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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)
Currency OptionsStrategies for
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
Currency OptionsStrategies for
Importers
(Bearish Market)
Currency OptionsStrategies for
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
Currency OptionsStrategies for
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.