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Currency Risk Management

INSTITUTE OF BUSINESS AND TECHNOLOGY

CURRENCY RISK MANAGEMENT

Prepared By

XXXXX

Course Code : MKT-606

MBA (Banking and Finance)

FACULTY OFMANAGEMENT AND SOCIAL SCIENCES

FALL - 2010

CONTENTS

Institute of Business and Technology 1


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Page No.ACKNOWLEDGEMENT .............................................................. 3

ABSTRACT ................................................................................... 4

CHAPTER NO: 1 INTRODUCTION

1.1 Introduction ...................................................................,.. 61.2 Purpose of Study ............................................................. 61.3 Research Objectives ....................................................... 71.4 Literature Research . 71.5 Research Methodology .................................................... 7

CHAPTER 2: CURRENCY RISK MANAGEMENT

2.1 What Is Currency Risk .................................................... 92.2 Currency Risk Management............................................. 92.3 Impact of Currency Values............................................... 102.4 Economic Analysis............................................................ 152.5 Liquidity and Valuation .................................................... 16

CHAPTER 3: TYPES OF RISKS

3.1 Types of Risk ................................................................. 203.2 Risk Avoidance .............................................................. 203.3 Risk Reduction ................................................................ 203.4 Risk Transfer ................................................................... 213.5 Risk Deferral .................................................................. 213.6 Risk Retention ................................................................ 213.7 Risk Analysis .................................................................. 213.8 Currency Risk Monitoring .............................................. 22

CHAPTER: 4.CURRENCY RISK MANAGEMENT

4.1 Risk Process...24



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4.2 Currency Risk Management Policy . 254.3 Keys to a Successful Policy.. 264.4 Automation through Treasury .. 27

CHAPTER 5. CURRENCY HEDGE RISK

5.1 Explaining Currency Risk 395.2 Currency Surprise 405.3 To Hedge or Not To Hedge 405.4 Instruments for Hedging Currency Risk 415.5 Non-Hedging Techniques to Minimize ..... 42

CHAPTER 6: CONCLUSION AND RECOMMENDATIONS

6.1 Conclusion 456.2 Recommendations . 46

BIBLOGRAPHY ................................................................................... 48

ACKNOWLEDGEMENT



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In the name of ALLAH most merciful most beneficial. First of all, I will say thanksto Almighty ALLAH for giving me courage to work on this report and foreverything, I have achieved or will achieve in future. After I would like to expressmy heartfelt gratitude towards all those people who have supported me for the

fair compilation of this research report. Firstly, I would like to thank my teacherSir Dr. Noor Ahmed Memon, whose guidance and encouragement motivated meto undergo this grueling exercise, secondly all those people whose help andsupport made this work possible. I hope that this report rightly serves its purposeof providing an in domain knowledge for Currency risk management analysis ofGrowing market. Where all efforts have been made to ensure objectivity andaccuracy in the information provided, any errors whatsoever may kindly beexcused.

ThanksMuhammad Aamir Bashir (BEM/983)

INSTITUTE OF BUSINESS AND

TECHNOLOGY



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ABSTRACT SUBMITTED BY: Muhammad Aamir Bashir

DISCIPLINE: EMBA(Finance)

TITLE OF PROJECT REPORT: Currency Risk Management

MONTH OF SUBMISSION: November - 2009

NAME OF PROJECT SUPERVISOR: Dr. Noor Ahmed Memon

ABSTRACT

The increased interest of risk management in the Currency market is evident

from the increased risk in the market due to current economic conditions along

with the increase in world currency market.

My research is distributed in two parts. The first part is the analysis of risk

management of Currency market attribute with the foregone market investmentreturns. Where as the second part deals with the analysis of the impact of risk

management operations. I will end my report by giving my conclusion and

recommendations.



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CHAPTER 1: Introduction

1.1 Introduction1.2 Purpose of Study1.3 Research Objectives1.4 Literature Research1.5 Research Methodology

1 . Introduction

1.1 Introduction

In this introductory section of the thesis, a general background of currency risk

management will be presented, along with a short presentation of the case



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company in this thesis - Following is a discussion of the problem, leading into the

purpose. To clarify the structure of the thesis, a disposition will conclude this first

section.Since last two decades the Currency market of Pakistan is progressing

very well and has made international recognition. This progress is the result

of reformation applied by the government of Pakistan, But still in comparison with

developed world market of the world, our market is far behind in terms of

infrastructure skill workers and technology using for risk management.

Pakistani financial market needs to improve a lot to reach at the level of

developed currency risk management for the strong business domain.

1.2 Purpose of Study

The main purpose of study is to highlight the shortcomings present in following

three aspects of Currency risk management and provide the suggestions to

accelerate the development process of it and manage professionally currency

risk.

Currency risk infra structure

Principles Of Risk management

Guidelines for Currency risk management

Secondary purpose of this research is to provide the basic information about the

importance and functions of investment bank, functions and player which are

Involved in the currency risk and other information with reference to risk literacy.

1.3 Research Objectives

How the currency risk can management in current market situation and growth of

currency market in Pakistani currency market can be reached at the level of

developed countries market by improving the risk management structure, risk

management and investing areas and developing and growth process?



