Financial Management Risk Management

Risk Management
Uncertainty

Where the incidence and likelihood of an event can’t reliably be estimated the situation is said to be
uncertain.

Risk

A risk can be defined as the likelihood of an unfavorable event being occurred. The higher the variations
in the outcomes of a project the riskier the project would be.

Before we move on to discuss risk management strategies we shall look into the following two types of
risks:

➢ Foreign Exchange risk

➢ Interest rate risk

Foreign Exchange risk

This type of risk is faced by organizations that are engaged in foreign trade.

Defined

“The risk that an investor will have to close out a long or short position in a foreign currency at a loss
due to an adverse movement in exchange rates. Also known as “currency risk” or “exchange rate
risk”.

Types of Foreign Exchange risks

➢ Translation risk
➢ Transaction risk
➢ Economic risk

Translation risk

This is the risk that the organization will make exchange losses when the accounting results of its foreign
branches or subsidiaries are translated into the home currency. Translation losses can result, for example,
from restating the book value of a foreign subsidiary's assets at the exchange rate on the statement of
financial position date.

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Transaction risk

Transaction risk is the foreign exchange risk that arises in transactions between two parties:

➢ where the normal transaction currency of each party is different, and

➢ when the transaction involves a future receipt/payment between the two parties

Transaction risk is the risk that, for any future transaction in a foreign currency, the amount received or
paid in domestic currency might be different from the amount originally expected because of movements
in the exchange rate between the date of the initial transaction and the date of settlement
(payment/receipt).

Example (transaction risk)

A ltd (a local company) has sold goods to B ltd (US based company) for $15,000. A ltd has
to receive the $10,000 in one month’s time. The current exchange rate is $1.5/1£. If he
receives this amount today and immediately converts into local currency (i.e. pounds) he
will have £10,000. Let us assume in one month’s time the exchange rate will be $2/1£. A
ltd will have only £7,500 upon conversion after one month. Due to adverse exchange rate
movement the company will suffer a loss of £2,500.

Economic risk

Economic risk refers to the long-term movement in exchange rates caused by changes in the
competitiveness of a country.

For example, over the long term the euro might increase in value against the US dollar. If this happens,
goods produced and paid for in US dollars will become cheaper relative to goods produced and paid for in
euros. US companies will therefore become more competitive in terms of price, relative to companies in
the euro-zone, because of the exchange rate movement.

Economic risk, in the context of foreign exchange, is therefore the risk that a company might choose to
locate its operations in a country whose currency gains in value over time against the currencies of its
competitors in world markets. The consequence of an increase in the value of the domestic currency is a
loss of competitiveness.

Causes of exchange rate fluctuations

There are several approaches to explaining the causes of exchange rate fluctuations

➢ Supply and Demand

➢ Purchasing Power Parity
➢ Interest rate parity

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Supply and demand

Exchange rates are determined by supply and demand in the foreign exchange markets. For example, the
value of the British pound against other currencies is determined by supply and demand for the pound.

➢ The demand for pounds comes from buyers of British exports, who are required to pay in pounds.
Pounds are also bought by British exporters who receive payments in foreign currencies and want
to exchange their currency receipts into pounds.

➢ Demand for pounds is also created by flows of investment capital and savings. Foreign investors
wishing to purchase investments in the UK must buy pounds to pay for their investments. UK
investors selling their foreign investments might exchange their sale receipts (in a foreign
currency) into pounds.

Purchase price parity

Purchasing power parity theory

Purchasing power parity theory (PPP S1= S0 x (1+hc)

theory) attempts to explain changes in an (1+hb)
exchange rate by the relative rate of price
Where;
inflation in each country. The theory is
based on the assumption that the exchange S1 = Expected spot rate (Forward rate)
rate will adjust to enable the same amount S0 = Current spot rate
of goods to be purchased in any country hc = Expected inflation rate in company C
with a given amount of money. hb = Expected inflation rate in company B

Interest rate parity

Interest rate parity theory 1 + ic = Forward rate

1 + ib Spot rate
Interest rate parity theory is based on the
assumption that exchange rates will adjust to Where;
eliminate differences in interest rates ic = interest rate in country C
between countries. For example, suppose ib = Interest rate in country

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International Fisher Effect

Countries with relatively high rates of

inflation will generally have high nominal
rates of interest, partly because high interest International fisher Effect
rates are a mechanism for reducing inflation,
and partly because of the Fisher effect:
higher nominal interest rates serve to allow 1 + ic = (1+hc)
investors to obtain a high enough real rate of
1 + ib (1+hb)
return where inflation is relatively high.
Where;
According to the international Fisher effect, ic = interest rate in country C
interest rate differentials between countries ib = interest rate in country B
provide an unbiased predictor of future hc= Expected inflation rate in company C
changes in spot exchange rates. The currency hb= Expected inflation rate in company B
of countries with relatively high interest rates
is expected to depreciate against currencies with lower interest rates, because the higher interest rates are
considered necessary to compensate for the anticipated currency depreciation. Given free movement of
capital internationally, this idea suggests that the real rate of return in different countries will equalize as a
result of adjustments to spot exchange rates.

