Unit 5 Forex Risk Management

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This presentation covers foreign exchange risk definition, types, management and measurement. Hedging tools and techniques; both internal and external are also discussed.

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Unit 5 Forex Risk Management

  1. 1. INTERNATIONAL FINANCEUnit 5: Forex Risk Management
  2. 2. AGENDA Risk definition and measurement Hedging tools and techniques – Internal andExternal2Mrs.CharuRastogi,Asst.Professor
  3. 3. FOREX RISK Foreign exchange risk (also known as exchange raterisk or currency risk) is a financial risk posed by an exposureto unanticipated changes in the exchange rate betweentwo currencies. A common definition of exchange rate risk relates to the effectof unexpected exchange rate changes on the value of the firm In particular, it is defined as the possible direct loss (as aresult of an unhedged exposure) or indirect loss in the firm’scash flows, assets and liabilities, net profit and, in turn, itsstock market value from an exchange rate movement. To manage the exchange rate risk inherent in multinationalfirms’ operations, a firm needs to determine the specific typeof current risk exposure, the hedging strategy and theavailable instruments to deal with these currency risks.3Mrs.CharuRastogi,Asst.Professor
  4. 4.  Multinational firms are participants in currencymarkets by virtue of their international operations. To measure the impact of exchange ratemovements on a firm that is engaged in foreign-currency denominated transactions, i.e., the impliedvalue-at-risk (VaR) from exchange rate movements,we need to identify the type of risks that the firm isexposed to and the amount of risk encountered4Mrs.CharuRastogi,Asst.Professor
  5. 5. TYPES OF RISKSExchange RateExposureTranslationexposure (notinvolving any cashflow)Economicexposure(involving cashflow)Transactionexposure(involving presentcash flow)Real operatingexposure(involving futurecash flow)5Mrs.CharuRastogi,Asst.Professor
  6. 6. TRANSLATION EXPOSURE Balance sheet exposure (or translation or accountingexposure) results from consolidation of financialstatements of different units of a multinational firm. The aim of the parent company is to maximize its overallprofits, so it consolidates the financial statements of itssubsidiaries with its own. A firms translation exposure is the extent to which itsfinancial reporting is affected by exchange ratemovements. As all firms generally must prepare consolidatedfinancial statements for reporting purposes, theconsolidation process for multinationals entailstranslating foreign assets and liabilities or the financialstatements of foreign subsidiaries from foreign todomestic currency6Mrs.CharuRastogi,Asst.Professor
  7. 7. TRANSLATION EXPOSURE Translation exposure depends on Extent of change in the value of related currencies Extent of involvement of subsidiaries in parentsbusiness Location of subsidiaries in countries with stable/unstablecurrencies Accounting methods used in translation of currencies7Mrs.CharuRastogi,Asst.Professor
  8. 8. TRANSLATION EXPOSURE Accounting methods used in translation of currencies: Current rate method All items of income statement and balance sheet are translated at currentrates Current/non current method Current assets and liabilities are translated at current rate and fixed assetsand long term liabilities at historical rate or at the rate at which they wereacquired Monetary/non monetary method (followed in India) Assets and liabilities are classified as monetary (cash, marketablesecurities, accounts receivable, etc) or non monetary (owners’ equity, land) All monetary balance sheet accounts are translated at the currentexchange and non monetary items are translated at historical rate oracquired rate Temporal method This method uses historical rate for items recorded at historical costs; fixedassets Items that are stated at replacement rates, market rates or expected futurevalue are stated at current rate8Mrs.CharuRastogi,Asst.Professor
  9. 9. Balance SheetItemsRs Historicalrate Rs.30 /US$Current rate = Rs. 35 /US $CurrentRateCurrent/noncurrentMonetary/NonmonetaryTemporalCurrent Assets 2000Inventory (MarketValue)4000Fixed Assets 4000Goodwill 1000Total Assets 11000Current Liabilities 4000Long term debt 3000Share capital 2000Retained earnings(A-L)2000Total Liabilities 11000Translation gain(loss)-9Mrs.CharuRastogi,Asst.Professor
  10. 10. TRANSACTION RISK The risk, faced by companies involved in internationaltrade, that currency exchange rates will change after thecompanies have already entered into financialobligations. Such exposure to fluctuating exchangerates can lead to major losses for firms. Transaction exposure emerges mainly on account ofexport and import of commodities, borrowing andlending in foreign currency and intra- firm flows in aninternational company.= rupee worth of accounts receivable (payable) whenactual settlement is made - rupee worth of accountsreceivable (payable) when trade transaction wasinitiated, 10Mrs.CharuRastogi,Asst.Professor
