Foreign exchange risk

Group - 4

Foreign-Exchange Risk
Management of Exposure Risk

FOREX-Management of exposure risks

Authors of Presentation
Vipin Das
Sreejith
Saranya S R
Renjil Mathew
Rinto Mathew
Likhitha
Jishnu
Lijo Stalin FOREX Risk Management
Manu C Pillali


Foreign-Exchange Risk

• The risk of an investment's value changing due
to changes in currency exchange rates.

• The risk that an investor will have to close out
a long or short position in a foreign currency
at a loss due to an adverse movement in
exchange rates. Also known as "currency risk"
or "exchange-rate risk".


• This risk usually affects businesses that export
and/or import
• But also affect investors making international
investments
• Financial risk management is the practice of
creating economic value in a firm by
using financial instruments to manage
exposure to risk


Foreign Exchange Exposure

• Foreign Exchange Exposure is a measure of
the potential change in a firm's profitability,
• net cash flow and /or market value of net
assets due to a change in exchange rates.

“When a US company sells to a foreign buyer and accepts the
buyers currency for payment, the US company bears the risk that
the foreign currency depreciates and that it will receive fewer
dollars once the foreign currency is converted back into the
dollar.”


TYPES OF RISK FROM FOREIGN
EXCHANGE EXPOSURE

• Transaction Risk
• Translation Risk
• Economic Risk


Transaction Risk

When a firm or individual has a receivable or a
payable in a foreign currency the foreign
exchange rate may change, causing an increase
in the liability of the home country's currency or
a decrease in receipts in the home country's
currency.


Transaction Risk

• The risk of changes in the expected value of a
contract between its signing and its execution
as a result of unexpected changes in foreign
exchange rates.
• Whoever makes a contract denominated in a
foreign currency bears transaction risk.
“Ocean Drilling has transaction risk if it borrows money
in French francs or Japanese yen, and Hintz-Kessels-
Kohl has transaction risk if it agrees to accept future
payments for its vehicles in U.S. dollars.”

Passive Transaction Risk Management

• Denominate all contracts in domestic
currency. This is a possible strategy for
companies with market power.
• Do nothing about transaction risk. This is a
possible strategy for companies with a large
number of small contracts in a large number
of currencies


Hedging

• Insuring against transaction risk to reduce or
eliminate the effects of unexpected changes in
exchange rates.
• You can hedge only at market rates. The
effects of expected changes in exchange rates
are incorporated in these market rates.
Hedging is insurance. The purpose of hedging
is to reduce or eliminate risks, not to make
profits.


Hedging

The purpose of hedging is to manage a firm's
foreign exchange exposure by minimizing home
currency outflows (payables/liabilities) and
maximizing home currency inflows
(receivables/assets).


Natural Transaction Risk Hedging

• Centralize cash management to net all
offsetting transactions, transactions which are
long and short the same currency.
• Time, lead and lag, offsetting business
transactions in the same currency.
• Create offsetting business transactions in the
same currency.


Translation Risk

When a home country entity is required to
consolidate its foreign subsidiaries' income
statements and balance sheets into the home
currency. Exchange rates may change, causing
an increase in liabilities or a decrease in assets
as measured in home country currency terms.


Translation Risk

• Gains or losses from exchange rate changes that
occur as a result of converting financial
statements from one currency to another in
order to consolidate them.
• Every company having at least one subsidiary
using a different functional currency bears
translation risk.
“MSDI has translation risk from having a subsidiary,
MSDI Alcala de Henares, whose financial
statements are kept in Spanish pesetas and not in
U.S. dollars.”


Hedging Translation Risk

• Translation risk is hedged in the same ways as
transaction risk.
• It appears as if investors are indifferent to
foreign currency translation gains and losses.


Market Translation Risk Hedging

• Forward Markets
• Futures Markets
• Money Markets


Forward and Futures Markets

1. Any currency, any amount, 1. Selected currencies, standard
any maturity contracts, standard maturities
2. Illiquid 2. Liquid
3. Self-regulated OTC market 3. Government-regulated
4. Contract with dealer exchange-based market
5. Requires credit-worthiness 4. Contract with exchange
6. Cash flow only at maturity 5. Requires margin account
7. Settled by executing 6. Marked to market daily
contract 7. Settled by offsetting trade
8. Hedge by buying forward 8. Hedge by making a
the short currency or
selling forward the long transaction whose gains or
currency losses offset those of the
underlying position


Forward and Money Markets

• Money markets can always be used to synthesize
forward markets.
• Money market rates are used to set forward
market rates.
• Money market transactions are likely to be more
costly than forward market transactions, since
three transactions having their own bid-ask
spreads are required to duplicate one forward
market transaction with one bid-ask spread.
• Money market transactions appear on the
balance sheet; forward market transactions do
not.


Economic Risk

The effect of exchange rate changes on the long
term expected income streams, i.e., expected
net wealth of home country stockholders. This
risk is usually managed with physical location of
assets and liabilities.


Economic Risk

• Changes in competitive position as a result of
permanent changes in exchange rates.
• Every company buying or selling abroad or
even just competing with foreign companies
has economic risk.
“Maybach has economic risk from manufacturing its
automobiles in Germany for export to the United
States, where it competes with Rolls Royces
manufactured in England.”


CONCLUSION

By incorporating foreign exchange risk solutions
into broader business strategy, we can help
protect your profitability by managing your
exposure to exchange rates – whatever your risk
appetite maybe.


THANK YOU


Foreign exchange risk

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