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 Chapter No. 7 Exposure and Risk in
International Finance

Concepts

1 & 2. Exposure and Risk

Exposure is a measure of the sensitivity of the value of a
financial item (asset, liability or cash flow) to changes in the relevant
risk factor while risk is a measure of variability of the value of the
item attributable to the risk factor. Let us understand this distinction
clearly. April 1993 to about July 1995 the exchange rate between
rupee and US dollar was almost rock steady. Consider a firm whose
business involved both exports to and imports from the US. During
this period the firm would have readily agreed that its operating
cash flows were very sensitive to the rupee-dollar exchange rate,
i.e.; it had significant exposure to this exchange rate; at the same
time it would have said that it didn’t perceive significant risk on this
account because given the stability of the rupee-dollar fluctuations
would have been perceived to be minimal. Thus, the magnitude of
the risk is determined by the magnitude of the exposure and the
degree of variability in the relevant risk factor.

3. Hedging:
Hedging means a transaction undertaken specifically to offset
some exposure arising out of the firm’s usual operations. In other
words, a transaction that reduces the price risk of an underlying
security or commodity position by making the appropriate offsetting
derivative transaction.
 In hedging a firm tries to reduce the uncertainty of cash flows
arising out of the exchange rate fluctuations. With the help of this a
firm makes its cash flows certain by using the derivative markets.

4. Speculation
Speculation means a deliberate creation of a position for the
express purpose of generating a profit from fluctuation in that
particular market, accepting the added risk. A decision not to hedge
an exposure arising out of operations is also equivalent to
speculation.
Opposite to hedging, in speculation a firm does not take two
opposite positions in the any of the markets. They keep their
positions open.

5. Call Option:
A call option gives the buyer the right, but not the obligation,
to buy the underlying instrument. Selling a call means that you have
sold the right, but not the obligation, to someone to buy something
from you.

6. Put Option:
A put option gives the buyer the right, but not the obligation,
to sell the underlying instrument. Selling a put means that you have
sold the right, but not the obligation, to someone to sell something
to you.

7. Strike Price:
The predetermined price upon which the buyer and the seller
of an option have agreed is the strike price, also called the ‘exercise
price’ or the striking price. Each option on an underlying instrument
shall have multiple strike prices.
8. Currency Swaps:
In a currency swap, the two payment streams being
exchanged are denominated in two different currencies. Usually, an
exchange of principal amount at the beginning and a re-exchange at
termination are also a feature of a currency swap.
A typical fixed-to-fixed currency swaps work as follows. One
party raises a fixed rate liability in currency X say US dollars while
the other raises fixed rate funding in currency Y say DEM. The
principal amounts are equivalent at the current market rate of
exchange. At the initiation of the swap contract, the principal
amounts are exchanged with the first party getting DEM and the
second party getting dollars. Subsequently, the first party makes
periodic DEM payments to the second, computed as interest at a
fixed rate on the DEM principal while it receives from the second
party payment in dollars again computed as interest on the dollar
principal. At maturity, the dollar and DEM principals are re-
exchanged.
A floating-to-floating currency swap will have both payments at
floating rate but in different currencies. Contracts without the
exchange and re-exchange do exist. In most cases, an intermediary-
a swap bank- structures the deal and routes the payments from one
party to another.
A fixed-to-floating currency swap is a combination of a fixed-to-
fixed currency swaps and a fixed-to-floating interest rate swap.
Here, one payment stream is at a fixed rate in currency X while the
other is at a floating rate in currency Y.

9. Futures
Futures are exchanged traded contracts to sell or buy financial
instruments or physical commodities for future delivery at an agreed
price. There is an agreement to buy or sell a specified quantity of
financial instrument/commodity in a designated future month at a
price agreed upon by the buyer and seller. The contracts have
certain standardized specification.

10. Transaction Exposure

This is a measure of the sensitivity of the home currency value
of the assets and liabilities, which are denominated, in the foreign
currency, to unanticipated changes in the exchange rates, when the
assets or liabilities are liquidated. The foreign currency values of
these items are contractually fixed, i.e.; do not vary with exchange
rate. It is also known as contractual exposure.