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1.4 Literature Review

Currently, currency market in crises because of economic downturn and inflation

and high-rises of Gold demand in the world market. Pakistan currency market is

also affected to law and order worst condition and worst political conditions. The

regulatory body (State Bank of Pakistan) needs to give incentives to all Currency

market dealers and investment and commercial banks because all of inflation in

the world market for other portfolio conditions is also not good. In this current

scenario of worst economy forex market need to diversified start stepping

towards internationalization by developing business relations with other

regional and international currency exchanges and try to attract the regional and

international companies for cross border exchange on its indices.

Currency risk management much necessary to growth of currency market in the

world, in our country state bank need to develop strong risk management

infrastructure, its need to also develop strong organizational Structure, Financial

support, Trading process, clearing and Settlement Process

1.5 Research Methodology

Qualitative Research approach is employed for this study. This is a comparative

study in which currency market of Pakistan development and growth in that

sense of financial support of other supporting industries and growth in multiple

financial controls in primary and secondary market and only secondary data is

used for analysis.



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CHAPTER 2: Currency Risk Management

2.1 What is Currency Risk

2.2 Currency Risk Management2.3 Impact of Currency Values2.4 Economic Analysis2.5 Liquidity and Valuation

2 . Currency Risk Management

2.1 What is Currency Risk



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The risk that the value of an asset/liability/financial instrument will (negatively)

change due to changes in FX rates (Financial risk applied to international

finance!)

2.2 Currency Risk Management

Our currency risk management group develops a wide range of currency solutions

for multinational corporations. We formulate cost-effective hedging strategies to

protect earnings and asset values from currency losses.

We work closely with clients to identify needs, objectives and FX exposures to

deliver custom-tailored strategies and policies to fully meet the financial objectives of

the client.

Futures or Forward Currency Contracts

Forward/Futures are agreements that set, today, the price of the exchange rate at a

given future date. The agreement specifies a given quantity.

Basic Terminology

Short: Agreement to Sell.

Long: Agreement to Buy.

Contract size: Number of units of foreign currency in each contract.

Maturity: Date in which the agreement has to be settled.

Futures price : The price at which the forward transaction at maturity will be executed.

Forward markets: Tailor-made contracts.

Location: none.

Reputation/collateral guarantees the contract.

Futures markets: Standardized contracts (standardized duration, size, collateral).

Location: organized exchanges

Clearinghouse guarantees the contract.

CME Standardized sizes: GBP 62,500, AUD 100,000, EUR 125,000, JPY 12.5M

CME expiration dates: Mar, June, Sep, and Dec + Two nearby months



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Margin account: Amount of money you deposit with a broker to cover your possible

losses involved in a futures/forward contract.

Initial Margin: initial level of margin account.

Maintenance Margin: lower bound allowed for margin account.

If margin account goes below maintenance level, a margin callis issue:

Table Comparison of Futures and Forward Contracts

Futures Forward

Amount Standardized Negotiated

Delivery Date Standardized Negotiated

Counter-party Clearinghouse BankCollateral Margin account Negotiated

Market Auction market Dealer market

Costs Brokerage and exchange fees Bid-ask spread

Secondary market Very liquid Highly illiquid

Regulation Government Self-regulated

Location Central exchange floor Worldwide

2.3 Impact of Currency Values

The impact of currency values on commercial operations is a familiar topic for the

international executive. It is a source of fascination for the armchair economist,

and a favorite explanation for this quarter's variance. Small and large players

alike enjoy the glimmer of excitement when the latest rates are quoted, signaling

the lead in a global sweepstakes.

Much of the attraction of currency markets stems from its synthesis of all aspectsof the world economy distilled into a single, digestible value. The significance of

relative currency values rests primarily on their relationship to world markets and

their interaction with international trade, investment, and monetary practices.



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A given exchange rate, when viewed in isolation, may at first appear to be little

more than an abstraction. Yet, it exercises a significant influence on commercial

relations as a pricing mechanism affecting every international transaction. The

impact of exchange rate fluctuations on domestic aggregates can also affect the

course of economic activity to the point that a sense of urgency is reached when

dealing with volatile markets.

As long as currencies remain the medium of exchange for commercial

transactions, market fluctuations of relative currency values will continue to

attract the attention of the exporter, the manufacturer, the investor, the banker,

the speculator, and the policy maker alike.

Exposure Defined

A currency is exposed to exchange rate fluctuations to the extent that it is used to

conduct transactions with external markets. The greater the proportion of

intercurrency exchange to total monetary transactions for a given market, the

greater the exposure to changes in exchange rates.

Commercial operations conducting international trade are exposed to exchange

rate fluctuations in proportion to their total volume of transactions. As the

magnitude of intercurrency transactions increases relative to aggregate

transactions, a business unit realizes greater exposure to exchange rate

fluctuations.

The transactions approach to exchange exposure has gained prominence in

recent years. A lingering preoccupation with currency translation for the

measurement of operating performance, however, has tended to divert attention

away from productive commercial activity towards disingenuous, while flashy,

hedging techniques. The clever money manager can still generate significant

cash gains from currency hedging without increasing the productive output of a

business unit.

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By defining currency exposure as the proportion of intercurrency transactions to

total transactions, greater management attention can be aimed at operating units

with a high degree of exposed risk to exchange rate changes.

