1. Chapter 12 Foreign Exchange Risk and Exposure

2. 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

3. 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 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.)

4. 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 Definitions of risk (cont.) The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum 12-4 (cont.)

5. 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 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

6. 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 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

7. 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 Rate of return 12-7

8. 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 Measuring risk: probability distribution 12-8

9. 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 Measuring risk: historical data 12-9

10. 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 Measurement of VAR Measurement unit (e.g. AUD) Time horizon (one day, one week, etc.) Probability (1-5%) 12-10

11. 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 Implementation of VAR analysis Parametric (analytical) approach Historical approach Simulation approach 12-11

12. 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 The parametric approach The approach is based on the assumption of the normality of rates of return 12-12 (cont.)

13. 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 The parametric approach (cont.) 12-13

14. 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 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

15. 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 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

16. 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 VAR: pros It is simple It is suitable for risk-limit setting and performance measurement It can take account of complex movements 12-16

17. 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 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

18. 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 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

19. 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 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

20. 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 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

21. 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 The slope of the exposure line where  is the slope of the exposure line.  is positive (negative) for assets (liabilities) 12-21

22. 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 Long and short exposures Long exposure  assets Short exposure  liabilities 12-22

23. 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 Combined exposure A combined exposure arises when a firm holds both foreign assets and foreign liabilities 12-23

24. 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 The relation between FX risk and exposure 12-24

25. 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 Multiple exposure Exposure to more than one currency: 12-25

26. 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 The volatility of the AUD exchange rates The standard deviations of monthly percentage changes in exchange rates 12-26

27. 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 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

28. 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 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

29. 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 Volatility and correlation Exposure to a currency that fluctuates sharply is more of a source of concern Exchange rate correlations are important 12-29

30. 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 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

31. 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 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

32. 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 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

33. 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 Translation rates Closing (current) rate Average rate Historical rate 12-33

34. 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 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

35. 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 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

36. 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 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

37. 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 Translation methods Current/non-current method Closing (current) rate method Monetary/non-monetary method Temporal method 12-37

38. 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 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

39. 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 Closing (current) rate method Assets and liabilities are translated at the exchange rate prevailing at the end of the accounting period 12-39

40. 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 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

41. 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 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

42. 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 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.)

43. 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 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