Assessment of Risks in International Portfolios

8/8/2019 Assessment of Risks in International Portfolios

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PART I: TYPE OF RISKSCurrency RiskCountry Risk

Political Risk

Social Risk

Estimation Risk


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CURRENCY RISK


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WHAT IS CURRENCY RISK?

The risk that an unfavourable change in

the value of a currency will result in

unpredictable increase in earnings, cash

flow, or value is Currency Risk.


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WHAT IS CURRENCY HEDGING?

It is a strategy that is generally used in

an attempt to reduce the risk and

impact of adverse currency

movements to protect the value of the

investment.


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STEPS FOR CURRENCY RISK MANAGEMENT

RiskDefinition

RiskDefinition

MeasurementMethodology

MeasurementMethodology

ExposureGathering

ExposureGathering

CoveringStrategy

CoveringStrategy

HedgeExecution

HedgeExecution


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TYPES OF RISKS

Currency

Risk

TransactionExposure

TranslationExposure

OperatingExposure


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Types of Risks

Transaction Risk:

The risk, faced by

companies involvedin international

trade, that currencyexchange rates will

change after thecompanies have

already entered intofinancial obligations.

Translation/AccountingExposure:

The risk that acompany's equities,assets, liabilities orincome will change

in value as a resultof exchange ratechanges.

Operating Exposure:

Operating Exposure

measures the extentto which currency

fluctuations can altera companys future

operating cashflows, that is, its

future costs andrevenues.


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HEDGING TRANSACTION RISK


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HEDGING TRANSACTION RISK

Futures

Contracts

Futures

Contracts

MoneyMarketMoneyMarket

OptionsOptions

SwapsSwaps

Forward

Contracts

Forward

Contracts


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FORWARD CONTRACTS

A forward contract is a transaction in which delivery

of the commodity is deferred until after the contract

has been made.

It is a made-to-measure agreement between two

parties to buy/sell a specified amount of a currency

at a specified rate on a particular date in the future.

Although the delivery is made in the future, the

price is determined on the initial trade date.


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FORWARD CONTRACTS

The depreciation of the receivable currency is hedged against by selling

a currency forward.

The appreciation of payable currency is hedged against by buying

currency forward.

For instance if RIL wants to buy crude oil in US dollars six months hence,

it can enter into a forward contract to pay INR and buy USD and lock in a

fixed exchange rate for INR-USD to be paid after 6 months, regardless of

the actual INR-Dollar rate at the time. Here, the risk is an appreciation of

Dollar which is protected by a fixed forward contract.


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FORWARD CONTRACTS

The main advantage of a forward is that it can be

tailored to the specific needs of the firm and an

exact hedge can be obtained.

On the downside, these contracts are not

marketable i.e. they cant be sold to another party

when they are no longer required, and are binding.


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FORWARD CONTRACTS

The gain from a forward position at maturity depends on the

relationship between the delivery price (K) and the spot

price STat that time.

For a long position this payoff is: fT= ST K

For a short position, it is: fT= K ST


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FUTURES CONTRACTS

A futures contract is similar to the forward contract but is more

liquid since it is traded in an organized exchange i.e. the

futures market.

Futures Contract is defined as a standardized, transferable,

exchange-traded contract that requires delivery of a

commodity, bond, currency, or stock index, at a specifiedprice, on a specified future date.


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FUTURES CONTRACTS

Accounts receivables are hedged by taking a short position,

and accounts payable are hedged by acquiring a long

position.

Also, expected depreciation of a currency can be hedged by

selling futures and appreciation can be hedged by buying

futures.


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FUTURES CONTRACTS

For example, a U.S. business has an account payable for

$50,000 Canadian, due on the third Wednesday in

September. The company could buy one September

Canadian Dollar futures contract. If the value of the Canadian

dollar increased, the U.S. dollar value of the companys

account payable would increase, resulting in a reduction in the

companys value. However, the value of the futures contract

would increase by an equal amount, leaving the net value of

the company unchanged. If the value of the Canadian Dollar

decreased, the U.S. dollar value of the payable account would

increase, but the value of the futures contract would decrease

by an equal amount.


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ADVANTAGES OF FUTURES CONTRACTS

Central market for futures, eliminating the problem of

double coincidence

Easily accessible to all market participants

Price transparency and efficiency is maintained by the

clearing house.

Futures require a small initial outlay providing leverage.


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DISADVANTAGES OF FUTURES CONTRACTS

Futures contract are marked to marketon a daily basis. Any

losses must be made up in cash on a daily basis, while the

offsetting gain on the currency transaction will be deferred until

the transaction actually occurs. This imbalance can result in a

severe liquidity crisis for small companies and for individuals.

Trade only in standardized amounts and maturities. Companies

may not have the choice of timing their receivables and payables

to coincide with standardized futures contracts. Consequently,

the hedges are not perfect.


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MONEY MARKET HEDGE

It is defined as the borrowing and lending in multiple currencies to

eliminate currency risk by locking in the value of a foreign currency

transaction in one's own country's currency).

For example, suppose a U.S. exporter expects to receive four million

Indian Rupees in one month from an Indian customer. The business

could eliminate uncertainty about the rate of currency exchange by

borrowing rupees in India at an interest rate of 10 percent per month:

The Company can convert the rupees into U.S. dollars at the spot rate.

