FX Risk Exposure, Measurement and Management.pdf

FOREIGN CURRENCY RISK MANAGEMENT

Foreign Currency Risk Management
FOREX
How to Convert
Currency
How Currency
Fluctuates
Types of Foreign
Risk
Hedging Methods

Risk Management
 Exchange Rate
1.50 $/£
 Buy $ 5,000
Rate 1.50 $/£
Answer in £
 Buy $ 8,000
Rate 1.20 $/€
Answer in €
 Buy $ 9,000
Rate 1.20 CAD/$
Answer in CAD :

Exchange rate conversion
Example
Buy 50,000 $
Rate 1.2520-1.2525 $/£
Answer in £
Bid Offer/ask
Bank Buy Bank Sell
1.2320 $/£ 1.2324 $/£
Example
Buy 50,000 $
Rate 1.1220-1.1225 $/€
Answer in €
Example
Sell 50,000 $
Rate 1.01-1.03 CAD/$
Answer in CAD
Example
Sell 60,000 $
Rate 1.07-1.08 $/CHF
Answer in CHF

- When dealing with converting Foreign currency, it is important to consider the
following points
 Always consider yourself at Adverse Position
 In Currency Division
In case of Receipt
(Lower Receipt)
In case of Payments
(Higher Payment)
In case of Receipt, Sell Currency, Exports, Gain or
Income
In case of Payment, Buy Currency, Import, Loss or
Expense
Divide with Higher
Currency Rate
Divide with Lower
Currency Rate

Supply & Demand
• Speculation
• Export and Import
• Foreign Direct Investment (FDI)
• Foreign Currency Loans
How Currency Fluctuate

Purchasing Power Parity (PPP)
According to PPP the exchange rate between two currencies can be explained by the difference between
inflation rated in respective countries.
PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country
with a LOW inflation rate has an expectation of increase in its currencies value.
The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by
banks.
Expected spot rate Future Spot rate= current spot rate × ( 1+ inflation of first currency)
(1 + inflation of 2nd currency)

Interest rate parity (IRP)
This concept says that the difference between 2 currencies worth can be explained by interest rate structure in the
countries of these 2 currencies.
According to IRP a country with a high interest rate structure normally has a currency at discount in relation to another
currency whose country has a low interest rate structure & vice versa.
HIGH INTEREST in country LOWER will be the value of currency
LOWER INTEREST in country HIGHER will be the value of currency
We can predict forward rate between two currencies by using interest rate parity concept as follows;
Forward rate Forward rate= current spot rate × ( 1+ interest of first currency)
(1 + interest of 2nd currency)

Fisher Effect
This concept tells us the relation between interest rate and inflation.
It assumes that real interest rate between two economies are same and nominal interest rates are different
because of inflation.
 Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly
because high interest rates are a mechanism for reducing inflation.
 USA 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
 UK 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
.

Types of Foreign Exchange Risk
Translation Risk
• Translation risk refers to the
possibility of accounting loss
that could occur because of
foreign subsidiary, as a result
of the conversion of the value
of assets and liabilities which
are denominated in foreign
currency, due to movements in
exchange rate.
• This risk is involved where a
parent company has foreign
subsidiaries in a depreciating
currency environment.
Translation Risk hedging
• Arrange Maximum
Borrowing in Subsidiary Co.
currency.
• Maintain Surplus Assets in
Parent Co. currency which
will reduce the overall
exposure of Translation risk.

Methods of Hedging FOREX Risk
Economic Risk Hedging
• Shift manufacturing to cheaper labor
areas
• Create innovative and differentiate units
to create brand loyalty
• Diversify into new products and into
new markets
Economic Risk
• Long-term movement in the rate
of exchange which puts the
company at some competitive
disadvantage is known as
economic risk.
• E.g. if competitor currency starts
depreciating or our company
currency starts appreciating.
• It may affect a company’s
performance even if the company
does not have any foreign
currency transactions.

