FOREIGN EXCHANGE RISK MANAGEMENT

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

FOREIGN EXCHANGE RISK Foreign Exchange Risk refers to the adverse effects that unanticipated exchange 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 is here on unexpected changes, as anticipated changes in 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 changes in exchange rate.

MEASUREMENT OF EXPOSURE AS THE SLOPE OF REGRESSION LINE The changes in the value of asset and liabilities (V) are affected by the unanticipated changes in exchange rate (S)  V = f ( S)  V =  +  S + UT Where, V = Changes in the value of asset and liabilities, and S = Unanticipated changes in exchange rate

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 liabilities, and S = Unanticipated changes in exchange rate

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   * 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 a transaction or the proceeds from a transaction in terms of domestic currency may change due to changed in exchange rate.

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 firm’s 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 a firm’s foreign currency denominated 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 statements denominated in the currency of the parent company.

METHODS OF TRANSLATION * Current / Non-Current Method * Monetary/ Non-Monetary Method * Temporal Method * Current Rate Method

BASIC CHARACTERISTICS OF DIFFERENT TYPES OF EXPOSURE Time Span Nature Change in Exchange Rate Translation Past Paper Nominal Transaction Present and future Cash Flow Nominal/ Real Economic Future Jyggtgg ygtv tvv bvy bv

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

OBJECTIVES OF HEDGING POLICY * To be conservative or aggressive. * 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 a 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 management technique, simply involves increasing prices to allow for expected changes in exchange rates.

INVOICING IN FOREIGN CURRENCY Invoicing in a particular currency to reduce the risk associated with invoicing in 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 be measured with precision. Firms are already hedged.

SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK (CONTD.…….) We invoice only in local currency. 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.

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