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Chapter 13
Foreign Exchange Risk and Exposure
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 2
Objectives
• To define risk and exposure.• To introduce value at risk (VAR).• To distinguish among transaction,
economic and translation exposure.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 3
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).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 4
Definitions of Risk (cont.)
• The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 5
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 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 6
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 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 7
Rate of Return
1)1)(1(
11
VSR
SVV
VV
VRt
t
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 8
Measuring Risk: Probability Distribution
21
2
1
)()(
)()(
RERpR
RpRE
i
n
ii
i
n
ii
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 9
Measuring Risk: Historical Data
2
1
2
1
)(11
)(σ
1
n
it
n
it
RRn
R
Rn
R
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 10
Value at Risk
• VAR is a new approach to risk measurement and management.
• Over a given period of time with a given probability, how much money might be lost on a certain position?
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 11
Measurement of VAR
• Measurement unit (e.g. AUD)• Time horizon (one day, one week,
etc.)• Probability (1-5%)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 12
Implementation of VAR Analysis
• Parametric (analytical) approach• Historical approach• Simulation approach
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 13
VAR: Pros
• It is simple.• It is suitable for risk-limit setting and
performance measurement.• It can take account of complex
movements.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 14
VAR: Cons
• It can be misleading.• VAR estimates are highly sensitive to
the underlying assumptions.• It cannot cope with sudden or sharp
changes.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 15
VAR: Conclusion
• VAR is useful but it should be handled with care and used in conjunction with other measures of risk.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 16
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.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 17
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.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 18
The Slope of the Exposure Line
SV β
where is the slope of the exposure line. is positive (negative) for assets (liabilities).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 19
Long and Short Exposures
• Long exposure assets
• Short exposure liabilities
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 20
Combined Exposure
• A combined exposure arises when a firm holds both foreign assets and foreign liabilities.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 21
The Relationship Between FX Risk and Exposure
)(σβ)(σ 222 SV
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 22
Multiple Exposure
• Exposure to more than one currency:
)/()/( 01010 nn xxSxxSV
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 23
The Volatility of the AUD Exchange Rates
• Volatility is measured by the standard deviation of the exchange rate.
• The AUD/USD rate is the least volatile.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 24
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.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 25
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
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 26
Volatility and Correlation
• Exposure to a currency that fluctuates sharply is more of a source of concern.
• Exchange rate correlations are important.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 27
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.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 28
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 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 29
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 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 30
Translation Rates
• Closing (current) rate• Average rate• Historical rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 31
Translation Methods
• Current/non-current method• Closing (current) rate method• Monetary/non-monetary method• Temporal method
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 32
Some Principles
• Translation of balance sheet items is based on the closing rate.
• Transaction gains and losses are accounted for in the income statement.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 33
Some Principles (cont.)
• Non-transaction gains and losses are reflected 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.
