MANAGING

FOREIGN
EXCHANGE RISK
BFS OCT 2022
 OVERVIEW
 DEFINING RISK
 UNDERSTAND HOW EXCHANGE RISK ARISES – TRANSACTION,
TRANSLATION, ECONOMIC EXPOSURE
 WHAT CAN YOU DO ABOUT RISK ? AVOID, SHARE, TRANSFER, OFFSET,
DIVERSIFY, RETAIN OR SEEK
 SHOULD COMPANIES HEDGE EXCHANGE RATE RISK ? SHOULD
INDIVIDUALS?
 HEDGING USING SIMPLE PRODUCTS – OFFSETTING CCY RISK, SPOT FX,
FORWARD FX, LIGHTLY STRUCTURED FX FWDS, CURRENCY SWAPS,
PROGRAMMED HEDGING
 HEDGING USING LIGHTLY STRUCTURED OPTIONS – RANGE FORWARD,
VANILLA OPTIONS – NO NET PREMIUM TO BE RECEIVED
 HEDGING USING EXOTIC OPTIONs – INCLUDING ZERO COST STRUCTURES
AND NET PREMIUM RECEIVING STRUCTURES
 DEFINING CCY RISK

 CCY RISK IS THE IMPACT (POSITIVE OR NEGATIVE) OF MOVEMENTS OF

FOREIGN EXCHANGE RATES ON ONE OR MORE OF THE BELOW

REVENUE (COSTS)
MARKET VALUE
BOOK VALUE
COMPETITIVE SITUATION
STRATEGIC DECISIONS
PUBLIC POLICY AND POLITICAL OUTCOMES (e.g SRI LANKA TODAY, INDIA IN
2013, ASIA IN 1997, BRAZIL IN 2001)

INDIVIDUALS, COMPANIES, INVESTORS, GOVERNMENTS, REGIONS,

CATEGORIES (EM for example) CAN ALL FACE CCY RISK
Examples of fx rate moves – different types of moves
USD INR YEARLY SINCE 1992
BBDXY – THE USD INDEX
BBDXY - GRAPH
THE BASKET – WHO GETS IN AND HOW DO YOU WEIGHT IT
THE REAL EFFECTIVE EXCHANGE RATE (REER) FOR ASIA
THE REAL EFFECTIVE EXCHANGE RATE (REER) FOR INDIA – 2010=100
BIG MAC PPP
REVISITING INR “WEAKNESS”
INR PPP
USD CNY
CROSS RATES – WHY DO THEY MATTER – AN EXAMPLE OF CNY/JPY
NON DELIVERABLE FORWARDS
 Types of exchange rate regimes – and associated

 Freely floating – sort of (EUR/USD, GBP/USD, USD/JPY)

 Managed floating – against what? (INR, SGD, CNY)
 Pegged – one rate or a band – why and who do you peg against ? What do you give up ?
(AED, HKD, SAR)
 The impossible trilemma
 Concept of financial conditions or monetary conditions ….
Goldman Sachs | Insights - The Case for a Financial Conditions Index
What do forward points mean in a pegged currency
 Euro

 The Euro is the currency used by 19 of the 27 countries of the EU. What is special about
the Eur?

The euro is managed and administered by the Frankfurt-based 

European Central Bank (ECB) and the Eurosystem (composed of the 
central banks of the eurozone countries).

As an independent central bank, the ECB has sole authority to set 

monetary policy.

 SO, IS THE EURO A LOCAL CURRENCY OR FOREIGN CURRENCY FOR THE

19 COUNTRIES THAT USE IT ? WHY IS THIS DISTINCTION IMPORTANT?
 What drives ccy rates – expected vs unexpected changes

 PPP
 Current account status
 Dependency on overseas financing (linked to above)
 Commodity prices – Rouble for example
 Real rates
 Policy
 Contagion
 Change of regime – economic, monetary or political
 EWIs
 DEFINING CCY RISK