Some typical situations, which give rise to transactions exposure,

are:
(a) A currency has to be converted in order to make or
receive payment for goods and services;
(b) A currency has to be converted to repay a loan or make
an interest payment; or
(c)A currency has to be converted to make a dividend payment,
royalty payment, etc.

Note that in each case, the foreign value of the item is fixed;
the uncertainty pertains to the home currency value. The important
points to be noted are (1) transaction exposures usually have short
time horizons and (2) operating cash flows are affected.

11. Translation Exposure

Also called Balance Sheet Exposure, it is the exposure on
assets and liabilities appearing in the balance sheet but which is not
going to be liquidated in the foreseeable future. Translation risk is
the related measure of variability.
The key difference is the transaction and the translation
exposure is that the former has impact on cash flows while the later
has no direct effect on cash flows. (This is true only if there are no
tax effects arising out of translation gains and losses.)
Translation exposure typically arises when a parent
multinational company is required to consolidate a foreign
subsidiary’s statements from its functional currency into the
parent’s home currency. Thus suppose an Indian company has a UK
subsidiary. At the beginning of the parent’s financial year the
subsidiary has real estate, inventories and cash valued at, 1000000,
200000 and 150000 pound respectively. The spot rate is Rs. 52 per
pound sterling by the close of the financial year these have changed
to 950000 pounds, 205000 pounds and 160000 pounds respectively.
However during the year there has been a drastic depreciation of
pound to Rs. 47. If the parent is required to translate the
subsidiary’s balance sheet from pound sterling to Rupees at the
current exchange rate, it has suffered a translation loss. The
translation value of its assets has declined from Rs. 70200000 to Rs.
61805000. Note that no cash movement is involved since the
subsidiary is not to be liquidated. Also note that there must have
been a translation gain on subsidiary’s liabilities, ex. Debt
denominated pound sterling.

12. Contingent Exposure

The principle focus is on the items which will have the impact
on the cash flows of the firm and whose values are not contractually
fixed in foreign currency terms. Contingent exposure has a much
shorter time horizon. Typical situation giving rises to such exposures
are
 a. An export and import deal is being negotiated and
quantities and prices are yet not to be finalized. Fluctuations
in the exchange rate will probably influence both and then it
will be converted into transactions exposure.
b. The firm has submitted a tender bid on an equipment
supply contract. If the contract is awarded, transactions
exposure will arise.
c. A firm imports a product from abroad and sells it in the
domestic market. Supplies from abroad are received
continuously but for marketing reasons the firm publishes a
home currency price list which holds good for six months
while home currency revenues may be more or less certain,
costs measured in home currency are exposed to currency
fluctuations.

In all the cases currency movements will affect future cash

flows.

13. Competitive exposure

Competitive exposure is the most crucial dimensions of the
currency exposure. Its time horizon is longer than of transactional
exposure – say around three years and the focus is on the future
cash flows and hence on long run survival and value of the firm.
Consider a firm, which is involved in producing goods for exports
and /or imports substitutes. It may also import a part of its raw
materials, components etc. a change in exchange rate gives rise to
no. of concerns for such a firm, example,
1. What will be the effect on sales volumes if prices are
maintained? If prices are changed? Should prices be changed?
For instance a firm exporting to a foreign market might benefit
from reducing its foreign currency priced to foreign customers.
 Following an appreciation of foreign currency, a firm, which
produces import substitutes, may contemplate in its domestic
currency price to its domestic customers without hurting its
sales. A firm supplying inputs to its customers who in turn are
exporters will find that the demand for its product is sensitive
to exchange rates.
2. Since a part of inputs are imported material cost will increase
following a depreciation of the home currency. Even if all
inputs are locally purchased, if their production requires
imported inputs the firms material cost will be affected
following a change in exchange rate.
3. Labour cost may also increase if cost of living increases and
the wages have to be raised.
4. Interest cost on working capital may rise if in response to
depreciation the authorities resort to monetary tightening.
5. Exchange rate changes are usually accompanied by if not
caused by difference in inflation across countries. Domestic
inflation will increase the firm’s material and labour cost quite
independently of exchange rate changes. This will affect its
competitiveness in all the markets but particularly so in
markets where it is competing with firms of other countries
6. Real exchange rate changes also alter income distribution
across countries. The real appreciation of the US dollar vis-à-
vis deutsche mark implies and increases in real incomes of US
residents and a fall in real incomes of Germans. For an
American firm, which sells both at home, exports to Germany,
the net impact depends upon the relative income elasticities in
addition to any effect to relative price changes.

