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Currency Risk Management
INSTITUTE OF BUSINESS AND TECHNOLOGY
CURRENCY RISK MANAGEMENT
Prepared By
XXXXX
Course Code : MKT-606
MBA (Banking and Finance)
FACULTY OFMANAGEMENT AND SOCIAL SCIENCES
FALL - 2010
CONTENTS
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Page No.ACKNOWLEDGEMENT .............................................................. 3
ABSTRACT ................................................................................... 4
CHAPTER NO: 1 INTRODUCTION
1.1 Introduction ...................................................................,.. 61.2 Purpose of Study ............................................................. 61.3 Research Objectives ....................................................... 71.4 Literature Research . 71.5 Research Methodology .................................................... 7
CHAPTER 2: CURRENCY RISK MANAGEMENT
2.1 What Is Currency Risk .................................................... 92.2 Currency Risk Management............................................. 92.3 Impact of Currency Values............................................... 102.4 Economic Analysis............................................................ 152.5 Liquidity and Valuation .................................................... 16
CHAPTER 3: TYPES OF RISKS
3.1 Types of Risk ................................................................. 203.2 Risk Avoidance .............................................................. 203.3 Risk Reduction ................................................................ 203.4 Risk Transfer ................................................................... 213.5 Risk Deferral .................................................................. 213.6 Risk Retention ................................................................ 213.7 Risk Analysis .................................................................. 213.8 Currency Risk Monitoring .............................................. 22
CHAPTER: 4.CURRENCY RISK MANAGEMENT
4.1 Risk Process...24
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4.2 Currency Risk Management Policy . 254.3 Keys to a Successful Policy.. 264.4 Automation through Treasury .. 27
CHAPTER 5. CURRENCY HEDGE RISK
5.1 Explaining Currency Risk 395.2 Currency Surprise 405.3 To Hedge or Not To Hedge 405.4 Instruments for Hedging Currency Risk 415.5 Non-Hedging Techniques to Minimize ..... 42
CHAPTER 6: CONCLUSION AND RECOMMENDATIONS
6.1 Conclusion 456.2 Recommendations . 46
BIBLOGRAPHY ................................................................................... 48
ACKNOWLEDGEMENT
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In the name of ALLAH most merciful most beneficial. First of all, I will say thanksto Almighty ALLAH for giving me courage to work on this report and foreverything, I have achieved or will achieve in future. After I would like to expressmy heartfelt gratitude towards all those people who have supported me for the
fair compilation of this research report. Firstly, I would like to thank my teacherSir Dr. Noor Ahmed Memon, whose guidance and encouragement motivated meto undergo this grueling exercise, secondly all those people whose help andsupport made this work possible. I hope that this report rightly serves its purposeof providing an in domain knowledge for Currency risk management analysis ofGrowing market. Where all efforts have been made to ensure objectivity andaccuracy in the information provided, any errors whatsoever may kindly beexcused.
ThanksMuhammad Aamir Bashir (BEM/983)
INSTITUTE OF BUSINESS AND
TECHNOLOGY
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ABSTRACT SUBMITTED BY: Muhammad Aamir Bashir
DISCIPLINE: EMBA(Finance)
TITLE OF PROJECT REPORT: Currency Risk Management
MONTH OF SUBMISSION: November - 2009
NAME OF PROJECT SUPERVISOR: Dr. Noor Ahmed Memon
ABSTRACT
The increased interest of risk management in the Currency market is evident
from the increased risk in the market due to current economic conditions along
with the increase in world currency market.
My research is distributed in two parts. The first part is the analysis of risk
management of Currency market attribute with the foregone market investmentreturns. Where as the second part deals with the analysis of the impact of risk
management operations. I will end my report by giving my conclusion and
recommendations.
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CHAPTER 1: Introduction
1.1 Introduction1.2 Purpose of Study1.3 Research Objectives1.4 Literature Research1.5 Research Methodology
1 . Introduction
1.1 Introduction
In this introductory section of the thesis, a general background of currency risk
management will be presented, along with a short presentation of the case
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company in this thesis - Following is a discussion of the problem, leading into the
purpose. To clarify the structure of the thesis, a disposition will conclude this first
section.Since last two decades the Currency market of Pakistan is progressing
very well and has made international recognition. This progress is the result
of reformation applied by the government of Pakistan, But still in comparison with
developed world market of the world, our market is far behind in terms of
infrastructure skill workers and technology using for risk management.
Pakistani financial market needs to improve a lot to reach at the level of
developed currency risk management for the strong business domain.
1.2 Purpose of Study
The main purpose of study is to highlight the shortcomings present in following
three aspects of Currency risk management and provide the suggestions to
accelerate the development process of it and manage professionally currency
risk.
Currency risk infra structure
Principles Of Risk management
Guidelines for Currency risk management
Secondary purpose of this research is to provide the basic information about the
importance and functions of investment bank, functions and player which are
Involved in the currency risk and other information with reference to risk literacy.
1.3 Research Objectives
How the currency risk can management in current market situation and growth of
currency market in Pakistani currency market can be reached at the level of
developed countries market by improving the risk management structure, risk
management and investing areas and developing and growth process?
