RISK MANAGEMENT

Foreign Currency Risk Management

When dealing with converting FOREX it is important to consider the following points
 Always consider yourself at Adverse Position

How Currency Fluctuate Supply & Demand

• Speculation
• Export and Import
• Foreign Direct Investment (FDI)
• Foreign Currency Loans
• Foreign Currency Remittance

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How Currency Fluctuate

Purchasing Power Parity (PPP)

It follows law of one price.

Different commodities in two different currencies will have same price, if there is any difference that will be
absorbed by exchange rate.

According to PPP the exchange rate between two currencies can be explained by the difference between
inflation rated in respective countries.
PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country
with a LOW inflation rate has an expectation of increase in its currencies value.

The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by
banks.

Expected spot rate Future Spot rate= current spot rate x (1+ inflation of first currency)
(1 + inflation of 2nd currency)

Interest Rate Parity (IRP)

This concept says that the difference between 2 currencies worth can be explained by interest rate structure in the
countries of these 2 currencies.

According to IRP a country with a high interest rate structure normally has a currency at discount in relation
to another currency whose country has a low.

HIGH INTEREST in country LOWER will be the value of currency

LOWER INTEREST in country HIGHER will be the value of currency

Forward rate Forward rate = current spot rat rate x ( 1+ interest of first currency)
(1 + interest of 2nd currency)
Fisher Effect

This concept tells us the relation between interest rate and inflation. It assumes that real interest rates between
two economies are same and nominal interest rates are different because of inflation.

Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly because high
interest rates are a mechanism for reducing inflation.

USA [1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
K [1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]

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Expectation Theory

Future spot rate and forward rate should be equal. If temporary difference arises b/w these two rates it will be
reduced due to expectation of investors over the time.

For example – if forward rate is lower than future spot rate, investors will start buying in forward rates and start
selling in future spot markets until the difference is negligible.

Four-way Equivalence Theory

Types of Foreign Currency Risk

Transaction Risk Translation Risk Economic Risk

 Transaction risk refers to
adverse charges in the exchange
rate between contract date and
the settlement date.
 It is the risk that occurs in
transactions where foreign
currency is involved, for
example exports & imports.
 Translation risk refers to the  Long-term movement in the rate
possibility of accounting loss that
could occur because of foreign
subsidiary, as a result of the
conversion of the value of assets and
liabilities which are denominated in 
foreign currency, due to movements
in exchange rate.
 This risk is involved where a parent 
company has foreign subsidiaries in a
depreciating currency environment.
of exchange which puts the
company at some competitive
disadvantage is known as
economic risk.
E.g. if competitor currency stars
depreciating or our company
currency starts appreciating.
It may affect a company's
performance even if the
company does not have any
Foreign currency transactions.

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Methods of Hedging FOREX Risk

Translation Economic
Risk Risk
 Arrange Maximum Borrowing in  Shift manufacturing to cheaper labor areas
Subsidiary Co. currency.  Create innovative and differentiate units to
 Maintain Surplus Assets in Parent Co. create brand loyalty
currency which will reduce the overall  Diversify into new products and into new
exposure of Translation risk. markets

Transaction Risk - Internal Hedging Method

• Invoice in Home Currency

Should have bargaining power to negotiate

• Matching Foreign Currency (Receipts and Payments)

Timing and currencies should be same

• Netting

Netting is a process in which all transaction of group companies are converted into the same currencies and then
credit balances are netted off against the debit balances, so that only reduced net amounts remain due to be paid or
received.

 Leading & Lagging

Transaction Risk - External Hedging Methods

Forward Contract :

A forward contract is a legally binding agreement between two parties to buy or sell currencies in future at
pre-determined rate and pre specified date.

Example
- Home Currency is British Pound £, Exports receipts = $ 500,000 after six months

Spot Rate = 1.30 – 1.31 $/£

Six month forward rate = 1.32 – 1.33 $/£

Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940

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Forward Contracts

It is a legally binding contract between two parties to buy or sell in future at a pre-determined rate and a pre-
specified date.

Advantages
 Eliminate currency risk, as foreign exchange costs are determined upfront.
 They are tailor made and can be matched against the time period of exposure as well as for the cash size of
the exposure, therefore they are referred to as a complete hedge.
 They are easy to understand.

