FX Risk Exposure

Foreign Exchange Risk and Exposure
Settlement Risk (Herstatt (Herstatt Risk)

Settlement Risk Risk of incorrectly funding or not receiving consideration Lesser understood and appreciated risk. Also called as Herstatt Risk Herstatt bank in Germany failed on 26 June 1974. Banking license was withdrawn after close of banking hours. By then DEM payments were received locally irrevocably. Correspondent bank in N.Y. suspended payments in New York.
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CLS [Continuous Linked Settlement)

SWIFT introduced in 1974 CLS Bank, N.Y. $1 bn spent In operation since 9th September 2002. Settlement time-Midnight Central European Time (CET) No bunching at the end of the day Banks have to fine tune their liquidity during the day rather than at the end of the day Liquidity and Operational Risk (Failure of the system itself)
Comparison
Macroeconomic Environmental Risks Due to uncertainties in response to changes in economic and financial variables. Risks affect all firms in the economy. Due to variance in:
Exchange rates Interest rates Inflation rates Relative prices so forth
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Core Business Risks Due to uncertainties related to operating business. Risks are specific to the firm. Due to interruption in
Raw material supply Labor trouble Success/failure of a new product Technology and so forth
Macroeconomic Risk Factors

The key macroeconomic risk factors are:
Exchange rate Interest rate Inflation rate
Note: Exchange rate, interest rate and inflation rate are intimately interrelated
Effect of Macroeconomic Risk Factors

Uncertainties arising out of fluctuations in exchange rates, interest rates create strategic exposure and risk for a firm. Long run response of the firm to these risks can involve significant changes in the firm's strategic posture.
Choice of product-market combinations Sourcing of inputs Choice of technology Location of manufacturing activities Strategic alliances and so forth
Effect of Macroeconomic Risk Factors

International Finance is vulnerable to both exchange rate & interest rate fluctuations. So companies prefer: Raising funds abroad or Doing investment abroad or Earning foreign exchange or Sourcing raw material from different countries These are subjected to exposure against exchange rate and interest rate fluctuations.
Definition of Risk
Risk is a measure of the variability of the value of performance measure attributable to the risk factor. Exchange risk is defined as the net potential gains or losses which can arise from exchange rate changes to the Forex exposure of an enterprise. The concept of exchange risk covers both the possibilities i.e. gain & loss
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Definition of Exposure
Exposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor.
Exchange exposure is defined as the extent to which transaction, assets and liabilities of an enterprise are denominated in currencies other than the reporting currency of the enterprise itself. Exposure is measured by the value of the assets and liabilities or transaction denominated in Forex. Exposure arises because the enterprise denominates transactions in Fx or it operates in a foreign market.
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Risk vs. Exposure

Risk It relates to the excess or shortfall in the cash flows or value of assets or liability likely to arise on account of exchange rate fluctuation. It is calculated in terms of domestic currency. It relates to the changes in the value. Exposure It relates to total value of assets, liabilities and cash flows of an enterprise denominated in foreign currency. It is normally determined in terms of foreign currency It relates to the absolute value of assets or liabilities involved.
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Definition of Risk Perception
Risk Perception is the way in which people and organizations view risk, based on their concerns and experiences, but not necessarily on objective data. Risk perceptions can influence: Business policies Investment decisions
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Financial Risk vs. Foreign Exchange Risk
Financial Risk is future cash flows deviating from budgets or expectations due to changes in financial prices.
Forex Risk is future cash flows deviating due to change in exchange rates.
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Volatility of Forex
Why FOREX rates are volatile? External factors that impact forex rates like
International trade Capital movements Speculations Government policies Political factors and so forth
For example, recent financial crises in USA led to large scale volatility in forex rate.
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Classification of Exposures
Foreign Exchange Exposure
Transaction or Conversion Exposure
Translation or Accounting Exposure
Economic or Operating/Strategic Exposure
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Foreign Exchange Exposure

Foreign Exchange Exposure measures the potential for a firms:
Profitability Net cash flow Market value to alter because of a change in exchange rates.
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Classification of Exposure
Transaction Exposure
The impact of unexpected exchange rate changes upon the cash flows from existing contractual obligations
Economic Exposure
The impact of unexpected exchange rate changes upon known and expected future cash flows of the firm
Translation Exposure
Exchange rate impacts on consolidated financial statements arising from MNCs need to translate foreign affiliates FC financial statements
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Transaction Exposure or Conversion Exposure
It result from an unanticipated change in the exchange rate which has an impact - favorable or adverse - on the firms cash flows during the upcoming accounting period.
Most often, the term is used to denote exposures on items the foreign currency values of which are contractually fixed Export receivables Import payables Interest payable
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Transaction Exposure or Conversion Exposure
Covers all types of transactions like:
Purchase Sales Borrowing Lending Investment
The risk from the exposure would depend upon the net position and the tenor.
Longer the tenor, higher the risk