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1.4 Literature Review
Currently, currency market in crises because of economic downturn and inflation
and high-rises of Gold demand in the world market. Pakistan currency market is
also affected to law and order worst condition and worst political conditions. The
regulatory body (State Bank of Pakistan) needs to give incentives to all Currency
market dealers and investment and commercial banks because all of inflation in
the world market for other portfolio conditions is also not good. In this current
scenario of worst economy forex market need to diversified start stepping
towards internationalization by developing business relations with other
regional and international currency exchanges and try to attract the regional and
international companies for cross border exchange on its indices.
Currency risk management much necessary to growth of currency market in the
world, in our country state bank need to develop strong risk management
infrastructure, its need to also develop strong organizational Structure, Financial
support, Trading process, clearing and Settlement Process
1.5 Research Methodology
Qualitative Research approach is employed for this study. This is a comparative
study in which currency market of Pakistan development and growth in that
sense of financial support of other supporting industries and growth in multiple
financial controls in primary and secondary market and only secondary data is
used for analysis.
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CHAPTER 2: Currency Risk Management
2.1 What is Currency Risk
2.2 Currency Risk Management2.3 Impact of Currency Values2.4 Economic Analysis2.5 Liquidity and Valuation
2 . Currency Risk Management
2.1 What is Currency Risk
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The risk that the value of an asset/liability/financial instrument will (negatively)
change due to changes in FX rates (Financial risk applied to international
finance!)
2.2 Currency Risk Management
Our currency risk management group develops a wide range of currency solutions
for multinational corporations. We formulate cost-effective hedging strategies to
protect earnings and asset values from currency losses.
We work closely with clients to identify needs, objectives and FX exposures to
deliver custom-tailored strategies and policies to fully meet the financial objectives of
the client.
Futures or Forward Currency Contracts
Forward/Futures are agreements that set, today, the price of the exchange rate at a
given future date. The agreement specifies a given quantity.
Basic Terminology
Short: Agreement to Sell.
Long: Agreement to Buy.
Contract size: Number of units of foreign currency in each contract.
Maturity: Date in which the agreement has to be settled.
Futures price : The price at which the forward transaction at maturity will be executed.
Forward markets: Tailor-made contracts.
Location: none.
Reputation/collateral guarantees the contract.
Futures markets: Standardized contracts (standardized duration, size, collateral).
Location: organized exchanges
Clearinghouse guarantees the contract.
CME Standardized sizes: GBP 62,500, AUD 100,000, EUR 125,000, JPY 12.5M
CME expiration dates: Mar, June, Sep, and Dec + Two nearby months
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Margin account: Amount of money you deposit with a broker to cover your possible
losses involved in a futures/forward contract.
Initial Margin: initial level of margin account.
Maintenance Margin: lower bound allowed for margin account.
If margin account goes below maintenance level, a margin callis issue:
Table Comparison of Futures and Forward Contracts
Futures Forward
Amount Standardized Negotiated
Delivery Date Standardized Negotiated
Counter-party Clearinghouse BankCollateral Margin account Negotiated
Market Auction market Dealer market
Costs Brokerage and exchange fees Bid-ask spread
Secondary market Very liquid Highly illiquid
Regulation Government Self-regulated
Location Central exchange floor Worldwide
2.3 Impact of Currency Values
The impact of currency values on commercial operations is a familiar topic for the
international executive. It is a source of fascination for the armchair economist,
and a favorite explanation for this quarter's variance. Small and large players
alike enjoy the glimmer of excitement when the latest rates are quoted, signaling
the lead in a global sweepstakes.
Much of the attraction of currency markets stems from its synthesis of all aspectsof the world economy distilled into a single, digestible value. The significance of
relative currency values rests primarily on their relationship to world markets and
their interaction with international trade, investment, and monetary practices.
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A given exchange rate, when viewed in isolation, may at first appear to be little
more than an abstraction. Yet, it exercises a significant influence on commercial
relations as a pricing mechanism affecting every international transaction. The
impact of exchange rate fluctuations on domestic aggregates can also affect the
course of economic activity to the point that a sense of urgency is reached when
dealing with volatile markets.
As long as currencies remain the medium of exchange for commercial
transactions, market fluctuations of relative currency values will continue to
attract the attention of the exporter, the manufacturer, the investor, the banker,
the speculator, and the policy maker alike.
Exposure Defined
A currency is exposed to exchange rate fluctuations to the extent that it is used to
conduct transactions with external markets. The greater the proportion of
intercurrency exchange to total monetary transactions for a given market, the
greater the exposure to changes in exchange rates.
Commercial operations conducting international trade are exposed to exchange
rate fluctuations in proportion to their total volume of transactions. As the
magnitude of intercurrency transactions increases relative to aggregate
transactions, a business unit realizes greater exposure to exchange rate
fluctuations.
The transactions approach to exchange exposure has gained prominence in
recent years. A lingering preoccupation with currency translation for the
measurement of operating performance, however, has tended to divert attention
away from productive commercial activity towards disingenuous, while flashy,
hedging techniques. The clever money manager can still generate significant
cash gains from currency hedging without increasing the productive output of a
business unit.
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By defining currency exposure as the proportion of intercurrency transactions to
total transactions, greater management attention can be aimed at operating units
with a high degree of exposed risk to exchange rate changes.
