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Risk and exposure
Business firms, whether operating domestically or
internationally, are exposed to risks of adverse
movements in their profits resulting from unexpected
movements in exchange rates.
Movement of exchange rates gives rise to foreign
exchange exposure and foreign exchange risk.
Though these two terms are often used interchangeably,
in reality they represent two different, yet closely
related, concepts. Let us first understand these two
Foreign Exchange Risk
Exposure refers to the degree(sensitivity) to which a company
is affected by exchange rate changes.
It is calculated by regression.
Exchange rate risk is defined as the variability of a firm’s
value due to uncertain changes in the rate of exchange.
It is calculated by variance or standard deviation.
Thus as the foreign exchange exposure is the sensitivity of values of
assets, liabilities and operating income to the unexpected change in
the exchange rate, we can relate this relationship to a regression
equation which is as mentioned below:
ΔV($) = β ΔS($/£) + µ ------ Eq.(I)
Here, β (exposure) =regression coefficient which explains the
systematic relation between ΔV and ΔS($/£).
ΔV=change in value of foreign assets denominated in domestic
ΔS=change in exchange rate (Direct quote)
µ = random error (regression error).
If we assume there is no random error then
exposure (β) = ΔV($) / ΔS($/£)
Transaction Exposure: Results from a firm taking on “fixed”
cash flow foreign currency denominated contractual agreements.
Examples of transation exposure:
An Account Receivable denominate in a foreign currency.
A maturing financial asset (e.g., a bond) denominated in a foreign
An Account Payable denominate in a foreign currency.
A maturing financial liability (e.g., a loan) denominated in a foreign
For instance, if a firm has entered into a contact
to sell computers to a foreign customer at a fixed
price denominated in foreign currency, then the
firm would be exposed to exchange rate
movements till it receives the payment and
converts the receipts into the domestic currency.
In contractual assets, the exposure value is equal to euro deposits
Exposure is positive magnitude i.e. change in exchange rate and
dollar value of the investment move same direction.
If investor gain when the spot value of foreign currency increase
and loss when it decrease is known as long position in foreign
In contractual liabilities exposure is negative magnitude i.e. change
in exchange rate and dollar value of the investment move opposite
If investor gain when the spot value of foreign currency decrease,
loss when it increase is known as short position in foreign currency
Translation exposure, (also called accounting exposure),
results from the need to restate foreign subsidiaries’
financial statements, usually stated in foreign currency,
into the parent’s reporting currency when preparing the
consolidated financial statements.
While translation exposure may not affect a firm's cash
flows, it could have a significant impact on a firm's
reported earnings and therefore its stock price
Restating financial statements may lead to changes in the
parent’s net worth or net income.
If exchange rates have changed since the previous reporting period,
translation/restatement of those assets/liabilities, revenues/expenses
that are denominated in foreign currencies will result in foreign
exchange gains or losses
When converting financial statement items (transactions)
denominated in currencies other than the parent currency,
two choices of exchange rate are possible:
The historical rate, the exchange rate prevailing at the time
of the transaction.
²The current rate, the exchange rate prevailing at the
balance sheet date or during the income statement period.
There are two method of adjusting Translation exposure:
Current Rate method
Management of transaction
Forward contract hedge
Money market hedge (borrowing or investing in local market)
It is a non standardized contract, which occurs
between two parties (buyer and seller) on a trading
(underlying) asset, at a known forward time and at a
price that is agreed on it today.
It does not cost anything to enter forward contact. This
contract as future contract has a long position and a
More specifically, forward contracts are done through
over the counter market (OTC), meaning the trading is
done through a network that is linked with the dealer
By entering into a forward rate agreement with a bank,
the businessman simply transfers the risk to the bank,
which will now have to bear this risk.
Example # 1: The Need to Hedge
• U.S. firm has sold a manufactured product to a German company.
– And as a result of this sale, the U.S. firm agrees to accept payment of
€100,000 in 30 days.
– What type of exposure does the U.S. firm have?
• Answer: Transaction exposure; an agreement to receive a fixed amount of
foreign currency in the future.
