final project economics

8/12/2019 Final Project Economics

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INTRODUCTION:

My Project Is EXCHANGE RATE RISK .

OBJECTIVES:

The objective of undertaking a project on EXCHANGE RATE RISK is to have in

depth knowledge about exchange rate risk and risk management.

To know more about exchange rates especially about how they are determined.

To know more about their types and how are they exposed.

To know about how are exchange rates predicted and determined.

RESEARCH PROBLEM:

One of the most influencing and most critical limitations is that I am not trained for

the research study and this is my first study. I tried hard to come at conclusion, but

there is lack of expertise.

Another limitation is that there is lack of time. If I give more time then studies will

be more effective.

The attitude of the research might be biased.


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RATIONALE METHOD:

To provide a thorough knowledge of the concept of Exchange Rate Risk and its

management.

To know the determinants of the exchange rate.

To know the how markets get affected due to exchange rate risk.

RESEARCH METHODOLOGY

The research-methodology adopted is mainly Non-doctrinal and descriptive. The

sources of data include secondary sources like Articles, books and Journals.

CHAPTER SCHEME:

EXCHANGE RATE

HOW ARE EXCHANGE RATES PERDICTED AND DETERMINED

EXCHANGE RATE RISK

TYPES OF EXCHANGE RATE RISK

MEASUREMENT OF THE RISK


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CHAPTER 1

1.1 INTRODUCTION

In finance, an EXCHANGE RATE (also known as a foreign-exchange rate, Forex rate between

two currencies is the rate at which one currency will be exchanged for another. It is also regarded

as the value of one countrys currency in terms of another currency. For example, an interbank

exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will

be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are

determined in the foreign exchange market, which is open to a wide range of different types of

buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e.

trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to

the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted

and traded today but for delivery and payment on a specific future date.

In the retail currency exchange market, a different buying rate and selling rate will be quoted by

money dealers. Most trades are to or from the local currency. The buying rate is the rate at which

money dealers will buy foreign currency, and the selling rate is the rate at which they will sell

the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in

trading, or else the margin may be recovered in the form of a "commission" or in some other

way. Different rates may also be quoted for cash (usually notes only), a documentary form (such

as traveler's cheques) or electronically (such as a credit card purchase). The higher rate on

documentary transactions is due to the additional time and cost of clearing the document, while

the cash is available for resale immediately. Some dealers on the other hand prefer documentary

transactions because of the security concerns with cash.
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An exchange rate has a base currency and a counter currency. In a direct quotation, the foreign

currency is the base currency and the domestic currency is the counter currency. In an indirect

quotation, the domestic currency is the base currency and the foreign currency is the counter

currency. Most exchange rates use the US dollar as the base currency and other currencies as the

counter currency. However, there are a few exceptions to this rule, such as the euro and

Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.

Exchange rates for most major currencies are generally expressed to four places after the

decimal, except for currency quotations involving the Japanese yen, which are quoted to two

places after the decimal. Exchange rates can be floating or fixed. While floating exchange rates in which currency rates are determined by market force are the norm for most major nations,

some nations prefer to fix or peg their domestic currencies to a widely accepted currency like the

US dollar. Exchange rates can also be categorized as the spot rate which is the current rate or

a forward rate, which is the spot rate adjusted for interest rate differentials


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1.2 HOW ARE EXCHANGE RATES DETERMINED AND PREDICTED.

Exchange rates are determined by the demand and supply for different currencies

Three factors impact future exchange rate movements

A countrys price inflation

A countrys interest rate

Market psychology

There are two schools of thought on predication (forecasting)

1. FUNDAMENTAL ANALYSIS : draws upon economic factors like interest rates,

monetary policy, inflation rates, or balance of payments information to predict exchange

rates. Fundamental analysis is about using real data to evaluate a security's value.

Although most analysts use fundamental analysis to value stocks, this method of

valuation can be used for just about any type of security. A method

of security valuation which involves examining the company's financials and operations,

especially sales, earnings, growth potential, assets, debt, management, products,

and competition. Fundamental analysis takes into consideration only those variables that

are directly related to the company itself, rather than the overall state of the market or

technical analysis data.

2. TECHNICAL ANALYSIS : charts trends with the assumption that past trends and

waves are reasonable predictors of future trends and waves. A method of evaluating

securities by analyzing statistics generated by market activity, such as past prices and
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volume. Technical analysts do not attempt to measure a security's intrinsic value, but

instead use charts and other tools to identify patterns that can suggest future activity.

Technical analysts believe that the historical performance of stocks and markets are

indications of future performance.

