APROJECT REPORT

ON“RISK MANAGEMENT IN FOREIGN EXCHANGE”

SUBMITTED TO – Ms. Ashima SinghInstitute of Management Sciences, University of Lucknow

SUBMITTED BY:

Ashish Mahendra (Roll No.07) Gaurav Kumar (Roll No.16)

Saurabh Singh (Roll No.47) Shivam Nigam(Roll No.52)

(BATCH 2013-15)MBA (FC)- Sem. IV

Table of Contents

1. Acknowledgement 3

2. Definition: Foreign Exchange Risk Management 4

3. Types of Foreign Exchange Risk 4 - 7

4. Reasons to Hedge Foreign Exchange Risk 7

5. Managing Foreign Exchange Risk 8 - 9

6. Techniques for Hedging FOREX Risk 10 - 13

7. References 14

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AcknowledgementIn performing our assignment, we had to take the help and guideline of some respected persons, who deserve our greatest gratitude. The completion of this assignment gives us much Pleasure. We would like to show our gratitude to our subject teacher Ms. Ashima Singh, Institute of Management Sciences, University of Lucknow for giving us a good guideline for assignment throughout numerous consultations. We would also like to expand our deepest gratitude to all those who have directly and indirectly guided us in writing this assignment.

Many people, especially our classmates and team members itself, have made valuable comment suggestions on this proposal which gave us an inspiration to improve our assignment. We thank all the people for their help directly and indirectly to complete our assignment.

Submitted By-

Ashish Mahendra

Gaurav Kumar

Saurabh Singh

Shivam Nigam

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Definition: Foreign Exchange Risk

Foreign Exchange Risk refers to the risk that an investor will have to close out a long or short position in aforeign currency at a loss due to an adverse movement in exchange rates. In general, the risk of an adverse movement in exchange rates.

The risk that the return on an investment may be reduced or eliminated because of a change inthe exchange rate of two currencies. 

For example, if an American has a CD in the United Kingdom worth 1 million British pounds and the exchange rate is 2 USD: 1 GBP, then the American effectively has $2 million in the CD. However, if the exchange rate changessignificantly to, say, 1 USD: 1 GBP, then the American only has $1 million in the CD, eventhough he/she still has 1 million pounds.

Types of Foreign Exchange Risk

Transaction Risk Translation Risk Economic Risk

Transaction Risk

This is the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion.

This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for debtors in its

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accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.

As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component oftreasury risk management.

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?

(b) The hedge period, the time period before the expected cash flows occurs.

The anticipated volatility of the exchange rates during the hedge period.

The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on whether the Treasury Department is been established as a cost or profit Centre.

Translation Risk

The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is the translation not the conversion of real money from one currency to another.

The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement.

If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then the UK parent company will

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anticipate a balance sheet value of £500,000 for the subsidiary. A depreciation of the US dollar to $/£2.00 would result in only £250,000 being translated.

Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.

Economic risk

Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the longer-term effects of changes in exchange rates on the market value of a company. Basically this means a change in the present value of the future after tax cash flows due to changes in exchange rates.

There are two ways in which a company is exposed to economic risk.

Directly:If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.

If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.

Indirectly:Even if your home currency does not move Vis-a -Vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and

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its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.

Even if your home currency does not move Vis-a -Vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.

Economic risk is difficult to quantify but a favored strategy to manage it is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.

Reasons to Hedge Foreign Exchange Risk

minimize the effects of exchange rate movements on profit margins

increase the predictability of future cash flows eliminate the need to accurately forecast the future direction of

exchange rates facilitate the pricing of products sold on export markets protect, temporarily, a company’s competitiveness if the value

of the Canadian dollar rises (thereby buying time for the company to improve productivity)

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Steps in Managing Foreign Exchange Risk

1. Identify & measure FX exposure

2. Develop company’s FX policy

3. Hedge exposure using Trades and/or other techniques

4. Evaluate and adjust

Identify & measure FX exposure

This Step involves identifying and measuring the foreign exchange exposures that is to be managed. The focus of companies is on transaction risk to forecast that to what extent they are exposed to the risk of foreign exchange.

Develop company’s FX policy

Once forecasted the transaction risk factor attached then its need to develop company’s foreign exchange policy. This policy is formulated by the Company’s top management laying guidelines to the following issues:

o When should foreign exchange exposure be hedged? o What tools and instruments can be used under what

circumstances? o Who is responsible for managing foreign exchange

exposure? o How will the performance of the company’s hedging

actions be measured? o What are the regular reporting requirements?

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Hedge exposure using Trades and/or other techniques

This step involves identification and application of hedge option that compliments the best with company’s policy.

For example,if a Company want to increase the value of raw materials imported from the U.S. to partly offset the exposure created by sales to U.S. buyers. Alternatively, company may put in place basic financial hedges with a bank or foreign exchange broker. The most commonly used financial hedges are discussed further below.

Evaluate and adjust

In this step there is need of measuring the results periodically to check whether the hedging technique used are effectively achieving goal of reducing the risk of foreign exchange attached to company. If it lacks to achieve its goal then there is need for taking corrective measures to overcome the same

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Techniques for Hedging FOREX Risk

The internal techniques

Internal techniques to manage/reduce forex exposure should always be considered before external methods on cost grounds. Internal techniques include the following:

Invoice in home currency

One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.

However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.

Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.

Leading and lagging

If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.

If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.

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The problem lies in guessing which way the exchange rate will move.

Matching

When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other.

It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.

An extension of the matching idea is setting up a foreign currency bank account.

Decide to do nothing?

The company would "win some, lose some".

Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.

In the short run, however, losses may be significant.

One additional advantage of this policy is the savings in transaction costs.

The external techniques

Transaction risk can also be hedged using a range of financial products. These are introduced below with links to more detailed pages.

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Forward contracts

The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward rate of exchange. This effectively fixes the future rate.

Money market hedges

The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur. This effectively fixes the future rate.

Futures contracts

Futures contracts are standard sized, traded hedging instruments.

The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.

Options

A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.

A call option gives the holder the right to buy the underlying currency.

A put option gives the holder the right to sell the underlying currency.

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Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.

Forex swaps

In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a fixed rate/fixed rate swap.

The main objectives of a forex swap are:

To hedge against forex risk, possibly for a longer period than is possible on the forward market.

Access to capital markets, in which it may be impossible to borrow directly.

Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.

Currency swaps

A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies.

In effect a currency swap has two elements:

An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.

An exchange of interest rates - the timing of these depends on the individual contract.

The swap of interest rates could be fixed for fixed or fixed for variable.

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References

http://financial-dictionary.thefreedictionary.com/ Foreign+Exchange+Risk

http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki %20Pages/Foreign%20Exchange%20Risk%20Management.aspx?mode=none

http://www.desjardins.com/ressources/pdf/d30p-ge-risque- change-e.pdf?resVer=1391550617000

file:///C:/Users/HP_PC/Downloads/managing-foreign- exchange-risk-guide.pdf

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