The Nature and Types of Risk and Approaches to Risk Management

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1 H. RISK MANAGEMENT 1. The Nature and Types of Risk and Approaches to Risk Management 2. Causes of Exchange Rate Differences and Interest Rate Fluctuations 3. Hedging Techniques for Foreign Currency Risk 4. Hedging Techniques for Interest Rate Risk The Nature and Types of Risk and Approaches to Risk Management What is an exchange rate? An exchange rate is the rate at which one country s currency can be traded for another country s currency. What is the spot rate? The spot rate is the exchange rate currently offered on a particular currency. It is also the interest rate currently offered on a particular security. The spot rate is the rate of exchange in currency for immediate delivery. What is the forward rate? The forward rate is an exchange rate set now for currencies to be exchanged at a future date. Note: The selling rate is known as the offer or ask price. The buying rate is known as the bid price. The bank expects to make a profit from selling and buying currency, and it does so by offering a rate for selling a currency which is different from the rate of buying the currency. The Foreign exchange markets: Banks buy and sell from and to customers Banks buy and sell from and to governments Banks buy and sell from and to other banks International trade involves foreign currency to buy in one currency and exchange to local currency Foreign exchange rates are not fixed but vary What are three types of foreign currency risks? Translation exposure Transaction exposure

2 Economic exposure What is translation risk? Translation risk is the risk that the organization will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into home currency. For example, restating the book value of a foreign subsidiary s assets at the exchange rate on the statement of financial position date. What is transaction risk? Transaction risk is the risk of adverse exchange rate movements occurring in the course of normal international trading transactions. For example, when the prices of imports or exports are fixed in foreign currency terms and there is movement in the exchange rate between the date when the price is agreed and the date when the cash is paid or received in settlement. What is Economic risk? Economic risk refers to the effect of exchange rate movements on the international competitiveness of a company and refers to the effect on the present value of longer term cash flows. A depreciation or appreciation of currencies can erode the competitiveness of the company. Economic exposure can be difficult to avoid, although diversification of the supplier and customer base across different countries will reduce this kind of exposure to risk. Causes of Exchange Rate Differences and Interest Rate Fluctuations How are exchange rates determined between two currencies? The exchange rate between two currencies is determined primarily by supply and demand in the foreign markets. Demand comes from individuals, firms and governments who want to buy a currency and supply comes from those who want to sell it. What influences the supply and demand for currencies? The rate of inflation, compared with the rate of inflation in other countries Interest rates, compared with interest rates in other countries The balance of payments Sentiment of foreign exchange market participants regarding economic prospects Speculation Government policy on intervention to influence the exchange rate

3 What is interest rate parity? Interest rate parity is a method of predicting foreign exchange rates based on the hypothesis that the difference between the interest rates in the two countries should offset the difference between the spot rates and the forward foreign exchange rates over the same period. The interest rate parity links the foreign exchange markets and the international money markets. Therefore: F0 = S0 x (1 + i1) / (1 + i2) F0 = forward rate, S0 = spot rate, i1 = interest rate in 1 st currency, i2 = interest rate in 2 nd currency What is the Purchasing Power Parity? The purchasing power parity theory states that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country. Therefore: S1 = S0 x (1 + IF1) / (1 + IF2) S1 = expected spot rate, S0 = current spot rate, IF1 = expected inflation rate in 1 st currency, IF2 = expected inflation rate in 2 st currency The Fisher effect: The term fisher effect is sometimes used in looking at the relationship between interest rates and expected rates of inflation. According to the international fisher effect, interest rate differentials between countries provide an unbiased predictor of future changes in spot exchange rates. The international fisher effect can be expressed as: 1 + i1 / 1 + i2 = 1+ IF1 / 1 + IF2 What is risk management? Hedging Techniques for Foreign Currency Risk Risk management describes the policies that a firm may adopt and the techniques that it may use to manage the risk it faces, such as: Currency of invoice one way of avoiding exchange risk is for an exporter to invoice his foreign customer in his domestic currency, or for an importer to arrange with his foreign supplier to be invoiced in his domestic currency. An alternative method of achieving the same result is to negotiate contracts expressed in the foreign currency but specifying a fixed rate of exchange as a condition of the contract. Matching receipts and payments a company can reduce or eliminate its foreign exchange transaction exposure by matching receipts and payments. A company that expects to make payments and have receipts in the

4 same foreign currency should plan to offset its payments against its receipts in the currency. It would not matter whether the currency strengthens or weakens against the company s domestic currency because there will be no purchase or sale of the currency. The process can be made simpler by having foreign currency accounts with a bank receipts of foreign currency can be credited to the account pending subsequent payments in the currency. Matching assets and liabilities a company that expects to receive a substantial amount of income in a foreign currency can hedge against foreign currency risk by borrowing in the foreign currency and using the foreign receipts to repay the loan. Long- term foreign investments similarly can try to match its foreign assets by a long- term loan in the foreign currency. Leading and lagging Companies might try using lead payments i.e. payments in advance and lagged payments i.e. delaying payments beyond their due date in order to take advantage of foreign exchange rate movements. Netting the objective of netting is to save transaction costs by netting off inter- company balances before arranging payment. This is where multinational groups engage in intragroup trading i.e. related companies located in different countries trade with one another. The advantages are: reduction in foreign exchange purchase costs, commission, selling and buying rates, and less loss in interest from having money in transit. Forward exchange contracts Forward exchange contracts hedge against transaction exposure by arranging with a bank to sell or buy quantity of foreign currency at a future date, at a rate of exchange determined when the forward contract is made. The trader will know in advance either how much local currency he will receive or how much local currency he must pay. The current spot price is irrelevant to the outcome of a forward contract. Money market hedging Money market hedging involves borrowing in one currency, converting the money borrowed into another currency and putting the money on deposit until the time the transaction is completed, hoping to take advantage of favorable exchange rate movements. Currency futures Currency options Currency swaps Hedging Techniques for Interest Rate Risk Interest rate risk is face by companies with floating and fixed rate debt. It relates to the sensitivity of profit and cash flows to changes in interest rates. A company will therefore need to analyze how profits and cash flows are likely to be affected by forecast changes in interest rates and decide whether to take action. Floating interest rates change according to general market conditions.

5 Some interest rate risks to which a firm is exposed may cancel each other out, where there are both assets and liabilities with which there is exposure to interest rate changes. If interest rates rise, more interest will be payable on loans and other liabilities, but this will be compensated for by higher interest received on assets such as money market deposits. Companies with high proportion of fixed interest payments will suffer from a loss of competitive advantage if interest rates fall sharply compared with companies using floating rate borrowing. Gap exposure o Negative gap exposure o Positive gap exposure They are several reasons why interest rates differ in different markets and market segments Risk The need to make a profit on re- lending The size of the loan Different types of financial asset The duration of the lending Expectation theory Market segmentation theory Government policy The general level of interest rates is affected by several factors Need for a real return Inflation Uncertainty about the future rates of inflation Liquidity preference of investors and the demand for borrowing Balance of payments Monetary policy Interest rates abroad Internal rate risk management: Interest rate risk can be managed using internal hedging in the form of: Matching and smoothing Matching and smoothing are two methods of internal hedging used to manage interest rate risk. Matching is where liabilities and assets with a common interest rate are matched. Smoothing is where a company keeps a balance between its fixed rate and floating rate borrowing. Forward rate agreements Future contracts Interest rate options

6 Interest rate caps, collars and floors Interest rate swaps (plain vanilla or generic swap) THE END.

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