3. Foreign Exchange Market and Management of Foreign Exchange Risk

7/24/2019 3. Foreign Exchange Market and Management of Foreign Exchange Risk

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International Finance I [CFI4102]

B.Com Finance

FOREIGN EXCHANGE MARKET AND

MANAGEMENT OF FOREIGN EXCHANGE RISK

Prepared by

Edson Mbedzi

1


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Topic Objectives

!o describe t"e #$ndamental operations o# t"e #orei%n e&c"an%emar'et.

!o e&plain t"e common met"ods $sed to determine and #orecast#orei%n e&c"an%e rates( and "o) t"ese are $sed in international*nance.

!o e&plain #actors t"at in+$ence t"e #orei%n e&c"an%e rate.

To identify the main international business exposures for MNCs;

To demonstrate how different international business exposures are determined

Understand and apply foreign exchange risk techniques that are commonly usedin managing international business exposures

2


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!"e mec"anism t"at permits international transactin% and t"e pricin%o# #orei%n e&c"an%e is t"e #orei%n e&c"an%e mar'et.

Foreign Exc!nge M!r"et

Participants are individuals, international

firms, and nonbank financial institutions.

Transactions classified as spot and

forward.

Spot transactions are for immediate

delivery, which is OTC.

Forward transactions are at a forward

rate for delivery at a designated date more

than days in the future.

Participants are local commercial

banks and large financial centre

banks.

!mmediate delivery is within

days in interbank market.

Forward transactions also apply in

the interbank market.

Trading is in large volume

transactions of "#mln or more per

trade

Trading takes place at an

organised e$change.

%ocal banks, nonbank customers

and financial centre banks allparticipate through brokers in this

market.

Transactions are for F& futures

contracts, F& Call and Put

Options.

,nli'e t"e commodity mar'et(t"is mar'et does not "a-e

p"ysical tradin% centres. Mosttransactions are done o-ert"eco$nter /!C( personal(telep"one and internetmessa%es.


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Meto#s o$ Foreign Exc!nge%&ot!tionsForei%n e&c"an%e rates /F can be o3cially $oted in t)o )ays. ,sin%

,56 as t"e "ome c$rrency.

Direct %&ot!tion7 8n amo$nt o# t"e local c$rrency /,56 e$i-alentper one $nit o# #orei%n c$rrency /e.%. 61.9 : ;.

It is also 'no)n as price $otation.

,nder direct $otation( -ariation in F rate is in-ersely related to t"e

-al$e o# t"e local c$rrency.

In#irect %&ot!tion7 8n amo$nt o# t"e Forei%n C$rrency per 1 $nit o#t"e local c$rrency /,56 /e.%. ;0.


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T'o T(pes o$ Exc!nge R!tes

Spot R!tes / B$yer and 5eller a%ree on Price /P and >$antity />#or immediate deli-ery.

For'!r# R!tes /F B$yer and 5eller a%ree on P and > #or deli-ery int"e #$t$re 1 mont"( @ mont"( < mont"s or more in t"e #$t$re.

Mar'et #orces determine bot" spot and #or)ard rates.

AB7 "en a c$rrency is e&pected to appreciate( it sells at a #or)ardpremi$m /( and )"en it is e&pected to depreciate( it sells at a #or)arddisco$nt /.

Example 1I# t"e D 100:6 and t"e 1 year F D 109:6( t"e dollar is sellin% a 9

#or)ard premi$m.For)ard Premi$m D D

!"is tells $s t"at t"e dollar is e&pected to appreciate by 9 o-er t"e ne&tyear.

