Foreign Exchange Exposure &

Risk
 Foreign Exchange Exposure

If V0= 1,00,000 $ = Rs 43,00,000 /-

(Rs/$ =43.00)

Over a period of time, price of asset changes

due to inflation and exchange rate also
changes. So,
V1= 1,40,000 $ = Rs 53,20,000 /-
(Rs/$ = 38.00)
 The actual change
ΔV = V1 – V0 = 53,20,000 – 43,00,000
= Rs 10,20,000
ΔS = S1- S0 = 43.00 – 38.00 = Rs 5.00
So, For ΔS = 11.6%
For ΔV = 23.7%
ΔS may be both positive and negative and so may be ΔV
Is there any relationship between change in
exchange rate and change in value of asset?
ΔV = F(ΔS)

+ΔV

- ΔS + ΔS

-ΔV
 Foreign Exchange Exposure

ΔV = ⍺ + βΔS + u
ΔV = change in the value of asset or liability
ΔS = Unanticipated change in the exchange rate
⍺ = intercept
β= sensitivity of changes in value of assets or liabilities in
response to ΔS
β= sensitivity of changes in value of assets or liabilities in
response to ΔS
β = Exposure

Now,
ΔV = ⍺ + βΔS + u
Assuming ⍺ = 0 , u = 0
ΔV = βΔS
=> β= ΔV / ΔS
 Change in value Change in value
of asset of Liability
+ΔV +ΔV

Asset Liability
Exposure Line Exposure Line

β = tan θ β = tan θ
- ΔS - ΔS + ΔS
+ ΔS

-ΔV -ΔV
 Defining Exposure
The sensitivity of the real home currency
value of an asset, liability or an operating
income to an unanticipated change in the
exchange rate, assuming unanticipated
changes in all other currencies as zero
• Does exposure affect Balance sheet of a
company or income statement?

• Does exposure affect only foreign assets or

domestic assets as well?
 Foreign Exchange Risk
Variability of the domestic currency values of
assets, liabilities, operating incomes due to
unanticipated changes in exchange rate.

Risk = variance in V
 Estimating Risk
Now, we know that by definition
ΔV = ⍺ + βΔS + u ------- Eq 1
Regressing the actual data of ΔV and ΔS
Δ`V = ⍺` + β`ΔS --------Eq 2
There will be a difference between the estimated change (Eq1
and Actual change (Eq 2)

ΔV = Δ`V + u
Now, the risk is given by
Var(ΔV) = Var( Δ`V + u)
Var(ΔV) = Var( Δ`V ) + Var( u) +2Cov(Δ`V , u)
 Risk Cont..
2Cov(Δ`V , u) = 0
Therefore,
Var(ΔV) = Var( Δ`V ) + Var( u)

Thus, the total risk of an asset includes estimated risk plus

risk due to other factors.
Relating Risk & Exposure
ΔV = ⍺ + βΔS

Var(ΔV) = Var(⍺ + βΔS)

Var(ΔV) = β2 Var(ΔS)
Defining Real Change in exchange rate

The real change in exchange rate is the

change that produces a difference between
overall rate of return on domestic versus
foreign assets / liabilities or in profitability
of export / import oriented firms.

“Real Change” is the extent of change in the value

due sensitivity and variability both
Real Change in Financial Assets
If IRP does not exist, then
(S1-S ) / S = (ia-ib) / (1+ib)

Hence, Real proportionate change in exchange

rate is
Rp = [(S1-S ) / S ] (1+ib) – (ia-ib)
 Real Change in Real Assets
We know that, irs = i^ rs + P ^ rs and i$ = i^ $ + P ^ $
Hence, Rate of return on 1 Rs invested in US
= S1/S [1+ i^ $ + P ^ $] – 1
Therefore, Real rate of return above domestic return
= S1/S [1+ i^ $ + P ^ $] – [1+(i^ rs + P ^ rs )]
Adding & Subtracting P$
= {S1/S [1+ i^ $ + P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )
= {S1/S + S1/S i^ $ + S1/S P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )
= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]
={S1/S [1+ i^ $ + P ^ $ ]– 1} – (i^ rs + P ^ rs ) – (P ^ $ – P ^ $ )

