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RISK MANAGEMENT
FOREIGN EXCHANGE
RISK
Foreign Exchange Risk is the risk
of loss due to changes in the
international
currencies.
value
of
national
FOREIGN EXCHANGE
RISK
Foreign Exchange Risk refers to
the
adverse
unanticipated
effects
exchange
that
rate
FOREIGN EXCHANGE
RISK (CONTD..)
Foreign Exchange Risk is the risk
that the value of a future receipt
or obligation will change due to a
change in foreign exchange rate.
THE EMPHASIS IS ON
UNEXPECTED AND NOT
ANTICIPATED
The
emphasis
unexpected
anticipated
is
here
changes,
changes
in
on
as
the
ORIGIN OF FOREIGN
EXCHANGE RISK
Exchange risk originates from the
(random) fluctuations of foreign
exchange rates.
FOREIGN EXCHANGE
EXPOSURE
Foreign Exchange exposure refers
to the possibility that a firm will
gain or lose due to changes in
exchange rates.
FOREIGN EXCHANGE
RISK V/S EXPOSURE
Foreign
exchange
exposure
MEASURE OF FOREIGN
EXCHANGE EXPOSURE
Exposure can be measured by the
slope coefficient in a regression
equation relating the real change
in
the
dollar
value
of
asset,
changes
in
MEASUREMENT OF
EXPOSURE AS THE SLOPE
OF REGRESSION LINE
The changes in the value of asset and
liabilities
(V)
unanticipated
are
affected
changes
in
by
the
exchange
rate (S)
V =
f ( S)
V =
+ S + UT
Where,
V = Changes in the value of asset and
liabilities, and
MEASUREMENT OF
EXPOSURE AS THE SLOPE OF
REGRESSION LINE (CONTD..)
Exposure
is
measured
by
the
COV. (V, S)
VAR. S
Where,
V = Changes in the value of asset and
FOREIGN EXCHANGE
RISK V/S EXPOSURE
Exchange rate volatility is
by itself a necessary, but not
sufficient condition for foreign
exchange risk.
*
*
What is required is to
assess
foreign
exchange
exposure.
TYPES OF EXPOSURE
*
Transaction Exposure
Translation Exposure
Economic Exposure
TRANSACTION
EXPOSURE
Transaction Exposure is concerned
with how changes in exchange
rates affect the home currency
value
of
anticipated
foreign
to
transactions
which
TRANSACTION
EXPOSURE (CONTD..)
The
risk
that
the
cost
of
may
change
due
to
ECONOMIC EXPOSURE
*
Economic Exposure relates to
the possibility that the present
value of
future cash flows of a
firm may
change due to foreign
currency
movements.
*
The risk that changes in
exchange
values might alter a
firms present
value of future
income streams.
TRANSLATION
EXPOSURE
Translation exposure also known as
accounting exposure is that risk which
results from the conversion of the
value
of
denominated
firms
foreign
currency
TRANSLATION
EXPOSURE (CONTD..)
Translation Exposure arises as a result
of
the
process
of
consolidation
of
group
financial
denominated in the
parent company.
statements
currency of the
METHODS OF
TRANSLATION
*
Monetary/
Non-Monetary
Method
*
Temporal Method
BASIC CHARACTERISTICS
OF DIFFERENT TYPES OF
EXPOSURE
Exposure
Translation
Time
Span
Past
Nature
Change in
Exchange
Rate
Paper
Nominal
Transaction Present
and
future
Cash Flow
Nominal/
Real
Economic
Cash Flow
Real
Future
HEDGING FOREIGN
EXCHANGE RISK
Hedge is an approach designed to
reduce or offset a possible risk.
OBJECTIVES OF
HEDGING POLICY
*
To
be
aggressive.
conservative
or
*
Decide
the
appropriate
performance measure.
*
The time horizon framework
also to considered.
TECHNIQUES OF
HEDGING FOREIGN
EXCHANGE RISK
Two ways of looking at the
techniques
of
exposure
management
1. Exposure based on techniques
of risk
management
2. Internal
V/s
External
techniques
Internal Techniques
External Techniques
EXPOSURE BASED
TECHNIQUES
OF RISK MANAGEMENT
*
HEDGING TRANSLATION
EXPOSURE
The technique used to hedge
translation exposure is balance
sheet hedge.
It involves the
selection of the currency in which
exposed assets and liabilities are
denominated so that an exchange
rate would make exposed assets
equal to exposed liabilities. Same
level of exposed assets and
liabilities should be maintained.
HEDGING TRANSACTION
EXPOSURE
Forward Market Hedge
Money Market Hedge
Options Market Hedge
Swap Market Hedge
HEDGING ECONOMIC
EXPOSURE
Diversity Production
Diversity Marketing
Diversity Financing
INTERNAL V/S
EXTERNAL TECHNIQUES
*
Internal Techniques
External Techniques
INTERNAL TECHNIQUES OF
FOREIGN EXCHANGE
EXPOSURE
Internal techniques of managing
foreign exchange exposure are
those which do not resort to
special contractual relationship
outside the group of companies
concerned.
INTERNAL TECHNIQUES OF
MANAGING FOREIGN
EXCHANGE EXPOSURE
*
Netting
Matching
Pricing Policy
NETTING
Netting
involves
associated
Bilateral Netting
Multi-lateral Netting
MATCHING
Netting
is
term
applied
to
PRICING POLICY
Pricing Policy is used as an
exposure
technique,
management
simply
involves
INVOICING IN FOREIGN
CURRENCY
Invoicing in a particular currency
to
reduce
with
the
invoicing
risk
in
associated
the
host
EXTERNAL TECHNIQUES
OF EXPOSURE
MANAGEMENT
External techniques of exposure
management resort to contractual
relationships outside of a group of
companies in order to reduce the
risk of foreign exchange losses.
EXTERNAL TECHNIQUES
OF EXPOSURE
MANAGEMENT
*
Forward
market
(forward
options)
*
Short-term borrowings.
EXTERNAL TECHNIQUES OF
EXPOSURE MANAGEMENT
(CONTD..)
Currency overdrafts.
Government exchange
risk
guarantee.
*
SHOULD FIRMS
MANAGE FOREIGN
EXCHANGE RISK
Some firms refrain from active
management of Foreign Exchange
Risk
even
though
they
understand that exchange rate
fluctuations
can
affect
their
earnings and value. They make
this decision for a number of
reasons.
be
We
invoice
currency.
only
in
local
CORPORATE HEDGING
STRATEGY
Justified on Economic Grounds.
Increases the Value of the firm as
there is an increase in expected
Cash Flows.
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