Disadvantages
 It is subject to default risk.
 There may be difficult to find counter-party.
 They are legally binding so difficult to cancel.

Money Market Hedging:

Foreign Currency Receipts / Exports

Steps:

a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of this
amount.

Present Value = Foreign Currency amount

(1+ borrowing rate of FCY)

b) Convert that present value into home currency using spot exchange rate.
c) Deposit the home currency at the deposit rate of home currency.
Total receipts= Home currency × ( 1 + lending rate of HCY )
Foreign Currency Payments / imports

Steps:

a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that amount.

Present Value = Foreign Currency amount

(1+ lending rate of FCY)
b) Convert that present value into home currency using spot exchange rate.
c) Borrow the home currency at the borrowing rate of home currency.

Total payment= Home currency × ( 1 + borrowing rate of HCY )

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Money Market Hedging

A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified
rate without recourse to the forward FOREX market. If a company is able to achieve preferential access to the
short term money markets in the base and counter currency zones then it can be a cost effective substitute
for a forward agreement. However, it is difficult to reverse quickly and is cumbersome to establish as it requires
borrowing/lending agreements to be established denominated in the two currencies.

With relatively small amounts, the OTC market represents the most convenient means of locking in exchange
rates. Where cross border flows are common and business is well diversified across different currency areas
then currency hedging is of questionable benefit. Where, as in this case, relatively infrequent flows occur then
the simplest solution is to engage in the forward market for hedging risk. The use of a money market hedge as
described may generate a more favorable forward rate than direct recourse to the forex market. However the
administrative and management costs in setting up the necessary loans and deposits are a significant
consideration.

Derivatives

• Future Settlement
• Initial amount to be paid is nil or low
• Drive their value from some underlying
• Traded in two types of market

1. Over the counter Market

2. Exchange Traded Derivatives)

FUTURE CONTRACTS

• Futures are standardized contracts traded on
a regulated exchange to make or take
delivery of a specified quantity of a foreign
currency, or a financial instrument at a
specified price, with delivery or settlement at
a specified future date.
• They are available in major currencies and
quoted against USD.
• There are four settlement dates
MARCH,JUNE,SEPT & DEC
• Tick = minimum movement of future
contract, 0.01% of contract size.
• Basis= current spot rate - future rate
• These contracts are highly standardized both
in size and in terms of their delivery
mechanism.
• Physical delivery is very rare. Contracts are
usually settled prior to the settlement date.
• An initial margin is required, a further mark-
to- market margin may be necessary.
• Standardized contracts
• Exchange traded derivatives are settled daily
by settling the difference in the contracted
price and the traded price in cash. This is
called the mark-to- market mechanism. No
Default Risk
• More liquid in nature (e.g. futures contracts).

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Currency Options

TYPES:

Currency options give the buyer the right CALL OPTION Right to buy at a specified rate
but not the obligation to buy or sell a specific PUT OPTION Right to sell at a specified rate
amount of foreign currency at a specific
exchange rate (the strike price) on or before
a predetermined future date.
For this protection, the buyer has to pay a OPTION BUYER - OPTION HOLDER LONG POSITION
premium.
OPTION SELLER - OPTION WRITER SHORT POISTION
A currency option may be either a call option
or a put option
Currency option contracts limit the maximum American Option - can be exercised at anytime
loss to the premium paid up-front and before maturity
provide the buyer with the opportunity to European Option - can be exercised at maturity only.
take advantage of
Favorable exchange rate movements.

INTEREST RATE RISK MANAGEMENT

Interest rate risk (IRR) can be explained as the impact on an institution’s financial condition if it is exposed to negative
movements in interest rates.

This risk can either be translated as an increase of interest payments that it has to make against borrowed
funds or a reduction in income that it receives from invested funds.

Methods of Hedging Interest Rate Risk

• Forward rate Agreement (FRA)

• Interest Rate Future
• Options
• Interest Rate Swaps
• CAP, FLOOR & COLLAR

Reasons for Interest Rate Fluctuation

1. RISK
 High risk, high return
 Low risk, low return
 No risk, some return

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 2. Need to make profit on re- lending
The more the changing hands, more the interest rate (due to margins of intermediation)

3. Size of the loan

More amount, more risk so more required interest rate Less amount, low risk so low interest rate.

