Chapter 12

Chapter 12
Foreign Exchange
Risk and Exposure
Objectives
• To define risk and exposure

• To elaborate on the concept of value at risk (VAR)
• To distinguish among transaction, economic and
translation exposure
Copyright  2010 McGraw-Hill Australia Pty Ltd

PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
12-2
Definitions of risk
• The chance of bad consequence, loss, etc.

(The Concise Oxford Dictionary)
• The possibility of loss, injury, disadvantage or
destruction (Webster’s Dictionary)
(cont.)
12-3
Definitions of risk (cont.)
• The origin of the word ‘risk’ is either the Arabic risq or

the Latin risicum
(cont.)
12-4
Definitions of risk (cont.)
• In finance, a distinction is made between risk and

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

12-5
FX risk
• FX risk arises because of uncertainty about the

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

12-6
Rate of return
Vt 1
R V 
 1
Vt
V  SV 

R  (1  S )(1  V )  1
 

12-7
Measuring risk: probability distribution
n
E ( R)   pi ( Ri )
i 1
 Ri  E ( R) 2
n
 ( R) 
2
 pi
i 1

12-8
Measuring risk: historical data
1 n
R
n
R
t 1
t
1 n
 (R)
2
n 1
t 1
( Rt  R )2

12-9
Measurement of VAR
• Measurement unit (e.g. AUD)

• Time horizon (one day, one week, etc.)
• Probability (1-5%)

12-10
Implementation of VAR analysis
• Parametric (analytical) approach

• Historical approach
• Simulation approach

12-11
The parametric approach
• The approach is based on the assumption of the

normality of rates of return
(cont.)
12-12
The parametric approach (cont.)
Per cent of Lowest r Highest r Probability VAR

Observations
68 r  r  16.0 K (r   )
90 r  1.65 r  1.65 5.0 K (r  1.65 )
95 r  1.96 r  1.96 2.5 K (r  1.96 )
98 r  2.33 r  2.33 1.0 K (r  2.33 )
99 r  3 r  3 0.5 K (r  3 )

12-13
The historical approach
• VAR with a certain probability is calculated from the

lower nth percentile of historical observations on the
rate of return

12-14
The simulation approach
• VAR with certain probability is calculated from the

lower nth percentile of simulated observations on the
rate of return
• Observations are generated from Monte Carlo
simulation by specifying a probability distribution and
its parameters

12-15
VAR: pros
• It is simple
• It is suitable for risk-limit setting and performance
measurement
• It can take account of complex movements

12-16
VAR: cons
• It can be misleading
• VAR estimates are highly sensitive to the underlying
assumptions
• It cannot cope with sudden or sharp changes

12-17
VAR: conclusion
• VAR is useful but it should be handled with care and

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

12-18
Exposure
• Risk measures the probability and magnitude of

deviation from some expected outcome
• Exposure is a measure of the sensitivity of what is at
risk to the source of risk

12-19
FX exposure
• Exposure to FX risk is a measure of the sensitivity of

the domestic currency value of FX items to changes
in the exchange rate
• Sometimes it is defined as the amount at risk

12-20
The slope of the exposure line
V  βS
where  is the slope of the exposure line.  is

positive (negative) for assets (liabilities)

12-21
Long and short exposures
• Long exposure  assets

• Short exposure  liabilities

12-22
Combined exposure
• A combined exposure arises when a firm holds both

foreign assets and foreign liabilities

12-23
The relation between FX risk and exposure
σ 2 (V )  β 2σ 2 ( S )

12-24
Multiple exposure
• Exposure to more than one currency:
V   0  1S ( x0 / x1 )     n S ( x0 / xn )

12-25
The volatility of the AUD exchange rates
• The standard deviations of monthly percentage

changes in exchange rates
USD/AUD JPY/AUD EUR/AUD GBP/AUD

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

12-26
Transaction exposure
• Transaction exposure arises if payables and

receivables are denominated in foreign currencies. It
is a cash flow exposure associated with trade and
capital flows