Thus, the total impact of a real exchange rate change on a

firm’s sales, costs and margins depends upon the response of
consumers, suppliers, competitors and the government to this
macroeconomic shock.

In general, an exchange rate change will effect both future

revenues as well as operating costs and hence exchange rates
changes, relative inflation rates at home and abroad, extent of
competition in the product and input markets, currency composition
of the firm’s costs as compared to its competitors’ costs, price
elasticities of export and import demand and supply and so forth.

 Descriptive
1. What is currency risk? Enumerate the different types of
currency risks with examples.
Ans. Currency risk arises due to exposures explained in concepts 10
to 13

2. Discuss the exposure and risk occurring due to the

changes in
a) Interest rates
b) Exchange rates
Ans.
a) Interest rate uncertainty exposes a firm to the following kinds of
risks:
1. If the firm has borrowed on a floating rate basis, at very reset
date, the rate for the following period would be set in line with
the market rate. The firm’s future interest payments are
 therefore uncertain. An increase in rates will adversely affect
the cash flows.
2. Consider a firm, which wants to undertake a fixed investment
project. Suppose it requires foreign currency financing and is
forced to borrow on a floating rate basis. Since its cost of
capital is uncertain, an additional element of risk is introduced
in project appraisal.
3. On the other hand, consider a firm, which has borrowed on a
fixed rate basis to finance a fixed investment project.
Subsequently inflation rate in the economy slows down and the
market rate of interest declines. The cash flows from the
project may decline as a result of the fall in the rate of inflation
but the firm is logged into high cost borrowing.
4. A fund manager expects to receive a sizable inflow of funds in
three months to be invested in five –year interest rate will
have declined thus reducing the return on his investments.
5. A bank has invested in a six-month loan at 18% and financed it
by means of a three-month deposit at 16.5%. At the end of
three months it must refinance its investment. If deposits rates
go up in the mean while its margin will be reduced or may
even turn negative.
6. A fund manager is holding a portfolio fixed income securities
such as government and corporate bonds. Fluctuations in
interest rates expose into two kinds of risks. The first is that
the market value of his portfolio varies inversely with interest
rates. This is the risk of capital gains or losses. Secondly he
receives periodic interest payments on his holdings, which
have to be reinvested. The return he can obtain on these
reinvestments in uncertain.
 In each of these cases, an adverse movement in interest rates
hurts the firm by either increasing the cost of borrowing or by
reducing the return on investment or producing capital losses on its
assets portfolio. During the early 80’s investor’s preferences shifted
towards floating rate instruments thus exposing borrowers to
substantial interest rate risks.
For most Indian companies the idea of interest rate risk is
relatively new. In an environment of administered rates and
fragmented, compartmentalized capital markets, neither investors
nor borrowers felt the need to worry fluctuations in interest rates.
With increasing resort to external commercial borrowings,
Indian companies have had to recognize and learn to manage
interest rate risk. Also, the Indian financial system is gradually
moving in the direction of market determined interest rate risk. Also,
the Indian financial system is gradually moving in the direction of
market determined interest rates. During the last few years the
environment has changed drastically. In particular, the steep rise in
interest rates during 1995-1996 has led to the painful realization
that careful management of the interest rate risk is crucial to a
firm’s financial health.

