Foreign Exchange Exposure
Foreign exchange exposure is the risk connected with the exchange rate that regularly fluctuates and an adverse impact on the financial transactions denominated in a foreign currency of a multinational company (Andersen, Fischer, & Aabo 2012).
It is also used to refer to the magnitude at which future profitability, expected market value, and net cash flow of a company’s value changes in result to the fluctuations in the exchange rates (Bartram, 2008). These variations determine the likelihood of making profit or losses because of change in the market rates. This exposure assists companies in determining their financial risk management.
There are different types of exposure that include;
1. Transaction exposure
It occurs because of actual transactions in business that involves foreign currency such as; payment of dividend, payment for imports, debtors of sale as well as receipts for daily transactions.
For example, if a firm has purchased imported goods to pay later, the company may end up paying more value on the due date as the currency value may fluctuate. This, in turn, will increase the projected purchase price and in overall lower the profit levels.
2. Translation exposure
Also known as accounting exposure, it occurs when the financial records are translated into the home currency of the organization (Bartram, 2008). This translation is carried out mostly for reporting to shareholders and other relevant authorities.
The type of exposure does not need much attention as the profits and losses do not weigh more than the reporting requirements.
3. Operating exposure
Often referred to as the economic exposure or edge exposure, it directly affects the value of a company. It measures the changes in the net present values which multinational organizations face due to changes in future cash flows that are caused by the alterations in exchange rates (Makar, & Huffman, 2008).
Since the value of a firm is associated with the operating cash flows, the exposures can have high relevance on assets.
These exposures can be managed through;
* Currency swaps- this is a contract where companies agree to exchange their cash flows
* Matching and netting- it is the arrangement to borrow and lend home currency
* Back to back lending and borrowing- this is similar to the barter trade system where individuals agree to buy the equivalent of the currencies
* Risk sharing and shifting- here, the parties agree to a risk sharing clause included in the agreement. However, when both sides agree that one is sole to bear the risk, it is referred to as risk shifting (Makar, & Huffman, 2008).
It is a public limited mining company incorporated in London, but it is predominantly based in South Africa. It deals with discovery, extraction refining and marketing of a platinum group of metals (PGM).
The groups reporting currency is the US dollar, and most of its revenue streams and cash received are in US dollars, but its taxes and operation costs are paid in Rand. In 2012 the approximate effect of a 10% movement in the rand to us dollar average exchange rate was;
Earnings before interest and tax————————————- $67m
Profits of the year —————————————————— $39
Earnings per share (cents)——————————————— 19.5c
Lonmin faces two types of foreign exchange risks;
Operating or economic exposure due to the unexpected fluctuations in the South Africa as a result of the country’s growing fiscal and current account deficits. Since 2013, the rand has been quite volatile and has been depreciating.
Lonmin also experiences transaction exposure due to massive export sales of minerals it handles. It also receives payments in foreign currency (USD), but its operations costs are in rand, so it has to convert the currency. The exposure is long term.
Lonmin manages transaction exposure by using foreign exchange derivatives such as;
1. Future contracts- the aim is to fix an exchange rate at a future date subject to risk.
2. Money market hedges- the objective is to prevent future exchange rate uncertainty using today’s spot rate.
3. Currency swap. – It allows two different parties to exchange interest rate obligation on borrowings in varied currencies (Bekaert, & Hodrick, 2009)
It manages its economic exposure by diversifying its exports across more countries.
It’s a Swiss multinational goods trading and mining company with its headquarters in Switzerland. It produces minerals, coal, oil products, natural gas, agricultural products, and metals.
It has worldwide operations having investments in over 40 countries and thus operates in various currencies. For this reason, its exposed to transaction exposure for instance when its paying shareholder’s dividends as its listed in London stock exchange, Hong Kong stock exchange and Johannesburg stock exchange (Kolari, Moorman, & Sorescu, 2008). It also handles colossal amounts of export sales.
Glencore also faces translation exposure when the finance managers have to convert all the other currencies to determine the group’s revenues, operating incomes and profit as it has subsidiaries worldwide.
Glencore manages its transaction exposure similar to Lonmin through a currency swap, money market hedges, leading and lagging and future contracts. It will control its translation exposure by performing a balance sheet hedge (Hutson, & Stevenson, 2010). A stock hedge is where an organization acquires a specified amount of exposed liabilities and assets hence adjusting outstanding discrepancies.
It is an Anglo- Australian multinational company dealing in mining, petroleum, and metals. Its headquarters is in Australia. Listed on the London Stock Exchange and the Australian Securities, it has word wide operations and is the world’s largest mining company as per 2013 revenues.
This company faces transaction exposure because of its significant export sales and translation exposure because it has various subsidiaries word wide such as in Gulf of Mexico, Japan, Indonesia, and Australia (García‐Canal, & Guillén, 2008)
This company manages its exposure through;
-foreign exchange derivatives
-use of money markets
-exposure netting and
– Balance sheet hedge
Significant Financial Decisions
In September 2015, the company made plans to scrap its dividend, dispose of its assets, and is working on equity sale of 2.5 billion dollars to help lower its borrowings
By this, the company’s stock valuation increases thus reducing the loan rate. It also addresses some of the company’s financial risk. Another decision made was to trip the firms output from two of its operating areas in Africa taking about 400000 metric tons of copper out of the market for the coming eighteen months.
It also made a decision in February to reduce production by 15 million tonnes causing mass unemployment in NSW and Queensland citing that they do not make a financial contribution
2. BHP Billiton
The best decision made was to reduce dividend payouts and reorganize its top executive arms as it designed to reduce its high operation costs. In 2015, it cut its dividends by half to US 16c after its profits rapidly cutting to US 412 million while the market expected it to be at least US 427 million.
The decision to cut its dividends was after the move to abandon the company’s progressive policy and switch to a dividend policy more suitable for the firm since it matches the profit performance each year. This decrease in profit is attributed to declining resource prices in the market
In November 2015, the shareholders at Lonmin gave their go-ahead for a $407 million rights issue structured to reduce their debt and recapitalize the platinum miners. As a result, the firm is now able to handle a well-detailed and structured business plan. This also improved their credit risk rating.
In conclusion, it is my opinion that Lonmin made the best financial decision because its outcome had a beneficial outcome to the organization by increasing its capital base, retain employees and improve its credit rating.
Andersen, L. S., Fischer, D. A., & Aabo, T. (2012). Foreign Exchange Exposure.
Bartram, S. M. (2008). What lies beneath: Foreign exchange rate exposure, hedging and cash flows. Journal of Banking & Finance, 32(8), 1508-1521.
Makar, S. D., & Huffman, S. P. (2008). UK Multinationals’ Effective Use of Financial Currency‐Hedge Techniques: Estimating and Explaining Foreign Exchange Exposure Using Bilateral Exchange Rates. Journal of International Financial Management & Accounting, 19(3), 219-235.
Kolari, J. W., Moorman, T. C., & Sorescu, S. M. (2008). Foreign exchange risk and the cross-section of stock returns. Journal of International Money and Finance, 27(7), 1074-1097.
Bekaert, G., & Hodrick, R. J. (2009). International financial management (p. 809pp). Upper Saddle River, New Jersey, NJ: Pearson Prentice Hall.
García‐Canal, E., & Guillén, M. F. (2008). Risk and the strategy of foreign location choice in regulated industries. Strategic Management Journal, 29(10), 1097-1115.
Hutson, E., & Stevenson, S. (2010). Openness, hedging incentives and foreign exchange exposure: A firm-level multi-country study. Journal of International Business Studies, 41(1), 105-122.