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Introduction to Foreign Exchange Risk Management Risk is inherent in the foreign dealings due to uncertain credibility & creditworthiness of exporter or importer & the countries involved in the dealings. Many countries are facing political & economic problems, & there is no certainty about their economic & financial policies & their willingness & capacity to repay the loans. Exchange risk is due to fluctuations in the rate of exchange in conversion of one currency into another& changes in interest rates. Thus, it depends on the economic strength of the currency & its foreign exchange reserves. Strength of currency Exchange risk depends on the strength or weakness of currency, which in turn is a reflection of the degree of strength of the economy. Thus, the country whose productivity is low & its competitive strength in international market is poor, cannot export enough of its domestic products abroad & its foreign exchange earnings will be poor. Such a country will have a weak currency & its rate of interest will be uncertain. Full convertibility of rupee The convertibility of trade account was launched in March 1993 & exports have become convertible at free market rates up to 100% of them. No unfavorable market fluctuations in the rupee were noticed during 1993-94 & then government has announced the full convertibility on current account as well in March 94. Thus, not only trade items but all invisible items or services are paid & received at the market rates. Factors affecting exchange rate: Hot money flows between countries & currencies will take place to take advantage of short-term economic & political factors or disturbances or fears of such developments leading to changes in currency rates & interst changes. Speculative attacks on currencies in anticipation of exchange rate changes & interest rate changes through short term flow of funds. Exchange rate volatility emerges out of erratic fund flow between countries, short-term flow of funds in either direction & inflows of funds followed by immediate reversals. Freely fluctuating exchange rate across countries lead to erratic movements of rates on either side, unless countervailed by Central Bank of the country to offset such excesses. Limited powers of IMF to discipline the surplus countries leading partial or lack of adjustment between currencies of the countries. Exchange risk defined: Exchange risk can be defined as the risk incurred as a result of a foreign currency exposure. It is a twin edged sword. There is risk of being ‘overbought’ in a currency i.e. liable to depreciate in relation to our own. The reverse risk is the risk of being ‘oversold’ in an appreciating currency. Types of risk in foreign exchange Credit risk – This risk arises out of default in foreign exchange contract. Credit rating by international banks & international credit rating agencies will help reducing this risk. Country risk – This risk arises out of country’s policies of economic & political nature & its external payments position & its export earnings. Currency risk – This risk arises out of volatility of the currency, its strength or weakness in terms of other currencies & interest rates & relative degrees of inflation in the respective countries, which influence the exchange rate. It also depends on hot money flow & speculative short term flows. Banks on guarantee of ECGC (Export Guarantee Corporation of India) cover this type of risk generally. Market risk – This risk arises out of market changes, changes in costs, change in government policies of taxation etc. This is borne by the exporter or ECGC in some cases. Market makers in foreign exchange market A market maker is one who takes the risk & gives two-way quotation for any currency & deals in given currencies. As RBI deals in dollars, the banks who act as market makers, concentrate deals in dollar to yen etc. A market maker has to forecast not only the currency rates but also the interest rates in the respective countries. He may cover the risk in some currencies but keep open position in others. He takes calculated risk to maximize his returns. Doing any kind of business is fraught with risks. In fact, what distinguishes entrepreneurs from others is their willingness to take risks. Broadly speaking, risks to which a firm is exposed can be divided into two categories, viz. Core business risks and environment risks. Core business risks are operational risks such as an unsuccessful new product launch, a new technology that does not perform up to expectations, interruptions in raw material supplies, labor problems, cyclical demand fluctuations and so forth. Environment risks arise out of unpredictable fluctuations in financial variables such as exchange rates, interest rates and stock prices, macroeconomic shocks such as a sudden steep rise in pieces of important commodities like crude oil shifts in government policies. Financial risks are thus a subset of environmental risks. While core business risks are peculiar to a firm, environmental risks are pervasive and affect all firms in a given industry. However, the direction and magnitude of the impact do vary from firm to firm. Thus a depreciation of the exchange rate might have a beneficial impact on an exporting firm while it hurts an importing firm; an increase in oil prices improves the performance of an oil producer but adversely affects the fortunes of an airline. Measuring Exposure & Risk Exposure of a firm to risk factor is the sensitivity of the real value of the firm’s assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in the risk factor. 1. Value of assets, liabilities or operating income are to be denominated in the functional currency of the firm. This is the primary currency of the firm in which its financial statements are published. For most firms, it is the domestic currency of their country. 2. Exposure is defined with respect to the real values, i.e. values adjusted for inflation. Theoretically this is the correct way of assessing exposure, in practice due to the difficulty of dealing with an uncertain inflation rate, this adjustment is often ignored, i.e. exposure is estimated with reference to changes in nominal values. 3. The definition stresses that only unanticipated changes in the relevant risk factor are to be considered. The reason is that markets will have already made an allowance for the unanticipated changes, For instance, an exporter invoicing a foreign buyer in the buyer’s currency will build an allowance for the expected depreciation of that currency into the price. A lender will adjust the rate of interest charged on the loan to incorporate an allowance for the expected depreciation. From an operational point of view, the question is how do we separate a given change in exchange rate or interest rate into its anticipated and unanticipated components since only the actual change is observable? One possible answer is to use the relevant forward rate as the expected value of the underlying risk factor. For instance, one possible estimate of what the exchange rate will be three months forward rate. Thus, suppose that the price of a pound sterling in terms of rupees for the immediate delivery ( spot rate ) is Rs.68.00 while the one month forward rate is Rs.68.20.
Approximate Word count = 4752
Approximate Pages = 19
(250 words per page double spaced)
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