Ans. 2. b) Same as descriptive question no. 1

3. Discuss the available tools to manage risk involved due to

fluctuations in exchange rates and interest rates.
Ans.
A firm may be able to reduce or eliminate currency exposure
by means of internal and external hedging strategies.
♦ INTERNAL HEDGING STARTEGIES
 Invoicing
 A firm may be able to shift the entire risk to another party by
invoicing its exports in its home currency and insisting that its
imports too be invoiced in its home currency, but in the presence of
well functioning forwards markets this will not yield any added
benefit compared to a forward hedge. At times, it may diminish the
firm’s competitive advantage if it refuses to invoice its cross-border
sales in the buyer’s currency.
In the following cases invoicing is used as a means of hedging:
1. Trade between developed countries in manufactured products
is generally invoiced in the exporter’s currency.
2. Trade in primary products and capital assets are generally
invoiced in a major vehicle currency such as the US dollar.
3. Trade between a developed and a less developed country
tends to be invoiced in the developed country’s currency.
4. If a country has a higher and more volatile inflation rate than
its trading partners, there is a tendency not to use that
country’s currency in trade invoicing.
Another hedging tool in this context is the use of “currency
cocktails” for invoicing. Thus for instance, British importer of
fertilizer from Germany can negotiate with the supplier that the
invoice is partly in DEM & partly in Sterling. This way both the
parties share exposure. Another possibility is to use one of the
“standard currency baskets” such as the SDR or the ECU for
invoicing trade transactions.
Basket invoicing offers the advantage of diversification and
can reduce the variance of home currency value of the payable or
receivable as long as there is no perfect correlation between the
constituent currencies. The risk is reduced but not eliminated. Also,
there is no way by which the exposure can be hedged since there is
no forward markets I these composite currencies. As a result, this
technique has not become very popular.
  Netting and Offsetting:
A firm with receivables and payables in diverse currencies can
net out its exposure in each currency by matching receivables with
payables. Thus a firm with exports to and imports from say Germany
need not cover each transaction separately; it can use a receivable
to settle all or part of a payable and take a hedge only for the net
DEM payable or receivable. Even if the timings of the two flows do
not match, it might be possible to lead or lag one of them to achieve
a match.
To be able to use netting effectively, the company must have
continuously updated information on inter-subsidiary payments
position as well as payables and receivables to outsiders. One way
of ensuring efficient information gathering is to centralise cash
management.
 Leading and lagging: Another internal way of managing
transactions exposure is to shift the timing of exposures by leading
or lagging payables and receivables. The general rule is lead, i.e.
advance payables and lag, i.e. postpone receivables in “strong”
currencies and, conversely, lead receivables and lag payables in
weak currencies. Simply shifting the exposure in time is not enough;
it has to be combined with a borrowing/lending transaction or a
forward transaction to complete the hedge.
Both these tools exist as a response to the existence of market
imperfections.

♦ External Tools
A. Using hedging for forwards market:
In the normal course of business, a firm will have several
contractual exposures in various currencies maturing at various
dates. The net exposure in a given currency at a given date is
simply the difference between the total inflows and the total
outflows to be settled on that date. Thus suppose ABC Co. has the
following items outstanding:
Item Value Dates to
maturity
1.USD receivable 800,000 60
2.NLG payable 2,000,000 90
3.USD interest payable 100,000 180
4.USD payable 200,000 60
5.USD purchased forward 300,000 60
6.USD loan installment due 250,000 60
7.NLG purchased forward 1,000,000 90

Its net exposure in USD at 60 days is:

(800,000+300,000)-(200,000+250,000)=+USD 650,000
Whereas it has a net exposure in NLG of –1,000,000 at 90 days.
The use of forward contracts to hedge transactions exposure at
a single date is quite straightforward. A contractual net inflow of
foreign currency is sold forward and a contractual net outflow is
bought forward. This removes all uncertainty regarding the domestic
currency value of the receivable or payable. Thus in the above
example, to hedge the 60 day USD exposure, ABC Co. can sell
forward USD 650,000 while for the NLG exposure it can buy NLG
1,000,000 90 day forward.
What about exposures at different date? One obvious solution
is to hedge each exposure separately with a forward sale or
purchase contract as the case may be. Thus in the example, the firm
can hedge the 60 day USD exposure with a forward sale and the 180
day USD exposure with a forward purchase.

