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.
Download ReportTranscript 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 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 1 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 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 2 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 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 3 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 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 4 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 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 5 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 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 6 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 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 7 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 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 8 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 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 9 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 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 10 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 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 11 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 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 12 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 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 13 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 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 14 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 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 15 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 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 16 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 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 17 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 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 18 17.3 Measuring Transaction Exposure (cont.) 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 19 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 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 20 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 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 21 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 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 22 17.3 Measuring Transaction Exposure (cont.) 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 23 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 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 24 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 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 25 17.3 Measuring Transaction Exposure (cont.) 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 26 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 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 27 17.3 Measuring Transaction Exposure (cont.) 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 28 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 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 29 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 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 30 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 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 31 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) 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 32 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 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 33 17.4 Risk Management: Market-based Hedging Techniques (cont.) 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 34 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 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 35 17.4 Risk Management: Market-based Hedging Techniques (cont.) 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 36 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 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 37 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 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 38 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 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 39 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 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 40 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 – 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 41 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 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 42 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 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 43 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 – 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 44 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 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 45 17.6 Summary • Foreign exchange risk exposures can be classified as Transaction exposure – Translation or accounting exposure – Operational exposure – Economic exposure – 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 46 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 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 47 17.6 Summary (cont.) • Transaction exposures can be measured by – Net cash flows – Currency variability – Currency correlations 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 48 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 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 49