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Foreign Exchange Risk

PRESENTED BY
SUCHISMITA PATI
ANITA KULLU
&
PRITI RAGINI
CONTENTS

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Foreign Exchange Risk
‡ Foreign exchange risk is the risk that the
value of an asset or liability will change
because of a change in exchange rates.
‡ Because these international obligations span
time, foreign exchange risk can arise.
Sources of Risk
‡ Transaction Exposure
‡ Translation Exposure.
‡ Economic Exposure
Basic risk in forex markets
‡ Currency rates speculation
‡ Risk in market arbitrage
‡ Risk associsted with forex instruments
‡ Determination of forex rates
‡ Economic factors
‡ Political factors
‡ Market psyhcology
Dealers in forex martket
‡ Banks
‡ Central banks
‡ Commercial companies
‡ Investment firms dealing woth forex
‡ Hedge fund as speculators
‡ Non bank foreign exchange companies
Hedging and Speculating
‡ Hedging is the act of offsetting an exposure
to risk.
‡ Speculation generates and exposure to risk.
Long and Short Positions
‡ One is m  in a foreign currency if the
value of their foreign-currency-denominated
assets exceeds the value of their foreign-
currency-denominated liabilities.
‡ One is   in a foreign currency if the
value of their foreign-currency-denominated
assets is less than the value of their foreign-
currency-denominated liabilities.
Speculation in forex markets
generating risk
Too much exposure to speculation
rather than hedging
Open margins are more and limiting
losses positions are very few
speculation

The "classical" definition of speculation comes from


Kaldor (1939), p. 1:"Purchase (or sale) of goods with a
view to re-sale (or re-purchase) at a later date, where the
motive behind such action is the expectation of a change
in the relevantprices relatively to the ruling price and not
a gain accruing through their use, or any kind of
transformation effected in them or their transfer between
different markets."
Types of speculation

Fundamental and non fundamental


speculation
Long term and short term specualtion
 m 
 m  


 
  
‡ therotical problems
‡ Emperical problems
Forward Exchange Contracts

The market for future delivery of a


currency.
Forward Market
‡ The forward market is the market for the future
delivery of a currency.
‡ Typical maturity is 1,3,6, 9 and 12 months.
‡ The forward rate is determined by market
participants¶ expectations of the future spot
value of the currency which, in turn, depends on
other economic variables.
‡ Hence, the forward market may provide some
information about future spot price movements.
Forward Premium
‡ The difference between the spot and
forward rates is expressed as the standard
(or annualized) forward premium or
discount.
‡ The standard premium is calculated as the
difference between the two rates as a
percent of the spot rate, and then annualized
(simple basis).
Example
‡ For example, suppose the spot rate is 1.6035
($/£) and the 3-month forward rate is
1.6050.
‡ The forward premium on the pound is:
[(1.6050-1.6035)/1.6035]*(12/3)*100 =
0.37%
International Interest Arbitrage
‡ Taking advantage of interest rate
differentials.
‡ ³Borrow Low - Lend High´
‡ Covered interest arbitrage involves the use
of a forward contract.
The Demand for
Foreign Currency Assets

‡ Profit Opportunities
‡ Liquidity
‡ Market Trend
‡ Leverage

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Risk associated with
currency trading
DEPENDS ON HOW YOU VIEW
RISK .
CURRENCY TRADING AS
USUALLY REFEREED AS
MAKING MONEY ON MONEY IS
A GOOD OPTION IF U ARE
CRACKING FOR RISK
Managing currency risk

hedging
What Is currencyHedging?
Forward Market Hedges:
Objective: To nullify future spot rate

II Situations:

1. Expected Inflows of Foreign Currency:


Example: A US firm is expected to receive 200,000 UK
pound in 60 days from a UK buyer. UK pound may
depreciate against US $ in 60 days.

What to Do for offsetting the risk of receiving less


amount of US $?
Make forward contracts to sell the foreign currency at a
specified rate to insulate against depreciation of value of
that foreign currency (in terms of home currency).
2. Expected Outflows of Foreign Currency:
Example: A US firm will have to pay 400,000
Euros in
30 days to a German seller. Euro may
appreciate against US $ in 30 days.
What to do for offsetting the risk of
spending more US $?
Make forward contracts to buy the foreign
currency at a specified rate to insulate against
appreciation of value of the currency (in
terms of home currency).
International Interest Arbitrage
‡ Taking advantage of interest rate
differentials.
‡ ³Borrow Low - Lend High´
‡ Covered interest arbitrage involves the use
of a forward contract.
Risk associated with
currency trading
DEPENDS ON HOW YOU VIEW
RISK .
CURRENCY TRADING AS
USUALLY REFEREED AS
MAKING MONEY ON MONEY IS
A GOOD OPTION IF U ARE
CRACKING FOR RISK
Managing currency risk

hedging
What Is currencyHedging?
Risk asociated with dollar
trading
The fluctuation in dollar movement
for past two years
PART II
RISK ASSOCIATED WITH
FOREX DERIVATIVES
Forex derivatives an
important risk control
vehicle
So where does the risk lies?
derivative is a a security, like an option
or asset, whose value is subject to
change due to adjustments in the
underlying variables on which is it
based. Forex derivatives typically
include currencies, commodities, bonds
and equities.
There are several types of derivatives:
forwards, futures, and option
MUCH MORE PRONE TO
EXCHANGE RATE
FLUCTUATION
HAD TO BE CONTINOUS
SWITCH BETWEEN LONG AND
SHORT POSITIONS
Risk of forex arbitrage
Arbitrage problems

Difficult to track price in efficency


Feasiblity of arbitrage opportunities
Slippage problem
Market movement: too fast or too
slow
Crash between arbitrage
hedging and speculation
Risk of forex leverage

Take a look at the chart summary below:


Stock Market provides leverage at 2:1.
Commodities market provides leverage at 10:1.
Currencies market provides leverage at 100:1 (or
200:1).
Over leveraging : the risk of
forex leverage

@   
   
@ 
  

  m

   

     
 m

400:1 0.25%
200:1 0.50%
100:1 1.00%
50:1 2.00%


 
 m

   
  
   

 
  m $10,000 $10,000

 m
   
  50 times 5 times

  m
 m

    $500,000 $50,000



 



  -$4,150 -$415


 

 
  m 41.5% 4.15%



 
  m

58.5% 95.8
  
Limiting losses

SAR TECHNIQUE
2 PERCENT LIMIT LOSS
6 PERCENT LIMIT LOSS