B. Hedging with the money market:

 Firms, which have access to international money markets for
short-term borrowing as well as investment, can use the money
market for hedging transactions exposure.
E.g.: Suppose a German firm ABC has a 90 day Dutch Guilder
receivable of NLG 10,000,000. It has access to Euro deposit markets
in DEM as well as NLG. To cover this exposure it can execute the
following sequence of transactions:
1. Borrow NLG in the euroNLG market for 90 days.
2. Convert spot to DEM.
3. Use DEM in its operations, e.g. to pay off a short-term bank
loan or finance inventory.
4. When the receivable is settled, use it to pay off the NLG loan.
Suppose the rates are as follows:
NLG/DEM Spot: 101025/35 90day forward: 1.1045/65
EuroNLG interest rates: 5 1/4/5 ½
EuroDEM interest rates: 4 3/4/5.00
Comparing the forward cover against the money market cover.
With forward cover, each NLG sold will give an inflow of DEM
(1/1.064)= DEM 0.9038, 90 days later. The present value of this (at
4.74%) is
0.9038/[1+ (0.0475/4)]= DEM 0.8931
To cover using the money market, for each NLG of receivable,
borrow NLG 1/[1+ (0.055/4)]
= NLG 0.9864, sell this spot to get DEM (0.9864/1.1035)
=DEM 0.8939
Pay off the NLG loan when the receivables mature. Thus the
money markets cover; there is a net gain of DEM 0.0008 per NLG of
receivable or DEM 8000 for the 10 million-guilder receivable.
Sometimes the money market hedge may turn out to be the
more economical alternative because of some constraints imposed
by governments. For instance, domestic firms may not be allowed
access to the Euromarket in their home currency or non-residents
may not be permitted access to domestic money markets. This will
lead to significant differentials between the Euromarket and
domestic money market interest rates for the same currency. Since
forward premia/ discounts are related to Euromarket interest
differentials between two currencies, such an imperfection will
present opportunities for cost saving.
E.g. A Danish firm has imported computers worth $ 5 million
from a US supplier. The payment is due in 180 days. The market
rates are as follows:
DKK/USD Spot: 5.5010/20
180 days forward: 5.4095/ 5.4110
Euro $: 9 1/2/ 9 ¾
Euro DKK: 6 1/4/ 6 ½
Domestic DKK: 5 1/4/ 5 ½
The Danish government has imposed a temporary ban on non-
residents borrowing in the domestic money market. For each dollar
of payable, forward cover involves an outflow of DKK 5.4110, 180
days from now. Instead for each dollar of payable, the firm can
borrow DKK 502525 at 5.5%, acquit $ 0.9547 in the spot market and
invest this at 9.50% in a Euro $ deposit to accumulate to one dollar
to settle the payable. It will have to repay DKK 5.3969 [=5.2525*
1.0275], 180 days later. This represents a saving of DKK 0.0141 per
dollar of payable or DKK 70,500 on the $5 million payable.
From the above example it is clear that from time to time cost
saving opportunities may arise either due to some market
imperfection or natural market conditions, which an alert treasurer
can exploit to make sizeable gains. Having decided to hedge an
exposure, all available alternatives foe executing the hedge should
be examined.
 C. Hedging with Currency Options:
Currency options provide a more flexible means to cover
transactions exposure. A contracted foreign currency outflow can be
hedged by purchasing a call option (or selling a put option) on the
currency while an inflow can be hedged by buying a put option. (Or
writing a call option. This is a “covered call” strategy).
Options are particularly useful for hedging uncertain cash
flows, i.e. Cash flows those are contingent on other events. Typical
situations are:
a. International tenders: Foreign exchange inflows will materialise
only if the bid is successful. If execution of the contract also
involves purchase of materials, equipments, etc. from third
countries, there are contingent foreign currency outflows too.
b. Foreign currency receivables with substantial default risk or
political risk, e.g. the host government of a foreign subsidiary
might suddenly impose restrictions on dividend repatriation.
c. Risky portfolio investment: A funds manager say in UK might
hold a portfolio of foreign stocks/bonds currently worth say
DEM 50 million, which he is planning to liquidate in 6 months
time. If he sells Dem 50 million forward and the portfolio
declines in value because of a falling German stock market and
rising interest rates, he will find himself to be over insured and
short in DEM.
E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on
September 1. The market rates are as follows:
DEM/GBP Spot: 2.8175/85
90-day Swap points: 60/55
September calls with a strike of 2.82 (DEM/GBP) are available
for a premium of 0.20p per DEM. Evaluating the forward hedge
versus purchase of call options both with reference to an open
position.
 i. Open position: Suppose the firm decides to leave the
payable unhedged. If at maturity the pound sterling/ DEM
spot rate is St., the sterling value of the payable is
(5,00,000) St.
ii. Forward hedge: If the firm buys DEM 5,00,000 forward at
the offer rate of DEM 2.8130/PS or PS0.3557/ DEM, the value
of the payable is PS (5,00,000 * 0.3557)=PS 1,77,850.
iii. A Call option: Instead the firm buys call options on DEM
5,00,000 for a total premium expense of PS 1000.
At maturity, its cash outflow will be
PS [(5,00,000)St +1025] for St<= 0.3546
and PS[5,00,000)(0.3546)+1025]
= PS 178325 for St>=0.3546.
Here it is assumed here that the premium expense is
financed by a 90 day borrowing at 10%.