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Transaction Exposure or Conversion Exposure It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it. The transaction losses or gains are absorbed in the P&L account for the year concerned and thus affect the profit of the enterprise.
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Managing Transaction Exposure

The objectives of a company in managing its transaction exposure is to avoid losses that may occur due to exchange rate fluctuations. At the same time to the extent possible it should not forgo likely gains from favorable changes in exchange rates. A company which wants to play safe and avoid totally the risk may go in for hedging. The company which takes active interest in the study of the rate movement ventures to speculate and accordingly devise strategies to gain out of exchange rate movement.
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Scene in India In India, the exchange control regulations do not allow free-rein to companies in India to indulge in unlimited speculative activities in the Forex market.
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External Hedging Internal Hedging
Forward contract Hedge Options Futures
Exposure netting Currency invoicing Leading and Lagging Foreign currency account EEFC Accounts One who retains 100 % One who retains 50 %
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Translations Exposures or Accounting Exposure It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future. Translation exposure arises when a firm has:
A foreign operation such as a branch, a joint venture or 100% subsidiary in a foreign currency Foreign currency fluctuations lead to translation gains or losses. No cash flow implications
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Assets and Liabilities denominated in one currency need to be translated into reporting currency. Likewise accounts of branches and subsidiaries. Can impact P & L
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How Translation Exposure Arises ??
India
Japan
Subsidiary Financials
INR
Headquarters INR Consolidated Financials

INR
United States $
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Germany
How Translation Exposure Arises ??
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Translation Exposure or Accounting Exposure The subsidiary of the company is a separate entity with its own assets and liabilities, managing its own cash flows and operating in a foreign country. However, when the parent company prepares its final accounts, the assets and liabilities of the subsidiary company are notionally merged with its own and presented as a consolidated statement so that the readers may have an overall picture of the enterprise.
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Translation Exposures or Accounting Exposure For restatement of the values of the assets and liabilities and cash flows of the subsidiary in the domestic currency, the concern may apply either the historic or the current rate of exchange between the foreign currency concerned and the domestic currency.
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Translation Exposure or Accounting Exposure Translation exposure is defined as the likely increase or decrease in the parent company's net worth caused by a change in exchange rates since last translation. This arises when an asset or liability is valued at current rate. No exposure arises in respect of assets/liabilities valued at current historical rate, as they are not affected by exchange rate differences.
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Methods of Translation
For translating a foreign entity's balance sheet into the parent's currency of reporting various methods can be followed, such as: CurrentCurrent -non Current Method MonetaryMonetary -non Monetary Method
Temporal Method Closing Rate Method
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Current-non current method uses the closing rate for current assets and liabilities and historical rates for non-current assets and liabilities.
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Monetary-non monetary method translates Monetary assets and liabilities (Cash, Bank Deposit Debtors & ST Loans) at the current rate while non- monetary
assets and liabilities such as inventories are translated at historical rates.
In contrast to the current/non current method this method translates long term debt at current rate. This can give to
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translation gain or losses.
Temporal Method translates cash, receivables and payables at a closing rate while other items are translated at historical rate.
Temporal Method
For revenue and expenses items from the
Closing Rate Method
income statement there is a choice between using the rate prevailing at the time the transaction is booked or a weighted average rate for the period covered by the
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statement.

Closing Rate Method uses the rate prevailing on the parent's balance sheet date.
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Managing Translation Exposure

Balance Sheet Hedge Exposure Netting Leading & Lagging Forward Contract
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Economic Exposure
Economic or operating exposure relates to the effect of unexpected exchange rates on the future operating cash flows of the company. In FM, a firm is valued by the NPV of the future cash flows . A change in the exchange rate may bring about changes in the cash flows of the company
Directly by affecting its revenues and costs Indirectly by affecting its competitiveness by the action of its consumers and competitors.
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Economic Exposure
As a result the NPV may differ from the one anticipated. Economic or operating exposure is less clearly perceived but has wider ramifications with far reaching effects than the accounting exposure. Accounting exposure is: More readily seen and provided for Insidious Economic Exposure is more difficult to measure and manage.
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Economic Exposure
In the long run, exchange rate effects can even undermine a firm's competitive advantage by raising its costs above those of its competitors or affecting its ability to service its market in other ways. It is also called as strategic exposure as it not only involves the action of the company but that of competitors and consumers also. Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rate and is horizon is medium term.
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Economic Exposure
Strategic exposure refers to a still longer horizon and contemplates longer-term operational flexibility such as:
Changing product-market mix Shifting location of operations Adopting new technologies
Value-based" exposure which focuses on the impact of currency fluctuations on market value of the firm that takes into account both short term accounting exposures as well as operating and strategic flexibility in responding to currency movements.
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Economic Exposure & Laker Airways