=S1/S + S1/S i^ $ + S1/S P ^ $ ]– 1}– (i^ rs + P ^ rs ) – (P ^$ – P ^$ )

={S1/S + S1/S i^ $ + S1/S P ^ $ – 1} – i^ rs - P ^ rs – P ^ $ + P ^ $

=S1/S + S1/S i^ $ + S1/S P ^ $ – S/S – i^ rs - P ^ rs – P ^ $ + P ^ $

= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

 Real Change in Real Assets

Rp = [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )– [i^ rs –(S1/S)i ^ $ ]

If i^ rs = (S1/S)i ^ $ then real proportionate change

= [(S1– S)/S] (1+ P ^ $ ) – ( P ^ rs – P ^ $ )

 Exposure

=> Translation Exposure or Accounting Exposure

⇒Economic Exposure
− Transaction exposure
− Operating exposure
 Translation Exposure
• Changes in Income Statement items and
book value of BS assets and liab, caused by
exchange rate change
• Resulting gains or losses are determined by
accounting rules and are on paper only

Impact – BS assets and liab and income

statements that already exist.
 Operating Exposure
• Changes in the amount of future operating
cash flows caused by exchange rate change
• Resulting gains or losses are determined by
changes in firm’s future competitive
position and are real.
Impact – Revenues and costs associated with
future sales.
 Transaction Exposure
• Changes in the value of foreign currency
denominated contracts that are brought about by
exchange rate change.
• The resulting changes are determined by the
nature of contracts already entered into and are
real.
Impact – Contracts already on BS are part of
Accounting Exp.
– Contracts yet to come on BS are part of
Operating Exp.
Types of Risk
• Financial Risk
• Political Risk
• Country Risk
 Financial Risk
• Refers more generally to unexpected events in a
country’s financial, economic, or business life

• Examples of financial risks

– currency risk
– interest rate risk
– Inflation risk
– unexpected changes in the current account balance
– unexpected changes in the balance of trade
 Political Risk
• The risk that a sovereign host government will
unexpectedly change the rules of the game under
which businesses operate

• Examples of political risks

– Expropriation risk
– Disruptions in operations
– Protectionism
– Blocked funds
– Loss of intellectual property rights
 Political risk insurers
• Government export credit agencies
• U.S. Overseas Private Investment Corporation
• U.K. Export Credits Guarantee Department
International
• World Bank - Multilateral Investment Guarantee
Agency Private
• Lloyd’s of London
• American International Group (AIG)
• MNCs are self-insured if their risk exposures are
diversified across a large number of countries
 Country Risk
• Macro risks - affect all firms in a host
country
• Micro risks - specific to an industry, firm
or project in a country
• Whether a particular country risk is macro
or micro affects the diversifiability of the
risk
 Country risks examples
• A1 - Africa, Asia, Europe, Mid East Americas, Australia, Switzerland,
Canada, UK
• A2 - Botswana, HK, Japan, Germany, Kuwait, USA, S. Korea Italy,
UAE
• A3 - Mauritius, China, Cyprus, Israel, Chile, Namibia, Thailand,
Czech Rep, Trinidad.
• A4 -Egypt, India, Latvia, Saudi, Mexico, S. Africa, Philippines,
Poland, Arabia, Panama.
• B - Algeria, Bangladesh, Slovakia, Egypt, Brazil, Peru, Uganda, Sri
Lanka, Russia, Jordan, Venezuela.
• C - Congo, Indonesia, Azerbaijan, Iran, Syria, Haiti, Kenya,
Vietnam, Romania, Turkey, Jamaica.
• D - Nigeria, Afghanistan, Albania, Iraq, Argentina, Sudan ,N. Korea,
Ukraine, Cuba ,Zimbabwe, Pakistan, Yugoslavia, Ecuador.
Strategies for managing country risk
• Negotiate the environment with the host country
prior to investment

• Structure foreign operations to minimize country

risk while maximizing return

• Limiting the scope of technology transfer to

foreign affiliates to include only non-essential
parts of the production process

• Limiting dependence on any single partner

 Types of Exposure

• Transaction Exposure & Translation Exposure

• Economic Exposure & Operating Exposure

Transaction & Translation Exposure
• Arises due to impact of exchange rate
movement on firm’s future contractually
committed cash flows.