Chapter 12

Chapter 12

Foreign Exchange Risk and Exposure

Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa

Slides prepared by Afaf Moosa

Objectives
To define risk and exposureTo elaborate on the concept of value at risk (VAR)To distinguish among transaction, economic and translation exposure
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Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. MoosaSlides prepared by Afaf Moosa



Definitions of risk
The chance of bad consequence, loss, etc. (The Concise Oxford Dictionary)The possibility of loss, injury, disadvantage or destruction (Websters Dictionary)
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(cont.)




Definitions of risk (cont.)
The origin of the word risk is either the Arabic risq or the Latin risicum
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(cont.)




Definitions of risk (cont.)
In finance, a distinction is made between risk and uncertaintyIn finance, risk is measured by the dispersion around the mean value of the rate of return, the cost of borrowing, the value of assets and liabilities, etc.
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FX risk
FX risk arises because of uncertainty about the future spot exchange rateIt refers to the variability of the domestic currency value of certain items resulting from the variability of the exchange rate
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Rate of return

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Measuring risk: probability distribution

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Measuring risk: historical data

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Measurement of VAR
Measurement unit (e.g. AUD)Time horizon (one day, one week, etc.)Probability (1-5%)
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Implementation of VAR analysis
Parametric (analytical) approachHistorical approachSimulation approach
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The parametric approach
The approach is based on the assumption of the normality of rates of return
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(cont.)




The parametric approach (cont.)

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Per cent of Observations

Lowest r

Highest r

Probability

VAR

68

16.0

90

5.0

95

2.5

98

1.0

99

0.5

)

(

s

-

r

K

s

65

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1

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r

s

65

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1

+

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65

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r

K

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96

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1

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r

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96

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1

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96

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1

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s

-

r

K

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33

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2

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r

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33

.

2

+

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33

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s

-

r

K

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3

-

r

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3

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3

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s

-

r

K

s

-

r

s

+

r



The historical approach
VAR with a certain probability is calculated from the lower nth percentile of historical observations on the rate of return
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VAR: pros
It is simpleIt is suitable for risk-limit setting and performance measurementIt can take account of complex movements
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VAR: cons
It can be misleadingVAR estimates are highly sensitive to the underlying assumptionsIt cannot cope with sudden or sharp changes
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VAR: conclusion
VAR is useful but it should be handled with care and used in conjunction with other measures of riskConfidence in VAR has been undermined by the global financial crisis as the VAR models used by financial institutions failed to predict the losses that they actually endured
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Exposure
Risk measures the probability and magnitude of deviation from some expected outcomeExposure is a measure of the sensitivity of what is at risk to the source of risk
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FX exposure
Exposure to FX risk is a measure of the sensitivity of the domestic currency value of FX items to changes in the exchange rateSometimes it is defined as the amount at risk
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The slope of the exposure line

where is the slope of the exposure line. is positive (negative) for assets (liabilities)

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Long and short exposures
Long exposure assets Short exposure liabilities
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Combined exposure
A combined exposure arises when a firm holds both foreign assets and foreign liabilities
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The relation between FX risk and exposure

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Multiple exposure
Exposure to more than one currency:
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The volatility of the AUD exchange rates
The standard deviations of monthly percentage changes in exchange rates
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USD/AUD

JPY/AUD

EUR/AUD

GBP/AUD

2004

2.88

3.38

1.70

2.11

2005

1.71

2.03

2.12

2.04

2006

2.62

2.18

2.30

1.74

2007

3.41

4.29

2.74

3.01

2008

6.44

7.93

3.62

5.41



Transaction exposure
Transaction exposure arises if payables and receivables are denominated in foreign currencies. It is a cash flow exposure associated with trade and capital flows
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Transaction exposure (examples)
Foreign assets or liabilities that are already recorded on the balance sheetA contract or an agreement involving a future foreign currency cash flow
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Volatility and correlation
Exposure to a currency that fluctuates sharply is more of a source of concernExchange rate correlations are important
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Economic exposure
Changes in exchange rates affect the firms non-contractual or unplanned cash flowsIt refers to future changes in earning power as a result of changes in exchange rates
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Measurement of economic exposure
Economic exposure cannot, in general, be known accurately in advanceIt can be estimated from a regression equation relating changes in cash flows to changes in exchange rates
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Translation (accounting) exposure
Translation exposure arises from the consolidation of foreign currency assets, liabilities, net income and other itemsConversion may produce gain or loss
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Translation rates
Closing (current) rateAverage rateHistorical rate
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The closing rate
The closing rate (or current rate) is the rate prevailing at the end of the accounting period (that is, coinciding with the balance sheet date)
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The average rate
The average rate is the average value of the exchange rate over the accounting periodThe simplest procedure is to take a simple average of the closing rate and the rate prevailing at the beginning of the period. Otherwise, a time-weighted average may be used
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The historical rate
The historical rate is the rate prevailing on the date when an asset is acquired or a liability is committed The historical rate may therefore fall outside the current accounting period. In fact, this is invariably the case for long-term assets and liabilities
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Translation methods
Current/non-current methodClosing (current) rate methodMonetary/non-monetary methodTemporal method
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Current/non-current method
According to this method, current items are translated at the closing rate, whereas long-term items are translated at the historical rate
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Closing (current) rate method
Assets and liabilities are translated at the exchange rate prevailing at the end of the accounting period
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Monetary/non-monetary method
Monetary items (such as bonds) are translated at the closing rate, whereas non-monetary items (such as real estate) are translated at the historical rate
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Temporal Method
According to the temporal method, the use of the closing rate or the historical rate is determined by the valuation of the underlying itemThe closing rate is used for items stated at replacement cost, realisable value or market valueThe historical rate is used for all items stated at historical cost
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Some principles
Translation of balance sheet items is based on the closing rateTransaction gains and losses are accounted for in the income statement
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(cont.)




Some principles (cont.)
Non-transaction gains and losses are represented by changes in reservesTransaction gains and losses from a hedge are accounted for by movements in reserves or are reported on the income statement
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Per cent of

Observations

Lowest r Highest r Probability VAR

68

r

r

16.0

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90

65.1r

65.1r

5.0

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95

96.1r

96.1r

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98

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USD/AUD JPY/AUD EUR/AUD GBP/AUD

2004 2.88 3.38 1.70 2.11

2005 1.71 2.03 2.12 2.04

2006 2.62 2.18 2.30 1.74

2007 3.41 4.29 2.74 3.01

2008 6.44 7.93 3.62 5.41

Chapter 12

Documents

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mcgrawhill australia

analytical approach

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uncertaintyin finance

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