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Unit 5 Forex Risk Management

Unit 5 Forex Risk Management

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

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 FINANCE Unit 5: Forex Risk Management
  2. 2. AGENDA  Risk definition and measurement  Hedging tools and techniques – Internal and External 2 Mrs.CharuRastogi,Asst.Professor
  3. 3. FOREX RISK  Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies.  A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm  In particular, it is defined as the possible direct loss (as a result of an unhedged exposure) or indirect loss in the firm’s cash flows, assets and liabilities, net profit and, in turn, its stock market value from an exchange rate movement.  To manage the exchange rate risk inherent in multinational firms’ operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy and the available instruments to deal with these currency risks. 3 Mrs.CharuRastogi,Asst.Professor
  4. 4.  Multinational firms are participants in currency markets by virtue of their international operations.  To measure the impact of exchange rate movements on a firm that is engaged in foreign- currency denominated transactions, i.e., the implied value-at-risk (VaR) from exchange rate movements, we need to identify the type of risks that the firm is exposed to and the amount of risk encountered 4 Mrs.CharuRastogi,Asst.Professor
  5. 5. TYPES OF RISKS Exchange Rate Exposure Translation exposure (not involving any cash flow) Economic exposure (involving cash flow) Transaction exposure (involving present cash flow) Real operating exposure (involving future cash flow) 5 Mrs.CharuRastogi,Asst.Professor
  6. 6. TRANSLATION EXPOSURE  Balance sheet exposure (or translation or accounting exposure) results from consolidation of financial statements of different units of a multinational firm.  The aim of the parent company is to maximize its overall profits, so it consolidates the financial statements of its subsidiaries with its own.  A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements.  As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency 6 Mrs.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 parents business  Location of subsidiaries in countries with stable/unstable currencies  Accounting methods used in translation of currencies 7 Mrs.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 current rates  Current/non current method  Current assets and liabilities are translated at current rate and fixed assets and long term liabilities at historical rate or at the rate at which they were acquired  Monetary/non monetary method (followed in India)  Assets and liabilities are classified as monetary (cash, marketable securities, accounts receivable, etc) or non monetary (owners’ equity, land)  All monetary balance sheet accounts are translated at the current exchange and non monetary items are translated at historical rate or acquired rate  Temporal method  This method uses historical rate for items recorded at historical costs; fixed assets  Items that are stated at replacement rates, market rates or expected future value are stated at current rate 8 Mrs.CharuRastogi,Asst.Professor
  9. 9. Balance Sheet Items Rs Historical rate Rs. 30 /US$ Current rate = Rs. 35 /US $ Current Rate Current/non current Monetary/ Non monetary Temporal Current Assets 2000 Inventory (Market Value) 4000 Fixed Assets 4000 Goodwill 1000 Total Assets 11000 Current Liabilities 4000 Long term debt 3000 Share capital 2000 Retained earnings (A-L) 2000 Total Liabilities 11000 Translation gain (loss) - 9 Mrs.CharuRastogi,Asst.Professor
  10. 10. TRANSACTION RISK  The risk, faced by companies involved in international trade, that currency exchange rates will change after the companies have already entered into financial obligations. Such exposure to fluctuating exchange rates can lead to major losses for firms.  Transaction exposure emerges mainly on account of export and import of commodities, borrowing and lending in foreign currency and intra- firm flows in an international company. = rupee worth of accounts receivable (payable) when actual settlement is made - rupee worth of accounts receivable (payable) when trade transaction was initiated, 10 Mrs.CharuRastogi,Asst.Professor
  11. 11. TRANSACTION RISK  Suppose an Indian firm exports goods to the US and the bill is invoiced in USD. It has to receive payment in 2 months but within this period USD depreciates.  This will cause a reduction in earnings in rupee terms. If USD appreciates it will make export earning bigger in rupee terms  If an Indian importer imports goods from US and if the USD appreciates before payment is made in USD, it will have to pay more in rupees 11 Mrs.CharuRastogi,Asst.Professor