 CURRENCY RISK IS BROADLY CLASSIFIED INTO THREE TYPES

 TRANSACTION EXPOSURE / RISK

 TRANSLATION EXPOSURE / RISK (aka ACCOUNTING RISK OR B/S RISK)
 ECONOMIC EXPOSURE / RISK
 DEFINING CCY RISK

 CURRENCY RISK IS BROADLY CLASSIFIED INTO THREE TYPES

 TRANSACTION EXPOSURE / RISK

 THE RISK THAT CURRENCY MOVEMENTS CAN AFFECT SPECIFIC FUTURE

PAYMENTS OR RECEIPTS DESIGNATED IN A FOREIGN CURRENCY

 This is usually clearly visible, like a foreign currency borrowing, or a foreign supplier
needing to be paid in their currency. This is recognized by most CFOs. However, it can be
misleading in terms of size or even direction, and is often poorly understood, measured,
monitored and managed
 DEFINING CCY RISK

 CURRENCY RISK IS BROADLY CLASSIFIED INTO THREE TYPES

 TRANSLATION EXPOSURE

The risk that balance sheet assets and liabilities in a currency different from the ”functional”
currency (usually the currency in which the books of accounts are prepared and/or the currency
of the jurisdiction in which the shares are listed) can change in value from one reporting date to
another due to change in the value of the functional currency

IS THIS A REAL RISK ? SHOULD COMPANIES MANAGE THIS ?

 DEFINING CCY RISK

 CURRENCY RISK IS BROADLY CLASSIFIED INTO THREE TYPES

 ECONOMIC EXPOSURE

THIS IS BY FAR THE MOST SIGNIFICANT, OFTEN HIDDEN, POORLY UNDERSTOOD,

HARDEST TO MANAGE EXPOSURE – THE RISK THAT THE FUTURE REVENUES / COSTS,
COMPETITIVE POSITION, STRATEGIC STRENGTHS AND WEAKNESSES MAY BE
AFFECTED BY CHANGES IN FOREIGN EXCHANGE RATES

THE RELEVANT FX RATES MAY BE YOURS, YOUR CUSTOMERS, COMPETITORS,

SUPPLIERS, VENDORS, INVESTORS, FUTURE COMPETITORS ……

 RISK MANAGEMENT REQUIRES YOU TO UNDERSTAND NOT ONLY THE EXPOSURE BUT ALSO
YOUR ABILITY TO BEAR IT – AND THIS CAN BE DIFFERENT FOR DIFFERENT COMPANIES
AND DIFFERENT FOR DIFFERENT PARTS / PRODUCTS OF THE SAME COMPANY
 RISK MANAGEMENT - DEFINITION

 Which is more risky ? A fixed rate mortgage or a floating rate mortgage?

 A fixed rate bond or a floating rate bond ?
 A foreign currency payable or a local currency payable?

 When you hedge any of the above risks, do you reduce risk ?

RISK MANAGEMENT IS ABOUT TRANSFORMING THE RISK

YOU ARE GIVEN INTO THE RISK THAT YOU WANT – IT IS NOT
ABOUT RISK REDUCTION PER SE
 RISK MANAGEMENT

 WHAT CAN YOU DO ABOUT CCY RISK ? SHOULD YOU DO SOMETHING AS A

BUSINESS ? WHAT DO SHAREHOLDERS WANT ? CAN YOU DO IT BETTER THAN THEM
? DOES THE ANSWER DEPEND ON THE TYPE OF EXPOSURE ?
 RISK MANAGEMENT BEGINS WITH IDENTIFICATION. THEN YOU HAVE A
RECURSIVE PROCESS INCLUDING, MEASUREMENT, SETTING A RISK APPETITE,
MONITORING, AND EXECUTING HEDGES, FOLLOWED BY REVIEW OF EXPOSURE
AND EFFECTIVENESS OF HEDGE

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

 REMEMBER THAT JUST BECAUSE SOMETHING IS A MARKET RISK, DOES NOT MEAN
THAT IT HAS TO BE MANAGED THROUGH MARKET PRODUCTS. UNDERSTANDING
THE ABILITY TO BEAR RISKS IS CRUCIAL TO RISK MANAGEMENT

 E.g, NISSAN VS MERCEDES, TOYOTA (LEXUS VS COROLLA), GLAXO (PATENT

PROTECTED VS NOT PROTECTED), APPLE VS A SUPPLIER, GE MEDICAL VS A HP
 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

 HOW DO YOU AVOID RISK ?

