Final FX Risk & Exposure Management

8/8/2019 Final FX Risk & Exposure Management

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Foreign Exchange & ForeignCurrency Risk/Exposure

Management


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Foreign Exchange & Foreign

Currency Risk/ExposureManagement

Amit Kalikar -19Kunal Kulkarni- 22Ketan palkar - 29Karuna salunke-40Jigar shah 44Mansi Trivedi-55


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Foreign Currency RiskCurrency risk is a form of risk that arises from the change inprice of one currency against another.

Foreign exchange risk is the risk that the value of an assetor liability will change because of a change in exchangerates.

The exchange risk associated with a foreign denominatedinstrument is a key element in foreign investment. This riskflows from differential monetary policy and growth in realproductivity, which results in differential inflation rates


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For example:

A New York-based manufacturing company signs a $1million contract with a French business partner. Thecontract amount is denominated in euros, and 1 euroequals 1 dollar on the date the contract is signed. Threeyears later, the euro rises with respect to the dollar, and 1

euro is now valued at 2 dollars. The manufacturing firmincurs a $500,000 foreign currency loss ($1 million dividedby two).

Foreign Currency Risk


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C urrency risk exists regardless of whether you areinvesting domestically or abroad. If you invest in yourhome country, and your home currency devalues, youhave lost money. Any and all stock market investments aresubject to currency risk, regardless of the nationality of theinvestor or the investment, and whether they are the

same or different. The only way to avoid currency risk is toinvest in commodities, which hold value independent of any monetary system.



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W hen a firm conducts transactions in different currencies,it exposes itself to risk. The risk arises because currenciesmay move in relation to each other. If a firm is buying andselling in different currencies, then revenue and costs canmove upwards or downwards as exchange rates betweencurrencies change. If a firm has borrowed funds in a

different currency, the repayments on the debt couldchange or, if the firm has invested overseas, the returnson investment may alter with exchange rate movements

this is usually known as foreign currency exposure.



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TYP ES OF FOREIGNEXCHANGE RISK

Transaction risk.Position risk.Settlement or credit risk.Operational risk.Sovereign risk.C ross- country risk


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Transaction risk : Any transaction leading to futurereceipts in any form or creation of long term asset

This consists of a number of:1 Trading items

2 Capital items

Position risk : A position risk occurs when a dealer inbank has an overbought (long) or an oversold (short)position.


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S ettlement risk : S ettlement risk is the risk of acounterparty failing to meet its obligations in a financialtransaction after the bank has fulfilled its obligations onthe date of settlement of the contract.

Operational risk : Operational risk are related to themanner in which transactions are settled or handled

operationally.S ome of the Operational risks are :

D ealing and settlementConfirmation

Pipeline transactions



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S overeign risk : Another risk which banks and otheragencies that deal in foreign exchange have to be awareof is sovereign risk- the risk on the government of acountry.

Cross- country risk : It is often not prudent to have large

exposures on any one country may go through troubledtimes however In such a situation, the bank/entity thathas an exposure could suffer huge losses



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TYPES OF EX

POSURE

The risk that the domestic cost or proceedsof a transaction may change

TransactionExposure

The risk that the translation of value of foreign-currency-denominated assets isaffect by exchange rate changes.

TranslationExposure

The risk that exchange rate changes mayaffect the present value of future incomestreams.

EconomicExposure


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Foreign Exchange ExposureManagement


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ForecastsAfter determining its exposure, the first step for a firm isto develop a forecast on the market trends and what themain direction/trend is going to be on the foreign

exchange rates.

The period for forecasts is typically 6 months.

It is important to base the forecasts on valid assumptions.

Along with identifying trends, a probability should beestimated for the forecast coming true as well as howmuch the change would be


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Risk EstimationB ased on the forecast, a measure of the Value at Risk (theactual profit or loss for a move in rates according to theforecast) and the probability of this risk should be

ascertained.

The risk that a transaction would fail due to market-specific problems should be taken into account.

Finally, the Systems Risk that can arise due toinadequacies such as reporting gaps and implementationgaps in the firms exposure management system shouldbe estimated.


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Benchmarking

G iven the exposures and the risk estimates, the firm hasto set its limits for handling foreign exchange exposure.

The firm also has to decide whether to manage itsexposures on a cost centre or profit centre basis.

A cost centre approach is a defensive one and the mainaim is ensure that cash flows of a firm are not adverselyaffected beyond a point.

A profit centre approach on the other hand is a moreaggressive approach where the firm decides to generate anet profit on its exposure over time


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HedgingThis is the general term used for the process of protectingthe accountable value of foreign currency monetary assetsand liabilities by anticipating future exchange ratemovements. Exposure to unrealized foreign exchange(translation) losses can be reduced to nil, or to a defined orbudgeted amount, by entering into forward exchangecontracts or using other hedging instruments, taking due

consideration of the cost/benefit relationships. It can bealso achieved by "natural" hedging, for instance, wherebyforeign assets are financed by foreign borrowings, both inthe same currency.


