Perspectives in Currency Risk of a Non Financial Corporation - Part 1

How do you frame the context of foreign exchange risk in a non-financial corporation?

Setting objectives

The objectives of risk management must be clearly articulated in terms of risk and return. The objectives set must be able to answer the concern of volatility of risk factors and how the corporation is impacted by this volatility. The metric upon which this volatility impacts the organization must also be defined. For example :

• Is the corporation concerned with the volatility of its cash flows impacted by risk factors such as foreign exchange and commodity prices?
• How does cash flow volatility impact the corporation's strategic business objectives? Will cash flow volatility exposure to risk factors left unmanaged will cause the corporation to reject potential business investment opportunities?
• What are the corporation's growth strategies and will cash flow volatility result in expensive ignorance of profitable opportunities?
• Linking this to performance reviews, how does cash flow volatility impact the firm's return on invested capital and more importantly, how does a firm gets the assurance that these risks are managed?

Knowing what is at risk : Economic exposure vs. accounting exposure

In setting objectives, we should also be clear on whether we are concerned about managing volatility of economic exposures or volatility in accounting exposures. This clearly will have some bearing especially if reported numbers through the strategic planning group relies heavily on accounting numbers. These two concepts will result into risk exposures that are very different. Economic exposure in general refers to the economic realities of the extent a corporation is affected by exchange rate changes. Accounting based foreign exchange gains and losses typically gets reported and many senior management are typically preoccupied with these numbers.

In making the distinction between economic vs. accounting exposure, one can use a few examples to illustrate. From an exposure recognition perpective, a revenue flow is recognized in accounting terms when an invoice is issued and the sales is recorded with a corresponding record of the account receivable consistent with the accrual accounting method. The economic exposure however would already be recognized at the bill of lading date, where a provisional invoice is issued, and the amount and timing of cash flows is still uncertain.

Similarly for expenses. Say if a project has been sanctioned and a contracting strategy has been developed. The economic exposure would recognize the impact of exchange rate changes in the project economics stage and once sanctioned, the impact of exchange rate changes in the expected future cash flows of the project. The accounting exposure would follow liability recognition rules, where liability is recognized when services have been rendered or goods have been received.

In a nutshell, the time pattern of an economic exposure happens much earlier than that of the accounting exposure, and that should be basis for exposure recognition in risk management.

Knowing what is at risk : Defining the metric

Accounting exposure focuses on the impact of exchange rates on reported earnings and in shareholders' equity, dependent on accounting rules that dictate how a transaction is recognized in the accounting books or how subsidiary balance sheet translation impacts that of the parent company.

Economic exposure focuses on the underlying cash flows of the firm; in this context the impact of exchange rate changes in the expected future cash flows of the firm.

In this regard, the expected future cash flows of the firm sensitivity to exchange rate changes or risk factors can be viewed in terms of its impact to the firm value (i.e. present value of future cash flows) or in terms of real operating exposure. Real operating exposure refers to the impact of exchange rate fluctuations on future revenues and costs i.e. its operating cash flows.

The link between operating cash flows and firm value

Getting a total view of the impact of exchange rate fluctuations onto operating cash flows

To assess the impact of exchange rate fluctuations onto operating cash flows requires a detailed understanding of the firm's core business operations and its cash flows and in a large organization such as ours requires also understanding the inter-company linkages. Once these cash flows have been identified, the risk exposure, whether in terms of sensitivity of cash flows to exchange rate changes or a more sophisticated measurement method of assessing the volatility of exchange rate risk factors onto the cash flows, therefore cash flow at risk, can then be performed.

To be continued