In a shopping mall, a fundamental analyst would go to each store, study the product that

was being sold, and then decide whether to buy it or not. By contrast, a technical analyst

would sit on a bench in the mall and watch people go into the stores. Disregarding the

intrinsic value of the products in the store, the technical analyst's decision would be based

on the patterns or activity of people going into each store.


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CHAPTER 2

2.1 EXCHANGE RATE RISK

Exchange rate risk management is an integral part in every firms decisions about foreign

currency exposure. Currency risk hedging strategies entail eliminating or reducing this risk, and

require understanding of both the ways that the exchange rate risk could affect the operations of

economic agents and techniques to deal with the consequent risk implications. Selecting the

appropriate hedging strategy is often a daunting task due to the complexities involved in

measuring accurately current risk exposure and deciding on the appropriate degree of risk

exposure that ought to be covered. The need for currency risk management started to arise after

the break down of the Bretton Woods system and the end of the U.S. dollar peg to gold in 1973.

The issue of currency risk management for non-financial firms is independent from their core

business and is usually dealt by their corporate treasuries. Most multinational firms have also

risk committees to oversee the treasurys strategy in managing the exchange rate (and interest

rate) risk. This shows the importance that firms put on risk management issues and techniques.

Conversely, international investors usually, but not always, manage their exchange rate risk

independently from the underlying assets and/or liabilities. Since their currency exposure is

related to translation risks on assets and liabilities denominated in foreign currencies, they tend

to consider currencies as a separate asset class requiring a currency overlay mandate. A common

definition of exchange rate risk relates to the effect of unexpected exchange rate changes on thevalue of the firm (Madura, 1989). In particular, it is defined as the possible direct loss (as a result

of an unhedged exposure) or indirect loss in the firms cash flows, assets and liabilities, net profit

and, in turn, its stock market value from an exchange rate move. To manage the exchange rate


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risk inherent in multinational firms operations, a firm needs to determine the specific type of

current risk exposure, the hedging strategy and the available instruments to deal with these

currency risks. The risk of an investment's value changing due to changes in currency exchange

rates. The risk that an investor will have to close out a long or short position in a foreign

currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk"

or "exchange-rate risk". Exchange-rate risk is the risk of receiving less in domestic currency

when investing in a bond that is in a different currency denomination than in the investor's home

country. When investors purchase a bond that is designated in another currency other than their

home countries, investors are opened up to exchange risk. This is because the payment of interestand principal will be in a foreign currency. When investors receive that currency, they have to go

into the foreign currency markets and sell it to purchase their home currency. The risk is that

their foreign currency will be devalued compared to the currency of their home countries and

that they will receive less money than they expected to receive. As an example, suppose that a

U.S. investor purchases a Euro denominated bond. When the interest payment comes due and if

the Euro has declined in value compared to USD, the investor will receive less in USD than

expected when he or she transacts in the foreign currency markets. In short, the investor will

receive fewer Euros to purchase USD.


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2.2 TYPES OF EXCHANGE RATE RISK

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EXCHANGE RATE RISK

TransactionRisk

Economic

Risk

TranslationRisk

ContingentRisk


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TRANSACTION RISK:

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. To realize the domestic value of its

foreign-denominated cash flows, the firm must exchange foreign currency for domestic

currency. As firms negotiate contracts with set prices and delivery dates in the face of a

volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a

risk of changes in the exchange rate between the foreign and domestic currency. It refers to

the risk associated with the change in the exchange rate between the time an enterprise

initiates a transaction and settles it.

ECONOMIC RISK:

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 market share 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. Any transaction that exposes the firm to

foreign exchange risk also exposes the firm economically, but economic exposure can be

caused by other business activities and investments which may not be mere international

transactions, such as future cash flows from fixed assets. A shift in exchange rates that

influence the demand for a good in some country would also be an economic exposure for a

firm that sells that good.


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CHAPTER 4

4.1 MEASUREMENT OF THE RISK

Measuring currency risk may prove difficult, at least with regards to translation and

economic risk. At present, a widely used method is the value-at-risk (VaR) model.

The VaR methodology can be used to measure a variety of types of risk, helping firms in

their risk management.

The VaR measure of exchange rate risk is used by firms to estimate the riskiness of a

foreign exchange position resulting from a firms activities, including the foreign

exchange position of its treasury, over a certain time period under normal conditions.

