chapter 12 foreign exchange risk and exposure. copyright 2010 mcgraw-hill australia pty ltd ppts...

Chapter 12

Foreign Exchange Risk and Exposure

Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa

Slides prepared by Afaf Moosa

Objectives

• To define risk and exposure• To elaborate on the concept of value at risk (VAR)• To distinguish among transaction, economic and

translation exposure

12-2



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)

12-3

(cont.)



Definitions of risk (cont.)

• The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum

12-4

(cont.)



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.

12-5



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

12-6



Rate of return

1)1)(1(

11

VSR

SVV

VV

VRt

t

12-7



Measuring risk: probability distribution

21

2

1

)()(

)()(

RERpR

RpRE

i

n

ii

i

n

ii

12-8



Measuring risk: historical data

2

1

2

1

1

1

1

)RR(n

)R(

Rn

R

n

tt

n

tt

12-9



Measurement of VAR

• Measurement unit (e.g. AUD)• Time horizon (one day, one week, etc.)• Probability (1-5%)

12-10



Implementation of VAR analysis

• Parametric (analytical) approach• Historical approach• Simulation approach

12-11



The parametric approach

• The approach is based on the assumption of the normality of rates of return

12-12

(cont.)



The parametric approach (cont.)

Per cent of

Observations Lowest r Highest r Probability VAR

68 r r 16.0 )( rK 90 65.1r 65.1r 5.0 )65.1( rK 95 96.1r 96.1r 2.5 )96.1( rK 98 33.2r 33.2r 1.0 )33.2( rK 99 3r 3r 0.5 )3( rK

12-13



The historical approach

• VAR with a certain probability is calculated from the lower nth percentile of historical observations on the rate of return

12-14



The simulation approach

• VAR with certain probability is calculated from the lower nth percentile of simulated observations on the rate of return

• Observations are generated from Monte Carlo simulation by specifying a probability distribution and its parameters

12-15



VAR: pros

• It is simple• It is suitable for risk-limit setting and performance

measurement• It can take account of complex movements

12-16



VAR: cons

• It can be misleading• VAR estimates are highly sensitive to the underlying

assumptions• It cannot cope with sudden or sharp changes

12-17



VAR: conclusion

• VAR is useful but it should be handled with care and used in conjunction with other measures of risk

• Confidence in VAR has been undermined by the global financial crisis as the VAR models used by financial institutions failed to predict the losses that they actually endured

12-18



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

12-19



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

12-20



The slope of the exposure line

SV β

where is the slope of the exposure line. is positive (negative) for assets (liabilities)

12-21



Long and short exposures

• Long exposure assets • Short exposure liabilities

12-22



Combined exposure

• A combined exposure arises when a firm holds both foreign assets and foreign liabilities

12-23



The relation between FX risk and exposure

)(σβ)(σ 222 SV

12-24



Multiple exposure

• Exposure to more than one currency:

)/()/( 01010 nn xxSxxSV

12-25



The volatility of the AUD exchange rates

• The standard deviations of monthly percentage changes in exchange rates

USD/AUD JPY/AUD EUR/AUD GBP/AUD 2004 2.88 3.38 1.70 2.11 2005 1.71 2.03 2.12 2.04 2006 2.62 2.18 2.30 1.74 2007 3.41 4.29 2.74 3.01 2008 6.44 7.93 3.62 5.41

12-26



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

12-27



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

12-28



Volatility and correlation

• Exposure to a currency that fluctuates sharply is more of a source of concern

• Exchange rate correlations are important

12-29



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

12-30



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

12-31



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

12-32



Translation rates

• Closing (current) rate• Average rate• Historical rate

12-33



The closing rate

• The closing rate (or current rate) is the rate prevailing at the end of the accounting period (that is, coinciding with the balance sheet date)

12-34



The average rate

• The average rate is the average value of the exchange rate over the accounting period

• The simplest procedure is to take a simple average of the closing rate and the rate prevailing at the beginning of the period. Otherwise, a time-weighted average may be used

12-35



The historical rate

• The historical rate is the rate prevailing on the date when an asset is acquired or a liability is committed

• The historical rate may therefore fall outside the current accounting period. In fact, this is invariably the case for long-term assets and liabilities

12-36



Translation methods

• Current/non-current method• Closing (current) rate method• Monetary/non-monetary method• Temporal method

12-37



Current/non-current method

• According to this method, current items are translated at the closing rate, whereas long-term items are translated at the historical rate

12-38



Closing (current) rate method

• Assets and liabilities are translated at the exchange rate prevailing at the end of the accounting period

12-39



Monetary/non-monetary method

• Monetary items (such as bonds) are translated at the closing rate, whereas non-monetary items (such as real estate) are translated at the historical rate

12-40



Temporal Method

• According to the temporal method, the use of the closing rate or the historical rate is determined by the valuation of the underlying item

• The closing rate is used for items stated at replacement cost, realisable value or market value

• The historical rate is used for all items stated at historical cost

12-41



Some principles

• Translation of balance sheet items is based on the closing rate

• Transaction gains and losses are accounted for in the income statement

12-42

(cont.)



Some principles (cont.)

• Non-transaction gains and losses are represented 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

12-43

chapter 12 foreign exchange risk and exposure. copyright 2010 mcgraw-hill australia pty ltd ppts...

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