Laker Airways was having a booming transatlantic business with a concept of no-frill, low-fare, stand-by air travel in Early 1980s Why did it fail?
It was highly leveraged company with a debt of more than $ 400 Mn. The high debt that was $ denominated resulted from the mortgage financing provided by the US Exim Bank and the US aircraft manufacturer McDonnell Douglas
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Laker Airways incurred three major categories of Cost
Fuel paid in $ Operating cost incurred in Financing costs in $
Revenues accruing from the sale of Transatlantic air fare was evenly divided between and $. Dollar fares were based upon the assumptions of a rate of 1 = $ 2.25 From above it is clear that $ denominated cash outflow far exceeding $ denominated cash inflows Now Laker airways left vulnerable to Depreciation A dramatic plunge of exchange rate of 1 = $ 1.60 brought Laker Airways to default
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Could Laker Airways have hedged its natural dollar liability exposure? If yes, how? Indexing the sale of sterling airfare to the day-to-day exchange rate of cable The other option would have been to finance the acquisition of DC-10 Aircrafts in sterling rather than dollars Forward or Option contracts to buy $ or long term oil futures contracts of maturities matching the financing of the aircraft purchase would have helped the company in pricing more realistically its air fare
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Economic Exposure & Caterpillar

Caterpillar is an American heavy construction Equipment Mnf. Its all plants were based in USA while it used to sell its product globally priced in local currencies In 1981 USD started rising against all currencies Caterpillars revenues measured in $ terms were shrinking while costs kept pace with US inflation Margins Shrank It could not compensate by raising local currency prices in export markets because Komatsu was holding the price line
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Economic Exposure Japs & Germans

As in mid 80s $ depreciated vis--vis with and Dm The Japanese and German car makers found their operating margins being squeezed They responded partly by starting manufacturing operations in US and partly by moving up market into premium priced luxury cars where consumer sensitivity to price increase is relatively less
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Economic Exposure & Merck
Merck an American pharma giant have found that during the time of strong $ their cash flows denominated in $ tend to shrink. Bulk of their R&D expenditure are denominated in $ and shortage of internally generated cash tends to have adverse impact on their R & D budgets which are crucial factor in their long-run competitiveness
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Exporters to suffer losses on ` hedges

Rupees huge fall in recent weeks limits benefits for exporters who have made large hedges against currency fluctuations. In India, IT companies usually make biggest hedges. TCS has over $3bn under hedge, followed by Cognizant $ 3.7bn, Wipro $2bn & HCL $1.3bn The lowest hedge cover by an IT company is $800m by Infosys Analysis expect IT companies may revise their hedging strategy.
Indian Auto Industry

Auto parts makers insist on currency fluctuation clause Indian auto component makers work in a very competitive environment with thin margins, many companies which do not have currency fluctuation clause built into the old agreements, are now trying to re-negotiate the contracts. But there are other manufacturers who are trying to shift their focus to Euro currency. Sona Koyo itself is trying to balance out this impact by focusing on European exports while decreasing its exports to the US.
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Managing Economic Exposure Marketing

Market Selection Depends upon in which market currency has appreciated and in which market it is depreciated. Pricing It mainly depends upon elasticity of demand for the product and competition faced by the company. Pricing involves whether to retain the market share or retain the profit margin and how frequently price can be changed. Product Decisions
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Managing Economic Exposure Production

MNCs has advantage as it has production and sourcing bases in different countries. The Input can be procured from foreign countries when the local currency is appreciated with respect to foreign currency. The production may be shifted from the nation whose currency has appreciated to plants in other countries.
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Managing Economic Exposure Finance

Balance Sheet Hedge Leading and Lagging Parallel Loans and Swaps Currency Invoicing
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Bharat Forges- Vision