  11. 11. TRANSACTION RISK Suppose an Indian firm exports goods to the USand the bill is invoiced in USD. It has to receivepayment in 2 months but within this period USDdepreciates. This will cause a reduction in earnings in rupeeterms. If USD appreciates it will make exportearning bigger in rupee terms If an Indian importer imports goods from US and ifthe USD appreciates before payment is made inUSD, it will have to pay more in rupees11Mrs.CharuRastogi,Asst.Professor
  12. 12. TRANSACTION RISK Transaction exposure also emerges whenborrowing or lending is done in foreign currency. Ifforeign currency appreciates, the burden ofborrowing will be more in terms of domesticcurrency and vice versa. In case of intra firm flow, suppose the Indiansubsidiary of an American firm has declared adividend and the amount has to be sent to theparent company. In the meanwhile the rupeedepreciates; the amount of dividend to be receivedby parent company in dollars will reduce and causeloss to parent company. Eg. Mahindra & Mahindra12Mrs.CharuRastogi,Asst.Professor
  13. 13. REAL OPERATING EXPOSURE/ ECONOMIC RISK Also called economic risk involving future cash flow A firm has real operating exposure to the degree thatits market value is influenced by unexpected exchange ratefluctuations. Such exchange rate adjustments can severely affect thefirms position with regards to its competitors, the firms futurecash flows, and ultimately the firms value Economic exposure can affect the present value of futurecash flows. Any transaction that exposes the firm to foreign exchange riskalso exposes the firm economically, but economic exposurecan be caused by other business activities and investmentswhich may not be mere international transactions, such asfuture cash flows from fixed assets. A shift in exchange rates that influences the demand for agood in some country would also be an economic exposurefor a firm that sells that good 13Mrs.CharuRastogi,Asst.Professor
  14. 14. REAL OPERATING EXPOSURE/ ECONOMICRISK This risk concerns the effect of exchange ratechanges on revenues (domestic sales and exports)and operating expenses (cost of domestic inputsand imports). Exposure = How will an unanticipated exchangerate change affect the cash flows of the firm? Domestic sales Exports Domestic costs Import costs14Mrs.CharuRastogi,Asst.Professor
  15. 15. REAL OPERATING EXPOSURE/ ECONOMICRISK Operating Exposure is determined by: The structure of the markets for: a) the firms inputs(labor, materials), and b) the firms products. Input(resource) market and Product Market (Retail). The firms ability to offset exchange rate changes byadjusting its markets, product mix, and sourcing. Given that: Profit = Retail Price - Input Cost, theGeneral Rule is that a firm has operating exposurewhen either its Price, or Cost, is sensitive toexchange rate changes, but NOT both. If bothPrice and Cost are equally sensitive, or if neitherPrice nor Cost are sensitive, then the firm has nomajor operating exposure15Mrs.CharuRastogi,Asst.Professor
  16. 16. REAL OPERATING EXPOSURE/ ECONOMIC RISK Examples: Ford Mexicana (subsidiary of Ford in Mexico),imports Fords into Mexico that are built by Ford in the U.S., forsale in Mexico. Assume Peso depreciates, USDappreciates. Two scenarios: Scenario A: Ford Mexicana competes against Mexican carmakers (whose peso costs did NOT rise) in a competitivemarket for cars, parts and service. Demand is highly elastic,price sensitive. Ford Mexicanas peso cost of imported U.S.Fords has gone up, but it cannot pass on the higher cost in theform of higher peso prices for its cars without losing sales andmarket share. It is at a competitive disadvantage, an importer,when the peso depreciates. Reason: Ford Mexicanas Cost is sensitive to ex-ratechanges, but its price (in pesos) is not. Profit margins will besqueezed, reflecting the operating exposure. 16Mrs.CharuRastogi,Asst.Professor
  17. 17. REAL OPERATING EXPOSURE/ ECONOMIC RISK Scenario B: There are no domestic Mexican automakers, and FordMexicana faces only import competition from other U.S. carmakers -GM and Chrysler. When peso depreciates, all firms will chargehigher peso prices in Mexico, offsetting some or all of the increasedcosts, maintaining the profit margins per car in dollars. There is lessoperating exposure under this scenario compared to the firstscenario. Ford Mexicanas operating exposure is also influenced by its abilityto source parts, materials and even production locally in Mexico. If itcan shift sourcing of parts, and even some (or all) production toMexico, more of its costs will be in pesos, making the firm lessexposed to changes in the dollar and peso. Firms flexibility regarding production locations, sourcing, andhedging determines the operating exposure to exchange risk.17Mrs.CharuRastogi,Asst.Professor
  18. 18. MEASUREMENT OF FOREIGNEXCHANGE RISK18Mrs.CharuRastogi,Asst.Professor
