Foreign Exchange Risk Exposure

7/29/2019 Foreign Exchange Risk Exposure

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WHAT IS FOREIGN EXCHANGE?

Foreign exchange refers to the financialtransaction where currency value of one country

is traded into another countrys currency. The

whole process gets done by a network of various

financial institutions like banks, investors andgovernments. The exchange rate varies according

to the value of each countrys currency which is

based on the health of that particular countrys

economy.


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FOREIGN EXCHANGE RISK EXPOSURE

Foreign exchange risk (also known as exchange rate risk or currency

risk) is a financial risk posed by an exposure to unanticipatedchanges in the exchange rate between two currencies.Investors and

multinational businesses exporting or importing goods and services

or making foreign investments throughout the global economy are

faced with an exchange rate risk which can have severe financialconsequences if not managed appropriately.

ProsEnhances export sales terms to help exporters remain competitive

Reduces non-payment risk because of local currency devaluation

ConsCost of using some FX risk management techniques

Burden of FX risk management
http://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Financial_risk


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TYPES OF RISK

Transaction exposure

A firm has transaction exposure whenever it has contractual cash

flows (receivables and payables) whose values are subject to

unanticipated changes in exchange rates due to a contract being

denominated in a foreign currency.

Firms generally become exposed as a direct result of activities such as

importing and exporting or borrowing and investing. Exchange rates

may move by up to 10% within any single year, which can significantly

affect a firm's cash flows, meaning a 10% decline in the value of a

receivable or a 10% rise in the value of a payable. Such outcomes could

be troublesome as export profits could be negated entirely or import

costs could rise substantially.
http://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Accounts_receivablehttp://en.wikipedia.org/wiki/Accounts_payablehttp://en.wikipedia.org/wiki/Accounts_payablehttp://en.wikipedia.org/wiki/Accounts_receivablehttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flow


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Economic exposure

A firm has economic exposure (also known as operating exposure) to the degree

that its market value is influenced by unexpected exchange rate fluctuations.

Such exchange rate adjustments can severely affect the firm's position with

regards to its competitors, the firm's future cash flows, and ultimately the firm's

value.

Economic exposure can affect the present value of future cash flows.

A shift in exchange rates that influences the demand for a good in some

country would also be an economic exposure for a firm that sells that

good.
http://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_sharehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_sharehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_value


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Translation exposure

A firm's translation exposure is the extent to which its

financial reporting is affected by exchange ratemovements.

Translation exposure may not affect a firm's cash

flows, it could have a significant impact on a firm's

reported earnings and therefore its stock price.

Translation gives special consideration to assets and

liabilities with regards to foreign exchange risk,

whereas exposures to revenues and expenses can oftenbe managed ex ante by managing transactional

exposures when cash flows take place.


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Contingent exposure

A firm has contingent exposure when bidding for

foreign projects or negotiating other contractsor foreign direct investments.

For example, a firm could be waiting for a project

bid to be accepted by a foreign business or

government that if accepted would result in animmediate receivable. While waiting, the firm faces a

contingent exposure from the uncertainty as to

whether or not that receivable will happen. If the bid

is accepted and a receivable is paid the firm then

faces a transaction exposure, so a firm may prefer to

manage contingent exposures.
http://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investment


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Market Risk:

This is when stock or bond prices drop and you appear to lose moneyon your investment. However, most losses are sustained over the short term of

a year or less. As long as you don't sell, your investment will have the chance

to recover from price declines and earn you a greater profit.

Inflation Risk:The risk that the rising costs of inflation will outpace the growth of

your investment over time.

Company Risk:This is the risk that the individual company in which you invest will

fail to perform as expected.

Credit Risk:Specific to bonds, credit risk refers to the company or government's

inability to repay principal plus interest to the bondholder.

OTHER RISKS


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Maturity Risk:Also specific to bonds, this is the risk that the value of a bond may

change from the time it is issued to when it matures. The longer the period to

maturity, the greater the potential for price fluctuation. That is why long-term

bonds generally offer a higher interest rate--to compensate for this greater

risk.

Legislative Risk:Whatever laws the government passes today may be extinct

tomorrow. For example, the long-term capital gains tax rate has been changedfive times in the last 20 years, with the most recent cut at 20%. Factors such

as tax deduction and deferral should never be your sole reason for selecting

an investment. These perks are at the mercy of Congress.

Timing Risk:Timing risk works two ways. First, you run the risk ofinvesting a large sum of money when share prices hit their peak.

Second, there's the risk that you'll need to access your money to pay for

retirement or college expenses during a temporary market setback--

causing you to lose money on your investment.


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Risk Management Process
http://leadershipchamps.files.wordpress.com/2008/06/risk_management_process.jpg


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Identify Risks Identify risks that affect the project (positively or negatively)

and documenting their characteristics.