4. Duration of the loan

Longer the period, higher the risk and so high interest required Shorter the period, lower the risk and
so lower the required interest
5. Types of financial assets and liabilities
6. Government policy

Methods of hedging interest rate risk

Forward rate Agreement (FRA)

 FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a
specified future time.
 The “buyer” of FRA is partly wishing to protect itself against a rise in rates while the “seller” is a party
protecting itself against an interest rate decline.
 FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest
rate futures for hedging purpose.
 FRAs do not involve any margin requirements.
 Interest rate set for FRA is reflection of the expectation of interest rate movements.

EXAMPLE

Company wants to borrow $10m in three months’ time for a period of 6 months. Company is expecting that
interest rate will rise in future and wants to hedge its position using FRA.

Following FRAs are available

3-6 6%-6.5%
3-9 7.5%-8%
Calculate the effective interest rate if forward hedge is taken. If after three months interest rates
are 10% & 5%
In case if interest moves to 10% In case if interest moves to 5%

Borrow from bank= 10% Borrow from bank= 5%

Compare forward rate with actual interest rate.
If actual is higher, then bank will pay the
difference
Difference from bank=10%-8%=2%
Effective interest rate=8%
Compare forward rate with actual interest rate.
If actual is lower, then bank will receive the
difference
Difference from bank=5%-8%=3%
Effective interest rate=8%

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Interest Rate Futures

• An interest rate futures contract is a futures contract with an interest-bearing instrument as its
underlying asset. The underlying asset could be Treasury bills and notes, certificates of deposit (CD),
commercial paper (CP), etc.
• IRF is an exchange traded derivative and has standard terms and conditions like contract size,
settlement dates etc.
• A borrowing company is concerned about a rise in interest rates and therefore, it will use an IRF to
hedge against a rise in interest rates. Conversely, a depositing company will use an IRF to hedge
against a fall in interest rates.

Interest Rate Options

An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a
maximum rate of interest (called strike price) for the option holder. The option is settled in cash.

This product is available on payment of an upfront fee, called a premium.

An interest rate call option guarantees the borrower a maximum rate of interest, whereas an interest rate put option
guarantees the depositor a minimum rate of interest.

Interest Rate CAPS

• An interest rate cap is a contract that enables companies with floating rate debt to limit or "cap" their
exposure to rising interest rates.
• A CAP fixed the interest rate to be paid on the borrowing.

Interest Rate FLOOR

• An interest rate floor is a series of European put options, that protects the lender against a decline
in the floating interest rates
• A floor guarantees that the interest rate received on a deposit will not be less than a specified level.

Interest Rate COLLAR

An interest rate collar is a combination of a cap and a floor transacted simultaneously. The buyer of an
interest rate cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the
same amount and covering the same period.

Interest Rate SWAP

It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount
from a fixed rate to a floating rate (or vice versa) or from one floating rate to another called plain vanilla swap.

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Currency Swaps

Advantages

• Swaps are easy to arrange and are flexible since they can be arranged in any size and are reversible.
• Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be
paid.
• The parties can obtain the currency they require without subjecting themselves to the uncertainties
of the foreign exchange markets.
• The company can gain access to debt finance in another country and currency where it is little
known, and consequently has a poorer credit rating, than in its home country. It can therefore take
advantage of lower interest rates than it could obtain if it arranged the currency loan itself.

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 • Currency swaps may be used to restructure the currency base of the company's liabilities.
This may be important where the company is trading overseas and receiving revenues in foreign
currencies, but its borrowings are denominated in the currency of its home country. Currency swaps
therefore provide a means of reducing exchange rate exposure.
• At the same time as exchanging currency, the company may also be able to convert fixed rate debt
to floating rate or vice versa. Thus it may obtain some of the benefits of an interest rate swap in
addition to achieving the other purposes of a currency swap.

Disadvantages
• If one party became unable to meet its swap payment obligations, this could mean that the other
party risked having to make them itself.
• A company whose main business lies outside the field of finance should not increase financial risk in
order to make speculative gains.
• There may be a risk of political disturbances or exchange controls in the country whose currency is
being used for a swap.
• Swaps have arrangement fees payable to third parties. Although these may appear to be cheap, this
is because the intermediary accepts no liability for the swap. (However, the third party does suffer
some spread risk, as it warehouses one side of the swap until it is matched with the other, and then
undertakes a temporary hedge on the futures market.)

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