FOREIGN EXCHANGE

RISK MANAGEMENT

FOREIGN EXCHANGE
RISK
Foreign Exchange Risk is the risk
of loss due to changes in the
international
currencies.

value

of

national

FOREIGN EXCHANGE
RISK
Foreign Exchange Risk refers to
the

adverse

unanticipated

effects
exchange

that
rate

changes can have on the value of

the firm.

FOREIGN EXCHANGE
RISK (CONTD..)
Foreign Exchange Risk is the risk
that the value of a future receipt
or obligation will change due to a
change in foreign exchange rate.

THE EMPHASIS IS ON
UNEXPECTED AND NOT
ANTICIPATED
The

emphasis

unexpected
anticipated

is

here

changes,
changes

in

on
as
the

foreign exchange rate including

all other available information
are already reflected in market
prices.

ORIGIN OF FOREIGN
EXCHANGE RISK
Exchange risk originates from the
(random) fluctuations of foreign
exchange rates.

FOREIGN EXCHANGE
EXPOSURE
Foreign Exchange exposure refers
to the possibility that a firm will
gain or lose due to changes in
exchange rates.

FOREIGN EXCHANGE
RISK V/S EXPOSURE
Foreign

exchange

exposure

quantifies the sensitivity of the

value of asset, liabilities and
operating income with respect
to exchange rate variations.

MEASURE OF FOREIGN
EXCHANGE EXPOSURE
Exposure can be measured by the
slope coefficient in a regression
equation relating the real change
in

the

dollar

value

of

asset,

liabilities, or operating incomes to

unanticipated
exchange rate.

changes

in

MEASUREMENT OF
EXPOSURE AS THE SLOPE
OF REGRESSION LINE
The changes in the value of asset and
liabilities

(V)

unanticipated

are

affected

changes

in

by

the

exchange

rate (S)
V =

f ( S)

V =

+ S + UT

Where,
V = Changes in the value of asset and
liabilities, and

MEASUREMENT OF
EXPOSURE AS THE SLOPE OF
REGRESSION LINE (CONTD..)
Exposure

is

measured

by

the

sensitivity of the relationship between

S and V.
Estimating exposure =

COV. (V, S)
VAR. S

Where,
V = Changes in the value of asset and

FOREIGN EXCHANGE
RISK V/S EXPOSURE
Exchange rate volatility is
by itself a necessary, but not
sufficient condition for foreign
exchange risk.
*

*
What is required is to
assess
foreign
exchange
exposure.

TYPES OF EXPOSURE
*

Transaction Exposure
Translation Exposure
Economic Exposure

TRANSACTION
EXPOSURE
Transaction Exposure is concerned
with how changes in exchange
rates affect the home currency
value

of

anticipated

foreign

currency denominated cash flows

relating

to

transactions

which

have already been entered into.

TRANSACTION
EXPOSURE (CONTD..)
The

risk

that

the

cost

of

transaction or the proceeds from

a transaction in terms of domestic
currency

may

change

changed in exchange rate.

due

to

ECONOMIC EXPOSURE
*
Economic Exposure relates to
the possibility that the present
value of
future cash flows of a
firm may
change due to foreign
currency
movements.
*
The risk that changes in
exchange
values might alter a
firms present
value of future
income streams.

TRANSLATION
EXPOSURE
Translation exposure also known as
accounting exposure is that risk which
results from the conversion of the
value

of

denominated

firms

foreign

currency

assets and liabilities

into a common currency value.

TRANSLATION
EXPOSURE (CONTD..)
Translation Exposure arises as a result
of

the

process

of

consolidation

of

foreign currency denominated items

into

group

financial

denominated in the
parent company.

statements

currency of the

METHODS OF
TRANSLATION
*

Current / Non-Current Method

Monetary/

Non-Monetary

Method
*

Temporal Method

Current Rate Method

BASIC CHARACTERISTICS
OF DIFFERENT TYPES OF
EXPOSURE
Exposure

Translation

Time
Span
Past

Nature

Change in
Exchange
Rate

Paper

Nominal

Transaction Present
and
future

Cash Flow

Nominal/
Real

Economic

Cash Flow

Real

Future

HEDGING FOREIGN
EXCHANGE RISK
Hedge is an approach designed to
reduce or offset a possible risk.

OBJECTIVES OF
HEDGING POLICY
*
To
be
aggressive.

conservative

or

*
Decide
the
appropriate
performance measure.
*
The time horizon framework
also to considered.