'S

'S'

'

S

SF()

#''#''#') =


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Exc!nge R!te Deter)in!tion!e shall consider two time hori"ons# short$run and long$run determinants offoreign exchange rates

1. Short-Run Foreign Exchange Rate Determination Tools

%re the most difficult to predict and are often determined based on bandwagoneffects& o'erreaction to news& and speculation

a) Tren-Follo!ing "eha#iour is the tendency for the market to follow a trend (n

other words an increase in the exchange rate is more likely to be followed byanother increase

$) %n#estor Sentiment is based on the consensus of the market )or example ifthe market is bullish on the dollar& then the dollar is likely to strengthen 'ersusother currencies

c) &rer Flo! $ there is e'idence of a positi'e correlation between spot exchangerate mo'ements and& order flows in the inter$dealer market and customer currencyorder flows


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2. (ong-Run Foreign Exchange Rate Determination Tools

!*+&rc!sing +o'er +!rit( ,+++*

5tates t"at since t"e prices s"o$ld be t"e same across co$ntries( t"ee&c"an%e rate bet)een t)o co$ntries s"o$ld be t"e ratio o# t"e pricesin eac" co$ntry. 8lso 'no)n as t"e la) o# e$al prices.

elati-ePPPstates t"at t"e e&c"an%e rate )ill c"an%e to oGsetdiGerences in national in+ation rates.

i.e. i# Co$ntry 8 "as higherin+ation t"an Co$ntry B( yo$ can e&pectCo$ntry 8Hs c$rrency to depreciate-ers$s Co$ntry BHs c$rrency i#parity is to be maintained.

Exc!nge R!te Deter)in!tion

* +

, + A

B

Price of a product in Country APPP Spot rate S

Price of a product in Country B

Pwhere the spot rate S is

P

=


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Deriv!tion o$ +&rc!sing +o'er +!rit( ,+++*etHs ass$me price o# "ome co$ntry / and t"at o# t"e #orei%n co$ntry

/ are e$al and t"eir in+ation rates are and respecti-ely.

J$e to in+ation t"eir respecti-e price inde&es becomes7

PPP t"eory s$%%ests t"at )"en in+ation rates diGer bet)een co$ntries(t"e percenta%e c"an%e in #orei%n c$rrency / s"o$ld necessarily

-ary to maintain parity in p$rc"asin% po)er.

I# in+ation occ$rs in t"e #orei%n co$ntry( t"en e&c"an%e rate o# #orei%nc$rrency "as to c"an%e and t"e #orei%n price inde& becomes as#ollo)s to maintain parity7

5ol-in% #or ( )e obtain

( %i-en t"at Phand Pfare e$al and )ill cancel eac" ot"er.

!"is #orm$la s"o)s t"e relations"ip bet)een relati-e in+ation rates o#


hP fP

hI fI

,#+,#+ ffhh IPIP +=+

fe

,#,+#+,#+ fffhh eIPIP ++=+fe

#,#+

,#+

+

+

= ffhh

f IP

IP

e

#,#+

,#+

++

=f

hf

I

Ie


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+sing ,,, to Determine Exchange Rates

%ssume exchange rate is in equilibrium initially Then the home country experiencea *+ inflation rate and foreign country experiences ,+& with current spot rate at-.*/01 %ccording to 222& the foreign exchange rate will ad3ust as follows#

4 //.56 or .56+

Thus the foreign currency should appreciate by .56+ in response to the higherinflation rate of the home country relati'e to that of the foreign country

The estimated future spot rate becomes#

%s a results of the exchange rate effect& price indexes of both countries rise by *+from the home country perspecti'e& thus the purchasing power is the same forforeign and home goods


#,#+

,#+

+

+=

f

h

fI

Ie #

'-.'#+

').'#+

+

+= fe

#++ # ftt eSSE +=+,'#/.'#+)'.#",+ # +=+tSE )-.#",+ # =+tSE


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$) %nternational Fisher Eect /%FE)

!"e t"eory $ses nominal interest rate / diGerential rat"ert"an in+ation rate diGerentials to e&plain c"an%es ine&c"an%e rate o-er time.

It is closely related to PPP beca$se interest rates are o#ten

"i%"ly correlated )it" in+ation rates.

It can be deri-ed li'e t"e PPP e$ilibri$m e$ation abo-e to%i-e.

