Definition
Net Open Position is defined as the exposure of companies towards foreign exchange risk that the company is exposed towards. The exposure of the foreign exchange risk is defined as the difference between total assets and total liabilities in the foreign currency.
This particular risk element describes the extent to which the company can see volatility in the financials as a result of the foreign exchange risk.
In this regard, it can be seen companies are often exposed to foreign exchange risk because when they are dealing with foreign exchange transactions.
This is because of the fact that currency rates keep on fluctuating because, and hence this makes the financials of the company vulnerable to uncalled for instability in profitability.
The foreign exchange risk is always inherent within companies particularly in cases where there is more than one currency in operation.
Therefore, this is the exposure that needs to be accounted for by companies in order to identify the element of risk that the organization has undertaken as a result of the foreign exchange-related transactions.
Formula
Net Open Position is calculated using three main parameters. These parameters include total assets in the foreign currency, total liabilities in the foreign currency, and the equity or the net worth of the company. Using these parameters, the following formula is then used:
Net Open Position = (Total Assets in the foreign currency – total liabilities in the foreign currency) / (Equity or Net Worth of the company)
However, in order to represent all currencies as one single currency, it is important to convert the international currencies into the functional currency of the organization. This is done using the prevalent spot rate at that point in time.
Example of Net Open Position
Net Open Position can further be explained using the illustration provided below:
Multinational Inc. is a trading concern sending goods from the US to the UK. They also import some of their raw materials from the UK. As of 31st December 2019, they had the following balances on their balance sheet:
Total Assets (Local Currency) = $ 500,000
Total Assets (Foreign Currency) = £ 200,000
Total Liabilities (Local Currency) = $300,000
Total Liabilities (Foreign Currency) = £ 100,000
Equity or Net worth of the company -= $ 200,000
As of 31st December 2019, the spot rate between USD and GBP was $0.9 = £ 1
In order to calculate the Net Open Position of Multinational Inc, the following calculations need to be made:
Total Assets (Foreign Currency) = £ 200,000
Total Foreign Assets (local currency) = $ 180,000
Total Liabilities (Foreign Currency) = £ 100,000
Total Foreign Liabilities (local currency) = $ 80,000
Therefore, after these conversions, the net open position of Multinational Inc. can be calculated as the following:
Net Open Position = (Total Assets in the foreign currency – total liabilities in the foreign currency) / (Equity or Net Worth of the company)
Net Open Position = ($180,000 – $80,000) / 300,000
Net Open Position = 100,000 / 300,000 = 33.33%
Importance of Assessing Net Open Position
There are numerous different advantages of calculating net open positions. Firstly, it can be seen that net open positions can greatly help companies to assess their inherent risk.
This is important for companies, and their stakeholders because it gives them a much-needed insight and overview regarding the existing risk position and how can this risk position be altered for the overall position of the company.
In the same manner, the net open position can also be used for business strategies, and in terms of devising a protocol that companies can follow in terms of minimizing and mitigating that risk in the coming years.
Limitations of Net Open Position
However, it can be seen that the net open position has certain limitations, which need to be included in the analysis too. Net Open Position is the risk exposure at a certain point in time. It provides a snapshot, which is based on the existing exchange rates.
However, it does not provide a longitudinal view. It does not incorporate the fact that foreign currency rates might constantly change from time to time, and hence, this is something that might change the net open position of the organization too.
In the same manner, a higher net open position is also perceived as a cause of higher risk for the company. However, it must be kept in mind that a lot of companies solely rely on international trade, and therefore, their net open position might be higher.
This does not necessarily mean that the company is a high-risk entity. In fact, this risk can be minimized over the course of time using techniques and strategies that can reduce the element of risk.
