Ferm Unit 5

Foreign Exchange Risk Exposure, Types of Risk
Exchange rate fluctuations affect not only multinationals and large corporations, but also small and
medium-sized enterprises. Therefore, understanding and managing exchange rate risk is an important
subject for business owners and investors.
There are various kinds of exposure and related techniques for measuring the exposure. Of all the
exposures, economic exposure is the most important one and it can be calculated statistically.
Companies resort to various strategies to contain economic exposure.
Types of Exposure
Companies are exposed to three types of risk caused by currency volatility −
Transaction exposure − Exchange rate fluctuations have an effect on a company’s obligations to make or
receive payments denominated in foreign currency in future. Transaction exposure arises from this
effect and it is short-term to medium-term in nature.
Translation exposure − Currency fluctuations have an effect on a company’s consolidated financial

statements, particularly when it has foreign subsidiaries. Translation exposure arises due to this effect. It
is medium-term to long-term in nature.
Economic (or operating) exposure − Economic exposure arises due to the effect of unpredicted currency
rate fluctuations on the company’s future cash flows and market value. Unanticipated exchange rate
fluctuations can have a huge effect on a company’s competitive position.
Note that economic exposure is impossible to predict, while transaction and translation exposure can be
estimated.
Economic Exposure – An Example
Consider a big U.S. multinational with operations in numerous countries around the world. The
company’s biggest export markets are Europe and Japan, which together offer 40% of the company’s
annual revenues.
The company’s management had factored in an average slump of 3% for the dollar against the Euro and
Japanese Yen for the running and the next two years. The management expected that the Dollar will be
bearish due to the recurring U.S. budget deadlock, and growing fiscal and current account deficits, which
they expected would affect the exchange rate.
However, the rapidly improving U.S. economy has triggered speculation that the Fed will tighten
monetary policy very soon. The Dollar is rallying, and in the last few months, it has gained about 5%
against the Euro and the Yen. The outlook suggests further gains, as the monetary policy in Japan is
stimulative and the European economy is coming out of recession.
The U.S. company is now facing not just transaction exposure (as its large export sales) and translation
exposure (as it has subsidiaries worldwide), but also economic exposure. The Dollar was expected to
decline about 3% annually against the Euro and the Yen, but it has already gained 5% versus these
currencies, which is a variance of 8 percentage points at hand. This will have a negative effect on sales
and cash flows. The investors have already taken into account the currency fluctuations and the stock of
the company fell 7%.
Calculating Economic Exposure
Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. We know from
statistics that a regression analysis of the asset value (P) versus the spot exchange rate (S) will offer the
following regression equation −
P = a + (b x S) + e
Where, a is the regression constant, b is the regression coefficient, and e is a random error term with a
mean of zero. Here, b is a measure of economic exposure, and it measures the sensitivity of an asset’s
dollar value to the exchange rate.
The regression coefficient is the ratio of the covariance between the asset value and the exchange rate,
to the variance of the spot rate. It is expressed as −
b =
Cov (P,S)Var (S)
Economic Exposure – Numerical Example
A U.S. company (let us call it USX) has a 10% stake in a European company – say EuroStar. USX is
concerned about a decline in the Euro, and as it wants to maximize the Dollar value of EuroStar. It would
like to estimate its economic exposure.
USX thinks the probabilities of a stronger and/or weaker Euro is equal, i.e., 50–50. In the strong-Euro
scenario, the Euro will be at 1.50 against the Dollar, which would have a negative impact on EuroStar
(due to export loss). Then, EuroStar will have a market value of EUR 800 million, valuing USX’s 10% stake
at EUR 80 million (or $120 million).
In the weak-Euro scenario, currency will be at 1.25; EuroStar would have a market value of EUR 1.2
billion, valuing USX’s 10% stake will be equal to $150 million.
If P represents the value of USX’s 10% stake in EuroStar in Dollar terms, and S represents the Euro spot
rate, then the covariance of P and S is −
Cov (P,S) = –1.875
Var (S) = 0.015625
Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million
USX’s economic exposure is a negative EUR 120 million, which is equivalent to saying that the value of
its stake in EuroStar decreases as the Euro gets stronger, and increases as the Euro weakens.
Determining Economic Exposure
The economic exposure is usually determined by two factors −
Whether the markets where the company inputs and sells its products are competitive or monopolistic?
Economic exposure is more when either a firm’s input costs or goods’ prices are related to currency
fluctuations. If both costs and prices are relative or secluded to currency fluctuations, the effects are
cancelled by each other and it reduces the economic exposure.
Whether a firm can adjust to markets, its product mix, and the source of inputs in a reply to currency
fluctuations? Flexibility would mean lesser operating exposure, while sternness would mean a greater
operating exposure.
Managing Economic Exposure
The economic exposure risks can be removed through operational strategies or currency risk mitigation
strategies.
Operational strategies
Diversifying production facilities and markets for products − Diversification mitigates the risk related
with production facilities or sales being concentrated in one or two markets. However, the drawback is
the company may lose economies of scale.
Sourcing flexibility − Having sourcing flexibilities for key inputs makes strategic sense, as exchange rate
moves may make inputs too expensive from one region.
Diversifying financing − Having different capital markets gives a company the flexibility to raise capital in
the market with the cheapest cost.
Currency risk mitigation strategies
The most common strategies are −
Matching currency flows − Here, foreign currency inflows and outflows are matched. For example, if a
U.S. company having inflows in Euros is looking to raise debt, it must borrow in Euros.
Currency risk-sharing agreements − It is a sales or purchase contract of two parties where they agree to
share the currency fluctuation risk. Price adjustment is made in this, so that the base price of the
transaction is adjusted.
Back-to-back loans − Also called as credit swap, in this arrangement, two companies of two nations
borrow each other’s currency for a defined period. The back-to-back loan stays as both an asset and a
liability on their balance sheets.
Currency swaps − It is similar to a back-to-back loan, but it does not appear on the balance sheet. Here,
two firms borrow in the markets and currencies so that each can have the best rates, and then they
swap the proceeds.
1. Transaction Exposure
Financial Techniques to Manage Transaction Exposure
The main feature of a transaction exposure is the ease of identifying its size. Additionally, it has a well-
defined time interval associated with it that makes it extremely suitable for hedging with financial
instruments.
The most common methods for hedging transaction exposures are −
Forward Contracts− If a firm has to pay (receive) some fixed amount of foreign currency in the future (a
date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in
the future (the date). This removes the uncertainty of future home currency value of the liability (asset)
into a certain value.
Futures Contracts− These are similar to forward contracts in function. Futures contracts are usually
exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral,
and several other features. In general, it is not possible to exactly offset the position to fully eliminate
the exposure.
Money Market Hedge− Also called as synthetic forward contract, this method uses the fact that the
forward price must be equal to the current spot exchange rate multiplied by the ratio of the given
currencies’ riskless returns. It is also a form of financing the foreign currency transaction. It converts the
obligation to a domestic-currency payable and removes all exchange risks.
Options− A foreign currency option is a contract that has an upfront fee, and offers the owner the right,
but not an obligation, to trade currencies in a specified quantity, price, and time period.
Note − The major difference between an option and the hedging techniques mentioned above is that an
option usually has a nonlinear payoff profile. They permit the removal of downside risk without having
to cut off the profit from upside risk.
The decision of choosing one among these different financial techniques should be based on the costs
and the penultimate domestic currency cash flows (which is appropriately adjusted for the time value)
based upon the prices available to the firm.
Transaction Hedging Under Uncertainty
Uncertainty about either the timing or the existence of an exposure does not provide a valid argument
against hedging.
Uncertainty about transaction date
Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-
currency cash flow. The key reason is that, even if they are sure that a foreign currency transaction will
occur, they are not quite sure what the exact date of the transaction will be. There may be a possible
mismatch of maturities of transaction and hedge. Using the mechanism of rolling or early unwinding,
financial contracts create the probability of adjusting the maturity on a future date, when appropriate
information becomes available.
Uncertainty about existence of exposure
Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids with
prices fixed in foreign currency for future contracts. The firm will pay or receive foreign currency when a
bid is accepted, which will have denominated cash flows. It is a kind of contingent transaction exposure.
In these cases, an option is ideally suited.
Under this kind of uncertainty, there are four possible outcomes. The following table provides a
summary of the effective proceeds to the firm per unit of option contract which is equal to the net cash
flows of the assignment.
State Bid Accepted Bid Rejected
Spot price better than exercise price : let option expire Spot Price 0
Spot price worse than exercise price: exercise option Exercise Price Exercise Price – Spot Price
Operational Techniques for Managing Transaction Exposure
Operational strategies having the virtue of offsetting existing foreign currency exposure can also
mitigate transaction exposure. These strategies include −
Risk Shifting− The most obvious way is to not have any exposure. By invoicing all parts of the
transactions in the home currency, the firm can avoid transaction exposure completely. However, it is
not possible in all cases.
Currency risk sharing− The two parties can share the transaction risk. As the short-term transaction
exposure is nearly a zero sum game, one party loses and the other party gains%
Leading and Lagging− It involves playing with the time of the foreign currency cash flows. When the
foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities
early and collect the receivables later. The first is known as leading and the latter is called lagging.
Reinvoicing Centers− A reinvoicing center is a third-party corporate subsidiary that uses to manage one
location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions
are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the
transaction exposure.
Reinvoicing centers have three main advantages −
The centralized management gains of transaction exposures remain within company sales.
Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting processes and
improve intra affiliate cash flows, as intra-company accounts use domestic currency.
Reinvoicing centers (offshore, third country) qualify for local non-resident status and gain from the
offered tax and currency market benefits.
2. Translation Exposure
Translation exposure, also known accounting exposure, refers to a kind of effect occurring for an
unanticipated change in exchange rates. It can affect the consolidated financial reports of an MNC.
From a firm’s point of view, when exchange rates change, the probable value of a foreign subsidiary’s
assets and liabilities expressed in a foreign currency will also change.
There are mechanical means for managing the consolidation process for firms that have to deal with
exchange rate changes. These are the management techniques for translation exposure.
We have discussed transaction exposure and the ways to manage it. It is interesting to note that some
items that create transaction exposure are also responsible for creating translation exposure.
Translation Exposure – An Exhibit
The following exhibit shows the transaction exposure report for Cornellia Corporation and its two
affiliates. Items that produce transaction exposure are the receivables or payables. These items are
expressed in a foreign currency.
Affiliate Amount Account Translation Exposure
Parent CD 200,000 Cash Yes
Parent Ps 3,000,000 Accounts receivable No
Spanish SF 375,000 Notes payable Yes
From the exhibit, it can be easily understood that the parent firm has mainly two sources of a probable
transaction exposure. One is the Canadian Dollar (CD) 200,000 deposit that the firm has in a Canadian
bank. Obviously, when the Canadian dollar depreciates, the deposit’s value will go down for Cornellia
Corporation when changed to US dollars.
It can be noted that this deposit is also a translation exposure. It is a translation exposure for the same
reason for which it is a transaction exposure. The given (Peso) Ps 3,000,000 accounts receivable is not a
translation exposure due to the netting of intra-company payables and receivables. The (Swiss Franc) SF
375,000 notes for the Spanish affiliate is both a transaction and a translation exposure.
Cornellia Corporation and its affiliates can follow the steps given below to reduce its transaction
exposure and translation exposure.
Firstly, the parent company can convert its Canadian dollars into U.S. dollar deposits.
Secondly, the parent organization can also request for payment of the Ps 3,000,000 the Mexican affiliate
owes to it.
Thirdly, the Spanish affiliate can pay off, with cash, the SF 375,000 loan to the Swiss bank.
These three steps can eliminate all transaction exposure. Moreover, translation exposure will be
diminished as well.
Translation Exposure Report for Cornellia Corporation and its Mexican and Spanish Affiliates (in 000
Currency Units) −
Canadian Dollar Mexican Peso Euro Swiss Frank
Assets
Cash CD0 Ps 3,000 Eu 550 SF0
A/c receivable 0 9,000 1,045 0
Inventory 0 15,000 1,650 0
Net Fixed Assets 0 46,000 4,400 0
Exposed Assets CD0 Ps 73,000 Eu 7,645 SF0

