Exposure transaction
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Exposure transaction

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Exposure transaction Exposure transaction Presentation Transcript

  • Foreign currency exposure and risk management… www.StudsPlanet.com
  • what exposure means… That part of company’s volume of business which may get affected by movements in exchange rates-  May / may not be favourable  Unpredictable - One can only forecast a strong probability..  How fast the exchange rate moves…. www.StudsPlanet.com
  • what exposure means…  ERR is inherent in the business of all multinational enterprises as they are to make or receive payments in foreign currencies  Hence foreign exchange risk has become an integral part of the management activities of any MNC www.StudsPlanet.com
  • Types of exposures….  Accounting Exposures  Transaction Exposure  Translation Exposure  Operating / Economic Exposure www.StudsPlanet.com
  • Transaction exposure www.StudsPlanet.com
  • Different types of transactions Transactions that can have an impact on currency movements… Trade related  Export bills receivables / Import Bills Payable  Advance payments – exports Loan repayments Repatriation of investments www.StudsPlanet.com
  • Different types of transactions Transactions that can have an impact on currency movements… Interest payments / receivables Inward remittances Whether these transactions will be concluded before the next balance sheet www.StudsPlanet.com
  • Transaction Exposure  How it generated  When it is generated and how it ends Conceived at the time of quoting a price in foreign currency Given birth when the quotation is accepted Anniversaries – on due dates and if not met on due dates crystallizes into an exposure… Final stage – extinguished when FC bought / sold www.StudsPlanet.com
  • Transaction Exposure Risk “Risk in adverse movement of exchange rates from the time the transaction is budgeted till the time of exposure is extinguished – by sale / purchase of a foreign currency against domestic currency….” www.StudsPlanet.com
  • Impact of Transaction Exposure.. It will be of short term in nature Will have an impact on cash flow of a company www.StudsPlanet.com
  • Impact of Transaction Exposure.. It will be of short term in nature Will have an impact on cash flow of a company www.StudsPlanet.com
  • Hedging Transaction Exposure Since exposure arises due to unanticipated movement of exchange rate , entering into a financial counter-transaction at a future point in time is known as hedging www.StudsPlanet.com
  • Basic Objectives of Formulating Hedging Strategy Hedging is an attempt to reduce the losses due to unexpected or unanticipated changes in exchange rate But hedging has associated costs; therefore costs are to be weighed against returns and the fulfillment of objective of maximisation of value of the firm Firms by nature are risk takers therefore the hedging strategy is not to eliminate total risk but to maximise the value of the firm www.StudsPlanet.com
  • Hedging Transaction Exposure The amount receivable ( exports) is technically referred as long position The amount payable ( imports) is technically referred as short position The MNCs will have both types of positions www.StudsPlanet.com
  • Hedging Transaction Exposure The basic rule of hedging is: The payables (short position) in a currency in the future is to be hedged with buying (long position) in the same currency in the forward; and receivables (long position) in a currency in the future is to be hedged with selling (short position) the same currency in the forward www.StudsPlanet.com
  • Instruments of Hedging 1. Forward contract 2. Money market hedge 3. Future contract 4. Option contract 5. Currency invoicing 6. Exposure netting 7. Currency Risk Sharing www.StudsPlanet.com
  • Forward Contract A forward contract is an agreement made today between a buyer and a seller to exchange the commodity or instrument for cash at a predetermined future date at a price agreed upon today In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity No money changes hands at the time the deal is signed www.StudsPlanet.com
  • Forward Contract  Forward contracts are not traded on an exchange, they are said to trade over the counter (OTC)  The secondary market do not exist for the forward contracts and faces the problem of liquidity and negotiability  Forward contracts face counter party risk www.StudsPlanet.com
  • Hedging with Forward contract ● Suppose an importer has imported a machine worth $ 1,00,000 ● The machine is expected to arrive in a month when the amount is payable ● The current exchange rate is $1= Rs. 46.75 ● He expects to move the rate to $1= Rs. 47.75 ● He checks the forward market and finds that one month forward rate is $1= Rs. 47.50 ● The importer buys $1,00,000 as the dollar was cheaper in the forward market as compared to his own perception www.StudsPlanet.com