Operating Performance

Evaluating operations performance on a global scale demands a shift in

perspective towards techniques based on multilateral transactions analysis. An

enterprise operating in a single market with single currency transactions can

easily be evaluated in the operations currency, while one which is engaged in

many markets and multiple currencies requires more extensive analysis.

Common financial accounting practices require financial positions to betranslated at current exchange rates from the operations currency into the

reference currency. Despite the need to consolidate financial results on a

consistent basis, direct translation at current exchange rates continues to

obscure actual operating results when the relative currency values fluctuate from

period to period. As a result of these exchange rate fluctuations, and the extent

of their volatility, comparisons over a number of periods become completely

invalid from the perspective of the reference currency.

A recurring theme throughout the deliberation of multicurrency financial

accounting is that a commercial operation should be evaluated from the

perspective of the economy in which the unit is located, as measured by the

operations currency; this is the fundamental argument for establishing current

rate translation accounting over historical rate translation methods. Resolving this

dichotomy can be an extensive process so long as the need remains to translate

operating results for consolidation into a single currency of reference.

The task of evaluating performance in multiple currencies extends beyond

contemporary financial accounting practices. One approach is to separate the

evaluation of operating results from their consolidation. A multi-tier evaluation

process then evolves as operations in an external market develop through a

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cycle from capital investment to normal commercial operations. Ongoing

business operations are evaluated in the operations currency, consolidated

enterprises from the reference currency, while the return on capital investment is

measured in the investment currency.

Yet all of these measures fail to consider the actual impact of exchange rate

fluctuations on business activity conducted between markets having different

currencies.

When an enterprise imports raw materials and components from external

markets, it is subject to currency transactions exposure between the time the

goods are ordered and when payment is disbursed. Exports to third markets are

affected by transactions exposure when their prices are denominated in third

currencies; even when denominated in the operations currency, the demand for

exports is directly related to the price of the goods as measured by the

customer's reference currency.

Transactions exposure for both imports and exports directly affect the overall

level of business activity through its impact on sales volumes, revenues, and

production costs. It then becomes a practical matter to determine the mostappropriate means for interpreting transactions exposure between the business

unit and external markets with which it conducts trade.

In a global setting, where multiple international operations transact business

between many different markets, the transactions exposure of one operation may

differ substantially from the exposure of other operations within the enterprise.

Aggregate transactions exposure of world-wide operations is determined by the

consolidation of intercurrency transactions across the entire enterprise.

Consolidation on the basis of currency, instead of by location or legal entity,

yields a more complete picture of the total currency transactions exposure.

Investment Risk

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Decisions to expand into a specific marketplace are primarily influenced by the

projected course of economic developments within the market under

consideration. Economic relationships between the external market and third

markets are also taken into consideration. Whereas prior exports to this external

market were likely to have been denominated in the base reference currency, a

physical business presence in the external market entails an indefinite term

commitment measured by a new operations currency.

Capital investment in an external market depends largely upon the expected rate

of return on the investment as measured relative to the investment currency. The

expected return is derived almost entirely from volume projections, expenditure

estimates, and the resulting cash flow in the operations currency. Theseprojections are then translated into the investment currency for comparison with

other capital investment opportunities on an equivalent basis. As a result,

investment decisions rely almost entirely on translations exposure when

considering currency risk.

Transactions exposure takes an entirely different perspective in the investment

risk assessment. In addition to normal economic risks which are present within a

specific external market, transactions risk between markets is involved in an

investment decision.

The transactions exposure for capital investment comprises two main factors:

Changing intercurrency exchange rates between the time the

investment is under consideration, and the time the investment

currencyis converted to the operations currency.

Changing intercurrency exchange rates for dividend remittancesconverted from the operations currencyto the base investment

currencyspanning an indefinite period.

Once a commitment is made to a long-term market presence, management of

exchange risk transfers from a focus on translations exposure to one based on



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transactions exposure. The external market operations can then be assessed

according to the inherent economic risk factors (rates of market growth, price

trends, technology developments, and product competition) attributable to the

local market. The total investment exposure to exchange rate fluctuations is

limited to the appropriations decision period and to the discounted dividend

stream.

2.4 Economic Analysis

Critics often cite economic projections as inaccurate and unavailing for business

operations. This criticism is so pervasive that economists themselves have come

to evaluate their own performance by the degree to which specific predictions

match actual results. This fixation with the accuracy of economic predictions

reflects the prominence of short term results over long term development.

The situation in international commerce and finance reflects many of the same

characteristics. Many in the field tend to view international operations and the

world market as abstractions. Even those who normally function in a global

environment perceive it through the filter of electronic media, continuously

updated and flashed upon a screen terminal.

Concepts which are familiar to the financial economist in planning for

international business operations may not be readily apparent to specific

functional units. Diminishing returns may seem to have little bearing in meeting

sales quotas; marginal productivity is rarely evoked during cost reduction

consolidations; and, elasticity of demand is hardly mentioned when preparing for

facilities expansion.

The value of economic analysis is the assessment of a given course of action

and a determination of the probability that a decision will generate positive

incremental economic activity. Economic activity is characterized by a number of

concepts relevant to operating in international markets, and tied to the



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opportunities and risks associated with the generation of wealth across national

boundaries.

