WHAT IS RISK?

RISK for an ENTITY, arises because it has an EXISTING SENSITIVITY to a FACTOR. This FACTOR changes in a random manner, and its movement is neither predictable nor controllable by the ENTITY. Generally, if this SENSITIVITY results into a LOSS, it is reckoned as RISK.

WHAT IS EXPOSURE?
The SENSITIVITY of an ENTITY to a FACTOR is known as EXPOSURE. Like I run the risk of skin cancer, if my skin is EXPOSED to the HARMFUL radiations of SUN. Hence, it is the EXPOSURE which causes RISK. RISK is not EXPOSURE.

What is Foreign Exchange (Forex) Exposure?

It is the sensitivity of a firm to UNEXPECTED exchange rate movements. When we say a firm, it is the sensitivity of PROFITS/ITS VALUE (measured in domestic currency), to movements in exchange rates. When we say PROFITS/VALUE, it is the sensitivity of future (foreign currency denominated) REVENUES, EXPENSES, and values of existing(foreign currency denominated) ASSETS, LIABILITIES, and OWNERS FUND.

What is Forex Risk?

It is the variability of the Profits and Value of the firm, due to unexpected exchange rate movements. Forex Risk necessarily arises due to forex exposure, but requires the following additional reasons a) Exchange Rate neither fixed nor predictable b) Compulsion for Conversion into domestic currency

Example of Exposure & Risk

Changes in US $ 1000 item
FOR.CUR E/R DOM.CU R G / (L)

1000
1000 1000 1000

46
45.50 45 44.5

46000
45500 45000 44500

1000
500 0 (500)

1000

44

44000

(1000)

Example Contd
The US $ 1000 is the Forex Exposure of the firm. So for any given change in the exchange rate, the gain or loss will be 1000 times, the change in the exchange rate. So the firm is sensitive 1000 times. The Standard Deviation of the given range of (5) domestic currency values of this exposure, is the Forex Risk.

Exposure & Risk

Exposure is measured in Foreign Currency Risk is measured in Domestic Currency Risk may not be there eventhough there is Exposure Certain Exposures can be avoided

Types of Forex Exposure

Forex Exposure is the sensitivity of the firms foreign currency denominated Receivables, Payables, Assets, Liabilities, and Operating cashflows, to unanticipated changes in exchange rates. Firms can experience broadly three types of exposure, namely TRANSACTION, TRANSLATION and ECONOMIC

TRANSACTION EXPOSURE
It is the exposure of a firms foreign currency denominated receivables and payables, to unanticipated exchange rate movements. It results into cash losses or gains, at the time of settlement of the receivables or payables. It is born on the day when an agreement to receive or pay in foreign currency is entered into.

Transaction Exposure Contd..

It expires on the day the receivable or payable is settled. The value of exposure does not change during the life of the item, as it is contractually fixed. It is prevalent in firms, which transact with the rest of the world in foreign currency. Typical examples: Exports receivables, Import payables, Inter Company Transfers, Dividend/Interest Payments, repayment of loans and receipts of loans.

Transaction Exposure Contd..

The term of the exposure is known. There is a desired exchange rate which the firm would like protect in the receivable or payable. It is short-term in nature.

Managing Transaction Exposure

Either we try to reduce the exposure or getting the desired exchange rate. Methods involving reducing the exposure are NETTING, MATCHING, OFFSETTING, CURRENCY RISK SHARING, INVOICING, LEADING, LAGGING ETC. The desired exchange rate can be protected by hedging with the help of derivatives, like FORWARD, FUTURES AND OPTION CONTRACTS.

Translation Exposure
It is the exposure of firms foreign currency denominated assets and liabilities to unanticipated changes in exchange rates. It results into book gains or losses at the time of translating the foreign currency values into domestic currency, on the date of closing of accounts. It exists as long as the asset or liability exists on the date of balance sheet.

Translation Exposure Contd..

The gains or losses arising out of translation depend on the accounting standards and method of translation. MNCs with and firms with foreign subsidiaries, experience this exposure, when consolidating their accounting statements, for reporting. Eg: Foreign Currency Loans, Subsidiary Assets, Investments in Financial assets abroad.

Translation Exposure Contd..

The term of the exposure is as long as the accounting item appears in the balance sheet. There is no desired exchange rate which the firm would like to protect in such an exposure. It is medium to long-term in nature.

Managing Translation Exposure

The focus of managing translation exposure is reducing the exposure, as there is no desired exchange rate to protect. Methods like BALANCE SHEET HEDGING, LEADING, LAGGING, & CREATING DERIVATIVES POSITIONS may be adopted.

Economic Exposure
It is the sensitivity of the firms future operating cashflows, to unanticipated exchange rate movements. It results in loss of sales realisation, loss of markets, increases in costs due to unfavourable movements in the exchange rate involving domestic currency or the currency of any other competitor country.

Economic Exposure Contd..

Firms not having any transactions with the rest of the world also experience this exposure if they are operating in an open economy The gains or losses are due to two affects, COMPETITIVE EFFECT and CONVERSION EFFECT.

Economic Exposure Contd...

The exposure is long-term in nature and affects the survival of the firm. It exists as long as the firm continues to operate in the respective sector, or in an open economy.

Economic Exposure Contd..

Cases where economic exposure exists. a) Domestic Firms output exported b) Domestic Firm having imported inputs c) A firm faces global competition, and operates in an open economy d) Domestic Firm produces and sells import substitutes e) Firm does not posses the flexibility for price adjustment.

Managing Economic Exposure

Exposure reduction and Locking the desired rate, cant effectively manage economic exposure. Requires strategic cross functional approach to manage it, like the following (a) Pricing (b) Product Innovation (c) Market Selection (d) Outsourcing (e) Relocation of Production Units (f) Raising Productivity (g) Changing sources of inputs