1. Chapter 14 Foreign Exchange Risk Management

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 explain why there is concern about FX risk. To illustrate how to manage 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 Why Is There No Need To Worry About FX Risk? If international parity conditions hold, FX risk will not arise. If it is possible to forecast exchange rates accurately, FX risk can be controlled. Shareholders are naturally hedged though diversification.

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 Why Worry About FX Risk? Parity conditions do not hold. Forecasting exchange rates is rather difficult. Hedging produces a more stable income stream.

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 Why is a Stable Income Stream Desirable? If a progressive tax rate is in operation, more stable before-tax income produces higher after-tax income. It is more conducive to sales. Volatile earnings may imply lack of job security.

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 Managing Short-Term Transaction Exposure Forward hedging Money market hedging Futures hedging Option hedging

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 Forward Hedging Forward hedging entails locking in the exchange rate at which payables and receivables are converted from the domestic currency into a foreign currency, and vice versa.

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 Forward Hedging (no-hedge) (hedge) V

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 Financial Hedging By taking an affecting position on a hedging instrument (forward), the profit/loss on the unhedged position is offset by the loss/profit on the hedging instrument.

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 Offsetting Profit/Loss on Payables + Long forward Payables – (a) (par)

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 Offsetting Profit/Loss on Payables (cont.) + Long forward Payables – (b) (premium)

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 Offsetting Profit/Loss on Payables (cont.) + Long forward Payables – (c) (discount)

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 Introducing the Bid-Offer Spread HN-H Payables Receivables

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 Futures Hedging Futures hedging results may differ quantitatively from those of forward hedging. Because of the standardisation of contracts, it may not be possible to hedge the exact amount.

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 Futures Hedging (cont.) The due date may not coincide with the settlement date. Marking-to-market introduces some variation.

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 Money Market Hedging A money market hedge amounts to taking a money market position to cover expected payables or receivables. By borrowing and lending, a synthetic forward contract is created.

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 Money Market Hedging of Payables

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 Money Market Hedging of Receivables

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 Money Market Hedging of Payables with Bid-Offer Spreads

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 Money Market Hedging of Receivables with Bid-Offer Spreads

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 Option Hedging The outcome of option hedging is not known with certainty, since it depends on whether or not the option is exercised.

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 Hedging with a Call Option

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 Hedging with a Put Option

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 Contingent Exposure A contingent exposure arises only if a certain outcome materialises, such as winning a contract.

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 Hedging a Contingent Long Exposure

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 Managing Long-Term Transaction Exposure Long-term forward contracts Currency swaps Parallel loans Leading and lagging

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 Managing Long-Term Transaction Exposure (cont.) Cross hedging Currency diversification Exposure netting Price variation and currency of invoicing

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 Managing Long-Term Transaction Exposure (cont.) Risk-sharing arrangements Currency collars

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 AUD Value of Receivables With and Without Risk-Sharing Arrangement

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 AUD Value of Receivables With and Without Currency Collar

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 Economic Exposure Economic exposure arises because revenues and costs vary with changes in the real exchange rate.

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 The Effect of Real Appreciation Assuming elastic demand, real appreciation of the foreign currency leads to:  Increase in domestic sales revenue  Increase in foreign sales revenue  Increase in the costs of imported raw materials and foreign borrowing

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 The Effect of Real Depreciation Assuming elastic demand, real depreciation of the foreign currency leads to:  Decrease in domestic sales revenue  Decrease in foreign sales revenue  Decrease in the costs of imported raw materials and foreign borrowing

34. 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 34 Hedging Economic Exposure Reducing economic exposure requires:  Changing sales in new or existing foreign markets  Changing dependence on foreign supply of raw materials  Establishing or eliminating production facilities abroad  Changing the level of foreign debt

35. 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 35 Why Worry About Translation Exposure? Translation exposure does not affect the economic value of the firm. Different translation methods affect reported earnings per share and other financial indicators.

36. 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 36 Hedging Translation Exposure Fund adjustment Forward contracts Exposure netting and balance sheet hedging