hjjjjif-2risk & exposure lec 13-14

8/12/2019 Hjjjjif-2risk & Exposure Lec 13-14

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Foreign Exchange Risk and Exposure

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Settlement Risk (Settlement Risk (HerstattHerstatt Risk)Risk) Settlement Risk Risk of incorrectly funding or not

receiving consideration

Lesser understood and appreciated risk. Also called asHerstatt Risk

Herstatt bank in Germany failed on 26 June 1974.Banking license was withdrawn after close of banking

hours. By then DEM payments were received locallyirrevocably. Correspondent bank in N.Y. suspendedpayments in New York.

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CLS [Continuous Linked Settlement)

SWIFT introduced in 1974

CLS Bank, N.Y. $1 bn spent

In operation since 9th September 2002. Settlement time-Midnight Central European Time (CET)

No bunching at the end of the day

rather than at the end of the day

Liquidity and Operational Risk (Failure of the systemitself)

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Comparison

MacroeconomicMacroeconomicEnvironmental RisksEnvironmental Risks

Due to uncertainties in

response to changes ineconomic and financialvariables.

Core Business RisksCore Business Risks

Due to uncertainties

related to operatingbusiness.

s s a ec a rms nthe economy.

Due to variance in:

Exchange rates

Interest rates Inflation rates

Relative prices so forth

s s are spec c o efirm.

Due to interruption in

Raw material supply

Labor trouble Success/failure of a

new product

Technology and so forth4


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Foreign Exchange Risk and ExposureForeign Exchange Risk and Exposure

The key macroeconomic risk factors are:

Exchange rate

Interest rate Inflation rate

Macroeconomic Risk Factors

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Note: Exchange rate, interest rate and inflation rate areintimately interrelated


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Uncertainties arising out of fluctuations in exchangerates, interest rates create strategic exposure and riskfor a firm.

Long run response of the firm to these risks can involvesi nificant chan es in the firm's strate ic osture.

Effect of Macroeconomic Risk Factors

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Choice of product-market combinations Sourcing of inputs

Choice of technology

Location of manufacturing activities

Strategic alliances and so forth


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International Finance is vulnerable to both exchange

rate & interest rate fluctuations. So companies prefer:

Raising funds abroad or Doing investment abroad or

Earning foreign exchange or

Effect of Macroeconomic Risk Factors

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Sourcing raw material from different countries

These are subjected to exposure against exchange rate

and interest rate fluctuations.


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Definition of Risk

Risk is a measure of the variability of the

value of performance measure attributable

to the risk factor.

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Exchange risk is defined as the net potential gains orlosses which can arise from exchange rate changes tothe Forex exposure of an enterprise.

The concept of exchange risk covers both thepossibilities i.e. gain & loss


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Definition of Exposure

Exposure is a measure of the sensitivity of

the value of a performance measure to

changes in the relevant risk factor.

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Exchange exposure is defined as the extent to whichtransaction, assets and liabilities of an enterprise aredenominated in currencies other than the reporting currencyof the enterprise itself.

Exposure is measured by the value of the assets andliabilities or transaction denominated in Forex.

Exposure arises because the enterprise denominatestransactions in Fxor it operates in a foreign market.


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Risk vs. Exposure

It relates to total value ofassets, liabilities and cash

flows of an enterprisedenominated in foreigncurrency.

It relates to the excess orshortfall in the cash flows

or value of assets orliability likely to arise onaccount of exchange ratefluctuation.

ExposureRisk

It is normally determinedin terms of foreigncurrency

It relates to the absolute

value of assets or liabilitiesinvolved.

It is calculated in termsof domestic currency.

It relates to the changesin the value.

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Definition of Risk Perception

Risk Perception is the way in which people and

organizations view risk, based on their concerns andexperiences, but not necessarily on objective data.

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Business policies Investment decisions


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Financial Risk is future cash flows deviatingfrom budgets or expectations due to changes in

financial prices.

Financial Risk vs. Foreign Exchange Risk

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Forex Risk is future cash flows deviating due to changein exchange rates.


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Volatility of Forex

Why FOREX rates are volatile?Why FOREX rates are volatile?

External factors that impact forex rates like International trade

Capital movements

Government policies Political factors and so forth

For example, recent financial crises in USA led to largescale volatility in forex rate.