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Stop LossIt is imperative to have stop loss arrangements in order torescue the firm if the forecasts turn out wrong.

For this, there should be certain monitoring systems inplace to detect critical levels in the foreign exchange ratesfor appropriate measure to be taken.


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Reporting and ReviewRisk management policies are typically subjected toreview based on periodic reporting. The reports mainlyinclude profit/ loss status on open contracts after markingto market, the actual exchange/ interest rate achieved oneach exposure, and profitability vis--vis the benchmarkand the expected changes in overall exposure due toforecasted exchange/ interest rate movements.The review analyses whether the benchmarks set arevalid and effective in controlling the exposures, what themarket trends arefinally whether the overall strategy is working or needschange.


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W hy should we hedge ?

Case Study


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Risk Management Policy approved by B oard of Directors stating risks, means tomitigate these risks; defining authorities, responsibilities & controls and statingbroad parameters within which treasury has to function. Policy reviewed by board

periodically.Risk Management B oard is responsible for policy implementation, strategyformulation & periodic review of decisions.

TC S Treasury is not a profit centre but a facilitator with an objective of protecting

accounting / budgeted rates thereby reducing unpredictability & volatilityFollows globally used FAS 133 accounting standard

Use of only simple accounting compliant structures. It necessitates that each hedgeto be

TCS Policy


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Hedge the net exposure:

Budgeted Revenue 100

Budgeted Expenses 30 (Provides Natural Hedge) _______________________________________________________________________________________________________________________________________________________________________________________

Net Exposure 70

Maximum Hedges 70

TCS Policy


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TCS Policy

Ty pes of Exposures


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All the current risks (Receivables, current revenue) & hedges against current

risks (non-cash flow hedges) are marked to market every quarter end andbooked in P&L based on matching concept.

Hedging has protected collection at billing rate, thereby providingpredictability in P&L & Had hedging not been done, operation would loseRs. 2.00 on collection in Case

Managing Current Risks


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TCS on an ongoing basis negotiates long term contracts with clients.pricing of which is done with targeted profit margins at a givenexchange rate.

Predictability of exchange rates in such long term contracts is essentialto meet the desired profit margin sharp exchange rate movements willmake entire costing go haywire.

Long term hedging (C

ash Flow Hedges) for such contracts ensures thatthe target profit margins are met and business is not exposed to longterm exchange fluctuations

Managing Future Risks


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5 year contract of USD 100 mio @ 40.00 while bidding. Target profitmargin of 30%, all expenses are in INR.

Sc enario Anal ysis

ILLU S T RA T ION


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FAS 133 & IAS 39 are globally accepted & progressive accountingstandards

Majority of the Fortune 500 companies use these standards for forex

accounting.Similar type of guidelines are proposed in AccountingStandard - 30 by I CAI

FAS differentiates between current risk and future risk . It requiresmapping of risk & hedge associated with it on a matching concept

FAS requires to state at hedge inception itself whether the current orfuture risk is being hedged. Hedge inception document needs to becreated establishing the relationship that has to pass statutory audittest. There is no discretion left to the user

FA S 133: Tool for Long Term Hedging


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On c e the hedge obje c tive and relationship are defined, under noc ir c umstan c e c an the relationship be altered. T he transfer of c ash flowhedge to non- c ash flow hedges and vi c e-versa is not allowed

Acc ordingl y, all c urrent risks and hedges to prote c t those risks shouldbe revalued and booked in P&L ever y quarter (Non- c ash flow hedges)

All hedges (Cash Flow Hedges) against future risks should be revalued& shown in Balan c e S heet. On maturit y, these hedges should bemat c hed against proje c ted revenue and passed through P&L statement

If due to an y reason, the CFH is terminated, the profit/loss will lie inBalan c e sheet till the period for whi c h the hedge was taken thereb y ensuring that market parti c ipants do not misuse the S andard

T he Robust A cc ounting S tandard


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Basi c Hedging Instrument


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Expected revenue of USD 100 mio for FY 09-10 at 40.0

Entity A lacks option expertise & hedges using forward contracts at40.25

Entity B hedges through a mix of forwards and options as under:

a) 25 % Forwards @ 40.25; b) 25% Plain Options @ 40; Cost 25 paise

And

c) 50% Range Forwards: Long Put @ 40 & participation up to 41.50as Short Call @41.50

CA S E S T UDY


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CA S E S T UDY


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E c onomi c Impa c t

Final FX Risk & Exposure Management

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