Transaction Risk - Internal Hedging Method
Transaction Risk
Transaction risk refers to adverse changes in the exchange rate before the transaction is finally settled.
Hedging Methods
Internal Hedging Methods
 Invoice in Home Currency
 Matching Foreign Currency (Receipts and Payments)
 Netting
 Invoice in Home Currency
Suitability: Monopoly power & customer has no option. Supplier agrees to invoice in your currency.
 Matching Foreign Currency (Receipts and Payments)
Timing and currencies should be same

 Netting
Netting is a process in which all transaction of group companies are converted into the same currency and
then credit balances are netted off against the debit balances, so that only reduced net amounts remain due to
be paid or received.
Step 1 : Convert all transactions of group companies or in case of multilateral netting the other non group
companies in to the same currency ( normally the parent Co currency.
Step 2 : prepare the Transaction matrix ( Netting Table )
Step 3 :
Companies with
negative balance
will pay the
amounts to
companies having
positive balance.
payment read down
USA UK Europe Total Receipts
Receipts USA X x x Xx
Read Across UK X x x Xx
Europe X x x Xx
Total Payments (xx)
(xx) (xx)
Total Receipts Xx xx xx
Net Amounts (xx) (xx) xx

Netting
Netting is a processes whereby the debt between group member companies or between
group members and other parties can be reduced.
Advantages:
The number of currency transactions can be minimized, saving transaction costs and focusing the
transaction risk onto a smaller set of transactions that can be more effectively hedged.
It may also be the case, if exchange controls are in place limiting currency flows across borders, that
balances can be offset, minimizing overall exposure. Where group transactions occur with other companies
the benefit of netting is that the exposure is limited to the net amount reducing hedging costs and
counterparty risk.
Disadvantages:
Some jurisdictions do not allow netting arrangements, and there may be taxation and other
cross border issues to resolve. It also relies upon all liabilities being accepted – and this is
particularly important where external parties are involved.
There will be costs in establishing the netting agreement and where third parties are involved
this may lead to re-invoicing or, in some cases, re-contracting.

Transaction Risk - External Hedging Method
Forward Contract :
A forward contract is an agreement made today between a buyer and seller to exchange a specified quantity of an underlying
asset at a predetermined future date, at a price agreed upon today.
Example
- Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months
Spot Rate = 1.30 – 1.31 $/£
Six month forward rate = 1.32 – 1.33 $/£
Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940
Adjustment :
3 month forward 1.28 $/£
8 month forward 1.38 $/£
6 month forward ?

Forward Contracts
It is a legally binding contract between two parties to buy or sell in future at a pre-determined
rate and a pre-specified date.
Advantages
Eliminate currency risk, as foreign exchange costs are determined upfront.
They are tailor made and can be matched against the time period of exposure as well as for the
cash size of the exposure, therefore they are referred to as a complete hedge.
They are easy to understand.
Disadvantages
It is subject to default risk.
There may be difficult to find a counter-party.
They are legally binding so difficult to cancel.

Foreign Currency Receipts / Exports
Steps:
a) Calculate present value of foreign currency using borrowing rate of foreign currency and
take loan of this amount.
Present Value = Foreign Currency amount
(1+ borrowing rate of FCY)
b) Convert that present value into home currency using spot exchange rate.
c) Deposit the home currency at the deposit rate of home currency.
Total receipts= Home currency × ( 1 + lending rate of HCY )
Money Market Hedging :

Foreign Currency Payments / imports
Steps:
a) Calculate present value of foreign currency using lending rate of foreign currency
and deposit that amount.
Present Value = Foreign Currency amount
(1+ lending rate of FCY)
b) Convert that present value into home currency using spot exchange rate.
c) Borrow the home currency at the borrowing rate of home currency.
Total payment= Home currency × ( 1 + borrowing rate of HCY )

