management of forex exposure

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S.Saravanakumar IFM - III unit - lecture 2 1 FOREIGN EXCHANGE RISK MANAGEMENT MEASURING EXPOSURE TO EXCHANGE RATE FLUCTUATIONS

EXCHANGE RISK : 

S.Saravanakumar IFM - III unit - lecture 2 2 EXCHANGE RISK EXCHANGE RATE RISK CAN be broadly defined as the risk that a company’s performance will be affected by exchange rate movements.

IS EXCHANGE RATE RISK RELEVANT? : 

S.Saravanakumar IFM - III unit - lecture 2 3 IS EXCHANGE RATE RISK RELEVANT? NO Some have argued that exchange rate risk is irrelevant

IS EXCHANGE RATE RISK RELEVANT? : 

S.Saravanakumar IFM - III unit - lecture 2 4 IS EXCHANGE RATE RISK RELEVANT? PURCHASING POWER PARITY (PPP) ARGUMENT According PPP theory , exchange rate movements are just a response to differentials in price changes between two countries.

IS EXCHANGE RATE RISK RELEVANT? : 

S.Saravanakumar IFM - III unit - lecture 2 5 IS EXCHANGE RATE RISK RELEVANT? THE INVESTOR HEDGE ARGUMENT 1. MNCs can hedge exchange rate risk on their own 2. They have sufficient information on corporate exposure to exchange rate fluctuations as well as capabilities to correctly insulate their individual exposure

IS EXCHANGE RATE RISK RELEVANT? : 

S.Saravanakumar IFM - III unit - lecture 2 6 IS EXCHANGE RATE RISK RELEVANT? CURRENCY DIVERSIFICATION ARGUMENT MNCs diversified their activities across numerous countries.

IS EXCHANGE RATE RISK RELEVANT? : 

S.Saravanakumar IFM - III unit - lecture 2 7 IS EXCHANGE RATE RISK RELEVANT? STAKEHOLDER DIVERSIFICATION ARGUMENT If stakeholders are well diversified, they will be somewhat insulated against losses experienced by an MNC due to exchange rate risk.

TYPES OF EXPOSURE : 

S.Saravanakumar IFM - III unit - lecture 2 8 TYPES OF EXPOSURE Exchange rates cannot be predicted with perfect accuracy, but the firm can at least measure its exposure to exchange rate fluctuations. 1. Transaction Exposure 2. Economic Exposure 3. Translation Exposure

TRANSACTION EXPOSURE : 

S.Saravanakumar IFM - III unit - lecture 2 9 TRANSACTION EXPOSURE The value of a firm’s cash inflows / outflows in various currencies will be affected by the respective exchange rates of these currencies when they are converted typically into home currency. The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure

ECONOMIC EXPOSURE : 

S.Saravanakumar IFM - III unit - lecture 2 10 ECONOMIC EXPOSURE The degree to which a firm’s present value of future cash flows can be influenced by the exchange rate fluctuations is referred to as economic exposure to exchange rates.

TRANSLATION EXPOSURE : 

S.Saravanakumar IFM - III unit - lecture 2 11 TRANSLATION EXPOSURE An MNC creates its financial statements in their local currency by consolidating all of its individual subsidiaries financial statements A subsidiary’s financial statements is normally measured in its local currency The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure.

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