It recognizes the fact that there are many factors beyond the control of the

individual decision maker. If it were possible to accurately predict the effect of

these externalities, there would be little if any need for anyone to carry out

normal daily business decisions, since the results of these decisions would have

already been predetermined. The ability to achieve the desired economic results

depends largely on the skill with which the associated risk is managed.

2.5 Liquidity and Valuation

When proceeds from financial instruments traded on one market are transferred

to another market using a different market currency, the resulting investment is

subject to intercurrency transactions exposure. Capital flows between world

financial markets are subject to the same intercurrency transactions exposure as

commercial operations. Yet the high liquidity of securities traded on financial

markets reflects a significantly greater frequency and aggregate value of these

transactions.

The income derived from investment instruments traded on an external financial

market is measured from the standpoint of the currency of reference established

by the individual investor. A divergence in portfolio valuation occurs when the

intercurrency exchange rate between the market currency and the reference

currency moves in a different direction (or at a different rate) than the native

financial market securities prices.

Investors measuring income in a reference currency other than the market

currency are concerned with two primary issues relating to the transactions

exposure of their investment positions:

Conversion of the instrument price from the market

currency to the reference currency; and,



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Dividend and interest proceeds converted from the

market currency to the reference currency.

In some cases, however, the currency transactions exposure exhibits opposite

characteristics. This involves equity securities which are traded on a financial

market having a market currency different from the reference currency for the

underlying assets of the instruments.

A large number of publicly traded equity securities are listed in more than one

financial market around the globe, where they are traded in the respective market

currency. The financial market with the largest trading volume in a specific equity

security generally determines the base trading price of the issue; arbitrage then

results in a direct conversion at the prevailing exchange rate in other markets.

In these cases, the individual investors trading in a reference currency native to

the market currency, are subject to transactions exposure without engaging in

intercurrency transactions.

Organizations which issue securities in financial markets, with market currencies

different from the issuer's reference currency, often have tangible fixed assets

and business operations in the same territory as the external financial market.

The related equity securities traded in these markets, however, are rarely

secured by the assets situated in the same market territory.

A given trading price for an equity security is a composite of all segments of the

issuing organization (exclusive of factors specific to the financial market) and

includes those business segments conducted in markets other than the reference

currency. Variances between market capitalization and fundamental valuation of

an equity security arise when the world-wide assets pertaining to the equity

appreciate, or depreciate in value.

Fundamental valuation of the equity security is thus subject to intercurrency

transactions exposure relating to:



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Sensitivity to exchange exposure relating to the internal

cash flow of the issuing organization;and,

Correlated demand for the products of the issuing

organization transacted in the world market.

As the exposure to exchange risk increases, the exposure to share price volatility

should also increase. Investors would agree that it is not feasible to identify the

price of a specific security as a basket of fundamental equity values. (Who would

trade in a security priced as: 15 Dollars + 1,000 Yen + 5 Pounds Sterling? Which

commercial organization would remit dividends in similar proportions?) Clearly, it

is the investor who assumes the risk of currency exposure from the standpoint of

the investment currency.

CHAPTER 3: TYPES OF RISKS

3.1 Types of Risk



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3.2 Risk Avoidance3.3 Risk Reduction3.4 Risk Transfer

3.5 Risk Deferral3.6 Risk Retention3.7 Risk Analysis3.8 Currency Risk Monitoring

3 . TYPES OF RISK

3.1 Types of Risk



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All techniques to manage the risks fall into one or more of the following five major

categories risk avoidance, risk reduction, risk transference, risk deferral and

risk retention.

3.2 Risk Avoidance

Also known as risk removal or risk prevention, risk avoidance involves altering

the original plans for the project so that particularly risky elements are removed.

It could include deciding not to perform an activity that carries a high risk. Less

drastically it could involve altering the activity in such a way that the risk is

removed.

Adopting such avoidance techniques may seem an obvious way to deal with all

risks. However, often the areas of the project that involve high risks are also the

areas of the project that potentially contain the highest worth or the best value for

money. Avoiding such risks may also result in removing potentially the 'best bits'

of a digital resource, and an alternative strategy that retains these risks may be

more appropriate.

3.3 Risk Reduction

Risk reduction or risk mitigation involves the employment of methods that reduce

the probability of a risk occurring, or reducing the severity of the impact of a risk

on the outcome of the project. The loss of highly skilled staff is a considerable

risk in any project and not one that can (legally) be totally avoided. Suitable risk

mitigation could involve the enforcement of a notice period, comprehensive

documentation allowing for replacement staff to continue with the job at hand and

adequate management oversight and the use of staff development programmes

to encourage staff to stay.

3.4 Risk Transfer



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Risk transfer moves the ownership of the risk to a third party normally by

contract. This also moves the impact of the risk away from the digitization project

itself to this third party.

3.5 Risk Deferral

The impact a risk can have on a project is not constant throughout the life of a

project. Risk deferral entails deferring aspects of the project to a date when a risk

is less likely to happen.

3.6 Risk Retention

Whilst a certain number of the risks to the project originally identified can beremove by changing the project plan or dealt with by transferring the

responsibility of the risk to third parties inevitably certain risks have to be

accepted as a necessary part of the project. All risks that have not been avoided

or transferred are retained or accepted risks by default.

