Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 17-1 Chapter 17 Foreign Exchange: Risk Identification and Management

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 17-2 Learning Objectives Identify the different types of foreign exchange (FX) risk faced by firms Formulate an FX policy document Outline methods to identify a company’s FX exposures and assess their risks Describe the implementation of market-based hedging techniques Explain non-market based techniques for managing FX risk

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 17-3 Chapter Organisation 17.1 FX Risk Policy Formation 17.2 Measuring Transaction Exposure 17.3 Risk Management: Market-based Hedging Techniques 17.4 Risk Management: Internal Hedging Techniques 17.5 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation Foreign exchange risk exposures can be classified in terms of the impact on a firm’s cash flows, balance sheet, competitive position and value –Transaction exposure –Translation or accounting exposure –Operational exposure –Economic exposure

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Transaction exposure –The risk that future foreign currency denominated cash flows will vary due to exchange rate movements  e.g. a contract to import goods from the US denominated in USD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Translation or accounting exposure –The risk that conversion and consolidation of foreign currency assets or liabilities will adversely impact the balance sheet  e.g. a firm accumulates assets and liabilities overseas and at a future date translates their value onto its consolidated balance sheet

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Operational exposure –The risk that day-to-day operating revenues and expenses will be affected by FX movements  E.g. foreign subsidiary operating expenses paid in the currency of the foreign country but sourced in another country such as the parent company

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Economic exposure –The effect of exchange rate movements on the ongoing business operations of a firm (i.e. the net present value of its future cash flows)  It includes both transaction exposures and operating FX exposures and extends further to recognise the impact of FX risk on the value of a firm

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) A company’s board of directors should document and circulate specific policies on FX risk management (i.e. policy document) including –FX objectives –Management structure –Authorisations –Exposure reporting systems –Communications –Performance evaluation –Audit and review procedures

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) FX objectives –Consideration of what the company intends to achieve and how it will achieve it by specifying  The products and services that can be used to manage FX risk exposures, e.g. forward exchange contracts and currency swaps  The style of risk management Active—hedging techniques continually adjusted in response to forecast changes in the exchange rate Defensive—a defined percentage of identified risk exposure is automatically hedged

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Management structure –Ensure appropriate organisational controls and reporting systems, skilled personnel and sufficient funding are in place  E.g. a company with a treasury division requires an FX dealing room, back office support, technical support and administration  The FX operation of a company may be Centralised—a single FX function in one location from which all policy is developed and transactions occur Decentralised—policy and trading is divested to each regional office

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Authorisations –A description of who, in the organisation, has the authority to do what, ensuring task segregation –Limits can relate to  Single transactions  Exposure to a particular client  Each currency  FX products used by the organisation  Each individual FX dealer  Maximum overnight exposures

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Exposure reporting systems –Determine which reports are required, how frequently they are required and who is responsible to act on them  e.g. exception reports—automatic computer-generated report when an FX authority is breached

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Communications –How communication should occur both horizontally and vertically within the treasury division and the overall organisation  e.g. Treasury must be advised of an import transaction so that it may arrange the payment of FX –Daily strategy meeting –Policy document should also outline communication system to apply in the event of a disaster, e.g. fire in the treasury and FX operations area

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Risk Policy Formation (cont.) Performance evaluation –Evaluation of the performance of the FX operations, given the FX objectives  SMART—specific, measurable, achievable, realistic and timely Audit and review procedures –A regular and structured process of carrying out internal and external audits of FX operations, including current objectives, policies and procedures, with appropriate lines of reporting

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 17.1 FX Risk Policy Formation 17.2 Measuring Transaction Exposure 17.3 Risk Management: Market-based Hedging Techniques 17.4 Risk Management: Internal Hedging Techniques 17.5 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure Transaction exposure –Is the risk faced by Australian firms that the AUD will change between the time an order is placed and the time of its payment –This risk is caused by the uncertainty as to the exact value of the transaction

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure risk has two directional components –Downside exposure  Amount received (paid) in the future is less (more) than the current projected amount –Upside exposure  Amount received (paid) in the future is more (less) than the current projected amount

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure has two elements –Net cash flows  Collate all receivables and payables in each currency to determine net exposure –Risk associated with transaction exposure  Currency variability  Currency correlations

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Net cash flows –Collate all receivables and payables in each foreign currency rather than considering each individual transaction –It is evident from Table 17.1 that the  Company has a natural hedge i.e. matching transactions have been used to offset a potential risk exposure  Net FX exposure is zero  Company had a perfect hedge because its receivables and payables were identical in size, currency and time

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposures: currency variability –Having determined the net FX exposure in each currency, the next step is to assess the extent of the risk (variability) of each exposure –Currency variability relates to the probability of the spot rate changing between contract date and payment date

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposures: currency variability (cont.) –Often measured by standard deviation –May need to examine trend in currency standard deviation over time as in Table 17.2, which illustrates  Standard deviations vary between currencies in the same period  Standard deviations vary over time

