FX Risk Management

Question 1

What are the types of foreign exchange exposure?

Answer 1

1. Transaction exposure
2. Translation exposure
3. Economic Exposure
4. Operating Exposure

Question 2

What is transaction exposure?

Answer 2

i. Occurs when a change in foreign exchange rate occurs between the time a
transaction is executed and the time it is settled
ii. Thus this risk occurs whenever the cash flow is affected in a particular transaction

Question 3

What is translation exposure?

Answer 3

Occurs when the assets and liabilities which are denominated in one currency are
translated into another currency for inclusion in financial statement

Question 4

What is the economic exposure?

Answer 4

This is the risk of a change in the foreign exchange rate due to change in the economic
condition of one country

Question 5

What is the operating exposure?

Answer 5

Sensitivity of operating income to changes in exchange rate

Question 6

What is foreign exchange risk management known as?

Answer 6

Exposure management

Question 7

With what does it cope?

Answer 7

Copes with the possibility of incurring a loss on account of a open or an unhedged position in foreign exchange

Question 8

When is it especially important?

Answer 8

iv. a large proportion of a corporate earnings / expenses are in foreign exchange; or
v. where any fluctuation in the FX has the potential to disturb the corporate ability to
execute a strategic plan

Question 9

Where did the South East Asian crisis originate?

Answer 9

This crisis originated in Thailand and later on spread to other countries like
Philippines, Taiwan etc.

Question 10

What were Thail;and and other coutries of the area witnissing?

Answer 10

Thailand and other SE countries were witnessing a very high level of GDP growth of
almost 9-12%.

Question 11

Was the foreign ewxchange rate pegged?

Answer 11

Moreover the exchange rate was pegged by the government and was not on a free float. This gave a false sense of security to local borrowers.

Question 12

What happened due to high GDP{ growth and interest rate differentialsd?

Answer 12

High GDP growth and interest rate differentials (due to fixed exchange rate
mechanism) resulted in huge inflows of foreign currency (mostly hot money) seeking
higher returns predominantly in the area of stock markets and real estate.

Question 13

What does the inflow of hot money often result in?

Answer 13

Inflow of hot money often results in a feeling of general well being with little or no attention being given to future growth strategies.

Question 14

What did the US do in the 90s?

Answer 14

However, in the mid 90s US federal bank (under the leadership of Alan Greenspan)
started raising interest rates to spur US economy

Question 15

What did this rise in US interest rates result in?

Answer 15

This rise in the US interest rates resulted in the hot money flowing out of the economy
leaving Thailand gasping for breath.

Question 16

What did the l;arge outflow result in?

Answer 16

The large outflow also resulted in the collapse of the banking system that was not
geared to handle such outflows.

Question 17

Why did the Thai government led the currency float again?

Answer 17

Thai baht after the Thai government was forced to float the baht due to lack of foreign currency to support its currency peg to the U.S. dollar.

Question 18

What was the result of the outflowes?

Answer 18

For the Southeast Asian nations which had currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to become more expensive and less competitive in the global markets. At the same time, Southeast Asia’s export growth slowed dramatically in the spring of 1996, deteriorating their current account position.

Question 19

What is hot money?

Answer 19

In economics, hot money is the flow of funds (or capital) from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. These speculative capital flows are called ‘hot money’ because they can move very quickly in and out of markets, potentially leading to market instability

Question 20

By when had Thailands economy recovered?

Answer 20

By 2001, Thailand’s economy had recovered. The increasing tax revenues allowed the country to balance its budget and repay its debts to the IMF in 2003, four years ahead of schedule. The Thai baht continued to appreciate to 29 Baht to the U.S. dollar in October 2010.

Question 21

What happened in Argentina 1989?

Answer 21

There was gross negligence in fiscal discipline in 1989 resulting in the economy being
in doldrums and widespread rioting.

Question 22

What was the solutiuon of the currency board?

Answer 22

The currency board provided an immediate solution by saying that each Argentine
peso issued would have to be backed by US$.

Question 23

What was ther conseuqwnece?

Answer 23

This put a stop to reckless printing of local currency. Inflation dropped and Argentina prospered overnight resulting in a general feeling of
well-being and prosperity.

Question 24

What followed inm terms of spending?

Answer 24

What followed was reckless spending with little thought to future growth plans. Increased government spending, along with red tapism and corruption resulted in an
increase in federal borrowing.

Question 25

What did the government had to do to meet the target?

Answer 25

To meet the deficit, the government raised the tax rates.This discouraged investment and encouraged tax evasion.

Question 26

What was the conseuqwnfce?

Answer 26

Increased tax burden, meant escalating government borrowings resulting in high
interest cost thereby triggering a vicious circle of debt trap. The financial crisis of Argentina is slowly spreading its tentacles to other Latin
American countries like Mexico as well.

Question 27

How does hedging have to be conducted?

Answer 27

Hedging must be done centrally to avoid duplication. A portfolio approach is required to take the net effect of exposures into account.

Question 28

Name some of the exchange rate risk management techniques

Answer 28

(i) Forward contract
(ii) Currency options
(iii) Range forwards
(iv) Ratio range forwards
(v) Currency swaps
(vi) Currency futures.
(vii) Caps, floors, collars and fixed rate derivatives
(viii) Selling and buying own currency
(ix) Matching receipts and payments
(x) Leads and lags
(xi) Netting
(xii) Arbitrage operations
(xiii) Cross currency rollover

Question 29

Namer a few interets rate management techniqwues:

Answer 29

(i) Forward interest rate agreements
(ii) Interest rate swaps
(iii) Interest rate caps
(iv) Interest rate collars
(v) Interest rate ceilings

Question 30

What is a forward contract?

Answer 30

(i) An immediate firm and binding agreement between bank and customer to buy or
sell an agreed amount of currency at a date of exchange and at a rate fixed at the
time the contract is made.

Question 31

HOw long can the time vary fopr forward contracts?

Answer 31

(ii) The time frame can vary from a few days to many years

Question 32

WEhere are forwards traded?

Answer 32

(iii) Forwards (unlike futures) are not traded on the exchange.

Question 33

On what does it depend whether you want to hedge?

Answer 33

The decision to hedge would depend upon the cost of hedging (forward premia) and
also the expected movement in the foreign exchange rates.

Question 34

How are forward premia determined?

Answer 34

Forward premia are determined by demand and supply.

Question 35

How does a currecny with a higher interest rate trade to one with a lower one?

Answer 35

As a rule a currency with a higher interest rate trades at a discount to a currency
with lower interest rates.