This content explains FX transaction risk management, focusing on internal netting as a strategy to reduce the number of external currency hedges required, thereby lowering costs.
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Now we'll be looking at FX risk management.
management.
I've spoken about price risk briefly in
my previous video. And um now FX risk is
not something that is totally new to you
because we covered it in FM. I'm going
to remind you again, please go to my FM
videos and watch those videos on risk
management. It will help you to give you
a very strong foundation especially if
you did not do FM with me. That video
will really help you. Yeah. In this
space. Remember we said usually you have
three types of FX risk. Just a quick
refresher. You have the transaction
risk, you have the translation risk, and
you have the economic risk.
This is the focus for now. This
transaction risk we're going to be
looking at. So,
and when we talk about transaction risk,
how do we manage it? What's our risk response?
response?
The response can either be internal
or external.
When you're talking about internal
saying either you want to invoice in
local currency, so which means you don't
want to employ anybody to help you, you
just want to do it as a company. So, you
might want to invoice in a local
currency. So when you sell to foreign
company you don't issue in the foreign
currency you issuing your own local
currency such that you are not exposed
to any conversion. You can also do matching
on net and I'm going to touch on that in
this video. The difference between
matching and netting is a similar
concept. The only difference is that
when you talk about netting you're
talking about within the group. This is
But this is external parties involved
for matching. So here maybe you are a
vendor. The vendor is also you have AR
and AP you can match
and maybe you are owing a vendor.
You also expect money from a customer.
The timing is the same. The currency is
the same. You can also match. Those are
external people involved, external
parties involved. And that's matching.
Netting is when you have everything
going on within the group, subsidiaries
owning each other in different currencies.
currencies.
I'm going to deal with netting in this
video. Like I said, yeah. So, XNAV
XNAV
method involves the use of derivatives.
So, you can use forwards.
Let me add one more to the internal lead
payments. All of that you will see
details in my FM videos. So back to
external fact methods forward can use features
features
Those are external methods.
So I'll quickly speak about internal
method which is a bit new to you and
that is netting not totally new but
I've spoke about net like I said netting
and matching are quite similar.
So the only difference is just that the
netting is within the group while
matching involves external pattern. What
are you trying to do? You're saying that
before you go to external party you want
to handle the FX risk first internally
by netting
asset from liability or income from
expenses. So take for instance what
we're saying is this. Imagine that A is
You pay B. Then
C is going to pay A
Let's say A is a UK company.
which means both transactions are
happening in foreign currency. If A is
going to be very inefficient, it's going
to try and edge $100 and edge $50
separately. But edging comes at a cost
as well. So that is very inefficient.
When you find yourself in situation, the
timing is the same. The currency is the
same. The best thing for A to do is to
realize that he can actually net 100
from 50 and the net exposure is just
$50. So when A wants to edge, A only
needs to think about edging externally
$50 and not $100 and another $50 because
the lower the amount of what you're
trying to edge, the lower your cost.
This is just between few parties.
Sometimes it get more complicated and
that is the part I want to do with you
take few minutes to go through the
question like I always advise then watch
the way I'm going to take care of the question.
question.
So what is going on here is that all these
these
companies you have four companies
involved here. You have company P, Q, R
R
and S.
They are owing each other.
This company P is actually
a parent company that has three
subsidiaries. This is the parent company.
company.
Q is in Europe. R is in US. S is in Canada.
Canada.
And we have all the
transactions, the balances owed to each other.
These are all foreign currencies.
We have 1 2 3 4 5 6 7 8. Imagine trying
to edge eight different balances. That's
a lot of cost
but instead
this is where neting comes handy so that
you will know what you have left after
you have netted off everything between
or amongst the group members. How much
do you need to reach out to an external
party for edging?
So there are two methods that can be used.
The first one is a tabular method which
I will show you. The second one is a
Either method is very simple and
straightforward. What you are saying
here is
regardless of the method you are using
please follow the steps. The first step
So which means I'm saying convert
all the balances
balances
to one currency. And usually it's better
to convert to the currency of the
parent. Yeah. Here, let's say pounds.
So, we're going to convert everything to
pound. Then we can do our table. And
what do you do on the table? First of
all, recognize the fact that you have
four companies. So I'm going to put P Q
I will say old by
P owed by Q. Then who are they paying
to? So going to pay to again going to
have on vertical axis P Q RS. So this is
paid to column.
is owed by. So
what we're saying owed by P
to S. So which means P is going to pay S3
S3
$3 million Canadian dollars. So P
will pay S3 million Canadian dollars. But
But
remember what I said, you need to
convert to one currency. So everything
that I'm picking here, I'll be
converting it into pounds. The exchange
rate has been given. Please note, you
always do the conversion
right? Because after everything is done,
once you are done with anything, you're
going to convert back to the whatever
you have left should be converted back
to the normal currency at the same spot
rate again. Okay? So owed by P paid to S
is3 million Canadian dollars which is
million
if you convert at 1.5
okay keep going next one is owed by P
paid to R5 million
million
if you convert that at the exchange rate
so Q is going to pay
R which is here.