D. Hedging with currency futures:

Hedging contractual foreign currency flows with currency
futures is in many respects similar to hedging with forward
contracts. A receivable is hedged by selling futures while a payable
is hedged by buying futures.
A futures hedge differs from a forward hedge because of the
intrinsic features of future contracts. The advantages of futures are,
it easier and has greater liquidity. Banks will enter into forward
contracts only with corporations (and in rare cases individuals) with
the highest credit rating. Second, a futures hedge is much easier to
unwind since there is an organized exchange with a large turnover.

A firm may be able to reduce or eliminate interest rate

exposure by mean of following hedging strategies.
  Forward rate Agreements:
A FRA is an Agreement between two parties in which one of
them (The seller of FRA), contracts to lend to other (Buyer), a
specified amount of funds, in a specific currency, for a specific
period starting at a specified future date, at an interest rate fixed at
the time of agreement. A typical FRA quote from a bank might look
like this:
USD 6/9 months: 7.20 – 7.30% P.a.
This is to be interpreted as follows.
 The bank is willing to accept a three month USD deposit
starting six months from now, maturing nine months from now,
at an interest rate of 7.20% P.a. (Bid Rate).
 The bank is willing to lend dollars for three months, starting six
months from now at a interest rate of 7.30% P.a. (Ask Rate).
The important thing to note is that there is no exchange of
principal amount.
 Interest rate futures:
Interest rate futures are one of the most successful financial
innovations in recent years. The underlying asset is a debt
instrument such as a treasury bill, a bond, and a time deposit in a
bank and so on. For e.g. the International Monetary Market (a part of
Chicago Mercantile Exchange) has a futures contract on US
government treasury bills, three-month Eurodollar time deposits and
US treasury notes and bonds. The LIFFE has contracts on Eurodollar
deposits, sterling time deposits and UK government bonds. The
Chicago Board of Trade offers contracts on long-term US treasury
bonds.
Interest rate futures are used by corporations, banks and
financial institutions to hedge interest rate risk. A corporation
planning to issue commercial paper for instance can use T-Bill
futures to protect itself against an increase in interest rate. A
corporate treasurer who expects some surplus cash in near future to
be invested in short-term instruments may use the same as
insurance against a fall in interest rates. A fixed income fund
manager might use bond futures to protect the value of her fund
against interest rate fluctuations. Speculators bet on interest rate
movements or changes in the term structure in the hope of
generating profits.

