Rates for PKR/US$ are quoted as follows: Rates for PKR/US$ are quoted as follows: Spot – Spot – month – month – months – months – months – months – Today is 4 th January. A Pak company has to pay US$ 245,000 to a supplier at the end of week 1 of April and want to fix exchange rate now. Today is 4 th January. A Pak company has to pay US$ 245,000 to a supplier at the end of week 1 of April and want to fix exchange rate now. What forward rate can be obtained for a currency transaction and what would the cost to Pak company? What forward rate can be obtained for a currency transaction and what would the cost to Pak company? Example

That rate will be That rate will be The cost to the company will be: The cost to the company will be: 245,000/ = PKR 14,730, ,000/ = PKR 14,730, For foreign currency rate’s calculation there are two factors underlined: For foreign currency rate’s calculation there are two factors underlined: – Demand and Supply of currency involved – Interest Rates of currencies Solution

Foreign Exchange Risk is divided into 3 categories: Foreign Exchange Risk is divided into 3 categories: 1 ) Transaction Exposure 1 ) Transaction Exposure 2 ) Translation Exposure 2 ) Translation Exposure 3 ) Economic Exposure 3 ) Economic Exposure 1 ) Transaction Exposure : 1 ) Transaction Exposure : Gains / losses made on settlement of buying-selling contracts of goods, import-export transactions, investment in foreign currency instruments, deriving dividend from abroad. Gains / losses made on settlement of buying-selling contracts of goods, import-export transactions, investment in foreign currency instruments, deriving dividend from abroad. The risk involved is normally covered through hedging contracts. The risk involved is normally covered through hedging contracts. Foreign Exchange Risks

2 ) Translation Exposure: 2 ) Translation Exposure: It arises from the accounting side when businesses are required to consolidate their group results in the compliance of local financial reporting laws. It arises from the accounting side when businesses are required to consolidate their group results in the compliance of local financial reporting laws.

3 ) Economic Exposure: 3 ) Economic Exposure: It is difficult to Pre-determine the dollar effect of economic effect because of the unexpected nature of change. It is difficult to Pre-determine the dollar effect of economic effect because of the unexpected nature of change. A subsidiary in the country X whose currency devalues unexpectedly has two effects on the value of the firm. A subsidiary in the country X whose currency devalues unexpectedly has two effects on the value of the firm. – i) Adverse effect on value as every dollar of profit will have less worth when repatriated to home country. – ii) there may be positive effect in terms of cheaper exports adding cash flow contributions of parent company.

How to reduce the Translation Exposure? Translation Exposure: Translation Exposure: – This translation exposure can be hedged by trying to equalize the assets and liabilities. For example, a group may reduce FCY dominated assets if it fears devaluation in that foreign currency like reducing FCY cash and stock levels. And increasing liabilities in local currency. – When FCY risk between assets and liabilities is equal, then translation exposure is eliminated.

Decentralized / Diversified Production Facilities: Decentralized / Diversified Production Facilities: If a company has a production facility in the country whose exchange rate remains strong, it will be difficult for the company to export to other countries. If a company has a production facility in the country whose exchange rate remains strong, it will be difficult for the company to export to other countries. How to reduce the Economic Exposure?

Diversification of Financing: Diversification of Financing: International borrowing can be used to hedge the adverse effects of currency exchange rates. International borrowing can be used to hedge the adverse effects of currency exchange rates. If borrowing is spread across several currencies it will be extremely unlikely they will all strengthen at the same time eventually reducing the economic exposure risk. If borrowing is spread across several currencies it will be extremely unlikely they will all strengthen at the same time eventually reducing the economic exposure risk.

Protection against Transaction Exposure: Protection against Transaction Exposure: 1- Invoicing in Home Currency 1- Invoicing in Home Currency 2- Leading and Lagging 2- Leading and Lagging

This will eliminate the need of exchange of currency upon receipt. However, the seller would be compelled to revise its prices periodically. This will eliminate the need of exchange of currency upon receipt. However, the seller would be compelled to revise its prices periodically. Seller can invoice: Seller can invoice: In home currency In home currency Currency stable than home currency Currency stable than home currency US $ - Market leader US $ - Market leader Currency with a positive forward markets Currency with a positive forward markets 1) Invoicing in Home Currency:

Leading refer to making payment before falling due. Lagging means to defer or delay the payment or settling the payment well past due date. 2 – Leading & Lagging:

3- Matching of Receipts and Payments Forex exposure can be partially hedged by matching payments and receipts of same currency. Forex exposure can be partially hedged by matching payments and receipts of same currency. For example a company will receive US$ 1 million during the next quarter and will need to pay US$ 1.2 million in the same period, then the net exposure will be US$ 200,000 as 1 million payment and receipt are net off. For example a company will receive US$ 1 million during the next quarter and will need to pay US$ 1.2 million in the same period, then the net exposure will be US$ 200,000 as 1 million payment and receipt are net off.

