14180112-Foreign-Exchange-Risk-and-Exposure

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Foreign Exchange Exposure & Risk:

Foreign Exchange Exposure & Risk

Foreign Exchange Exposure:

Foreign Exchange Exposure If V 0 = 1,00,000 $ = Rs 43,00,000 /- (Rs/$ =43.00) Over a period of time, price of asset changes due to inflation and exchange rate also changes. So, V 1 = 1,40,000 $ = Rs 53,20,000 /- (Rs/$ = 38.00)

The actual change:

The actual change ΔV = V 1 – V 0 = 53,20,000 – 43,00,000 = Rs 10,20,000 ΔS = S 1 - S 0 = 43.00 – 38.00 = Rs 5.00 So, For ΔS = 11.6% For ΔV = 23.7% ΔS may be both positive and negative and so may be ΔV

PowerPoint Presentation:

Is there any relationship between change in exchange rate and change in value of asset? ΔV = F(ΔS) + ΔS - ΔS -ΔV +ΔV

Foreign Exchange Exposure:

Foreign Exchange Exposure ΔV = ⍺ + βΔS + u ΔV = change in the value of asset or liability ΔS = Unanticipated change in the exchange rate ⍺ = intercept β= sensitivity of changes in value of assets or liabilities in response to ΔS

PowerPoint Presentation:

β= sensitivity of changes in value of assets or liabilities in response to ΔS β = Exposure Now, ΔV = ⍺ + βΔS + u Assuming ⍺ = 0 , u = 0 ΔV = βΔS => β= ΔV / ΔS

PowerPoint Presentation:

+ ΔS - ΔS -ΔV +ΔV Asset Exposure Line β = tan θ + ΔS - ΔS -ΔV +ΔV Liability Exposure Line β = tan θ Change in value of asset Change in value of Liability

Defining Exposure:

Defining Exposure The sensitivity of the real home currency value of an asset, liability or an operating income to an unanticipated change in the exchange rate, assuming unanticipated changes in all other currencies as zero

PowerPoint Presentation:

Does exposure affect Balance sheet of a company or income statement? Does exposure affect only foreign assets or domestic assets as well?

Foreign Exchange Risk:

Foreign Exchange Risk Variability of the domestic currency values of assets, liabilities, operating incomes due to unanticipated changes in exchange rate. Risk = variance in V

Estimating Risk:

Estimating Risk Now, we know that by definition ΔV = ⍺ + βΔS + u ------- Eq 1 Regressing the actual data of ΔV and ΔS Δ`V = ⍺` + β`ΔS --------Eq 2 There will be a difference between the estimated change (Eq1 and Actual change (Eq 2) ΔV = Δ`V + u Now, the risk is given by Var(ΔV) = Var( Δ`V + u) Var(ΔV) = Var( Δ`V ) + Var( u) +2Cov( Δ`V , u)

Risk Cont..:

Risk Cont.. 2Cov( Δ`V , u) = 0 Therefore, Var(ΔV) = Var( Δ`V ) + Var( u) Thus, the total risk of an asset includes estimated risk plus risk due to other factors.

Relating Risk & Exposure:

Relating Risk & Exposure ΔV = ⍺ + βΔS Var(ΔV) = Var( ⍺ + βΔS) Var(ΔV) = β 2 Var(ΔS)

Defining Real Change in exchange rate:

Defining Real Change in exchange rate The real change in exchange rate is the change that produces a difference between overall rate of return on domestic versus foreign assets / liabilities or in profitability of export / import oriented firms. “Real Change” is the extent of change in the value due sensitivity and variability both

Real Change in Financial Assets:

Real Change in Financial Assets If IRP does not exist, then (S 1 -S ) / S = (i a -i b ) / (1+i b ) Hence, Real proportionate change in exchange rate is R p = [(S 1 -S ) / S ] (1+i b ) – (i a -i b )

Real Change in Real Assets:

Real Change in Real Assets We know that, i rs = i ^ rs + P ^ rs and i $ = i ^ $ + P ^ $ Hence, Rate of return on 1 Rs invested in US = S 1 /S [1+ i ^ $ + P ^ $ ] – 1 Therefore, Real rate of return above domestic return = S 1 /S [1+ i ^ $ + P ^ $ ] – [1+(i ^ rs + P ^ rs )] Adding & Subtracting P $ = {S 1 /S [1+ i ^ $ + P ^ $ ]– 1} – (i ^ rs + P ^ rs ) – (P ^ $ – P ^ $ ) = {S 1 /S + S 1 /S i ^ $ + S 1 /S P ^ $ ]– 1} – (i ^ rs + P ^ rs ) – (P ^ $ – P ^ $ ) = [(S 1 – S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i ^ rs –(S 1 /S)i ^ $ ]