 Interest Rate Swaps:

A standard fixed-to-floating interest rate swap, known in the market
jargon as a plain vanilla coupon swap (also referred to as “exchange
of borrowings”) is an agreement between two parties in which each
contracts to make payments to the other on particular dates in the
future till a specified termination date. One party, known as the
fixed ratepayer, makes fixed payments all of which are determined
at the outset. The other party known as the floating ratepayer will
make payments the size of which depends upon the future evolution
of a specified interest rate index (such as the 6-month LIBOR). The
key feature of this is:
The Notional Principal:
The fixed and floating payments are calculated if they were interest
payments on a specified amount borrowed or lent. It is notional
because the parties do not exchange this amount at any time; it is
only used to compute the sequence of payments. In a standard
swap the notional principal remains constant through the life of the
swap.

 Interest rate Options:

A less conservative hedging device for interest rate exposure is
interest rate options. A call option on interest rate gives the holder
the right to borrow funds for a specified duration at a specified
interest rate, without an obligation to do so. A put option on interest
rate gives the holder the right to invest funds for a specified
duration at a specified return without an obligation to do so. In both
cases, the buyer of the option must pay the seller an up-front
premium stated as a fraction of the face value of the contact.
As interest rate cap consists of a series of call options on
interest rate or a portfolio of calls. A cap protects the borrower from
increase in interest rates at each reset date in a medium-to-long-
term floating rate liability. Similarly, an interest rate floor is a series
or portfolio of put options on interest rate, which protects a lender
against fall in interest rate on rate dates of a floating rate asset. An
interest rate collar is a combination of a cap and a floor.

4.

5. Explain the importance and relevance of hedging in

foreign exchange market.
Ans.
Foreign Exchange Market
The foreign exchange market is the market in which currencies
are brought and sold against each other. It is the largest market in
the world. Foreign exchange market is an over the counter market.
This means there is no single market place or an organized market
place or an organized exchange (like a stock exchange) where
traders meet and exchange currency. The traders sit in the offices
(foreign exchange dealing rooms) of major commercial banks
around the world and communicate with each other through
telephones, telex, computer terminals and other electronic means of
communication.
Hedging:
Hedging means a transaction undertaken specifically to offset
some exposure arising out of the firm’s usual operations. In other
words, a transaction that reduces the price risk of an underlying
security or commodity position by making the appropriate offsetting
derivative transaction.
Different types of exposures
Refer to concept questions 10 to 13.
Conclusion
Hence after looking at the different types of exposures, traders
faces it is very clear that Hedging with the help of derivatives will
ensure a safe transaction in Foreign exchange market.

6. Is it possible to hedge the foreign exchange risk in the

forwards market?
Ans. It is not possible to hedge forex risk fully.
This is so because as long as there exists currency as a
medium of exchange the person holding the currency is exposed to
different types of risks e.g. political, financial, …
This can be explained with the help of example of an Indian
exporter. If he has contracted for exports worth 1000 USD and the
spot rate was 45 Rs./$ for a period of 6months with a co. in USA. He
would receive his payments 6 months from now, the commercial risk
involved here is with respect to the fluctuations in exchange rates. If
the rates 6 months from now become 50 Rs/$ then he would receive
50000 USD i.e. he incurs a profit of 5000 USD and vice a versa when
the value of Rs. appreciate.
 In above case, if we hedge our position the cash flow would be
certain, but still we have Rs. i.e. a currency in our hand with which
risk prevails.
Here comes in the political risk i.e. even when the Indian
exporter has the home currency. In case the country’s economy
crashes the currency will loose all it value throughout the world.
Thus, with the help of above e.g. it can be proved that as long
as currency is involved we have risk.

7. Explain with an example how to cover exchange risk in the

forwards market.
Ans. Please refer to answer 3 (A)

8. What factors determine the value of an option?

Ans. The factors are
a. Maturity of an option: higher the price higher the value of
an option and vice a versa
b. Spot price of underlying assets:
c. Strike price of underlying assets:
d. Interest rate structure in the market: higher the
interest rate structure in the market higher the value of an
option and vice a versa
e. Volatility: higher the volatility in the market higher the
value of an option and vice a versa. This is so because
higher the volatility in the market, higher the potential for
earning more, thus the buyer of an option has to pay more
premium.