Liabilities
A/c payable CD0 Ps 7,000 Eu 1,364 SF0
Notes payable 0 17,000 935 0
Long term debt 0 27,000 3,520 3,520
Exposed liabilities CD0 Ps51,000 Eu 5,819 SF0
Net exposure CD0 Ps22,000 Eu 1,826 SF0
The report shows that no translation exposure is associated with the Canadian dollar or the Swiss franc.
Hedging Translation Exposure
The above exhibit indicates that there is still enough translation exposure with changes in the exchange
rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major methods for
controlling this remaining exposure. These methods are: balance sheet hedge and derivatives hedge.
Balance Sheet Hedge
Translation exposure is not purely entity specific; rather, it is only currency specific. A mismatch of net
assets and net liabilities creates it. A balance sheet hedge will eliminate this mismatch.
Using the currency Euro as an example, the above exhibit presents the fact that there are €1,826,000
more net exposed assets than liabilities. Now, if the Spanish affiliate, or more probably, the parent firm
or the Mexican affiliate, pays €1,826,000 as more liabilities, or reduced assets, in Euros, there would be
no translation exposure with respect to the Euro.
A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar (€/$)
exchange rate would not have any effect on the consolidated balance sheet, as the change in value of
the assets would completely offset the change in value of the liabilities.
Derivatives Hedge
According to the corrected translation exposure report shown above, depreciation from €1.1000/$1.00
to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which was more when the
transaction exposure was not taken into account.
A derivative product, such as a forward contract, can now be used to attempt to hedge this loss. The
word “attempt” is used because using a derivatives hedge, in fact, involves speculation about the forex
rate changes.
3. Economic Exposure
Economic exposure is the toughest to manage because it requires ascertaining future exchange rates.
However, economists and investors can take the help of statistical regression equations to hedge against
economic exposure. There are various techniques that companies can use to hedge against economic
exposure. Five such techniques have been discussed in this chapter.
It is difficult to measure economic exposure. The company must accurately estimate cash flows and the
exchange rates, as transaction exposure has the power to alter future cash flows while fluctuation of the
currency exchange rates occur. When a foreign subsidiary gets positive cash flows after it corrects for
the currency exchange rates, the subsidiary’s net transaction exposure is low.
Note − It is easier to estimate economic exposure when currency exchange rates display a trend, and the
future cash flows are known.
Regression Equation
Analysts can measure economic exposure by using a simple regression equation, shown in Equation 1.
P = α + β.S + ε (1)
Suppose, the United States is the home country and Europe is the foreign country. In the equation, the
price, P, is the price of the foreign asset in dollars while S is spot exchange rate, expressed as Dollars per
Euro.
The Regression equation estimates the connection between price and the exchange rate. The random
error term (ε) equals zero when there is a constant variance while (α) and (β) are the estimated
parameters. Now, we can say that this equation will give a straight line between P and S with an
intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex Beta or Exposure
Coefficient. β indicates the level of exposure.
We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset’s price to the
exchange rate, while the variance measures the variation of the exchange rate. We see that two factors
influence (β): one is the fluctuations in the exchange rate and the second is the sensitivity of the asset’s
price to changes in the exchange rate.
β = Covariance (P,S)Variance (S)
(2) Economic Exposure – A Practical Example
Suppose you own and rent out a condominium in Europe. A property manager recruited by you can vary
the rent, making sure that someone always rents and occupies the property.
Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in Table 1.
Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability. The forecasted
exchange rate for each state, which is S has also been estimated. We can now calculate the asset’s price,
P, in U.S. dollars by multiplying that state’s rent by the exchange rate.
Table 1 – Renting out your Condo for Case 1
State Probability Rent (Euro) Exchange Rate (S) Rent (P)
1 1/3 €1,800 $1/1.00 E $1,800

