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Foreign Exposure Risk

Foreign Exposure Risk. By Pete Schonebaum March 4, 2008. Risks for firms Book examples Issues concerning forex risk 1 Exchange risk for a firm-how to measure Hedging strategy Tools to apply 1 Giddy,Ian. Management of Foreign Exchange Risk. Intro to Concept. Risk Measurement.

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Foreign Exposure Risk

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  1. Foreign Exposure Risk By Pete Schonebaum March 4, 2008

  2. Risks for firms Book examples Issues concerning forex risk1 Exchange risk for a firm-how to measure Hedging strategy Tools to apply 1 Giddy,Ian. Management of Foreign Exchange Risk Intro to Concept

  3. Risk Measurement • Two underlying variables • Volatility of exchange rate • Level of exposure • General scenarios • Fixed exchange rate: low risk • Exposed and low variance of exchange rate: moderate risk • Exposed and high variance of exchange rate: high risk

  4. Exchange Rate Risk • Real or nominal? • Typically measured using nominal • When to use real? • When inflation differentials affect nominal • Example: Mexican Peso nominal variance =2392 real variance=1561

  5. Calculating Exchange Rate Risk • Determine exchange rates over period • Calculate percentage change • Determine standard deviation of percentage changes • Assuming normal distribution • Example

  6. Exchange Risk: One Currency • Example: • Receivable of 2 million bugaboos in 1 month • Standard deviation of % change (1 mnth): 4.5% • 30 day forward rate: 1.5$/bugaboo • Expected exposure? • Foreign exchange risk?

  7. Exchange Risk: Multiple Currencies • Currency diversification • Firms face less risk • Risk and exposure cannot be added with multiple currencies • Correlation effects • Positive correlation: total exposure=approximate sum of two exposures • Negative correlation: risk and exposure cannot be added

  8. Exchange Risk: Multiple Currencies • Example: • $100 worth of IL, $100 worth of JPY • Variance IL/$: 520, Variance JPY/$: 600 • Covar of IL & JPY: 275 • What is the exchange risk of this portfolio?

  9. Exchange Risk and Firm Cash Flows • What: Relate currency portfolio risk with volatility of firm cash flows • How: • Devise ratio of portfolio st.deviation with that of firm cash flows • Run regression-cash flows as dependent, exchange rate as independent • Low R2 indicates low exchange risk

  10. Value at Risk • Definition: greatest possible loss over specified horizon, given confidence interval1 • Example: • Portfolio value: $10 million • Standard deviation of currency portfolio: 15% over 1 year • 99% confidence= 2.57 standard deviations • VAR=0.15 X 2.57 X $10 million =$3.85 million • Common terms: “Most we can lose, under normal market conditions, is $3.85 million.” 1: Click, Reid. International Financial Management

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