Operating Performance
Evaluating operations performance on a global scale demands a shift in
perspective towards techniques based on multilateral transactions analysis. An
enterprise operating in a single market with single currency transactions can
easily be evaluated in the operations currency, while one which is engaged in
many markets and multiple currencies requires more extensive analysis.
Common financial accounting practices require financial positions to betranslated at current exchange rates from the operations currency into the
reference currency. Despite the need to consolidate financial results on a
consistent basis, direct translation at current exchange rates continues to
obscure actual operating results when the relative currency values fluctuate from
period to period. As a result of these exchange rate fluctuations, and the extent
of their volatility, comparisons over a number of periods become completely
invalid from the perspective of the reference currency.
A recurring theme throughout the deliberation of multicurrency financial
accounting is that a commercial operation should be evaluated from the
perspective of the economy in which the unit is located, as measured by the
operations currency; this is the fundamental argument for establishing current
rate translation accounting over historical rate translation methods. Resolving this
dichotomy can be an extensive process so long as the need remains to translate
operating results for consolidation into a single currency of reference.
The task of evaluating performance in multiple currencies extends beyond
contemporary financial accounting practices. One approach is to separate the
evaluation of operating results from their consolidation. A multi-tier evaluation
process then evolves as operations in an external market develop through a
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cycle from capital investment to normal commercial operations. Ongoing
business operations are evaluated in the operations currency, consolidated
enterprises from the reference currency, while the return on capital investment is
measured in the investment currency.
Yet all of these measures fail to consider the actual impact of exchange rate
fluctuations on business activity conducted between markets having different
currencies.
When an enterprise imports raw materials and components from external
markets, it is subject to currency transactions exposure between the time the
goods are ordered and when payment is disbursed. Exports to third markets are
affected by transactions exposure when their prices are denominated in third
currencies; even when denominated in the operations currency, the demand for
exports is directly related to the price of the goods as measured by the
customer's reference currency.
Transactions exposure for both imports and exports directly affect the overall
level of business activity through its impact on sales volumes, revenues, and
production costs. It then becomes a practical matter to determine the mostappropriate means for interpreting transactions exposure between the business
unit and external markets with which it conducts trade.
In a global setting, where multiple international operations transact business
between many different markets, the transactions exposure of one operation may
differ substantially from the exposure of other operations within the enterprise.
Aggregate transactions exposure of world-wide operations is determined by the
consolidation of intercurrency transactions across the entire enterprise.
Consolidation on the basis of currency, instead of by location or legal entity,
yields a more complete picture of the total currency transactions exposure.
Investment Risk
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Decisions to expand into a specific marketplace are primarily influenced by the
projected course of economic developments within the market under
consideration. Economic relationships between the external market and third
markets are also taken into consideration. Whereas prior exports to this external
market were likely to have been denominated in the base reference currency, a
physical business presence in the external market entails an indefinite term
commitment measured by a new operations currency.
Capital investment in an external market depends largely upon the expected rate
of return on the investment as measured relative to the investment currency. The
expected return is derived almost entirely from volume projections, expenditure
estimates, and the resulting cash flow in the operations currency. Theseprojections are then translated into the investment currency for comparison with
other capital investment opportunities on an equivalent basis. As a result,
investment decisions rely almost entirely on translations exposure when
considering currency risk.
Transactions exposure takes an entirely different perspective in the investment
risk assessment. In addition to normal economic risks which are present within a
specific external market, transactions risk between markets is involved in an
investment decision.
The transactions exposure for capital investment comprises two main factors:
Changing intercurrency exchange rates between the time the
investment is under consideration, and the time the investment
currencyis converted to the operations currency.
Changing intercurrency exchange rates for dividend remittancesconverted from the operations currencyto the base investment
currencyspanning an indefinite period.
Once a commitment is made to a long-term market presence, management of
exchange risk transfers from a focus on translations exposure to one based on
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transactions exposure. The external market operations can then be assessed
according to the inherent economic risk factors (rates of market growth, price
trends, technology developments, and product competition) attributable to the
local market. The total investment exposure to exchange rate fluctuations is
limited to the appropriations decision period and to the discounted dividend
stream.
2.4 Economic Analysis
Critics often cite economic projections as inaccurate and unavailing for business
operations. This criticism is so pervasive that economists themselves have come
to evaluate their own performance by the degree to which specific predictions
match actual results. This fixation with the accuracy of economic predictions
reflects the prominence of short term results over long term development.
The situation in international commerce and finance reflects many of the same
characteristics. Many in the field tend to view international operations and the
world market as abstractions. Even those who normally function in a global
environment perceive it through the filter of electronic media, continuously
updated and flashed upon a screen terminal.
Concepts which are familiar to the financial economist in planning for
international business operations may not be readily apparent to specific
functional units. Diminishing returns may seem to have little bearing in meeting
sales quotas; marginal productivity is rarely evoked during cost reduction
consolidations; and, elasticity of demand is hardly mentioned when preparing for
facilities expansion.
The value of economic analysis is the assessment of a given course of action
and a determination of the probability that a decision will generate positive
incremental economic activity. Economic activity is characterized by a number of
concepts relevant to operating in international markets, and tied to the
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opportunities and risks associated with the generation of wealth across national
boundaries.