Four-way equivalence

The four-way equivalence model states that in equilibrium, differences between forward and spot rates,
differences in interest rates, expected differences in inflation rates and expected changes in spot rates are
equal to one another.

(equals)
Difference in interest Fisher effects Expected differences in
rates Expected inflation rates
differences in inflation
rates
(equals)
(equals)
Interest rate parity (equals)
International (equals)
Fisher Effects purchasing power

Difference between Expected change in

forward and spot spot rate
Equals Expectations theory

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The FX markets: spot rates

Bid and offer prices
In an examination, you might be given one figure for the current exchange rate between two currencies.
In practice, banks quote two rates: a bid rate (bank buys at ) and an offer rate (bank sells at).

In the foreign exchange markets, most exchange rates are quoted to four decimal places. It is easy to get
confused about which exchange rate should be applied to a particular transaction.

The basic rule to remember is that the bank will use the rate that is more favourable to itself and less
favourable to the customer.

Example

A UK company needs $20,000 to pay a US supplier. The bank’s current rates for
sterling/US dollar (US$/£1) are 1.8850 – 1.8860. The company needs to buy US dollars in
exchange for British pounds, in order to pay the US supplier. The bank is selling dollars and
receiving British pounds in exchange. It will apply a rate of 1.8850 to the currency
transaction with the company, because 1.8850 will give it more British pounds than the rate
of 1.8855. The cost of buying the dollars is therefore £10,610.08 (= $20,000/1.8850).

Example

The same UK company receives US$25,000 from a customer, and it wants to convert
these dollar receipts into British pounds. The exchange rate is 1.8850 – 1.8860. The bank
will buy dollars and sell the pounds at 1.8860, and so the company will receive £13,255.57 (=
$25,000/1.8860) in exchange for the dollars. Taking this transaction and the previous
example together, the UK company’s cash flows in British pounds from the two transactions
would be as follows:
£
Buy $20,000 at 1.8850: pay (10,610.08)
Sell $25,000 at 1.8860: receive 13,255.57
Net receipts 2,645.49

It would be more sensible for the company to pay $20,000 to the US supplier out of the
$25,000 it receives from its customer. That would leave it needing to sell just US$5,000 at
1.8860. The receipts in British pounds would then be £2,651.11 (= $5,000/1.8860) which is
more than from buying $20,000 and selling $25,000 in separate transactions. The difference
is small, but for a company engaged extensively in foreign trade, the total amounts involved
can become very large over time.

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Spot Exchange rate

The spot exchange rate is the current exchange rate for a transaction ‘now’ to buy one currency in
exchange for another.

Forward Exchange rate

The forward exchange rate is the rate for a transaction (at some future date) to buy one currency in
exchange for another.

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Foreign Currency Risk Management

Foreign currency risk needs to be managed so that the company does not suffer from the adverse
exchange rate movements. The process is known as “hedging”.

Following are the methods of hedging foreign exchange risk:

1. Invoicing in own currency (internal)

2. Matching & Netting receipts and payments (internal)
3. Matching assets and liabilities (internal)
4. Leading and lagging (internal)
5. Forward Exchange contracts (external)
6. Foreign currency derivatives (external)
➢ Currency Futures
➢ Currency Options
➢ Currency Swaps
7. Money Market Hedging (external)

1. Invoicing in Own currency

One way to avoid transaction risk is to invoice foreign customer in home currency, or to arrange
with the foreign supplier to be invoiced in home currency. In this case the risk is transferred to
customer or supplier.

Why will an exporter still like to invoice in foreign currency:

➢ There is the possible marketing advantage by proposing to invoice in the buyer's own
currency, when there is competition for the sales contract.
➢ The exporter may also be able to offset payments to his own suppliers in a particular
foreign currency against receipts in that currency.
➢ By arranging to sell goods to customers in a foreign currency, a UK exporter might be
able to obtain a loan in that currency at a lower rate of interest than in the UK, and at
the same time obtain cover against exchange risks by arranging to repay the loan out of
the proceeds from the sales in that currency.

2. Netting and matching

Netting and matching can be applied to cash flows in a foreign currency or to assets and liabilities
denominated in a foreign currency.

➢ Netting means offsetting a payment against a receipt to get a net payment or a net receipt.
Netting can reduce a currency exposure to the net amount.
➢ Alternatively netting means offsetting a liability against an asset in the same currency.
➢ Matching is similar, except the receipt and payment are the same amount, or the asset and
liability are for the same amount. Matching reduces an exposure to currency risk to 0.