Q is going to pay R4 $4 million
and that is at exchange rate Q2R
remember to use exchange rate Q2R is in
US dollars so you using 1.6 six rate
very important. The next one is Q paying
to S 7 million Canadian.
If you convert that as well, that will
The next one is I'll pay how much
I will be paying as $2 million Canadian
dollars. And that is equivalent to 1.3.
And R will have to pay P which is up
here. I was paying P how much? $6
million US.
S is going to be paying Q.
How much
We convert S paying Q of 12 million at
1.2. Yeah, that's 10. Then the last one
is S paying P and S will be paying P
5 million Canadian which is equivalent to
3.33.
So now what we've done is we've been
able to plot the cash flows on the
table. So life is now super easy cuz all
we need to do is to get the total for
each side and each person. So this
column is owed by so the total amount
owed by P is addition of this and this
So we have that that is we enlarge it.
Now let's see what is going on with the
paid to paid to paid to paid to so how
much is paid to P
the total amount that's paid to P is 3.8
+ 3.3 now we are doing horizontal addition
addition
this is 10
only 10 is paid to Q how much is paid to
the total amount paid to S
is 2 4.67 67 and 1.3 and that amounts to eight.
eight.
So we have all the information that we
need because all we need to do now is to
understand that if you are owing someone
and you expecting a receivable then you
can net off. So what you can do is now
that you've plotted the cash
on this initial table that we did this
one then you can do a summary table that
helps a lot and with that you can be
rest assured that you are not missing
anything out. So you have account
receivable and account payable for each
company. So let's start from the parent
to subsidiary Q, subsidiary R and
subsidiary S. Let's find out what they
have are they have and the AP they have
amongst the group. With that we can
determine what the net position is for
each company and decide on who do we
need to
make contact with externally to hedge
the leftover balance. So for P
look at the initial table you have owed
by owed by is definitely a liability. So
for P is owed by is downward right and
that is 5.13.
So that is account payable of 5.13
7.17 for Q 5.1
5.1
for R 13.3 for S. Then receivable is on
this line this A R column which is paid
to because you must have account
receable for someone to be paying you.
So P that's 7.08
Q is 10 5.63
and 8.
That is it. Then the next thing is to
find the net and that's why it's called
netting. So the net for P will be let me
is account receivable the positive of 1
96 and yeah approximately Q is also
and um S is liability
is 5 3.
So
this is the net situation that we find ourselves
ourselves
It's actually showing that the main
transaction that we're having is S
having to pay
P 1.96 Q
Q 2.83
2.83
and S 0.54
and that is why S is owing 5.3.
So and that is happening in two months
time. So which means looking at the
situation on ground now the group
actually just have
a liability of 5.3 and this is the area
where the group needs to focus on. So if
there's anything to be edged this is
just 5.3 then it's veg. They don't have
to edge all these eight items that you
see here. They don't have to edge all of
these items
individually because if they have to do
it individually then there's a lot of
transaction cost a lot of fees that they
will be paying but by the time you
finish netting you realize that you only
have few transaction to take care of
that is using table for this same
example we can use diagram and that's
what I'm going to show you right now
All right.
So let me
let's use
remember what I said there are two ways
of doing this. You can use tabular or
graphical. Let's try and use the
graphical approach for the same. I mean
don't forget like I said the first step
is always conversion to one currency
usually the parent currency and
[clears throat] in this example is
pounds. So we've done that before. So
what we just need to do is to put the
companies in a form of graph. So we have
four companies P Q RS. So I'm going to
put on a graph P Q
Q
R S
from what we seen we know that R
is owing S
13 from the conversion that we have done
R we have to pay S
no not 1.3 actually cuz that is uh 2
million and if you convert to
with the exchange rate that will give us 1.3.
1.3.
So R is OS
1.3. So put 1.3 here. We also know that
put two there.
I've done P will pay R. Q will pay R as
well. So this way
that's 7 million Canadian dollars and if
R will pay S. We've done that. 1.3
R will pay P as well. So you can see
there's another line that needs to come here.
here.
and S will pay Q. So there's another
line going up this way.
S will pay Q
S is paying Q10 million.
million.
million Canadian dollars. And if you
and that's everything. So we've plotted
all the cash flows on the graph. So
please pay attention to this carefully
because this is very important and
follow the steps. Remember step one I
said convert to one currency. Step two
Step three. Now it's time to start
elimination. The first step of
elimination is to cancel bilateral transaction.
transaction.
And what [snorts] do I mean by bilateral
transaction? Anywhere you see arrow
going opposite direction like this.
That's what I mean by bilateral. And in
this example, we have two of them. In
fact, three of them. There's one here.
There's another one here. And there's
another one here.