2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E
3 1/3 €2,200 $1.50/1.00 E $3,300
In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the fluctuating
exchange rate, and there is a potential economic exposure.
A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A forward
contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against the exchange rate
risk.
In Table 2, (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the forward
contract and it is the spot exchange rate for a state.
Suppose we bought a forward contract with a price of $1.25 per euro.
If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into Dollars, we gain
$200, and we compute it in the Yield column in Table 2.
If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose anything.
State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the forward
contract. We know that each state is equally likely to occur, so we, on average, break even by
purchasing the forward contract.
Table 2 – The Beta is the Correct Hedge for Case 1
State Forward Price Exchange rate Yield
1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$
2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0
3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $
Total $0
The rents have changed in Table 3. In Case 2, you could now get € 1,667.67, € 2,000, or € 2,500 per
month in cash, and all rents are equally likely. Although your rent fluctuates greatly, the exchange
moves in the opposite direction of the rent.
State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,500 $1/1E $2,500
2 1/3 2,000 $1.25/1E $2,500
3 1/3 1,666.67 $1.50/1E $2,500
Now, do you notice that when you calculate the rent in dollars, the rent amounts become $2,500 in all
cases, and (β) equals –1,666.66? A negative (β) indicates that the exchange rate fluctuations cancel the
fluctuations in rent. Moreover, you do not need a forward contract because you do not have any
economic exposure.
We finally examine the last case in Table 4. The same rent, € 2000, is charged for Case 3 without
considering the exchange rate changes. As the rent is calculated in U.S. dollars, the exchange rate and
the rent amount move in the same direction.
1 1/3 2,000 $1/1E $2,000
2 1/3 2,000 $1.25/1E $2,500
3 1/3 2,000 $1.50/1E $3,000
However, the (β) equals 0 in this case, as rents in Euros do not vary. So, now, it can be hedged against
the exchange rate risk by buying a forward for €2000 and not the amount for the (β). By deciding to
charge the same rent, you can use a forward to protect this amount.
Techniques to Reduce Economic Exposure
International firms can use five techniques to reduce their economic exposure −
Technique 1− A company can reduce its manufacturing costs by taking its production facilities to low-
cost countries. For example, the Honda Motor Company produces automobiles in factories located in
many countries. If the Japanese Yen appreciates and raises Honda’s production costs, Honda can shift its
production to its other facilities, scattered across the world.
Technique 2− A company can outsource its production or apply low-cost labor. Foxconn, a Taiwanese
company, is the largest electronics company in the world, and it produces electronic devices for some of
the world’s largest corporations.
Technique 3− A company can diversify its products and services and sell them to clients from around the
world. For example, many U.S. corporations produce and market fast food, snack food, and sodas in
many countries. The depreciating U.S. dollar reduces profits inside the United States, but their foreign
operations offset this.
Technique 4− A company can continually invest in research and development. Subsequently, it can offer
innovative products at a higher price. For instance, Apple Inc. set the standard for high-quality
smartphones. When dollar depreciates, it increases the price.
Technique 5− A company can use derivatives and hedge against exchange rate changes. For example,
Porsche completely manufactures its cars within the European Union and exports between 40% to 45%
of its cars to the United States. Porsche financial managers hedged or shorted against the U.S. dollar
when the U.S. dollar depreciated. Some analysts estimated that about 50% of Porsche’s profits arose
from hedging activities.
Hedging with Forwards
The Forward Contract is an agreement between two parties wherein they agree to buy or sell the
underlying asset at a predetermined future date and a price specified today. The Forward contracts are
the most common way of hedging the foreign currency risk.
The foreign exchange refers to the conversion of one currency into another, and while dealing in the
currencies, there exist two markets: Spot Market and Forward Market. The Spot market means where
the delivery is made right away, while in the forward market the payment is made at the predetermined
date in the future.
In the spot market, the rate is the current rate, which is prevailing at the time the currencies are being
exchanged. Whereas, the rate in the forward market is the rate which has been fixed today or at the
time the transaction is agreed to but the actual delivery takes place at a specified date in the future.
Thus, forward currency contracts enable the parties to the contract to lock the exchange rate today, to
buy or sell the currency on the predefined future date.
The party who agrees to buy the underlying asset at a specified future date assumes the long position,
whereas the seller who promises to deliver the asset at a rate locked today assumes the short position.
In a forward currency contract, the buyer hopes the currency to appreciate, while the seller expects the
currency to depreciate in the future. Thus, the gain and loss of the buyer can be calculated as follows:
Gain = Spot Rate– Contract Rate
Loss = Contract Rate – Spot Rate
Where, the spot rate is the actual rate prevailing at the future date while the contract rate is the rate
which was locked at the time transaction was agreed upon.
The forward contracts are similar to the options in hedging risk, but there is a significant difference
between these two. The parties to the forward contracts are obliged to buy or sell the underlying
securities at a specified date in the future, whereas in the case of the options, the buyer has the right to
whether exercise the option or not. The other difference is that the forward contracts do not require
any upfront payment in the form of premium which is very much required when buying the options
contracts.
Pricing of Futures Contract, Currency Futures, Hedging In Currency Futures
Pricing Of Futures Contract
The value of a futures contract is derived from the cash value of the underlying asset. While a futures
contract may have a very high value, a trader can buy or sell the contract with a much smaller amount,
which is known as the initial margin.
The initial margin is essentially a down payment on the value of the futures contract and the obligations
associated with the contract. Trading futures contracts is different than trading stocks due to the high
degree of leverage involved. This leverage can amplify profits and losses.
Initial Margin
The initial margin is the initial amount of money a trader must place in an account to open a futures
position. The amount is established by the exchange and is a percentage of the value of the futures
contract.
For example, a crude oil contract futures contract is 1,000 barrels of oil. At $75 per barrel, the notional
value of the contract is $75,000. A trader is not required to place this amount into an account. Rather,
the initial margin for a crude oil contract could be around $5,000 per contract as determined by the
exchange. This is the initial amount the trader must place in the account to open a position.
Maintenance Margin
The maintenance margin amount is less than the initial margin. This is the amount the trader must keep
in the account due to changes in the price of the contract.
In the oil example, assume the maintenance margin is $4,000. If a trader buys an oil contract and then
the price drops $2, the value of the contract has fallen $2,000. If the balance in the account is less than
the maintenance margin, the trader must place additional funds to meet the maintenance margin. If the
trader does not meet the margin call, the broker or exchange could unilaterally liquidate the position.
Currency Futures
The global forex market is the largest market in the world with over $4 trillion traded daily, according to
Bank for International Settlements (BIS) data. The forex market, however, is not the only way for
investors and traders to participate in foreign exchange. While not nearly as large as the forex market,
the currency futures market has a respectable daily average closer to $100 billion.
Currency futures – futures contracts where the underlying commodity is a currency exchange rate –
provide access to the foreign exchange market in an environment that is similar to other futures
contracts.
Currency futures, also called forex futures or foreign exchange futures, are exchange-traded futures
contracts to buy or sell a specified amount of a particular currency at a set price and date in the future.
Currency futures were introduced at the Chicago Mercantile Exchange (now the CME Group) in 1972
soon after the fixed exchange rate system and gold standard were discarded. Similar to other futures
products, they are traded in terms of contract months with standard maturity dates typically falling on
the third Wednesday of March, June, September and December.
Hedging In Currency Futures
Currency Hedging is an act of entering into a financial contract in order to protect against anticipated or
unexpected changes in currency exchange rates. Currency hedging is used by businesses to eliminate
risks they encounter when conducting business internationally.
The concept of Currency hedging is the use of various financial instruments, like Forward Contract and
other Derivative contracts, to manage financial risk. It involves the designation of one or more financial
instruments (usually a Bank or an Exchange) as a buffer for potential loss.
Suppose a firm receives an export order today with the delivery date being in 3 months time. The
contract is worth, say, US$100,000. At the time the contract is placed, the INR is say Rs. 65 per US$.
Hence the value of the order, when placed, is Rs. 65,00,000. But suppose that the exchange rate
changes significantly between the date when the order is received and the date the order is paid for
(which we will assume is one month after the delivery date). The exchange rate of the INR & US$ is at
Rs. 62 on payment date. Which means that the firm receives only Rs. 62,00,000 rather than Rs.
65,00,000. This will result in loss of Rs. 3,00,000 for the exporter. To insure against this happening, the
firm can, at the time it receives the order, hedge the currency risk.
So any business that has dealing in overseas market is open to such Currency or more popularly known
as Forex exposure. There may be other kinds of exposure including commodity risk, Interest rate risk,
wage inflation etc. Un-hedged exposure of FX can affect the balance sheet or profitability, which can
create cash flow and operational issues. Hedging reduces a firm’s exposure to unwanted risk. This helps
in sustaining profits, reducing volatility and ensuring smoother operations.
Different type of Exposure
Revenue Exposure (in Foreign

