Foreign Exchange Market-Group 4

FOREIGN
EXCHANGE
MARKET
FOREIGN EXCHANGE RISK AND EXPOSURES, HEDGING
AND DERIVATIVES
FOREIGN EXCHANGE RISKS
This is a risk of an investment’s value changing due to changes in currency
exchange rates. The risk that an investor will have to close out a long or
short position in a foreign currency at a loss due to an adverse movement in
exchange rates, and it usually affects businesses that export and/or import.
It also affect investors making international investments.
FOREIGN EXCHANGE EXPOSURE
It is a measure of the potential change in firm’s profitability, net cash flow
and/or market value of net assets due to a change in exchange rates.
TRANSACTION RISK
This is a risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected
changes in foreign exchange rates. Or it is a risk of an exchange rate changing between the transaction date and the
subsequent settlement date.
For example, a UK-based company agreeing to buy some machinery in 9 months time for 10 million euros, in this case, a
payment of 10 million euros has to made in 9 months time. Assuming the exchange rate at the moment is one euro 25 per
pound. If the settlement was to be made today, and the decision was to pay for it up front, we divide 10 million by 1.25 the
cost would be 8 million pounds, and in the UK currency it would currently cost 8 million pounds. If the exchange rate does not
move against us and in 9 months time the exchange rate is now 1.15 euros per pound instead, the pound has weakened, this
means that one can buy less for their pound. When 10 million is divided by 1.15 the cost would be 8.7million pounds.
Whoever makes the contract denominated in foreign currency bears transaction risk.
E.G, Ocean Drilling has transaction risk if it borrows money in French Francs or Japanese yen, and Hintz-Kessels-Kohl has a
transaction risk if it agrees to accept future payments for its vehicles in U.S dollars.
MITIGATIONS
Practical solutions;
 Only settle in home currency
 Leading (speed up settlement)
 Lagging (slow down settlement)
 Matching inflows and outflows in the foreign currency
Hedging techniques;
 Forwards, where one fix the rate in advance
 Futures, same as forwards however, they are standardized, they are like little blocks.
 Options, gives one choice, they are more like insurance policy
 Money market hedges where you borrow and deposit at the same time in two different currencies
TRANSLATION RISK
It is about the change in value of a subsidiary due to change in exchange rates. It is the potential for
account-derived changes in owner’s equity to occur because of the need to “translate” foreign
currency financial statements of foreign subsidiaries into a single reporting currency to prepare
worldwide consolidated financial statements.
For example, we’ve got this year and year-end next year, now imagine that we’ve got a European
subsidiary of a UK company currently worth 50 million euros, exchange rate is 1.15 euros per
pound, so the value of the subsidiary at the moment is 43.5 million. If the exchange rate then
changes, it is now 1.3 euros per pound, dividing 50 million by 1.3, the value of the subsidiary now is
38.5million. We can conclude that there is 5 million decrease from last year to this year.
Every company having at least one subsidiary using a different functional currency bears translation
risk.
E.G, MSDI has translation risk from having a subsidiary, MSDI Alcala de Henares, whose financial
statements are kept in Spanish pesetas and not in U.S dollars.
Mitigations;
 This is an accounting risk rather that cash-based risk, it is just a presentation thing no money is
actually lost it’s all theoretical. Therefore most companies would not look to hedge translation risk.
ECONOMIC RISK
This is a risk of changes in exchange rate causing a loss in competitive strength. Or changes in
competitive position as a result of permanent changes in exchange rates.
For example, we’ve got a UK company, this is not a one-off deal but rather a general trade, and
we’re buying goods in regularly for 5 thousand dollars per unit from the U.S, what we’re going to
do is we usually sell them in the UK for this price of 7 000 pounds per unit. Now we buy the goods
from the U.S for five thousand dollars per unit and then we sell them for seven thousand pounds
per unit back in the UK. Now if we take this arbitrary exchange rate of 1.4 dollars per pound, at the
moment these goods are costing us ( 5 000 dollars divided by 1.4) 3.6 thousand pounds per unit.
So for the profit, we sell them for seven thousand they’re costing us 3.6 , now the profit is 3.4k per
unit at the moment. If in 9 months time the rate now is 1.2, the cost will now be 4.2 thousand per
unit and our profit is 2.8k per unit.
Every company buying or selling abroad or even just competing with foreign companies has
economic risk.
E.G, Maybach has economic risk from manufacturing its automobiles in Germany for export to the
United States, where it competes with Rolls Royces manufactured in England.
Mitigations;
Unlikely to be able to use traditional hedging techniques like forwards, futures and options. This is
because this is like an ongoing risk all year round and it is affecting the overall business.
Companies could diversify the currencies in which they trade, rather than getting all your supplies
from Europe you can get some from America, Japan, China and by using a range of currencies,
hopefully it will spread out that risk a bit, so if the pound gets weaken against one of those then
you can switch your supplier.
Prudent predictions of exchange rates can be used in NPVs and forecasts.
HEDGING
This is a risk management strategy used by firms to mitigate various financial risk
exposures. It involves the use of financial instruments to offset potential losses from
adverse price movements, and its main aim is to protect against risk.
For example, a company can hedge transaction risk by entering into a forward contract,
where they agree to buy or sell currencies at a predetermined rate in the future. As a
result, this helps lock in the exchange rate and reduces uncertainty.
Companies usually hedge against risks such as foreign exchange, interest rates, and
commodity price fluctuations.
Benefits of hedging;
 Risk reduction, hedging helps in stabilizing cash flows and protects against adverse
market movements.
 Enhanced decision-making, by reducing uncertainty, hedging allows companies to make
informed decisions.
 Effective hedging can enhance investor confidence and improve creditworthiness.
DERIVATIVES
These are financial contracts whose value depends on an underlying asset
(e.g., currency, interest rate, commodity). Common derivatives include futures,
options, and swaps.
Uses of derivatives;
Traders use derivatives to speculate on price movements.
Companies use derivatives to manage risk exposure, hedging.
Derivatives provide access to markets that may otherwise be in accessible.
Benefits of derivatives;
Derivatives allow precise risk management tailored to specific needs.
They offer liquidity and flexibility.
They enable diversification beyond traditional assets.

Foreign Exchange Market-Group 4

Uploaded by

Copyright:

Available Formats

Foreign Exchange Market-Group 4

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Foreign Exchange Market-Group 4

Uploaded by

Copyright:

Available Formats

FOREIGN

 Leading (speed up settlement)

 Lagging (slow down settlement)

 Matching inflows and outflows in the foreign currency

You might also like