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Using this method we can Fix the exchange rate now for a future transaction of the needed currency. Because spot rates are changing every day and fixing the exchange rate for future date ‘Now’ reduces the risk to significant extent. Using this method we can Fix the exchange rate now for a future transaction of the needed currency. Because spot rates are changing every day and fixing the exchange rate for future date ‘Now’ reduces the risk to significant extent. A forward contract is binding upon both the parties – currency dealer and a company/client. A forward contract is binding upon both the parties – currency dealer and a company/client. 4) Hedging (Forward Contracts)

Hedging is based on the assumption or estimate that it will be expensive to pay us$ in three months time because of the fact the PKR will be weakening against US$. therefore, a company enters into a contract to buy X dollars after 3 months at an exchange rate of Rs 60/ US $ decided now. At the maturity date both parties have to honor their respective commitments of buying and selling of US $ at agreed rates. Hedging is based on the assumption or estimate that it will be expensive to pay us$ in three months time because of the fact the PKR will be weakening against US$. therefore, a company enters into a contract to buy X dollars after 3 months at an exchange rate of Rs 60/ US $ decided now. At the maturity date both parties have to honor their respective commitments of buying and selling of US $ at agreed rates. Now if on the maturity date, the spot ex rate is Rs 61/US$, (PKR weakened against US$), then the company has actually eliminated the loss and benefited financially. Now if on the maturity date, the spot ex rate is Rs 61/US$, (PKR weakened against US$), then the company has actually eliminated the loss and benefited financially. Example: Hedging (Forward Contracts)

Money markets are whole-sale (large scale) markets for lending and borrowing of money for short term. Money markets are whole-sale (large scale) markets for lending and borrowing of money for short term. Bank are major player of money markets and companies seek their services to hedge against the ex rate fluctuations in short term. Bank are major player of money markets and companies seek their services to hedge against the ex rate fluctuations in short term. As forward ex rate (which is agreed now) is derived from sport rates Using interest rates, a money market hedge can produce the same results as of forward contract. As forward ex rate (which is agreed now) is derived from sport rates Using interest rates, a money market hedge can produce the same results as of forward contract. 5) Money Market Hedging:

There will be two situations: There will be two situations: A company is to receive money in FCY A company is to receive money in FCY A company needs to pay FCY A company needs to pay FCY Situation - Future Income in FCY: Situation - Future Income in FCY: What is needed at this point is to fix the exchange value of the future currency income. What is needed at this point is to fix the exchange value of the future currency income. A hedge will be created by fixing the value of income now in local currency. A hedge will be created by fixing the value of income now in local currency.

We can do it: We can do it: Borrow now in foreign currency (The same that the company will receive in future). The maturity of both loan and receipt should be the same. Borrow now in foreign currency (The same that the company will receive in future). The maturity of both loan and receipt should be the same. The loan + interest on FCY loan should equal the amount of FCY future receipt. The loan + interest on FCY loan should equal the amount of FCY future receipt. When the FCY receipt hit the account, loan will be paid off. When the FCY receipt hit the account, loan will be paid off. The FCY loan can be converted to local currency immediately and may be put to a short term deposit to earn interest. The FCY loan can be converted to local currency immediately and may be put to a short term deposit to earn interest.

A Pak company exports US$ 1 million goods to a customer in united states with a payment to be received after 3 months. A Pak company exports US$ 1 million goods to a customer in united states with a payment to be received after 3 months. Current spot rate is US $/PKR = – Current spot rate is US $/PKR = – Months Interest Rates DepositLoan 3 Months Interest Rates DepositLoan (Per Annum) (Per Annum) PKR Rs3.55%4.45% PKR Rs3.55%4.45% US $3.15%4.52% US $3.15%4.52% How can a firm establish a Money Market Hedge? How can a firm establish a Money Market Hedge? Example Money Market Hedge Future Receipt in FCY