Managing Foreign Exchange Risk By Dr AshokK. Nag Chief Consulting Officer Riskraft Consulting Ltd.

Transcription

1 Managing Foreign Exchange Risk By Dr AshokK. Nag Chief Consulting Officer Riskraft Consulting Ltd.

2 Foreign Exchange Risk! What is it? - It arises when movement in exchange rate results in an adverse outcome of an economic entity.! Who are affected? " Corporate " Banks " Individuals including SMEs, Exporters and Importers " Central Bank

3 Types of FX Risk! Valuation or Translation Risk " Assets / Liabilities is denominated in foreign currency while holder s functional currency is different " Factor payments / receipts in foreign currency.! Income or Transactional Risk! Competition or Economic Risk

4 Techniques of FX Risk Management! Two Broad Types of Techniques " Natural Hedging " Hedging with financial instruments / derivatives

5 Natural Hedging! Undertake appropriate operational procedure that mitigate or eliminate FX risk. " Match Asset and Liability currency wise " If expenses are denominated in the same currency as income, the impact on bottom-line profitability is reduced

6 Hedging with Financial Instruments! Use of financial instruments for FX risk management is effective under two basic conditions " Amount and timing of the exposure being hedged is known with reasonable certainty. " Risk creating asset or a closely correlated one is traded in markets.! Such hedges may not perfectly offset the underlying business exposure, leaving a residual speculative trading position.

7 To Hedge or Not to Hedge! For-Earning volatility reduction " Against- PPP and CIP will take care! For- Reduced possibility of technical insolvency " Against- Adoption of prudential norm is a better option! For- Tax smoothing, pay out smoothing and better market valuation " Against- With transaction costs, hedging is a losing bet on average! To main drivers for hedging decisions " What is the risk appetite of the organization " What cost is acceptable for hedging

8 FX Risk Management Strategy- A Step by Step Approach! Step One- Define Your Objective and Goal! You need to answer questions of following types " What % of your receivables and payables is in foreign currency " At which point will the exchange rate affect your profitability " Extent of pass through capability " Etc..

9 Step 1 - Define Risk Tolerance and Hedging Policies and Procedures! Which exposure and how much to hedge?! If hedged, what should be stop-loss policy?! What should be hedge period?! What are the approved hedge instruments?! The decision hierarchy and accountability is formally established and codified.

10 Step 2 - Identify and Quantify Exposures! What is the risk type?! Which exposures are significant and what should be the optimum hedging ratio?! Should we use VaR as a measure of exposure?! Choose the specific hedging technique depending upon the objective of hedging the exposure.

11 Step 3 - Execution of Strategy! Identify who are authorized to execute the strategy already decided.! Levels of approval based on size and nature of transaction are specified! A counterparty or parties, together with credit limits would be specified.! Internal controls including independent confirmation of trades would be activated

12 Step 4 - Monitor, Review and Measure Performance! The underlying exposures need to be monitored on an on-going basis so that the position does not become over or under hedged.! Valuation and pricing of instruments needs to be revisited to assess their appropriateness.

13 Thank You Riskraft Consulting Ltd. 1st Floor, Boston House, Suren Road, Chakala, Andheri East, Mumbai