Foreign Exchange Risk

1
Foreign Exchange Risk

• The likelihood and severity of losses caused by
  changes in the relative price of foreign
  currency.
• Foreign Exchange Rate
• the price of one currency measured (denominated)
  in another
• all foreign exchange (F/X) rates are relative
• all F/X rates can be expressed in two ways
• British pound and U.S. dollar
• 1.00 US 1.60 ? US 1.00 0.625
• 0.625 1/1.60 (reciprocals)
• Some reasons for changes in F/X rates
• macroeconomic fundamentals
• balance of trade
• speculative pressures
• flight to quality

2
Foreign Exchange Risk

• Types of F/X risk
• transaction exposures
• need to exchange one currency for another at some
  point in the future
• translation exposures
• need to restate earnings or asset values from a
  foreign currency into the domestic currency
• Sources of F/X risk exposure
• overseas investment with local funding
• exposure is the expected gross return of the
  investment (loan) credit risk of investment
  complicates F/X risk measurement/management
• local investment with overseas funding
• exposure is the promised gross cost of the
  funding exposure is certain
• overseas investment with overseas funding
• exposure is the expected net return (expected
  investment return less funding cost)
• smallest level of F/X risk

3
Measuring F/X Risk

• grid approach w/maturity buckets separate
  currency exposures
• assumes all F/X is with one home currency
• positive need to buy, negative need to
  sell
• can be more complicated if F/X needs include
  other combinations (e.g., ? , as well as ?
  and ? )
• each point in the grid can be managed with
  futures and/or options, if the size of the
  exposure is large enough

4
Managing F/X Risk

• F/X futures forwards
• from the grid, the size, direction, and date of
  the exposure is known
• enter agreement to purchase (long) or sell
  (short) the currency
• Options on F/X futures
• start with the size, direction, and date of the
  exposure (from the grid)
• decide the extent to which F/X rate can move
  before unacceptable losses accrue
• purchase appropriate calls or puts
• F/X swaps
• useful if faced with a periodic, relatively
  stable need to buy or sell a foreign currency

5
F/X Futures Forwards

• Hedging with F/X futures
• a British company will pay us 4.3 million on
  October 20th, on which date we intend to convert
  the entire amount into US.
• we do not want this F/X risk, so we intend to
  enter into futures contracts sufficient to
  eliminate it
• CME trades a contract with expiration every 3
  months (Mar/Jun/Sep/Dec) on 3rd Wednesday
• contract size is 62,500. 4,300,000/62,500
  68.8 or 69 contracts
• long buy , so we want to short (sell pounds)
• closest maturity is September contract (or could
  use December)
• Notes
• amount not exact
• date not exact
• residual risk but much less than without the
  hedge
• What happens if the company doesnt pay us the
  4.3 million?

6
F/X Futures Forwards

• F/X forward exchange rates
• cost of carry model ? Interest Rate Parity theory
• Choice 1
• invest in the domestic riskless bond for T
  periods
• Choice 2
• buy foreign currency
• invest in foreign riskless bond for T periods
• sell (known amount of) foreign currency proceeds
  using a forward agreement
• as long as both bonds are perceived as truly
  riskless and transactions costs are low, these
  should be equivalent

7
F/X Futures Forwards

• (1rD,T)T 1/S0 (1rF,T)T F0,T
• rD/F,T is the domestic/foreign T-period riskless
  rate
• T is the maturity
• S0 is the current spot exchange rate
• units of domestic currency per unit of foreign
  currency
• F0,T is the current forward exchange rate for
  delivery at T
• units of domestic currency per unit of foreign
  currency
• F0,T S0 (1rD,T)/(1rF,T)T S0 (1C)T
• Example
• 2-year riskless rates are 4.0 in U.S. and 1.0
  in Japan
• Spot exchange rate is US0.0085/yen
• F0,T US0.0085 1.04/1.012 US0.0090