Expense Exposure (in Foreign Currency)
Currency)
Value of Imports, Purchase of products and

Value of Exports (FOB value)
services
Revenue from Services and other

Salaries and other administrative overheads
consultancy
Other Income (Interest/ Dividend) Business establishment expenses
Purchase of Fixed Assets
Introduction to Options, Hedging with Currency Options
An option is a financial contract that gives an investor the right, but not the obligation, to either buy or
sell an asset at a pre-determined price (known as the strike price) by a specified date (known as the
expiration date).
Options are derivative instruments, meaning that their prices are derived from the price of their
underlying security, which could be almost anything: stocks, bonds, currencies, indexes, commodities,
etc. Many options are created in a standardized form and traded on an options exchange like the
Chicago Board Options Exchange (CBOE), although it is possible for the two parties to an options
contract to agree to create options with completely customized terms.
There are two types of options: call options and put options. A buyer of a call option has the right to buy
the underlying asset for a certain price. The buyer of a put option has the right to sell the underlying
asset for a certain price.
Here’s a brief look at a few of the most common types of options:
Every option represents a contract between the options writer and the options buyer.
The options writer is the party that “writes,” or creates, the options contract, and then sells it. If the
investor who buys the contract chooses to exercise the option, the writer is obligated to fulfill the
transaction by buying or selling the underlying asset, depending on the type of option he wrote. If the
buyer chooses to not exercise the option, the writer does nothing and gets to keep the premium (the
price the option was originally sold for).
The options buyer has a lot of power in this relationship. He chooses whether or not they will complete
the transaction. When the option expires, if the buyer doesn’t want to exercise the option, he doesn’t
have to. The buyer has purchased the option to carry out a certain transaction in the future — hence the
name.
1.1 option-table.gif
Why it Matters:
Investors use options for two primary reasons: to speculate and to hedge risk. Rational investors realize
there is no “sure thing,” as every investment incurs at least some risk. This risk is what the investor is
compensated for when he or she purchases an asset.
Hedging is like buying insurance. It is protection against unforeseen events, but you hope you never
have to use it. Should a stock take an unforeseen turn, holding an option opposite of your position will
help to limit your losses.
If you’d like to read more in-depth information about options, check out these definitions:
Call Option: Option to purchase the underlying asset.
Put Option: Option to sell the underlying asset.
Options Contract: The agreement between the writer and the buyer.
Expiration Date: The last day an options contract can be exercised.
Strike Price: The pre-determined price the underlying asset can be bought/sold for.
Intrinsic Value: The current value of the option’s underlying asset.
Time Value: The additional amount that traders are willing to pay for an option.
Vanilla Option: A normal option with no special features, terms or conditions.
American Option: Option that can be exercised any time before the expiration date.
European Option: Option that can be exercised only on the expiration date.
Exotic Option: Any option with a complex structure or payoff calculation.
Hedging with Currency Options
Currency options are useful for all those who are the players or the users of the foreign currency. This is
particularly useful for those who want to gain if the exchange rate improves but simultaneously want a
protection it the exchange rate deteriorate. The most the holder of an option can lose is the premium he
paid for it. Naturally, the option writer faces the mirror image of the holder’s picture: if you sell an
option, the most you can get is the premium if the option dies for lack of exercise. The writer of a call
option can face a substantial loss if the option is exercised: he is forced to deliver a currency-futures
contract at a below-market price. If he wrote a put option and the put is exercised, then he is obliged to
buy the currency at an above-market price.
Foreign exchange options present an asymmetrical risk profile unlike futures, forwards and currency
options. This lopsidedness works in favor of the holder and to the disadvantage of the writer. This is why
because the holder pays for it i.e he takes the risk. When two parties enter into a symmetrical contract
;ole a forward, both can gain or lose equally and neither party feels obliged to charge the other for the
privilege. Forwards, futures, and swaps are mutual obligations; options are one-sided. The holder of a
call has a downside risk limited to the premium paid up front; beyond that he gains one-for –one as the
price of the underlying security.
One who has brought p put option gains one-for-one as the price of the underlying instrument falls
below the strike price. Traders who have written or sold options face the upside down mirror image
profit profile of those who have bought the same options.
From the asymmetrical risk profile of options, it follows that options are ideally suited to offsetting
exchange risks that are themselves asymmetrical. The risk of a forward-rate agreement is symmetrical;
hence, matching it worth a currency option will not be a perfect hedge. Because doing so would leave
you with an open, or speculative, position. Forward contracts, futures or currency swaps are suitable
hedges for symmetrical risks. Currency options are suitable in which currency risk is already lopsided,
and for those who choose to speculate on the direction and volatility of rates.
Options are not only for hedgers, but also for those who wish to take a “view”. However, for one who is,
say, bearish on the deutschemark, a DM put is not necessarily the best choice. One can easily bet on the
direction of a currency by suing futures or forwards. A DM bear would simply sell DM futures, limiting
his loss, if wants to do so, via a stop loss order.
For an investor who has a view on direction and on volatility, the option is the right choice. If you think
the DM is likely to fall below the forward rate, and you believe that the market has underestimated the
mark’s volatility, then buying a put on German marks is the right strategy.
Who needs American option? Because if offers an additional right- the privilege of exercise on any date
up to the expiration date- it gives the buyer greater flexibility and the writer greater risk. American
options will therefore tend to be priced slightly higher than European options. Even so, the American
option is almost always worth more ‘alive’ than “dead”, meaning that it pays to sell rather than exercise
early. The reason for this statement lies in the fact that most option trade at a price higher than the gain
that would be made from exercising the option.
expiration date).