So we have three bilaterals that we have
to cancel and we have to cancel with the
lowest amount. So take for instance
for bilateral one we have 10 and 4.67
because it's straightforward. What is
happening is that if S is meant to pay Q
10 and Q is meant to pay S 4.67 we can
net it off and say 10 - 4.67 that is
5.33. So that means S is left with
paying Q. So next, so plot PQ
RS. So
this one we've taken care of it. Then
This one is not a bilateral, so we are
not dealing with it yet. So we'll keep
it there.
This is not a bilateral. We'll keep it there.
there.
Now let's deal with the bilateral number
two. This one in the middle when P is
meant to pay S2 and S is meant to pay P
3.33. So we can eliminate that as well
and know that. Okay. So we are only left
with S
and we can eliminate net the third
bilateral 3.8US 8 - 3.13 and that is
still owing after netting I will be
owing P. So I will have to still pay P 0.67
and with that there's no more bilateral
that we have to deal with.
Once we've dealt with bilateral
then we need to look at the trilateral.
Those are the three-way direction
[snorts] and that's triangle. So
anywhere you can find a triangle, you
know that
you have to deal with it elimination.
And where are the triangles in this that
we have left? We have triangle P
R S as you can see it
is a triangle.
And likewise we have another triangle
that is
So those are the two triangles that we
have to eliminate. Once we eliminate all
the triangles, we're done. So, let's
start with the first triangle, PRS. So, eliminate
using the smallest
side. So, when you're eliminating
triangle, you look at the smallest side
and you do it from the understanding of
the transaction perspective. Please
don't just cancel out because the
direction of the arrow matters. And this
is where it gets tricky. I need you to
pay attention. PQ
PQ RS.
When you look at what is happening with
P R S, you discover that R is paying 67
to P. R is also paying 1.3 to S and S is
paying 1.3 to P.
So if you look at it, how can we
you look at it you realize that okay you
need to work with the smallest figure
and that is 0.67
so how can we take that off if we need
to take 67 off which means if I would
not have to pay P67
then someone would need to pay P
R will not pay P 0.67 67 but will need
to ask another person to help to pay P.
And who will help to pay P?
R is also supposed to pay S 1.3.
So which practically means that
R is owing two people 67 and 1.33.
I will pay it to S
this 67 I'll give it to S then S can
just pay everything
for me. So if I I'm only supposed R is
only supposed to pay 1.3 to S. But
because we want to eliminate the
smallest figure we say okay yeah
I'm owing S. I will give it to S. So
which means I'll now be giving S 1.3 + 67
67
which makes it uh 1.97.
Once I give to S, S S will help me to
remit to P. So instead of S remitting
1.33 to P, S will be remitting 1.33 and
67 to P and that is how we're going to
eliminate that. So which means this
direction will will mean will now be
valued at 1.97
and suddenly
this guy as well would change to two
actually because when you add 67 to 1.33
you have two and that takes care of that
triangle. Now we don't have triangle
again but we still have triangle
let me put it here. This triangle QRS
is still there.
This is 5.33
and this is 2.5. Please pay attention.
Gradually we eliminating. Now let's
and like I always say it must always
come from a place of understanding
because there's no one way of
eliminating. You can't just deduct you.
Sometimes you have to add
this part. There's nothing that's going
to happen to it. We already know there's
no more triangle there. This remains two.
two.
This remains 1.97.
There's nothing going on there.
Okay. No, this might not remain 1.97.
Remember, it's part of the triangle that
we want to eliminate. Now QRS cuz this
is is part is what we want to eliminate
now. So which means these three lines
will change only line S to P will remain
the same. So we always work with this
smallest figure.
We have 1.97 here.
We have 2.5 here and we have 5.33 here.
If we use the smallest figure to
eliminate, how does that help us? That's
first thing you have to check. So which
means if R will not have to give money
to S,
who will pay S on his behalf?
As we can see, there's nobody paying.
Now S is practically the one paying. So
S is paying Q 5.33 but Q is paying R.
So the easiest thing to eliminate here
actually is what Q is paying R because
you can say Q does not have to pay R actually
actually because
because
if S is meant to give Q a sum that is as
much as 5.33
then Q can forfeit 2.5 out of that money
and say S should actually
pay R for name
and see how it's going to look. So what
you are saying now is that 2.5 will
reduce this then S will now have
something like a bilateral here paying
to S 2.5 S pay to R 2.5
and Q will now be
deducting that 2.5 from this because it
mean Q will want to forfeit 2.5 out of
5.33 which means that this S O will be less
less
and that'll be 5.33 minus plus 2.5 which
and this bilateral will now be taken
care of because that is meant to pay S
1.97 before is now looking at the
possibility of receiving 2.5 from S and
that's a bilateral forming and you have
to eliminate it which means that arrow
will change direction
and all of a sudden turns this way and
2.5 and 1.97 give you 0
53 three
and you can see that is exactly what we
had before 2 2.83 A3 from the tabular
that 5.3 that S is owing is what has
been shared into these five places yeah
yeah
which you can see S is meant to pay P 1.96
1.96
S is meant to pay Q 2.83 83 and 0.54.
This is 2.83 and 0.53. Very similar. So
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