foreign exchange risk

International Finance

PresentationForeign-Exchange Risk

Management of Exposure Risk

Group - 4

FOREX-Management of exposure risks


Authors of Presentation

FOREX Risk Management

4 Vipin DasSreejithSaranya S RRenjil MathewRinto MathewLikhithaJishnuLijo StalinManu C Pillali


Foreign-Exchange Risk

• The risk of an investment's value changing due to changes in currency exchange rates.

• The risk that an investor will have to close out a

long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk".


• This risk usually affects businesses that export and/or import

• But also affect investors making international investments

• Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk

Foreign Exchange Exposure

• Foreign Exchange Exposure is a measure of the potential change in a firm's profitability,

• net cash flow and /or market value of net assets due to a change in exchange rates.

“When a US company sells to a foreign buyer and accepts the buyers currency for payment, the US company bears the risk that

the foreign currency depreciates and that it will receive fewer dollars once the foreign currency is converted back into the

dollar.”



TYPES OF RISK FROM FOREIGN EXCHANGE EXPOSURE

• Transaction Risk• Translation Risk• Economic Risk

3


Transaction Risk

When a firm or individual has a receivable or a payable in a foreign currency the foreign exchange rate may change, causing an increase in the liability of the home country's currency or a decrease in receipts in the home country's currency.


Transaction Risk

• The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates.

• Whoever makes a contract denominated in a foreign currency bears transaction risk.

“Ocean Drilling has transaction risk if it borrows money in French francs or Japanese yen, and Hintz-Kessels-Kohl has transaction risk if it agrees to accept future

payments for its vehicles in U.S. dollars.”


Passive Transaction Risk Management

• Denominate all contracts in domestic currency. This is a possible strategy for companies with market power.

• Do nothing about transaction risk. This is a possible strategy for companies with a large number of small contracts in a large number of currencies


Hedging

• Insuring against transaction risk to reduce or eliminate the effects of unexpected changes in exchange rates.

• You can hedge only at market rates. The effects of expected changes in exchange rates are incorporated in these market rates.

Hedging is insurance. The purpose of hedging is to reduce or eliminate risks, not to make profits.


Hedging

The purpose of hedging is to manage a firm's foreign exchange exposure by minimizing home currency outflows (payables/liabilities) and maximizing home currency inflows (receivables/assets).


Natural Transaction Risk Hedging

• Centralize cash management to net all offsetting transactions, transactions which are long and short the same currency.

• Time, lead and lag, offsetting business transactions in the same currency.

• Create offsetting business transactions in the same currency.


Translation Risk

When a home country entity is required to consolidate its foreign subsidiaries' income statements and balance sheets into the home currency. Exchange rates may change, causing an increase in liabilities or a decrease in assets as measured in home country currency terms.


Translation Risk

• Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them.

• Every company having at least one subsidiary using a different functional currency bears translation risk.

“MSDI has translation risk from having a subsidiary, MSDI Alcala de Henares, whose financial statements are kept in Spanish pesetas and not in U.S. dollars.”


Hedging Translation Risk

• Translation risk is hedged in the same ways as transaction risk.

• It appears as if investors are indifferent to foreign currency translation gains and losses.


Market Translation Risk Hedging

• Forward Markets• Futures Markets• Money Markets


Forward and Futures Markets

1. Any currency, any amount, any maturity

2. Illiquid3. Self-regulated OTC market4. Contract with dealer5. Requires credit-worthiness6. Cash flow only at maturity7. Settled by executing

contract8. Hedge by buying forward

the short currency or selling forward the long currency

1. Selected currencies, standard contracts, standard maturities

2. Liquid3. Government-regulated

exchange-based market4. Contract with exchange5. Requires margin account6. Marked to market daily7. Settled by offsetting trade8. Hedge by making a

transaction whose gains or losses offset those of the underlying position


Forward and Money Markets

• Money markets can always be used to synthesize forward markets.

• Money market rates are used to set forward market rates.

• Money market transactions are likely to be more costly than forward market transactions, since three transactions having their own bid-ask spreads are required to duplicate one forward market transaction with one bid-ask spread.

• Money market transactions appear on the balance sheet; forward market transactions do not.


Economic Risk

The effect of exchange rate changes on the long term expected income streams, i.e., expected net wealth of home country stockholders. This risk is usually managed with physical location of assets and liabilities.


Economic Risk

• Changes in competitive position as a result of permanent changes in exchange rates.

• Every company buying or selling abroad or even just competing with foreign companies has economic risk.“Maybach has economic risk from manufacturing its

automobiles in Germany for export to the United States, where it competes with Rolls Royces

manufactured in England.”

CONCLUSION

By incorporating foreign exchange risk solutions into broader business strategy, we can help protect your profitability by managing your exposure to exchange rates – whatever your risk appetite maybe.


THANK YOU

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