Lecture International finance: An analytical approach (3/e): Chapter 12 - Imad A. Moosa

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

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)

Definitions of risk (cont.)

• The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum

(cont.)

Definitions of risk (cont.)

• In finance, a distinction is made between risk and

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

Rate of return

1 )

1 )(

1 (

1

1

V S

R

SV V

V

V V

R

t t







Measuring risk: probability

distribution

2 1

2

1

) ( )

(

) (

) (

R E R

p R

R p

R E

i

n

i n

Measuring risk: historical data

2

1 2

1

1 1

1

) R R

( n

) R (

R n

Measurement of VAR

• Measurement unit (e.g AUD)

• Time horizon (one day, one week, etc.)

• Probability (1-5%)

Implementation of VAR analysis

• Parametric (analytical) approach

• Historical approach

• Simulation approach

The parametric approach

• The approach is based on the assumption of the

normality of rates of return

(cont.)

The parametric approach (cont.)

The historical approach

• VAR with a certain probability is calculated from the lower nth percentile of historical observations on the rate of return

The simulation approach

• VAR with certain probability is calculated from the

lower nth percentile of simulated observations on the rate of return

• Observations are generated from Monte Carlo

simulation by specifying a probability distribution and its parameters

VAR: conclusion

• VAR is useful but it should be handled with care and used in conjunction with other measures of risk

• Confidence in VAR has been undermined by the

global financial crisis as the VAR models used by

financial institutions failed to predict the losses that they actually endured

Exposure

• Risk measures the probability and magnitude of

deviation from some expected outcome

• Exposure is a measure of the sensitivity of what is at risk to the source of risk

FX exposure

• Exposure to FX risk is a measure of the sensitivity of the domestic currency value of FX items to changes

in the exchange rate

• Sometimes it is defined as the amount at risk

The slope of the exposure line

S

V  β 

where is the slope of the exposure line is

positive (negative) for assets (liabilities)

Long and short exposures

• Long exposure assets

• Short exposure liabilities

Combined exposure

• A combined exposure arises when a firm holds both foreign assets and foreign liabilities

The relation between FX risk and

exposure

) ( σ β )

(

σ 2 V  2 2 S 

Multiple exposure

• Exposure to more than one currency:

) /

( )

The volatility of the AUD exchange rates

• The standard deviations of monthly percentage

changes in exchange rates

Transaction exposure

• Transaction exposure arises if payables and

receivables are denominated in foreign currencies It

is a cash flow exposure associated with trade and

capital flows

Transaction exposure (examples)

• Foreign assets or liabilities that are already recorded

on the balance sheet

• A contract or an agreement involving a future foreign currency cash flow

Volatility and correlation

• Exposure to a currency that fluctuates sharply is

more of a source of concern

• Exchange rate correlations are important

Economic exposure

• Changes in exchange rates affect the firm’s

non-contractual or unplanned cash flows

• It refers to future changes in earning power as a

result of changes in exchange rates

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

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

Translation rates

• Closing (current) rate

• Average rate

• Historical rate

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)

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

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

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

Closing (current) rate method

• Assets and liabilities are translated at the exchange rate prevailing at the end of the accounting period

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

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

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.)

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