"ere and represent t"e "ome and #orei%n interest raterespecti-ely.


#,#+

,#+

+

+=

f

hf

r

re

hr fr

i


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+sing %FE to etermine F0 Rate

8ss$me t"at t"e interest rate on a one year ins$red "ome co$ntry ban'deposit is 11 and on a #orei%n co$ntry is 12. For t"e act$al ret$rns o#t"ese t)o in-estments to be similar #rom t"e perspecti-e o# in-estors int"e "ome co$ntry( t"e #orei%n e&c"an%e rate )o$ld "a-e to c"an%e o-ert"e in-estment "orizon based on t"e IFE t"eory7

-.* or -.*

!"$s t"e #orei%n c$rrency s"o$ld depreciate by 0.=K to ma'e t"eact$al ret$rn o# 12 on t"e #orei%n deposit e$al t"e 11 #rom t"eperspecti-e o# t"e in-estors in t"e "ome co$ntry. !"is )o$ld ma'e t"eret$rn on t"e #orei%n co$ntry e$al to t"e ret$rn on a domesticin-estment.


#,#+

,#+

+

+=

f

hf

r

re

##.'#+

##.'#+

+

+= fe


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c) %nterest Rate ,arit /%R,)

7tates that an exchange rate quoted today for settlement at a future date 8forwardrate premium or discount9 should be linked to interest rate differentials

!here& is the spot rate and are the annual foreign and domestic interest ratesrespecti'ely)orward rates are unbiased predictors of future exchange rates%n unbiased predictor means that :on a'erage the estimation will be wrong onthe up side or the downside with equal frequency and degree (n other words& theerrors are normally distributed


+

+

=

-0'#

-0'#

'days

xi

daysxi

SF

d

f

days

'S


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Determination o the For!ar Rate using %R,%ssume the Mexican peso exhibits a six months interest rate of


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+se o %R, to ar$itrage in %nternational FinanceThere are two ways to it#

a) o#ere %nterest-Rate ,arit >the idea that an imbalance in parityconditions can create a :risk less opportunity for a foreign exchange trader& in thiscase a corporate arbitrager

Examle%ssume the home country interest rate is ?+ pa in U7 and 6+ pa in @apanAi'en that the spot rate is B./


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1515151515

+sing o#ere %nterest Rate ,arit in %nternational Finance

-.1*.

This means the B should depreciate by //.5 to B./,5


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+sing +nco#ere %nterest Rate ,arit in %nternational Finance

$) +nco#ere %nterest-Rate ,arit $ Unco'ered interest arbitrage is great

when you are dealing with fixed exchange currencies& because the profit at the endof the period is dependant on the pre'ailing exchange rate 8and since this is:unco'ered it is a 'ery risky in'estment and therefore in free rate system& yourestimate of the forward rate must be 'ery accurate9


/895300100

/875777177


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1'1'1'1'1'1'1'

The equilibrium exchange rate will change o'er time as supply and demandschedules change

The factors that cause currency supply and demand to change are discussedbelow based on a hypothetical initial equilibrium of the Eritish pound exchange rateof -.**01 to U7 dollar& shown in figure , below

F!ctors in:&encing Exc!nge R!te

;!133

S

D

%&!ntit(o$ =

/>130

/>160

Figure 3 E8uili$rium Exchange Rate Determination

F!ctors in: encing E c!nge R!te


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1

a) Re


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1*1*

$) Re


;!137

S>

D>

%&!ntit(

/>130

/>160S

D

/>133

Figure 5 %mact o rising +S interest on E8uili$rium #alue o "ritish =



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c) Re

no correspondin% c"an%e in income in Britain. !"ere#ore( e$ilibri$m e&c"an%erate o# t"e po$nd is e&pected to rise toN say 61.9< as s"o)n on *%$re < belo).