  • Money Market Hedge  Money market hedge involves mixing of foreign exchange and money markets to hedge at the minimum cost  It involves taking advantage of disequilibrium between the two markets www.StudsPlanet.com
  • Money Market Hedge One possibility: The importer buys that amount of dollars in the spot market which when deposited in the US at US interest grows to $1,00,000 in one month Second possibility: The importer buys $1,00,000 in the forward market and to make the payment in Indian rupees, deposits that much amount in the bank deposit to grow to honour the contract www.StudsPlanet.com
  • Futures Contract  A futures contract is a financial security, issued by an organised exchange to buy or sell a commodity, security or currency at a predetermined future date at a price agreed upon today  Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price www.StudsPlanet.com
  • Futures Contract  The contract expires on a pre-specified date which is called the expiry date of the contract  On expiry, futures can be settled by delivery of the underlying asset or cash  The futures contract relates to a given quantity of the underlying asset and only whole contracts can be traded www.StudsPlanet.com
  • Currency Futures  Currency Futures means a standardised foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract  Currency future contracts allow investors to hedge against foreign exchange risk  Reserve Bank of India Act, 1934 permitted currency futures trading with effect from August 6, 2008. www.StudsPlanet.com
  • Forwards Vs. Futures Two parties negotiate a forward transaction Futures is structured as two transactions Party BParty A Party A Party B Clearing House www.StudsPlanet.com
  • Difference between Forward Hedge and a Future Hedge Forward Market Hedge Future Hedge Contracts executed by banks Contracts executed by brokerage houses of future exchanges Tailor-made contracts Standardised contracts Price quoted reflects banker’s perception of future price Price paid is determined by forces of demand and supply Contract bilateral between two parties Contract with the future exchange www.StudsPlanet.com
  • Options ‘ An option is a contractual agreement that gives the option buyer the right, but not the obligation, to purchase (call option) or to sell (put option) a specified instrument at a specified price at any time of the option buyers choosing by or before a fixed date in the future The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium www.StudsPlanet.com
  • Options Seller (writer) Purchaser (holder) Premium Striking or exercise price www.StudsPlanet.com
  • Options European Option: The holder of the option can only exercise his right ( if he so desire) on the expiration date American Option : The holder can exercise his right any time between purchase date and expiration date www.StudsPlanet.com
  • Options Call Option : A call option gives the buyer the right to buy a fixed number of shares/commodities at the exercise price upto the date of expiration of the contract Put Option: A put option gives the buyer the right to sell a fixed number of shares/commodities at the exercise price upto the date of expiration of the contract www.StudsPlanet.com
  • Options Example Current price of oil is $65 per barrel. An airlines company feels oil prices might rise 6 months later & wishes to hold an option to buy oil 6 months hence at, at most $67. An oil refinery feels prices will fall 6 months later & wishes to hold an option to sell oil 6 months hence at, at least $67. Both companies approach the exchange and place their orders. Exchange has options which fulfill the requests at $67 per barrel. 1. What is the expiration period ? 2. Is Airline Company a holder or writer ? 3. Is Oil Refinery a holder or writer ? 4. What option type does Airline Company hold ? 5. What option type does Oil Refinery hold ? 6. What are the Strike Prices ? www.StudsPlanet.com
  • Features of Options The option is exercisable only by the owner, namely the buyer of the option The owner has limited liability Options have high degree of risk to the option writers Options involve buying counter positions by the option sellers Options are popular because they allow the buyer profits from favourable movements in exchange rate www.StudsPlanet.com
  • Call Option - Example Call option grants the owner the right to purchase a specified financial instrument for a specified strike price over a specified period of time I buy a call today for $0.33 for 15 barrels oil, strike price $50, exercise date June 1 2010 Today’s oil price is $49 per barrel. Tomorrow If the oil price is $52 my intrinsic value = $2, option premium = $0.45 (say) MTM (mark-to-market) = $(0.45 - 0.33)*15 = $0.12*15 = $1.80 www.StudsPlanet.com
