Forex risk management

FOREIGN EXCHANGE RISK MGMT.

On analysis, at least two fundamental exchange risk management strategies can be distinguished which is called “Aggressive” and “Defensive”.

Whether to follow an aggressive policy or to pursue a defensive policy would actually depend on the foreign exchange rate projections and the ability of the company to beat the forward rates.

NEED FOR FOREIGN EXCHANGE RATE PROJECTIONS

The decision making process in the MNC’s are very much dependant on exchange rate projections.

•Hedging decision : MNC’s are constantly confronted with the decision of whether to hedge future payables and receivables in foreign countries. Now, whether the firm should hedge or not is dependant on its forecasts of foreign currency values. As for example ---------


Consider a firm in US that plans to pay for Gems imported from India in 90 days. If the forecasted value of Indian rupee in 90 days is sufficiently below the 90 day forward rate, the MNC may decide not to hedge.

Short term financing decision : When large corporations borrow they generally have access to several different currencies. The currency in which they borrow ideally has two features, namely ……


It will exhibit a low interest rate.It will weaken in value over the financing period (observation on an average basis globally).Now, suppose an Indian firm borrows US dollars and then converts it into rupees. If the dollar depreciates as per the above theory, the Indian firms will have to pay back less amount than earlier. Hence, it is important for the multinational companies to have access to proper forex rate projections.


Short term investment decision : Corporations sometimes have substantial amount of excess cash available for a short term. They also have the access to create investments in several currencies. In contrast to borrowing, the ideal currency would (a) exihibit high interest rates and (b) would strengthen in value over the investment period. Hence, here also the forex rate projections would be necessary to select the ideal currency for investment purpose.


Capital budgeting decision: When an MNC attempts to determine whether or not to establish a subsidiary in a foreign country, they do resort to some sort of capital budgeting.

Forecasts of the future cash flows will definitely be dependant on future exchange rates and currency values. Hence, in order to have a realistic assessment of future cash flows for the purpose of capital budgeting , the forecast of forex rates need to be good.


Long term financing decision: MNC’s may at times issue bonds to raise funds in foreign currencies. In order to estimate the cost of issuing bonds denominated in a foreign currency, forecasts of exchange rate are required.

FORECASTING TECHNIQUESTechnical forecasting : Technical forecasting of exchange rates is at times, similar to technical forecasting of stock prices. Such type of forecasting is not supposed to hold good, when the currency values do not follow a trend line and appears to be random.

Technical forecasting models have at times proved themselves BUT a model that has worked well in one particular period may not necessarily do justice in another period.

Technical forecastingWith the abundance of technical forecasting models that exist today, some are bound to generate profits and prove themselves, while most of them actually fail.

Some of the participants even say that once a technical forecasting model is used by a large number of other participants, it ceases to remain useful. This is because of the fact that trading based on the recommendations of the model pushes the currency value to a new position, where a separate strategy is required.

Technical forecasting

From the corporate point of view, use of technical forecasting is very much limited, as because it always focuses on the near future, which is not that helpful for developing corporate policy.

In totality, technical forecasting methods are rarely used by the MNC’s because of their unsuitability.

Fundamental forecasting

Such kind of forecasting is based on fundamental relationships between economic variables and the exchange rates.For example : High inflation in a given country can lead to depreciation in the home currency. Many other factors may also influence the exchange rates.The forecast may be based on, simply a subjective assessment of the degree of movement in the economic variables and their corresponding effect on the exchange rates.


Consider for an example that a firm’s objective is to forecast the percentage change in the Indian rupee with respect to US Dollar, during the next quarter.

The forecast may be dependant on many factors, however the major factors could be :A) Inflation in US relative to inflation in India.B) Income growth rate in US relative to income

growth rate in India.

Fundamental forecastingTaking into consideration the two factors a regression analysis is conducted, and an equation is developed, based on previous historical data of both the countries.

The following type of conclusions could be derived by such regression analysis.a) For one unit percentage change in inflation differential, the rupee is expected to change by 00 % in the same direction, other things remaining constant.

Fundamental forecastingb) For one unit percentage change in income differential, the rupee is expected to change by 00 % in the same direction , other things remaining constant.C) Given the current figures of inflation rates and growth in income, the rupee should appreciate or depreciate by 00% in the next quarter.

A full blown model of fundamental forecasting may consider more than two variables, yet the application would be somewhat similar.


Use of PPP for fundamental forecasting : PPP specifies the fundamental relationship between the inflation differential and the exchange rate.PPP states that the currency of a relatively inflated country will depreciate by an amount that reflects the country’s inflation differential.If this theory would be accurate in reality, there would not be a need to consider any other alternative forecasting technique.


However, using the inflation differential of two countries, to forecast their exchange rate will not always hold good, because of the following reasons :a) The timing of the major impact of inflation and the timing of corresponding impact on exchange rates is never known with certainty.b) Data used to measure the relative inflations in the two countries may not be accurate or similar.


c) Barriers to trade can disrupt the trade patterns that should emerge in accordance with PPP theory.d) Other factors such as interest rates in the two countries may also affect the exchange rates.

Market based forecasting

This is a process of forecasting, developed from market indicators viz. THE SPOT RATE AND THE FORWARD RATE.Assume that the British Pound is expected to appreciate against the Rupee in the near future. This will encourage the speculators to buy the Pound with Rupee today, in anticipation of gain. Conversely, if the Pound is expected to depreciate against the Rupee, speculators will tend to sell of the Pounds now.


Such actions of the speculators, would in fact force the currencies to depreciate or appreciate in the near future.

Thus the corporations, can use the spot rates to forecast the spot rates of the near future.

Market based forecastingAssume that the forward rate of British pound is Rs.70/- and the general expectation of speculators is that the spot rate of pound will be 73/- , at the end of the forward period. Such a situation will drive the speculators to buy pounds in the forward market at 70/-, just to gain 3/- at the end of the forward period. Such general drives in the market may cause the forward rate to increase, until this speculative demand ceases.Possible forward rate may rise to 73/- thus driving away any profit due.


Thus, the general craze of the market regarding the forward rates and the following outcomes, can also help the firms to forecast the future movements in the exchange rates.

Economy & Finance

Forex risk management