;!133

S

D

%&!ntit(

/>130

/>160

D>

/>139

Figure 6 %mact o rising +S income le#els on E8uili$rium 9alue o "ritish =

F ti F i E R t


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212121

"y International Firms #orecast e&c"an%e rates

!"e #ollo)in% are some o# t"e corporate #$nctions #or )"ic"e&c"an%e rates #orecasts are essential7

Financin% Jecisions

In-estment Jecisions

Oed%in% Jecisions

Forec!sting Foreign Exc!nge R!te

F ti T i


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!* Tecnic!< Forec!sting

It in-ol-es $se o# "istorical e&c"an%e rate data to predict #$t$re -al$es int"e s"ortr$n period.

It "as -ery limited $se beca$se it estimates e&c"an%e rates #or t"e near#$t$re )"ic" is rarely $sed #or de-elopin% corporate policies.

,ses #actors #or s"ortterm e&c"an%e rate determinants s$c" asNtrend#ollo)in% be"a-io$r(in-estor sentiment and(order+o) by traders in t"e #orei%n e&c"an%e mar'et.

It is a per#ect #$sion o# pro#essional 'no)led%e and t"e diGerent met"odso# researc".

Forec!sting Tecni@&es

Forec!sting Tecni@&es


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$) F&n#!)ent!< Forec!sting

It is based on #$ndamental relations"ips bet)een economic -ariables /relati-einterest( in+ation( and national income and t"e e&c"an%e rate.

>* se o$ Sensitivit( An!


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2) se o$ +++ $or F&n#!)ent!< Forec!sting

ecall t"e t"eory o# PPP speci*es t"e #$ndamental relations"ip bet)een in+ation

diGerential and e&c"an%e rate( meanin% t"is t"eory can be $sed to #orecast#$t$re e&c"an%e rates.

Ex!)p


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25252525

3. :ar;et-"ase ForecastingThe process of de'eloping forecasts from market indicators and usually uses either the sotrate or the or!ar rate as its basis

ExamleThe U7 annualised fi'e$year interest rate is currently ./+ pa while the Eritish one is .,+pa and the current Eritish spot rate is -/?*


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4. :ixe Forecasting

5ince no sin%le #orecastin% tec"ni$e can be 100 acc$rate andconsistently s$perior to ot"ers( many MACs pre#er to $se -ario$stec"ni$es.

!ec"ni$es $sed are assi%ned )ei%"ts totallin% 100( )it" tec"ni$esconsidered more reliable o-er t"e period $nder consideration %i-en more)ei%"ts.

!"e act$al #orecast prod$ced becomes t"e )ei%"ted a-era%e o# t"e-ario$s #orecast tec"ni$es $sed by t"e instit$tion.

g 8

Forecasting Techni8ues


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2'2'2'2'2'2'

E#aluation o Forecast ,erormance o an :>

MACs t"at #orecast e&c"an%e rates need to monitor t"eir per#ormance o-er time

to ascertain t"at t"e #orecastin% proced$res are satis#actory.

!"is leads $s to t"e calc$lation o# t"e $orec!st error %i-en by7

Ex!)p


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it" data %i-en( $orec!st error #or t"e po$nd is7

The orecast error for the Mexican peso is#

Thus& o'er the period under study& the peso had been forecasted with less accuracy Eytracking its forecasting error o'er time& the MNC can e'aluate its forecast performance o'erse'eral periods and understand whether it has good precision for short period or o'er longperiods

>"# ue to the increasing corporate need to forecast currency 'alues& there are now se'eralindependent consulting companies which pro'ide these ser'ices& including Eusiness(nternational and !harton Gconometric )orecasting %ssociates among others

g 8

(#'#'.')'.#"

#).'"

)'.#"

)'.#"-).#"8e(

or

a!uea!isedofasErrorForecastAbso!ute

=

=

=

(''.'

#'.'"

'.'"

#'.'"

#'.'"#.'"8e(

or

a!uea!isedofasErrorForecastAbso!ute

=

=

=

Exchange Rate Sstems


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2*2*2*2*2*2*

Fixe# exc!nge r!te s(ste) ate *&ed by %o-ernment as constantor #orced to stay )it"in de*ned narro) limits.