  • Call Option - Example If the oil price is $60 on June 1 2010 (the spot price) then I would exercise my option (i.e. buy the oil from the counter-party). I could then sell oil in the open market for $60, i.e. the payoff would be worth $10; my profit would be $10 minus the premium I paid for the option $0.33 = $9.67. Net gain = $9.67*15 = $145.05 www.StudsPlanet.com
  • Call Option - Example If however the spot price is $40 then I would not exercise the option. I would buy the stocks in the open market for $40, why waste $50 on it? The option would expire worthless Thus, in any future state of the world, I am certain not to lose money on the underlying by owning the option; my loss is limited to the premium I have paid. www.StudsPlanet.com
  • Put Option - Example Put option grants the owner the right to sell a specified financial instrument for a specified strike price over a specified period of time. I buy a put option today at $ 0.5 to sell 10 coal per metric tons on June 1, 2010, at $50 per metric ton. Today coal price is $48 per metric tons. Tomorrow If the share price is $49 my intrinsic value = $1, option premium = $0.6 (say) MTM (mark-to-market) = $(0.6 - 0.5)*10 = $0.1*10 = $1www.StudsPlanet.com
  • Put Option - Example On June 1, 2010 the coal price is $40 (spot price) I would exercise my option (i.e. sell the share to the counter-party) I could then buy coal in the open market for $40, i.e. the payoff would be $10; my profit would be $10 minus the premium of $ 4.5 I paid for the option = $0.5. Net gain = $0.5*10 = $5 www.StudsPlanet.com
  • Put Option - Example If, however, the spot price is more than the strike price, say, $60, then I would not exercise the option. I would sell such a share in the open market for $60, and earn more than I would by selling through the option. My option would be worthless and I would have lost the premium for the option. Thus, in any future state of the world, I am certain not to lose money by owning the option; my loss is limited to the premium I have paid. www.StudsPlanet.com
  • Option Benefits Holder (Buyer who has gone Long) Writer (Seller who has gone Short) Call Right to Buy No Obligation Premium Pay No Right Obligation to Sell Premium Receive Put Right to Sell No Obligation Premium Pay No Right Obligation to Buy Premium Receive www.StudsPlanet.com
  • Hedging with Options In the case of hedging with options, if the price surpass the expectations, only then the option is exercised and the hedge comes into operation This kind of hedging is usually resorted when there is a possibility of non-performance of contract The cost involved in purchasing an option is called premium www.StudsPlanet.com
  • Hedge through Currency Invoicing If during the negotiation of an import contract, an importer of a country having weak currency may get goods invoiced in domestic currency and the exporter from this country should invoice goods in strong currency The risk shifts from one party to the other www.StudsPlanet.com
  • Exposure Netting  Netting means the net of payables and receivables  The exposure, if netted, is reduced so also the cost of hedge www.StudsPlanet.com
  • Currency Risk Sharing  It is the practice of introducing a clause in the transaction contract  The parties would declare a neutral zone within which the risk is not shared www.StudsPlanet.com
  • MNCs and Transaction Exposure Management  The companies dealing in multicurrency environment or multicurrency cash flows need to prepare cash budgets to know the exact extent of transaction exposure  The net transaction exposure is arrived at on quarterly basis www.StudsPlanet.com
  • Foreign currency inflow-outflow cash budget   Q-1 Q-2 Q-3 Q-4 Total RECEIPTS   American Dollars ($) 300 280 320 400 1300 British Pound(BP) 20 25 18 40 103 Canadian Dollars(C$) 40 25 45 45 155 DISBURSEMENTS 0 American Dollars ($) 200 160 240 300 900 British Pound(BP) 40 15 20 40 115 Canadian Dollars(C$) 20 40 75 20 155 Japanese Yen (JPY) 10 30 20 20 80 NET EXPOSURE 0 American Dollars ($) 100 120 80 100 400 British Pound(BP) -20 10 -2 0 -12 Canadian Dollars(C$) 20 -15 -30 25 0 Japanese Yen (JPY) -10 -30 -20 -20 -80www.StudsPlanet.com
  • MNCs and Transaction Exposure Management The net positive transaction exposure (+ ve flows) indicates strengthening of domestic currency against foreign currency ($) will cause loss to the firm and depreciation makes it profitable The net negative transaction exposure (- ve flows) indicates strengthening of domestic currency against foreign currency ($) will give profit to the firm and weakening of domestic currency would cause the loss www.StudsPlanet.com
  • Hedging Transaction Exposure of MNCs MNCs by nature are risk takers and they take risk when adequate compensation is present in the venture In a multicurrency environment, it is not necessary that foreign exchange risk to be zero for international business to become attractive for the firm Strategies to decrease transaction exposure:  International Diversification  Hedging www.StudsPlanet.com
  • Thank You Best of Luck…. www.StudsPlanet.com