Foreign Exposure Risk

By Pete SchonebaumMarch 4, 2008

Intro to Concept

• Risks for firms• Book examples• Issues concerning forex risk1

• Exchange risk for a firm-how to measure• Hedging strategy• Tools to apply

1 Giddy,Ian. Management of Foreign Exchange Risk

Risk Measurement

• Two underlying variables• Volatility of exchange rate• Level of exposure

• General scenarios• Fixed exchange rate: low risk• Exposed and low variance of exchange rate:

moderate risk• Exposed and high variance of exchange

rate: high risk

Exchange Rate Risk

• Real or nominal?• Typically measured using nominal

• When to use real?• When inflation differentials affect nominal• Example: Mexican Peso nominal variance

=2392 real variance=1561

Calculating Exchange Rate Risk

• Determine exchange rates over period• Calculate percentage change• Determine standard deviation of

percentage changes• Assuming normal distribution• Example

Exchange Risk: One Currency

• Example:• Receivable of 2 million bugaboos in 1

month• Standard deviation of % change (1 mnth):

4.5%• 30 day forward rate: 1.5$/bugaboo• Expected exposure?• Foreign exchange risk?

Exchange Risk: Multiple Currencies

• Currency diversification• Firms face less risk

• Risk and exposure cannot be added with multiple currencies

• Correlation effects• Positive correlation: total

exposure=approximate sum of two exposures

• Negative correlation: risk and exposure cannot be added

Exchange Risk: Multiple Currencies

• Example:• $100 worth of IL, $100 worth of JPY• Variance IL/$: 520, Variance JPY/$: 600• Covar of IL & JPY: 275• What is the exchange risk of this portfolio?

Exchange Risk and Firm Cash Flows

• What: Relate currency portfolio risk with volatility of firm cash flows

• How: • Devise ratio of portfolio st.deviation with

that of firm cash flows• Run regression-cash flows as dependent,

exchange rate as independent• Low R2 indicates low exchange risk

Value at Risk

• Definition: greatest possible loss over specified horizon, given confidence interval1

• Example:• Portfolio value: $10 million• Standard deviation of currency portfolio: 15% over

1 year• 99% confidence= 2.57 standard deviations

• VAR=0.15 X 2.57 X $10 million =$3.85 million• Common terms: “Most we can lose, under

normal market conditions, is $3.85 million.”1: Click, Reid. International Financial Management