It recognizes the fact that there are many factors beyond the control of the
individual decision maker. If it were possible to accurately predict the effect of
these externalities, there would be little if any need for anyone to carry out
normal daily business decisions, since the results of these decisions would have
already been predetermined. The ability to achieve the desired economic results
depends largely on the skill with which the associated risk is managed.
2.5 Liquidity and Valuation
When proceeds from financial instruments traded on one market are transferred
to another market using a different market currency, the resulting investment is
subject to intercurrency transactions exposure. Capital flows between world
financial markets are subject to the same intercurrency transactions exposure as
commercial operations. Yet the high liquidity of securities traded on financial
markets reflects a significantly greater frequency and aggregate value of these
transactions.
The income derived from investment instruments traded on an external financial
market is measured from the standpoint of the currency of reference established
by the individual investor. A divergence in portfolio valuation occurs when the
intercurrency exchange rate between the market currency and the reference
currency moves in a different direction (or at a different rate) than the native
financial market securities prices.
Investors measuring income in a reference currency other than the market
currency are concerned with two primary issues relating to the transactions
exposure of their investment positions:
Conversion of the instrument price from the market
currency to the reference currency; and,
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Dividend and interest proceeds converted from the
market currency to the reference currency.
In some cases, however, the currency transactions exposure exhibits opposite
characteristics. This involves equity securities which are traded on a financial
market having a market currency different from the reference currency for the
underlying assets of the instruments.
A large number of publicly traded equity securities are listed in more than one
financial market around the globe, where they are traded in the respective market
currency. The financial market with the largest trading volume in a specific equity
security generally determines the base trading price of the issue; arbitrage then
results in a direct conversion at the prevailing exchange rate in other markets.
In these cases, the individual investors trading in a reference currency native to
the market currency, are subject to transactions exposure without engaging in
intercurrency transactions.
Organizations which issue securities in financial markets, with market currencies
different from the issuer's reference currency, often have tangible fixed assets
and business operations in the same territory as the external financial market.
The related equity securities traded in these markets, however, are rarely
secured by the assets situated in the same market territory.
A given trading price for an equity security is a composite of all segments of the
issuing organization (exclusive of factors specific to the financial market) and
includes those business segments conducted in markets other than the reference
currency. Variances between market capitalization and fundamental valuation of
an equity security arise when the world-wide assets pertaining to the equity
appreciate, or depreciate in value.
Fundamental valuation of the equity security is thus subject to intercurrency
transactions exposure relating to:
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Sensitivity to exchange exposure relating to the internal
cash flow of the issuing organization;and,
Correlated demand for the products of the issuing
organization transacted in the world market.
As the exposure to exchange risk increases, the exposure to share price volatility
should also increase. Investors would agree that it is not feasible to identify the
price of a specific security as a basket of fundamental equity values. (Who would
trade in a security priced as: 15 Dollars + 1,000 Yen + 5 Pounds Sterling? Which
commercial organization would remit dividends in similar proportions?) Clearly, it
is the investor who assumes the risk of currency exposure from the standpoint of
the investment currency.
CHAPTER 3: TYPES OF RISKS
3.1 Types of Risk
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3.2 Risk Avoidance3.3 Risk Reduction3.4 Risk Transfer
3.5 Risk Deferral3.6 Risk Retention3.7 Risk Analysis3.8 Currency Risk Monitoring
3 . TYPES OF RISK
3.1 Types of Risk
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All techniques to manage the risks fall into one or more of the following five major
categories risk avoidance, risk reduction, risk transference, risk deferral and
risk retention.
3.2 Risk Avoidance
Also known as risk removal or risk prevention, risk avoidance involves altering
the original plans for the project so that particularly risky elements are removed.
It could include deciding not to perform an activity that carries a high risk. Less
drastically it could involve altering the activity in such a way that the risk is
removed.
Adopting such avoidance techniques may seem an obvious way to deal with all
risks. However, often the areas of the project that involve high risks are also the
areas of the project that potentially contain the highest worth or the best value for
money. Avoiding such risks may also result in removing potentially the 'best bits'
of a digital resource, and an alternative strategy that retains these risks may be
more appropriate.
3.3 Risk Reduction
Risk reduction or risk mitigation involves the employment of methods that reduce
the probability of a risk occurring, or reducing the severity of the impact of a risk
on the outcome of the project. The loss of highly skilled staff is a considerable
risk in any project and not one that can (legally) be totally avoided. Suitable risk
mitigation could involve the enforcement of a notice period, comprehensive
documentation allowing for replacement staff to continue with the job at hand and
adequate management oversight and the use of staff development programmes
to encourage staff to stay.
3.4 Risk Transfer
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Risk transfer moves the ownership of the risk to a third party normally by
contract. This also moves the impact of the risk away from the digitization project
itself to this third party.
3.5 Risk Deferral
The impact a risk can have on a project is not constant throughout the life of a
project. Risk deferral entails deferring aspects of the project to a date when a risk
is less likely to happen.
3.6 Risk Retention
Whilst a certain number of the risks to the project originally identified can beremove by changing the project plan or dealt with by transferring the
responsibility of the risk to third parties inevitably certain risks have to be
accepted as a necessary part of the project. All risks that have not been avoided
or transferred are retained or accepted risks by default.
It is therefore important to develop appropriate plans outlining how these residual
risks will be dealt with should they occur.