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Classification of Exposures

Foreign ExchangeExposure

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Transaction orConversion

Exposure

Translation orAccounting

Exposure

Economic orOperating/Strategic

Exposure


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Foreign Exchange Exposure

Foreign Exchange Exposure measures thepotential for a firms:

Profitability

Net cash flow

Market value to alter because of a change in

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Classification of Exposure

Transaction Exposure The impact of unexpected exchange rate changes upon

the cash flows from existing contractual obligations

Economic Exposure The im act of unex ected exchan e rate chan es u on

known and expected future cash flows of the firm

Translation Exposure Exchange rate impacts on consolidated financial

statements arising from MNCs need to translate foreignaffiliates FC financial statements

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Transaction Exposure

Transaction Exposure or Conversion Exposure

It result from an unanticipated change in the exchangerate which has an impact - favorable or adverse - on the

firms cash flows during the upcoming accounting period.

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Most often, the term is used to denote exposures on items the

foreign currency values of which are contractually fixed

Export receivables

Import payables

Interest payable


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Covers all types of transactions like: Purchase

Sales

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Lending Investment

The risk from the exposure would depend upon the netposition and the tenor.

Longer the tenor, higher the risk


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It refers to the risk associated with the change in theexchange rate between the time an enterprise initiates atransaction and settles it.

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The transaction losses or gains are absorbed in the P&Laccount for the year concerned and thus affect the profit ofthe enterprise.


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The objectives of a company in managing its transactionexposure is to avoid losses that may occur due to exchangerate fluctuations. At the same time to the extent possible itshould not forgo likely gains from favorable changes inexchange rates.

Managing Transaction Exposure

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company w c wants to p ay sa e an avo tota y t e r smay go in for hedging.

The company which takes active interest in the study of the

rate movement ventures to speculate and accordingly devisestrategies to gain out of exchange rate movement.


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Scene in India

In India, the exchange control regulations do not allowfree-rein to companies in India to indulge in unlimited

speculative activities in the Forex market.


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Forward contract Exposure netting

ExternalExternal

HedgingHedging

InternalInternal

HedgingHedging

Hedge Options

Futures

Currency invoicing Leading and Lagging

Foreign currency account

EEFC Accounts One who retains 100 %

One who retains 50 %

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Translation Exposure

Translations Exposures or Accounting Exposure

It is the exposure on assets and liabilities

appearing in the balance sheet but which are notgoing to be liquidated in the foreseeable future.

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Trans ation exposure arises w en a irm as: A foreign operation such as a branch, a joint venture or 100%

subsidiary in a foreign currency

Foreign currency fluctuations lead to translation gains or

losses.

No cash flow implications


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Assets and Liabilitiesdenominated in one

currency need to betranslated into reporting

currency.

Likewise accounts ofbranches and subsidiaries.

Can impact P & L

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How Translation Exposure Arises ??

$Japan United States

India

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SubsidiaryFinancials

SubsidiaryFinancialsConsolidated

Financials

INR

INR

GermanySubsidiaryFinancials


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How Translation Exposure Arises ??

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Translation Exposure or Accounting Exposure

The subsidiary of the company is a separate entity with its

own assets and liabilities, managing its own cash flows and

operating in a foreign country.


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However, when the parent company prepares its final

accounts, the assets and liabilities of the subsidiary company

are notionally merged with its own and presented as a

consolidated statement so that the readers may have an

overall picture of the enterprise.


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Translation Exposures or Accounting Exposure

For restatement of the values of the assets and liabilities

and cash flows of the subsidiary in the domestic currency,the concern may apply either the historic or the current rate

of exchange between the foreign currency concerned and


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e omes c currency.


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Translation Exposure or Accounting Exposure

Translation exposure is defined as the likely

increase or decrease in the parent company's net

worth caused by a change in exchange rates

since last translation.


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This arises when an asset or liability is valued atcurrent rate.

No exposure arises in respect of assets/liabilitiesvalued at current historical rate, as they are notaffected by exchange rate differences.


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For translating a foreign entity's balance sheet into the parent's

currency of reporting various methods can be followed, such as:

Methods of Translation

CurrentCurrent--non Current Methodnon Current Method

MonetarMonetar --non Monetar Methodnon Monetar Method

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Temporal MethodTemporal Method

Closing Rate MethodClosing Rate Method

F i E h Ri k d E

F i E h Ri k d E


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Current-non current method uses the

closing rate for current assets and liabilities

and historical rates for non-current

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assets and liabilities.

F i E h Ri k d E

F i E h Ri k d E


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Monetary-non monetary method

translates Monetary assets and liabilities

Cash, Bank De osit Debtors & ST Loans

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at the current rate while non- monetary

assets and liabilities such as inventories are

translated at historical rates.

In contrast to the current/non current

method this method translates long term

debt at current rate. This can give to

translation gain or losses.

