Foreign Exchange Risk Management

Introduction

Financial risk management can be considered as the practice of creation of economic value in companies safeguarding the company against risks like foreign exchange, interest rate fluctuations, credit and liquidity, and inflation risks. The objective of traditional risk management is to enable the firms to protect their physical assets against loss in their valuation by adopting various methods. It becomes important for the businesses to protect themselves against losses in their values, increase in the cost of liabilities or decrease in the return on the assets due to changes in the interest rates and fluctuations in foreign exchange. The firms have started using a number of improved tools and techniques for their protection against the financial risks. If the established principles are followed effectively the financial risk management policies may prove to be one of the powerful tools for managing the financial risks of any company (MoneyInsructor, 2000). This paper examines the scope and magnitude of various risks and the management of such risks.

Foreign Exchange Risk

Foreign exchange risk is the impact of any unanticipated changes in the exchange rate on the value of the assets and liabilities of a firm (Giddy & Dufery, 1992). In simple terms, exchange risk is a potential gain or loss which results because of changes in the currency values which affect the economic profits of the firm by the impact of the changes in the value of the firm’s assets liabilities held in foreign countries. Change in the domestic currency value of assets and liabilities may be positive in which case it will be a gain for the firm or negative in which case it will be a loss.

Many of the firms do not involve themselves in active management of their exposure to foreign exchange risks due to various reasons. One of the main reasons cited is that it is not possible to exactly measure the exposure to foreign exchange. However it is important that the foreign exchange risk is properly analyzed and adequate measures taken to protect the firm against exposure to this risk. The objective of such an analysis is to protect the value of the company’s assets and the economic profits of the firm. By instituting proper measures the company would also be able to maximize its profits by increasing the value of the firm’s export revenue to be realized in any foreign currency.

Hedging is usually the technique employed to protect against the foreign exchange risk. However if the institution is exposed to foreign exchange transactions in any particular currency which calls for both inflows and outflows, then the institution will be able to offset the transactions between inflows and outflows of specific foreign currency without hedging or any other technique to be used. The institution has to settle only for the differential amount between the inflows and outflows. This will save the firm from the trouble of covering the foreign exchange under a forward contract.

Hedging and Foreign Exchange Risk

Hedging is the process by which a firm protects the price of a financial instrument at a future date by taking an opposite position at the current date. For this purpose the firm uses derivatives such as Currency Options, Currency Futures, Forward Contracts, Currency Swaps, and Money Markets.

Forward contract is a definite commitment on the part of the firms to deliver specified foreign currency at a fixed price for a future date. The forward contract extends an upside benefit whenever there is a favorable movement in the value of the underlying foreign currency; but forward contract does not provide any protection against downward fluctuation in the foreign currency value.

‘Currency futures’, which is another form of derivatives, enable exporters and importers to hedge their respective positions undertaking to buy or sell future contracts. By entering into futures transactions, traders would be able to take their positions in exchange rates covering their transactions. The traders can purchase (is called a long hedge) or sell (is called a short hedge) currency futures and through these transactions the firm would be able to manage the inflows and outflows of any foreign currency with respect to another currency. Khoury & Chan, (1988) and Glaum, (1990) have a contradicting view that firms use the futures contract as a last resort.

Options and Foreign Exchange Risk

Currency options “are instruments, which give the buyer of the option the right but not the obligation to execute a specified transaction in the underlying currency pair.” (Banking and Finance, 2006) The buyer is at liberty whether to execute the settlement or refrain from settling. Currency options have a different characteristic in which they provide the benefits of both a downside protection against exposure to foreign exchange risk and an upside benefit when there is a favorable movement in the currency.

Credit Risk

There are the financial, managerial and strategic factors involved in any credit decision (Servigny & Renault, 2004). Credit risk arises when there is a potential situation that the promised repayment commitments are not met and the cash flows therefore are affected. The implications of growing credit risk can be seen from the increased credit screening by the banks and financial institutions. Diversification of the credit portfolios is the usual technique used by the banks to safeguard them against credit risk. The objective of analyzing credit risk is to ensure that there is an increased monitoring of the credit already extended and there is adequate control on the future credits to be extended. The analysis of credit risk is primarily to reduce earnings volatility and to avoid large losses by way of bad debts.

Managing Credit Risk

The critical element in managing credit risk successfully involves the management of the dynamics of credit risk (Moody’s, 2004). The dynamics of credit risk lies in the default probabilities rather than ranking the credits for their eligibility. Banks and other financial institutions extending credit follow several protection techniques to safeguard themselves against their exposure to this important risk.