– What is the potential problem for the U.S. firm if it decides not hedge
(i.e., not to cover)?
• Problem for the U.S. firm is in assuming the risk that the euro might
weaken over this period, (or we can say dollar might strengthen) and in 30
days it will be worth less (in terms of U.S. dollars) than it is now say
• This would result in a foreign exchange loss for the firm.
Hedging Example #1 with a
• So the U.S. firm decides it wants to hedge (cover) this foreign
exchange transaction exposure.
– It goes to a market maker bank and requests a 30 day forward quote on
– He need to sell euro after three month so he take or sell forward
– Investor only take short position in forward contract if he think
expected future exchange rate (s*) less than forward rate (F)
Example #2: The Need to Hedge
U.S. firm has purchased a product from a British company.
And as a result of this purchase, the U.S. firm agrees to pay
the U.K. company £100,000 in 30 days.
What type of exposure is this for the U.S. firm?
Answer: Transaction exposure; an agreement to pay a fixed amount of
foreign currency in the future.
What is the potential problem if the firm does not hedge?
Problem for the U.S. firm is in assuming the risk that the pound might
strengthen (or we can say dollar might weaken) over this period, and in
30 days it take more U.S. dollars than now to purchase the required
pounds say $1.50/£.
This would result in a foreign exchange loss for the firm.
Hedging Example #2 with a Forward
• So the U.S. firm decides it wants to hedge (cover) this foreign
exchange transaction exposure.
– It goes to a market maker bank and requests a 30 day forward quote
– He need to purchase pound after three month so he take or sell
– Investor only take long position in forward contract if he think
expected future exchange rate (s*) greater than forward rate (F)
Advantages and Disadvantages of the Forward Contract
For some exact amount of a foreign currency (complete
For some specific date in the future.
No upfront fees or commissions..
Global firm knows exactly what the home currency equivalent
of a fixed amount of foreign currency will be in the future.
However, global firm cannot take advantage of a favorable
change in the foreign exchange spot rate.
They are often illiquid Counter parties to a forward contract
usually design them to meet specific needs.
They have credit risk. Each party to the agreement must trust
that its counterparty will perform in the agreed upon manner.
They are unregulated no formal body has the responsibility of
setting down rules and procedures
Firm cannot take advantage of a favorable change in the
foreign exchange spot rate.
Foreign Exchange Options
Contracts• One type of financial contract used to hedge foreign exchange
exposure is an options contract.
• Definition: An options contract offers a global firm the right, but
not the obligation, to buy (a “call” option) or sell (a “put”
option) a given quantity of some foreign exchange, and to do so:
– at a specified price (i.e., exchange rate), and
– at some date in the future.
Foreign Exchange Options Contracts
Options contracts are either written by global banks (market
maker banks) or purchased on organized exchanges (e.g., the
Chicago Mercantile Exchange).
Options contracts provide the global firm with:
(1) “Insurance” against unfavorable changes in the
exchange rate, and additionally
(2) the ability to take advantage of a favorable change in
the exchange rate.
This latter feature is potentially important as it is something a forward
contract will not allow the firm to do.
But the investor must pay for this right.
This is the option premium (which is a non-refundable fee).
A Put Option: To Sell Foreign Exchange
• Put Option:
– Allows a investor to sell a (1) specified amount of foreign currency at
(2) a specified future date and at (3) a specified price (i.e., exchange
rate) all of which are set today.
• Put option is used to offset a foreign currency long position (e.g., an
• Provides the firm with an lower limit price (exercise price) for the foreign
currency it expects to receive in the future.
• If spot rate proves to be advantageous, the holder will not exercise the put
option, but instead sell the foreign currency in the spot market.
– Firm will not exercised if the spot rate is “worth more.”
A Call Option: To Buy Foreign Exchange
• Call Option:
– Allows a global firm to buy a (1) specified amount of foreign currency
at (2) a specified future date and at a (3) specified a price (i.e., at an
exchange rate) all of which are set today.
• Call option is used to offset a foreign currency short position (e.g., an
• Provides the holder with an upper limit (exercise) price for the foreign
currency the firm needs in the future.