Derivatives:
• Future Settlement
• Initial amount to be paid is nil or low
• Drive their value from some underlying
• Traded in two types of market
(Over the counter Market & Exchange Traded)
Over-the-Counter
Derivatives
Exchange-Traded Derivatives
Customized Contracts Standardized Contracts
Any Amount Standardized Contract Size (e.g. $ 62,500)
Available in any Currency Major Currencies
Settlement on any date Settlement Date – Mar/Jun/Sept/Dec
No Initial margin
requirement
Initial Margin Requirement
Gain or Loss settled at
maturity
Gain or Loss settled on daily basis using ‘Mark to
Market”
High Risk of Default No Risk of Default
Counter Party is another
Investor
Counter Party is clearing house.
E.G FORWARD
CONTRACTS
E.G FUTURE CONTACTS

Future Contracts
It is a legally binding contract between chairing house & investor to buy & sell currency in future at pre-
determined rate and pre-specified date.
Features of Future Contracts
Standardized Contract Size
Available in all currency except $
Settlements in March, June, Sept, Dec
Minimum moment is in ticks
Tick = Contract size x 0.01%
For Japanese ¥ = Contract size x 0.00001%
If you want to buy any currency in Future Buy future contracts
If you want to sell any currency in Future Sell future contracts
Think according to contract size currency

Examples of Future Contracts
Example 1
Country USA, Currency $
Export £300,000
Contract size £62,500
Solution
Sell £ future contracts
Example 2
Country UK, Currency £
Export $600,000
Contract Size £62,500
Solution
Buy £ Future Contracts
Example 3
Currency €
Export £600,000
Contract size £62,500
Solution
Sell £ Future Contracts
Example 4
Currency ¥
Imports $1,000,000
Contract size ¥1.5million
Solution
Sell ¥ Future Contracts

Steps of Future Contracts
1) Identify the amount of currency to be hedged
2) Decide whether to buy or sell future
3) Identify the settlement date expiring immediately after the payment is due to be paid or received
4) Calculate no. of contracts = (Transaction Amount/ Contract Size)
If transaction amount currency is different from the contract size currency then using
future rates, convert transaction amount currency into the same currency as contract size.
5) Close the future contract by taking opposite position:
Buy £ Future 1.50 $/£
Sell £ Future 1.60 $/£
Gain 0.10 $/£ x No.of Contracts x Contract size
Gain or loss will be in $ amount if $ amount is not home currency, then using transaction date spot rate, convert this into home
currency.
Steps in future contract hedging
6) Actual buying or selling of currency in market xxx
Gain or loss in future contract xx
Net Receipt or payment xx

Example
Home Currency £ 1st Jan
Exports $400,000 at 1st May
Spot 1.40-1.41 $/£
June Future 1.45 $/£
March Future 1.44 $/£
Contract Size £ 25,000
On 1st May
Spot 1.466-1.467 $/£
June Future 1.47 $/£
Example:

Solution
Buy £ Future
June Contract @ 1.45 $/£
No.of Contracts = (400000/ 1.45)/ 25000
= 11
Close the Future by
Buy Future @ 1.45
Sell Future @ 1.47
0.02 $/£ x 11 x 25000 = 5500
Gain £ = 5500/ 1.4670 = 3749
Sell 400,000 at actual market rate
400000/1.467 = 272665
Gain = 3749
Total Receipt 276414
Exports $400,000

Types of Future
TYPE :1
1. Opening Future rate is given
2. Closing Future rate is given
3. Closing Spot rate is given
TYPE: 2
1. Opening Future rate is given
2. Closing Future rate is not given
3. Closing Spot rate is given
BASIS = Current SPOT RATE – OPENING FUTURE RATE
Example – Continued :
Basis = 1.2022 – 1.2520 = 0.04982/7 x 2
If increasing +
If increasing -
Remaining Basis = 0.0142
Closing Future = Closing Spot +/- Remaining Basis
Closing Future = 1.2722 + 0.0142
Closing Future = 1.2864
Remaining Basis = x remaining months