Free


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Eac" co$ntry "as a %o-ernment a%ency /t"e central ban' t"at mayinter-ene in t"e #orei%n e&c"an%e mar'et to control t"e -al$e o# t"e

co$ntryHs c$rrency.

In t"e ,nited 5tates( t"e Federal eser-e 5ystem /Fed is t"e centralban' and in Rimbab)e is BR.

Central banks manage exchange rates

to smoot" e&c"an%e rate mo-ements(to establis" implicit e&c"an%e rate bo$ndaries( and:orto respond to temporary dist$rbances.

#ten( inter-ention is o-er)"elmed by mar'et #orces( inter-entioneGorts may "a-e little impact.

Oo)e-er( c$rrency mo-ements may be e-en more -olatile in t"eabsence o# inter-ention.

@o#ernment %nter#ention in the Exchange Rate


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Direct intervention

e#ers to t"e direct in-ol-ement by t"e co$ntryHs central ban' in t"e#orei%n e&c"an%e mar'et to p$s" t"e price o# t"e local c$rrency todesired le-els.

P$rc"ase and sell o# #orei%n reser-es

B$yin% and sellin% %o-ernment sec$rities e.%. So-ernments bonds(M etc

In#irect intervention!"is in-ol-es central ban' in+$encin% #$ndamental #actors t"atdetermine t"e -al$e o# t"e c$rrency to optimal le-els.

Interest rateIn+ationIncome le-els

:ar;et


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Foreign Exc!nge Expos&reMe!s&re)ent !n# M!n!ge)ent

33

Foreign Exc!nge Expos&re


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Concept o# e&pos$re re#ers to t"e e&tent to )"ic" t"e b$siness o# an MAC isaGected by #orei%n e&c"an%e rate.

T(pes o$ Expos&res

E&pos$res ta'e t"ree #orms( namely translation /acco$ntin% e&pos$re(transaction e&pos$re and economic e&pos$re.

!* Tr!ns

Re!sons-

/i Taxes in the parents home country on income earned by the foreignsubsidiary are payable in home currency.

/ii Most co$ntries re$ire consolidation o# t"e parentsH and s$bsidiaryHsnancial statements for nancial reporting purposes.

/iii 8 *rm needs to consolidate data in order to make investment and nancialdecisions.

/i- In order to ma'eperformance measures comparable. Jecisions topromote or *re mana%ers are also based on per#ormance.

/- !o -al$e t"e entire *rm. 34

Meto#s o$ Tr!ns


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Meto#s o$ Tr!ns1 C&rrentBNonc&rrent Meto#

,nder t"is met"od( all #orei%n s$bsidiary c$rrent assets and liabilities are translatedinto t"e "ome c$rrency at t"e c$rrent e&c"an%e rate( )"ile nonc$rrent assets and

liabilities are translated at "istorical e&c"an%e rate /rate applyin% )"en ac$ired orinc$rred.

1 Monet!r(BNon)onet!r( Meto#

!"is met"od separates monetary assets and liabilitiesN t"ose items representin% cas"claim to recei-e or obli%ation to pay( s$c" as cas"( acco$nts payables and

recei-ables( and lon%term debt are all translated at c$rrent rate( )"ere asnonmonetary items li'e in-entory( *&ed assets and lon%term in-estments are

translated at "istorical rates.

71 Te)por!< Meto#

5ame as t"e monetary:nonmonetary met"od e&cept #or t"e treatment o# in-entory.,nder t"is met"ods it is translated at c$rrent )"ene-er it appears in t"e balances"eet at c$rrent mar'et -al$e.

41 C&rrent R!te Meto#

In t"is met"od( all balance s"eet and income items are translated at t"e c$rrent rate.

35

HC U7- before Monetar 0 Temporal C rrent0 C rrent

Financial Statements %mact o Translation :ethos /+S) ollo!ing a 25 ereciation o local currenc


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HC U7- before

change of )D

HC6 4-.

