Banking

and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

Foreign Exchange Risk: An overview

A recap of concepts and terminology relating to foreign exchange
A foreign exchange transaction is an agreement (between two parties) where one party agrees to
pay a fixed amount of one currency in exchange for another currency at an agreed rate.
Currencies are traded (i.e. bought and sold) in foreign exchange markets across the Globe.
Participants in the foreign exchange market comprise individuals and firms, banks and non-banks,
speculators and arbitrageurs, foreign exchange brokers and, last but not the least, Central Banks.
There are two distinct activities associated with any foreign exchange transaction: trading and
settlement. Therefore, every foreign exchange transaction will have two dates: a trade date and a
settlement date.

Types of Transactions:
On the basis of the difference between trade date and settlement date, the types of transactions
traded in the foreign exchange market are shown in the table below:

Dierence Between Trade Date And Se3lement Date

t is referred to as Trade Date

TRANSACTIONS TYPE DENOTES

SETTLEMENT DATE

CASH

t+0

Same as trade date

TOM

t+1

One day aFer trade date

SPOT

t+2

Two days aFer trade date

FORWARD

t+n

n days aFer trade date

(n is greater than two days)

SWAP

t+n1
t+n2

Two transacOons entered into

simultaneously, with same trade date
and two dierent se3lement dates

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

How are foreign Exchange Rates quoted?

Each Currency has a unique code (made up of three alphabets) allocated to it by the International
Standards Organization. Example: USD for US Dollars, EUR for Euro, JPY for Japanese Yen, etc.
Exchange rates are quoted in all markets in currency pairs. For example, if the price of 1 USD is 100
Japanese Yen, the quotation will be USD/JPY 100. This nomenclature is to be interpreted as the
price of 1 Unit of the base currency (on the left side of the slash - in this case the US Dollar) equal to
100 Units of the price currency (on the right side of the slash, in our case the Japanese Yen).
A direct quote in foreign exchange markets parlance is the price of one unit of foreign currency in
domestic currency units, and an indirect quote is the price of one unit of domestic currency in the
foreign currency units. Therefore, in the Tokyo market, USD/JPY 100 is a direct quote, and JPY/USD
0.01 or 1/100 is an indirect quote since JPY is the domestic currency in the Tokyo market. In the New
York market, it would be the exact converse.
Exchange rate is quoted with a set of two values, normally referred to as a two-way quote. Say, if a
foreign exchange dealer in London quotes EUR/USD, 1.0921/38, it is expanded as 1.0921/1.0938.
This nomenclature is interpreted as:
The dealer is willing to buy Euros and sell US Dollars at 1.0921 US Dollar per Euro, referred
to as the Bid Rate.
The dealer is willing to sell Euros and buy US Dollars at 1.0938 US Dollars per Euro,
referred to as the Ask Rate.
Based on the above, the dealers BidAsk spread is 1.0938 1.0921 = 0.0017 US Dollars per Euro.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

Managing Foreign Exchange Risk

Foreign exchange risk relates to the gain or loss that arises due to fluctuations in foreign exchange
rates. All assets and liabilities as well as income and expenditure denominated in foreign currency
are exposed to foreign exchange risk.
Foreign exchange exposure is generally classified into three categories:
1. Transaction Exposure which refers to the risk arising from fluctuations in the foreign exchange rate
between the time the transactions is entered into and the time it is settled, i.e. when the payment is
received.
What causes Transaction Exposure?
Transaction Exposure could arise for several reasons, here are some possibilities:
a) Sale or purchase of goods and services on credit, which is to be received or paid for in foreign
currency.
b) A cross-border loan, where the repayment of interest and principal is in a foreign currency.
Firms attempt to minimize their risk and potential losses from Transaction Exposure using hedging
techniques broadly classified as:
i)

Internal hedging: Internal Hedging Techniques are largely endogenous to the firm, i.e. driven
by circumstances and initiatives that are internal and specific to that firm. Internal hedging
technique often pursued by firms include:
a. Invoicing in home currency
b. Netting and off-setting
c. Shifting timing

ii)

External hedging: External hedging technique to manage Transaction Exposure involves the
use of forward market, money market, Options market or other such alternatives
available in financial markets.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

a. Hedging using the Forward Market - This form of hedging involves entering into a
forward foreign exchange contract at the time the foreign exchange exposure is
created/identified. Hedging using the forward market protects the downside (possible
loss), but does not give the hedger the benefit of the upside (possible gain).
b. Hedging using the Money Market - Money market hedge involves, for instance, an
exporter borrowing against future receivables in one currency (usually the home
currency of the importer) today and immediately exchanging the proceeds for another
currency (usually the home currency of the exporter). The cash flow required to repay
the borrowed amount is met when the future receivable is realized from the importer
on the future date.
c. Hedging using the Options Market- This technique involves buying a Put Option or a
Call Option that allows the hedger to benefit from the upside but protect the downside
when exchange rates fluctuate up to the settlement date.

