Final FX Risk & Exposure Management

Foreign Exchange & Foreign
Currency Risk/Exposure
Management
Foreign Exchange & Foreign
Currency Risk/Exposure
Management
Amit Kalikar -19

Kunal Kulkarni- 22
Ketan palkar - 29
Karuna salunke-40
Jigar shah – 44
Mansi Trivedi-55
Foreign Currency Risk
Currency risk is a form of risk that arises from the change in
price of one currency against another.
Foreign exchange risk is the risk that the value of an asset

or liability will change because of a change in exchange
rates.
The exchange risk associated with a foreign denominated

instrument is a key element in foreign investment. This risk
flows from differential monetary policy and growth in real
productivity, which results in differential inflation rates
For example:
A New York-based manufacturing company signs a $1

million contract with a French business partner. The
contract amount is denominated in euros, and 1 euro
equals 1 dollar on the date the contract is signed. Three
years later, the euro rises with respect to the dollar, and 1
euro is now valued at 2 dollars. The manufacturing firm
incurs a $500,000 foreign currency loss ($1 million divided
by two).
Currency risk exists regardless of whether you are

investing domestically or abroad. If you invest in your
home country, and your home currency devalues, you
have lost money. Any and all stock market investments are
subject to currency risk, regardless of the nationality of the
investor or the investment, and whether they are the
same or different. The only way to avoid currency risk is to
invest in commodities, which hold value independent of
any monetary system.
When a firm conducts transactions in different currencies,

it exposes itself to risk. The risk arises because currencies
may move in relation to each other. If a firm is buying and
selling in different currencies, then revenue and costs can
move upwards or downwards as exchange rates between
currencies change. If a firm has borrowed funds in a
different currency, the repayments on the debt could
change or, if the firm has invested overseas, the returns
on investment may alter with exchange rate movements
— this is usually known as foreign currency exposure.
TYPES OF FOREIGN
EXCHANGE RISK
• Transaction risk.
• Position risk.
• Settlement or credit risk.
• Operational risk.
• Sovereign risk.
• Cross- country risk
TYPES OF FOREIGN
EXCHANGE RISK
• Transaction risk : Any transaction leading to future
receipts in any form or creation of long term asset
This consists of a number of:
1 Trading items
2 Capital items
• Position risk : A position risk occurs when a dealer in

bank has an overbought (long) or an oversold (short)
position.
TYPES OF FOREIGN
EXCHANGE RISK
• Settlement risk : Settlement risk is the risk of a counterparty
failing to meet its obligations in a financial transaction after the
bank has fulfilled its obligations on the date of settlement of the
contract.
• Operational risk : Operational risk are related to the manner in

which transactions are settled or handled operationally.
Some of the Operational risks are :
 Dealing and settlement
 Confirmation
 Pipeline transactions
TYPES OF FOREIGN
EXCHANGE RISK
• Sovereign risk : Another risk which banks and other
agencies that deal in foreign exchange have to be aware
of is sovereign risk- the risk on the government of a
country.
• Cross- country risk : It is often not prudent to have large

exposures on any one country may go through troubled
times however In such a situation, the bank/entity that
has an exposure could suffer huge losses
TYPES OF EXPOSURE
Foreign Exchange Exposure
Management
Forecasts
• After determining its exposure, the first step for a firm is to
develop a forecast on the market trends and what the main
direction/trend is going to be on the foreign exchange
rates.
• The period for forecasts is typically 6 months.
• It is important to base the forecasts on valid assumptions.
• Along with identifying trends, a probability should be

estimated for the forecast coming true as well as how much
the change would be
Risk Estimation
• Based on the forecast, a measure of the Value at Risk (the
actual profit or loss for a move in rates according to the
forecast) and the probability of this risk should be
ascertained.
• The risk that a transaction would fail due to market-

specific problems should be taken into account.
• Finally, the Systems Risk that can arise due to

inadequacies such as reporting gaps and implementation
gaps in the firms’ exposure management system should
be estimated.
Benchmarking
• Given the exposures and the risk estimates, the firm has to set
its limits for handling foreign exchange exposure.
• The firm also has to decide whether to manage its exposures on

a cost centre or profit centre basis.
• A cost centre approach is a defensive one and the main aim is

ensure that cash flows of a firm are not adversely affected
beyond a point.
• A profit centre approach on the other hand is a more

aggressive approach where the firm decides to generate a net
profit on its exposure over time
Hedging
This is the general term used for the process of protecting
the accountable value of foreign currency monetary assets
and liabilities by anticipating future exchange rate
movements. Exposure to unrealized foreign exchange
(translation) losses can be reduced to nil, or to a defined or
budgeted amount, by entering into forward exchange
contracts or using other hedging instruments, taking due
consideration of the cost/benefit relationships. It can be
also achieved by "natural" hedging, for instance, whereby
foreign assets are financed by foreign borrowings, both in
the same currency.
Hedging Tools
• Spot
• Forward Outright Contracts
• Swaps
• Options
• Zero Cost Collars
Stop Loss
• It is imperative to have stop loss arrangements in order to
rescue the firm if the forecasts turn out wrong.
• For this, there should be certain monitoring systems in