12-27
Transaction exposure (examples)
• Foreign assets or liabilities that are already recorded

on the balance sheet
• A contract or an agreement involving a future foreign
currency cash flow

12-28
Volatility and correlation
• Exposure to a currency that fluctuates sharply is

more of a source of concern
• Exchange rate correlations are important

12-29
Economic exposure
• Changes in exchange rates affect the firm’s non-

contractual or unplanned cash flows
• It refers to future changes in earning power as a
result of changes in exchange rates

12-30
Measurement of economic exposure
• Economic exposure cannot, in general, be known

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

12-31
Translation (accounting) exposure
• Translation exposure arises from the consolidation of

foreign currency assets, liabilities, net income and
other items
• Conversion may produce gain or loss

12-32
Translation rates
• Closing (current) rate

• Average rate
• Historical rate

12-33
The closing rate
• The closing rate (or current rate) is the rate

prevailing at the end of the accounting period (that is,
coinciding with the balance sheet date)

12-34
The average rate
• The average rate is the average value of the

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

12-35
The historical rate
• The historical rate is the rate prevailing on the date

when an asset is acquired or a liability is committed
• The historical rate may therefore fall outside the
current accounting period. In fact, this is invariably
the case for long-term assets and liabilities

12-36
Translation methods
• Current/non-current method
• Closing (current) rate method
• Monetary/non-monetary method
• Temporal method

12-37
Current/non-current method
• According to this method, current items are

translated at the closing rate, whereas long-term
items are translated at the historical rate

12-38
Closing (current) rate method
• Assets and liabilities are translated at the exchange

rate prevailing at the end of the accounting period

12-39
Monetary/non-monetary method
• Monetary items (such as bonds) are translated at the

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

12-40
Temporal Method
• According to the temporal method, the use of the

closing rate or the historical rate is determined by the
valuation of the underlying item
• The closing rate is used for items stated at
replacement cost, realisable value or market value
• The historical rate is used for all items stated at
historical cost

12-41
Some principles
• Translation of balance sheet items is based on the

closing rate
• Transaction gains and losses are accounted for in
the income statement
(cont.)
12-42
Some principles (cont.)
• Non-transaction gains and losses are represented by

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

12-43

Chapter 12

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Chapter 12

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Chapter 12

• To define risk and exposure

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The chance of bad consequence, loss, etc.

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

• In finance, a distinction is made between risk and

Copyright  2010 McGraw-Hill Australia Pty Ltd

• FX risk arises because of uncertainty about the

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Measurement unit (e.g. AUD)

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Parametric (analytical) approach

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The approach is based on the assumption of the

Per cent of Lowest r Highest r Probability VAR

Copyright  2010 McGraw-Hill Australia Pty Ltd

• VAR with a certain probability is calculated from the

Copyright  2010 McGraw-Hill Australia Pty Ltd

• VAR with certain probability is calculated from the

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• VAR is useful but it should be handled with care and

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Risk measures the probability and magnitude of

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Exposure to FX risk is a measure of the sensitivity of

Copyright  2010 McGraw-Hill Australia Pty Ltd

where  is the slope of the exposure line.  is

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Long exposure  assets

Copyright  2010 McGraw-Hill Australia Pty Ltd

• A combined exposure arises when a firm holds both

Copyright  2010 McGraw-Hill Australia Pty Ltd

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Exposure to more than one currency:

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The standard deviations of monthly percentage

USD/AUD JPY/AUD EUR/AUD GBP/AUD

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Transaction exposure arises if payables and

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Foreign assets or liabilities that are already recorded

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Exposure to a currency that fluctuates sharply is

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Changes in exchange rates affect the firm’s non-

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Economic exposure cannot, in general, be known

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Translation exposure arises from the consolidation of

Copyright  2010 McGraw-Hill Australia Pty Ltd

• Closing (current) rate

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The closing rate (or current rate) is the rate

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The average rate is the average value of the

Copyright  2010 McGraw-Hill Australia Pty Ltd

• The historical rate is the rate prevailing on the date

Copyright  2010 McGraw-Hill Australia Pty Ltd