3.7 Risk Analysis
Risk assessment is not simply about identifying risks so that the project team and
stakeholders are aware of them. It also involves assessing the potential severity
of these risks, thereby identifying where to most effectively focus attention and
resources in managing them.
In order to assess the seriousness of a potential risk it is necessary to estimatethe rough probability of it happening and the impact, should it occur, on the
project timetable, project costs and end quality of the digital resource.
3.8 Currency Risk Monitoring
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Identifying, analyzing and planning for risk is an important planning stage of any
project. However, risk management does not stop once the risks have been
identified. Initial risk management plans will never be perfect. Practice,
experience, and actual loss, will necessitate changes in the plan and inform
decisions about how to most effectively deal with certain risks. Risk identification
and analysis should be ongoing throughout the project but particularly at project
start-up and milestones. The best risk planning becomes useless unless a clear
picture is maintained of how the project and its associated potential risks are
developing. A reliable reading or assessment of a projects situation can only be
achieved through iteration, in other words, the continuous repetition of all steps of
the risk management process. It is important to keep track of identified risks, to
revisit the risk assessment to monitor the effectiveness of the chosen responses
and to identify new or changed risks and to make the necessary changes to the
risk log. This will mean that when a risk does occur your chosen response will be
appropriate and more likely to be implemented effectively. It also means that you
can communicate the risk to key stakeholders and demonstrate how it was
anticipated and dealt with. A practical example of a risk monitoring action was the
creation and implementation, by the OHPR project team, of a purpose design
and built process management tool known as the Issue Tracker. This tool
consists of a website interfaced to a database which enables the sharing of the
management of quality assurance between the OHPR team and the supplier of
the image data. The Issue Tracker was specifically designed to fulfill the quality
control management requirements of the OHPR project; however it is applicable
to other digitization projects and is now available as a download
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CHAPTER: 4.CURRENCY RISK PROCESS
4.1 RISK PROCESS4.2 Currency Risk Management Policy4.3 Keys to a Successful Policy4.4 Automation through Treasury
4 . CURRENCY RISK PROCESS
4.1 Risk Process
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1. Risk Definition - Define the type of currency risk to be managed
2. Measurement Methodology- Create a model to measure the currency
exposure to be managed
3. Exposure Gathering- Gather data and calculate exposure
4. Covering Strategy- Determine to what extent and how exposure will
be hedged
5. Hedge Execution- Hedge exposure through trade execution and other
techniques
Step 1: Risk Definition
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Economic Exposure
Toytel designs, manufacturers, and distributes Star Wars action figures, primarily
for retailers in the U.S. A contract manufacturer based in China produces the
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EconomicExposure
TransactionExposure
TranslationExposure
Effect of exchange rateson revenue andoperating expenses
Effect of exchangerates on foreigncurrency denominatedcurrent assets andliabilities
Effect of exchangerates on translation offoreign subsidiaries
CurrencyRisk
ForecastedExposure
Effect of exchangerates on forecastedor committed FXexposures
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toys for Toytel, invoicing in $US. Due to revaluations of the Yuan during 2005
and 2006, the Chinese manufacturer increased the $US unit prices for its toy
production, reducing Toytels operating margin.
Table of Economic Exposure Example
Scenario Current ExchangeRate
5% YUANRevaluation
Revenue 1,000 1,000
Operating Expenses 900 945
Transaction (Gains)/Losses -- --
Net Income 100 55
Translation Gain (Loss) -- --
Comprehensive Income 100 55
Transaction Exposure
El Dorado is a US-based maker of designer watches. The company exports to a
worldwide distribution network, invoicing in local currencies. The company holds
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a large book of yen denominated receivables. A recent depreciation of the yen
resulted in a reduced $US valuation of these receivables.
Table of Transaction Exposure
Scenario Current ExchangeRate
5% YENDepreciation
Revenue 1,000 1,000
Operating Expenses 900 900
Transaction (Gains)/Losses -- 45
Net Income 100 55
Translation Gain (Loss) -- --
Comprehensive Income 100 55
Forecasted Exposure
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Zendix is an auto parts manufacturer. The companys Canadian subsidiary
produces brake parts under a long-term contract with Ford, with highly
predictable delivery volumes. During the year, the $US weakens against the
$CN, reducing the functional currency revenue levels, partially offset by reduced
functional currency input costs
Table of Forecasted Exposure
Scenario Current ExchangeRate
5% US$Depreciation
Revenue 1,000 950
Operating Expenses 900 875
Transaction (Gains)/Losses -- --
Net Income 100 75
Translation Gain (Loss) -- --
Comprehensive Income 100 75
Translation Exposure
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Security Check is an international provider of criminal background checks.The companys Indian subsidiary is a recent acquisition that operates primarilywithin India, with functional currency of the rupee. A recent devaluation of therupee against the dollar resulted in a translation loss by the parent when the localcurrency balance sheet was translated and consolidated at year end.