EXAMPLE:
• Home Currency € Now 1st June
• Import $600,000 1st Nov
• Spot rate - 1.2020 – 1.2022 $/ €
• Sept Future - 1.2420
• Dec Futture - 1.2520
• Contract size € 25,000
• 1st Nov Spot rate - 1.2710 – 1.2720 $/ €
• Sell € Future
Solution :
No of Contract = (600,000 / 1.2520) / 25,000 = 19 Contracts
Basis = 1.2020 -1.2710 = (0.069/7) x 2 = 0.0143
= 1.2710 + 0.0143
= 1.2853Imports $ 600,000
Sell € future
Dec contract @ 1.2520 $/ €
Sell € Future - 1.2520 $/ €
Buy € Future - 1.2853 $/ €
LOSS 0.0333 x 19 x 25,000 =
15,818
LOSS in € = 15,818/1.2710 = 12,445
BUY $ 600,000 in Acutal Market
• 600,000 / 1.2710 = 472,069
LOSS = 12,445
Total Payment = 484,514
Imports $ 600,000
Sell € future
Dec contract @ 1.2520 $/ €

TYPE 3
1) Opening Future Rate is Given
2) Closing Future Rate is not Given
3) Closing Spot Rate is not Given
It is assumed that all parity theories hold true & forward rate will be equal to the Future Spot
Rate.

Future Contract
Step 1: Identify the amount of currency to be hedged
Step 2: Decide whether to buy or sell future
If you want to buy currency  Buy that currency future
If you want to sell currency  Sell that currency future
Think according to the contract size currency
Step 3: Identify the settlement date expiring immediately after the payment is due to be paid or received
Step 4: Calculate no of contracts  Transaction Amount/Contract Size
If transaction currency is different from the contract size currency then using future rate convert that transaction amount
currency into the same currency of contract size.
Step 5: Calculate Basis Risk.
BASIS = Current Spot rate – Opening Future Rate
Remaining Basis =( Difference/Total months)* remaining months
Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future rate.
Lock in Rate= opening future rate ± Remaining Basis ( opposite to normal rule )
Convert the foreign currency into home currency using Lock in rate.

Future Contracts
It is a legally binding contract between two parties to buy or sell in future at a pre-determined rate and a
pre-specified date.
Advantages
The commission charges for futures trading are relatively small as compared to other type of investments.
Futures contracts are highly leveraged financial instruments which permit achieving greater gains using a limited
amount of invested funds.
It is possible to open short as well as long positions. Position can be reversed easily.
Lead to high liquidity.
Disadvantages
Leverage can make trading in futures contracts highly risky for a particular strategy.
Futures contract is standardized product and written for fixed amounts and terms.
Lower commission costs can encourage a trader to take additional trades and lead to over-trading.
It offers only a partial hedge.
It is subject to basis risk which is associated with imperfect hedging using futures.

Imagine it is 10 July 2017. A UK company has a US$6.65m invoice to pay on 26 August 2014. They are concerned that exchange rate fluctuations could
increase the £ cost and, hence, seek to effectively fix the £ cost using exchange traded futures. The current spot rate is $/£1.7111.
Research shows that $/£ futures, where the contract size is denominated in £, are available on the CME Europe exchange at the following prices:
September expiry – 1.7103
December expiry – 1.7086
The contract size is £100,000 and the futures are quoted in US$ per £1.
SETTING UP THE HEDGE
1. US$6.65m payment
2. Settlement Date – September:
3. Sell £ future
4. Contracts 39
($6.65m ÷ 1.7103)/£100,000 ≈ 39.
$/£
Sell – on 10 July 1.7103
Buy back – on 26 August (1.6575)
Gain 0.0528
Outcome on 26 August:
On 26 August the following was true:
Spot rate – $/£ 1.6577
September futures price – $/£1.6575
Gain/loss on futures:
As the exchange rate has moved adversely for the UK company a gain should be expected on the futures hedge.