Create Global Market Low cost labour in India will go gradually Keep plant where the market is located Emphasis on SCM and CRM Easy flexibility in case of labour problems Export driven company
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Derivatives
What are they?
Derivatives are financial contracts which provide hedge against a particular type of risk. The risk may be exchange rate risk, credit risk, interest rate risk etc. A derivative is a financial instrument whose value depends on the value of another asset /instrument called Underlying ( basic ) variable. Derivatives are also known as Contingent claims.
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Currency Options
Meaning and features
A currency options arrangement between an option holder (buyer) and an option writer (Seller) A currency option gives the buyer the right ,but not the obligation to either buy or sell a specified quantity of one currency in exchange for another at a predetermined exchange rate known as Strike price
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Currency Options
Meaning and features
Option holder has no obligation to exercise an option The writer of the option must comply with its terms and should be prepared to buy or sell the underlying currency when a holder decides to exercise an option
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Currency Options
Types
To acquire the right the buyer pays a premium to the seller The potential loss to an option seller is unlimited while to the buyer it is limited to the premium paid. There are Two Types of Options Call Option Put Option
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Currency Options
Call Option
Important Terminologies
The right to buy specific amount of one currency against another currency is known as call option
Put Option
The right to sell specific amount of one currency against another currency is known as put option
Buyer
The person who buys the right to buy or sell specified amount of currency against another currency The person who sells the right to buy or sell specified amount of a currency against another currency The amount paid by the buyer of an option to the seller is called premium
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Seller (Writer)
Premium
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Currency Options
Strike Price
This represents predetermined price at which the option can be exercised For effecting delivery of Forex the buyer of the option must notify the seller about his decision for taking or giving delivery and this is known as exercising the option The date on which the option can be exercised is called as exercised date
Exercise Date
Expiration Date
The last date upto which the option can be exercised.
American Option
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An option which can be exercised at a any time between the initial deal date and the expiry date.
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Currency Options
European Option
An option which can be exercised only at the expiry date.
In the Money Option
If by exercising option ,the buyer has advantage then it is called as ITM Option
Out of the Money Option
If by exercising option, the buyer has disadvantage then it is called as OTM Option
At the Money Option
If by exercising option, the buyer has neither advantage nor disadvantage then it is called as ATM Option. The strike price in this case is equal to spot or future rate. This option has no Intrinsic Value
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Currency Options
Let take an example
Status of an option a. In-the-money Call: Spot(54.35) > strike(54.28) Put: Spot (54.20)< strike(54.28) b. Out-of-the-money Call: Spot (54.20)< strike(54.28) Put: Spot (54.35)> strike(54.28) c. At-the-money Spot = the strike
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Currency Options
How to use Option
Buy call option
expect currency to appreciate exercise option if price increases beyond strike
price buy at strike price and sell at spot rate Sell (write) call option
expect currency to decline in value obligated to sell a currency at a specified price make money if option not exercised
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Currency Options
Option in India
Authorized dealers having adequate internal control, risk monitoring/ management systems, mark to market mechanism and fulfilling the following criteria will be allowed to run an option book after obtaining a one time approval from the Reserve Bank
i. Continuous profitability for at least three years ii. Minimum CRAR of 9 per cent iii. Net NPA's at reasonable levels (not more than 5 per cent of net advances) iv. Minimum Net worth not less than Rs. 200 crores
Initially, authorized dealers can offer only plain vanilla European options.
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Currency Futures
Brief History
Chicago Becomes the Junction of Rail & Telegraph in USA. So it becomes Hub of East USA in 1840 Bumper crop of wheat in East USA. Everyone rushed to Chicago as Brokers, Agents were present their to distribute wheat across USA The problem was Chicago was not having proper storage facilities, weighing equipments of standard quality, every thing has to be settled in cash.
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Currency Futures
Brief History
Many times farmers use to come without full quantity of wheat also brokers do not have full amount many times to settled the transaction. Hence it is decided that transaction will be settled at a particular date in future so on particular date farmer will bring a particular quantity of wheat and broker/buyer will come with amount and deal will be settled
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Currency Futures
Players
Hedgers Farmers, manufacturers, importers and exporters
can all be hedgers.
A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks
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Currency Futures
Players
Speculators
These People do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits.
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Currency Futures
Futures Contract
A futures contract is a form of forward contract In that it conveys the right to purchase or sell a specified quantity of a Forex at a fixed exchange rate on a specified future date, Whereas in a forward contract the quantum of foreign currency and the due date are determined by the customer
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Currency Futures
Futures Contract- Features
Size of Contract GBP 62,500 Euro - 125,000 CAD - 100,000 JPY - 12,500,000 CHF - 125,000 Aus $ - 100,000
Delivery Dates at CME March,June,September&December Deliver date is third Wednesday of respective month. The month during which a contract expires is referred to as the spot month. All trading stops two business days prior to delivery date to enable the participants deliver the currencies
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Features of Currency Futures

