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# Foreign exchange risk and exposure

Types of risk and exposure with some examples

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### Foreign exchange risk and exposure

1. 1.  Foreign exchange risk and exposure Kanchan Kandel BBA 8th
2. 2. Risk and exposure  Business firms, whether operating domestically or internationally, are exposed to risks of adverse movements in their profits resulting from unexpected movements in exchange rates.  Movement of exchange rates gives rise to foreign exchange exposure and foreign exchange risk.  Though these two terms are often used interchangeably, in reality they represent two different, yet closely related, concepts. Let us first understand these two terms. 2
3. 3. Foreign Exchange Risk Management  Exposure refers to the degree(sensitivity) to which a company is affected by exchange rate changes.  It is calculated by regression.  Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.  It is calculated by variance or standard deviation. 3
4. 4. Cont…  Thus as the foreign exchange exposure is the sensitivity of values of assets, liabilities and operating income to the unexpected change in the exchange rate, we can relate this relationship to a regression equation which is as mentioned below: ΔV(\$) = β ΔS(\$/£) + µ ------ Eq.(I)  Here, β (exposure) =regression coefficient which explains the systematic relation between ΔV and ΔS(\$/£).  ΔV=change in value of foreign assets denominated in domestic currency  ΔS=change in exchange rate (Direct quote)  µ = random error (regression error).  If we assume there is no random error then exposure (β) = ΔV(\$) / ΔS(\$/£) 4
5. 5. Types of Exposures  Transaction Exposure  Translation Exposure (Accounting Exposure)  Operating Exposure (Economic Exposure) 5
6. 6. Transaction Exposure  Transaction Exposure: Results from a firm taking on “fixed” cash flow foreign currency denominated contractual agreements.  Examples of transation exposure:  An Account Receivable denominate in a foreign currency.  A maturing financial asset (e.g., a bond) denominated in a foreign currency.  An Account Payable denominate in a foreign currency.  A maturing financial liability (e.g., a loan) denominated in a foreign currency. 6
7. 7. Cont…  For instance, if a firm has entered into a contact to sell computers to a foreign customer at a fixed price denominated in foreign currency, then the firm would be exposed to exchange rate movements till it receives the payment and converts the receipts into the domestic currency.
8. 8. Cont…  In contractual assets, the exposure value is equal to euro deposits (Face value).  Exposure is positive magnitude i.e. change in exchange rate and dollar value of the investment move same direction.  If investor gain when the spot value of foreign currency increase and loss when it decrease is known as long position in foreign currency  In contractual liabilities exposure is negative magnitude i.e. change in exchange rate and dollar value of the investment move opposite direction.  If investor gain when the spot value of foreign currency decrease, loss when it increase is known as short position in foreign currency
9. 9. Translation exposure  Translation exposure, (also called accounting exposure), results from the need to restate foreign subsidiaries’ financial statements, usually stated in foreign currency, into the parent’s reporting currency when preparing the consolidated financial statements.  While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price  Restating financial statements may lead to changes in the parent’s net worth or net income.  If exchange rates have changed since the previous reporting period, translation/restatement of those assets/liabilities, revenues/expenses that are denominated in foreign currencies will result in foreign exchange gains or losses
10. 10. Cont…  When converting financial statement items (transactions) denominated in currencies other than the parent currency, two choices of exchange rate are possible:  The historical rate, the exchange rate prevailing at the time of the transaction.  ²The current rate, the exchange rate prevailing at the balance sheet date or during the income statement period.  There are two method of adjusting Translation exposure:  Temporal Method  Current Rate method
11. 11. Management of transaction exposure  Forward contract hedge  Option hedge  Money market hedge (borrowing or investing in local market)
12. 12. Forward contract  It is a non standardized contract, which occurs between two parties (buyer and seller) on a trading (underlying) asset, at a known forward time and at a price that is agreed on it today.  It does not cost anything to enter forward contact. This contract as future contract has a long position and a short position.  More specifically, forward contracts are done through over the counter market (OTC), meaning the trading is done through a network that is linked with the dealer markets.  By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk.