This gain is in terms of $ per £ hedged. Hence, the total gain is:
0.0528 x 39 contracts x £100,000 = $205,920
Alternatively, the contract specification for the futures states that the tick size is 0.0001$ and that the tick
value is $10. Hence, the total gain could be calculated in the following way:
0.0528/0.0001 = 528 ticks
528 ticks x $10 x 39 contracts = $205,920
This gain is converted at the spot rate to give a £ gain of:
$205,920/1.6577 = £124,220
SUMMARY
All of the above is essential basic knowledge. As the exam is set at a particular point in time you are unlikely
to be given the futures price and spot rate on the future transaction date. Hence, an effective rate would need
to be calculated using basis. Alternatively, the future spot rate can be assumed to equal the forward rate and
then an estimate of the futures price on the transaction date can be calculated using basis. The calculations
can then be completed as above.

INITIAL MARGIN
When a futures hedge is set up the market is concerned that the party opening a position by buying or selling
futures will not be able to cover any losses that may arise. Hence, the market demands that a deposit is
placed into a margin account with the broker being used – this deposit is called the ‘initial
Margin
These funds still belong to the party setting up the hedge but are controlled by the broker and can be used if a
loss arises. Indeed, the party setting up the hedge will earn interest on the amount held in their account with
their broker. The broker in turn keeps a margin account with the exchange so that the exchange is holding
sufficient deposits for all the positions held by brokers’ clients.
In the scenario above the CME contract specification for the $/£ futures states that an initial margin of
$1,375 per contract is required.( assumption)
Hence, when setting up the hedge on 10 July the company would have to pay an initial margin of $1,375 x
39 contracts = $53,625 into their margin account. At the current spot rate the £ cost of this would be
$53,625/1.7111 = £31,339.

MARKING TO MARKET
In the scenario given above, the gain was worked out in total on the transaction date. In reality, the
gain or loss is calculated on a daily basis and credited or debited to the margin account as appropriate.
This process is called ‘marking to market’.
Hence, having set up the hedge on 10 July a gain or loss will be calculated based on the futures
settlement price of $/£1.7092 on 11 July. This can be calculated in the same way as the total gain
was calculated:
$/£
Sell – on 10 July 1.7103
Settlement price – 11 July (1.7092)
Gain 0.0011
Gain in ticks – 0.00110/0.0001 = 11
Total gain – 11 ticks x $10 x 39 contracts = $4,290
This gain would be credited to the margin account taking the balance on this account to $53,625 +
$4,290 = $57,915.

At the end of the next trading day (Monday 14 July), a similar calculation would be performed:
$/£
Settlement price – 11 July 1.7092
Gain 0.0012
Gain in ticks – 0.0012/0.0001 = 12
Total gain – 12 ticks x $10 x 39 contracts = $4,680.
This gain would also be credited to the margin account taking the balance on this account to $57,915 + $4,680 =
$62,595.
Similarly, at the end of the next trading day (15 July), the calculation would be performed again:
$/£
Settlement price – 14 July 1.7080
Loss 0.0055
Loss in ticks – 0.0055/0.0001 = 55
Total loss – 55 ticks x $10 x 39 contracts = $21,450.
This loss would be debited to the margin account, reducing the balance on this account to $62,595 – $21,450 =
$41,145.
This process would continue at the end of each trading day until the company chose to close out their position by
buying back 39 September futures.

