. This cumulatively results in
appreciation of the exchange rate of the currency.

3. Economic performance

One of the many factors that affect the economic performance of a country is its
political stability. A country, which has a stable political environment, attracts more
foreign investment and vice versa. An increase in foreign capital results in appreciation in
the value of its domestic currency. Such stability also directly affects the financial and
trade policy, thus eliminating any uncertainty in the value of its currency.

4. Recession

During a recession, a country’s interest rates are likely to fall, thus decreasing its
chances to acquire foreign capital. This in turn weakens the currency of the country in
question, weakening the exchange rate.

5. Speculation

Investors demand more of a country’s currency when its value is expected to rise
to make a profit in the near future. As a result, the value of the currency rises due to its
increased demand. Which in turn results in a rise in the exchange rate as well.

Foreign Exchange Risk

Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact
due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a
business’ financial performance or financial position will be impacted by changes in the
exchange rates between currencies.

Types of Foreign Exchange Risk

 Transaction Risk

Transaction risk is the risk faced by a company when making financial

transactions between jurisdictions. The risk is the change in the exchange rate before
transaction settlement. Essentially, the time delay between transaction and settlement is
the source of transaction risk. Transaction risk can be mitigated using forward contracts
and options.

3 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

 Economic risk

Economic risk, also known as forecast risk, is the risk that a company’s market
value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of
risk is usually created by macroeconomic conditions such as geopolitical instability
and/or government regulations.

 Translation risk

Translation risk, also known as translation exposure, refers to the risk faced by a
company headquartered domestically but conducting business in a foreign jurisdiction,
and of which the company’s financial performance is denoted in its domestic currency.
Translation risk is higher when a company holds a greater portion of its assets, liabilities,
or equities in a foreign currency.

ii. Types of Currencies

1. Fiat Currency

Government-issued currency that is not backed by a physical commodity but

rather by the trust in the government.

Examples: US Dollar (USD), Euro (EUR), Japanese Yen (JPY).

2. Commodity Currency

A currency that is backed by a physical commodity, such as gold or silver.

Examples: Gold Standard currencies historically; some cryptocurrencies attempt

to mimic this model.

3. Cryptocurrency

Digital or virtual currencies that use cryptography for security and operate on
decentralized networks based on blockchain technology.

Examples: Bitcoin (BTC), Ethereum (ETH).

4. Digital Currency:

4 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

Any currency that exists only in digital form, including both cryptocurrencies and
central bank digital currencies (CBDCs).

Examples: Central Bank Digital Currency (e.g., digital Yuan).

5. Local Currency

Currency that is used in a specific local area, often to encourage spending within
the community.

Examples: Bristol Pound, Chiemgauer.

6. Reserve Currency

Currency that is held in significant quantities by governments and institutions as

part of their foreign exchange reserves.

Examples: US Dollar (USD), Euro (EUR), British Pound (GBP).

iii. Managing foreign exchange risk is crucial for businesses involved in international trade.
Here are several techniques:

 Forward Contracts

Lock in exchange rates for future transactions to avoid fluctuations.

 Options

Purchase options to secure the right, but not the obligation, to exchange currencies
at a predetermined rate.

 Futures Contracts

Similar to forward contracts but standardized and traded on exchanges, allowing

for more liquidity.

 Currency Swaps

Exchange cash flows in different currencies to manage exposure.

 Natural Hedging

Offset currency risk by matching revenue and expenses in the same currency.

5 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

 Diversification

Spread exposure across multiple currencies to reduce risk concentration.

 Netting:

Consolidate receivables and payables in the same currency to minimize the need
for currency conversion.

 Financial Instruments

Use currency ETFs or mutual funds to hedge against currency fluctuations.

 Regular Monitoring

Keep an eye on market trends and economic indicators to make informed

decisions.

 Expert Consultation

Work with financial advisors or currency specialists for tailored strategies.

Implementing a combination of these techniques can help mitigate foreign exchange risk
effectively.

iv. Hedging Strategies in Treasury Operations

Hedging is a risk management strategy used to protect against potential losses by taking
an offsetting position in a related asset, financial instrument, or contract. It acts as a kind of
"insurance" to reduce exposure to various types of financial risks, such as fluctuations in
currency exchange rates, interest rates, commodity prices, or stock prices.

Hedging is a risk management strategy employed to offset losses in investments by

taking an opposite position in a related asset. The reduction in risk provided by hedging also
typically results in a reduction in potential profits. Hedging requires one to pay money for the
protection it provides, known as the premium. Hedging strategies typically involve derivatives,
such as options and futures contracts.