2. Translation Exposure pertains to the valuation of foreign currency assets and liabilities when
consolidating the balance sheet of a multinational enterprise (MNE) at current exchange rates. This
could result in a loss or a gain to the MNE depending on the composition of its assets and liabilities
and the direction of exchange rate movements.
Broadly four methods are used to translate the financial statements of foreign subsidiaries.
1. Current/Non-Current Method
2. Monetary/Non-Monetary Method
3. Temporal Method
4. Current Rate Method

Rapid globalization and significant increase in the number of MNEs domiciled in several countries
has accentuated the problems associated with accounting for profits (losses) arising from
translation.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

3. Operating Exposure (or economic exposure) measures the changes in expected profit due to
changes in the operating cash flows of the firm caused due to fluctuations in exchange rate on future
transactions that are not yet contracted for. Operating Exposure could arise for reasons other than
fluctuations in exchange rates such as increase in the inflation differential between the domicile
country of the exporter and importer.

Operating Exposure could result from a Conversion Effect or a Competitive Effect or both, as

Opera2ng (Economic) Exposure

shown in the diagram below:

Conversion Eect

reects the impact of change in

the domes2c currency value of a
foreign currency cash ow

Compe22ve Eect

reects the impact of changes in

quan2ty and price not in line with
the uctua2ons in exchange rate

Opera&ng exposure is manifested

through a variety of factors:

Invoicing currency
Ina&on rate
Input prices
Elas&city of demand

Opera&ng cost
Market power of the buyer or the seller
Reac&on of compe&tors to the above factors

Although Transaction Exposure and Operating Exposure are both a result of unexpected changes
in future cash flows, the difference is that Transaction Exposure pertains to future cash flows already
contracted for whereas Operating Exposure refers to expected future cash flows not yet contracted
for.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

Managing Foreign Exchange Risk Using Currency Options

Currency Options are very versatile instruments (manifested in the option holders right, but no
obligation, to exercise the contract). Hence, Currency Options are widely used around the world to
hedge against exchange rate risk. In global financial markets, Option contracts exist on several asset
classes such as equity stocks, currency, treasury bonds, etc.
Terminology used in the Options markets include the following:

Call Option: A Call Option gives the buyer of the Option the right, but no obligation, to purchase
currency X against a currency Y at a stated price of say K units of Y per unit of X on or
before a stated date.

Put Option: A Put Option gives the buyer of the Option the right, but no obligation, to sell
currency X against currency Y at a stated price of say of K units of Y per unit of X on or
before a stated date.

Strike Price: Strike price is the price K specified in the Options contract

Maturity Date: This is the date of expiry of the Options contract

European Option: A European Option can be exercised by the Option buyer only on the maturity
date.

American Option: An American Option (unlike a European Option) can be exercised by the
Option buyer on any business day from the contract date to maturity date of the Option.

Premium: Premium is the fee that the Option seller (also called the Option writer) receives upfront from the Option buyer for granting the Option buyer the right, without the obligation, to
exercise the Option on any business day up to the maturity date in the case of an American
Option or on the maturity date in the case of a European Option.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Week Four Summary

Managing Foreign Exchange Risk Using Currency Futures

A Currency Futures contracts is a legally binding agreements to buy/sell a standard quantity of one
currency against another currency at a pre-determined future date and at a pre-agreed price
between the counterparties. Currency Futures contracts specify the quantity, the price and the date
of delivery.
Currency Futures markets have broadly two types of participants:
(1) Hedgers who wish to lock-in an exchange rate for their foreign currency transactions in the
future, thereby eliminating foreign exchange risk.
(2) Speculators who participate in the futures market only to make a profit by taking positions
based on their view about exchange rate movements in the future.
A hedger would use the Currency Futures market to minimize the risk arising from exchange rate
fluctuations. To hedge against exchange rate fluctuations, for instance, the hedger would sell (or
buy) Currency Futures contract based on his foreign currency exposure. At a later date he would
undertake an equal and opposite transaction i.e. buy (or sell) Currency Futures contract to square
his position in the futures market. He would also do another transaction i.e. to sell (or buy) the same
amount of home currency in the spot market at an exchange rate that would be prevailing on the
date he squared his position in the futures market.
Using the Currency Futures market, a hedger can realize at a future date the same amount that he
would have realized (at the spot exchange rate prevailing) on the day he entered into foreign
exchange transaction, irrespective of whether the exchange rate appreciates or depreciates in the
intervening period.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)