Foreign Exchange Exposure & Risk

Foreign Exchange Exposure

If V0= 1,00,000 $ = Rs 43,00,000 /(Rs/$ =43.00) Over a period of time, price of asset changes due to inflation and exchange rate also changes. So,
V1= 1,40,000 $ = Rs 53,20,000 /(Rs/$ = 38.00)

The actual change

V = V1 V0 = 53,20,000 43,00,000 = Rs 10,20,000 S = S1- S0 = 43.00 38.00 = Rs 5.00
So, For S = 11.6% For V = 23.7% S may be both positive and negative and so may be V

Is there any relationship between change in exchange rate and change in value of asset?
V = F(S)

+V

- S -V

+ S

Foreign Exchange Exposure

V = + S + u V = change in the value of asset or liability

S = Unanticipated change in the exchange rate

= intercept = sensitivity of changes in value of assets or liabilities in response to S

= sensitivity of changes in value of assets or liabilities in response to S = Exposure Now, V = + S + u Assuming = 0 , u = 0 V = S => = V / S

+V

Change in value of asset

+V

Change in value of Liability

Asset Exposure Line

= tan

Liability Exposure Line

= tan

- S -V

+ S

- S

+ S

-V

Defining Exposure
The sensitivity of the real home currency value of an asset, liability or an operating income to an unanticipated change in the exchange rate, assuming unanticipated changes in all other currencies as zero

 Does exposure affect Balance sheet of a company or income statement?

Does exposure affect only foreign assets or domestic assets as well?

Foreign Exchange Risk

Variability of the domestic currency values of assets, liabilities, operating incomes due to unanticipated changes in exchange rate.
Risk = variance in V

Estimating Risk
Now, we know that by definition V = + S + u `V = ` + `S ------- Eq 1

Regressing the actual data of V and S

--------Eq 2

There will be a difference between the estimated change (Eq1 and Actual change (Eq 2) V = `V + u Now, the risk is given by Var(V) = Var( `V + u) Var(V) = Var( `V ) + Var( u) +2Cov(`V , u)

Risk Cont..
2Cov(`V , u) = 0 Therefore, Var(V) = Var( `V ) + Var( u)
Thus, the total risk of an asset includes estimated risk plus risk due to other factors.

Relating Risk & Exposure

V = + S
Var(V) = Var( + S) Var(V) = 2 Var(S)

Defining Real Change in exchange rate

The real change in exchange rate is the change that produces a difference between overall rate of return on domestic versus foreign assets / liabilities or in profitability of export / import oriented firms.

Real Change is the extent of change in the value due sensitivity and variability both

Real Change in Financial Assets

If IRP does not exist, then (S1-S ) / S = (ia-ib) / (1+ib)
Hence, Real proportionate change in exchange rate is Rp = [(S1-S ) / S ] (1+ib) (ia-ib)

Real Change in Real Assets

We know that, irs = i^ rs + P ^ rs and i$ = i^ $ + P ^ $ Hence, Rate of return on 1 Rs invested in US = S1/S [1+ i^ $ + P ^ $] 1 Therefore, Real rate of return above domestic return = S1/S [1+ i^ $ + P ^ $] [1+(i^ rs + P ^ rs )] Adding & Subtracting P$ = {S1/S [1+ i^ $ + P ^ $ ] 1} (i^ rs + P ^ rs ) (P ^ $ P ^ $ )
= {S1/S + S1/S i^ $ + S1/S P ^ $ ] 1} (i^ rs + P ^ rs ) (P ^ $ P ^ $ ) = [(S1 S)/S] (1+ P ^ $ ) ( P ^ rs P ^ $ ) [i^ rs (S1/S)i ^ $ ]

={S1/S [1+ i^ $ + P ^ $ ] 1} (i^ rs + P ^ rs ) (P ^ $ P ^ $ )

=S1/S + S1/S i^ $ + S1/S P ^ $ ] 1} (i^ rs + P ^ rs ) (P ^$ P ^$ )

