MODULE 2 : FOREIGN

EXCHANGE RISK
MANAGEMENT
 FOREIGN EXCHANGE RATE
• It is the rate at which one unit of domestic currency is exchanged with the number of units of
currency of another country.
• The price of one currency in terms of other currency is known as foreign exchange rate or
exchange rate.
• Ex- Rs.74.77 is being paid to buy $1, then exchange rate will be $1= 77.77 ( written as Rs./$
exchange rate.)
• There are in total 180 currencies which are recognized as legal tender .
 TYPE OF EXCHANGE RATE
• There are 3 types of exchange rates:

Type of exchange rate

Fixed exchange Flexible exchange Managed

rate rate exchange rate
 FIXED EXCHANGE RATE
• In this exchange rate is determined by the central bank of a country and the changes can be
made by the central bank only.
• There are two methods to determine exchange rate under this system:
Gold standard system
The Bretton woods system of exchange rate

• When value of domestic currency is tied to the value of another currency, it is called
Pegging.
• When the value of currency is fixed in terms of some other currency or in terms of gold, it is
called Parity value.
Gold system exchange rate
• According to this system, gold was taken as the common unit of parity between the
currencies of different countries in circulation.
• Each country has to define the value of its currency in terms of gold. Accordingly, value of
one currency in terms of the other currency was fixed, considering the gold value of each
currency.
The Bretton woods system of exchange rate
• The Bretton woods conference held in 1944, re-established a system of fixed exchange rates.
• This was different from the international gold standard in the choice of the asset in which national
currencies would be convertible.
• Under this system, countries were required to fix their currency against US dollar.
• International monetary fund was delegated with supervisory role under this system.
• Merits of fixed exchange rate system
1. It ensures stability in exchange rate
2. Promote capital movements because it does not involve any uncertainties about exchange
rate that may cause capital loss.
3. It prevents capital outflow
4. It stops speculation in foreign exchange market
5. It helps the government to check inflation
• Demerits of fixed exchange rate
1. It requires high reserves of gold. Huge gold reserve hinder movement of capital or foreign
exchange.
2. It discourages the objective of having free markets.
3. It may not lead to the market equilibrium.
4. An economy following this system, may find it difficult to combat either depression or
recession
5. It may result in undervaluation or overvaluation of currency.
 Undervaluation : it is a situation in which the exchange rate of a currency exceeds what the
open market is willing to pay.
 Over valuation: it is a situation in which the value of currency is lower than what is expected
in the exchange market.
 FLEXIBLE EXCHANGE RATE
• Flexible exchange rates can be defined as exchange rates determined by global supply and
demand of currency.
• In other words, they are prices of foreign exchange determined by the market, that can
rapidly change due to supply and demand, and are not pegged nor controlled by central
banks.
• It is the rate which is determined by the demand and the supply of different currencies in the
foreign exchange market.
• The value of currency is allowed to fluctuate freely according to the changes in the demand
and supply of foreign exchange.
• There is no official ( government) intervention in the foreign exchange market.
• It is also known as floating exchange rate.
Merits of flexible exchange rate
• There is no need for the government to hold any reserve
• It eliminates the problems of undervaluation or over valuation of currency.
• It promotes venture capital in the form of foreign exchange.
• It enhances efficiency in resource allocation.

Demerits of flexible exchange rate

• It creates a situation of market instability.
• International trade and investment is discouraged due to the uncertainty caused by currency
fluctuations.
• It encourages speculation.
 MANAGED EXCHANGE RATE
• It is a mixture of flexible exchange rate system ( the float part) and a fixed exchange rate
system ( the manged part), wherein exchange rate is determined in the foreign exchange
market freely by the market forces of demand and supply.
• Excessive fluctuation is checked by the central bank.
• In this system, central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close
to the desired target value.
• For this central banks maintains reserves of foreign exchange to ensure that the exchange
rate stays within the targeted value.
Merits of manged exchange rate
• It allows monetary policy independence.
• It also allows the central bank to use other policies such as interest rates to stabilize
exchange rate movements not just using foreign exchange reserves.