name.
Why it Matters:

expiration date).
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Why it Matters:
Foreign Exchange Risk Exposure, Types of Risk
Exchange rate fluctuations affect not only multinationals and large corporations, but also small and
medium-sized enterprises. Therefore, understanding and managing exchange rate risk is an important
subject for business owners and investors.
There are various kinds of exposure and related techniques for measuring the exposure. Of all the
exposures, economic exposure is the most important one and it can be calculated statistically.
Companies resort to various strategies to contain economic exposure.
Types of Exposure
Companies are exposed to three types of risk caused by currency volatility −
Transaction exposure − Exchange rate fluctuations have an effect on a company’s obligations to make or
receive payments denominated in foreign currency in future. Transaction exposure arises from this
effect and it is short-term to medium-term in nature.
Translation exposure − Currency fluctuations have an effect on a company’s consolidated financial

statements, particularly when it has foreign subsidiaries. Translation exposure arises due to this effect. It
is medium-term to long-term in nature.
Economic (or operating) exposure − Economic exposure arises due to the effect of unpredicted currency
rate fluctuations on the company’s future cash flows and market value. Unanticipated exchange rate
fluctuations can have a huge effect on a company’s competitive position.
Note that economic exposure is impossible to predict, while transaction and translation exposure can be
estimated.
Economic Exposure – An Example
Consider a big U.S. multinational with operations in numerous countries around the world. The
company’s biggest export markets are Europe and Japan, which together offer 40% of the company’s
annual revenues.
The company’s management had factored in an average slump of 3% for the dollar against the Euro and
Japanese Yen for the running and the next two years. The management expected that the Dollar will be
bearish due to the recurring U.S. budget deadlock, and growing fiscal and current account deficits, which
they expected would affect the exchange rate.
However, the rapidly improving U.S. economy has triggered speculation that the Fed will tighten
monetary policy very soon. The Dollar is rallying, and in the last few months, it has gained about 5%
against the Euro and the Yen. The outlook suggests further gains, as the monetary policy in Japan is
stimulative and the European economy is coming out of recession.
The U.S. company is now facing not just transaction exposure (as its large export sales) and translation
exposure (as it has subsidiaries worldwide), but also economic exposure. The Dollar was expected to
decline about 3% annually against the Euro and the Yen, but it has already gained 5% versus these
currencies, which is a variance of 8 percentage points at hand. This will have a negative effect on sales
and cash flows. The investors have already taken into account the currency fluctuations and the stock of
the company fell 7%.
Calculating Economic Exposure
Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. We know from
statistics that a regression analysis of the asset value (P) versus the spot exchange rate (S) will offer the
following regression equation −
P = a + (b x S) + e
Where, a is the regression constant, b is the regression coefficient, and e is a random error term with a
mean of zero. Here, b is a measure of economic exposure, and it measures the sensitivity of an asset’s
dollar value to the exchange rate.
The regression coefficient is the ratio of the covariance between the asset value and the exchange rate,
to the variance of the spot rate. It is expressed as −
b =
Cov (P,S)Var (S)
Economic Exposure – Numerical Example
A U.S. company (let us call it USX) has a 10% stake in a European company – say EuroStar. USX is
concerned about a decline in the Euro, and as it wants to maximize the Dollar value of EuroStar. It would
like to estimate its economic exposure.
USX thinks the probabilities of a stronger and/or weaker Euro is equal, i.e., 50–50. In the strong-Euro
scenario, the Euro will be at 1.50 against the Dollar, which would have a negative impact on EuroStar
(due to export loss). Then, EuroStar will have a market value of EUR 800 million, valuing USX’s 10% stake
at EUR 80 million (or $120 million).
In the weak-Euro scenario, currency will be at 1.25; EuroStar would have a market value of EUR 1.2
billion, valuing USX’s 10% stake will be equal to $150 million.
If P represents the value of USX’s 10% stake in EuroStar in Dollar terms, and S represents the Euro spot
rate, then the covariance of P and S is −
Cov (P,S) = –1.875
Var (S) = 0.015625
Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million

USX’s economic exposure is a negative EUR 120 million, which is equivalent to saying that the value of
its stake in EuroStar decreases as the Euro gets stronger, and increases as the Euro weakens.
Determining Economic Exposure
The economic exposure is usually determined by two factors −
Whether the markets where the company inputs and sells its products are competitive or monopolistic?
Economic exposure is more when either a firm’s input costs or goods’ prices are related to currency
fluctuations. If both costs and prices are relative or secluded to currency fluctuations, the effects are
cancelled by each other and it reduces the economic exposure.
Whether a firm can adjust to markets, its product mix, and the source of inputs in a reply to currency
fluctuations? Flexibility would mean lesser operating exposure, while sternness would mean a greater
operating exposure.
Managing Economic Exposure
The economic exposure risks can be removed through operational strategies or currency risk mitigation
strategies.
Operational strategies
Diversifying production facilities and markets for products − Diversification mitigates the risk related
with production facilities or sales being concentrated in one or two markets. However, the drawback is
the company may lose economies of scale.
Sourcing flexibility − Having sourcing flexibilities for key inputs makes strategic sense, as exchange rate
moves may make inputs too expensive from one region.
Diversifying financing − Having different capital markets gives a company the flexibility to raise capital in
the market with the cheapest cost.
Currency risk mitigation strategies
The most common strategies are −
Matching currency flows − Here, foreign currency inflows and outflows are matched. For example, if a
U.S. company having inflows in Euros is looking to raise debt, it must borrow in Euros.
Currency risk-sharing agreements − It is a sales or purchase contract of two parties where they agree to
share the currency fluctuation risk. Price adjustment is made in this, so that the base price of the
transaction is adjusted.
Back-to-back loans − Also called as credit swap, in this arrangement, two companies of two nations
borrow each other’s currency for a defined period. The back-to-back loan stays as both an asset and a
liability on their balance sheets.
Currency swaps − It is similar to a back-to-back loan, but it does not appear on the balance sheet. Here,
two firms borrow in the markets and currencies so that each can have the best rates, and then they
swap the proceeds.
1. Transaction Exposure
Financial Techniques to Manage Transaction Exposure
The main feature of a transaction exposure is the ease of identifying its size. Additionally, it has a well-
defined time interval associated with it that makes it extremely suitable for hedging with financial
instruments.
The most common methods for hedging transaction exposures are −
Forward Contracts− If a firm has to pay (receive) some fixed amount of foreign currency in the future (a
date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in
the future (the date). This removes the uncertainty of future home currency value of the liability (asset)
into a certain value.
Futures Contracts− These are similar to forward contracts in function. Futures contracts are usually
exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral,
and several other features. In general, it is not possible to exactly offset the position to fully eliminate
the exposure.
Money Market Hedge− Also called as synthetic forward contract, this method uses the fact that the
forward price must be equal to the current spot exchange rate multiplied by the ratio of the given
currencies’ riskless returns. It is also a form of financing the foreign currency transaction. It converts the
obligation to a domestic-currency payable and removes all exchange risks.
Options− A foreign currency option is a contract that has an upfront fee, and offers the owner the right,
but not an obligation, to trade currencies in a specified quantity, price, and time period.
Note − The major difference between an option and the hedging techniques mentioned above is that an
option usually has a nonlinear payoff profile. They permit the removal of downside risk without having
to cut off the profit from upside risk.
The decision of choosing one among these different financial techniques should be based on the costs
and the penultimate domestic currency cash flows (which is appropriately adjusted for the time value)
based upon the prices available to the firm.
Transaction Hedging Under Uncertainty
Uncertainty about either the timing or the existence of an exposure does not provide a valid argument
against hedging.
Uncertainty about transaction date
Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-
currency cash flow. The key reason is that, even if they are sure that a foreign currency transaction will
occur, they are not quite sure what the exact date of the transaction will be. There may be a possible
mismatch of maturities of transaction and hedge. Using the mechanism of rolling or early unwinding,
financial contracts create the probability of adjusting the maturity on a future date, when appropriate
information becomes available.
Uncertainty about existence of exposure
Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids with
prices fixed in foreign currency for future contracts. The firm will pay or receive foreign currency when a
bid is accepted, which will have denominated cash flows. It is a kind of contingent transaction exposure.
In these cases, an option is ideally suited.
Under this kind of uncertainty, there are four possible outcomes. The following table provides a
summary of the effective proceeds to the firm per unit of option contract which is equal to the net cash
flows of the assignment.
State Bid Accepted Bid Rejected
Spot price better than exercise price : let option expire Spot Price 0
Spot price worse than exercise price: exercise option Exercise Price Exercise Price – Spot Price
Operational Techniques for Managing Transaction Exposure
Operational strategies having the virtue of offsetting existing foreign currency exposure can also
mitigate transaction exposure. These strategies include −
Risk Shifting− The most obvious way is to not have any exposure. By invoicing all parts of the
transactions in the home currency, the firm can avoid transaction exposure completely. However, it is
not possible in all cases.
Currency risk sharing− The two parties can share the transaction risk. As the short-term transaction
exposure is nearly a zero sum game, one party loses and the other party gains%
Leading and Lagging− It involves playing with the time of the foreign currency cash flows. When the
foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities
early and collect the receivables later. The first is known as leading and the latter is called lagging.
Reinvoicing Centers− A reinvoicing center is a third-party corporate subsidiary that uses to manage one
location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions
are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the
transaction exposure.
Reinvoicing centers have three main advantages −
The centralized management gains of transaction exposures remain within company sales.
Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting processes and
improve intra affiliate cash flows, as intra-company accounts use domestic currency.
Reinvoicing centers (offshore, third country) qualify for local non-resident status and gain from the
offered tax and currency market benefits.
2. Translation Exposure
Translation exposure, also known accounting exposure, refers to a kind of effect occurring for an
unanticipated change in exchange rates. It can affect the consolidated financial reports of an MNC.
From a firm’s point of view, when exchange rates change, the probable value of a foreign subsidiary’s
assets and liabilities expressed in a foreign currency will also change.
There are mechanical means for managing the consolidation process for firms that have to deal with
exchange rate changes. These are the management techniques for translation exposure.
We have discussed transaction exposure and the ways to manage it. It is interesting to note that some
items that create transaction exposure are also responsible for creating translation exposure.
Translation Exposure – An Exhibit
The following exhibit shows the transaction exposure report for Cornellia Corporation and its two
affiliates. Items that produce transaction exposure are the receivables or payables. These items are
expressed in a foreign currency.
Affiliate Amount Account Translation Exposure
Parent CD 200,000 Cash Yes
Parent Ps 3,000,000 Accounts receivable No
Spanish SF 375,000 Notes payable Yes