F ig E h g Ri k d E

F ig E h g Ri k d E


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Temporal Method translates cash,

receivables and payables at a closing rate

while other items are translated at historical

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rate.

For revenue and expenses items from the

income statement there is a choice between

using the rate prevailing at the time the

transaction is booked or a weighted average

rate for the period covered by the

statement.




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Closing Rate MethodClosing Rate MethodClosing Rate Method uses the rate

prevailing on the parent's balance sheet

date.




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Managing Translation Exposure

Balance Sheet Hedge

Exposure Netting

Leading & Lagging

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Forward Contract




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Economic or operating exposure relates to the

effect of unexpected exchange rates on the

future operating cash flows of the company.

In FM, a firm is valued by the NPV of the future cash

Economic Exposure

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flows .

A change in the exchange rate may bring about changesin the cash flows of the company

Directly by affecting its revenues and costs

Indirectly by affecting its competitiveness by the actionof its consumers and competitors.




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As a result the NPV may differ from the one

anticipated.

Economic or operating exposure is less clearly

perceived but has wider ramifications with far

Economic Exposure

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reac ng e ec s an e accoun ng exposure.

Accounting exposure is:

More readily seen and provided for

Insidious

Economic Exposure is more difficult to measure andmanage.




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In the long run, exchange rate effects can even

undermine a firm's competitive advantage by raising

its costs above those of its competitors or affecting

its ability to service its market in other ways.

It is also called as strate ic ex osure as it not onl

Economic Exposure

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involves the action of the company but that ofcompetitors and consumers also.

Operating exposure is defined as the sensitivity of

future operating profits to unanticipated changes in

the exchange rate and is horizon is medium term.




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Strategic exposure refers to a still longer horizon

and contemplates longer-term operational

flexibility such as:

Changing product-market mix Shifting location of operations

Adopting new technologies

Economic Exposure

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Value-based" exposure which focuses on the

impact of currency fluctuations on market value

of the firm that takes into account both short

term accounting exposures as well as operating and

strategic flexibility in responding to currency

movements.




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Economic Exposure & Laker Airways

Laker Airways was having a booming

transatlantic business with a concept ofno-frill, low-fare, stand-by air travel in Early 1980s

Why did it fail?

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400 Mn. The high debt that was $ denominated resulted from the

mortgage financing provided by the US Exim Bank and the USaircraft manufacturer McDonnell Douglas




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g g pg g p


Laker Airways incurred three major categoriesof Cost Fuel paid in $

Operating cost incurred in Financing costs in $

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evenly divided between and $. Dollar fares were basedupon the assumptions of a rate of 1 = $ 2.25

From above it is clear that $ denominated cash

outflow far exceeding $ denominated cash inflows

Now Laker airways left vulnerable to Depreciation A dramatic plunge of exchange rate of 1 = $ 1.60

brought Laker Airways to default




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Could Laker Airways have hedged its natural

dollar liability exposure? If yes, how?

Indexing the sale of sterling airfare to the day-to-dayexchange rate of cable

The other option would have been to finance the

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acquisition of DC-10 Aircrafts in sterling rather than dollars Forward or Option contracts to buy $ or long

term oil futures contracts of maturities matching

the financing of the aircraft purchase would have helped the

company in pricing more realistically its air fare




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Economic Exposure & Caterpillar

Caterpillar is an American heavy construction

Equipment Mnf.

Its all plants were based in USA while it used tosell its product globally priced in local

currencies

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n s ar e r s ng aga ns a currenc es

Caterpillars revenues measured in $ terms were

shrinking while costs kept pace with US inflation

Margins Shrank

It could not compensate by raising localcurrency prices in export markets because

Komatsu was holding the price line




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Economic Exposure Japs & Germans

As in mid 80s $ depreciated vis--vis with and

Dm

The Japanese and German car makers found

their operating margins being squeezed

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They responded partly by starting manufacturing

operations in US and partly by moving up market

into premium priced luxury cars where

consumer sensitivity to price increase is

relatively less




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Economic Exposure & Merck

Merck an American pharma giant have found that

during the time of strong $ their cash flows

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.

Bulk of their R&D expenditure are denominated

in $ and shortage of internally generated cash

tends to have adverse impact on their R & Dbudgets which are crucial factor in their long-run

competitiveness




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Exporters to suffer losses on ` hedges

Rupees huge fall in recent weeks limits benefits forexporters who have made large hedges against currencyfluctuations.

In India, IT companies usually make biggest hedges. TCS has over $3bn under hedge, followed by Cognizant $

3.7bn, Wipro $2bn & HCL $1.3bn

The lowest hedge cover by an IT company is $800m byInfosys

Analysis expect IT companies may revise their hedgingstrategy.