VALUE-AT-RISK (VaR)

Value at risk is one of the most common methods used in Risk Measurement. There are several

methods to measure VaR, three basic methods are: the parametric method, historical simulation

and Monte Carlo simulation. One of the most important risk factors is the risk of exchange rate

fluctuations which has very large impact on the performance of banks and the economy. Because

of high sensitivity in banking operations such as monetary, financial and currency exchange

operations as well as sensitivity to international fluctuations and also due to the significant

impact of exchange rate fluctuations on the country's economy, therefore banks as the main pillar

of the country's economy influenced with exchange rate fluctuations and therefore highly insists

on calculating relevant risks for measuring capital required to cover to prevent large losses or

even bankruptcy. Banks use various methods and tools to calculate the relevant risks, in which


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each method has its own advantages and disadvantages. As proposed in 1995 and 1996 by the

Basle Committee on Banking Supervision, banks are now allowed to calculate capital

requirements for their trading books and other involved risks based on a VaR concept and in

Basel committee VaR is recognized as the most comprehensive benchmark for risk

measurement. Value at risk is one of the most common methods used in Risk Measurement.

There are several methods to measure VaR, three basic methods are: the parametric method,

historical simulation and Monte Carlo simulation. One of the most important risk factors is the

risk of exchange rate fluctuations which has very large impact on the performance of banks and

the economy. Because of high sensitivity in banking operations such as monetary, financial andcurrency exchange operations as well as sensitivity to international fluctuations and also due to

the significant impact of exchange rate fluctuations on the country's economy, therefore banks as

the main pillar of the country's economy influenced with exchange rate fluctuations and therefore

highly insists on calculating relevant risks for measuring capital required to cover to prevent

large losses or even bankruptcy. Banks use various methods and tools to calculate the relevant

risks, in which each method has its own advantages and disadvantages. As proposed in 1995 and

1996 by the Basle Committee on Banking Supervision, banks are now allowed to calculate

capital requirements for their trading books and other involved risks based on a VaR concept and

in Basel committee VaR is recognized as the most comprehensive benchmark for risk

measurement. VaR is an estimate of the worst possible loss (i.e., the decrease in the market value

of a foreign exchange position) an investment could realize over a given time horizon, under

normal market conditions (defined by a given level of confidence).


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THE VAR CALCULATION DEPENDS ON 3 PARAMETERS:

The holding period , i.e., the length of time over which the foreign exchange position is

planned to be held. The typical holding period is 1 day. The confidence level at which the estimate is planned to be made. The usual confidence

levels are 99 percent and 95 percent.

The unit of currency to be used for the denomination of the VaR.

As proposed by the Basle Committee on Banking Supervision, banks are now allowed to

calculate capital requirements for their trading books and other involved risks based on a VaR

concept and in Basel committee VaR is recognized as the most comprehensive benchmark for

risk measurement.


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BEST PRACTICES FOR EXCHANGE RATE RISK MANAGEMENT

For their currency risk management decisions, firms with significant exchange rate exposure

often need to establish an operational framework of best practices.

These practices or principles may include :

1. Identification of the types of exchange rate risk that a firm is exposed to and

measurement of the associated risk exposure. This involves determination of the

transaction, translation and economic risks, along with specific reference to the

currencies that are related to each type of currency risk. In addition, measuring these

currency risks-using various models (e.g. VaR)-is another critical element in identifying

hedging positions.

2.

Development of an exchange rate risk management strategy. After identifying the typesof currency risk and measuring the firms risk exposure, a currency strategy needs to be

established on how to deal with these risks. In particular, this strategy should specify the

firms currency hedging objectives whether and why the firm should fully or partially

hedge its currency exposures. Furthermore, a detailed currency hedging approach should

be established. It is imperative that a firm details the overall currency risk management

strategy on the operational level, including the execution process of currency hedging, the

hedging instruments to be used, and the monitoring procedures of currency hedges.


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3. Creation of a centralized entity in the firms treasury to deal with the practical aspects of

the execution of exchange rate hedging. This entity will be responsible for exchange rate

forecasting, the hedging approach mechanisms, the accounting procedures regarding

currency risk, costs of currency hedging, and the establishment of benchmarks for

measuring the performance of currency hedging. (These operations may be undertaken by

a specialized team headed by the treasurer or, for large multinational firms, by a chief

dealer.)

4. Development of a set of controls to monitor a firms exchange rate risk and ensure

appropriate position taking. This includes setting position limits for each hedging

instrument, position monitoring through mark-to-market valuations of all currency

positions on a daily basis (or intraday), and the establishment of currency hedging benchmarks for periodic monitoring of hedging performance (usually monthly).

5. Establishment of a risk oversight committee. This committee would in particular approve

limits on position taking, examine the appropriateness of hedging instruments and

associated VaR positions, and review the risk management policy on a regular basis.

Managing exchange rate risk exposure has gained prominence in the last decade, as a

result of the unusual occurrence of a large number of currency crises. From the corporate


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managers perspective, currency risk management is increasingly viewed as a prudent

approach to reducing a firms vulnerabilities from major exchange rate moveme nts. This

attitude has also been reinforced by recent international attention on both accounting and

balance sheet risks

final project economics

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