From the exhibit, it can be easily understood that the parent firm has mainly two sources of a probable
transaction exposure. One is the Canadian Dollar (CD) 200,000 deposit that the firm has in a Canadian
bank. Obviously, when the Canadian dollar depreciates, the deposit’s value will go down for Cornellia
Corporation when changed to US dollars.
It can be noted that this deposit is also a translation exposure. It is a translation exposure for the same
reason for which it is a transaction exposure. The given (Peso) Ps 3,000,000 accounts receivable is not a
translation exposure due to the netting of intra-company payables and receivables. The (Swiss Franc) SF
375,000 notes for the Spanish affiliate is both a transaction and a translation exposure.
Cornellia Corporation and its affiliates can follow the steps given below to reduce its transaction
exposure and translation exposure.
Firstly, the parent company can convert its Canadian dollars into U.S. dollar deposits.
Secondly, the parent organization can also request for payment of the Ps 3,000,000 the Mexican affiliate
owes to it.
Thirdly, the Spanish affiliate can pay off, with cash, the SF 375,000 loan to the Swiss bank.
These three steps can eliminate all transaction exposure. Moreover, translation exposure will be
diminished as well.
Translation Exposure Report for Cornellia Corporation and its Mexican and Spanish Affiliates (in 000
Currency Units) −
Canadian Dollar Mexican Peso Euro Swiss Frank
Assets
Cash CD0 Ps 3,000 Eu 550 SF0
A/c receivable 0 9,000 1,045 0

Inventory 0 15,000 1,650 0
Net Fixed Assets 0 46,000 4,400 0
Exposed Assets CD0 Ps 73,000 Eu 7,645 SF0
Liabilities
A/c payable CD0 Ps 7,000 Eu 1,364 SF0
Notes payable 0 17,000 935 0
Long term debt 0 27,000 3,520 3,520
Exposed liabilities CD0 Ps51,000 Eu 5,819 SF0
Net exposure CD0 Ps22,000 Eu 1,826 SF0
The report shows that no translation exposure is associated with the Canadian dollar or the Swiss franc.
Hedging Translation Exposure
The above exhibit indicates that there is still enough translation exposure with changes in the exchange
rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major methods for
controlling this remaining exposure. These methods are: balance sheet hedge and derivatives hedge.
Balance Sheet Hedge
Translation exposure is not purely entity specific; rather, it is only currency specific. A mismatch of net
assets and net liabilities creates it. A balance sheet hedge will eliminate this mismatch.
Using the currency Euro as an example, the above exhibit presents the fact that there are €1,826,000
more net exposed assets than liabilities. Now, if the Spanish affiliate, or more probably, the parent firm
or the Mexican affiliate, pays €1,826,000 as more liabilities, or reduced assets, in Euros, there would be
no translation exposure with respect to the Euro.
A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar (€/$)
exchange rate would not have any effect on the consolidated balance sheet, as the change in value of
the assets would completely offset the change in value of the liabilities.
Derivatives Hedge
According to the corrected translation exposure report shown above, depreciation from €1.1000/$1.00
to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which was more when the
transaction exposure was not taken into account.
A derivative product, such as a forward contract, can now be used to attempt to hedge this loss. The
word “attempt” is used because using a derivatives hedge, in fact, involves speculation about the forex
rate changes.
3. Economic Exposure
Economic exposure is the toughest to manage because it requires ascertaining future exchange rates.
However, economists and investors can take the help of statistical regression equations to hedge against
economic exposure. There are various techniques that companies can use to hedge against economic
exposure. Five such techniques have been discussed in this chapter.
It is difficult to measure economic exposure. The company must accurately estimate cash flows and the
exchange rates, as transaction exposure has the power to alter future cash flows while fluctuation of the
currency exchange rates occur. When a foreign subsidiary gets positive cash flows after it corrects for
the currency exchange rates, the subsidiary’s net transaction exposure is low.
Note − It is easier to estimate economic exposure when currency exchange rates display a trend, and the
future cash flows are known.
Regression Equation
Analysts can measure economic exposure by using a simple regression equation, shown in Equation 1.
P = α + β.S + ε (1)
Suppose, the United States is the home country and Europe is the foreign country. In the equation, the
price, P, is the price of the foreign asset in dollars while S is spot exchange rate, expressed as Dollars per
Euro.
The Regression equation estimates the connection between price and the exchange rate. The random
error term (ε) equals zero when there is a constant variance while (α) and (β) are the estimated
parameters. Now, we can say that this equation will give a straight line between P and S with an
intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex Beta or Exposure
Coefficient. β indicates the level of exposure.
We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset’s price to the
exchange rate, while the variance measures the variation of the exchange rate. We see that two factors
influence (β): one is the fluctuations in the exchange rate and the second is the sensitivity of the asset’s
price to changes in the exchange rate.
β = Covariance (P,S)Variance (S)
(2) Economic Exposure – A Practical Example
Suppose you own and rent out a condominium in Europe. A property manager recruited by you can vary
the rent, making sure that someone always rents and occupies the property.
Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in Table 1.
Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability. The forecasted
exchange rate for each state, which is S has also been estimated. We can now calculate the asset’s price,
P, in U.S. dollars by multiplying that state’s rent by the exchange rate.

