International Finance - Module V

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MODULE V
Module V

 Derivatives

 Foreign currency derivatives
 Currency forwards
 Currency futures
 Currency options and swaps
 Foreign exchange risk and exposure
 Operating exposure
 Transaction exposure
 Translation exposure
 Management of foreign exchange
 Internal hedging
 leading and lagging
 Exposure netting
 Currency risk sharing
 Hedging through sourcing
 Hedging by choosing the currency of invoice
 External Hedging
 Hedging with forward and futures
 Money market hedging
 The Numerical problems in money market hedging to be covered.
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 Foreign exchange risk and exposure
 Operating exposure
 Transaction exposure
 Translation exposure
Business firms, whether operating domestically or internationally, are

exposed to risks of adverse movements in their profits resulting from
unexpected movements in exchange rates
Movement of exchange rates gives rise to
 foreign exchange exposure

 and foreign exchange risk
Exposure refers to the degree(sensitivity) to which a company is affected by

exchange rate changes.
 It is calculated by regression.
Exchange rate risk is defined as the variability of a firm’s value due to
uncertain changes in the rate of exchange.
 It is calculated by variance or standard deviation
Types of Exposures
 Transaction Exposure
 Translation Exposure (Accounting Exposure)
 Operating Exposure (Economic Exposure)
Transaction Exposure
Results from a firm taking on “fixed” cash flow foreign currency denominated
contractual agreements.
Examples of transaction exposure:
 An Account Receivable denominate in a foreign currency.

 A maturing financial asset (e.g., a bond) denominated in a foreign
currency.
 An Account Payable denominate in a foreign currency.
 A maturing financial liability (e.g., a loan) denominated in a foreign
currency.
For instance, if a firm has entered into a contact to sell computers to a foreign
customer at a fixed price denominated in foreign currency, then the firm
would be exposed to exchange rate movements till it receives the payment
and converts the receipts into the domestic currency.
In contractual assets, the exposure value is equal to euro deposits (Face
value).
 Exposure is positive magnitude i.e. change in exchange rate and dollar

value of the investment move same direction.
 If investor gain when the spot value of foreign currency increase and
loss when it decreases is known as long position in foreign currency
 In contractual liabilities exposure is negative magnitude i.e. change in
exchange rate and dollar value of the investment move opposite
direction.
 If investor gain when the spot value of foreign currency decrease, loss
when it increases is known as short position in foreign currency
Translation Exposure (Accounting Exposure)

Translation exposure, (also called accounting exposure), results from the need
to restate foreign subsidiaries’ financial statements, usually stated in foreign
currency, into the parent’s reporting currency when preparing the
consolidated financial statements.
 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
 Restating financial statements may lead to changes in the parent’s net
worth or net income.
 If exchange rates have changed since the previous reporting period,
translation/restatement of those assets/liabilities, revenues/expenses
that are denominated in foreign currencies will result in foreign
exchange gains or losses
When converting financial statement items (transactions) denominated in

currencies other than the parent currency, two choices of exchange rate are
possible
The historical rate, the exchange rate prevailing at the time of the transaction.
The current rate, the exchange rate prevailing at the balance sheet date or
during the income statement period.
There are two method of adjusting Translation exposure:
 Temporal Method
 Current Rate method
Management of transaction exposure
 Forward contract hedge

 Option hedge
 Money market hedge (borrowing or investing in local market)
Forward contract
 It is a non-standardized contract, which occurs between two parties
(buyer and seller) on a trading (underlying) asset, at a known forward
time and at a price that is agreed on it today.
 It does not cost anything to enter forward contact. This contract as
future contract has a long position and a short position.
 More specifically, forward contracts are done through over the counter
market (OTC), meaning the trading is done through a network that is
linked with the dealer markets.
 By entering into a forward rate agreement with a bank, the
businessman simply transfers the risk to the bank, which will now have
to bear this risk.

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Click on Highlighted Words

 Foreign exchange risk and exposure

Business firms, whether operating domestically or internationally, are

Movement of exchange rates gives rise to

 foreign exchange exposure

Exposure refers to the degree(sensitivity) to which a company is affected by

 It is calculated by variance or standard deviation

Examples of transaction exposure:

 An Account Receivable denominate in a foreign currency.

 Exposure is positive magnitude i.e. change in exchange rate and dollar

Translation Exposure (Accounting Exposure)

When converting financial statement items (transactions) denominated in

There are two method of adjusting Translation exposure:

Management of transaction exposure

 Forward contract hedge

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