TECHNIQUES OF
HEDGING FOREIGN
EXCHANGE RISK
Two ways of looking at the
techniques
of
exposure
management
1. Exposure based on techniques
of risk
management
2. Internal
V/s
External
techniques
Internal Techniques
External Techniques

EXPOSURE BASED
TECHNIQUES
OF RISK MANAGEMENT
*

Hedging Translation Exposure

Hedging Transaction Exposure

Hedging Economic Exposure

HEDGING TRANSLATION
EXPOSURE
The technique used to hedge
translation exposure is balance
sheet hedge.
It involves the
selection of the currency in which
exposed assets and liabilities are
denominated so that an exchange
rate would make exposed assets
equal to exposed liabilities. Same
level of exposed assets and
liabilities should be maintained.

HEDGING TRANSACTION
EXPOSURE
Forward Market Hedge
Money Market Hedge
Options Market Hedge
Swap Market Hedge

HEDGING ECONOMIC
EXPOSURE
Diversity Production

Diversity Marketing

Diversity Financing

INTERNAL V/S
EXTERNAL TECHNIQUES
*

Internal Techniques

External Techniques

INTERNAL TECHNIQUES OF
FOREIGN EXCHANGE
EXPOSURE
Internal techniques of managing
foreign exchange exposure are
those which do not resort to
special contractual relationship
outside the group of companies
concerned.

INTERNAL TECHNIQUES OF
MANAGING FOREIGN
EXCHANGE EXPOSURE
*

Netting

Matching

Leading and Lagging

Pricing Policy

Invoicing in Foreign Currency

NETTING
Netting

involves

associated

companies that trade with each

other. Associate companies simply
cancel out amount owned with
amounts due and settle for the
difference.

Bilateral Netting

Multi-lateral Netting

MATCHING
Netting

is

term

applied

to

potential flows with in a group of

companies whereas matching can
be applied to both intra-group and
third party balancing.

LEADING AND LAGGING

Making the payment in advance or
delaying considering the future
valuation of currency.
Leading and lagging are techniques
which are resorted to in the light of
expected
evaluations
or
revaluations.
The mechanism simply involves
making an advance payment or
delaying the amount of payment.

PRICING POLICY
Pricing Policy is used as an
exposure
technique,

management
simply

involves

increasing prices to allow for

expected changes in exchange
rates.

INVOICING IN FOREIGN
CURRENCY
Invoicing in a particular currency
to

reduce

with

the

invoicing

risk
in

associated
the

host

currency when a devaluation is

expected. This may not always
help.

ASSET AND LIABILITY

MANAGEMENT
Matching the timings of cash
outflows and inflows

EXTERNAL TECHNIQUES
OF EXPOSURE
MANAGEMENT
External techniques of exposure
management resort to contractual
relationships outside of a group of
companies in order to reduce the
risk of foreign exchange losses.

EXTERNAL TECHNIQUES
OF EXPOSURE
MANAGEMENT
*

Forward

market

(forward

options)
*

Short-term borrowings.

Discounting foreign currency

denominated bills receivables.

* Factoring foreign currency

denominated receivables.

EXTERNAL TECHNIQUES OF
EXPOSURE MANAGEMENT
(CONTD..)

Currency overdrafts.

Government exchange

risk

guarantee.
*

Exchange risk guarantees.

Counter party risk (banks are

involved).

SHOULD FIRMS
MANAGE FOREIGN
EXCHANGE RISK
Some firms refrain from active
management of Foreign Exchange
Risk
even
though
they
understand that exchange rate
fluctuations
can
affect
their
earnings and value. They make
this decision for a number of
reasons.

SHOULD FIRMS MANAGE

FOREIGN EXCHANGE RISK
(CONTD..)

Managers do not take time to

understand
the
issue
and
consider
the
use
of
risk
management
tools
as
speculative.
Currency exposure cannot
measured with precision.
Firms are already hedged.

be

SHOULD FIRMS MANAGE

FOREIGN EXCHANGE RISK
(CONTD..)

We
invoice
currency.

only

in

local

Doing business is risky and

firms are rewarded for bearing
that risk.

CORPORATE HEDGING
STRATEGY
Justified on Economic Grounds.
Increases the Value of the firm as
there is an increase in expected
Cash Flows.

kp_kaushik@hotmail.com