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure: currency correlations –In considering whether to hedge an FX exposure, the correlations between the currencies should also be considered –Correlation measures the degree to which two currencies move in relation to each other –Correlation ranges from + 1 (perfectly positively correlated) to – 1 (perfectly negatively correlated)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure: currency correlations (cont.) –Figure 17.2 indicates  Currencies A and B are highly positively correlated  Currency C is highly negatively correlated with both currencies A and B

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure: currency correlations (cont.) –Table 17.3 demonstrates the use of correlation coefficients in assessing whether an FX exposure requires hedging  Date t+6 A change in the AUD will result in a similar change in both inflows and outflows which offset each other –A natural hedge exists

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure: currency correlations (cont.)  Date t+8 A change in the AUD will result in either a gain or a loss on both flows –The exposure should be hedged  Date t+9 A change in the AUD will result in either a gain or a loss on both flows –The exposure should be hedged

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Transaction Exposure (cont.) Transaction exposure: currency correlations (cont.)  Date t+11 A change in the AUD will result in a similar change in both inflows and outflows which offset each other –A natural hedge exists

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 17.1 FX Risk Policy Formation 17.2 Measuring Transaction Exposure 17.3 Risk Management: Market-based Hedging Techniques 17.4 Risk Management: Internal Hedging Techniques 17.5 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Market-based Hedging Techniques A firm may attempt to minimise FX risk (particularly downside exposure) through the use of hedging techniques/instruments Hedging instruments include –Forward exchange contracts –Money-market hedge –Futures, options and swaps (discussed in Part 6 of text)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Market-based Hedging Techniques (cont.) Forward exchange contracts –Lock in an exchange rate today for delivery or receipt of a foreign currency at a specified future date –Figure 17.3 provides an example of the use of a forward exchange contract to hedge a USD1 million receivable in 6 months’ time

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Market-based Hedging Techniques (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Market-based Hedging Techniques (cont.) Money-market hedging to cover FX risk –Also called ‘BSI hedge’—borrow, spot, invest –Example  A company has USD1 million receivable in 6 months’ time  Money market hedging involves STEP I: Borrow USD today STEP II: Spot convert USD to AUD STEP III: Invest the AUD today

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Market-based Hedging Techniques (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 17.1 FX Risk Policy Formation 17.2 Measuring Transaction Exposure 17.3 Risk Management: Market-based Hedging Techniques 17.4 Risk Management: Internal Hedging Techniques 17.5 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques Internal hedging minimises FX exposures and the need to use market-based hedging techniques Main internal hedging techniques –Invoicing in the home currency –Creating a natural hedge –Currency diversification –Leading and lagging FX transactions –Mark-ups –Counter-trades and currency offsets

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques (cont.) Invoicing in the home currency –Avoids FX exposure –Effectively transfers all FX risk to the other party in the business transaction –The other party may charge a higher price to compensate for the extra risk

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques (cont.) Creating a natural hedge –Match foreign currency receivables and payables in terms of currency, timing and magnitude –Difficulties with this approach  Unlikely that an exact hedge can be achieved  Costs of hedge-motivated transactions Extra costs associated with borrowing in markets where the business may not be well known Are imported inputs or lease agreements superior in quality or price than another supplier in a non-matching currency?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques (cont.) Currency diversification –Limit impact of adverse exchange rate movements by spreading transactions over a large number of currencies –Chance of adverse movements in a large number of currencies is very small –Greatest diversification achieved where currencies are perfectly negatively correlated

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques (cont.) Leading and lagging FX transactions –Leading  Changing the timing of a cash flow so that it takes place prior to the originally agreed date  e.g. pay a USD payable before an expected AUD depreciation –Lagging  Delaying the timing of an existing FX cash flow  e.g. delay a USD payable to coincide with a USD receivable –Need to assess costs/impact of strategies, e.g. unpredictable payment behaviour

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques (cont.) Mark-ups –Increasing prices on exports or imports to cover worst- case scenario changes in an exchange rate  e.g. exporter marks-up export price of goods sold  e.g. importer marks-up the domestic price of imported goods –Competition is a constraint to this strategy

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Risk Management: Internal Hedging Techniques (cont.) Counter-trade and currency offsets –Counter-trade  The exchange of product for product, rather then currency- based buy or sell contracts  Limited to companies wishing to exchange products of equal value and at the same time –Currency offsets  Recognition of the timing and amount of cash inflows and outflows in the same currency  Applicable to both internal cash flows of a firm and FX cash flows between different firms

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 17.1 FX Risk Policy Formation 17.2 Measuring Transaction Exposure 17.3 Risk Management: Market-based Hedging Techniques 17.4 Risk Management: Internal Hedging Techniques 17.5 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Summary Foreign exchange risk exposures can be classified as –Transaction exposure –Translation or accounting exposure –Operational exposure –Economic exposure

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Summary (cont.) FX risk policy formulation involves a number of aspects necessary to measure and manage FX risk including –FX objectives, authorisations, exposure reporting systems, communications, performance evaluation, audit and review procedures Transaction exposures can be measured by –Net cash flows –Currency variability –Currency correlations

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Summary (cont.) Risk management techniques include –Market-based hedging—forward exchange contracts and money market hedging –Internal hedging—invoicing in home currency, natural hedge, currency diversification, leading and lagging FX transactions, mark-ups, counter-trade and currency offsets