State Probability Rent (Euro) Exchange Rate (S) Rent (P)
1 1/3 €1,800 $1/1.00 E $1,800
2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E
3 1/3 €2,200 $1.50/1.00 E $3,300
In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the fluctuating
exchange rate, and there is a potential economic exposure.
A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A forward
contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against the exchange rate
risk.
In Table 2, (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the forward
contract and it is the spot exchange rate for a state.
Suppose we bought a forward contract with a price of $1.25 per euro.
If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into Dollars, we gain
$200, and we compute it in the Yield column in Table 2.
If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose anything.
State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the forward
contract. We know that each state is equally likely to occur, so we, on average, break even by
purchasing the forward contract.
Table 2 – The Beta is the Correct Hedge for Case 1
State Forward Price Exchange rate Yield
1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$
2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0

3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $
Total $0
The rents have changed in Table 3. In Case 2, you could now get € 1,667.67, € 2,000, or € 2,500 per
month in cash, and all rents are equally likely. Although your rent fluctuates greatly, the exchange
moves in the opposite direction of the rent.
1 1/3 2,500 $1/1E $2,500
2 1/3 2,000 $1.25/1E $2,500
3 1/3 1,666.67 $1.50/1E $2,500
Now, do you notice that when you calculate the rent in dollars, the rent amounts become $2,500 in all
cases, and (β) equals –1,666.66? A negative (β) indicates that the exchange rate fluctuations cancel the
fluctuations in rent. Moreover, you do not need a forward contract because you do not have any
economic exposure.
We finally examine the last case in Table 4. The same rent, € 2000, is charged for Case 3 without
considering the exchange rate changes. As the rent is calculated in U.S. dollars, the exchange rate and
the rent amount move in the same direction.
1 1/3 2,000 $1/1E $2,000
2 1/3 2,000 $1.25/1E $2,500
3 1/3 2,000 $1.50/1E $3,000

However, the (β) equals 0 in this case, as rents in Euros do not vary. So, now, it can be hedged against
the exchange rate risk by buying a forward for €2000 and not the amount for the (β). By deciding to
charge the same rent, you can use a forward to protect this amount.
Techniques to Reduce Economic Exposure
International firms can use five techniques to reduce their economic exposure −
Technique 1− A company can reduce its manufacturing costs by taking its production facilities to low-
cost countries. For example, the Honda Motor Company produces automobiles in factories located in
many countries. If the Japanese Yen appreciates and raises Honda’s production costs, Honda can shift its
production to its other facilities, scattered across the world.
Technique 2− A company can outsource its production or apply low-cost labor. Foxconn, a Taiwanese
company, is the largest electronics company in the world, and it produces electronic devices for some of
the world’s largest corporations.
Technique 3− A company can diversify its products and services and sell them to clients from around the
world. For example, many U.S. corporations produce and market fast food, snack food, and sodas in
many countries. The depreciating U.S. dollar reduces profits inside the United States, but their foreign
operations offset this.
Technique 4− A company can continually invest in research and development. Subsequently, it can offer
innovative products at a higher price. For instance, Apple Inc. set the standard for high-quality
smartphones. When dollar depreciates, it increases the price.
Technique 5− A company can use derivatives and hedge against exchange rate changes. For example,
Porsche completely manufactures its cars within the European Union and exports between 40% to 45%
of its cars to the United States. Porsche financial managers hedged or shorted against the U.S. dollar
when the U.S. dollar depreciated. Some analysts estimated that about 50% of Porsche’s profits arose
from hedging activities.
Managing Interest Rate Exposure
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s
financial condition. The management of Interest Rate Risk should be one of the critical components of
market risk management in banks. The regulatory restrictions in the past had greatly reduced many of
the risks in the banking system. Deregulation of interest rates has, however, exposed them to the
adverse impacts of interest rate risk.
What is the Impact of IRR:
The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term
impact of changing interest rates is on the bank’s networth since the economic value of a bank’s assets,
liabilities and off-balance sheet positions get affected due to variation in market interest rates.
The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of
interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating
assets or liabilities), expose bank’s NII or NIM to variations. The earning of assets and the cost of
liabilities are closely related to market interest rate volatility.
The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and
‘economic value’ perspective, respectively.
Management of interest rate risk aims at capturing the risks arising from the maturity and repricing
mismatches and is measured both from the earnings and economic value perspective.
(a) Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported
earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or
Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest
expense.
(b) Economic Value perspective involves analysing the changes of impact og interest on the expected
cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance
sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest
rate sensitive positions. The economic value perspective identifies risk arising from long-term interest
rate gaps.
Board and senior management oversight of interest rate risk
Principle 1: In order to carry out its responsibilities, the board of directors in a bank should approve
strategies and policies with respect to interest rate risk management and ensure that senior
management takes the steps necessary to monitor and control these risks. The board of directors should
be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring
and controlling of such risk.
Principle 2: Senior management must ensure that the structure of the bank’s business and the level of
interest rate risk it assumes are effectively managed, that appropriate policies and procedures are
established to control and limit these risks, and that resources are available for evaluating and
controlling interest rate risk.
Principle 3: Banks should clearly define the individuals and/or committees responsible for managing
interest rate risk and should ensure that there is adequate separation of duties in key elements of the
risk management process to avoid potential conflicts of interest. Banks should have risk measurement,
monitoring and control functions with clearly defined duties that are sufficiently independent from
position-taking functions of the bank and which report risk exposures directly to senior management
and the board of directors. Larger or more complex banks should have a designated independent unit
responsible for the design and administration of the bank’s interest rate risk measurement, monitoring
and control functions.
Adequate Risk Management Policies and Procedures
Principle 4: It is essential that banks’ interest rate risk policies and procedures are clearly defined and
consistent with the nature and complexity of their activities. These policies should be applied on a
consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising
legal distinctions and possible obstacles to cash movements among affiliates.
Principle 5: It is important that banks identify the risks inherent in new products and activities and
ensure these are subject to adequate procedures and controls before being introduced or undertaken.
Major hedging or risk management initiatives should be approved in advance by the board or its
appropriate delegated committee.
Risk Measurement, Monitoring and Control Functions
Principle 6: It is essential that banks have interest rate risk measurement systems that capture all
material sources of interest rate risk and that assess the effect of interest rate changes in ways that are
consistent with the scope of their activities. The assumptions underlying the system should be clearly
understood by risk managers and bank management.
Principle 7: Banks must establish and enforce operating limits and other practices that maintain
exposures within levels consistent with their internal policies.
Principle 8: Banks should measure their vulnerability to loss under stressful market conditions –
including the breakdown of key assumptions – and consider those results when establishing and
reviewing their policies and limits for interest rate risk.
Principle 9: Banks must have adequate information systems for measuring, monitoring, controlling and
reporting interest rate exposures. Reports must be provided on a timely basis to the bank’s board of
directors, senior management and, where appropriate, individual business line managers.
Internal controls
Principle 10: Banks must have an adequate system of internal controls over their interest rate risk
management process. A fundamental component of the internal control system involves regular
independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring
that appropriate revisions or enhancements to internal controls are made. The results of such reviews
should be available to the relevant supervisory authorities.
Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely information with
which to evaluate their level of interest rate risk. This information should take appropriate account of
the range of maturities and currencies in each bank’s portfolio, including off-balance sheet items, as well
as other relevant factors, such as the distinction between trading and non-trading activities.
Capital adequacy
Principle 12: Banks must hold capital commensurate with the level of interest rate risk they undertake.
Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest rate risk and their
policies for its management.
Sources, effects and measurement of interest rate risk
Interest rate risk is the exposure of a bank’s financial condition to adverse movements in interest rates.
Accepting this risk is a normal part of banking and can be an important source of profitability and
shareholder value. However, excessive interest rate risk can pose a significant threat to a bank’s
earnings and capital base. Changes in interest rates affect a bank’s earnings by changing its net interest
income and the level of other interest-sensitive income and operating expenses. Changes in interest
rates also affect the underlying value of the bank’s assets, liabilities and off-balance sheet instruments
because the present value of future cash flows (and in some cases, the cash flows themselves) change
when interest rates change.
Sources of Interest Rate Risk