13. 13. Example # 1: The Need to Hedge • U.S. firm has sold a manufactured product to a German company. – And as a result of this sale, the U.S. firm agrees to accept payment of €100,000 in 30 days. – What type of exposure does the U.S. firm have? • Answer: Transaction exposure; an agreement to receive a fixed amount of foreign currency in the future. – What is the potential problem for the U.S. firm if it decides not hedge (i.e., not to cover)? • Problem for the U.S. firm is in assuming the risk that the euro might weaken over this period, (or we can say dollar might strengthen) and in 30 days it will be worth less (in terms of U.S. dollars) than it is now say \$1.3500/€ • This would result in a foreign exchange loss for the firm.
14. 14. Hedging Example #1 with a Forward • So the U.S. firm decides it wants to hedge (cover) this foreign exchange transaction exposure. – It goes to a market maker bank and requests a 30 day forward quote on the euro. – He need to sell euro after three month so he take or sell forward contract. – Investor only take short position in forward contract if he think expected future exchange rate (s*) less than forward rate (F)
15. 15. Example #2: The Need to Hedge  U.S. firm has purchased a product from a British company.  And as a result of this purchase, the U.S. firm agrees to pay the U.K. company £100,000 in 30 days.  What type of exposure is this for the U.S. firm?  Answer: Transaction exposure; an agreement to pay a fixed amount of foreign currency in the future.  What is the potential problem if the firm does not hedge?  Problem for the U.S. firm is in assuming the risk that the pound might strengthen (or we can say dollar might weaken) over this period, and in 30 days it take more U.S. dollars than now to purchase the required pounds say \$1.50/£.  This would result in a foreign exchange loss for the firm.
16. 16. Hedging Example #2 with a Forward • So the U.S. firm decides it wants to hedge (cover) this foreign exchange transaction exposure. – It goes to a market maker bank and requests a 30 day forward quote on pounds. – He need to purchase pound after three month so he take or sell forward contract. – Investor only take long position in forward contract if he think expected future exchange rate (s*) greater than forward rate (F)
17. 17. Advantages and Disadvantages of the Forward Contract  For some exact amount of a foreign currency (complete hedge).  For some specific date in the future.  No upfront fees or commissions..  Global firm knows exactly what the home currency equivalent of a fixed amount of foreign currency will be in the future.  However, global firm cannot take advantage of a favorable change in the foreign exchange spot rate.
18. 18. disadvantage  They are often illiquid Counter parties to a forward contract usually design them to meet specific needs.  They have credit risk. Each party to the agreement must trust that its counterparty will perform in the agreed upon manner.  They are unregulated no formal body has the responsibility of setting down rules and procedures  Firm cannot take advantage of a favorable change in the foreign exchange spot rate.
19. 19. Foreign Exchange Options Contracts• One type of financial contract used to hedge foreign exchange exposure is an options contract. • Definition: An options contract offers a global firm the right, but not the obligation, to buy (a “call” option) or sell (a “put” option) a given quantity of some foreign exchange, and to do so: – at a specified price (i.e., exchange rate), and – at some date in the future.
20. 20. Foreign Exchange Options Contracts  Options contracts are either written by global banks (market maker banks) or purchased on organized exchanges (e.g., the Chicago Mercantile Exchange).  Options contracts provide the global firm with:  (1) “Insurance” against unfavorable changes in the exchange rate, and additionally  (2) the ability to take advantage of a favorable change in the exchange rate.  This latter feature is potentially important as it is something a forward contract will not allow the firm to do.  But the investor must pay for this right.  This is the option premium (which is a non-refundable fee).
21. 21. A Put Option: To Sell Foreign Exchange • Put Option: – Allows a investor to sell a (1) specified amount of foreign currency at (2) a specified future date and at (3) a specified price (i.e., exchange rate) all of which are set today. • Put option is used to offset a foreign currency long position (e.g., an account receivable). • Provides the firm with an lower limit price (exercise price) for the foreign currency it expects to receive in the future. • If spot rate proves to be advantageous, the holder will not exercise the put option, but instead sell the foreign currency in the spot market. – Firm will not exercised if the spot rate is “worth more.”
22. 22. A Call Option: To Buy Foreign Exchange • Call Option: – Allows a global firm to buy a (1) specified amount of foreign currency at (2) a specified future date and at a (3) specified a price (i.e., at an exchange rate) all of which are set today. • Call option is used to offset a foreign currency short position (e.g., an account payable). • Provides the holder with an upper limit (exercise) price for the foreign currency the firm needs in the future. • If spot rate proves to be advantageous, the holder will not exercise the call option, but instead buy the needed foreign currency in the spot market. – Firm will not exercise if the spot rate is “cheaper.”