Table of Translation Exposure
Scenario Current ExchangeRate
5% INRDepreciation
Revenue 1,000 1,000
Operating Expenses 900 900
Transaction (Gains)/Losses -- --
Net Income 100 100
Translation Gain (Loss) -- (25)
Comprehensive Income 100 75
Step 2: Measurement Methodology
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Table of Measurement Methodology
Methodology Exposure Types Addressed Description
Foreign currencycommitments
TransactionTranslation
Booked non-functionalassets and liabilities
Forecasted foreign currencypayments
Transaction Forecasted committedand non-committednon-functional currencypayments
Forecasted net investment Translation Projected netinvestment of a foreignsub as of a futureperiod end
Value-at-Risk Translation VaR of translation proforma recent period end
Earnings-at-Risk Transaction EaR of transactionlosses pro form arecent earnings period
Regression Economic Regression analysis of correlation betweenrevenues and expensesand currencymovements
Step 3: Exposure Gathering
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Table of Exposure Gathering
Methodology Example Data Needed
Foreign currency
commitments
JPY receivables as of
3/31/06
3/31/06 balance sheet
with JPY receivablesdetail
Forecasted foreigncurrency payments
Projected receipts ofEuros through 2006 byUK-based sub
Forecast of monthly Eurobillings and collections atUK sub
Forecasted netinvestment
Projected net investmentas of 12/31/06 of aTaiwan-based sub
Projected net investment(assets and liabilities) ofTaiwan sub, translated atbudget rate
Value-at-Risk Consolidated VaR of USCompany, representing95% confidence thattranslation loss does notexceed a benchmark proforma 12/31/05
Translation consolidationmodel with distribution ofexchange rates
Earnings-at-Risk Consolidated EaR of USCompany, representing95% confidence that
transaction does notexceed a benchmark proforma 2005 net income
2005 transaction gain/lossmodel with distribution ofexchange rates
Regression Regression model for revenue and expense for$CN, Euro, BP
Regression analysis
Exposure Gathering Techniques
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Step 4: Covering Strategy
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Excel Template
Treasury
Workstation
CurrencyNetting/Pairing
Applications
General Ledger
ERP and OtherForecast
Consolidators
ProprietaryApplications
E Mail
WebInterface
File Upload
Application
Telephone
Aggregate
Currency
Exposure
Hedge Trading
Hedge Administration
Executive Dashboard
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Common Currency Exposure Covering Strategies
Strategy Feature Execution Risk Accounting Risk
Currency Forwards Lock in forward rate Low Low
Currency Options Cover unfavorable rate
scenarios
Low Medium
Cross CurrencyInterest Rate Swaps
Hedge non-functionalcurrency debt
Low Medium
Functional CurrencyDebt Issuance
Match functionalcurrency liabilities toassets
Medium Medium
Exotic Derivatives Tailor derivative tomarket and risk views
Medium High
Functional CurrencyInvoicing
Pass FX risk tocustomers and suppliers
High LOW
Revenue/ExpenseMatching
Source cost inputs incurrency of customers
High LOW
Step 5: Hedge Execution
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4.2 Currency Risk Management Policy
Currency Risk Management Policy
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How to TradeDerivatives and Live
to Tell About It
Log Hedge
Trade Hedge
Confirm
Hedge Trade
Book Hedge
to G/L
Set Hedgeper Policy
Identify
MeasureExposure
Test Hedge effectiveness
Financial ReportingRemeasure exposure
Current Period Subsequent Period
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Objectives Establishes why the company manages currency risk,objective of policyDefinitions Defines key terms used to formulate the policyPolicy Guidelines Sets purpose and philosophy of the hedging programRoles and Responsibilities Defines delegations, segregation of duties
FX Exposure Management Establishes types of currency risk to hedged,strategies and coverage levels; derivatives that may be tradedReporting - Establishes FAS 133 elections and administrationControls - Establishes key internal controls such as limits andreconciliations.
4.3 Keys to a Successful Policy:
Signed off by Executive Management
Annually reviewed Identifies procedures for SOX documentation
4.4 Automation through Treasury Technology
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Front Office Middle Office Back office FAS 133
Pricing Analytics Market ExposureRisk
Inventory Documentation
Deal Capture What-if Analysis P&L Hedge Designation
Portfolio Allocation Marks-to-Market Resets Analytics
Term Sheet Payment Reporting
Option Expiry EffectivenessTesting
Audit Report Tracking
Cash Flow Hedge
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Market Data
Infrastructure Support
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Source: Mark Trombley Accounting for Derivatives and Hedging
www.TreasuryStrategies.com
1. Risk Assessment - Assess aggregate exposure to key currencies throughEarnings-at-Risk (pro forma) or scenario analysis
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Change in fairValue of derivative
Change in fairvalue of Derivative
Earnings affect ofhedged item
(transaction gain/loss)
Without Hedge Accounting
With Hedge Accounting
Adjust carryingvalue of
derivatives tofair value
Adjust carryingvalue of
derivatives to
fair value
Record gain or
lossfrom effectivehedging as OCI
and accumulate inAOCI
Recognizechange in fair
value inearnings
Recognize gain orloss from in
effective hedgingin earnings
Recognizehedge item in
earning inusual way
Balance Sheet Income Statement
Recognizedeferred gain/lossin same period ashedge item effect
earnings
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2. Strategy Development- Recommend alternatives for measuring and managingexposures
3. Implementation - Recommend policies and procedures execution, tracking andreporting
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CHAPTER 5. CURRENCY HEDGE RISK
5.1 Explaining Currency Risk5.2 Currency surprise5.3 To Hedge or Not to Hedge5.4 Instruments for Hedging Currency Risk5.5 Non-Hedging Techniques to Minimize
5 . CURRENCY HEDGE RISK
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Investment professionals face a tough climate. Fixed income yields are at near
lows. U.S. equity markets have been depressed for the past three years. Given
the recent geopolitical uncertainties, the foreign currency markets have been in
turmoil. What little returns that can be achieved by investment managers need
protection. The investing public more and more is reaching out to global markets
to make money and the issue of protecting investment returns from foreign
exchange risk becomes critical.