It is therefore important to develop appropriate plans outlining how these residual

risks will be dealt with should they occur.

3.7 Risk Analysis

Risk assessment is not simply about identifying risks so that the project team and

stakeholders are aware of them. It also involves assessing the potential severity

of these risks, thereby identifying where to most effectively focus attention and

resources in managing them.

In order to assess the seriousness of a potential risk it is necessary to estimatethe rough probability of it happening and the impact, should it occur, on the

project timetable, project costs and end quality of the digital resource.

3.8 Currency Risk Monitoring



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Identifying, analyzing and planning for risk is an important planning stage of any

project. However, risk management does not stop once the risks have been

identified. Initial risk management plans will never be perfect. Practice,

experience, and actual loss, will necessitate changes in the plan and inform

decisions about how to most effectively deal with certain risks. Risk identification

and analysis should be ongoing throughout the project but particularly at project

start-up and milestones. The best risk planning becomes useless unless a clear

picture is maintained of how the project and its associated potential risks are

developing. A reliable reading or assessment of a projects situation can only be

achieved through iteration, in other words, the continuous repetition of all steps of

the risk management process. It is important to keep track of identified risks, to

revisit the risk assessment to monitor the effectiveness of the chosen responses

and to identify new or changed risks and to make the necessary changes to the

risk log. This will mean that when a risk does occur your chosen response will be

appropriate and more likely to be implemented effectively. It also means that you

can communicate the risk to key stakeholders and demonstrate how it was

anticipated and dealt with. A practical example of a risk monitoring action was the

creation and implementation, by the OHPR project team, of a purpose design

and built process management tool known as the Issue Tracker. This tool

consists of a website interfaced to a database which enables the sharing of the

management of quality assurance between the OHPR team and the supplier of

the image data. The Issue Tracker was specifically designed to fulfill the quality

control management requirements of the OHPR project; however it is applicable

to other digitization projects and is now available as a download



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CHAPTER: 4.CURRENCY RISK PROCESS

4.1 RISK PROCESS4.2 Currency Risk Management Policy4.3 Keys to a Successful Policy4.4 Automation through Treasury

4 . CURRENCY RISK PROCESS

4.1 Risk Process



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1. Risk Definition - Define the type of currency risk to be managed

2. Measurement Methodology- Create a model to measure the currency

exposure to be managed

3. Exposure Gathering- Gather data and calculate exposure

4. Covering Strategy- Determine to what extent and how exposure will

be hedged

5. Hedge Execution- Hedge exposure through trade execution and other

techniques

Step 1: Risk Definition



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Economic Exposure

Toytel designs, manufacturers, and distributes Star Wars action figures, primarily

for retailers in the U.S. A contract manufacturer based in China produces the


EconomicExposure

TransactionExposure

TranslationExposure

Effect of exchange rateson revenue andoperating expenses

Effect of exchangerates on foreigncurrency denominatedcurrent assets andliabilities

Effect of exchangerates on translation offoreign subsidiaries

CurrencyRisk

ForecastedExposure

Effect of exchangerates on forecastedor committed FXexposures


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toys for Toytel, invoicing in $US. Due to revaluations of the Yuan during 2005

and 2006, the Chinese manufacturer increased the $US unit prices for its toy

production, reducing Toytels operating margin.

Table of Economic Exposure Example

Scenario Current ExchangeRate

5% YUANRevaluation

Revenue 1,000 1,000

Operating Expenses 900 945

Transaction (Gains)/Losses -- --

Net Income 100 55

Translation Gain (Loss) -- --

Comprehensive Income 100 55

Transaction Exposure

El Dorado is a US-based maker of designer watches. The company exports to a

worldwide distribution network, invoicing in local currencies. The company holds



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a large book of yen denominated receivables. A recent depreciation of the yen

resulted in a reduced $US valuation of these receivables.

Table of Transaction Exposure


5% YENDepreciation

Revenue 1,000 1,000


Transaction (Gains)/Losses -- 45

Net Income 100 55



Forecasted Exposure



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Zendix is an auto parts manufacturer. The companys Canadian subsidiary

produces brake parts under a long-term contract with Ford, with highly

predictable delivery volumes. During the year, the $US weakens against the

$CN, reducing the functional currency revenue levels, partially offset by reduced

functional currency input costs

Table of Forecasted Exposure


5% US$Depreciation

Revenue 1,000 950



Net Income 100 75



Translation Exposure



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Security Check is an international provider of criminal background checks.The companys Indian subsidiary is a recent acquisition that operates primarilywithin India, with functional currency of the rupee. A recent devaluation of therupee against the dollar resulted in a translation loss by the parent when the localcurrency balance sheet was translated and consolidated at year end.