  19. 19. VALUE AT RISK MODEL VaR model is a widely used measure for measuringexchange rate risk The VaR measure of exchange rate risk is used by firmsto estimate the riskiness of a foreign exchange positionresulting from a firm’s activities over a certain timeperiod under normal conditions The VaR calculation depends on 3 parameters: The holding period, i.e., the length of time over which theforeign exchange position is planned to be held. The typicalholding period is 1 day. The confidence level at which the estimate is planned to bemade. The usual confidence levels are 99 percent and 95percent. The unit of currency to be used for the denomination of theVaR 19Mrs.CharuRastogi,Asst.Professor
  20. 20. VAR Assuming a holding period of x days and a confidencelevel of y%, the VaR measures what will be themaximum loss over x days Thus, if the foreign exchange position has a 1-day VaRof $10 million at the 99 percent confidence level, the firmshould expect that, with a probability of 99 percent, thevalue of this position will decrease by no more than $10million during 1 day, provided that usual conditions willprevail over that 1 day. In other words, the firm should expect that the value ofits foreign exchange rate position will decrease by nomore than $10 million on 99 out of 100 usual tradingdays, or by more than $10 million on 1 out of every 100usual trading days. 20Mrs.CharuRastogi,Asst.Professor
  21. 21. MODELS FOR CALCULATING VAR The historical simulation, which assumes thatcurrency returns on a firm’s foreign exchangeposition will have the same distribution as they hadin the past The variance-covariance model, which assumesthat currency returns on a firm’s total foreignexchange position are always (jointly) normallydistributed and that the change in the value of theforeign exchange position is linearly dependent onall currency returns; and Monte Carlo simulation, which assumes thatfuture currency returns will be randomly distributed21Mrs.CharuRastogi,Asst.Professor
  22. 22. VAR: HISTORICAL SIMULATION The historical simulation is the simplest method of calculation. This involves running the firm’s current foreign exchange positionacross a set of historical exchange rate changes to yield adistribution of losses in the value of the foreign exchangeposition, say 1,000, and then computing a percentile (the VaR). Thus, assuming a 99 percent confidence level and a 1-dayholding period, the VaR could be computed by sorting inascending order the 1,000 daily losses and taking the 11 thelargest loss out of the 1,000 (since the confidence level impliesthat 1 percent of losses – 10 losses –should exceed the VaR). The main benefit of this method is that it does not assume anormal distribution of currency returns, as it is well documentedthat these returns are not normal but rather leptokurtic. Its shortcomings, however, are that this calculation requires alarge database and is computationally intensive22Mrs.CharuRastogi,Asst.Professor
  23. 23. VAR: VARIANCE – COVARIANCE MODEL The variance – covariance model assumes that (1) the change inthe value of a firm’s total foreign exchange position is a linearcombination of all the changes in the values of individual foreignexchange positions, so that also the total currency return islinearly dependent on all individual currency returns; and (2) thecurrency returns are jointly normally distributed. Thus, for a 99 percent confidence level, the VaR can becalculated as: VaR= -Vp (Mp + 2.33 Sp) where Vp is the initial value (in currency units) of the foreignexchange position Mp is the mean of the currency return on the firm’s total foreignexchange position, which is a weighted average of individualforeign exchange positions Sp is the standard deviation of the currency return on the firm’stotal foreign exchange position, which is the standard deviation ofthe weighted transformation of the variance-covariance matrix ofindividual foreign exchange positions23Mrs.CharuRastogi,Asst.Professor
  24. 24. VAR: MONTE CARLO SIMULATION Monte Carlo simulation usually involves principalcomponents analysis of the variance-covariancemodel, followed by random simulation of thecomponents. While its main advantages include its ability tohandle any underlying distribution and to moreaccurately assess the VaR when non-linearcurrency factors are present in the foreignexchange position (e.g., options), its seriousdrawback is the computationally intensive process.24Mrs.CharuRastogi,Asst.Professor
  25. 25. MANAGEMENT OF FOREX RISK:HEDGING TOOLS AND TECHNIQUES -INTERNAL & EXTERNAL25Mrs.CharuRastogi,Asst.Professor
  26. 26. INTERNAL TECHNIQUES/NATURAL HEDGES Form a part of the firm’s regulatory financialmanagement Do not involve contractual relationship with anyparty outside the firm Leads and lags Cross-hedging Currency diversification Risk sharing Pricing of transactions Parallel loans Currency swaps Matching of cash flows26Mrs.CharuRastogi,Asst.Professor
  27. 27. EXTERNAL TECHNIQUES/CONTRACTUALTECHNIQUES Involve contractual relationships with externalparties Forward market hedge Hedging through currency futures Hedging through currency options Money market hedge27Mrs.CharuRastogi,Asst.Professor
  28. 28. 28Mrs.CharuRastogi,Asst.Professor

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