  12. 12. TRANSACTION RISK  Transaction exposure also emerges when borrowing or lending is done in foreign currency. If foreign currency appreciates, the burden of borrowing will be more in terms of domestic currency and vice versa.  In case of intra firm flow, suppose the Indian subsidiary of an American firm has declared a dividend and the amount has to be sent to the parent company. In the meanwhile the rupee depreciates; the amount of dividend to be received by parent company in dollars will reduce and cause loss to parent company. Eg. Mahindra & Mahindra 12 Mrs.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 that its market value is influenced by unexpected exchange rate fluctuations.  Such exchange rate adjustments can severely affect the firm's position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value  Economic exposure can affect the present value of future cash flows.  Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets.  A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good 13 Mrs.CharuRastogi,Asst.Professor
  14. 14. REAL OPERATING EXPOSURE/ ECONOMIC RISK  This risk concerns the effect of exchange rate changes on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports).  Exposure = How will an unanticipated exchange rate change affect the cash flows of the firm?  Domestic sales  Exports  Domestic costs  Import costs 14 Mrs.CharuRastogi,Asst.Professor
  15. 15. REAL OPERATING EXPOSURE/ ECONOMIC RISK  Operating Exposure is determined by:  The structure of the markets for: a) the firm's inputs (labor, materials), and b) the firm's products. Input (resource) market and Product Market (Retail).  The firm's ability to offset exchange rate changes by adjusting its markets, product mix, and sourcing.  Given that: Profit = Retail Price - Input Cost, the General Rule is that a firm has operating exposure when either its Price, or Cost, is sensitive to exchange rate changes, but NOT both. If both Price and Cost are equally sensitive, or if neither Price nor Cost are sensitive, then the firm has no major operating exposure 15 Mrs.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., for sale in Mexico. Assume Peso depreciates, USD appreciates. Two scenarios:  Scenario A: Ford Mexicana competes against Mexican car makers (whose peso costs did NOT rise) in a competitive market for cars, parts and service. Demand is highly elastic, price sensitive. Ford Mexicana's peso cost of imported U.S. Fords has gone up, but it cannot pass on the higher cost in the form of higher peso prices for its cars without losing sales and market share. It is at a competitive disadvantage, an importer, when the peso depreciates.  Reason: Ford Mexicana's Cost is sensitive to ex-rate changes, but its price (in pesos) is not. Profit margins will be squeezed, reflecting the operating exposure. 16 Mrs.CharuRastogi,Asst.Professor
  17. 17. REAL OPERATING EXPOSURE/ ECONOMIC RISK  Scenario B: There are no domestic Mexican automakers, and Ford Mexicana faces only import competition from other U.S. carmakers - GM and Chrysler. When peso depreciates, all firms will charge higher peso prices in Mexico, offsetting some or all of the increased costs, maintaining the profit margins per car in dollars. There is less operating exposure under this scenario compared to the first scenario.  Ford Mexicana's operating exposure is also influenced by its ability to source parts, materials and even production locally in Mexico. If it can shift sourcing of parts, and even some (or all) production to Mexico, more of its costs will be in pesos, making the firm less exposed to changes in the dollar and peso.  Firm's flexibility regarding production locations, sourcing, and hedging determines the operating exposure to exchange risk. 17 Mrs.CharuRastogi,Asst.Professor
  18. 18. MEASUREMENT OF FOREIGN EXCHANGE RISK 18 Mrs.CharuRastogi,Asst.Professor
  19. 19. VALUE AT RISK MODEL  VaR model is a widely used measure for measuring exchange rate risk  The VaR measure of exchange rate risk is used by firms to estimate the riskiness of a foreign exchange position resulting from a firm’s activities over a certain time period under normal conditions  The VaR calculation depends on 3 parameters:  The holding period, i.e., the length of time over which the foreign exchange position is planned to be held. The typical holding period is 1 day.  The confidence level at which the estimate is planned to be made. The usual confidence levels are 99 percent and 95 percent.  The unit of currency to be used for the denomination of the VaR 19 Mrs.CharuRastogi,Asst.Professor
