You are on page 1of 42

Chapter 12

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

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

12-2

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

Definitions of risk (cont.)


The origin of the word risk is either the Arabic risq or
the Latin risicum

(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

Definitions of risk (cont.)


In finance, a distinction is made between risk and
uncertainty
In finance, risk is measured by the dispersion around
the mean value of the rate of return, the cost of
borrowing, the value of assets and liabilities, etc.

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

12-5

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

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

12-6

Rate of return
Vt 1

R V
1
Vt
V SV

R (1 S )(1 V ) 1

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

12-7

Measuring risk: probability distribution

E ( R)

n
pi ( Ri )
i 1

( R)
2

n
pi
i 1

Ri E ( R) 2

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

12-8

Measuring risk: historical data


1
R
n

t 1

1
2
(R)
n 1

( Rt R )2

t 1

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

12-9

Measurement of VAR
Measurement unit (e.g. AUD)
Time horizon (one day, one week, etc.)
Probability (1-5%)

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

12-10

Implementation of VAR analysis


Parametric (analytical) approach
Historical approach
Simulation approach

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

12-11

The parametric approach


The approach is based on the assumption of the
normality of rates of return

(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

The parametric approach (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

12-13

The historical approach


VAR with a certain probability is calculated from the
lower nth percentile of historical observations on the
rate of return

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

12-14

VAR: pros
It is simple
It is suitable for risk-limit setting and performance
measurement
It can take account of complex movements

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

12-15

VAR: cons
It can be misleading
VAR estimates are highly sensitive to the underlying
assumptions
It cannot cope with sudden or sharp changes

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

12-16

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

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

12-17

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

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

12-18

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

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

12-19

The slope of the exposure line


V S
where is the slope of the exposure line. is
positive (negative) for assets (liabilities)

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

12-20

Long and short exposures


Long exposure
Short exposure

assets
liabilities

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

12-21

Combined exposure
A combined exposure arises when a firm holds both
foreign assets and foreign liabilities

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

12-22

The relation between FX risk and exposure

2 (V ) 2 2 ( S )

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

12-23

Multiple exposure
Exposure to more than one currency:

V 0 1S ( x0 / x1 ) n S ( x0 / xn )

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

12-24

The volatility of the AUD exchange rates


The standard deviations of monthly percentage
changes in exchange rates

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

12-25

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

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

12-26

Transaction exposure (examples)


Foreign assets or liabilities that are already recorded
on the balance sheet
A contract or an agreement involving a future foreign
currency cash flow

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

12-27

Volatility and correlation


Exposure to a currency that fluctuates sharply is
more of a source of concern
Exchange rate correlations are important

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

12-28

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

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

12-29

Measurement of economic exposure


Economic exposure cannot, in general, be known
accurately in advance
It can be estimated from a regression equation
relating changes in cash flows to changes in
exchange rates

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

12-30

Translation (accounting) exposure


Translation exposure arises from the consolidation of
foreign currency assets, liabilities, net income and
other items
Conversion may produce gain or loss

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

12-31

Translation rates
Closing (current) rate
Average rate
Historical rate

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

12-32

The closing rate


The closing rate (or current rate) is the rate
prevailing at the end of the accounting period (that is,
coinciding with the balance sheet date)

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

12-33

The average rate


The average rate is the average value of the
exchange rate over the accounting period
The simplest procedure is to take a simple average
of the closing rate and the rate prevailing at the
beginning of the period. Otherwise, a time-weighted
average may be used

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

12-34

The historical rate


The historical rate is the rate prevailing on the date
when an asset is acquired or a liability is committed
The historical rate may therefore fall outside the
current accounting period. In fact, this is invariably
the case for long-term assets and liabilities

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

12-35

Translation methods

Current/non-current method
Closing (current) rate method
Monetary/non-monetary method
Temporal method

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

12-36

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

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

12-37

Closing (current) rate method


Assets and liabilities are translated at the exchange
rate prevailing at the end of the accounting period

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

12-38

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

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

12-39

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

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

12-40

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

12-41

Some principles (cont.)


Non-transaction gains and losses are represented by
changes in reserves
Transaction gains and losses from a hedge are
accounted for by movements in reserves or are
reported on the income statement

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

12-42

You might also like