Monetary0

Nonmonetary

HC* 4-.

Temporal

HC6 4-.

Current0

Noncurrent

HC* 4-.

Current

HC* 4-.

7ssets

Current %ssets

Cash F&


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!"e de%ree to )"ic" t"e -al$e o# #$t$re cas" transactions /cas" in+o)s to berecei-ed or cas" o$t+o)s to be paid can -ary d$e to e&c"an%e rate +$ct$ationso# $nderlyin% c$rrencies is transaction e&pos$re.

It arises )"en an MAC is committed to a #orei%n c$rrency denominated

transaction.

:easuring Transaction ExosureThere are 'arious steps in'ol'ed#

a)Transaction exosure $ase on >et ash Flo!s

!o meas$re its transaction e&pos$re( MAC *rst needs to proLect its consolidated

net c$rrency by c$rrency in+o)s and o$t+o)s #or all its s$bsidiaries.urrenc Total %nlo!s Total outlo!s >et cash lo! Execte

Exchange rate at

en o erio

>et Exosure o

cash lo! in +S?

"ritish C C1'AA C'AA C1AA ?1.5 ?15AA

anaian ? ?12AA ?2AA ?1AA ?. ?AA

S!eish=ronor

S=2AA S=12AA /S=1AA) ?.15 /?15AA)

:exican ,eso :0,*AA :0,1AA :0,AA ?.1 ?AA

Me!s&ring Tr!ns!ction Expos&re


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3

From a %lance( t"e MAC can tell t"at it "as more e&pos$re in t"e 5)edis" andBritis" c$rrencies.

Oo)e-er a scenario analysis %i-es more insi%"ts7

C&rrenc( Net c!s :o's R!nge o$ expecte#

exc!nge r!te !t en# o$

perio#

R!nge o$ possib0050005000* /01>4 to /01>6 ,/>450005000* to ,/>650005000*

Mexic!n

+eso

MX+8050005000 /0106 to /01>> /458005000 to /85800500

Me!s&ring Tr!ns!ction Expos&re


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b* Me!s&ring Tr!ns!ction Expos&re b!se# on C&rrenc( ;!ri!bi


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c) Me!s&ring Tr!ns!ction expos&re b!se# on c&rrenc(corre

!"e correlations amon% c$rrencies mo-ements can be meas$red by t"eircorrelation coe3cientsN i.e. t"e de%ree to )"ic" t)o c$rrencies mo-e relati-e toeac" ot"er.

4

0

310

13

310

13C&rrenc(

C&rrenc(

C&rrenc(X

Jc!ngeo$

c&rrenc(!g!instS/

Ti)e

%ssume MNC needs -,/ million topurchase currencies D and J at aratio of .#F and another -,/ ofcurrency K

Ai'en the correlation amongcurrencies any changes in 'alue ofcurrencies D and J are offset bychanges in currency K

!hat happens if currencies D and J

appreciate by F/+L

For)s o$ )!n!ging Tr!ns!ctionExpos&re


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Expos&ree )ill $se t"e #ollo)in% e&ample #or all met"ods o# mana%in% transactione&pos$re. 8ss$me a ,5Hs Seneral Electrical /SEHs Je$tsc"e Mar' /JMe&pos$re. n 1 Uan$ary( SE is a)arded a contract to s$pply t$rbine blades to$#t"ansa( t"e Sermany 8irline and SE )ill recei-e JM29 million on @1

Jecember t"e same year. !"e c$rrent spot rate #or de$tsc"e mar' isJM1D60.40 and t"e oneyear #or)ard rate is JM1D60.@=2=. !"e #ollo)in% arepotential e&c"an%e rate e&pos$re mana%ement options.

a) For!ar :ar;et ege(n forward market hedge a company that expect to recei'e a foreign currency sells foreign

currency forward and one that expect to pay 8short position9 a foreign currency buys thecurrency forward (n our case& AG sell the proceeds of the sale forward and transforms thecurrency denomination of its expected MF* million into dollars& thereby eliminating allcurrency risk on the sale

41

Sot Exchange rate 9alue o original

recei#a$le/1)

@ainB(oss on

or!ar contract/2)

Total ash Flo!