Demerits of manged exchange rate

• This system can trigger speculation activities.
 FOREIGN EXCHANGE MARKET
• Foreign exchange market is the market in which national currencies are traded for one
another.
• The major participants in this market are commercial banks, MNCs share brokers, other
authorised dealers and monetary authorities.
• Foreign exchange market (forex, FX, or currency market) is a global decentralized market
for the trading of currencies.
• Financial centers around the world function as anchors of trading between a wide range of
multiple types of buyers and sellers around the clock, with the exception of weekends.
• The foreign exchange market determines the relative values of different currencies.
 TYPE OF FOREIGN EXCHANGE
MARKET
1. Spot market :
• Refers to the market in which the receipts and payments are made immediately.
• The rate of exchange is termed as spot exchange rate or current rate of exchange.
• A two day margin is allowed as it takes two days for payments made through cheques to be
cleared.
• A spot transaction is a two-day delivery transaction (except in the case of trades between the
US Dollar, Canadian Dollar, Turkish Lira, Euro and Russian Ruble, which settle the next
business day), as opposed to the futures contracts, which are usually three month
• Forward market
• The market of foreign exchange which deals with the purchase and sale of foreign exchange
which are contracted today but are implemented in future is called forward market.
• The exchange rate is known as forward exchange rate.
• e.g bills of exchange
• A buyer and seller agree on an exchange rate for any date in the future, and the transaction
occurs on that date, regardless of what the market rates are then. The duration of the trade
can be one day, a few days, months or years
• Swap - The most common type of forward transaction is the foreign exchange swap. In a
swap, two parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded through an
exchange. A deposit is often required in order to hold the position open until the transaction
is completed.

• Futures - Futures are standardized forward contracts and are usually traded on an exchange
created for this purpose. The average contract length is roughly 3 months. Futures contracts
are usually inclusive of any interest amounts. Currency futures contracts are contracts
specifying a standard volume of a particular currency to be exchanged on a specific
settlement date.
• Thus the currency futures contracts are similar to forward contracts in terms of their
obligation, but differ from forward contracts in the way they are traded. They are commonly
used by MNCs to hedge their currency positions. In addition they are traded by speculators
who hope to capitalize on their expectations of exchange rate movements
• Option- Foreign exchange option (commonly shortened to just FX option) is a derivative
where the owner has the right but not the obligation to exchange money denominated in one
currency into another currency at a preagreed exchange rate on a specified date. The FX
options market is the deepest, largest and most liquid market for options of any kind in the
world.
 FUNCTION OF FOREIGN EXCHANGE
MARKET
1. Transfer function – it facilitates transfer of purchasing power across different countries of
world.
2. Credit function – it facilitates credit for international trade. Bills of exchange with
maturity period of three months, are generally used.
3. Hedging function – it facilitates protection against risks of foreign exchange fluctuations
etc. exporters and importers enter into agreement to sell and buy goods on some future
date at the current prices and exchange rate.
 FACTORS THAT INFLUENCE EXCHANGE
RATES
Determinants of Exchange Rates
- Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a comparison
of the currencies of two countries. The following are some of the principal determinants of the
exchange rate between two countries. Note that these factors are in no particular order; like many
aspects of economics, the relative importance of these factors is subject to much debate.
1. Differentials in Inflation
- As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation
typically see depreciation in their currency in relation to the currencies of their trading partners.
This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
• Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values. Higher interest rates offer lenders in an
economy a higher return relative to other countries.
• Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
The impact of higher interest rates is mitigated, however, if inflation in the country is much
higher than in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease
exchange rates.
3. Current-Account Deficits
• The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends. A
deficit in the current account shows the country is spending more on foreign trade than it is
earning, and that it is borrowing capital from foreign sources to make up the deficit.
• In other words, the country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's exchange rate until domestic
goods and services are cheap enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.
4. Public Debt
• Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors.
• The reason ---- A large debt encourages inflation, and if inflation is high, the debt will be serviced
and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a
government may print money to pay part of a large debt, but increasing the money supply
inevitably causes inflation.
• Moreover, if a government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply of securities for
sale to foreigners, thereby lowering their prices.
• Finally, a large debt may prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own securities denominated in that
currency if the risk of default is great. For this reason, the country's debt rating (as determined by
Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.
5. Terms of Trade
• A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a greater rate
than that of its imports, its terms of trade have favorably improved.
• Increasing terms of trade shows greater demand for the country's exports. This, in turn, results
in rising revenues from exports, which provides increased demand for the country's currency
(and an increase in the currency's value). If the price of exports rises by a smaller rate than
that of its imports, the currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic Performance

• Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk. Political
turmoil, for example, can cause a loss of confidence in a currency and a movement of capital
to the currencies of more stable countries.
 THEORIES OF FX
1. Supply and Demand
• As stated earlier, the exchange rate, just like commodities, determines its price responding to
the forces of supply and demand. Therefore, if for some reason people increase their demand
(shift of the curve from D to D1) for a specific currency, then the price will rise from A to B,
provided the supply remains stable. On the contrary, if the supply is increased (shift of the
curve from S to S1), the price will decline from
• This theory is also known as balance of payment theory.
• It maintains that the rate of exchange of the currency of one country with the other is
determined by the factors which are autonomous of internal price level and money supply.
• A deficit in the balance of payment of a country signifies a situation in which the demand for
foreign exchange ( currency) exceeds the supply of it at a given rate of exchange.
• The demand for foreign exchange arise from the demand for foreign goods and services.
• The supply of foreign exchange, on the contrary, arise from the supply of goods and services
by the home country to the foreign country.
• In other words, the excess of demand for foreign exchange over the supply of foreign
exchange is coincidental to the BOP deficit.
• The demand pressure results in an appreciation in the exchange value of foreign currency. As
a consequence, the exchange rate of home currency to the foreign currency undergoes
depreciation.
• A balance of payments surplus signifies an excess of the supply of foreign currency over the
demand for it.
• In such situation, there is a depreciation of foreign currency but an appreciation of the
currency of the home country.
• The equilibrium rate of exchange is determined when there is neither a BOP deficit nor a
surplus. In other words, the equilibrium rate of exchange corresponds with the BOP
equilibrium of a country.
2. Purchasing power parity (PPP)
• is a component of some economic theories and is a technique used to determine the relative
value of different currencies.
• The purchasing power parity exchange rate serves two main functions.
1. PPP exchange rates can be useful for making comparisons between countries because they
stay fairly constant from day to day or week to week and only change modestly, if at all,
from year to year.
2. Second, over a period of years, exchange rates do tend to move in the general direction of
the PPP exchange rate and there is some value to knowing in which direction the exchange
rate is more likely to shift over the long run
• This theory states that the equilibrium rate of exchange is determined by the equality of the
purchasing power of two inconvertible paper currencies.
• It implies that the rate of exchange between two inconvertible paper currencies is determined by
the internal price levels in two countries.
• There are two versions of the purchasing power parity theory:
1. The absolute version
2. The relative version

The absolute version:

