Risk Management

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Risk Management
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Approach to Risk Management

• Identify the risks faced by the firm.
• Measure the potential effect of each risk.
• Decide how each relevant risk should be handled.

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Foreign Exchange Risks

• Transaction Risk The real value of a contract
  changes between signing a contract and executing
  it as a result of changes in exchange rates.

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Foreign Exchange Risks

• Translation Risk The recorded performance of a
  firm changes when financial statements are
  converted from one currency to another.

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Foreign Exchange Risks

• Economic Risk The competitive position of a
  company changes as a result of permanent changes
  in exchange rates.

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Simple Transaction Risk Management

• Dont do business abroad.
• Only write contracts in your own currency.
• Ignore transaction risk.

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Total Risk Management

• Forward Contract
• Exact currency, amount, maturity date.
• With commercial bank.
• Illiquid.
• Requires proof of execution.
• Settled by execution.

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Total Risk Management

• Futures Contract
• Only certain currencies, amounts, maturity dates.
• With exchange.
• Liquid.
• Requires margin account.
• Settled by offsetting trade.

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Total Risk Management

• Swap
• Series of forward contracts.
• Arranged through commercial bank.

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Problems with Total Risk Management

• Lose upside potential.
• Contract may fall through.

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Partial Risk Managment

• Partial forwards, futures, or swaps.
• Call options Right, but not obligation, to buy.
• Put options Right, but not obligation, to sell

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Problems with Options

• Expensive

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Option Combinations

• Buy call and sell put.
• Buy put and sell call.
• Place floor on gain and ceiling on loss.
• Accept risk within specific range.