Repricing risk: As financial intermediaries, banks encounter interest rate risk in several ways. The
primary and most often discussed form of interest rate risk arises from timing differences in the
maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet
(OBS) positions. While such repricing mismatches are fundamental to the business of banking, they can
expose a bank’s income and underlying economic value to unanticipated fluctuations as interest rates
vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a
decline in both the future income arising from the position and its underlying value if interest rates
increase. These declines arise because the cash flows on the loan are fixed over its lifetime, while the
interest paid on the funding is variable, and increases after the short-term deposit matures.
Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope and shape of the
yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a
bank’s income or underlying economic value. For instance, the underlying economic value of a long
position in 10-year government bonds hedged by a short position in 5-year government notes could
decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in
the yield curve.
Basis risk: Another important source of interest rate risk (commonly referred to as basis risk) arises from
imperfect correlation in the adjustment of the rates earned and paid on different instruments with
otherwise similar repricing characteristics. When interest rates change, these differences can give rise to
unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS
instruments of similar maturities or repricing frequencies.
Optionality: An additional and increasingly important source of interest rate risk arises from the options
embedded in many bank assets, liabilities and OBS portfolios. Formally, an option provides the holder
the right, but not the obligation, to buy, sell, or in some manner alter the cash flow of an instrument or
financial contract. Options may be stand alone instruments such as exchange-traded options and over-
the-counter (OTC) contracts, or they may be embedded within otherwise standard instruments. While
banks use exchange-traded and OTC-options in both trading and non-trading accounts, instruments with
embedded options are generally most important in non-trading activities. They include various types of
bonds and notes with call or put provisions, loans which give borrowers the right to prepay balances,
and various types of non-maturity deposit instruments which give depositors the right to withdraw
funds at any time, often without any penalties. If not adequately managed, the asymmetrical payoff
characteristics of instruments with optionality features can pose significant risk particularly to those
who sell them, since the options held, both explicit and embedded, are generally exercised to the
advantage of the holder and the disadvantage of the seller. Moreover, an increasing array of options can
involve significant leverage which can magnify the influences (both negative and positive) of option
positions on the financial condition of the firm.
Effects of Interest Rate Risk
As the discussion above suggests, changes in interest rates can have adverse effects both on a bank’s
earnings and its economic value. This has given rise to two separate, but complementary, perspectives
for assessing a bank’s interest rate risk exposure.
Earnings perspective: In the earnings perspective, the focus of analysis is the impact of changes in
interest rates on accrual or reported earnings. This is the traditional approach to interest rate risk
assessment taken by many banks. Variation in earnings is an important focal point for interest rate risk
analysis because reduced earnings or outright losses can threaten the financial stability of an institution
by undermining its capital adequacy and by reducing market confidence. In this regard, the component
of earnings that has traditionally received the most attention is net interest income (i.e. the difference
between total interest income and total interest expense). This focus reflects both the importance of
net interest income in banks’ overall earnings and its direct and easily understood link to changes in
interest rates. However, as banks have expanded increasingly into activities that generate fee-based and
other non-interest income, a broader focus on overall net income – incorporating both interest and non-
interest income and expenses – has become more common. The non-interest income arising from many
activities, such as loan servicing and various asset securitisation programs, can be highly sensitive to
market interest rates. For example, some banks provide the servicing and loan administration function
for mortgage loan pools in return for a fee based on the volume of assets it administers. When interest
rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages
prepay. In addition, even traditional sources of non-interest income such as transaction processing fees
are becoming more interest rate sensitive. This increased sensitivity has led both bank management and
supervisors to take a broader view of the potential effects of changes in market interest rates on bank
earnings and to factor these broader effects into their estimated earnings under different interest rate
environments.
Economic value perspective: Variation in market interest rates can also affect the economic value of a
bank’s assets, liabilities and OBS positions. Thus, the sensitivity of a bank’s economic value to
fluctuations in interest rates is a particularly important consideration of shareholders, management and
supervisors alike. The economic value of an instrument represents an assessment of the present value of
its expected net cash flows, discounted to reflect market rates. By extension, the economic value of a
bank can be viewed as the present value of bank’s expected net cash flows, defined as the expected
cash flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on
OBS positions. In this sense, the economic value perspective reflects one view of the sensitivity of the
net worth of the bank to fluctuations in interest rates. Since the economic value perspective considers
the potential impact of interest rate changes on the present value of all future cash flows, it provides a
more comprehensive view of the potential long-term effects of changes in interest rates than is offered
by the earnings perspective. This comprehensive view is important since changes in near-term earnings
– the typical focus of the earnings perspective – may not provide an accurate indication of the impact of
interest rate movements on the bank’s overall positions.
Embedded losses: The earnings and economic value perspectives discussed thus far focus on how future
changes in interest rates may affect a bank’s financial performance. When evaluating the level of
interest rate risk it is willing and able to assume, a bank should also consider the impact that past
interest rates may have on future performance. In particular, instruments that are not marked to market
may already contain embedded gains or losses due to past rate movements. These gains or losses may
be reflected over time in the bank’s earnings. For example, a long term fixed rate loan entered into
when interest rates were low and refunded more recently with liabilities bearing a higher rate of
interest will, over its remaining life, represent a drain on the bank’s resources.
Measuring Interest Rate Risk
The techniques available for measuring interest rate risk range from calculations that rely on simple
maturity and repricing tables, to static simulations based on current on- and off-balance sheet positions,
to highly sophisticated dynamic modelling techniques that incorporate assumptions about the
behaviour of the bank and its customers in response to changes in the interest rate environment. Some
of these general approaches can be used to measure interest rate risk exposure from both an earnings
and an economic value perspective, while others are more typically associated with only one of these
two perspectives. In addition, the methods vary in their ability to capture the different forms of interest
rate exposure: the simplest methods are intended primarily to capture the risks arising from maturity
and repricing mismatches, while the more sophisticated methods can more easily capture the full range
of risk exposures.

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Foreign Exchange Risk Exposure, Types of Risk

Companies resort to various strategies to contain economic exposure.

Companies are exposed to three types of risk caused by currency volatility −

Translation exposure − Currency fluctuations have an effect on a company’s consolidated financial

Economic Exposure – An Example

Calculating Economic Exposure

Cov (P,S)Var (S)

Economic Exposure – Numerical Example

Cov (P,S) = –1.875

Var (S) = 0.015625

Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million

The economic exposure is usually determined by two factors −

Managing Economic Exposure

Currency risk mitigation strategies

The most common strategies are −

Financial Techniques to Manage Transaction Exposure

The most common methods for hedging transaction exposures are −

Transaction Hedging Under Uncertainty

Uncertainty about transaction date

Uncertainty about existence of exposure

State Bid Accepted Bid Rejected

Operational Techniques for Managing Transaction Exposure

Reinvoicing centers have three main advantages −

Translation Exposure – An Exhibit

Affiliate Amount Account Translation Exposure

Parent CD 200,000 Cash Yes

Parent Ps 3,000,000 Accounts receivable No

Spanish SF 375,000 Notes payable Yes

Canadian Dollar Mexican Peso Euro Swiss Frank

Cash CD0 Ps 3,000 Eu 550 SF0

A/c receivable 0 9,000 1,045 0

Inventory 0 15,000 1,650 0

Net Fixed Assets 0 46,000 4,400 0

Exposed Assets CD0 Ps 73,000 Eu 7,645 SF0

A/c payable CD0 Ps 7,000 Eu 1,364 SF0

Notes payable 0 17,000 935 0

Long term debt 0 27,000 3,520 3,520

Exposed liabilities CD0 Ps51,000 Eu 5,819 SF0

Net exposure CD0 Ps22,000 Eu 1,826 SF0

Hedging Translation Exposure

Balance Sheet Hedge

β = Covariance (P,S)Variance (S)

(2) Economic Exposure – A Practical Example

Table 1 – Renting out your Condo for Case 1

State Probability Rent (Euro) Exchange Rate (S) Rent (P)

1 1/3 €1,800 $1/1.00 E $1,800

3 1/3 €2,200 $1.50/1.00 E $3,300

Suppose we bought a forward contract with a price of $1.25 per euro.

Table 2 – The Beta is the Correct Hedge for Case 1

State Forward Price Exchange rate Yield

1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$

2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0

3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $

Table 3 – Renting out your Condo for Case 2

State Probability Rent (E) Exch. Rate Rent (P)

1 1/3 2,500 $1/1E $2,500

2 1/3 2,000 $1.25/1E $2,500

3 1/3 1,666.67 $1.50/1E $2,500