IS IT REALLY POSSIBLE TO AVOID CURRENCY RISK ? ESP A SME, OR EVEN A

LARGE CORPORATE IN INDIA, EM, CHINA, SMALL DM, LARGE DM ?
 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

AN EXAMPLE OF SHARING RISK – AUTOMATIC REPRICING ?

 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

ARE YOU TRASFERRING OR EXCHANGING IT FOR A DIFFERENT RISK ? WHO CAN YOU
TRASNFER IT TO ?

 SUPPLIERS - IS INVOICING IN LOCAL CURRENCY AN ANSWER

(YOU ARE A LOCAL RETAILER IN INIDA, IMPORTING TELEVISIONS FROM SONY)

CUSTOMERS – INVOICING IN YOUR LOCAL CURRENCY - “THE BILLING IS ALL IN

RUPEES”……
THIRD PARTY RISK TAKERS / WAREHOUSERS (LIKE BANKS)
SHAREHOLDERS – HOW ?
 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

BY CREATING ASSETS AND LIABILITIES IN MATCHING CURRENCIES ?

DO YOU USE THE CURRENCY OF DENOMINATION OR THE CURRENCY OF

DETERMINATION

THE CONCEPT OF A CURRENCY MAP

EXAMPLE OF HSBC’S DESIRE TO MINIMISE RISK TO CAPITAL RATIOS BY CCY

MANAGING TRANSLATION
EXPOSURE – TRANSFER TO
SHAREHOLDERS AND
OFFSET RISKS TO CAPITAL
RATIOS
 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

BY HAVING ASSET AND LIABILITIES, SUPPLIERS, CUSTOMERS AND INVESTORS

IN MULTIPLE CURRENCIES ? IS THIS ALWAYS FEASIBLE ? WHAT IS TRUE
DIVERSIFICATION – HOW DOES IT WORK IN THEMATIC SCENARIOS – LIKE ASIAN
CRISIS, TAPER TANTRUM, OR NOW, WHEN THE DOLLAR IS GOING UP AGAINST
PRETTY MUCH EVERY CURRENCY ?
 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

LARGE COMPANIES, WITH MULTIPLE CURRENCIES CAN CHOOSE TO RUN AN

INTERNAL TREASURY, RELYING ON THEIR OWN ABILITY TO SELF-INSURE,
OFFSET, RISK MANAGE USING FINANCIAL PRODUCTS TO MANAGE CURRENCY
RISKS EITHER AS A COST / PROFIT CENTRE – E.G. ABB, AMAZON, APPLE, MANY
BANKS
 RISK MANAGEMENT…..

 WHAT CAN YOU DO ABOUT RISK ?

 AVOID, SHARE, TRANSFER, OFFSET, DIVERSIFY, RETAIN OR SEEK

GO BACK TO THE DEFINITION OF RISK MANAGEMENT AS RISK

TRANSFORMATION. SEEKING A DESIRED RISK PROFILE IS AN EXTENSION OF
RETAIN … AND MOST LARGE BANKS AND MNCs WILL SEEK TO CREATE THIS
THROUGH BOTH MARKET AND NON-MARKET METHODS
 FINANCIAL PRODUCTS

MARKETS PRODUCTS TO MANAGE CCY RISK INCLUDE

SPOT
FORWARDS,
LIGHTLY STRUCTURED FORWARDS (for example, with a window for maturity,
cancellable at a known cost, leaving exposure open within a range etc)
CURRENCY SWAPS (WE WILL COVER THIS AS PART OF SESSIONS 9-11)
VANILLA OPTIONS / PACKAGES – INCLUDING THOSE INVOLVING THE HEDGER
RECEIVING NET PREMIUM – WHAT DOES THIS MEAN
EXOTIC OPTIONS – ASIAN OPTIONS, KNOCK-OUTS / INS, DIGITAL OPTIONS,
COMPOUND OPTIONS
Some recommended reading