Foreign Exchange Risk And Exposure

Foreign Exchange Exposure & Risk

Foreign Exchange Exposure If V0= 1,00,000 $ = Rs 43,00,000 /(Rs/$ =43.00) Over a period of time, price of asset changes due to inflation and exchange rate also changes. So, V1= 1,40,000 $ = Rs 53,20,000 /(Rs/$ = 38.00)

The actual change ΔV = V1 – V0 = 53,20,000 – 43,00,000 = Rs 10,20,000 ΔS = S1- S0 = 43.00 – 38.00 = Rs 5.00 So, For ΔS = 11.6% For ΔV = 23.7% ΔS may be both positive and negative and so may be ΔV

Is there any relationship between change in exchange rate and change in value of asset? ΔV = F(ΔS)

+ΔV

- ΔS -ΔV

+ ΔS

Foreign Exchange Exposure ΔV = ⍺ + βΔS + u ΔV = change in the value of asset or liability ΔS = Unanticipated change in the exchange rate ⍺ = intercept β= sensitivity of changes in value of assets or liabilities in response to ΔS

β= sensitivity of changes in value of assets or liabilities in response to ΔS β = Exposure Now, ΔV = ⍺ + βΔS + u Assuming ⍺ = 0 , u = 0 ΔV = βΔS => β= ΔV / ΔS

+ΔV

Change in value of asset

+ΔV

Liability Exposure Line

Asset Exposure Line

β = tan θ

β = tan θ

- ΔS -ΔV

Change in value of Liability

+ ΔS

- ΔS -ΔV

+ ΔS

Defining Exposure The sensitivity of the real home currency value of an asset, liability or an operating income to an unanticipated change in the exchange rate, assuming unanticipated changes in all other currencies as zero

• Does exposure affect Balance sheet of a company or income statement?

• Does exposure affect only foreign assets or domestic assets as well?

Foreign Exchange Risk Variability of the domestic currency values of assets, liabilities, operating incomes due to unanticipated changes in exchange rate. Risk = variance in V

Estimating Risk Now, we know that by definition ΔV = ⍺ + βΔS + u

------- Eq 1

Regressing the actual data of ΔV and ΔS Δ`V = ⍺` + β`ΔS

--------Eq 2

There will be a difference between the estimated change (Eq1 and Actual change (Eq 2) ΔV = Δ`V + u Now, the risk is given by Var(ΔV) = Var( Δ`V + u) Var(ΔV) = Var( Δ`V ) + Var( u) +2Cov(Δ`V , u)

Risk Cont.. 2Cov(Δ`V , u) = 0 Therefore, Var(ΔV) = Var( Δ`V ) + Var( u) Thus, the total risk of an asset includes estimated risk plus risk due to other factors.

Relating Risk & Exposure ΔV = ⍺ + βΔS Var(ΔV) = Var(⍺ + βΔS) Var(ΔV) = β2 Var(ΔS)

Defining Real Change in exchange rate The real change in exchange rate is the change that produces a difference between overall rate of return on domestic versus foreign assets / liabilities or in profitability of export / import oriented firms.

“Real Change” is the extent of change in the value due sensitivity and variability both

Real Change in Financial Assets If IRP does not exist, then (S1-S ) / S = (ia-ib) / (1+ib) Hence, Real proportionate change in exchange rate is Rp = [(S1-S ) / S ] (1+ib) – (ia-ib)

Real Change in Real Assets We know that, irs = i^ rs + P ^ rs and i$ = i^ $ + P ^ $ Hence, Rate of return on 1 Rs invested in US = S1/S [1+ i^ $ + P ^ $] – 1 Therefore, Real rate of return above domestic return = S1/S [1+ i^ $ + P ^ $] – [1+(i^ rs + P ^ rs )] Adding & Subtracting P$ = {S1/S [1+ i^ $ + P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ ) = {S1/S + S1/S i^ $ + S1/S P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ ) = [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