Banks develop their own internal credit rating systems and other credit risk considerations before they decide on extending the credit to any party. There is the technique of portfolio diversification which provides enough cover to the banks and institutions against exposure to this risk. Banks based on the relative default probabilities decide on the industries/sectors to which credit may be extended and the proportions of credits to be extended to ensure that they do not make any loss on account of credit risk. Banks started adopting techniques like (i) stand-alone valuation techniques, (ii) comprehensive and relevant databases, (iii) attempts to resolve the portfolio credit-risk problem and (iv) the advent and impressive growth in the structuring and trading of credit-risk derivatives and various types of credit insurance and guarantees in order to have a sophisticated treatment of corporate credit evaluation and credit portfolio management (Altman, 2001)

Interest Rate Risk

Bartram et al., (2003) state interest rate exposure refers to the risk covering unexpected changes in the rates of interest which will have the effect of adversely affecting the profits and cash flow of any firm. “Interest rate risk is the potential impact on an institution’s earnings and net assets values of changes in interest rates.” (Bank of Jamica, 1996) Interest rate risk results from financial intermediation. The intermediation may result in mismatch in maturities of assets and liabilities due to changes in interest rates over the period. Interest rate risk also arises from the chances of future cash flows getting vitiated on account of changing interest rates which change the fair value of financial instruments in the possession of the banks. The amount of interest rate risk is calculated as a function of the magnitude and direction of the changes taking place in the interest rates and the size of the mismatch between the values of assets and liabilities. The objective of managing the interest rate risk efficiently is to protect the organization from incurring losses on account of changes in the interest rates.

Managing Interest Rate Risk

Managing interest rate risk (Servigny & Renault, 2004) is a complex task. For efficiently managing interest rate risk there is the need to understand the scope and extent of risk involved and the impact of such risk on the banks. Banks and financial services organizations have to evolve specific techniques and systems to guard them against potential losses that may arise out of exposure to interest rate risk. It is particularly important that the institutions engage proper systems for measuring the impact of potential interest rate fluctuations on the profitability of the banks.

Generally in order to assess the exposure to interest rate risk institutions engage techniques like VaR, Gap Analysis and Duration Analysis. Interest rate gap represents the difference between the values of variable rate assets and liabilities at a given point of time in future. Banks will try to have a positive gap when the interest rates are expected to fall so that they can increase the profitability. On the other hand when the interest rates are expected to go up banks will try to have a negative gap to avoid the loss on account of interest rate risk. By duration analysis banks would be able to assess the sensitivity of the value of a financial asset with respect to fluctuations in interest rates (Gestel & Baesens, 2009).

Managing the interest rate exposure has become more common in the present day business environment and the associated corporate activities. This situation has developed due to increase in the competition among the firms and the availability of various tools for mitigating the interest rate risks. For the purpose of managing interest rate risk firms usually undertake different types of derivative transactions such as futures, options and swaps.

Futures

Future contracts resemble forward contracts and are usually traded in derivative exchanges. However futures have somewhat standardized terms in respect of maturity, amounts and currency. Mostly the futures contract are similar in all respects with the forward contract except for the point that in the forward contract the gains and losses are realized and transferred at the maturity of the contract, while in the case of futures contract the gains and losses on them are realized and settled every day. Hedging against assets which are risky is often undertaken by using futures contracts.

Options

Options are financial contracts under which the buyer gets a right but not an obligation to perform his part of the contract to buy or sell under the contract (Ross et al., 2005). Usually the buyer pays a premium for acquiring this right. The transaction may relate to selling or buying a particular asset. However the contract does not place any obligation on the holder to buy or sell the asset. Interest rate options are being increasingly used as a hedging technique because of the distinct advantage of protecting the company from any unfavorable movements in the interest rates.

Swaps

“A swap is a derivative whereby two parties agree to exchange a series of cash flows according to pre-specified terms.” Swaps are normally over the counter (OTC) transactions. Interest rate swaps are swap contracts which are linked to changes in interest rates. The interest is calculated on a notional amount and exchange of cash flows take place between the parties based on the movements in the interest rates. Currency swap represents a derivative contract under which two parties agree to mutually exchange the cash flows arising out of principal and interest payments. The cash flows are expected to happen over a specified period of time at a pre fixed exchange rate. Currency swap is often used by the firms which need to operate by borrowing in another currency and it is usually found cost effective to borrow funds in the own currency of the company that is borrowing as the receipt of funds upfront and repayment of the principal as well as settlement of interests are being made in the same currency.

Conclusion

The covering of the exchange rate risks and interest rate risks assume greater importance in view of the fact that such fluctuations affect the value of existing foreign assets and liabilities of the firm. With the continuous movement in the currency and interest rates the firms may sometimes lose their competitive strength in the international markets. This is due to the fact that the company may not be able to quote competitive prices if they do not guard themselves against the foreign exchange risks. The exchange rate risks may be complex in nature and sometimes the risks may not be apparent.

References

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BankingandFinance, 2006. Hedging Foreign Exchange Risk – Isn’t is also a Risk? [Online] 2009. Web.

BankofJamica, 1996. Interest Rate Risk Management. [Online] 2009. Web.

Bartram, S.M., Brown, G.W. & Fehle, F.R., 2003. International Evidence on Financial Derivative Usage. Economics Working Paper at WUSTL.

Gestel, T.v. & Baesens, B., 2009. Credit Risk Management: Basic Concepts: Financial Risk Components, Rating Analysis, Models, Economic and Regulatory Capital. United States: Oxford University Press.

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Servigny, A.D. & Renault, O., 2004. Measuring and managing credit risk. UK: Mc-Graw Hills Professional.