Manage foreign exchange risk with VaR

INTERNATIONAL FINANCE
Unit 5: Forex Risk Management

AGENDA
 Risk definition and measurement
 Hedging tools and techniques – Internal and
External
2
Mrs.CharuRastogi,Asst.Professor

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

 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

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

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

 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

 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
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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

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

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

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

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

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

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

 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

 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

MEASUREMENT OF FOREIGN
EXCHANGE RISK
18

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

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

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

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

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

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

MANAGEMENT OF FOREX RISK:
HEDGING TOOLS AND TECHNIQUES -
INTERNAL & EXTERNAL
25

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

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

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Manage foreign exchange risk with VaR

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