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A

PROJECT REPORT
ON
RISK MANAGEMENT IN FOREIGN EXCHANGE

SUBMITTED TO Ms. Ashima Singh


Institute of Management Sciences, University of Lucknow

SUBMITTED BY:
Ashish Mahendra (Roll No.07)
Gaurav Kumar (Roll No.16)
Saurabh Singh (Roll No.47)
Shivam Nigam(Roll No.52)
(BATCH 2013-15)
MBA (FC)- Sem. IV

Table of Contents

1. Acknowledgement

2. Definition: Foreign Exchange Risk Management

3. Types of Foreign Exchange Risk


4. Reasons to Hedge Foreign Exchange Risk
5. Managing Foreign Exchange Risk
6. Techniques for Hedging FOREX Risk
7. References

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8-9
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Acknowledgement
In performing our assignment, we had to take the help and
guideline of some respected persons, who deserve our
greatest gratitude. The completion of this assignment gives
us much Pleasure. We would like to show our gratitude to
our subject teacher Ms. Ashima Singh, Institute of
Management Sciences, University of Lucknow for
giving us a good guideline for assignment throughout
numerous consultations. We would also like to expand our
deepest gratitude to all those who have directly and
indirectly guided us in writing this assignment.

Many people, especially our classmates and team members


itself, have made valuable comment suggestions on this
proposal which gave us an inspiration to improve our
assignment. We thank all the people for their help directly
and indirectly to complete our assignment.

Submitted ByAshish Mahendra


Gaurav Kumar
Saurabh Singh
Shivam Nigam
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Definition: Foreign Exchange Risk


Foreign Exchange Risk refers to the risk that an investor will
have to close out a long or short position in aforeign currency at
a loss due to an adverse movement in exchange rates.
In general, the risk of an adverse movement in exchange rates.
The risk that the return on an investment may be reduced or elim
inated because of a change inthe exchange
rate of two currencies.
For example, if an American has a CD in the United
Kingdom worth 1 million British pounds and the exchange rate is
2 USD: 1 GBP, then the American effectively has $2 million in the
CD. However, if the exchange rate changessignificantly to, say, 1 US
D: 1 GBP, then the American only has $1 million in the CD, eventho
ugh he/she still has 1 million pounds.

Types of Foreign Exchange Risk


Transaction Risk
Translation Risk
Economic Risk

Transaction Risk
This is the risk of an exchange rate changing between the transaction
date and the subsequent settlement date, i.e. it is the gain or loss
arising on conversion.
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This type of risk is primarily associated with imports and exports. If a


company exports goods on credit then it has a figure for debtors in its
accounts. The amount it will finally receive depends on the foreign
exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a
company, most companies choose to hedge against such exposure.
Measuring and monitoring transaction risk is normally an important
component oftreasury risk management.
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows
occurs.
The anticipated volatility of the exchange rates during the hedge
period.
The corporate risk management policy should state what degree of
exposure is acceptable. This will probably be dependent on whether
the Treasury Department is been established as a cost or profit Centre.

Translation Risk
The financial statements of overseas subsidiaries are usually
translated into the home currency in order that they can be
consolidated into the group's financial statements. Note that this is
purely a paper-based exercise - it is the translation not the conversion
of real money from one currency to another.
The reported performance of an overseas subsidiary in home-based
currency terms can be severely distorted if there has been a significant
foreign exchange movement.
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If initially the exchange rate is given by $/1.00 and an American


subsidiary is worth $500,000, then the UK parent company will
anticipate a balance sheet value of 500,000 for the subsidiary. A
depreciation of the US dollar to $/2.00 would result in only 250,000
being translated.
Unless managers believe that the company's share price will fall as a
result of showing a translation exposure loss in the company's
accounts, translation exposure will not normally be hedged. The
company's share price, in an efficient market, should only react to
exposure that is likely to have an impact on cash flows.

Economic risk
Transaction exposure focuses on relatively short-term cash flows
effects; economic exposure encompasses these plus the longer-term
effects of changes in exchange rates on the market value of a
company. Basically this means a change in the present value of the
future after tax cash flows due to changes in exchange rates.

There are two ways in which a company is exposed to


economic risk.

Directly:If your firm's home currency strengthens then foreign


competitors are able to gain sales at your expense because your
products have become more expensive (or you have reduced your
margins) in the eyes of customers both abroad and at home.
If your firm's home currency strengthens then foreign competitors are
able to gain sales at your expense because your products have become
more expensive (or you have reduced your margins) in the eyes of
customers both abroad and at home.

Indirectly:Even if your home currency does not move Vis-a -Vis


your customer's currency you may lose competitive position. For
example suppose a South African firm is selling into Hong Kong and
its main competitor is a New Zealand firm. If the New Zealand dollar
weakens against the Hong Kong dollar the South African firm has lost
some competitive position.
Even if your home currency does not move Vis-a -Vis your customer's
currency you may lose competitive position. For example suppose a
South African firm is selling into Hong Kong and its main competitor
is a New Zealand firm. If the New Zealand dollar weakens against the
Hong Kong dollar the South African firm has lost some competitive
position.
Economic risk is difficult to quantify but a favored strategy to manage
it is to diversify internationally, in terms of sales, location of
production facilities, raw materials and financing. Such diversification
is likely to significantly reduce the impact of economic exposure
relative to a purely domestic company, and provide much greater
flexibility to react to real exchange rate changes.