Table of Translation Exposure


5% INRDepreciation

Revenue 1,000 1,000



Net Income 100 100

Translation Gain (Loss) -- (25)


Step 2: Measurement Methodology



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Table of Measurement Methodology

Methodology Exposure Types Addressed Description

Foreign currencycommitments

TransactionTranslation

Booked non-functionalassets and liabilities

Forecasted foreign currencypayments

Transaction Forecasted committedand non-committednon-functional currencypayments

Forecasted net investment Translation Projected netinvestment of a foreignsub as of a futureperiod end

Value-at-Risk Translation VaR of translation proforma recent period end

Earnings-at-Risk Transaction EaR of transactionlosses pro form arecent earnings period

Regression Economic Regression analysis of correlation betweenrevenues and expensesand currencymovements

Step 3: Exposure Gathering



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Table of Exposure Gathering

Methodology Example Data Needed

Foreign currency

commitments

JPY receivables as of

3/31/06

3/31/06 balance sheet

with JPY receivablesdetail

Forecasted foreigncurrency payments

Projected receipts ofEuros through 2006 byUK-based sub

Forecast of monthly Eurobillings and collections atUK sub

Forecasted netinvestment

Projected net investmentas of 12/31/06 of aTaiwan-based sub

Projected net investment(assets and liabilities) ofTaiwan sub, translated atbudget rate

Value-at-Risk Consolidated VaR of USCompany, representing95% confidence thattranslation loss does notexceed a benchmark proforma 12/31/05

Translation consolidationmodel with distribution ofexchange rates

Earnings-at-Risk Consolidated EaR of USCompany, representing95% confidence that

transaction does notexceed a benchmark proforma 2005 net income

2005 transaction gain/lossmodel with distribution ofexchange rates

Regression Regression model for revenue and expense for$CN, Euro, BP

Regression analysis

Exposure Gathering Techniques



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Step 4: Covering Strategy


Excel Template

Treasury

Workstation

CurrencyNetting/Pairing

Applications

General Ledger

ERP and OtherForecast

Consolidators

ProprietaryApplications

E Mail

WebInterface

File Upload

Application

Telephone

Aggregate

Currency

Exposure

Hedge Trading

Hedge Administration

Executive Dashboard


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Common Currency Exposure Covering Strategies

Strategy Feature Execution Risk Accounting Risk

Currency Forwards Lock in forward rate Low Low

Currency Options Cover unfavorable rate

scenarios

Low Medium

Cross CurrencyInterest Rate Swaps

Hedge non-functionalcurrency debt

Low Medium

Functional CurrencyDebt Issuance

Match functionalcurrency liabilities toassets

Medium Medium

Exotic Derivatives Tailor derivative tomarket and risk views

Medium High

Functional CurrencyInvoicing

Pass FX risk tocustomers and suppliers

High LOW

Revenue/ExpenseMatching

Source cost inputs incurrency of customers

High LOW

Step 5: Hedge Execution



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4.2 Currency Risk Management Policy

Currency Risk Management Policy


How to TradeDerivatives and Live

to Tell About It

Log Hedge

Trade Hedge

Confirm

Hedge Trade

Book Hedge

to G/L

Set Hedgeper Policy

Identify

MeasureExposure

Test Hedge effectiveness

Financial ReportingRemeasure exposure

Current Period Subsequent Period


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Objectives Establishes why the company manages currency risk,objective of policyDefinitions Defines key terms used to formulate the policyPolicy Guidelines Sets purpose and philosophy of the hedging programRoles and Responsibilities Defines delegations, segregation of duties

FX Exposure Management Establishes types of currency risk to hedged,strategies and coverage levels; derivatives that may be tradedReporting - Establishes FAS 133 elections and administrationControls - Establishes key internal controls such as limits andreconciliations.

4.3 Keys to a Successful Policy:

Signed off by Executive Management

Annually reviewed Identifies procedures for SOX documentation

4.4 Automation through Treasury Technology



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Front Office Middle Office Back office FAS 133

Pricing Analytics Market ExposureRisk

Inventory Documentation

Deal Capture What-if Analysis P&L Hedge Designation

Portfolio Allocation Marks-to-Market Resets Analytics

Term Sheet Payment Reporting

Option Expiry EffectivenessTesting

Audit Report Tracking

Cash Flow Hedge


Market Data

Infrastructure Support


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Source: Mark Trombley Accounting for Derivatives and Hedging

www.TreasuryStrategies.com

1. Risk Assessment - Assess aggregate exposure to key currencies throughEarnings-at-Risk (pro forma) or scenario analysis


Change in fairValue of derivative

Change in fairvalue of Derivative

Earnings affect ofhedged item

(transaction gain/loss)

Without Hedge Accounting

With Hedge Accounting

Adjust carryingvalue of

derivatives tofair value

Adjust carryingvalue of

derivatives to

fair value

Record gain or

lossfrom effectivehedging as OCI

and accumulate inAOCI

Recognizechange in fair

value inearnings

Recognize gain orloss from in

effective hedgingin earnings

Recognizehedge item in

earning inusual way

Balance Sheet Income Statement

Recognizedeferred gain/lossin same period ashedge item effect

earnings


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2. Strategy Development- Recommend alternatives for measuring and managingexposures

3. Implementation - Recommend policies and procedures execution, tracking andreporting



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CHAPTER 5. CURRENCY HEDGE RISK

5.1 Explaining Currency Risk5.2 Currency surprise5.3 To Hedge or Not to Hedge5.4 Instruments for Hedging Currency Risk5.5 Non-Hedging Techniques to Minimize

5 . CURRENCY HEDGE RISK



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Investment professionals face a tough climate. Fixed income yields are at near

lows. U.S. equity markets have been depressed for the past three years. Given

the recent geopolitical uncertainties, the foreign currency markets have been in

turmoil. What little returns that can be achieved by investment managers need

protection. The investing public more and more is reaching out to global markets

to make money and the issue of protecting investment returns from foreign

exchange risk becomes critical.