/123)

D:1?.4 ?1AA /?43A) ?*A5'A

D:1?.32 ?*A5'A ?*A5'A

D:1?.36 ?*AA 5'A ?*A5'A

For)s o$ )!n!ging Tr!ns!ction


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Expos&rec* Mone( )!r"et He#ge

8 money mar'et "ed%e in-ol-es sim$ltaneo$s borro)in% and lendin% acti-ities

in t)o diGerent mar'ets. 5$ppose de$tsc"e mar' and dollar interest rates are 19 and 10 respecti-ely.

,sin% money mar'et "ed%e( SE )ill borro) JM21.4 million /JM29:1.19 #or oneyear( co-ert it into 6=. million /21.4&60.40 in t"e spot mar'et and in-est it #orone year in t"e ,56 mar'et.

n @1 Jecember( SE recei-es 6K.9 million /6=.&1.10 #rom its local

in-estment and at t"e same SE recei-es JM29 million #rom $#t"ansa )"ic" it$ses to pay bac' t"e loan /21.4&1.19DJM29.

#* Ris" Si$ting

SE can a-oid t"e transaction e&pos$re by pricin% t"e t$rbine blades in dollars.

Jollar in-oicin% "o)e-er does not eliminate t"e c$rrency ris'( b$t merely s"i#ts

t"e ris' #rom t"e b$yer to t"e seller. For t"is reason( it is common in international b$siness to in-oice e&ports in

stron% c$rrencies and imports in )ea' c$rrencies.

42

For)s o$ )!n!ging Tr!ns!ction


43/56


e* Expos&re Netting

It in-ol-es oGsettin% e&pos$res in one c$rrency )it" e&pos$res in t"e same orot"er c$rrencies.

In practice( t"ere are t"ree e&pos$re nettin% strate%ies7

oGset a lon% position in a c$rrency )it" a s"ort position in t"e same c$rrency.

oGset a lon% position in one c$rrency )it" a s"ort position in anot"erc$rrency i# t"e t)o c$rrencies are positi-ely correlated.

oGset a lon% /s"ort position in one c$rrency )it" anot"er lon% /s"ortposition in anot"er c$rrency i# t"e t)o c$rrencies are ne%ati-ely correlated.

43



44/56

Expos&re$* C&rrenc( Ris" S!ring It is a trade transaction )it" a price cla$se )"ereby base price is adL$sted #or

certain #orei%n rate c"an%es beyond t"e ne$tral zone.

!"e ne$tral zone is t"e c$rrency ran%e )it"in )"ic" ris' is not s"ared(s$pposedly inc$rred by one party.

5$ppose )e speci#y o$r ne$tral zone as [email protected] JM1( )it" t"e base rateo# spot rate 60.40. !"ere#ore( #or any #$t$re rate )it"in t"e ne$tral zone( SErecei-es JM29 million at t"e base rate o# 60.40 or 610 million. !"$s

$#t"ansaHs cost in t"is case -aries #rom JM24.@K million to JM29.


45/56

Expos&re!"e dia%ram belo) compares t"e c$rrency ris' s"arin% contract to a #or)ard"ed%e contract.

8t any point belo) t"e lo)er bo$ndary o# ne$tral zone( say at rate o# 60.@9( SEHsloss is red$ced #rom 6=.9 million dollars to 6K.9 million d$e to ris' s"arin%.

8lso( beyond t"e $pper bo$ndary( say at 60.49 e&c"an%e rate( SEHs transaction%ain is also red$ced #rom 611.29 million to 610.9 million as t"e #$ll potential%ain is s"ared 45

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3. Foreign Exchange Market and Management of Foreign Exchange Risk