={S1/S [1+ i^ $ + P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )

=S1/S + S1/S i^ $ + S1/S P ^ $ ]– 1}– (i^ rs + P ^ rs ) – (P ^$ – P ^$ )

={S1/S + S1/S i^ $ =S1/S + S1/S i^ $

+ S1/S P ^ $ – 1} – i^ rs - P ^ rs – P ^ $ + P ^ $

+ S1/S P ^ $ – S/S – i^ rs - P ^ rs – P ^ $ + P ^ $

= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

Real Change in Real Assets

Rp = [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ] If i^ rs = (S1/S)i ^ $ then real proportionate change = [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )

Exposure => Translation Exposure or Accounting Exposure

⇒Economic Exposure − Transaction exposure − Operating exposure

Translation Exposure • Changes in Income Statement items and book value of BS assets and liab, caused by exchange rate change • Resulting gains or losses are determined by accounting rules and are on paper only Impact – BS assets and liab and income statements that already exist.

Operating Exposure • Changes in the amount of future operating cash flows caused by exchange rate change • Resulting gains or losses are determined by changes in firm’s future competitive position and are real. Impact – Revenues and costs associated with future sales.

Transaction Exposure • Changes in the value of foreign currency denominated contracts that are brought about by exchange rate change. • The resulting changes are determined by the nature of contracts already entered into and are real. Impact – Contracts already on BS are part of Accounting Exp. – Contracts yet to come on BS are part of Operating Exp.

Types of Risk • Financial Risk • Political Risk • Country Risk

Financial Risk • Refers more generally to unexpected events in a country’s financial, economic, or business life • Examples of financial risks – – – – –

currency risk interest rate risk Inflation risk unexpected changes in the current account balance unexpected changes in the balance of trade

Political Risk • The risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate • Examples of political risks – – – – –

Expropriation risk Disruptions in operations Protectionism Blocked funds Loss of intellectual property rights

Political risk insurers • Government export credit agencies • U.S. Overseas Private Investment Corporation • U.K. Export Credits Guarantee Department International • World Bank - Multilateral Investment Guarantee Agency Private • Lloyd’s of London • American International Group (AIG) • MNCs are self-insured if their risk exposures are diversified across a large number of countries

Country Risk • Macro risks - affect all firms in a host country • Micro risks - specific to an industry, firm or project in a country • Whether a particular country risk is macro or micro affects the diversifiability of the risk

Country risks examples • A1 - Africa, Asia, Europe, Mid East Americas, Australia, Switzerland, Canada, UK • A2 - Botswana, HK, Japan, Germany, Kuwait, USA, S. Korea Italy, UAE • A3 - Mauritius, China, Cyprus, Israel, Chile, Namibia, Thailand, Czech Rep, Trinidad. • A4 -Egypt, India, Latvia, Saudi, Mexico, S. Africa, Philippines, Poland, Arabia, Panama. • B - Algeria, Bangladesh, Slovakia, Egypt, Brazil, Peru, Uganda, Sri Lanka, Russia, Jordan, Venezuela. • C - Congo, Indonesia, Azerbaijan, Iran, Syria, Haiti, Kenya, Vietnam, Romania, Turkey, Jamaica. • D - Nigeria, Afghanistan, Albania, Iraq, Argentina, Sudan ,N. Korea, Ukraine, Cuba ,Zimbabwe, Pakistan, Yugoslavia, Ecuador.

Strategies for managing country risk • Negotiate the environment with the host country prior to investment • Structure foreign operations to minimize country risk while maximizing return • Limiting the scope of technology transfer to foreign affiliates to include only non-essential parts of the production process • Limiting dependence on any single partner

Types of Exposure • Transaction Exposure & Translation Exposure • Economic Exposure & Operating Exposure

Transaction & Translation Exposure • Arises due to impact of exchange rate movement on firm’s future contractually committed cash flows.