Examples of Hedging Strategies

6 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

 Diversification

The adage that goes “don’t put all your eggs in one basket” never gets old, and it
actually makes sense even in finance. Diversification is when an investor puts his
finances into investments that don’t move in a uniform direction. Simply put, it is
investing in a variety of assets that are not related to each other so that if one of these
declines, the others may rise.

 Arbitrage

The arbitrage strategy is very simple yet very clever. It involves buying a product
and selling it immediately in another market for a higher price; thus, making small but
steady profits. The strategy is most commonly used in the stock market.

 Average down

The average down strategy involves buying more units of a particular product
even though the cost or selling price of the product has declined. Stock investors often
use this strategy of hedging their investments. If the price of a stock they’ve previously
purchased declines significantly, they buy more shares at the lower price. Then, if the
price rises to point between their two buy prices, the profits from the second buy may
offset losses in the first.

 Staying in cash

This strategy is as simple as it sounds. The investor keeps part of his money in cash,
hedging against potential losses in his investments.

v. Use of Derivatives and Other Hedging Instruments

Derivative

The term “derivative” refers to a type of financial contract whose value is

dependent on an underlying asset, a group of assets, or a benchmark.

There are two classes of derivative products:

1. Lock (e.g., futures, forwards, or swaps)

2. Option (e.g., stock options)

The most common derivative types are:

1. Futures
2. Forwards

7 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

3. Swaps
4. Options

Three common ways of using derivatives for hedging include:

1. Foreign Exchange Risks

2. Interest Rate Risk
3. Commodity or product input price risks

 Foreign Exchange Risks

One of the more common corporate uses of derivatives is for hedging foreign currency
risk.

 Hedging Interest Rate Risk

Companies can hedge interest rate risk in various ways. If the company strongly believes
interest rates will drop between now and then, it could purchase (or take a long position on) a
Treasury futures contract.

 Commodity or Product Input Hedge

Companies depending heavily on raw-material inputs or commodities are sensitive,

sometimes significantly, to the price change of the inputs.

vi. Case Study on Effective Hedging Strategy

There are several effective hedging strategies to reduce market risk, depending on the
asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options,
and volatility indicators.

Market risk or systematic risk

Is the possibility that an investor will see huge losses as a result of factors that impact the
overall financial markets, as opposed to just one specific security.

Modern Portfolio Theory

Is one of the tools for reducing market risk, in that it allows investors to use
diversification strategies to limit volatility.

Options

8 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

Which allow investors to protect against the risk of big losses.

Investors can also make trades based on market volatility by tracking the volatility index
indicator, the VIX, often referred to as the "fear index," due to its tendency to spike during
periods of greater volatility.

Hedging Strategies are a crucial aspect of mitigating risks in the financial market, and
one of the most effective methods is to use counter currencies. Hedging strategies with counter
currencies involve buying or selling a currency pair in which one of the currencies is a counter
currency, such as the USD, EUR, or GBP. This method has been tested, and it has proven to be
effective in managing risks in the foreign exchange market.

Some case studies that showcase the effectiveness of counter-currency hedging strategies:

The Coca-Cola Company

Coca-Cola is a multinational beverage company with operations in over 200 countries.

The company is exposed to a lot of risks in the foreign exchange market due to its global
operations. To manage these risks, Coca-Cola has implemented a hedging strategy that involves
using counter currencies. This strategy involves buying or selling currency pairs that involve the
USD as a counter currency. As a result, the company has been able to reduce its exposure to
market fluctuations and mitigate its risks.

9 of 10 / Prepared by: Group 7

 FE 103 – Treasury Management

IV. REFERENCES

Catalano,T. 2024, June 16. Beginner's Guide to Hedging: Definition and Example of Hedges in
Finance. Investopedia. https://www.investopedia.com/trading/hedging-beginners-guide/

Chen, J. (2024). Fiat Money: What It Is, How It Works, Example, Pros & Cons. Retrieved from
https://www.investopedia.com/terms/f/fiatmoney.asp

Ganti, A.2024 September 25 Foreign Exchange Risk: What It Is and Hedging Against It, With
Examples. Investopedia.

The Investopedia Team. (2024). The Most Effective Hedging Strategies to Reduce Market Risk.
Retrieved from https://www.investopedia.com/ask/answers/050615/what-are-most-
effective-hedging-strategies-reduce-market-risk.asp#:~:text=Investors%20use
%20hedging%20strategies%20to,for%20creating%20a%20balanced%20portfolio

Twin, A. (2024). September 14. Factors Affecting Foreign exchange risk. Investopedia.
https://www.investopedia.com/trading/factors-influence-exchange-rates/

10 of 10 / Prepared by: Group 7