5.1 Explaining Currency Risk
A key difference between investing in domestic and foreign assets is that the
latter exposes the investor to a currency risk. Over the years, most investors
have not been careful in characterizing this risk to returns from unhedged
portfolios. One simplistic view was to measure the return in domestic currency
terms and compare it with returns in local currency terms, and characterize the
difference as the currency effect. The reasoning was that if the exchange rate
remains constant from the time of purchase of the foreign asset to its sale, then
the currency risk has had zero impact. On the other hand, if the domestic
currency has weakened (strengthened) against the foreign currency, the
exposure would result in a gain (loss).
In August 1998, the Association for Investment Management Research (AIMR)
argued that the use of changes in spot exchange rates (over the investment
period) as a measure of the influence of currency risk on foreign asset returns
was misleading. AIMR preferred an alternate approach, one that involved
splitting the currency effect into components: expected or known effect captured
by forward premium or discount.
5.2 Currency surprise
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In other words, currency surprise can be interpreted as the unexpected
movement of the foreign currency relative to its forward rate or market predicted
rate.
The assumption here is that the forward premium or discount (expected currency
effect) will be embedded in the return from a fully hedged portfolio. This implies
that Unheeded foreign asset return (US$) = Currency surprise + Hedged foreign
asset return (US$)
Currency surprise is essentially noise. So every investor in foreign assets must
make an explicit decision on whether or not he wants to take on exposure to this
noise factor.
5.3 To Hedge or Not to Hedge
Over the years, there has been considerable controversy on it. As might be
expected, there are multiple view points regarding the relative merits of hedging
away currency risks. Here are a couple of classic arguments in favor of not
hedging.
Uncorrelated risks
On a historical basis, changes in exchange rates (and hence currency returns)
have had very low correlations with foreign equity and bond returns. The belief is
that this lack of any systematic relationship could in theory lower portfolio risk.
Expected returns are zero
Viewed over a long investment horizon, currency movements cancel out each
other the mean-reversion argument. In other words, exchange rates have an
expected return of zero. So why bother hedging against currency surprise.
Realized versus expected returns
Currency returns tend to be episodic. In other words, there can be sufficient
movement in exchange rates in the short run that in theory could be exploited togenerate positive returns. More important, these movements also tend to exhibit
some degree of persistence.
5.4 Instruments for Hedging Currency Risk
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Foreign currency markets are deep, highly liquid, and relatively inexpensive.
Fund managers seeking to manage their currency exposures can pursue one or
more strategies: trade over-the-counter (OTC) market currency forwards and
options, exchange-traded futures and options on futures, or hire the services of
an overlay manager. Overlay managers are essentially specialist currency
trading firms that will actively manage a currency hedge mandate, and in
addition, attempt to generate a positive excess return. These firms too rely on
currency futures, forwards and options contracts.
Exchange-Traded Currency Futures Exchange-traded currency products offer at
least three major advantages vis--vis the inter-bank over-the-counter (OTC)
market:
1. Price transparency and efficiency,
2. Elimination of counterparty credit risk, and
3. Accessibility for all types of market participants.
Price Transparency and Efficiency
Futures and options exchanges bring together in one place divergent categories
of buyers and sellers to determine foreign exchange prices. This efficient price
discovery process is further enhanced by transparent trading arrangements.
Whether the trading venue is open outcry or electronic, the prices for exchange-
traded foreign currency products are disseminated worldwide via major quote
vendors such as Reuters, Bloomberg, and others. Electronic trading on
computerized trading systems takes place on a nearly 24-hour basis.
Elimination of Counterparty Credit Risk
Exchange-traded currency contracts have the exchange clearing house as the
counterparty to every trade. For example, the CME Clearing House is the buyer
to every seller and the seller to every buyer of all its currency products. Marketparticipants then need not evaluate the credit worthiness of multiple
counterparties. The CME Clearing House is their counterparty. All clearing
members of the CME Clearing House stand behind trades at the exchange.
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Importantly, there has never been a single default in the 104-year history of the
exchange. The OTC inter-bank market operates on the basis of credit limits for
every potential counterparty. BIS requires banks to maintain adequate levels of
capital to cover forward-maturity currency transaction risk. These requirements
are waived for foreign exchange transactions booked on exchanges, where
performance bonds are required and daily mark to market of open positions is
done.
Accessible to All Market Participants
The advent of financial futures began in the early 1970s because some inventive
and persistent commodity traders at Chicago Mercantile Exchange did not have
access to the inter-bank foreign exchange markets when they believed significantmoves were about to take place in currency prices. They established the
International Monetary Market (now a division of CME), which launched trading in
seven currency futures contracts on May 16, 1972creating the worlds first
financial futures. No longer was the arena of foreign exchange trading limited to
large commercial banks and their big corporate customers. Individuals, small
and medium-sized banks and corporations, investment funds and governments
can buy and sell currencies for future delivery or cash settlement. Universal
access to its markets is an important defining characteristic of exchange-traded
foreign currency futures and options.
