Foreign Exchange

Risk Management
Risk and Exposure
 Risk is the possibility of deviation between actual result and
expected result.
 Greater the magnitude of deviation and greater probability of its
occurrence, greater is the risk.
 Exposure indicates a situation of being open or being vulnerable to
risks
 Risk Management is the steps taken to minimize the risk by
adopting appropriate techniques or policies.
 Risk management is possible through
• Pooling (Insurance or the risk taken by third party)
• Hedging (Risk of one party is cancelled by other part)
Foreign Exchange Risk
 Exchange risk originates from the (random) fluctuations of foreign
exchange rates.
 Risk of loss due to changes in the international value of national
currencies
 The value of a future receipt or obligation will change due to a
change in foreign exchange rate.
 Adverse effects that unanticipated exchange rate changes can have
on the value of the firm.

The emphasis is here on unexpected changes, as anticipated changes

in the foreign exchange rate including all other available
information are already reflected in market prices.
Foreign Exchange Exposure
 Translation Exposure/Accounting Exposure/Balance Sheet Exposure
 Changes in income statement items and
 The book value of balance sheet assets and liabilities
 That are caused by an exchange rate change.
 Transaction Exposure
 Changes in the value of outstanding foreign-currency-denominated
contracts
 Measurement of transaction exposure mixes the retrospective and
prospective
 Operating Exposure
 Changes in the amount of future operating cash flow caused by an
exchange rate change
 Prospective in nature as it is based on future activities.
Question
On 1st February, a business entity in Delhi purchases materials from
Euroland. The invoice amount of 5,00,000 Euro is payable at the end of
April. The spot rate on 1st February was Rs. 49 – 50. the entity incurs a
conversion expenditure of Rs. 50 Lacs. Finished goods were sold to a
company in USA on 15th March. Invoice value of FG was US $12,50,000.
terms of sale included payment at the end of April. Spot rate on 15 th
March was Rs. 45-46. other selling expenses amounted to Rs. 10 Lacs. At
the end of April, the spot rates stood at
INR/Euro : 51 – 52
INR/$ : 44-45
Calculate the actual cash profit
Compute Impact of exchange rate movements on profitability
Name the nature of Foreign Exchange Risk
Computation of Actual Profit (In Lacs except Exchange Rate)

Particulars FC ER Rs.
Materials (Euro) 5.00 50.00 250.00
Conversion Cost 50.00
Other Expenses 10.00
Total Expenses 310.00
Invoice Value of Sales 12.50 45.00 562.50
Profit 252.50

Impact on Profits due to Exchange Rate

Particulars FC in Lacs Impact Rs. In Lacs
Profit earned 252.50
Materials (Euro) 5.00 52-50 = (2) (10.00)
Sales 12.50 45-44 = (1) (12.50)
Net Impact (22.50)
Cash Profit 230.00
Management of Transaction Exposure
Transaction Exposure
Management

Home
Leading and Hedging
Currency Netting
Lagging
Invoicing

Forward

Bilateral Multi-lateral
Netting Netting Futures

Options

Forward-
Options
International Equity Investing
 Direct Investing
 American Depository Receipts (ADR) – Sponsored, Unsponsored
 Global Depository Receipts (GDR) – Sponsored, Unsponsored
 Mutual Funds (International Funds)

 Change in Currency Exchange Rate

 Dramatic changes in market value
Risk in
International  Political, Economic and Social events
Equity Investing  Liquidity risk
 Less information
 Reliance on foreign legal remedies
 Different market operations
International CAPM (ICAPM)
 CAPM is fundamental toll for assessing the relationship between risk and
return for any investment decision.
 ICAPM is extension of CAPM
 ICAPM considers the significance of global diversification and its impact on
asset pricing.

 Global Consideration
 Exchange Rate Risk
Factors of
ICAPM  Global Market Portfolio
 Investors Preference
 International Risk factors
 Market proxies
International CAPM (ICAPM)

RFR - Domestic Risk Free Rate

Rm​- Expected return of market
Rf​- Risk free rate
Rm​− Rf​- Premium for global market risk measured in local currency
FCRP - Foreign Currency Risk Premium​
International CAPM (ICAPM)
 Should the corporate proxies be Domestic or Foreign
companies?
 Is the relevant base portfolio against which the proxy betas
are estimated the Indian market portfolio, the local
portfolio, or the world market portfolio?
 Should the market risk premium be based on the foreign
market or the local market?
 How, if at all, should country risk be incorporated in the cost
of capital estimates?
Corporate Proxies for ICAPM
Relevant Base Case Portfolio