={S1/S + S1/S i^ $ =S1/S + S1/S i^ $

+ S1/S P ^ $ 1} i^ rs - P ^ rs P ^ $ + P ^ $

+ S1/S P ^ $ S/S i^ rs - P ^ rs P ^ $ + P ^ $

= [(S1 S)/S] (1+ P ^ $ ) ( P ^ rs P ^ $ ) [i^ rs (S1/S)i ^ $ ]

Real Change in Real Assets

Rp = [(S1 S)/S] (1+ P ^ $ ) ( P ^ rs P ^ $ ) [i^ rs (S1/S)i ^ $ ]

If i^ rs = (S1/S)i ^ $ then real proportionate change
= [(S1 S)/S] (1+ P ^ $ ) ( P ^ rs P ^ $ )

Exposure
=> Translation Exposure or Accounting Exposure

Economic Exposure
Transaction exposure Operating exposure

Translation Exposure
Changes in Income Statement items and book value of BS assets and liab, caused by exchange rate change Resulting gains or losses are determined by accounting rules and are on paper only
Impact BS assets and liab and income statements that already exist.

Operating Exposure
Changes in the amount of future operating cash flows caused by exchange rate change Resulting gains or losses are determined by changes in firms future competitive position and are real. Impact Revenues and costs associated with future sales.

Transaction Exposure
Changes in the value of foreign currency denominated contracts that are brought about by exchange rate change. The resulting changes are determined by the nature of contracts already entered into and are real. Impact Contracts already on BS are part of Accounting Exp. Contracts yet to come on BS are part of Operating Exp.

Types of Risk
Financial Risk Political Risk Country Risk

Financial Risk
Refers more generally to unexpected events in a countrys financial, economic, or business life Examples of financial risks
currency risk interest rate risk Inflation risk unexpected changes in the current account balance unexpected changes in the balance of trade

Political Risk
The risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate
Examples of political risks
Expropriation risk Disruptions in operations Protectionism Blocked funds Loss of intellectual property rights

Political risk insurers

Government export credit agencies U.S. Overseas Private Investment Corporation U.K. Export Credits Guarantee Department International World Bank - Multilateral Investment Guarantee Agency Private Lloyds of London American International Group (AIG) MNCs are self-insured if their risk exposures are diversified across a large number of countries

Country Risk
Macro risks - affect all firms in a host country Micro risks - specific to an industry, firm or project in a country Whether a particular country risk is macro or micro affects the diversifiability of the risk

Country risks examples

A1 - Africa, Asia, Europe, Mid East Americas, Australia, Switzerland, Canada, UK A2 - Botswana, HK, Japan, Germany, Kuwait, USA, S. Korea Italy, UAE A3 - Mauritius, China, Cyprus, Israel, Chile, Namibia, Thailand, Czech Rep, Trinidad. A4 - Egypt, India, Latvia, Saudi, Mexico, S. Africa, Philippines, Poland, Arabia, Panama. B - Algeria, Bangladesh, Slovakia, Egypt, Brazil, Peru, Uganda, Sri Lanka, Russia, Jordan, Venezuela. C - Congo, Indonesia, Azerbaijan, Iran, Syria, Haiti, Kenya, Vietnam, Romania, Turkey, Jamaica. D - Nigeria, Afghanistan, Albania, Iraq, Argentina, Sudan ,N. Korea, Ukraine, Cuba ,Zimbabwe, Pakistan, Yugoslavia, Ecuador.

Strategies for managing country risk

Negotiate the environment with the host country prior to investment Structure foreign operations to minimize country risk while maximizing return Limiting the scope of technology transfer to foreign affiliates to include only non-essential parts of the production process Limiting dependence on any single partner

Types of Exposure
Transaction Exposure & Translation Exposure

Economic Exposure & Operating Exposure

Transaction & Translation Exposure

Arises due to impact of exchange rate movement on firms future contractually committed cash flows.