Professional Documents
Culture Documents
Foreign Exchange
Risk and Exposure
Objectives
To define risk and exposure
To elaborate on the concept of value at risk (VAR)
To distinguish among transaction, economic and
translation exposure
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Definitions of risk
The chance of bad consequence, loss, etc.
(The Concise Oxford Dictionary)
The possibility of loss, injury, disadvantage or
destruction (Websters Dictionary)
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
12-3
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
12-4
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FX risk
FX risk arises because of uncertainty about the
future spot exchange rate
It refers to the variability of the domestic currency
value of certain items resulting from the variability of
the exchange rate
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Rate of return
Vt 1
R V
1
Vt
V SV
R (1 S )(1 V ) 1
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E ( R)
n
pi ( Ri )
i 1
( R)
2
n
pi
i 1
Ri E ( R) 2
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t 1
1
2
(R)
n 1
( Rt R )2
t 1
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Measurement of VAR
Measurement unit (e.g. AUD)
Time horizon (one day, one week, etc.)
Probability (1-5%)
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(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
12-12
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VAR: pros
It is simple
It is suitable for risk-limit setting and performance
measurement
It can take account of complex movements
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VAR: cons
It can be misleading
VAR estimates are highly sensitive to the underlying
assumptions
It cannot cope with sudden or sharp changes
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VAR: conclusion
VAR is useful but it should be handled with care and
used in conjunction with other measures of risk
Confidence in VAR has been undermined by the
global financial crisis as the VAR models used by
financial institutions failed to predict the losses that
they actually endured
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Exposure
Risk measures the probability and magnitude of
deviation from some expected outcome
Exposure is a measure of the sensitivity of what is at
risk to the source of risk
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FX exposure
Exposure to FX risk is a measure of the sensitivity of
the domestic currency value of FX items to changes
in the exchange rate
Sometimes it is defined as the amount at risk
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assets
liabilities
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Combined exposure
A combined exposure arises when a firm holds both
foreign assets and foreign liabilities
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2 (V ) 2 2 ( S )
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Multiple exposure
Exposure to more than one currency:
V 0 1S ( x0 / x1 ) n S ( x0 / xn )
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Transaction exposure
Transaction exposure arises if payables and
receivables are denominated in foreign currencies. It
is a cash flow exposure associated with trade and
capital flows
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Economic exposure
Changes in exchange rates affect the firms noncontractual or unplanned cash flows
It refers to future changes in earning power as a
result of changes in exchange rates
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Translation rates
Closing (current) rate
Average rate
Historical rate
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Translation methods
Current/non-current method
Closing (current) rate method
Monetary/non-monetary method
Temporal method
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Current/non-current method
According to this method, current items are
translated at the closing rate, whereas long-term
items are translated at the historical rate
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Monetary/non-monetary method
Monetary items (such as bonds) are translated at the
closing rate, whereas non-monetary items (such as
real estate) are translated at the historical rate
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Temporal Method
According to the temporal method, the use of the
closing rate or the historical rate is determined by the
valuation of the underlying item
The closing rate is used for items stated at
replacement cost, realisable value or market value
The historical rate is used for all items stated at
historical cost
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Some principles
Translation of balance sheet items is based on the
closing rate
Transaction gains and losses are accounted for in
the income statement
(cont.)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
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