place to detect critical levels in the foreign exchange rates
for appropriate measure to be taken.
Reporting and Review
• Risk management policies are typically subjected to review
based on periodic reporting. The reports mainly include
profit/ loss status on open contracts after marking to
market, the actual exchange/ interest rate achieved on each
exposure, and profitability vis-à-vis the benchmark and the
expected changes in overall exposure due to forecasted
exchange/ interest rate movements.
• The review analyses whether the benchmarks set are valid
and effective in controlling the exposures, what the market
trends are
• finally whether the overall strategy is working or needs
change.
Why should we hedge ?
“Case Study”
TCS Policy
Risk Management Policy approved by Board of Directors stating risks, means to

mitigate these risks; defining authorities, responsibilities & controls and
stating broad parameters within which treasury has to function. Policy
reviewed by board periodically.
Risk Management Board is responsible for policy implementation, strategy

formulation & periodic review of decisions.
TCS Treasury is not a profit centre but a facilitator with an objective of protecting
accounting / budgeted rates thereby reducing unpredictability & volatility
Follows globally used FAS 133 accounting standard
Use of only simple accounting compliant structures. It necessitates that each hedge
to be
TCS Policy
Hedge the “net” exposure:
Budgeted Revenue 100

Budgeted Expenses 30 (Provides Natural Hedge)
_______________________________________________________________________________________________________________________________________________________________________________________
Net Exposure 70
Maximum Hedges 70
TCS Policy
Types of Exposures
Managing Current Risks
All the current risks (Receivables, current revenue) & hedges against current
risks (non-cash flow hedges) are marked to market every quarter end and
booked in P&L based on matching concept.
Hedging has protected collection at billing rate, thereby providing

predictability in P&L & Had hedging not been done, operation would
lose Rs. 2.00 on collection in Case
Managing Future Risks
TCS on an ongoing basis negotiates long term contracts with clients.

pricing of which is done with targeted profit margins at a given
exchange rate.
Predictability of exchange rates in such long term contracts is essential

to meet the desired profit margin sharp exchange rate
movements will make entire costing go haywire.
Long term hedging (Cash Flow Hedges) for such contracts ensures that
the target profit margins are met and business is not exposed to
long term exchange fluctuations
Scenario Analysis
ILLUSTRATION
5 year contract of USD 100 mio @ 40.00 while bidding. Target profit
margin of 30%, all expenses are in INR.
FAS 133: Tool for Long Term Hedging
FAS 133 & IAS 39 are globally accepted & progressive accounting
standards
Majority of the Fortune 500 companies use these standards for forex
accounting.Similar type of guidelines are proposed in Accounting
Standard - 30 by ICAI
FAS differentiates between “current risk” and “future risk”. It requires

mapping of risk & hedge associated with it on a “matching
concept”
FAS requires to state at hedge inception itself whether the current or

future risk is being hedged. Hedge inception document needs to
be created establishing the relationship that has to pass
statutory audit test. There is no discretion left to the user
The Robust Accounting Standard
Once the hedge objective and relationship are defined, under no

circumstance can the relationship be altered. The transfer of cash
flow hedge to non-cash flow hedges and vice-versa is not allowed
Accordingly, all current risks and hedges to protect those risks should
be revalued and booked in P&L every quarter (Non-cash flow
hedges)
All hedges (Cash Flow Hedges) against future risks should be revalued
& shown in Balance Sheet. On maturity, these hedges should be
matched against projected revenue and passed through P&L
statement
If due to any reason, the CFH is terminated, the profit/loss will lie in
Balance sheet till the period for which the hedge was taken
thereby ensuring that market participants do not misuse the
Sandard
Basic Hedging Instrument
CASE STUDY
Expected revenue of USD 100 mio for FY 09-10 at 40.0

Entity A lacks option expertise & hedges using forward contracts at
40.25
Entity B hedges through a mix of forwards and options as under:
a) 25 % Forwards @ 40.25; b) 25% Plain Options @ 40; Cost 25 paise

And
c) 50% Range Forwards: Long Put @ 40 & participation up to 41.50
as Short Call @41.50
CASE STUDY
Economic Impact

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Foreign Exchange & Foreign

Amit Kalikar -19

Foreign exchange risk is the risk that the value of an asset

The exchange risk associated with a foreign denominated

A New York-based manufacturing company signs a $1

Currency risk exists regardless of whether you are

When a firm conducts transactions in different currencies,

• Position risk : A position risk occurs when a dealer in

• Operational risk : Operational risk are related to the manner in

• Cross- country risk : It is often not prudent to have large

• The period for forecasts is typically 6 months.

• It is important to base the forecasts on valid assumptions.

• Along with identifying trends, a probability should be

• The risk that a transaction would fail due to market-

• Finally, the Systems Risk that can arise due to

• The firm also has to decide whether to manage its exposures on

• A cost centre approach is a defensive one and the main aim is

• A profit centre approach on the other hand is a more

• For this, there should be certain monitoring systems in

Risk Management Policy approved by Board of Directors stating risks, means to

Risk Management Board is responsible for policy implementation, strategy

Hedge the “net” exposure:

Budgeted Revenue 100

Hedging has protected collection at billing rate, thereby providing

TCS on an ongoing basis negotiates long term contracts with clients.

Predictability of exchange rates in such long term contracts is essential

FAS differentiates between “current risk” and “future risk”. It requires

FAS requires to state at hedge inception itself whether the current or

Once the hedge objective and relationship are defined, under no

Expected revenue of USD 100 mio for FY 09-10 at 40.0

Entity B hedges through a mix of forwards and options as under:

a) 25 % Forwards @ 40.25; b) 25% Plain Options @ 40; Cost 25 paise

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