Foreign Exchange Exposure & Risk

Foreign Exchange Exposure

If V0= 1,00,000 $ = Rs 43,00,000 /-

(Rs/$ =43.00)

Over a period of time, price of asset changes due to inflation and exchange rate also

changes. So,

V1= 1,40,000 $ = Rs 53,20,000 /-(Rs/$ = 38.00)

The actual change

ΔV = V1 – V0 = 53,20,000 – 43,00,000

= Rs 10,20,000

ΔS = S1- S0 = 43.00 – 38.00 = Rs 5.00

So, For ΔS = 11.6%

For ΔV = 23.7%

ΔS may be both positive and negative and so may be ΔV

Is there any relationship between change in exchange rate and change in value of asset?

ΔV = F(ΔS)

+ ΔS- ΔS

-ΔV

+ΔV

Foreign Exchange Exposure

ΔV = + ⍺ βΔS + u

ΔV = change in the value of asset or liability

ΔS = Unanticipated change in the exchange rate

⍺ = intercept

β= sensitivity of changes in value of assets or liabilities in response to ΔS

β= sensitivity of changes in value of assets or liabilities in response to ΔS

β = Exposure

Now,

ΔV = + ⍺ βΔS + u

Assuming = 0 , ⍺ u = 0

ΔV = βΔS

=> β= ΔV / ΔS

+ ΔS- ΔS

-ΔV

+ΔV

Asset Exposure Line

β = tan θ+ ΔS- ΔS

-ΔV

+ΔV

Liability Exposure Line

β = tan θ

Change in value of asset

Change in value of Liability

Defining Exposure

The sensitivity of the real home currency value of an asset, liability or an operating income to an unanticipated change in the

exchange rate, assuming unanticipated changes in all other currencies as zero

• Does exposure affect Balance sheet of a company or income statement?

• Does exposure affect only foreign assets or domestic assets as well?

Foreign Exchange Risk

Variability of the domestic currency values of assets, liabilities, operating incomes due to unanticipated changes in exchange rate.

Risk = variance in V

Estimating RiskNow, we know that by definition

ΔV = + ⍺ βΔS + u ------- Eq 1

Regressing the actual data of ΔV and ΔS

Δ`V = ` + ⍺ β`ΔS --------Eq 2

There will be a difference between the estimated change (Eq1 and Actual change (Eq 2)

ΔV = Δ`V + u

Now, the risk is given by

Var(ΔV) = Var( Δ`V + u)

Var(ΔV) = Var( Δ`V ) + Var( u) +2Cov(Δ`V , u)

Risk Cont..

2Cov(Δ`V , u) = 0

Therefore,

Var(ΔV) = Var( Δ`V ) + Var( u)

Thus, the total risk of an asset includes estimated risk plus risk due to other factors.

Relating Risk & Exposure

ΔV = + ⍺ βΔS

Var(ΔV) = Var( + ⍺ βΔS)

Var(ΔV) = β2 Var(ΔS)

Defining Real Change in exchange rate

The real change in exchange rate is the change that produces a difference between overall rate of return on domestic versus

foreign assets / liabilities or in profitability of export / import oriented firms.

“Real Change” is the extent of change in the value due sensitivity and variability both

Real Change in Financial Assets

If IRP does not exist, then

(S1-S ) / S = (ia-ib) / (1+ib)

Hence, Real proportionate change in exchange

rate is

Rp = [(S1-S ) / S ] (1+ib) – (ia-ib)

Real Change in Real AssetsWe know that, irs = i^ rs + P ^ rs and i$ = i^ $ + P ^ $

Hence, Rate of return on 1 Rs invested in US

= S1/S [1+ i^ $ + P ^ $] – 1

Therefore, Real rate of return above domestic return

= S1/S [1+ i^ $ + P ^ $] – [1+(i^ rs + P ^ rs )]

Adding & Subtracting P$

= {S1/S [1+ i^ $ + P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )

= {S1/S + S1/S i^ $ + S1/S P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )

= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

={S1/S [1+ i^ $ + P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )

=S1/S + S1/S i^ $ + S1/S P ^ $ ]– 1}– (i^ rs + P ^ rs ) – (P ^$ – P ^$ )

={S1/S + S1/S i^ $ + S1/S P ^ $ – 1} – i^ rs - P ^ rs – P ^ $ + P ^ $

=S1/S + S1/S i^ $ + S1/S P ^ $ – S/S – i^ rs - P ^ rs – P ^ $ + P ^ $

= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

Rp = [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

If i^ rs = (S1/S)i ^ $ then real proportionate change

= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )

Real Change in Real Assets

Exposure

Economic Exposure

Transaction exposure

Operating exposure

=> Translation Exposure or Accounting Exposure

Translation Exposure

• Changes in Income Statement items and book value of BS assets and liab, caused by exchange rate change

• Resulting gains or losses are determined by accounting rules and are on paper only

Impact – BS assets and liab and income statements that already exist.

Operating Exposure

• Changes in the amount of future operating cash flows caused by exchange rate change

• Resulting gains or losses are determined by changes in firm’s future competitive position and are real.

Impact – Revenues and costs associated with future sales.

Transaction Exposure

• Changes in the value of foreign currency denominated contracts that are brought about by exchange rate change.

• The resulting changes are determined by the nature of contracts already entered into and are real.

Impact – Contracts already on BS are part of Accounting Exp.

– Contracts yet to come on BS are part of Operating Exp.

Types of Risk

• Financial Risk

• Political Risk

• Country Risk

Financial Risk

• Refers more generally to unexpected events in a country’s financial, economic, or business life

• Examples of financial risks– currency risk

– interest rate risk

– Inflation risk

– unexpected changes in the current account balance

– unexpected changes in the balance of trade

Political Risk

• The risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate

• Examples of political risks– Expropriation risk– Disruptions in operations– Protectionism– Blocked funds– Loss of intellectual property rights

Political risk insurers• Government export credit agencies• U.S. Overseas Private Investment Corporation• U.K. Export Credits Guarantee Department

International• World Bank - Multilateral Investment Guarantee

Agency Private• Lloyd’s of London• American International Group (AIG)• MNCs are self-insured if their risk exposures are

diversified across a large number of countries

Country Risk

• Macro risks - affect all firms in a host country

• Micro risks - specific to an industry, firm or project in a country

• Whether a particular country risk is macro or micro affects the diversifiability of the risk

Country risks examples• A1 - Africa, Asia, Europe, Mid East Americas, Australia,

Switzerland, Canada, UK• A2 - Botswana, HK, Japan, Germany, Kuwait, USA, S. Korea

Italy, UAE• A3 - Mauritius, China, Cyprus, Israel, Chile, Namibia, Thailand,

Czech Rep, Trinidad.• A4 - Egypt, India, Latvia, Saudi, Mexico, S. Africa, Philippines,

Poland, Arabia, Panama.• B - Algeria, Bangladesh, Slovakia, Egypt, Brazil, Peru, Uganda,

Sri Lanka, Russia, Jordan, Venezuela.• C - Congo, Indonesia, Azerbaijan, Iran, Syria, Haiti, Kenya,

Vietnam, Romania, Turkey, Jamaica.• D - Nigeria, Afghanistan, Albania, Iraq, Argentina, Sudan ,N.

Korea, Ukraine, Cuba ,Zimbabwe, Pakistan, Yugoslavia, Ecuador.

Strategies for managing country risk

• Negotiate the environment with the host country prior to investment

• Structure foreign operations to minimize country risk while maximizing return

• Limiting the scope of technology transfer to foreign affiliates to include only non-essential parts of the production process

• Limiting dependence on any single partner

Types of Exposure

• Transaction Exposure & Translation Exposure

• Economic Exposure & Operating Exposure

Transaction & Translation Exposure

• Arises due to impact of exchange rate movement on firm’s future contractually committed cash flows.