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Indian Auto Industry

Auto parts makers insist on currency fluctuationclause

Indian auto component makers work in a very

competitive environment with thin margins,many companies which do not have currency

fluctuation clause built into the old agreements, are

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now trying to re-negotiate the contracts. But there

are other manufacturers who are trying to shift their

focus to Euro currency.

Sona Koyo itself is trying to balance out this impactby focusing on European exports while decreasing its

exports to the US.




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Managing Economic Exposure

Marketing

Market Selection

Depends upon in which market currency has

appreciated and in which market it is depreciated.

Pricing

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It mainly depends upon elasticity of demand

for the product and competition faced by the

company. Pricing involves whether to retain the marketshare or retain the profit margin and how frequently

price can be changed. Product Decisions




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Production

MNCs has advantage as it has production and

sourcing bases in different countries.

The Input can be procured from foreign countries when

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e oca currency s apprec a e w respec o

foreign currency.

The production may be shifted from the nation

whose currency has appreciated to plants inother countries.



M i E i E


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Finance

Balance Sheet Hedge

Leading and Lagging

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Parallel Loans and Swaps

Currency Invoicing



Bh t F Vi i


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Bharat Forges- Vision

Create Global Market

Low cost labour in India will go gradually

Keep plant where the market is located

Emphasis on SCM and CRM

Easy flexibility in case of labour problems

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xpor r ven company



Derivatives


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Derivatives

Derivatives are financial contracts which provide

hedge against a particular type of risk.

The risk may be exchange rate risk, credit risk, interest

What are they?

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rate r s etc.

A derivative is a financial instrument whose valuedepends on the value of another asset /instrument called

Underlying ( basic ) variable.

Derivatives are also known as Contingent claims.


Foreign Exchange Risk and ExposureCurrency Options


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y p

A currency options arrangement between an option

holder (buyer) and an option writer (Seller)

A currency option gives the buyer the right ,but not

the obligation to either buy or sell a specified quantity

Meaning and features

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predetermined exchange rate known as Strike price


Currency Options


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Currency Options

Option holder has no obligation to exercise an option

The writer of the option must comply with its terms

and should be prepared to buy or sell the underlying

Meaningand features

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currency when a holder decides to exercise an option

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To acquire the right the buyer pays a premium to theseller

The potential loss to an option seller is unlimited while tothe buyer it is limited to the premium paid.

Types

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There are Two Types of Options

Call Option

Put Option



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Important Terminologies

Put Option

The right to sell specific amount of one currency

against another currency is known as put option

Call Option The right to buy specific amount of one currencyagainst another currency is known as call option

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The amount paid by the buyer of an option to theseller is called premiumPremium

Buyer

Seller (Writer)

specified amount of currency against anothercurrency

The person who sells the right to buy or sellspecified amount of a currency against another

currency

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Exercise Date

For effecting delivery of Forex the buyer of the

option must notify the seller about his decision fortaking or giving delivery and this is known asexercising the option

Strike Price This represents predetermined price at which theoption can be exercised

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The date on which the option can be exercised is

called as exercised date

Expiration Date

American Option

The last date upto which the option can beexercised.

An option which can be exercised at a any timebetween the initial deal date and the expiry date.

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European Option

In the MoneyOption

An option which can be exercised only at theexpiry date.

If by exercising option ,the buyer has advantagethen it is called as ITM Option

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If by exercising option, the buyer hasdisadvantage then it is called as OTM OptionOut of the MoneyOption

At the MoneyOption

If by exercising option, the buyer has neither

advantage nor disadvantage then it is called asATM Option.

The strike price in this case is equal to spot orfuture rate. This option has no Intrinsic Value

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Status of an optiona. In-the-money

Call: Spot(54.35) > strike(54.28)Put: Spot (54.20)< strike(54.28)

Let take an example

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. ut-o -t e-money

Call: Spot (54.20)< strike(54.28)Put: Spot (54.35)> strike(54.28)

c. At-the-money

Spot = the strike


Foreign Exchange Risk and ExposureCurrency OptionsHow to use Option


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Buy call option

expect currency to appreciate

exercise option if price increases beyond strikeprice

buy at strike price and sell at spot rate

How to use Option

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Sell (write) call option

expect currency to decline in value obligated to sell a currency at a specified price

make money if option not exercised



Option in IndiaCurrency Options


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Authorized dealers having adequate internal control, riskmonitoring/ management systems, mark to market mechanism andfulfilling the following criteria will be allowed to run an option bookafter obtaining a one time approval from the Reserve Bank

Option in India

i. Continuous profitability for at least three years

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Initially, authorized dealers can offer only plain vanilla European

options.

