Foreign Currency Risk

Refer: Chapter 13,22(part),23(part)-Financial Institutions Management

by Saunders/Cornett
FX Risk

• Cross Country Transactions, facilitating such transactions(Banks) or

conducting such transactions(Corporate) expose entities to Foreign Currency
Risk
• Foreign Currency: (Often not obvious for MNC and Transnational)Any
Currency which is different from currency in which the balance sheet is
created-Usually the domestic currency of the country in which the entity is
incorporated.
• Volatility in FX rate movement leading to volatility in local/domestic
currency value of the Net FX position is FX risk
• Unmatched FX positions both in Balance Sheet or PnL can expose the entity
to FX Risk
 FX Risk: Exposure are Balance Sheet Level
Balance Sheet 1 (INR) Balance Sheet 1 (INR) INR Depreciates to 60/USD
• Balanced Exposure to FX denominated
Asset Liability Asset Liability
Asset and FX Denominated Liability
FX Fin. Asset of FX Debt of FX Fin. Asset of FX Debt of
USD 100 @ USD 100 USD 100 @ USD 100 • No Change in Capital Structure
50/USD 5000 @50/USD 5000 60/USD 6000 @50/USD 6000
Domestic Asset 10000 Equity 10000 Domestic Asset 10000 Equity 10000

Balance Sheet 2 (INR) Balance Sheet 2(INR) INR Depreciates to 60/USD

Asset Liability Asset Liability • FX Liability(Debt) with No FX Assets
FX Debt of
• Deterioration in Capital Structure due to
FX Debt of
USD 100 USD 100 Domestic currency depreciation
@50/USD 5000
Domestic
@50/USD
•
6000 Typical Emerging Market Company Feature

Domestic Asset 15000 Equity 10000 Asset 15000 Equity 9000

Balance Sheet 3 (INR) Balance Sheet 3 (INR) • FX Denominated Asset But No FX

Asset Liability Asset Liability
denominated Liability
FX Fin. Asset of Domestic FX Fin. Asset of Domestic
USD 100 @ Currency USD 100 @ Currency • Likely situation in developed countries ;
50/USD 5000 Debt 5000 60/USD 6000 Debt 5000 owners of reserve currencies and Low
Domestic Asset 10000 Equity 10000 Domestic Asset 10000 Equity 11000
interest rate
 FX Risk: Exposure are Profit & Loss Account Level
PnL1 (INR) PnL1 (INR) INR Depreciates to 60/USD
Revenue Expenses Revenue Expenses • Balanced Revenue-Cost Structure (FX Revenue
FX Revenue (USD FX Revenue (USD as Proportion of total revenue Same As FX
100 @ 50/USD) 5000 FX Expense 4000 100 @ 60/USD) 6000 FX Expense 4800 Cost as a proportion of total expense
Domestic Revenue 10000 Domestic 8000 Domestic Revenue 10000 Domestic 8000
PBT 3000 PBT 3200
• Currency Fluctuation does not change
operating margin

PnL –Theoretical Pure Exporter (INR) PnL –Theoretical Pure Exporter (INR) INR60/USD
Revenue Expenses Revenue Expenses
• Margin Expansion with Domestic
FX Revenue (USD
currency depreciation
FX Revenue (USD
100 @ 50/USD) 5000 FX Expense 0 100 @ 60/USD) 6000 FX Expense 0
Domestic Revenue 10000 Domestic 12000 Domestic Revenue 10000 Domestic 12000
PBT 3000 PBT 4000

PnL –Real Exporter 1 (INR) INR60/USD PnL –More Real Exporter 1 (INR) INR60/USD
Revenue Expenses Revenue Expenses
FX Revenue (USD FX Revenue (USD
100 @ 60/USD) 6000 FX Expense 2400 100 @ 60/USD) 5500 FX Expense 2400
Domestic Revenue 10000 Domestic 10000 Domestic Revenue 10000 Domestic 10000
PBT 3600 PBT 3100

Margin Expansion limited by FX Margin Expansion limited by FX

expenses also incurred ; Such cost of expenses AND long term contact
FX raw material, cost of sells, FX clauses refer to price renegotiation
 FX Risk: Exposure are Profit & Loss Account Level
PnL –Theoretical Pure Importer (INR) PnL –Theoretical Pure Importer (INR) INR60/USD • Commodities such as Oil and Steel are
Revenue Expenses Revenue Expenses domestically priced at import parity
FX Revenue (USD FX Revenue (USD pricing(IPP) so the absolute domestic
100 @ 50/USD) 0 FX Expense 8000 100 @ 50/USD) 0 FX Expense 9600
Domestic Revenue 15000 Domestic 4000
currency PBT remains broadly unaffected
Domestic Revenue 15000 Domestic 4000
PBT 3000 PBT 1400 • All importers who are able to pass on the
price to customers keep their absolute
PnL –Commodity Importer (INR) INR60/USD
margin intact but percentage margin
Revenue Expenses
suffers;
FX Revenue (USD • Of Course higher price affects volumes
100 @ 50/USD) 0 FX Expense 9600 which may squeeze profitability
Domestic Revenue 16600 Domestic 4000
PBT 3000
 FX Risk: Net Exposure
Net Exposure:{ FX Assets – FX Liabilities} + {FX Bought(or FX Received)-FX Sold(or FX Spend)}
Net Exposure >0; Long on FX; Benefits from Domestic Currency Depreciation
Exporters are long of FX; As well as Investors in FX denominated Asset; These entities benefit
when FX Appreciates ( ie; Domestic Currency Depreciates)
Net Exposure <0; Short on FX; Benefits from Domestic Currency Appreciation
Importers are Short on FX; They Benefit when FX Depreciates (ie; Domestic currency Appreciates)
As well as companies with USD/EURO/Yen Denominated debt

FX Hedging is done to provide higher certainty/predictability to cashflow against variability of FX

FX Hedging Can be On Balance Sheet( Taking actual balance sheet level exposure to cancel FX
exposure) or off-Balance Sheet Exposure.
Off-Balance Sheet Exposure ( Forwards/Future/Swap-At Time of Inception; Options) are in nature
of contingent assets/liabilities.
FX Risk: Hedging

• The Derivatives position is exactly opposite to the underlying

asset/cash position.
• In absence of basis risk( a theoretical premise which assumes perfect
correlation between future and spot market) the loss or gain in
underlying position is exactly matched by a corresponding gain or loss
in the derivatives position- Generating pre-determined cashflow-Thus
Hedged
• Since the correlation between the spot position and forward position
is not perfect, historical data is used to calculate the correlation and
determine the number of futures that is required to hedge the
underlying…. Of Course the correlation itself often changes in future
time .. Increasing the basis risk.