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When a company expects to have future cash receipts in a foreign currency and future cash
payments in the same currency at about the same time, it can use the receipts to make some or
all of the payments. To the extent that future receipts match future payments, the foreign
exchange risk is eliminated. Movements in the spot exchange rate will affect the receipts and
payments equally. The loss from the adverse movement affecting the cash receipts or payments
will be offset by the gain from the favourable movement affecting the cash payments or
receipts.

Example

A UK company expects to receive US$400,000 in two months’ time and to make payments
of $600,000, also in two months. To hedge its currency exposures, the company can match
$400,000 of receipts and payments, leaving a net exposure of just $200,000 in payments.
This net exposure might be hedged with a forward exchange contract

3. Matching assets and liabilities

A company might also try to match assets and liabilities in the same currency, to reduce exposures to
foreign exchange risk.

For example suppose that a UK company plans to make an investment in a business operation in the
USA. The investment would involve buying non-current assets in US dollars. The company might
finance the project by obtaining a US dollar loan. The assets of the project and the financial liabilities
would therefore be matched in the same currency. Cash flows from the project in US dollars could
then be used to pay interest on the loan and repay the loan principal. The company’s only exposure to
foreign exchange risk would then be the net cash flow surplus from the project.

Matching assets and liabilities to reduce translation exposure

A company with a foreign subsidiary might raise debt capital in the currency of the subsidiary, so that
when consolidated accounts are prepared for the group, the assets of the subsidiary will be matched,
at least partially, by the foreign currency borrowings (liabilities). This will reduce exposure to
translation risk, i.e. reduce the reported gains or losses on consolidation.

4. Leading and Lagging

Leading means making a payment early, before the end of the credit period allowed. Lagging means
making a payment as late as possible, possible by taking longer credit than allowed. Leading or
lagging might be used by a company when it believes that the exchange rate between two currencies
will change significantly up or down during a credit period.

➢ The purpose of leading is to pay early in a currency that is expected to increase in value
against the payer’s own currency during the credit period.

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➢ The purpose of lagging is to delay payment as long as possible in a currency that is expected
to fall in value

5. Forward contract
A forward contract or simply a forward is a non-standardized contract between two parties to buy
or sell given amount of foreign currency at a specified future time at a price agreed today. This is in
contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to
enter a forward contract. The party agreeing to buy the underlying currency in the future assumes a
long position, and the party agreeing to sell the currency in the future assumes a short position. The
price agreed upon is called the delivery price.

For example, if an exporter knows that he will receive 83,000 USD in three months time, he can pass
a forward contract with a counterpart who agrees to buy that amount in three months at a given
exchange rate, the forward exchange rate.

Limitations of forward exchange contracts

Although forward exchange contracts are used extensively by companies to hedge exposures to
currency risks, they have some limitations.

➢ It is not possible to arrange forward exchange contracts for some currencies, because not all
currencies are traded in the forward market. Some currencies that are traded ‘spot’ cannot be
traded forward.

➢ There is a limit to time horizon for forward contracts. For the major currencies, such as the US
dollar, the euro and the British pound, forward contracts with other major currencies can be
arranged with a settlement date of up to one year forward. For other exchange rates, forward
contracts might only be possible with a settlement date of several months. Forward contracts
cannot therefore be used to hedge long-term exposures to currency risk.

6. Futures

A future is a forward contract for the purchase or sale of a standard quantity of an item, for settlement
or delivery at a specified future date. Futures contracts have some special features.

➢ They are traded on an exchange, known as a futures exchange. In contrast, actual forward
contracts are negotiated ‘over-the-counter’. For example, a company wishing to hedge a
currency risk with a forward contract must negotiate a deal directly with a bank. A company
using currency futures must buy or sell futures contracts on a futures exchange that deals in
the relevant type of contract.

➢ Futures are standardized contracts. Every futures contract for the purchase/sale of a
particular item is identical to every other futures contract for the same item, with the only
exception that their settlement dates/delivery dates may differ. For example, a currency future
for Euros against the US dollar is for the purchase/sale of €125,000.

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➢ On every futures exchange, there are regular settlement dates for futures contracts. These
are usually in March, June, September and December. A company might therefore buy or sell
March futures for settlement in March, or June futures for settlement in June, and so on.

Other features of currency futures

Other features of currency futures that should be noted are as follows.

➢ It is not usually possible to arrange a ‘perfect hedge’ for a currency risk exposure with futures
contracts. This is because futures contracts are for a standard amount of a currency, and the
exposure might not be for a convenient multiple of this standard amount.

➢ The current exchange rate for buying or selling currency futures is never the same as the
current spot exchange rate, until the futures contract eventually reaches settlement date. If a
position is closed out before then, the hedge will not be ‘perfect’.