  20. 20. VAR  Assuming a holding period of x days and a confidence level of y%, the VaR measures what will be the maximum loss over x days  Thus, if the foreign exchange position has a 1-day VaR of $10 million at the 99 percent confidence level, the firm should expect that, with a probability of 99 percent, the value of this position will decrease by no more than $10 million during 1 day, provided that usual conditions will prevail over that 1 day.  In other words, the firm should expect that the value of its foreign exchange rate position will decrease by no more than $10 million on 99 out of 100 usual trading days, or by more than $10 million on 1 out of every 100 usual trading days. 20 Mrs.CharuRastogi,Asst.Professor
  21. 21. MODELS FOR CALCULATING VAR  The historical simulation, which assumes that currency returns on a firm’s foreign exchange position will have the same distribution as they had in the past  The variance-covariance model, which assumes that currency returns on a firm’s total foreign exchange position are always (jointly) normally distributed and that the change in the value of the foreign exchange position is linearly dependent on all currency returns; and  Monte Carlo simulation, which assumes that future currency returns will be randomly distributed 21 Mrs.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 position across a set of historical exchange rate changes to yield a distribution of losses in the value of the foreign exchange position, say 1,000, and then computing a percentile (the VaR).  Thus, assuming a 99 percent confidence level and a 1-day holding period, the VaR could be computed by sorting in ascending order the 1,000 daily losses and taking the 11 the largest loss out of the 1,000 (since the confidence level implies that 1 percent of losses – 10 losses –should exceed the VaR).  The main benefit of this method is that it does not assume a normal distribution of currency returns, as it is well documented that these returns are not normal but rather leptokurtic.  Its shortcomings, however, are that this calculation requires a large database and is computationally intensive 22 Mrs.CharuRastogi,Asst.Professor
  23. 23. VAR: VARIANCE – COVARIANCE MODEL  The variance – covariance model assumes that (1) the change in the value of a firm’s total foreign exchange position is a linear combination of all the changes in the values of individual foreign exchange positions, so that also the total currency return is linearly dependent on all individual currency returns; and (2) the currency returns are jointly normally distributed.  Thus, for a 99 percent confidence level, the VaR can be calculated as: VaR= -Vp (Mp + 2.33 Sp)  where Vp is the initial value (in currency units) of the foreign exchange position  Mp is the mean of the currency return on the firm’s total foreign exchange position, which is a weighted average of individual foreign exchange positions  Sp is the standard deviation of the currency return on the firm’s total foreign exchange position, which is the standard deviation of the weighted transformation of the variance-covariance matrix of individual foreign exchange positions 23 Mrs.CharuRastogi,Asst.Professor
  24. 24. VAR: MONTE CARLO SIMULATION  Monte Carlo simulation usually involves principal components analysis of the variance-covariance model, followed by random simulation of the components.  While its main advantages include its ability to handle any underlying distribution and to more accurately assess the VaR when non-linear currency factors are present in the foreign exchange position (e.g., options), its serious drawback is the computationally intensive process. 24 Mrs.CharuRastogi,Asst.Professor
  25. 25. MANAGEMENT OF FOREX RISK: HEDGING TOOLS AND TECHNIQUES - INTERNAL & EXTERNAL 25 Mrs.CharuRastogi,Asst.Professor
  26. 26. INTERNAL TECHNIQUES/NATURAL HEDGES  Form a part of the firm’s regulatory financial management  Do not involve contractual relationship with any party outside the firm  Leads and lags  Cross-hedging  Currency diversification  Risk sharing  Pricing of transactions  Parallel loans  Currency swaps  Matching of cash flows 26 Mrs.CharuRastogi,Asst.Professor
  27. 27. EXTERNAL TECHNIQUES/CONTRACTUAL TECHNIQUES  Involve contractual relationships with external parties  Forward market hedge  Hedging through currency futures  Hedging through currency options  Money market hedge 27 Mrs.CharuRastogi,Asst.Professor
  28. 28. 28 Mrs.CharuRastogi,Asst.Professor

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