Chapter 4 Integrating cash and trade
expected. It also affects a company which
raises funds in foreign currencies, and it
impacts on its underlying costs, especially
energy costs. Companies tendering to
provide services to an overseas project will
also be subject to foreign exchange risk,
as they are exposed to the risk once they
commit to making a tender.
Translation risk.
This is primarily an accounting risk which
arises when a company is translating assets
and liabilities denominated in one currency
into its reporting currency when preparing
company reports and other documents. It
arises primarily when reporting on foreign
operations or longer-term projects, or where
relatively high levels of inventory are held
in a foreign currency. Where this has an
impact on the balance sheet, the treasurer
will need to explain why the impact arose.
Any impact on the balance sheet could have
a wider impact on the company, as banks,
credit analysts and other counterparties will
review balance sheet strength as part of the
process of evaluating the strength of the
company. Where the company is operating
close to any limits set in any covenants, this
translation risk needs careful management,
as changes could affect its ability to borrow,
and the cost of that borrowing.
Economic risk.
This is the risk that changes in the
exchange rate could affect the economics
behind a company’s business decision.
This is most likely to affect international
companies that decide to expand into a new
market. If the exchange rate moves against
them, the underlying economics behind the
decision makes it less attractive. It will also
affect international companies exporting to
countries where there are local competitors
for similar products.
There are a number of techniques for
managing foreign exchange risk. Companies
effectively have three choices once they have
identified an exposure:
Do nothing – appropriate when the
company has natural hedges in place. This
is where the effects of exchange rates on
the company as a whole (rather than ona specific transaction) are assessed as
being broadly neutral. This can arise when,
for example, a company sells into and
sources supplies from the same country.
Fix the exchange rate, either by entering
into a foreign exchange transaction
immediately or by contracting to buy foreign
exchange at a fixed point in the future
through a forward outright agreement.
Fix a worst-case rate by purchasing a
foreign exchange option. The company will
have to pay a premium to agree a foreign
exchange option, which can be expensive.
Even so, options are very effective in
providing protection where the company
still faces some uncertainty, such as when
tendering in a foreign currency. Options
can also be used to give cover against
economic risk where to fix an exchange
rate at the wrong rate can be as damaging
as not fixing at all.
For longer-term agreements it may also be
appropriate to enter into a currency swap,
which swaps one set of expected cash flows
in one currency for a set of cash flows in
another. This can apply, for example, when a
company enters into a forfaiting agreement
(see page 126), or as a mechanism to create
a synthetic borrowing to be used to hedge a
foreign currency asset.
There is no general requirement on a
company to transact all foreign currency
receipts into operating currency immediately.
Indeed, in some countries such activity is
prohibited or made very difficult by exchange
control rules. Instead companies can
structure their cash management activities to
protect themselves against foreign exchange
risk. This may be by operating bank accounts
in those locations where there are significant
cash inflows and outflows in the same
currency. Where the company relies on local
currency borrowing, local currency cash
inflows can be used to meet future repayment
obligations.
When approaching foreign exchange risk
management, the treasurer should have a
clear idea of the company’s objectives. These
will depend on the company’s activities,
including their geographic spread, as well as a
wider approach to risk.