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Foreign Exchange Risk

Developed by Dr IKRAM CPA, PhD

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Background

Globalization of financial markets has


increased foreign exposure of most FIs.
FI may have assets or liabilities denominated in
foreign currency (in addition to direct positions
in foreign currency).
Foreign currency holdings exceed direct
portfolio investments.
Net exposure = (FX assets - FX liab.) + (FX
bought - FX sold)
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Foreign Exchange Risk

What is the foreign exchange risk?

Foreign exchange risk (also known as FX risk,


exchange rate risk or currency risk) is a financial
risk that exists when a financial transaction is
denominated in a currency other than that of the
base currency of the company.

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Foreign Exchange Risk

What is the foreign exchange risk?

Foreign exchange risk - also called FX risk,


currency risk, or exchange rate risk - is the
financial risk of an investment's value changing
due to the changes in currency exchange rates.

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Foreign Exchange Risk

What is meant by currency exposure?


Currencies are constantly exposed to fluctuations
in exchange rates on the global foreign exchange
market making them inherently liable to
volatility. Holders of a given currency are
vulnerable to its depreciation against other
currencies. ... Currency exposure is a non-
controllable currency risk.

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Foreign Exchange Risk

What is meant by currency exposure?


The currency exposure of an asset, such as stocks,
is the sensitivity of that asset's return, measured
in the investor's domestic currency, to fluctuations
in exchange rates. Investors, as owners of
companies and assets, have currency exposure
through exchange rate fluctuations.

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Foreign Exchange Risk

What is the meaning of exchange rate risk?

Exchange-rate risk, also called currency risk, is


the risk that changes in the relative value of
certain currencies will reduce the value of
investments denominated in a foreign currency.

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Foreign Exchange Risk

What is meant by translation exposure?


Translation exposure is the risk that a company's
equities, assets, liabilities or income will change
in value as a result of exchange rate changes. This
occurs when a firm denominates a portion of its
equities, assets, liabilities or income in a foreign
currency, and it's also known as "accounting
exposure.

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Foreign Exchange Risk

Spot Rate
The price quoted for immediate settlement on a
commodity, a security or a currency. The spot rate,
also called spot price, is based on the value of an
asset at the moment of the quote. ... As a result,
spot rates change frequently and sometimes
dramatically.

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Foreign Exchange Risk

Spot Rate
In finance, a spot contract, spot transaction, or
simply spot, is a contract of buying or selling a
commodity, security or currency for settlement
(payment and delivery) on the spot date, which is
normally two business days after the trade date.

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Foreign Exchange Risk
Forward Rate or Forward Contract
In finance, a forward contract or simply a forward is a non-
standardized contract between two communities to buy or to sell
an asset at a specified time at a price agreed upon today, making
it a type of derivative instrument. The party agreeing to buy the
underlying asset in the future assumes a long position, and the
party agreeing to sell the asset in the future assumes a short
position. A closely related contract is a futures contract; they
differ in certain respects. Forward contracts are very similar to
futures contracts, except they are not exchange-traded, or defined
on standardized assets.

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Foreign Exchange Risk
Forward Rate or Forward Contract
A forward contract is a customized contract between
two parties to buy or sell an asset at a specified price on
a future date. A forward contract can be used for
hedging or speculation, although its non-standardized
nature makes it particularly apt for hedging.

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Foreign Exchange Risk
Futures Rate or Futures Contract

A futures contract is a contract between two parties


where both parties agree to buy and sell a particular
asset of specific quantity and at a predetermined price,
at a specified date in future.
A futures contract is a legal agreement, generally made
on the trading floor of a futures exchange, to buy or sell
a particular commodity or financial instrument at a
predetermined price at a specified time in the future.
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Foreign Exchange Risk

What is the difference between forward and futures


contracts?
Fundamentally, forward and futures contracts have
the same function: both types of contracts allow
people to buy or sell a specific type of asset at a
specific time at a given price.
However, it is in the specific details that these
contracts differ.

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Foreign Exchange Risk
First of all, futures contracts are exchange-traded and,
therefore, are standardized contracts. Forward
contracts, on the other hand, are private agreements
between two parties and are not as rigid in their stated
terms and conditions. Because forward contracts are
private agreements, there is a high counterparty risk
i.e. a chance that a party may default on its side of the
agreement. Futures contracts have clearing houses
that guarantee the transactions, which drastically
lowers the probability of default to almost never.
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Foreign Exchange Risk
Secondly, the specific details concerning settlement
and delivery are quite distinct. For forward contracts,
settlement of the contract occurs at the end of the
contract. Futures contracts are marked-to-market
daily, which means that daily changes are settled day
by day until the end of the contract. Furthermore,
settlement for futures contracts can occur over a
range of dates. Forward contracts, on the other hand,
only possess one settlement date.

Lastly, because futures contracts are quite frequently


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Foreign Exchange Risk

Lastly, because futures contracts are quite frequently


employed by speculators, who bet on the direction in
which an asset's price will move, they are usually
closed out prior to maturity and delivery usually
never happens. On the other hand, forward contracts
are mostly used by hedgers that want to eliminate the
volatility of an asset's price, and delivery of the asset
or cash settlement will usually take place.

