1. Chapter 13 Foreign Exchange Risk and Exposure

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To define risk and exposure. To introduce value at risk (VAR). To distinguish among transaction, economic and translation exposure.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 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).

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Definitions of Risk (cont.) The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 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.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 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.

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Rate of Return

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Measuring Risk: Probability Distribution

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Measuring Risk: Historical Data

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Value at Risk VAR is a new approach to risk measurement and management. Over a given period of time with a given probability, how much money might be lost on a certain position?

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Measurement of VAR Measurement unit (e.g. AUD) Time horizon (one day, one week, etc.) Probability (1-5%)

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Implementation of VAR Analysis Parametric (analytical) approach Historical approach Simulation approach

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 VAR: Pros It is simple. It is suitable for risk-limit setting and performance measurement. It can take account of complex movements.

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 VAR: Cons It can be misleading. VAR estimates are highly sensitive to the underlying assumptions. It cannot cope with sudden or sharp changes.

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 VAR: Conclusion VAR is useful but it should be handled with care and used in conjunction with other measures of risk.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 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.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 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.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 The Slope of the Exposure Line where  is the slope of the exposure line.  is positive (negative) for assets (liabilities).

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Long and Short Exposures Long exposure  assets Short exposure  liabilities

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Combined Exposure A combined exposure arises when a firm holds both foreign assets and foreign liabilities.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 The Relationship Between FX Risk and Exposure

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Multiple Exposure Exposure to more than one currency:

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 The Volatility of the AUD Exchange Rates Volatility is measured by the standard deviation of the exchange rate. The AUD/USD rate is the least volatile.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 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.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 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

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Volatility and Correlation Exposure to a currency that fluctuates sharply is more of a source of concern. Exchange rate correlations are important.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 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.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 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.

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 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.

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 Translation Rates Closing (current) rate Average rate Historical rate

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Translation Methods Current/non-current method Closing (current) rate method Monetary/non-monetary method Temporal method

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 Some Principles Translation of balance sheet items is based on the closing rate. Transaction gains and losses are accounted for in the income statement.

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 Some Principles (cont.) Non-transaction gains and losses are reflected 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.