23. 23. Overview of Options Contracts  Important advantage:  Options provide the investor which the potential to take advantage of a favorable change in the spot exchange rate.  Recall that this is not possible with a forward contract.  Important disadvantage:  Options can be costly:  Firm must pay an upfront non-refundable option premium which it loses if it does not exercise the option.  Recall there are no upfront fees with a forward contract.  This fee must be considered in calculating the home currency equivalent of the foreign currency.  This cost can be especially relevant for smaller firms and/or those firms with liquidity issues.
24. 24. Hedging Through Money market • Another strategy used to hedge foreign exchange exposure is through the use of borrowing or investing in foreign currencies. – investor can borrow or invest in foreign currencies as a means of offsetting foreign exchange exposure. – Borrowing in a foreign currency is done to offset a long position (in case of receivable). – Investing in a foreign currency is done to offset a short position (payable ).
25. 25. Specific Strategy for a Long Position  Investor expecting to receive foreign currency in the future (long position):  Will take out a loan (i.e., borrow) in the foreign currency that will equal (both interest plus principal ) to the amount of receivable in maturity.  Will convert the foreign currency loan amount into its home currency at the spot exchange rate.  And eventually use the long position (receivable) to pay off the foreign currency denominated loan at maturity.  What has the firm accomplished?  Has effectively offset its foreign currency long position (with the foreign currency loan, which is a short position).  Plus, immediate conversion of its foreign currency long position into its home currency.
26. 26. Specific Strategy for a Short Position (payable)  Investor needing to pay out foreign currency in the future (short position).  Will borrow in its home currency (an amount equal to its short position at the current spot rate).  Will convert the home currency loan into the foreign currency at the spot rate.  Will invest in a foreign currency denominated asset  And eventually use the proceeds from the maturing financial asset to pay off the short position.  investor has:  Offset its foreign currency short exposure (with the foreign currency denominate asset which is a long position)  Plus immediate conversion of its foreign currency liability into a home currency liability.
27. 27. Secondary instruments of hedge  Currency invoicing  Mix currency invoicing  Lead- lag
28. 28. Leading and lagging  To “lead” means to pay or collect early, whereas to “lag” means to pay or collect late.  If there is payable and you expect that foreign currency will appreciate in near future but before credit period, it may attempts to expedite the payment to exporter before the foreign currency appreciation. As we know if foreign currency appreciate you have to pay more. This is the leading strategy.  As second scenario, assume that you expect the foreign currency will depreciate in near future but before credit period, it may attempts to stall its payment until the after the foreign currency depreciate. Deprecation of pound gives lower payments. This is the lagging strategy
29. 29. Manager hedge vs. Shareholder hedge  There is always question of who should hedge corporate risk? It should hedge by corporate manager or individual shareholder. Following are some of the strong reason to hedge corporate risk by manager not by shareholder.  Progressive tax rate: Volatile EBT  Cost of hedging: Economic of scale  Operating cost: Volatile income  Debt repayment: If organization loan mature when their income is low  Strategic planning: Difficult to collect information  Instrument availability: Specialization
30. 30. Exposure, IRP and CIA  We have, (1+rd)n =F/S (1+rf)n  This equation shows that investor is hedging his/ her foreign investment against the exchange rate risk.  If we held our foreign investment until maturity, then unexpected change in exchange rate (exchange rate) has no effect on our foreign currency denominated investment because forward contract protect our investment at maturity.  Risk is only arise if you withdraw your investment before maturity.
31. 31. Exposure and purchase power parity  Relative theory of PPP suggests that the exchange between two countries should change as difference of inflation rate of these two countries  If relative purchasing power is hold then there will be no exposure. Exposure arise due to change in exchange rate and when change in exchange rate is offset by inflation change there is no question about arising exposure.  Suppose euro depreciate from 1.500/€ to 1.3500/€ during the year. American MNC has building worth €1,000,000 in Europe. In same year America experience 0% inflation and Europe 11.1111% inflation. new price of building after inflation will be €1000,000*1.111111=€1,111,111.