Chapter 12 Foreign Exchange Risk and Exposure. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs...

Chapter 12

Foreign Exchange Risk and Exposure

Slides prepared by Afaf Moosa

Objectives

• To define risk and exposure• To elaborate on the concept of value at risk (VAR)• To distinguish among transaction, economic and

translation exposure

Definitions of risk

• The chance of bad consequence, loss, etc. (The Concise Oxford Dictionary)

• The possibility of loss, injury, disadvantage or destruction (Webster’s Dictionary)

(cont.)

Definitions of risk (cont.)

• The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum

(cont.)

Definitions of risk (cont.)

• In finance, a distinction is made between risk and uncertainty

• In finance, risk is measured by the dispersion around the mean value of the rate of return, the cost of borrowing, the value of assets and liabilities, etc.

FX risk

• FX risk arises because of uncertainty about the future spot exchange rate

• It refers to the variability of the domestic currency value of certain items resulting from the variability of the exchange rate

Rate of return

1)1)(1(

Measuring risk: probability distribution

Measuring risk: historical data

Measurement of VAR

• Measurement unit (e.g. AUD)• Time horizon (one day, one week, etc.)• Probability (1-5%)

Implementation of VAR analysis

• Parametric (analytical) approach• Historical approach• Simulation approach

The parametric approach

• The approach is based on the assumption of the normality of rates of return

(cont.)

The parametric approach (cont.)

Per cent of

Observations Lowest r Highest r Probability VAR

68 r r 16.0 )( rK 90 65.1r 65.1r 5.0 )65.1( rK 95 96.1r 96.1r 2.5 )96.1( rK 98 33.2r 33.2r 1.0 )33.2( rK 99 3r 3r 0.5 )3( rK

The historical approach

• VAR with a certain probability is calculated from the lower nth percentile of historical observations on the rate of return

The simulation approach

• VAR with certain probability is calculated from the lower nth percentile of simulated observations on the rate of return

• Observations are generated from Monte Carlo simulation by specifying a probability distribution and its parameters

VAR: pros

• It is simple• It is suitable for risk-limit setting and performance

measurement• It can take account of complex movements

VAR: cons

• It can be misleading• VAR estimates are highly sensitive to the underlying

assumptions• It cannot cope with sudden or sharp changes

VAR: conclusion

• VAR is useful but it should be handled with care and used in conjunction with other measures of risk

• Confidence in VAR has been undermined by the global financial crisis as the VAR models used by financial institutions failed to predict the losses that they actually endured

Exposure

• Risk measures the probability and magnitude of deviation from some expected outcome

• Exposure is a measure of the sensitivity of what is at risk to the source of risk

FX exposure

• Exposure to FX risk is a measure of the sensitivity of the domestic currency value of FX items to changes in the exchange rate

• Sometimes it is defined as the amount at risk

The slope of the exposure line

where is the slope of the exposure line. is positive (negative) for assets (liabilities)

Long and short exposures

• Long exposure assets • Short exposure liabilities

Combined exposure

• A combined exposure arises when a firm holds both foreign assets and foreign liabilities

The relation between FX risk and exposure

)(σβ)(σ 222 SV

Multiple exposure

• Exposure to more than one currency:

)/()/( 01010 nn xxSxxSV

The volatility of the AUD exchange rates

• The standard deviations of monthly percentage changes in exchange rates

USD/AUD JPY/AUD EUR/AUD GBP/AUD 2004 2.88 3.38 1.70 2.11 2005 1.71 2.03 2.12 2.04 2006 2.62 2.18 2.30 1.74 2007 3.41 4.29 2.74 3.01 2008 6.44 7.93 3.62 5.41

Transaction exposure

• Transaction exposure arises if payables and receivables are denominated in foreign currencies. It is a cash flow exposure associated with trade and capital flows

Transaction exposure (examples)

• Foreign assets or liabilities that are already recorded on the balance sheet

• A contract or an agreement involving a future foreign currency cash flow

Volatility and correlation

• Exposure to a currency that fluctuates sharply is more of a source of concern

• Exchange rate correlations are important

Economic exposure

• Changes in exchange rates affect the firm’s non-contractual or unplanned cash flows

• It refers to future changes in earning power as a result of changes in exchange rates

Measurement of economic exposure

• Economic exposure cannot, in general, be known accurately in advance

• It can be estimated from a regression equation relating changes in cash flows to changes in exchange rates

Translation (accounting) exposure

• Translation exposure arises from the consolidation of foreign currency assets, liabilities, net income and other items

• Conversion may produce gain or loss

Translation rates

• Closing (current) rate• Average rate• Historical rate

The closing rate

• The closing rate (or current rate) is the rate prevailing at the end of the accounting period (that is, coinciding with the balance sheet date)

The average rate

• The average rate is the average value of the exchange rate over the accounting period

• The simplest procedure is to take a simple average of the closing rate and the rate prevailing at the beginning of the period. Otherwise, a time-weighted average may be used

The historical rate

• The historical rate is the rate prevailing on the date when an asset is acquired or a liability is committed

• The historical rate may therefore fall outside the current accounting period. In fact, this is invariably the case for long-term assets and liabilities

Translation methods

• Current/non-current method• Closing (current) rate method• Monetary/non-monetary method• Temporal method

Current/non-current method

• According to this method, current items are translated at the closing rate, whereas long-term items are translated at the historical rate

Closing (current) rate method

• Assets and liabilities are translated at the exchange rate prevailing at the end of the accounting period

Monetary/non-monetary method

• Monetary items (such as bonds) are translated at the closing rate, whereas non-monetary items (such as real estate) are translated at the historical rate

Temporal Method

• According to the temporal method, the use of the closing rate or the historical rate is determined by the valuation of the underlying item

• The closing rate is used for items stated at replacement cost, realisable value or market value

• The historical rate is used for all items stated at historical cost

Some principles

• Translation of balance sheet items is based on the closing rate

• Transaction gains and losses are accounted for in the income statement

(cont.)

Some principles (cont.)

• Non-transaction gains and losses are represented by changes in reserves

• Transaction gains and losses from a hedge are accounted for by movements in reserves or are reported on the income statement

Chapter 12 Foreign Exchange Risk and Exposure. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs...

Documents

Transcript of Chapter 12 Foreign Exchange Risk and Exposure. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs...

MIS+ +Classroom+Ppts

Aanimation Ppts

Ppts El Petroleo

Iwasiw ppts ch08_3_e

Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 1.

Ppts memes

Ppts Razia Mam

PPTS TARWI1

Gilded Age PPTs

Ppts plan v1.3

Iwasiw ppts ch02_3_e

Matera 2k13 Ppts

53862096 Globalisation Ppts

Iwasiw ppts ch05_3_e

Hetal Ppts.

Iwasiw ppts ch10_3_e

Semianr ppts

du pont ppts

PPTs MATROMOTRICIDAD

PPts Sesiones