• If spot rate proves to be advantageous, the holder will not exercise the call
option, but instead buy the needed foreign currency in the spot market.
– Firm will not exercise if the spot rate is “cheaper.”
Overview of Options Contracts
Options provide the investor which the potential to take
advantage of a favorable change in the spot exchange rate.
Recall that this is not possible with a forward contract.
Options can be costly:
Firm must pay an upfront non-refundable option premium which it
loses if it does not exercise the option.
Recall there are no upfront fees with a forward contract.
This fee must be considered in calculating the home currency
equivalent of the foreign currency.
This cost can be especially relevant for smaller firms and/or those
firms with liquidity issues.
Hedging Through Money market
• Another strategy used to hedge foreign exchange exposure is
through the use of borrowing or investing in foreign currencies.
– investor can borrow or invest in foreign currencies as a means of
offsetting foreign exchange exposure.
– Borrowing in a foreign currency is done to offset a long position
(in case of receivable).
– Investing in a foreign currency is done to offset a short position
Specific Strategy for a Long Position
Investor expecting to receive foreign currency in the future (long
Will take out a loan (i.e., borrow) in the foreign currency that
will equal (both interest plus principal ) to the amount of
receivable in maturity.
Will convert the foreign currency loan amount into its home
currency at the spot exchange rate.
And eventually use the long position (receivable) to pay off the
foreign currency denominated loan at maturity.
What has the firm accomplished?
Has effectively offset its foreign currency long position (with
the foreign currency loan, which is a short position).
Plus, immediate conversion of its foreign currency long
position into its home currency.
Specific Strategy for a Short Position
Investor needing to pay out foreign currency in the future (short
Will borrow in its home currency (an amount equal to its
short position at the current spot rate).
Will convert the home currency loan into the foreign
currency at the spot rate.
Will invest in a foreign currency denominated asset
And eventually use the proceeds from the maturing financial
asset to pay off the short position.
Offset its foreign currency short exposure (with the foreign
currency denominate asset which is a long position)
Plus immediate conversion of its foreign currency liability
into a home currency liability.
Secondary instruments of hedge
Mix currency invoicing
Leading and lagging
To “lead” means to pay or collect early, whereas to
“lag” means to pay or collect late.
If there is payable and you expect that foreign
currency will appreciate in near future but before
credit period, it may attempts to expedite the payment
to exporter before the foreign currency appreciation.
As we know if foreign currency appreciate you have
to pay more. This is the leading strategy.
As second scenario, assume that you expect the
foreign currency will depreciate in near future but
before credit period, it may attempts to stall its
payment until the after the foreign currency
depreciate. Deprecation of pound gives lower
payments. This is the lagging strategy
Manager hedge vs. Shareholder hedge
There is always question of who should hedge corporate
risk? It should hedge by corporate manager or individual
shareholder. Following are some of the strong reason to
hedge corporate risk by manager not by shareholder.
Progressive tax rate: Volatile EBT
Cost of hedging: Economic of scale
Operating cost: Volatile income
Debt repayment: If organization loan mature when their
income is low
Strategic planning: Difficult to collect information
Instrument availability: Specialization
Exposure, IRP and CIA
We have, (1+rd)n =F/S (1+rf)n
This equation shows that investor is hedging his/ her foreign
investment against the exchange rate risk.
If we held our foreign investment until maturity, then unexpected
change in exchange rate (exchange rate) has no effect on our foreign
currency denominated investment because forward contract protect
our investment at maturity.
Risk is only arise if you withdraw your investment before maturity.
Exposure and purchase power parity
Relative theory of PPP suggests that the exchange between
two countries should change as difference of inflation rate
of these two countries
If relative purchasing power is hold then there will be no
exposure. Exposure arise due to change in exchange rate
and when change in exchange rate is offset by inflation
change there is no question about arising exposure.
Suppose euro depreciate from 1.500/€ to 1.3500/€ during
the year. American MNC has building worth €1,000,000 in
Europe. In same year America experience 0% inflation and
Europe 11.1111% inflation. new price of building after
inflation will be €1000,000*1.111111=€1,111,111.