Post on 04-Apr-2018
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WHAT IS FOREIGN EXCHANGE?
Foreign exchange refers to the financialtransaction where currency value of one country
is traded into another countrys currency. The
whole process gets done by a network of various
financial institutions like banks, investors andgovernments. The exchange rate varies according
to the value of each countrys currency which is
based on the health of that particular countrys
economy.
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FOREIGN EXCHANGE RISK EXPOSURE
Foreign exchange risk (also known as exchange rate risk or currency
risk) is a financial risk posed by an exposure to unanticipatedchanges in the exchange rate between two currencies.Investors and
multinational businesses exporting or importing goods and services
or making foreign investments throughout the global economy are
faced with an exchange rate risk which can have severe financialconsequences if not managed appropriately.
ProsEnhances export sales terms to help exporters remain competitive
Reduces non-payment risk because of local currency devaluation
ConsCost of using some FX risk management techniques
Burden of FX risk management
http://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Financial_risk7/29/2019 Foreign Exchange Risk Exposure
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TYPES OF RISK
Transaction exposure
A firm has transaction exposure whenever it has contractual cash
flows (receivables and payables) whose values are subject to
unanticipated changes in exchange rates due to a contract being
denominated in a foreign currency.
Firms generally become exposed as a direct result of activities such as
importing and exporting or borrowing and investing. Exchange rates
may move by up to 10% within any single year, which can significantly
affect a firm's cash flows, meaning a 10% decline in the value of a
receivable or a 10% rise in the value of a payable. Such outcomes could
be troublesome as export profits could be negated entirely or import
costs could rise substantially.
http://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Accounts_receivablehttp://en.wikipedia.org/wiki/Accounts_payablehttp://en.wikipedia.org/wiki/Accounts_payablehttp://en.wikipedia.org/wiki/Accounts_receivablehttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flow7/29/2019 Foreign Exchange Risk Exposure
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Economic exposure
A firm has economic exposure (also known as operating exposure) to the degree
that its market value is influenced by unexpected exchange rate fluctuations.
Such exchange rate adjustments can severely affect the firm's position with
regards to its competitors, the firm's future cash flows, and ultimately the firm's
value.
Economic exposure can affect the present value of future cash flows.
A shift in exchange rates that influences the demand for a good in some
country would also be an economic exposure for a firm that sells that
good.
http://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_sharehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_sharehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Market_value7/29/2019 Foreign Exchange Risk Exposure
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Translation exposure
A firm's translation exposure is the extent to which its
financial reporting is affected by exchange ratemovements.
Translation exposure may not affect a firm's cash
flows, it could have a significant impact on a firm's
reported earnings and therefore its stock price.
Translation gives special consideration to assets and
liabilities with regards to foreign exchange risk,
whereas exposures to revenues and expenses can oftenbe managed ex ante by managing transactional
exposures when cash flows take place.
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Contingent exposure
A firm has contingent exposure when bidding for
foreign projects or negotiating other contractsor foreign direct investments.
For example, a firm could be waiting for a project
bid to be accepted by a foreign business or
government that if accepted would result in animmediate receivable. While waiting, the firm faces a
contingent exposure from the uncertainty as to
whether or not that receivable will happen. If the bid
is accepted and a receivable is paid the firm then
faces a transaction exposure, so a firm may prefer to
manage contingent exposures.
http://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investmenthttp://en.wikipedia.org/wiki/Foreign_direct_investment7/29/2019 Foreign Exchange Risk Exposure
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Market Risk:
This is when stock or bond prices drop and you appear to lose moneyon your investment. However, most losses are sustained over the short term of
a year or less. As long as you don't sell, your investment will have the chance
to recover from price declines and earn you a greater profit.
Inflation Risk:The risk that the rising costs of inflation will outpace the growth of
your investment over time.
Company Risk:This is the risk that the individual company in which you invest will
fail to perform as expected.
Credit Risk:Specific to bonds, credit risk refers to the company or government's
inability to repay principal plus interest to the bondholder.
OTHER RISKS
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Maturity Risk:Also specific to bonds, this is the risk that the value of a bond may
change from the time it is issued to when it matures. The longer the period to
maturity, the greater the potential for price fluctuation. That is why long-term
bonds generally offer a higher interest rate--to compensate for this greater
risk.
Legislative Risk:Whatever laws the government passes today may be extinct
tomorrow. For example, the long-term capital gains tax rate has been changedfive times in the last 20 years, with the most recent cut at 20%. Factors such
as tax deduction and deferral should never be your sole reason for selecting
an investment. These perks are at the mercy of Congress.
Timing Risk:Timing risk works two ways. First, you run the risk ofinvesting a large sum of money when share prices hit their peak.
Second, there's the risk that you'll need to access your money to pay for
retirement or college expenses during a temporary market setback--
causing you to lose money on your investment.
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Risk Management Process
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Identify Risks Identify risks that affect the project (positively or negatively)
and documenting their characteristics.