5.1 Explaining Currency Risk

A key difference between investing in domestic and foreign assets is that the

latter exposes the investor to a currency risk. Over the years, most investors

have not been careful in characterizing this risk to returns from unhedged

portfolios. One simplistic view was to measure the return in domestic currency

terms and compare it with returns in local currency terms, and characterize the

difference as the currency effect. The reasoning was that if the exchange rate

remains constant from the time of purchase of the foreign asset to its sale, then

the currency risk has had zero impact. On the other hand, if the domestic

currency has weakened (strengthened) against the foreign currency, the

exposure would result in a gain (loss).

In August 1998, the Association for Investment Management Research (AIMR)

argued that the use of changes in spot exchange rates (over the investment

period) as a measure of the influence of currency risk on foreign asset returns

was misleading. AIMR preferred an alternate approach, one that involved

splitting the currency effect into components: expected or known effect captured

by forward premium or discount.

5.2 Currency surprise



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In other words, currency surprise can be interpreted as the unexpected

movement of the foreign currency relative to its forward rate or market predicted

rate.

The assumption here is that the forward premium or discount (expected currency

effect) will be embedded in the return from a fully hedged portfolio. This implies

that Unheeded foreign asset return (US$) = Currency surprise + Hedged foreign

asset return (US$)

Currency surprise is essentially noise. So every investor in foreign assets must

make an explicit decision on whether or not he wants to take on exposure to this

noise factor.

5.3 To Hedge or Not to Hedge

Over the years, there has been considerable controversy on it. As might be

expected, there are multiple view points regarding the relative merits of hedging

away currency risks. Here are a couple of classic arguments in favor of not

hedging.

Uncorrelated risks

On a historical basis, changes in exchange rates (and hence currency returns)

have had very low correlations with foreign equity and bond returns. The belief is

that this lack of any systematic relationship could in theory lower portfolio risk.

Expected returns are zero

Viewed over a long investment horizon, currency movements cancel out each

other the mean-reversion argument. In other words, exchange rates have an

expected return of zero. So why bother hedging against currency surprise.

Realized versus expected returns

Currency returns tend to be episodic. In other words, there can be sufficient

movement in exchange rates in the short run that in theory could be exploited togenerate positive returns. More important, these movements also tend to exhibit

some degree of persistence.

5.4 Instruments for Hedging Currency Risk



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Foreign currency markets are deep, highly liquid, and relatively inexpensive.

Fund managers seeking to manage their currency exposures can pursue one or

more strategies: trade over-the-counter (OTC) market currency forwards and

options, exchange-traded futures and options on futures, or hire the services of

an overlay manager. Overlay managers are essentially specialist currency

trading firms that will actively manage a currency hedge mandate, and in

addition, attempt to generate a positive excess return. These firms too rely on

currency futures, forwards and options contracts.

Exchange-Traded Currency Futures Exchange-traded currency products offer at

least three major advantages vis--vis the inter-bank over-the-counter (OTC)

market:

1. Price transparency and efficiency,

2. Elimination of counterparty credit risk, and

3. Accessibility for all types of market participants.

Price Transparency and Efficiency

Futures and options exchanges bring together in one place divergent categories

of buyers and sellers to determine foreign exchange prices. This efficient price

discovery process is further enhanced by transparent trading arrangements.

Whether the trading venue is open outcry or electronic, the prices for exchange-

traded foreign currency products are disseminated worldwide via major quote

vendors such as Reuters, Bloomberg, and others. Electronic trading on

computerized trading systems takes place on a nearly 24-hour basis.

Elimination of Counterparty Credit Risk

Exchange-traded currency contracts have the exchange clearing house as the

counterparty to every trade. For example, the CME Clearing House is the buyer

to every seller and the seller to every buyer of all its currency products. Marketparticipants then need not evaluate the credit worthiness of multiple

counterparties. The CME Clearing House is their counterparty. All clearing

members of the CME Clearing House stand behind trades at the exchange.



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Importantly, there has never been a single default in the 104-year history of the

exchange. The OTC inter-bank market operates on the basis of credit limits for

every potential counterparty. BIS requires banks to maintain adequate levels of

capital to cover forward-maturity currency transaction risk. These requirements

are waived for foreign exchange transactions booked on exchanges, where

performance bonds are required and daily mark to market of open positions is

done.

Accessible to All Market Participants

The advent of financial futures began in the early 1970s because some inventive

and persistent commodity traders at Chicago Mercantile Exchange did not have

access to the inter-bank foreign exchange markets when they believed significantmoves were about to take place in currency prices. They established the

International Monetary Market (now a division of CME), which launched trading in

seven currency futures contracts on May 16, 1972creating the worlds first

financial futures. No longer was the arena of foreign exchange trading limited to

large commercial banks and their big corporate customers. Individuals, small

and medium-sized banks and corporations, investment funds and governments

can buy and sell currencies for future delivery or cash settlement. Universal

access to its markets is an important defining characteristic of exchange-traded

foreign currency futures and options.