Price Movement
Price Movement The price for the futures is quoted as so many units of US $ per unit of foreign Currency. i.e. 1 CAD = $0.8800(Incase of Fwd 1$=CAD 1.1366) The value of the futures will be the price per unit of foreign currency multiplied by the size of the contract. One Bought a CAD $ at a price of US $ 0.8800 The exchange may fix the minimum size of price movement called as tick . If price changed to 0.8801 that means buyer gains
0.0001 x 100,000 = $ 10
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Price Movement
Future Quantity Amount of tick $ Value of each point change 6.25 $ 12.50 $ 12.50 $ 12.50 $ 10.00 $ 10.00 $ 2.50 INR
1 GBP 2 Yen 3 Euro 4 CHF 5 CAD 6 AUS $ 7 USD

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62,500 12,500,000 125,000 125,000 100,000 100,000 1,000
0.0001 0.000001 0.0001 0.0001 0.0001 0.0001 0.0025

Trading by members
Trading by members Demand supply ,Open out Cry electronically on the CME Globex trading platform Clearing House Acts as a counter party Margins Mark to Market
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Liquidity
LiquidityThe buyer of the future need not hold up till maturity. On any intermediary date he can sell to another and wind up his position with the exchange. Similarly a seller can enter into a purchase deal before the due date and square his position It is the reason that future is sometimes described
as a bet on the future price of the currency, rather than an obligation to buy the currency.
Most of futures contracts are not delivered on the due date, but extinguished by counter deals.
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Currency Futures in India

AD Category I Banks are permitted to become trading and clearing members of the currency futures market of recognized stock exchanges, on their own account and on behalf of their clients, subject to fulfilling the following minimum prudential requirements:
i. Continuous profitability for at least three years ii. Minimum CRAR of 10 per cent iii. Net NPA's at reasonable levels (not more than 3 per cent of net advances) iv. Minimum Net worth not less than Rs. 500 Crores
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In Nut Shell
Lets Compare
Fwd Contracts Delivery
Generally
Currency Futures
Less than a %
Currency Options
Buyers Discretion. Seller must honour if buyer exercises 3/6/9 Months 31,250, Can$50000.etc. Friday before 3rd Wednesday of March, June, Sept, or Dec on regular Options. Last Friday of month on endof-month options
Maximum Length Contracted Amount Maturity Date
Several Years Any value Any Date
12 Months 62,500 Can$100,00.etc. Third Wednesday of March, June, Sept or Dec
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In Nut Shell
Lets Compare
Fwd Contracts Secondary Market
Must Offset with Bank
Currency Futures
Currency Options
Can Sell Via Exchange
Can Sell Via Exchange
Margin Guarantor
Fees None
Margin3-20% Futures Clearing Corporation Primarily Speculators
Premium Options Clearing Corporation Hedgers and Speculators
Major Users
Primarily Hedgers
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FX Risk Exposure

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FX Risk Exposure

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Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Settlement Risk (Herstatt (Herstatt Risk)

Foreign Exchange Risk and Exposure

CLS [Continuous Linked Settlement)

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Macroeconomic Risk Factors

Foreign Exchange Risk and Exposure

Effect of Macroeconomic Risk Factors

Foreign Exchange Risk and Exposure

Effect of Macroeconomic Risk Factors

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Risk vs. Exposure

Foreign Exchange Risk and Exposure

Definition of Risk Perception

Foreign Exchange Risk and Exposure

Financial Risk vs. Foreign Exchange Risk

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Exposure

Transaction or Conversion Exposure

Translation or Accounting Exposure

Economic or Operating/Strategic Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Longer the tenor, higher the risk

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Managing Transaction Exposure

Foreign Exchange Risk and Exposure

Managing Transaction Exposure

Foreign Exchange Risk and Exposure

Managing Transaction Exposure

Forward contract Hedge Options Futures

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

How Translation Exposure Arises ??

Headquarters INR Consolidated Financials

Foreign Exchange Risk and Exposure

How Translation Exposure Arises ??

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Foreign Exchange Risk and Exposure

Temporal Method Closing Rate Method

Foreign Exchange Risk and Exposure

Temporal Method Closing Rate Method

Foreign Exchange Risk and Exposure

Temporal Method Closing Rate Method

assets and liabilities such as inventories are translated at historical rates.

translation gain or losses.

Foreign Exchange Risk and Exposure

Closing Rate Method

Foreign Exchange Risk and Exposure

Temporal Method Closing Rate Method