Reasons to Hedge Foreign Exchange Risk


minimize the effects of exchange rate movements on profit
margins
increase the predictability of future cash flows
eliminate the need to accurately forecast the future direction of
exchange rates
facilitate the pricing of products sold on export markets
protect, temporarily, a companys competitiveness if the value of
the Canadian dollar rises (thereby buying time for the company
to improve productivity)
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Steps in Managing Foreign Exchange Risk


1. Identify & measure FX exposure
2. Develop companys FX policy
3. Hedge exposure using Trades and/or other techniques
4. Evaluate and adjust
Identify & measure FX exposure
This Step involves identifying and measuring the foreign
exchange exposures that is to be managed. The focus of
companies is on transaction risk to forecast that to what extent
they are exposed to the risk of foreign exchange.

Develop companys FX policy


Once forecasted the transaction risk factor attached then its need
to develop companys foreign exchange policy. This policy is
formulated by the Companys top management laying guidelines
to the following issues:
o When should foreign exchange exposure be hedged?
o What tools and instruments can be used under what
circumstances?
o Who is responsible for managing foreign exchange
exposure?
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o How will the performance of the companys hedging


actions be measured?
o What are the regular reporting requirements?

Hedge exposure using Trades and/or other techniques


This step involves identification and application of hedge option
that compliments the best with companys policy.
For example,if a Company want to increase the value of
raw materials imported from the U.S. to partly offset the
exposure created by sales to U.S. buyers. Alternatively,
company may put in place basic financial hedges with a bank or
foreign exchange broker. The most commonly used financial
hedges are discussed further below.

Evaluate and adjust


In this step there is need of measuring the results periodically to
check whether the hedging technique used are effectively
achieving goal of reducing the risk of foreign exchange attached
to company. If it lacks to achieve its goal then there is need for
taking corrective measures to overcome the same

Techniques for Hedging FOREX Risk

The internal techniques


Internal techniques to manage/reduce forex exposure should
always be considered before external methods on cost grounds.
Internal techniques include the following:

Invoice in home currency


One easy way is to insist that all foreign customers pay in your
home currency and that your company pays for all imports in your
home currency.
However the exchange-rate risk has not gone away, it has just been
passed onto the customer. Your customer may not be too happy with
your strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a
competitive environment this is an unrealistic approach.

Leading and lagging


If an importer (payment) expects that the currency it is due to pay
will depreciate, it may attempt to delay payment. This may be
achieved by agreement or by exceeding credit terms.

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If an exporter (receipt) expects that the currency it is due to receive


will depreciate over the next three months it may try to obtain
payment immediately. This may be achieved by offering a discount
for immediate payment.
The problem lies in guessing which way the exchange rate will move.

Matching
When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against each
other.
It is then only necessary to deal on the forex markets for the
unmatched portion of the total transactions.
An extension of the matching idea is setting up a foreign currency
bank account.

Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave
a similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction
costs.

The external techniques


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Transaction risk can also be hedged using a range of financial


products. These are introduced below with links to more detailed
pages.

Forward contracts
The forward market is where you can buy and sell a currency, at a
fixed future date for a predetermined rate, i.e. the forward rate of
exchange. This effectively fixes the future rate.

Money market hedges


The basic idea is to avoid future exchange rate uncertainty by
making the exchange at today's spot rate instead. This is achieved by
depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur. This effectively fixes the future rate.

Futures contracts
Futures contracts are standard sized, traded hedging instruments.
The aim of a currency futures contract is to fix an exchange rate at
some future date, subject to basis risk.

Options
A currency option is a right, but not an obligation, to buy or sell a
currency at an exercise price on a future date. If there is a favourable
movement in rates the company will allow the option to lapse, to take
advantage of the favourable movement. The right will only be
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exercised to protect against an adverse movement, i.e. the worst-case


scenario.
A call option gives the holder the right to buy the underlying
currency.
A put option gives the holder the right to sell the underlying
currency.
Options are more expensive than the forward contracts and
futures but result in an asymmetric risk exposure.

Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of
currency for a period and then re-swap them at the end of the period
at an agreed swap rate. The swap rate and amount of currency is
agreed between the parties in advance. Thus it is called a fixed
rate/fixed rate swap.

The main objectives of a forex swap are:


To hedge against forex risk, possibly for a longer period than is
possible on the forward market.
Access to capital markets, in which it may be impossible to
borrow directly.
Forex swaps are especially useful when dealing with countries
that have exchange controls and/or volatile exchange rates.

Currency swaps
A currency swap allows the two counter parties to swap interest rate
commitments on borrowings in different currencies.

In effect a currency swap has two elements:


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An exchange of principal in different currencies, which are


swapped back at the original spot rate - just like a forex swap.
An exchange of interest rates - the timing of these depends on
the individual contract.

The swap of interest rates could be fixed for fixed or fixed for
variable.

References
http://financialdictionary.thefreedictionary.com/Foreign+Exchange+Risk

http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki
%20Pages/Foreign%20Exchange%20Risk
%20Management.aspx?mode=none

http://www.desjardins.com/ressources/pdf/d30p-ge-risquechange-e.pdf?resVer=1391550617000

file:///C:/Users/HP_PC/Downloads/managing-foreignexchange-risk-guide.pdf

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