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Chapter 12 - Foreign exchange risk and exposure. In this chapter, the learning objectives are: To define risk and exposure; to elaborate on the concept of value at risk (VAR); to distinguish among transaction, economic and translation exposure;…
Chapter 12 Foreign Exchange Risk and Exposure Objectives • To define risk and exposure • To elaborate on the concept of value at risk (VAR) • To distinguish among transaction, economic and translation 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 12-2 Definitions of risk • The chance of bad consequence, loss, etc (The Concise Oxford Dictionary) • The possibility of loss, injury, disadvantage or destruction (Webster’s Dictionary) (cont.) 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 12-3 Definitions of risk (cont.) • The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum (cont.) 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 12-4 Definitions of risk (cont.) • In finance, a distinction is made between risk and uncertainty • In 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 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 12-5 FX risk • FX risk arises because of uncertainty about the future spot exchange rate • It refers to the variability of the domestic currency value of certain items resulting from the variability of the exchange rate 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 12-6 Rate of return R V Vt 1 Vt V SV R (1 S )(1 V ) 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 12-7 Measuring risk: probability distribution E ( R) ( R) n i pi ( Ri ) n i pi Ri E ( R) 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 12-8 Measuring risk: historical data n R (R) n Rt t 1 n n ( Rt R )2 t 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 12-9 Measurement of VAR • Measurement unit (e.g AUD) • Time horizon (one day, one week, etc.) • Probability (1-5%) 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 12-10 Volatility and correlation • Exposure to a currency that fluctuates sharply is more of a source of concern • Exchange rate correlations are important 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 12-29 Economic exposure • Changes in exchange rates affect the firm’s noncontractual or unplanned cash flows • It refers to future changes in earning power as a result of changes in exchange rates 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 12-30 Measurement of economic exposure • Economic exposure cannot, in general, be known accurately in advance • It can be estimated from a regression equation relating changes in cash flows to changes in exchange rates 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 12-31 Translation (accounting) exposure • Translation exposure arises from the consolidation of foreign currency assets, liabilities, net income and other items • Conversion may produce gain or loss 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 12-32 Translation rates • Closing (current) rate • Average rate • Historical rate 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 12-33 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) 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 12-34 The average rate • The average rate is the average value of the exchange rate over the accounting period • The 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 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 12-35 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 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 12-36 Translation methods • • • • Current/non-current method Closing (current) rate method Monetary/non-monetary method Temporal method 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 12-37 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 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 12-38 Closing (current) rate method • Assets and liabilities are translated at the exchange rate prevailing at the end of the accounting period 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 12-39 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 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 12-40 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 item • The closing rate is used for items stated at replacement cost, realisable value or market value • The historical rate is used for all items stated at historical cost 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 12-41 Some principles • Translation of balance sheet items is based on the closing rate • Transaction gains and losses are accounted for in the income statement (cont.) 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 12-42 Some principles (cont.) • Non-transaction gains and losses are represented by changes in reserves • Transaction gains and losses from a hedge are accounted for by movements in reserves or are reported on the income statement 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 12-43 ... Probability ( 1-5 %) 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 1 2- 10 Implementation of VAR analysis... Parametric (analytical) approach • Historical approach • Simulation approach Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides... McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa / xn ) 1 2- 25 The volatility of the AUD exchange rates • The standard