Lecture 4 Nature and Measurement of Exposure and Risk

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Lecture 4Nature and Measurement of Exposure and
Risk
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Concept of Exposure

• Foreign Exchange Exposure occurs because of
  unanticipated change in the exchange rate
• For example the difference in the spot rate one
  month forward rate is 0.30 rupee per USD and
  after one month rupee depreciates by 30 paisa
  there would be no FE exposure but if actual
  depreciation is more, then exposure would be said
  to exist

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Classification of Foreign Exchange Exposure

• Accounting Exposure or Translation Exposure
  derived from the consolidated financial
  statements of the parent company and it does not
  influence the cash flow
• Economic Exposure results from altered cash flow
  of a company, further divided into transaction
  exposure and real operating exposure
• Transaction exposure refers to FE loss or gain on
  transaction already entered into denominated in
  a foreign currency. It is connected with changes
  in the present cash flows
• Real operating exposure relates to changes in
  future cash flows- impact of inflation on the
  cost revenue structure in addition to change in
  FE rate

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Translation Exposure

• Emerges on a/c of consolidation of financial
  statements of foreign subsidiaries by the parent
  company
• With changes in exchange rate b/w host country
  home country, picture of consolidated statement
  changes. This change represents the size of
  translation exposure
• Accounting exposure also explained in terms of
  net worth exposure where changes in exchange rate
  affect market value of assets liabilities

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Transaction Exposure

• Difference between expected cash flow actual
  cash flow on a/c of exchange rate changes
  emerges
• - owing to foreign trade in open account
• - borrowing or lending in foreign currency
• - intra firm cash flows
• In case of MNCs the consolidated net figure of
  cash flows determines the size of transaction
  exposure5
• I

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Real Operating Exposure

• Varies if the cost and revenue streams differ
  under different market conditions
• Cost revenue streams under different market
  conditions are estimated and brought to the
  present value and then compared with the expected
  cash flow in absence of any change in exchange
  rate
• Estimated also by regression analysis

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Management of FE ExposureHedging Decision

• PPP Theory- movement in exchange rate offsets the
  changes in price level
• Secondly, gains losses of exchange rate change
  do tend to average out over a period of time
• Shareholders minimise currency risk through
  diversification of investment portfolio
• Hedging uses up scarce resource and may thus
  lower the value of the firm
• Debate seems to be academic, in practice firms do
  involve in various kind of hedging

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Hedging Techniques for Transaction Exposure

• Contractual hedges and Natural hedges
• Contractual hedge include forward market hedge,
  money market hedge, future market hedge and
  options market hedge
• Money market hedge involve borrowing in local
  currency, convert the same into the currency of
  payables and then investing it for matching
  period (for imports). For hedging exports, the
  exporter first borrows in foreign currency and
  then converts in local currency before investment
• If the firm has sufficient cash from business
  operations to fund for this, it is called
  covered hedge otherwise an uncovered money market
  hedge
• Firm adopts a particular technique where cost is
  smallest or gain is largest

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Natural Hedging

• Natural hedging is resorted to when contractual
  hedging fails to give results
• In the absence of a forward market in the
  currency in which the firm is exposed a perfect
  contractual hedge is not available
• Leads and lags lead means accelerating or
  advancing the timing of receipt or of payment of
  foreign currency. Lag is just the reverse.
  Practiced for transactions between weak currency
  to hard currency areas or vice versa

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Natural Hedging (2)

• Cross hedging adopted when desired currency
  cannot be hedged. Firm has to first identify a
  currency that can be hedged and volatility of
  which is highly correlated with desired currency
• Currency diversification diversifying operations
  in a larger no. of currencies as a hedging tool
• Risk sharing contractual arrangement where buyer
  an seller agree to share the risk if variation
  crosses an accepted neutral zone