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ACCA AFM | FX Risk Management | Internal Netting Method | Lecture 34

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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

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

$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.

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

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

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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YouTube 字幕：ACCA AFM | FX Risk Management | Internal Netting Method | Lecture 34