PowerPoint Presentation:

={S 1 /S [1+ i ^ $ + P ^ $ ]– 1} – (i ^ rs + P ^ rs ) – (P ^ $ – P ^ $ ) = S 1 /S + S 1 /S i ^ $ + S 1 /S P ^ $ ]– 1}– (i ^ rs + P ^ rs ) – (P ^$ – P ^$ ) = {S 1 /S + S 1 /S i ^ $ + S 1 /S P ^ $ – 1} – i ^ rs - P ^ rs – P ^ $ + P ^ $ = S 1 /S + S 1 /S i ^ $ + S 1 /S P ^ $ – S/S – i ^ rs - P ^ rs – P ^ $ + P ^ $ = [(S 1 – S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i ^ rs –(S 1 /S)i ^ $ ]

Real Change in Real Assets:

R p = [(S 1 – S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i ^ rs –(S 1 /S)i ^ $ ] If i ^ rs = (S 1 /S)i ^ $ then real proportionate change = [(S 1 – S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ ) Real Change in Real Assets

Exposure:

Exposure Economic Exposure Transaction exposure Operating exposure => Translation Exposure or Accounting Exposure

Translation Exposure:

Translation Exposure Changes in Income Statement items and book value of BS assets and liab, caused by exchange rate change Resulting gains or losses are determined by accounting rules and are on paper only Impact – BS assets and liab and income statements that already exist.

Operating Exposure:

Operating Exposure Changes in the amount of future operating cash flows caused by exchange rate change Resulting gains or losses are determined by changes in firm’s future competitive position and are real. Impact – Revenues and costs associated with future sales.

Transaction Exposure:

Transaction Exposure Changes in the value of foreign currency denominated contracts that are brought about by exchange rate change. The resulting changes are determined by the nature of contracts already entered into and are real. Impact – Contracts already on BS are part of Accounting Exp. – Contracts yet to come on BS are part of Operating Exp.

Types of Risk:

Types of Risk Financial Risk Political Risk Country Risk

Financial Risk:

Financial Risk Refers more generally to unexpected events in a country’s financial, economic, or business life Examples of financial risks currency risk interest rate risk Inflation risk unexpected changes in the current account balance unexpected changes in the balance of trade

Political Risk:

Political Risk The risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate Examples of political risks Expropriation risk Disruptions in operations Protectionism Blocked funds Loss of intellectual property rights

Political risk insurers :

Political risk insurers Government export credit agencies U.S. Overseas Private Investment Corporation U.K. Export Credits Guarantee Department International World Bank - Multilateral Investment Guarantee Agency Private Lloyd’s of London American International Group (AIG) MNCs are self-insured if their risk exposures are diversified across a large number of countries

Country Risk:

Country Risk Macro risks - affect all firms in a host country Micro risks - specific to an industry, firm or project in a country Whether a particular country risk is macro or micro affects the diversifiability of the risk

Country risks examples:

Country risks examples A1 - Africa, Asia, Europe, Mid East Americas, Australia, Switzerland, Canada, UK A2 - Botswana, HK, Japan, Germany, Kuwait, USA, S. Korea Italy, UAE A3 - Mauritius, China, Cyprus, Israel, Chile, Namibia, Thailand, Czech Rep, Trinidad. A4 - Egypt, India, Latvia, Saudi, Mexico, S. Africa, Philippines, Poland, Arabia, Panama. B - Algeria, Bangladesh, Slovakia, Egypt, Brazil, Peru, Uganda, Sri Lanka, Russia, Jordan, Venezuela. C - Congo, Indonesia, Azerbaijan, Iran, Syria, Haiti, Kenya, Vietnam, Romania, Turkey, Jamaica. D - Nigeria, Afghanistan, Albania, Iraq, Argentina, Sudan ,N. Korea, Ukraine, Cuba ,Zimbabwe, Pakistan, Yugoslavia, Ecuador.

Strategies for managing country risk:

Strategies for managing country risk Negotiate the environment with the host country prior to investment Structure foreign operations to minimize country risk while maximizing return Limiting the scope of technology transfer to foreign affiliates to include only non-essential parts of the production process Limiting dependence on any single partner

Types of Exposure:

Types of Exposure Transaction Exposure & Translation Exposure Economic Exposure & Operating Exposure

Transaction & Translation Exposure:

Transaction & Translation Exposure Arises due to impact of exchange rate movement on firm’s future contractually committed cash flows.

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