Assess & Analyze Risks- Assess the risk impact, Analyze the probability of
risk occurrence and prioritize the risks, numerically analyze the effect ofidentified risks on project objectives (usually on cost, schedule and scope
targets)
Plan ActionsExplore all the possible ways to reduce the impact of threats (or
exploit opportunities). Plan actions to eliminate the risks (or enhance the
opportunities). Action plans should be appropriate, cost effective andrealistic.
Monitor & Implement the ActionTrack the risks throughout the project. If
risks occur then implement the risk strategy based on action plan. Ex. If
mitigation strategy is selected, execute the contingency plan based on risk
triggers. In case contingency plan fails, execute fallback plan.
Measure the effectiveness & Control the risk impact - Measure the
effectiveness of the planned action and controlling the risk impact by
understanding risk triggers & timely implementation of planned actions.
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HEDGINGA hedge is used to reduce any substantial losses/gains suffered by an individual
or an organization.Ex:-
Agricultural commodity price hedging
A typical hedger might be a commercial farmer. The market values
ofwheat and other crops fluctuate constantly as supply and demand for
them vary, with occasional large moves in either direction. Based oncurrent prices and forecast levels at harvest time, the farmer might decide
that planting wheat is a good idea one season, but the forecast prices are
only that forecasts. Once the farmer plants wheat, he is committed to it
for an entire growing season. If the actual price of wheat rises greatly
between planting and harvest, the farmer stands to make a lot ofunexpected money, but if the actual price drops by harvest time, he could
be ruined.
http://en.wikipedia.org/wiki/Wheathttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Supply_and_demandhttp://en.wikipedia.org/wiki/Wheat7/29/2019 Foreign Exchange Risk Exposure
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SWAPS A swap is a foreign currency contract whereby the buyer and seller exchange
equal initial principal amounts of two different currencies at the spot rate.
The buyer and seller exchange fixed or floating rate interest payments intheir respective swapped currencies over the term of the contract. At
maturity, the principal amount is effectively re-swapped at a predetermined
exchanger ate so that the parties end up with their original currencies.
Ex: Consider an export oriented company that has entered into a swap for a
notional principal of USD 1 mn at an exchange rate of 42/dollar. The
company pays US 6months LIBOR to the bank and receives 11.00% p.a.
every 6 months on 1st January & 1st July, till 5 years. Such a company
would have earnings in Dollars and can use the same to pay interest for thiskind of borrowing (in dollars rather than in Rupee) thus hedging its
exposures.
Swaps were first introduced to the public in 1981 when IBM and the World
Bankentered into a swap agreement
http://en.wikipedia.org/wiki/IBMhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/World_Bankhttp://en.wikipedia.org/wiki/IBM7/29/2019 Foreign Exchange Risk Exposure
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FUTURESIn finance, a futures contract is a standardized contract between two parties to
buy or sell a specified asset of standardized quantity and quality for a priceagreed today (the futures price or strike price) with delivery and payment
occurring at a specified future date, the delivery date. The contracts are
negotiated at a futures exchange, which acts as an intermediary between the two
parties. The party agreeing to buy the underlying asset in the future, the "buyer"
of the contract, is said to be "long", and the party agreeing to sell the asset in the
future, the "seller" of the contract, is said to be "short".
OPTIONS
Anoption
is a derivativefinancial instrument that specifies a contract betweentwo parties for a future transaction on an asset at a reference price (the
strike). The buyer of the option gains the right, but not the obligation, to engage
in that transaction, while the seller incurs the corresponding obligation to fulfill
the transaction.
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Long_(finance)http://en.wikipedia.org/wiki/Short_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Financial_instrumenthttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Short_(finance)http://en.wikipedia.org/wiki/Long_(finance)http://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Strike_pricehttp://en.wikipedia.org/wiki/Contracthttp://en.wikipedia.org/wiki/Finance7/29/2019 Foreign Exchange Risk Exposure
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TYPES OF DERIVATIVES
Derivatives are products whose value is derived from one or more basic
variables called underlying assets or base . In simpler form, derivatives arefinancial security such as an option or future whose value is derived in part
from the value and characteristics of another an underlying asset. The primary
objectives of any investor are to bring an element of certainty to returns and
minimize risks. Derivatives are contracts that originated from the need to limit
risk.
Advantages of Derivatives:
They help in transferring risks from risk adverse people to risk oriented people.
They help in the discovery of future as well as current prices.
They increase the volume traded in markets because of participation of riskadverse people in greater numbers.
They increase savings and investment in the long run.
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Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today.
Future ContractsA futures contract is an agreement between two parties a buyer and a seller
to buy or sell something at a future date.
Options Contracts
Options are of two types calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price onor before a given future date. Puts give the buyer the right, but not the obligation
to sell a given quantity of the underlying asset at a given price on or before a
given date.
Swaps
Swaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula.
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