• According to this version of purchasing power parity theory, the rate of exchange should normally
reflect the relation between the internal purchasing power of the national currency units.
• In other words, the rate of exchange equals the ratio of outlay required to buy a particular set of
goods at home as compared with what it would buy in a foreign country.
• Ex- suppose 10 units of commodity X, 12 units of commodity Y and 15 units of commodity
Z can be bought through spending Rs 1500 and the same quantities of X,Y, and Z
commodities can be bought in the united states at an outlay of 25 dollars.
• It signifies that the purchasing power of 25 dollars is equivalent to that of Rs. 1500 in their
respective countries. That can form the basis for determining the rate of exchange between
rupee and dollar.
• Rate of exchange = (units of currency A/ units of currency B) * ( internal purchasing power
of A/ internal purchasing power of B)
• The Relative Version:
• According to this version, the equilibrium rate of exchange in the current period (R1) is
determined by the equilibrium rate of exchange in the base period(R0) and the ratio of price
indices of current and base period in the other country.
• R1 = R0 * (PB1/PB0)/ (PA1/PA0)
• R1- rate of exchange in the current period
• R0 – rate of exchange in the base period or the original rate of exchange.
• PB1 – price indices in the country B in current year
• PB0- price indices in the country B in base year.
• PA1- price indices in the country A in current year
• PA0 - price indices in the country A in base year
 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.
• This is a potential gain or loss that results from a change in the exchange rate. An uncovered
claim, is called a “long” and an uncovered liability in a foreign currency is called “ short”
• Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial
statements in a currency other than the reporting currency of the consolidated entity.
• The risk is that there may be an adverse movement in the exchange rate of the denomination
currency in relation to the base currency before the date when the transaction is completed.
• Investors and businesses exporting or importing goods and services or making foreign
investments have an exchange rate risk which can have severe financial consequences; but
steps can be taken to manage (i.e., reduce) the risk.
 TYPES OF EXPOSURE
• Transaction exposure –
• A firm has transaction exposure whenever it has contractual cash flows (receivables and
payables) whose values are subject to unanticipated changes in exchange rates due to a
contract being denominated in a foreign currency.
• To realize the domestic value of its foreign-denominated cash flows, the firm must exchange
foreign currency for domestic currency.
• As firms negotiate contracts with set prices and delivery dates in the face of a volatile
foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of
changes in the exchange rate between the foreign and domestic currency.
• Economic exposure –
• A firm has economic exposure (also known as forecast risk) to the degree that its market
value is influenced by unexpected exchange rate fluctuations.
• Such exchange rate adjustments can severely affect the firm's market share position with
regards to its competitors, the firm's future cash flows, and ultimately the firm's value.
• Economic exposure can affect the present value of future cash flows. Any transaction that
exposes the firm to foreign exchange risk also exposes the firm economically, but economic
exposure can be caused by other business activities and investments which may not be mere
international transactions, such as future cash flows from fixed assets.
• A shift in exchange rates that influences the demand for a good in some country would also
be an economic exposure for a firm that sells that good
• Translation exposure - A firm's translation exposure is the extent to which its financial
reporting is affected by exchange rate movements.
• As all firms generally prepare consolidated financial statements for reporting purposes, the
consolidation process for multinationals entails translating foreign assets and liabilities or
the financial statements of foreign subsidiary subsidiaries from foreign to domestic currency.
• While translation exposure may not affect a firm's cash flows, it could have a significant
impact on a firm's reported earnings and therefore its stock price.
• Translation exposure is distinguished from transaction risk as a result of income and losses
from various types of risk having different accounting treatments.
• Contingent exposure - A firm has contingent exposure when bidding for foreign projects or
negotiating other contracts or foreign direct investments. Such an exposure arises from the
potential for a firm to suddenly face a transactional or economic foreign exchange risk,
contingent on the outcome of some contract or negotiation.
• For example, a firm could be waiting for a project bid to be accepted by a foreign business
or government that if accepted would result in an immediate receivable.
• While waiting, the firm faces a contingent exposure from the uncertainty as to whether or
not that receivable will happen. If the bid is accepted and a receivable is paid the firm then
faces a transaction exposure, so a firm may prefer to manage contingent exposures.
 CURRENCY RISK
• A form of risk that arises from the change in price of one currency against another.
• Whenever investors or companies have assets or business operations across national borders,
they face currency risk if their positions are not hedged.
• For example, if you are a U.S. investor and you have stocks in Canada, the return that you
will realize is affected by both the change in the price of the stocks and the change in the
value of the Canadian dollar against the U.S. dollar.
• So, if you realize a 15% return in your Canadian stocks but the Canadian dollar depreciates
15% against the U.S. dollar, this will amount to no gain at all.
 TYPES OF CURRENCY RISK
• 1. Transaction risk - which is basically cash flow risk and deals with the effect of exchange rate
moves on transactional account exposure related to receivables (export contracts), payables (import
contracts) or repatriation of dividends. An exchange rate change in the currency of denomination of
any such contract will result in a direct transaction exchange rate risk to the firm;
• 2. Translation risk - which is basically balance sheet exchange rate risk and relates exchange rate
moves to the valuation of a foreign subsidiary and, in turn, to the consolidation of a foreign
subsidiary to the parent company’s balance sheet.
• Translation risk for a foreign subsidiary is usually measured by the exposure of net assets (assets
less liabilities) to potential exchange rate moves.
• In consolidating financial statements, the translation could be done either at the end-of-the-period
exchange rate or at the average exchange rate of the period, depending on the accounting regulations
affecting the parent company. Thus, while income statements are usually translated at the average
exchange rate over the period, balance sheet exposures of foreign subsidiaries are often translated at
the prevailing current exchange rate at the time of consolidation.
• 3. Economic risk - which reflects basically the risk to the firm’s present value of future
operating cash flows from exchange rate movements.
• In essence, economic risk concerns the effect of exchange rate changes on revenues
(domestic sales and exports) and operating expenses (cost of domestic inputs and imports).
• Economic risk is usually applied to the present value of future cash flow operations of a
firm’s parent company and foreign subsidiaries. Identification of the various types of
currency risk, along with their measurement, is essential to develop a strategy for managing
currency risk.
 MANAGEMENT OF CURRENCY RISK