MAINTENANCE MARGIN, VARIATION MARGIN AND MARGIN CALLS
Having set up the hedge and paid the initial margin into their margin account with their broker, the company may be required to pay in
extra amounts to maintain a suitably large deposit to protect the market from losses the company may incur. The balance on the margin
account must not fall below what is called the ‘maintenance margin’. In our scenario, the CME contract specification for the $/£
futures states that a maintenance margin of $1,250 per contract is required. Given that the company is using 39 contracts, this means
that the balance on the margin account must not fall below 39 x $1,250 = $48,750.
As you can see, this does not present a problem on 11 July or 14 July as gains have been made and the balance on the margin account
has risen. However, on 15 July a significant loss is made and the balance on the margin account has been reduced to $41,340, which is
below the required minimum level of $48,750.
Hence, the company must pay an extra $7,410 ($48,750 – $41,340) into their margin account in order to maintain the hedge. This
would have to be paid for at the spot rate prevailing at the time of payment unless the company has sufficient $ available to fund it.
When these extra funds are demanded it is called a ‘margin call’. The necessary payment is called a ‘variation margin’.
If the company fails to make this payment, then the company no longer has sufficient deposit to maintain the hedge and action will be
taken to start closing down the hedge. In this scenario, if the company failed to pay the variation margin the balance on the margin
account would remain at $41,340, and given the maintenance margin of $1,250 this is only sufficient to support a hedge of
$41,340/$1,250 ≈ 33 contracts. As 39 futures contracts were initially sold, six contracts would be automatically bought back so that the
markets exposure to the losses the company could make is reduced to just 33 contracts. Equally, the company will now only have a
hedge based on 33 contracts and, given the underlying transaction’s need for 39 contracts, will now be under hedged.
Conversely, a company can draw funds from their margin account so long as the balance on the account remains at, or above, the
maintenance margin level, which, in this case, is the $48,750 calculated.

Option Contract
• Currency options give the buyer the right but not
the obligation to buy or sell a specific amount of
foreign currency at a specific exchange rate (the
strike price) on or before a predetermined future
date.
• For this protection, the buyer has to pay a
premium.
• A currency option may be either a call option or a
put option
• Currency option contracts limit the maximum loss
to the premium paid up-front and provide the buyer
with the opportunity to take advantage of favorable
exchange rate movements.
TYPES:
CALL OPTION  Right to buy at a specified rate
PUT OPTION  Right to sell at a specified rate
OPTION BUYER – OPTION HOLDER  LONG POSITION
OPTION SELLER – OPTION WRITER  SHORT POISTION
American Option – can be exercised at anytime before maturity
European Option – can be exercised at maturity only.

Option Contract
Step 1: Identify the amount of currency to be hedged
Step 2: Decide whether to buy Call or Put
if you want to buy any currency in future  Call
If you want to sell any currency in future  Put
Think according to the contract size currency
Step 3: Identify the settlement date expiring immediately after the payment
is due to be paid or received
Step 4: Identify the exercise price
Step 5: Calculate the no of contracts =
(Foreign Currency Amount/ Exercise Price) / Contract Size
Step 6: Calculate the premium cost = No of contract x Contract size x Premium
If premium answer is not in your home currency then using current spot
rate convert it into home currency.
Step 7 :
NOTE: It is assumed that option will be exercised.
Exercise the option × × ×
Over or under hedge amount × ××
Premium ×××
Net Amount ××

Currency Options
A currency option is an agreement involving a right, but not an obligation, to buy or sell a certain amount of currency
at a stated rate of exchange (the exercise price) at some time in the future.
Currency options protect against adverse exchange rate movements while allowing the investor to take advantage of
favorable exchange rate movements. They are particularly useful in situations where the cash flow is not certain to occur
(eg when tendering for overseas contracts).
Options are of two types, traded and over the counter, and both have different kinds of benefits.

Advantages of Traded and OTC Options
Traded
Traded options are standard sizes and are thus 'tradable' which
means they can be sold on to other parties if not required. OTC
options are designed for a specific purpose and are therefore
unlikely to be suitable for another party.
Traded options are more flexible in that they cover a period of
time (American options, whereas OTC options are fixed date
(European options).
OTC
OTC options can be agreed for a longer period than the
standard two-year maximum offered by traded options. This gives
greater flexibility and protection from currency movements in the
longer term should the transaction require it.
OTC options are tailored specifically for a particular
transaction, ensuring maximum protection from currency
movements. As traded options are of a standard size, the full
amount of the transaction may not be hedged, as fractions of
options are not available.

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