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Foreign Exchange Risk
Options Contract
An options contract is an agreement between a buyer
and seller that gives the purchaser of the option the
right to buy or sell a particular asset at a later date at an
agreed upon price. Options contracts are often used in
securities, commodities, and real estate transactions.
An options contract is an agreement between two
parties to facilitate a potential transaction on the
underlying security at a preset price, referred to as the
strike price, prior to the expiration date.
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Foreign Exchange Risk
The right, but not the obligation, to buy (for a call
option) or sell (for a put option) a specific amount of a
given stock, commodity, currency, index, or debt, at a
specified price (the strike price) during a specified
period of time. For stock options, the amount is usually
100 shares. Each option contract has a buyer, called the
holder, and a seller, known as the writer. If the option
contract is exercised, the writer is responsible for
fulfilling the terms of the contract by delivering the
shares to the appropriate party.

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Foreign Exchange Risk
Options Contract
In the case of a security that cannot be delivered such
as an index, the contract is settled in cash. For the
holder, the potential loss is limited to the price paid to
acquire the option. When an option is not exercised, it
expires. No shares change hands and the money spent
to purchase the option is lost. For the buyer, the upside
is unlimited. Option contracts, like stocks, are therefore
said to have an asymmetrical payoff pattern. For the
writer, the potential loss is unlimited unless the
contract is covered, meaning that the writer already
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owns the security underlying the option. (including 20
Foreign Exchange Risk
Option contracts
Option contracts, like stocks, are therefore said to have
an asymmetrical payoff pattern. For the writer, the
potential loss is unlimited unless the contract is
covered, meaning that the writer already owns the
security underlying the option. (including both
commissions and the bid/ask spread) is higher on a
percentage basis than trading the underlying stock. In
addition, options are very complex and require a great
deal of observation and maintenance. also called
option.
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Foreign Exchange Risk
Swaps contracts
A swap is one of the most simple and successful forms
of OTC-traded derivatives. It is a cash-settled contract
between two parties to exchange (or "swap") cash flow
streams. As long as the present value of the streams is
equal, swaps can entail almost any type of future cash
flow. They are most often used to change the character
of an asset or liability without actually having to
liquidate that asset or liability.

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Foreign Exchange Risk
Swaps contracts
For example, an investor holding common stock can
exchange the returns from that investment for lower
risk fixed income cash flows - without having to
liquidate his equity position.
The difference between a forward contract and a swap
is that a swap involves a series of payments in the
future, whereas a forward has a single future payment.

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Foreign Exchange Risk
Swaps contracts Two of the most basic swaps are:
Interest Rate Swap - This is a contract to exchange
cash flow streams that might be associated with some
fixed income obligations. The most popular interest rate
swaps are fixed-for-floating swaps, under which cash
flows of a fixed rate loan are exchanged for those of a
floating rate loan.
Currency Swap - This is similar to an interest rate
swap except that the cash flows are in different
currencies. Currency swaps can be used to exploit
inefficiencies in international debt markets.
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FX Risk Exposure

FI may have positions in spot and forward


markets.
Could match foreign currency assets and
liabilities to hedge F/X risk
Must also hedge against foreign interest rate risk (by
matching durations, for example)
Greater exposure to a foreign currency
combined with greater volatility of the foreign
currency implies greater DEAR.
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FX Trading Activities

FX markets turnover often greater than $1


trillion per day.
The market moves between Tokyo, NYC and
London over the day allowing for what is
essentially a 24-hour market.
Overnight exposure adds to the risk.

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Trading Activities

Basically 4 trading activities:


Purchase and sale of currencies to complete
international transactions.
Facilitating positions in foreign real and
financial investments.
Accommodating hedging activities
Speculation.

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Profitability of Foreign Currency
Trading

For large US banks, trading income is a major


source of income. It is also very volatile.
In first two activities, bank acts primarily as an
agent.
FI does not assume FX risk in first two
activities.

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Profitability of Foreign Currency
Trading (continued)

Risk arises from taking open positions in


currencies.
Effects of Euro on FX volatilities.
Emerging markets effects.
Increased volatility in some currencies.
Recent calls for additional regulation.

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Risk and Hedging

Hedge can be constructed on balance sheet or


off balance sheet.
On - balance-sheet hedge will also require
duration matching to control exposure to
foreign interest rate risk.
Off-balance-sheet hedge using forwards,
futures, or options.

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No Arbitrage Condition:

Equilibrium condition is that there should be no


arbitrage opportunities available through
lending and borrowing across currencies. This
requires that
1+R(domestic) = (F/S)[1+R (foreign)]
Difference in interest rates will be offset by the
expected change in exchange rates.
Interest rate parity theorem.

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Diversification Effects

Since the banks generally take positions in


more than one currency simultaneously, their
risk is partially reduced through diversification.
Overall, world bond markets are partially but
not fully integrated which leaves open the
opportunity to reduce exposure by diversifying.

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Diversification Effects (continued)

Low correlations between the bond returns


may be due to low correlation of real
interest rates over time and/or inflation
expectations.

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