Foreign Exposure and Risk Management

FOREX

The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies.

The foreign exchange market determines the relative values of different currencies by forces of demand and supply, which is called Flexible Exchange Rate regime.

The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency.

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency.

Market Size and LiquidityThe foreign exchange market is the most liquid financial market

in the world. Traders include large banks, central banks, institutional

investors, currency speculators, corporations, governments, other financial institutions, and retail investors.

According to the 2010 Triennial Central Bank Survey, average daily turnover was US$3.98 trillion in April 2010 (vs. $1.7 trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004.

Foreign Exchange Exposure and Risk and Risk Management

Exposure refers to the degree to which a company is affected by exchange rate changes.

Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.

Managing Foreign Exposure with the concept of Risk Management is called Hedging.

Entering into an offsetting currency position so whatever is lost/gained on the original currency exposure is exactly offset by a corresponding currency gain/loss on the currency hedge.

USD-INR Spot Price- 1$- Rs 45 F1= Rs 44 r = .07 F2= Rs 50 rf = .02, t= 1 year

F0= S*e^{(r-rf)^t) = 47.30Since F1<F0

CASE 1- Borrow Foreign Currency, 1000 USD @ 2% for 1 year1. F0= 1000*e^(.02*1) = 1020.202. After 1 Year, You have to pay

44*1020.20 = Rs 44888.83. Conversion 1000 USD into INR = 1000*45 = Rs 450004. Invest in India, 45000 @ 7% for 1 year

45000*e(.07*1) = Rs 48252.864. Profit = 48262.86-44288.8 = Rs 3374.06

CASE 2 – F2>F0, Borrow INR and Invest in USYou will make the Profit of Rs

2747.14

Types of Exposure

• Translation Exposure

• Transaction Exposure

• Economic Exposure

Transaction Exposure

The transaction exposure component of the foreign exchange rates is also referred to as a short-term economic exposure. This relates to the risk attached to specific contracts in which the company has already entered that result in foreign exchange exposures. A company may have a transaction exposure if it is either on the buy side or sell side of a business transaction. Any transaction that leads to an inflow or outflow of a foreign currency results in a transaction exposure. For example, Company A located in the United States has a contract for purchasing raw material from Company B located in the United Kingdom for the next two years at a product price fixed today. In this case, Company A is the foreign exchange payer and is exposed to a transaction risk from movements in the pound rate relative to dollar. If the pound sterling depreciates, Company A has to make a smaller payment in dollar terms, but if the pound appreciates, Company A has to pay a larger amount in dollar terms leading to foreign currency exposure.

Sources of Transaction Exposure

Transaction exposure arises from:

Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.

Borrowing or lending funds when repayment is to be made in a foreign currency.

Being a party to an unperformed foreign exchange forward contract.

Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

Translation Exposure

Translation exposure of foreign exchange is of an accounting nature and is related to a gain or loss arising from the conversion or translation of the financial statements of a subsidiary located in another country. A company such as General Motors may sell cars in about 200 countries and manufacture those cars in as many as 50 different countries. Such a company owns subsidiaries or operations in foreign countries and is exposed to translation risk. At the end of the financial year the company is required to report all its combined operations in the domestic currency terms leading to a loss or gain resulting from the movement in various foreign currencies

Economic Exposure

Economic exposure is a rather long-term effect of the transaction exposure. If a firm is continuously affected by an unavoidable exposure to foreign exchange over the long-term, it is said to have an economic exposure. Such exposure to foreign exchange results in an impact on the market value of the company as the risk is inherent to the company and impacts its profitability over the years. A beer manufacturer in Argentina that has its market concentration in the United States is continuously exposed to the movements in the dollar rate and is said to have an economic foreign exchange exposure.

World Monetary System

The Pre World War: 1870–1914transactions were facilitated by widespread participation in the gold standard, by both independent nations and their colonies. Great Britain was at the time the world's pre-eminent financial, imperial, and industrial power, ruling more of the world

Between the World Wars: 1919–1939The years between the world wars have been described as a period of de-globalisation, as both international trade and capital flows shrank compared to the period before World War I. During World War I countries had abandoned the gold standard and, except for the United States, returned to it only briefly. By the early 30's the prevailing order was essentially a fragmented system of floating exchange rates .

World Monetary System

The Bretton Woods Era: 1945–1971Under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves

World Monetary System

The post Bretton Woods system: 1971 – present, Multi-Currency International Monetory System.

 After 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves.

Determinants of FX rates

International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect.

Balance of payments model- This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows.

 Asset market modelThe asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

Economic factorsGovernment Fiscal PoliciesGovernment Budget Deficits or SurplusesBalance of Trade Levels and Trends Inflation Level and TrendsEconomic Growth and health.Productivity of Economy.

Political conditions Internal, regional, and international political conditions

and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party.

Market Psychology

Long-term trends: Currency markets often move in visible long-term trends.

"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves.

Hedging

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

ObjectivesMinimize translation exposure.Minimize transaction exposure.Minimize economic exposure.Minimize quarter-to-quarter earnings fluctuations

arising from exchange rate changes.Minimize foreign exchange risk management costs.Avoid surprises.

Opponents of Hedging

Opponents of currency hedging commonly make the following arguments:

Stockholders are much more capable of diversifying currency risk than the management of the firm.

Currency risk management does not add value to the firm and it incurs costs.

Hedging might benefit corporate management more than shareholders.

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm.

Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress).

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm.

Individuals and corporations do not have same access to hedging instruments or same cost.

To Hedge or Not

Hedging Strategies/ Instruments

ForwardsFuturesOptionsSwapsForeign Debt

Forwards:-A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The Depreciation of the receivable currency is hedgedagainst by selling a currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward.

Futures:-A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market.Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence

Options:-A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend

Swaps :-A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies.

Foreign Debt:-Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship.