Chapter 17 Foreign Exchange Risk Identification and Management Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger.
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Transcript Chapter 17 Foreign Exchange Risk Identification and Management Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger.
Chapter 17
Foreign Exchange Risk
Identification and
Management
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Learning Objectives
• Identify the different types of foreign
exchange (FX) risk faced by firms
• Understand how firms can manage their
foreign exchange risk using market-based
or internal hedging techniques
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Chapter Organisation
17.1 Introduction
17.2 FX Risk Policy formation
17.3 Measuring Transaction Exposure
17.4 Risk Management: Market-based
Hedging Techniques
17.5 Risk Management: Internal
Hedging Techniques
17.6 Summary
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17.1 Introduction
• 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
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17.1 Introduction (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 USA
denominated in USD
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17.1 Introduction (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
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17.1 Introduction (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 i.e. the parent company
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17.1 Introduction (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
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Chapter Organisation
17.1
17.2
17.3
17.4
Introduction
FX Risk Policy Formation
Measuring Transaction Exposure
Risk Management: Market-based
Hedging Techniques
17.5 Risk Management: Internal
Hedging Techniques
17.6 Summary
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17.2 FX Risk Policy Formation
• A company’s board of directors should
document and circulate specific policies on
FX risk management including
–
–
–
–
–
–
–
FX objectives
Management structure
Authorisations
Exposure reporting systems
Communications
Performance evaluation
Audit and review procedures
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17.2 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 mange
FX risk exposures e.g. natural hedges
The style of risk management e.g. active or defensive
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17.2 FX Risk Policy Formation
(cont.)
• Management structure
– Ensure appropriate organisational controls and
reporting systems, skilled personnel and
sufficient funding are in place
• Authorisations
– A description of who, in the organisation, has
the authority to do what, ensuring task
segregation
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17.2 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
• Communications
– How communication should occur both
horizontally and vertically within the Treasury
division and the overall organisation
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17.2 FX Risk Policy Formation
(cont.)
• Performance evaluation
– Evaluation of the performance of the FX
operations, given the FX objectives
• 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
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Chapter Organisation
17.1
17.2
17.3
17.4
Introduction
FX Risk Policy Formation
Measuring Transaction Exposure
Risk Management: Market-based
Hedging Techniques
17.5 Risk Management: Internal
Hedging Techniques
17.6 Summary
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17.3 Measuring Transaction
Exposure
• This 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
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17.3 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
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17.3 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
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17.3 Measuring Transaction
Exposure (cont.)
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17.3 Measuring Transaction
Exposure (cont.)
• Net cash flows (cont.)
– 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
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17.3 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
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17.3 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
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17.3 Measuring Transaction
Exposure (cont.)
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17.3 Measuring Transaction
Exposure (cont.)
• Transaction exposure: currency correlations
– In considering whether to hedge a FX exposure,
the correlations between the currencies should
be considered
– Correlation measures the degree to which two
currencies move in relation to each other
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17.3 Measuring Transaction
Exposure (cont.)
• Transaction exposure: currency correlations
(cont.)
Ranges from + 1 (perfectly positively correlated) to
– 1 (perfectly negatively correlated)
– Figure 17.2 indicates
–
Currencies A and B are highly positively correlated
Currency C is highly negatively correlated with both
currencies A and B
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17.3 Measuring Transaction
Exposure (cont.)
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17.3 Measuring Transaction
Exposure (cont.)
• Transaction exposure: currency correlations
(cont.)
–
Table 17.3 is used to demonstrate the use of
correlation coefficients in assessing whether a
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
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17.3 Measuring Transaction
Exposure (cont.)
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17.3 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 loss
on both flows
– The exposure should be hedged
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17.3 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
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Chapter Organisation
17.1
17.2
17.3
17.4
Introduction
FX Risk Policy Formation
Measuring Transaction Exposure
Risk Management: Market-based
Hedging Techniques
17.5 Risk Management: Internal
Hedging Techniques
17.6 Summary
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17.4 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
Chapters 18, 19 and 20 respectively)
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17.4 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
– Table 17.4 provides an example of the use of a
forward exchange contract to hedge a US$1
million receivable in 6-months’ time
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17.4 Risk Management:
Market-based Hedging
Techniques (cont.)
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17.4 Risk Management:
Market-based Hedging
Techniques (cont.)
• Money market hedging to cover FX risk
Also called BSI hedge
– Example
–
A company has US$1 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
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17.4 Risk Management:
Market-based Hedging
Techniques (cont.)
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Chapter Organisation
17.1
17.2
17.3
17.4
Introduction
FX Risk Policy Formation
Measuring Transaction Exposure
Risk Management: Market-based
Hedging Techniques
17.5 Risk Management: Internal
Hedging Techniques
17.6 Summary
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17.5 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
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Main internal hedging techniques
• 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
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Main internal hedging techniques
(cont.)
• Creating a natural hedge
– Match foreign currency receivables and payables
in terms of currency, timing and magnitude
– Unlikely that an exact hedge can be achieved
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Main 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
–
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Main 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
–
Lagging: delaying the timing of an existing FX cash flow
–
E.g. pay a USD payable before an expected AUD
depreciation
E.g. delaying a USD payable to coincide with a USD
receivable
Need to assess costs/impact of strategies
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Main 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
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Main internal hedging techniques
(cont.)
• Counter-trade and currency offsets
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
– Applicable to both internal cash flows of a firm and
FX cash flows between firms
–
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Chapter Organisation
17.1
17.2
17.3
17.4
Introduction
FX Risk Policy Formation
Measuring Transaction Exposure
Risk Management: Market-based
Hedging Techniques
17.5 Risk Management: Internal
Hedging Techniques
17.6 Summary
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17.6 Summary
• Foreign exchange risk exposures can be
classified as
Transaction exposure
– Translation or accounting exposure
– Operational exposure
– Economic exposure
–
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17.6 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
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17.6 Summary (cont.)
• Transaction exposures can be measured by
– Net cash flows
– Currency variability
– Currency correlations
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17.6 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, countertrade and currency offsets
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