9. Explain with examples how options are used to cover

exchange risks?
Ans. Currency options provide corporate treasurer another tool for
hedging foreign exchange risks arising out of firms operations.
Unlike forward contract, options allow the hedger to gain from
favorable exchange rate movements, while been unprotected from
unfavorable movements. However forward contracts are costless
while options involve up front premium cost.
a) Hedging a Foreign Currency with calls.
In late February an American importer anticipates a yen
payment of JYP 100 million to a Japanese supplier sometime late in
May. The current USD/JYP spot is 0.007739 (which implies a JYP/USD
rate of 129.22.). A June yen call option on the PHLX, with strike price
of $0.0078 per yen is available for a premium of 0.0108 cents per
yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million.
Premium per contract is therefore: $(0.000108 * 6250000) = $675.
The firm decides to purchase 16 calls for a premium of $10800 .In
addition there is a brokerage fee of $20 per contract. Thus the total
expense in buying the option is $11,120.The firm has in effect
ensured that its buying rate for yen will not exceed $0.0078+
$(11120/100,000,000)= $0.0078112 per yen.
The price the firm will actually end up paying for yen depends
on the spot rate at the time of payment .For further clarification the
following 2 e.g. are considered:
1. Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late
May when the payment becomes due .The firm will not
exercise its options. It can sell 16 calls in the market provided
the resale value exceeds the brokerage commission it will have
to pay. (The June calls will still have some positive premium) .It
buys yen in the spot market .In this case the price per yen it
will have paid is $0.0075 + $0.0000112 - ${(Sale of value
options – 320) /100000000}
 If the resale value of the options is less than $320, it will
simply let the options lapse .In this case the effective rate will
be $0.0075112 per yen or yen 133.13 per $. It would have
been better to leave the payable uncovered. The forward
purchase at $0.0078 would have fixed the rate at that value
and would be worse than the option.
2. Yen appreciates to $0.08
Now the firm can exercise the options and procure the yen at
the strike price of $0.0078.In addition, there will be transaction
cost associated with the exercise. Alternatively, it can sell the
option and buy the yen in the spot market. Assume that June
yen calls are trading at $0.00023per yen in late May. With the
latter alternative, the dollar will be $800000- $(0.00023 * 16*
6250000)+ $320= $777320. Including the premium, the
effective rate the firm has paid is $(0.0077732+0.0000112) =
$0.0077844.

b) Hedging a receivable with a put option

A German chemical firm has supplied goods worth Pound 26
million to a British customer. The payment is due in two months. The
current DEM/GBP spot rate is 2.8356 and two month forward rate is
2.8050. An American put option on sterling with 3 month maturity
and strike price of DEM 2.8050 is available in the inter bank market
with a premium of DEM 0.03 per sterling. The firm purchases a put
option on pound 26 million .The premium paid is DEM (0.03 *
26000000) = DEM 780000. There are no other costs.
Effectively the firm has put a floor on the value of its
receivable at approximately DEM 2.7750 per sterling (= 2.8050-
0.03). Again two e.g. are considered:
1. The pound sterling depreciates to DEM 2.7550 .The firm
exercises its put option and delivers pound 26 million to the
 bank at the price of 2.8050. The effective rate is 2.7750. It
would have been better off with a forward contract.
Sterling appreciates to DEM 2.8575. The option has no secondary
market and the firm allows it to lapse. It sells the receivable in the
spot market. Net of the premium paid, it obtains an effective rate of
2.8275, which is better than forward rate. If the interest forgone on
premium payment is accounted for, the superiority of the option
over the forward contract will be slightly reduced.
10. Write a short note on currency swaps
Ans. Please refer to concept answer 8
11. What types of exchange exposure in a multinational
enterprise subject to?
Ans. Please refer to descriptive answer 1