5.5 Non-Hedging Techniques to Minimize

Transactions Exposure Two obvious ways in which transactions exposure can be

minimized, short of using the hedging techniques described below, are

transferring exposure and netting transaction exposure. The first of these is

premised on transferring the transaction exposure to another company. For

example, a U.S. exporter could quote the sales price of its product for sale in

Germany in dollars. Then the German importer would face the transaction

exposure resulting from uncertainty about the exchange rate. Another simple

means of transferring exposure is to price the export in Deutsche Marks but



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demand immediate payment, in which case the current spot rate will determine

the dollar value of the export.

A second way in which transaction risk can be minimized is by netting it out. This

is especially important for larger companies that do frequent and sizeable

amounts of foreign currency transactions.

Unexpected exchange rate charges net out over many different transactions. A

receivable of 100 million Deutsche Marks owed to a U.S. company in 45 days is

much less risky if the U.S. Company must pay a different German supplier 75

million Deutsche Marks in 30 days. The risk is reduced further if the business has

only receipts in Deutsche Marks on a continuing basis.

Transaction exposure is further reduced when payments and receipts are in

many different currencies. Foreign currency values are never perfectly

correlated. Therefore, an unexpected increase in the value of the French Franc

may improve the profit margin on receipts from France. However, an unexpected

decrease in the value of the Canadian Dollar may reduce profits on a receipt

from Canada. Although transaction exposure cannot be completely netted away,

it may be small enough that the company is better off accepting the exposure

rather than incur the costs associated with the hedging techniques described

below.



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CHAPTER NO: 6. CONCLUSION ANDRECOMMENDATIONS

6.1 Conclusion6.2 Recommendations



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6 . CONCLUSION AND RECOMMENDATIONS

6.1 Conclusions

Risk management is the most important sector of the forex industry with the keysuccess by attending directly the needs of the end Currency market is having

glorious future in coming years.

Risk management in Currency Market as a whole is facing a lot of competition

ever since financial sector reforms were started in the country. Walk-in business

is a thing of past and banks are now on their toes to capture business. Banks

and DFI therefore, are now competing for increasing competition and availability

of day by day growing financial products and current modernization era financial

market business going more risky area.

There is a need for constant innovation in Risk management area Currency

market. This requires product development and differentiation, micro-planning,

marketing, prudent pricing, customization, technological up gradation, home /

electronic / mobile banking, effective risk management and asset liability

management techniques.

While Risk management covered products offers phenomenal opportunities for

growth, the challenges are equally discouraging. How far the financial market is

able to lead growth of banking industry in future would depend upon the

comprehensive risk management and capacity building of banks to meet the

challenges and make use of opportunities profitably.

However, the kind of technology used and the efficiency of operations would

provide the much needed competitive edge for success risk management

business. Furthermore, in all these customer interest is of chief importance. The

banking sector in Pakistan is representing this and I do hope they would continue

to succeed in this traded path.



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6.2 Recommendations

Current Situation and Issue Currency Risk management is most essential part of

any sort of operation in commercial banks and DFI. It is also depend the policy of

institution to work on strong and comprehensive risk management which will be

effective tool to secure and develop organizational growth and helpful for

professional way of working without harmful effects

Current Situation and Issue Description

Assessment of facilities for standard physical losses (Equity and Debt) and

potential occupational hazards is handled routinely by institutional Environmental.

The program of neither risk analysis nor a fully-dedicated position for loss control

and loss prevention at any institution. Responsibilities for risk management are

spread among a variety of departments. Thus, pre-loss process review and loss

prevention implementation is rare. Such strategies are generally handled on a

post-incident, department-only basis.

Rationale for Change

Institutions typically respond to property and liability losses in a reactive mode.

The work group believes it is essential to move to a proactive stance in

preventing losses. In addition, this reactive stance may well be the result of the

fact that no institution has a fully dedicated position to analyze losses, decide

upon methods of prevention, and coordinate implementation of loss prevention

measures.

As the position of risk coordinator is currently configured at the institutions, only a

small percentage of the total FTE is all risk activities. These activities are

confined to information gathering and dissemination of that information to RMD.

RMD then makes all the decisions regarding resolution of the claim. In general,

Risk Coordinators process the claim rather than manage it.

In contrast, workers compensation coordinators spend a majority of their time

performing claims management activities. They generally have an extensive

background in workers compensation and the associated loss control practices.



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Use of these practices allows them to impact the outcome of the claim and better

control the associated costs. Working in cooperation with SAIF Corporation

adjusters, they provide input and help design the best cost control strategy for

each claim.

Key Concerns Regarding the Development of a Comprehensive Risk Program

The key concern with developing a comprehensive risk program across the

System is the potential for initial increased resource costs. The challenge of

implementing a new program is to demonstrate that the benefits of the program

will outweigh the costs.

Another concern with implementing a risk management program is whether

incremental resources will possess the proper expertise. For a risk managementprogram to work effectively, the risk manager position at each institution would

ideally have professional experience. Without the proper experience and training

(i.e. if the risk manager position was staffed at a clerical level), the benefits

gained by implementing a Currency risk management program would be

considerably less



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