.iii. Net NPA's at reasonable levels (not more than 5 per cent of net

advances)iv. Minimum Net worth not less than Rs. 200 crores


Foreign Exchange Risk and ExposureCurrency Futures


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Chicago Becomes the Junction of Rail & Telegraph inUSA. So it becomes Hub of East USA in 1840

Bumper crop of wheat in East USA. Everyone rushed toChicago as Brokers, Agents were present their to

Brief History

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The problem was Chicago was not having proper storagefacilities, weighing equipments of standard quality,every thing has to be settled in cash.


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Currency Futures


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Hedgers

Farmers, manufacturers, importers and exporterscan all be hedgers.

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Players

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A hedger buys or sells in the futures market tosecure the future price of a commodity intendedto be sold at a later date in the cash market.

This helps protect against price risks

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Foreign Exchange Risk and ExposureCurrency Futures


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Speculators

These People do not aim to minimize risk butrather to benefit from the inherently risky natureof the futures market.

Players

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These are the speculators, and they aim to profitfrom the very price change that hedgers areprotecting themselves against.

Hedgers want to minimize their risk no matter

what they're investing in, while speculators wantto increase their risk and therefore maximize theirprofits.



Futures ContractCurrency Futures


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A futures contract is a form of forward contract

In that it conveys the right to purchase or sell a specified

quantity of a Forex at a fixed exchange rate on a specifiedfuture date,

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currency and the due date are determined by thecustomer


Futures Contract Features

Currency Futures


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Size of Contract

GBP - 62,500

Euro - 125,000

CAD - 100,000

-

Delivery Dates at

CME

March,June,September&December

Deliver date is third Wednesday of

Futures Contract-Features

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, ,

CHF - 125,000 Aus $ - 100,000

.

The month during which a contract expiresis referred to as the spot month.

All trading stops two business days prior

to delivery date to enable the participants

deliver the currencies



Features of Currency Futures


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Price Movement The price for the futures is quotedas so many units of US $ per unit of foreign Currency.i.e. 1 CAD = $0.8800(Incase of Fwd 1$=CAD

1.1366)The value of the futures will be the price per unit of

Price Movement

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One Bought a CAD $ at a price of US $ 0.8800 Theexchange may fix the minimum size of pricemovement called as tick .

If price changed to 0.8801 that means buyer gains0.0001 x 100,000 = $ 10




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Future Quantity Amount of tick $ Value of each

point change

1 GBP 62,500 0.0001 6.25 $

Price Movement

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9

, , . .

3 Euro 125,000 0.0001 12.50 $

4 CHF 125,000 0.0001 12.50 $

5 CAD 100,000 0.0001 10.00 $

6 AUS $ 100,000 0.0001 10.00 $

7 USD 1,000 0.0025 2.50 INR





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y

Trading by members Demand supply ,Open out Cry

electronically on the CME Globex trading platform

Clearing House Acts as a counter party

Trading by members

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0

Margins

Mark to Market





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Liquidity-The buyer of the future need not hold up tillmaturity.

On any intermediary date he can sell to anotherand wind up his position with the exchange.

Liquidity

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Similarly a seller can enter into a purchase dealbefore the due date and square his position

It is the reason that future is sometimes describedas a bet on the future price of the currency, rather than an

obligation to buy the currency. Most of futures contracts are not delivered on the

due date, but extinguished by counter deals.


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Foreign Exchange Risk and ExposureIn Nut ShellLets Compare


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Fwd

Contracts

Currency Futures Currency Options

Delivery Generally Less than a % Buyers Discretion. Seller

must honour if buyerexercises

Maximum Several Years 12 Months 3/6/9 Months

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Contracted

Amount

Any value 62,500

Can$100,00.etc.

31,250,

Can$50000.etc.

Maturity

Date

Any Date Third Wednesday of March,

June, Sept or Dec

Friday before 3rd Wednesday

of March, June, Sept, or Dec

on regular Options.

Last Friday of month on end-of-month options

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Lets CompareIn Nut Shell


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Fwd

Contracts

Currency Futures Currency Options

SecondaryMarket

Must Offsetwith Bank

Can Sell Via Exchange Can Sell Via Exchange

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Margin Fees Margin3-20% Premium

Guarantor None Futures ClearingCorporation

Options ClearingCorporation

Major Users PrimarilyHedgers Primarily Speculators Hedgers and Speculators

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hjjjjif-2risk & exposure lec 13-14

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