Advantages of futures

Transaction costs should be lower than other hedging methods

✓ Futures are tradable and can be bought and sold on a secondary market so there is pricing
transparency, unlike forward contracts where prices are set by financial institutions
✓ The exact date of receipt or payment of the currency does not have to be known, because the
futures contract does not have to be closed out until the actual cash receipt or payment is
made

Disadvantages of futures

✓ The contracts cannot be tailored to the user's exact requirements

✓ Hedge inefficiencies are caused by having to deal in a whole number of contracts and by
basis risk (the risk that the futures contract price may move by a different amount from the
price of the underlying currency or commodity)
✓ Only a limited number of currencies are the subject of futures contracts (although the number
of currencies is growing, especially with the rapid development of Asian economies)
✓ Unlike options (see below), they do not allow a company to take advantage of favourable
currency

7. Currency Options

Whereas a forward or future contains the contractual obligation to deliver at the agreed time and
forward rate, an option offers a choice. Take the example of a euro-area exporter buying an option to
sell 100,000 USD at an exchange rate (strike price) of 1.35 in three months. If at maturity the spot
exchange rate of the euro is anywhere above the strike price, the exporter will exercise this option and
receive 74,074 EUR. However, if the spot rate has moved to, say, 1.32, he will not exercise the option
but sell his dollars in the spot market where he receives 75,758 EUR.
The option thus protects the exporter against adverse moves in the exchange rate without removing
the opportunity to benefit from favorable movements. Put differently, hedging with an option leads to
an asymmetric risk distribution. The seller of the option, however, faces a loss if the option is
exercised and has no gain if it is not exercised. In order to compensate for this risk, he will demand a
premium (rather like an insurance premium) for writing the option.
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The differences between forwards and options can be summarized in three points:

 Options cost a premium while forwards don't;

 at maturity, options offer a choice where forwards have an obligation to deliver;
 Options create asymmetric hedges while forward hedges eliminate upward risk as well
as downward risk.

Described above is the simplest single option. However, there exist more complex constructions such
as "exotic" options or combinations of several simple options. It is, e.g. possible to reduce the option
premium by combining sell and buy options with different strike prices. Of course, this also implies a
more complex risk structure.

8. Currency Swap

Cross-currency swaps exchange a cash flow in one currency against a cash flow in another currency.
If, say, a multinational enterprise wishes to issue a bond to finance a subsidiary in an emerging
market country, it may obtain best financing conditions by issuing a bond denominated in EUR,
rather than in the local currency of its subsidiary and then use a swap to convert the payment of
interest and principle into the relevant local currency.

Example Currency Swap

Consider a UK company X with a subsidiary Y in France which owns vineyards. Assume a spot rate
of £1 = 1.6 Euros. Suppose the parent company X wishes to raise a loan of 1.6 million Euros for the
purpose of buying another French wine company. At the same time, the French subsidiary Y
wishes to raise £1 million to pay for new up-to-date capital equipment imported from the UK. The
UK parent company X could borrow the £1 million sterling and the French subsidiary Y could
borrow the 1.6 million Euros, each effectively borrowing on the other's behalf. They would then
swap currencies.

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9. Money Market Hedging

A money market hedge is another method of creating a hedge against an exposure to currency risk.
Instead of hedging with a forward exchange contract, a company can create a hedge by borrowing or
lending short-term in the international money markets, to fix an effective exchange rate ‘now’ for a
future currency transaction.

A slightly different arrangement is needed for a money market hedge for an exposure arising from:

➢ a future receipt in a foreign currency

➢ a future payment in a foreign currency

Example for hedging a Receipt

A UK company expects to receive a payment of US$800,000 in three months’ time. It wants

to hedge this exposure to currency risk using a money market hedge. Spot three-month
interest rates currently available in the money markets are:
Deposits Borrowing
US dollar 4.125% 4.250%
British pound 6.500% 6.625%

The spot exchange rate (US/£1) is 1.9770 – 1.9780.

Example for hedging a Payment

Suppose that a UK company is expecting to pay a supplier US$500,000 in six months’ time,
and it wants to fix an effective exchange rate for this transaction with a money market
hedge.
Spot six-month interest rates currently available in the money markets are as
follows:
Deposits Borrowing
US dollar 4.125% 4.250%
British pound 6.500% 6.625%

The spot exchange rate (US/£1) is 1.9770 – 1.9780.

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Interest Rate Risk

Interest rate risk is the risk that arises from the potential consequences of unexpected
movements, up or down, in an interest rate.

Interest rates could be of two types

1. fixed rate
2. floating rate

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What Does Direct Quote Mean?

A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other
words, it involves quoting in fixed units of foreign currency against variable amounts of the domestic
currency.

For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1.
Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.

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