Foreign Exposure Risk By Pete Schonebaum March 4, 2008.

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Presentation transcript:

Foreign Exposure Risk By Pete Schonebaum March 4, 2008

Intro to Concept Risks for firms Book examples Issues concerning forex risk 1 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 R 2 indicates low exchange risk

Value at Risk Definition: greatest possible loss over specified horizon, given confidence interval 1 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

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