• Transaction Risk can be reduced either by use of money market, foreign exchange
derivatives such as forward contract future contract options and swap
• Economical Risk can be mitigated by carefully selecting production site with mind for
lowering cost, establishing strong research and development unit, diversifying its export
market across a greater number of countries.
• Translation Risk can be minimizing by following universal standard between parent unit and
its subsidiaries.
 COUNTRY RISK
• A collection of risks associated with investing in a foreign country. These risks include
political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the
risk of capital being locked up or frozen by government action.
• Country risk varies from one country to the next. Some countries have high enough risk to
discourage much foreign investment.
• Country risk can reduce the expected return on an investment and must be taken into
consideration whenever investing abroad.
• Some country risk does not have an effective hedge. Other risk, such as exchange rate risk,
can be protected against with a marginal loss of profit potential.
• The United States is generally considered the benchmark for low country risk and most
nations can have their risk measured as compared to the U.S. Country risk is higher with
longer term investments and direct investments, which are investments not made through a
regulated market or exchange
• Country risk is a risk that denotes the probability of a foreign government (country) defaulting
on its financial obligations as a result of economic slowdown or political unrest. Even a small
rumor or revelation can make a state less attractive to investors who want to park their hard-
earned income in a place that is reliable and significantly less likely to default
• Let us assume Two Countries – the US and Algeria. Assuming both have some up-and-coming
projects coming up for which they intend to issue bonds
• to raise finance. Which bonds are safe and which are more likely to default? Here comes the
assessment part. An investor has to scrutinize various factors attributing to the country’s stability,
like its political situation, inflation rates, economic health, tax systems, and many other factors.

• Upon careful assessment, investors might find that the US is a far better investment option than
Algeria owing to its solid political structure, demographics, tax system, technological
advancement, and economic wellbeing. Hence, it can be said that Algeria has a much higher
country risk than the US. The US is found to have the lowest country risk in the world.
• Five significant country risk types are as follows:

(1) Sovereign Risk means the risk those commercial banks’ sovereign borrowers or
counterparties are unable or unwilling to repay their debts, or refuse to fulfill their
contracts or obligations either directly or indirectly, such as debt moratorium policy.

(2) Transfer risk means the risk that non-resident counterparties are unable to secure foreign
exchange to repay their debts to the commercial banks due to certain restrictions, for example,
when the host country government imposes the capital control or foreign exchange control
measures.
3) Contagion Risk means the risk that arises when changes in certain factors in one country affects
other countries in the region whose residents are bank’s counterparties, for example, downgrading of
credit rating of one country has an effect on debt repayment or business undertaking with residents in
other countries in the same region.
(4) Macroeconomic Risk means the risk that arises when non-resident counterparties are unable to or do
not repay their debt or are unable to fulfill their obligations as a result of changes in economic policies
of their countries, i.e., raising interest rates to preserve currency value or changes in tax policy.
Advantages
1. As indicated earlier, country risk assessment keeps investors warned and aware of what to
expect from an investment in a particular country.
2. Not only investors but such analysis also helps corporations in formulating strategies
suited to a particular country’s environment. Such strategic planning helps them treat
different countries differently.
3. It includes both economic and political risks. Measurement provides a tentative idea of the
financial health and the political environment of a country. This 2-pronged approach to
risk assessment is very beneficial for governments who can devise their foreign policies
accordingly.
4. Many corporations and publications use their own country risk analysis tool. By using this
tool, they can devise different methods to get insured against such risk
Disadvantages
1. This is dependent on hundreds of factors, making its assessment difficult and not so
accurate. The error of measurement or error of omission is bound to happen. Even the
most sophisticated algorithms fail to capture all the factors accurately.
2. Qualitative assessment is primarily based on the availability and inclusion of information.
However, the report found is never perfect. So, it doesn’t aptly capture everything.
Managing Exposure
1. Investors and financial corporations should devise a proper framework that includes
segregates between different parts of country risk.
2. It is also governed by a country’s resources and the primary occupation the economy is
based on. Setting up teams to closely monitor these areas will also be beneficial in the
assessment.
3. Risk exposure should continually be monitored and updated to stay abreast.
4. Using ratings to evaluate a country’s standing in the global markets.