Foreign Exchange Risk Management
International
Foreign Exchange Risk Management
Syllabus tag: KASNEB CPA | Advanced Level | CA33 Advanced Financial Management | Topic 8 Foreign Exchange Risk Management
Lesson objectives
By the end of this topic, you will be able to:
- Distinguish transaction, translation and economic exposure
- Apply purchasing power parity and interest rate parity
- Construct a forward hedge and a money market hedge
- Compare hedging instruments and select between them
- Explain internal hedging techniques
Why this matters
A Kenyan company importing from abroad or borrowing in dollars carries a risk it cannot control and did not choose. This topic is about measuring that risk and deciding what to do about it.
Three exposures
Transaction exposure. A committed cash flow in a foreign currency — an invoice payable in ninety days. Short-term, specific, and hedgeable with financial instruments. This is what most examination questions concern.
Translation exposure. An accounting effect: consolidating a foreign subsidiary whose net assets are worth fewer shillings than last year. No cash moves, and hedging it can create real cash risk to remove a paper one.
Economic exposure. The long-term effect of exchange rate movements on the value of the business — a competitor in a country whose currency has weakened can now undercut you. It affects companies with no foreign transactions at all, and cannot be hedged financially. The response is operational: diversifying markets, sourcing and production.
The ordering matters. Transaction exposure is the most visible and the least important strategically; economic exposure is the reverse.
Purchasing power parity
The expected change in the spot rate reflects the inflation differential.
Forward rate = Spot × (1 + inflation in currency A) / (1 + inflation in currency B)
Spot KES 145.00 per USD, Kenyan inflation 7.5%, US inflation 2.5%:
Expected rate in one year = 145.00 × 1.075 / 1.025 = KES 152.0732
In two years = 145.00 × (1.075 / 1.025)² = KES 159.4914
The currency of the higher-inflation country is expected to weaken — which is why the shilling figure rises.
Interest rate parity
The forward rate reflects the interest rate differential, and unlike PPP this one is enforced by arbitrage rather than being a tendency.
Forward = Spot × (1 + interest in currency A) / (1 + interest in currency B)
Kenyan rate 11.5%, US rate 4.5%:
One-year forward = 145.00 × 1.115 / 1.045 = KES 154.7129
If the forward rate departed from this, a trader could borrow in one currency, convert, deposit in the other and lock in a riskless profit. That is why the relationship holds tightly while PPP is only a long-run tendency.
Two hedges, one answer
A company owes USD 500,000 in one year.
Forward hedge. Contract now at 154.7129:
Cost = 500,000 × 154.7129 = KES 77,356,450
Money market hedge. Create the dollars synthetically:
| Step | Working | KES |
|---|---|---|
| Deposit USD now to grow to 500,000 | 500,000 / 1.045 = USD 478,469 | |
| Buy those dollars at spot | 478,469 × 145.00 | 69,377,990 |
| Borrow that in shillings at 11.5% | 69,377,990 × 1.115 | 77,356,459 |
The two costs are the same, to within rounding. That is not a coincidence — it is interest rate parity holding. Where the two differ materially in an examination question, the rates given are inconsistent and the cheaper hedge is the answer.
:::checkpoint A company hedges a dollar payable using the money market and finds it costs KES 400,000 more than the forward. Explain what this implies about the rates quoted, and what a bank would do if the discrepancy were real and persistent. :::
Other instruments
| Instrument | Obligation | Cost | Suits |
|---|---|---|---|
| Forward contract | Binding both ways | No premium | A certain exposure |
| Currency futures | Binding; exchange traded | Margin | Standard amounts and dates |
| Currency option | Right, not obligation | Premium payable | An uncertain exposure |
| Currency swap | Exchange of principal and interest | Arranged | Long-term financing |
The option is the one to understand. It caps the downside while leaving the upside available — but the premium is paid whether or not the option is exercised.
The decision rule follows from that: use a forward where the exposure is certain, because the premium buys nothing you need. Use an option where the exposure itself is uncertain — a tender that may not be won — because a forward would leave the company obliged to deliver currency it may not need.
Internal techniques
Cheaper than financial hedging and often overlooked:
- Netting — offsetting receipts and payments in the same currency within a group, so only the balance is hedged
- Matching — funding a foreign asset with borrowing in the same currency
- Leading and lagging — accelerating or delaying settlement in the expected direction of the rate
- Invoicing in the home currency — which does not remove the risk but transfers it to the counterparty, at a price
Should a company hedge at all?
For: cash flow certainty aids planning; it avoids distress caused by an adverse move; and lenders and shareholders value predictability.
Against: hedging costs money; shareholders can diversify currency risk themselves; and over a long period gains and losses tend to offset.
The judgement usually turns on size relative to the business. An exposure that could threaten solvency should be hedged whatever the theory says. One that is small relative to operations may not be worth the cost.
:::checkpoint A Kenyan company sells only domestically and imports nothing. Its main competitor imports from a country whose currency has just fallen 20%. Identify the exposure, explain why no financial hedge helps, and suggest two operational responses. :::