Assess & Analyze Risks- Assess the risk impact, Analyze the probability of

risk occurrence and prioritize the risks, numerically analyze the effect ofidentified risks on project objectives (usually on cost, schedule and scope

targets)

Plan ActionsExplore all the possible ways to reduce the impact of threats (or

exploit opportunities). Plan actions to eliminate the risks (or enhance the

opportunities). Action plans should be appropriate, cost effective andrealistic.

Monitor & Implement the ActionTrack the risks throughout the project. If

risks occur then implement the risk strategy based on action plan. Ex. If

mitigation strategy is selected, execute the contingency plan based on risk

triggers. In case contingency plan fails, execute fallback plan.

Measure the effectiveness & Control the risk impact - Measure the

effectiveness of the planned action and controlling the risk impact by

understanding risk triggers & timely implementation of planned actions.


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HEDGINGA hedge is used to reduce any substantial losses/gains suffered by an individual

or an organization.Ex:-

Agricultural commodity price hedging

A typical hedger might be a commercial farmer. The market values

ofwheat and other crops fluctuate constantly as supply and demand for

them vary, with occasional large moves in either direction. Based oncurrent prices and forecast levels at harvest time, the farmer might decide

that planting wheat is a good idea one season, but the forecast prices are

only that forecasts. Once the farmer plants wheat, he is committed to it

for an entire growing season. If the actual price of wheat rises greatly

between planting and harvest, the farmer stands to make a lot ofunexpected money, but if the actual price drops by harvest time, he could

be ruined.
http://en.wikipedia.org/wiki/Wheathttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Wheat


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SWAPS A swap is a foreign currency contract whereby the buyer and seller exchange

equal initial principal amounts of two different currencies at the spot rate.

The buyer and seller exchange fixed or floating rate interest payments intheir respective swapped currencies over the term of the contract. At

maturity, the principal amount is effectively re-swapped at a predetermined

exchanger ate so that the parties end up with their original currencies.

Ex: Consider an export oriented company that has entered into a swap for a

notional principal of USD 1 mn at an exchange rate of 42/dollar. The

company pays US 6months LIBOR to the bank and receives 11.00% p.a.

every 6 months on 1st January & 1st July, till 5 years. Such a company

would have earnings in Dollars and can use the same to pay interest for thiskind of borrowing (in dollars rather than in Rupee) thus hedging its

exposures.

Swaps were first introduced to the public in 1981 when IBM and the World

Bankentered into a swap agreement
http://en.wikipedia.org/wiki/IBMhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/IBM


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FUTURESIn finance, a futures contract is a standardized contract between two parties to

buy or sell a specified asset of standardized quantity and quality for a priceagreed today (the futures price or strike price) with delivery and payment

occurring at a specified future date, the delivery date. The contracts are

negotiated at a futures exchange, which acts as an intermediary between the two

parties. The party agreeing to buy the underlying asset in the future, the "buyer"

of the contract, is said to be "long", and the party agreeing to sell the asset in the

future, the "seller" of the contract, is said to be "short".

OPTIONS

Anoption

is a derivativefinancial instrument that specifies a contract betweentwo parties for a future transaction on an asset at a reference price (the

strike). The buyer of the option gains the right, but not the obligation, to engage

in that transaction, while the seller incurs the corresponding obligation to fulfill

the transaction.
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Long_(finance)http://en.wikipedia.org/wiki/Short_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Short_(finance)http://en.wikipedia.org/wiki/Long_(finance)http://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Finance


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TYPES OF DERIVATIVES

Derivatives are products whose value is derived from one or more basic

variables called underlying assets or base . In simpler form, derivatives arefinancial security such as an option or future whose value is derived in part

from the value and characteristics of another an underlying asset. The primary

objectives of any investor are to bring an element of certainty to returns and

minimize risks. Derivatives are contracts that originated from the need to limit

risk.

Advantages of Derivatives:

They help in transferring risks from risk adverse people to risk oriented people.

They help in the discovery of future as well as current prices.

They increase the volume traded in markets because of participation of riskadverse people in greater numbers.

They increase savings and investment in the long run.


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Forward Contracts

A forward contract is an agreement between two parties a buyer and a seller to

purchase or sell something at a later date at a price agreed upon today.

Future ContractsA futures contract is an agreement between two parties a buyer and a seller

to buy or sell something at a future date.

Options Contracts

Options are of two types calls and puts. Calls give the buyer the right but not

the obligation to buy a given quantity of the underlying asset, at a given price onor before a given future date. Puts give the buyer the right, but not the obligation

to sell a given quantity of the underlying asset at a given price on or before a

given date.

Swaps

Swaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula.


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Documents

Foreign Exchange Risk Exposure