When the Indian customer pays the four million rupees one month later,

it is used to pay off the principle and interest accrued on the loan in India.


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MONEY MARKET HEDGE

The difference between the borrowing and the lending interest

rates is the cost of a money market hedge.

Banks lend funds at a higher interest rate than they pay forfunds to earn a profit. The interest rate increases if default risk

is present.

When the banks risk is low, the companys borrowing and

lending rates are close to the risk-free rate. In this case, even

if forward and futures contracts are available, a money market

hedge may be the least costly hedging alternative.


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OPTIONS

A currency Option is a contract giving the right, not the

obligation, to buy or sell a specific quantity of one foreign

currency in exchange for another at a fixed price, called the

Exercise Price or Strike Price.

The fixed nature of the exercise price reduces the uncertainty

of exchange rate changes and limits the losses of open

currency positions.


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OPTIONS

If the exchange rate moves in favour of the option holder, the option can be

exercised and the holder is protected from loss. On the other hand, if the rate

moves against the holders, they can let the option expire, but profit, by selling the

foreign currency in the spot market.

For example RIL needs to purchase crude oil in USD in 6 months. If RIL buys a

Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a

specified amount of dollars at a fixed rate on a specified date, there are two

scenarios. If the exchange rate movement is favourable i.e. the dollar depreciates,

then RIL can buy them at the spot rate as they have become cheaper, and let the

option expire. In the other case, if the dollar appreciates compared to todays spot

rate, RIL can exercise the option to purchase it at the agreed strike price. In either

case RIL benefits by paying the lower price to purchase the dollar


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OPTION STRATEGIES

Currency OptionsStrategies for

Importers

(Bullish Market)


Importers

(Bullish Market)

Purchase Call OptionPurchase Call Option Sell Put OptionSell Put OptionPurchase Call and

Sell Put Option

Purchase Call and

Sell Put Option


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OPTION STRATEGIES


Importers

(Bearish Market)


Importers

(Bearish Market)

Purchase Put OptionPurchase Put Option Sell Call OptionSell Call OptionPurchase Put andSell Call Option

Purchase Put andSell Call Option


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OPTION STRATEGIES


Importers

(Volatile Market)

Long Straddle Long Strangle Short Butterfly Short Condor


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SWAPS

Swap is defined as an exchange of streams of payments over time

according to specified terms.

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 in

their respective swapped currencies over the term of the contract. At

maturity, the principal amount is effectively re-swapped at a

predetermined exchange rate so that the parties end up with their

original currencies.


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SWAPS

Consider an export oriented company that has entered into a

swap for a notional principal of USD 1 million at an exchange rate

of Rs. 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 this kind of borrowing (in dollars rather

than in Rupee) thus hedging its exposures.


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SWAPS

The advantages of swaps are that firms with limited appetite

for exchange rate risk may move to a partially or completely

hedged position through the mechanism of foreign currency

swaps, while leaving the underlying borrowing intact.

Apart from covering the exchange rate risk, swaps also allow

firms to hedge the floating interest rate risk.


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HEDGING TRANSLATION RISK


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TRANSLATION RISK

Translation or accounting risk is the risk that a company's

equity, assets, or income will change in value as a result of

exchange rate changes.

Translation exposures arise from accounting conventions

rather than cash movements and can be subdivided into those

arising in the balance sheet, and those arising in the profit andloss account.


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METHODS OF TRANSLATION

The translation of all of a foreign subsidiary's currentassets and liabilities into home currency at the current exchange rate whilenoncurrent assets and liabilities are translated at the historical exchangerate; that is, the rate in effect at the time the asset was acquired or theliability incurred.

Current/Non-Current Method

Under this translation method, monetary items (e.g. cash, accounts

payable and receivable, and long-term debt) are translated at the currentrate while non-monetary items (e.g. inventory, fixed assets, and long-term investments) are translated at historical rates.

Monetary/Non-MonetaryMethod

A currency translation method under which the choice of exchangerate depends on the underlying method of valuation. Assets andliabilities valued at historical cost (market cost) are translated at the

historical (current market) rate.

TemporalMethod

All balance sheet items are translated at the current rate under this method

Current Method


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FASB 8

Essentially the temporal method, with some subtleties, such

as translating inventory at historical rates, which is a hassle.

Requires taking foreign exchange gains and losses through

the income statement.

This leads to variability in reported earnings.


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FASB 52

Functional Currency

The currency that the business is conducted in.

Reporting Currency

The currency in which the MNC prepares its

consolidated financial statements.


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FASB 52

Two-Stage Process

First, determine in which currency the foreign entity

keeps its books.

If the local currency in which the foreign entity keeps

its books is not the functional currency, re-

measurement into the functional currency is required.

Second, when the foreign entitys functional currency

is not the same as the parents currency, the foreign

entitys books are translated using the current rate

method.


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FASB 52 Is the currency usedfor book-keepingparent companys

currency?

Yes

Simply add to theparent companys

books

No

Is the currency usedfor book-keeping

functional?

Yes

Translate into parentcompanys currency

No

Translate into afunctional curreency


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FASB 52

Translation Gains or Losses

1. Recorded in separate equityaccount on balance sheet.

2. Known as cumulative

translation adjustment account.

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Assessment of Risks in International Portfolios

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