Economic Exposure to FX Movements
Economic exposure to FX movement’s is something that every CFO needs to play very close attention to. In the era of Brexit and the outcome of the US presidential election what steps should a prudent CFO take to reduce the negative impact on cash flows?Student 1:It is first important for the CFO to determine how the firm is affected by exchange rate movements through analysis of all cash flows and their various impacts as a result of exchange rate movement scenarios. Utilizing the regression model allows the CFO to compartmentalize the exposure and pinpoint which units or areas of the business have cash flows that are most correlated to the movement of exchange rates. This will ensure that the areas most in need of attention receive it. Next, the CFO must understand the precise reasons behind the statistical results and make organizational adjustments as required to hedge the risks. This may involve changing pricing policies, restructuring, foreign financing, hedging using forwards, futures or options or even adjusting operations in other units to offset exchange rate movements that result in a reduction in cash flows. For each proposed viable strategy, the CFO should project cash flows at several exchange rate scenarios in order to determine which option optimizes cash flows most effectively.Student 2:There are numerous steps CFOs can take in order to reduce the potential impact on cash flows from substantial political changes. One method of doing so involves restructuring operations to reduce economic exposure. This can be done by shifting sources of revenue or expenses to match cash inflows and outflows in foreign currencies. This way, a lesser percentage of a companys revenues will be at risk of adverse FX movements. CFOs can also utilize derivative contracts to hedge against inflation risk, such as futures contracts and forward contracts. This ensures that the MNC has a guarantee of a certain asset or commodity at a specified amount at a specified date.If a foreign currency has a greater impact on cash inflows than outflows, a prudent CFO may consider pricing foreign sales in the MNCs local currency, increasing foreign supply orders, and/or restructuring debt to increase debt payments in foreign currencies. All of these actions allow an MNC to deal with foreign currencies, rather than having to convert capital to the domestic currency where adverse exchange rate movements can lower the amount of capital being recognized. If a foreign currency has a greater impact on cash outflows than inflows, a CFO may consider increasing foreign sales, reducing foreign supply orders, and/or restructuring debt to reduce debt payments in foreign currency.Firms can reduce economic exposure by reducing foreign sales, but that could reduce potential cash flows. Firms should instead seek to restructure their business so that existing interests are maintained while reducing the mismatch between cash inflows and cash outflows in each foreign currency over a period of time. An example of such restructuring can involve opening production facilities in foreign countries, but this can only be done if the MNC maintains substantial cash inflows in a foreign currency and cash outflows in the domestic currency.Student 3:Knowing that elections cause a wave of the unknown financially, plus any other unexpected circumstance can arise, CFO’s should always be prepared as much as possible. The best way to do so would be like we learned in earlier chapters to use things like forward contracts in order to sell things in future time for a set price. This is great because even if things take a hit, it’s something agreed upon beforehand. A currency derivative would also be helpful because then the CFO wouldn’t have to worry too much of currency fluctuations as they are setting it again, beforehand. Interest rate derivatives are similar to the previous derivative except it protects the company from fluctuations in interest rates, which happens often when one country is dealing with an election or issue. This way, the CFO minimize the interest rate risk by using Vanilla and Quasi Vanilla.