5.5 Non-Hedging Techniques to Minimize
Transactions Exposure Two obvious ways in which transactions exposure can be
minimized, short of using the hedging techniques described below, are
transferring exposure and netting transaction exposure. The first of these is
premised on transferring the transaction exposure to another company. For
example, a U.S. exporter could quote the sales price of its product for sale in
Germany in dollars. Then the German importer would face the transaction
exposure resulting from uncertainty about the exchange rate. Another simple
means of transferring exposure is to price the export in Deutsche Marks but
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demand immediate payment, in which case the current spot rate will determine
the dollar value of the export.
A second way in which transaction risk can be minimized is by netting it out. This
is especially important for larger companies that do frequent and sizeable
amounts of foreign currency transactions.
Unexpected exchange rate charges net out over many different transactions. A
receivable of 100 million Deutsche Marks owed to a U.S. company in 45 days is
much less risky if the U.S. Company must pay a different German supplier 75
million Deutsche Marks in 30 days. The risk is reduced further if the business has
only receipts in Deutsche Marks on a continuing basis.
Transaction exposure is further reduced when payments and receipts are in
many different currencies. Foreign currency values are never perfectly
correlated. Therefore, an unexpected increase in the value of the French Franc
may improve the profit margin on receipts from France. However, an unexpected
decrease in the value of the Canadian Dollar may reduce profits on a receipt
from Canada. Although transaction exposure cannot be completely netted away,
it may be small enough that the company is better off accepting the exposure
rather than incur the costs associated with the hedging techniques described
below.
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CHAPTER NO: 6. CONCLUSION ANDRECOMMENDATIONS
6.1 Conclusion6.2 Recommendations
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6 . CONCLUSION AND RECOMMENDATIONS
6.1 Conclusions
Risk management is the most important sector of the forex industry with the keysuccess by attending directly the needs of the end Currency market is having
glorious future in coming years.
Risk management in Currency Market as a whole is facing a lot of competition
ever since financial sector reforms were started in the country. Walk-in business
is a thing of past and banks are now on their toes to capture business. Banks
and DFI therefore, are now competing for increasing competition and availability
of day by day growing financial products and current modernization era financial
market business going more risky area.
There is a need for constant innovation in Risk management area Currency
market. This requires product development and differentiation, micro-planning,
marketing, prudent pricing, customization, technological up gradation, home /
electronic / mobile banking, effective risk management and asset liability
management techniques.
While Risk management covered products offers phenomenal opportunities for
growth, the challenges are equally discouraging. How far the financial market is
able to lead growth of banking industry in future would depend upon the
comprehensive risk management and capacity building of banks to meet the
challenges and make use of opportunities profitably.
However, the kind of technology used and the efficiency of operations would
provide the much needed competitive edge for success risk management
business. Furthermore, in all these customer interest is of chief importance. The
banking sector in Pakistan is representing this and I do hope they would continue
to succeed in this traded path.
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6.2 Recommendations
Current Situation and Issue Currency Risk management is most essential part of
any sort of operation in commercial banks and DFI. It is also depend the policy of
institution to work on strong and comprehensive risk management which will be
effective tool to secure and develop organizational growth and helpful for
professional way of working without harmful effects
Current Situation and Issue Description
Assessment of facilities for standard physical losses (Equity and Debt) and
potential occupational hazards is handled routinely by institutional Environmental.
The program of neither risk analysis nor a fully-dedicated position for loss control
and loss prevention at any institution. Responsibilities for risk management are
spread among a variety of departments. Thus, pre-loss process review and loss
prevention implementation is rare. Such strategies are generally handled on a
post-incident, department-only basis.
Rationale for Change
Institutions typically respond to property and liability losses in a reactive mode.
The work group believes it is essential to move to a proactive stance in
preventing losses. In addition, this reactive stance may well be the result of the
fact that no institution has a fully dedicated position to analyze losses, decide
upon methods of prevention, and coordinate implementation of loss prevention
measures.
As the position of risk coordinator is currently configured at the institutions, only a
small percentage of the total FTE is all risk activities. These activities are
confined to information gathering and dissemination of that information to RMD.
RMD then makes all the decisions regarding resolution of the claim. In general,
Risk Coordinators process the claim rather than manage it.
In contrast, workers compensation coordinators spend a majority of their time
performing claims management activities. They generally have an extensive
background in workers compensation and the associated loss control practices.
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Use of these practices allows them to impact the outcome of the claim and better
control the associated costs. Working in cooperation with SAIF Corporation
adjusters, they provide input and help design the best cost control strategy for
each claim.
Key Concerns Regarding the Development of a Comprehensive Risk Program
The key concern with developing a comprehensive risk program across the
System is the potential for initial increased resource costs. The challenge of
implementing a new program is to demonstrate that the benefits of the program
will outweigh the costs.
Another concern with implementing a risk management program is whether
incremental resources will possess the proper expertise. For a risk managementprogram to work effectively, the risk manager position at each institution would
ideally have professional experience. Without the proper experience and training
(i.e. if the risk manager position was staffed at a clerical level), the benefits
gained by implementing a Currency risk management program would be
considerably less
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