Chapter No.

7 Exposure and Risk in International Finance

Concepts

1 & 2. Exposure and Risk

Exposure is a measure of the sensitivity of the value of a financial item
(asset, liability or cash flow) to changes in the relevant risk factor while risk is
a measure of variability of the value of the item attributable to the risk factor.
Let us understand this distinction clearly. April 1993 to about July 1995 the
exchange rate between rupee and US dollar was almost rock steady. Consider
a firm whose business involved both exports to and imports from the US.
During this period the firm would have readily agreed that its operating cash
flows were very sensitive to the rupee-dollar exchange rate, i.e.; it had
significant exposure to this exchange rate; at the same time it would have said
that it didn’t perceive significant risk on this account because given the
stability of the rupee-dollar fluctuations would have been perceived to be
minimal. Thus, the magnitude of the risk is determined by the magnitude of
the exposure and the degree of variability in the relevant risk factor.

3. Hedging:
Hedging means a transaction undertaken specifically to offset some
exposure arising out of the firm’s usual operations. In other words, a
transaction that reduces the price risk of an underlying security or commodity
position by making the appropriate offsetting derivative transaction.
In hedging a firm tries to reduce the uncertainty of cash flows arising
out of the exchange rate fluctuations. With the help of this a firm makes its
cash flows certain by using the derivative markets.
4. Speculation
Speculation means a deliberate creation of a position for the express
purpose of generating a profit from fluctuation in that particular market,
accepting the added risk. A decision not to hedge an exposure arising out of
operations is also equivalent to speculation.
Opposite to hedging, in speculation a firm does not take two opposite
positions in the any of the markets. They keep their positions open.

5. Call Option:
A call option gives the buyer the right, but not the obligation, to buy the
underlying instrument. Selling a call means that you have sold the right, but
not the obligation, to someone to buy something from you.

6. Put Option:
A put option gives the buyer the right, but not the obligation, to sell the
underlying instrument. Selling a put means that you have sold the right, but
not the obligation, to someone to sell something to you.

7. Strike Price:
The predetermined price upon which the buyer and the seller of an
option have agreed is the strike price, also called the ‘exercise price’ or the
striking price. Each option on an underlying instrument shall have multiple
strike prices.

8. Currency Swaps:
In a currency swap, the two payment streams being exchanged are
denominated in two different currencies. Usually, an exchange of principal
amount at the beginning and a re-exchange at termination are also a feature of
a currency swap.
 A typical fixed-to-fixed currency swaps work as follows. One party
raises a fixed rate liability in currency X say US dollars while the other raises
fixed rate funding in currency Y say DEM. The principal amounts are
equivalent at the current market rate of exchange. At the initiation of the swap
contract, the principal amounts are exchanged with the first party getting
DEM and the second party getting dollars. Subsequently, the first party makes
periodic DEM payments to the second, computed as interest at a fixed rate on
the DEM principal while it receives from the second party payment in dollars
again computed as interest on the dollar principal. At maturity, the dollar
and DEM principals are re-exchanged.
A floating-to-floating currency swap will have both payments at
floating rate but in different currencies. Contracts without the exchange and
re-exchange do exist. In most cases, an intermediary- a swap bank- structures
the deal and routes the payments from one party to another.
A fixed-to-floating currency swap is a combination of a fixed-to-fixed
currency swaps and a fixed-to-floating interest rate swap. Here, one payment
stream is at a fixed rate in currency X while the other is at a floating rate in
currency Y.

9. Futures
Futures are exchanged traded contracts to sell or buy financial
instruments or physical commodities for future delivery at an agreed price.
There is an agreement to buy or sell a specified quantity of financial
instrument/commodity in a designated future month at a price agreed upon
by the buyer and seller. The contracts have certain standardized specification.

10. Transaction Exposure

This is a measure of the sensitivity of the home currency value of the
assets and liabilities, which are denominated, in the foreign currency, to
unanticipated changes in the exchange rates, when the assets or liabilities are
liquidated. The foreign currency values of these items are contractually fixed,
i.e.; do not vary with exchange rate. It is also known as contractual exposure.

Some typical situations, which give rise to transactions exposure, are:

(a) A currency has to be converted in order to make or receive payment for
goods and services;
(b) A currency has to be converted to repay a loan or make an interest
payment; or
(c) A currency has to be converted to make a dividend payment, royalty
payment, etc.

Note that in each case, the foreign value of the item is fixed; the
uncertainty pertains to the home currency value. The important points to be
noted are (1) transaction exposures usually have short time horizons and (2)
operating cash flows are affected.

11. Translation Exposure

Also called Balance Sheet Exposure, it is the exposure on assets and
liabilities appearing in the balance sheet but which is not going to be
liquidated in the foreseeable future. Translation risk is the related measure of
variability.
The key difference is the transaction and the translation exposure is that
the former has impact on cash flows while the later has no direct effect on
cash flows. (This is true only if there are no tax effects arising out of
translation gains and losses.)
Translation exposure typically arises when a parent multinational
company is required to consolidate a foreign subsidiary’s statements from its
functional currency into the parent’s home currency. Thus suppose an Indian
company has a UK subsidiary. At the beginning of the parent’s financial year
the subsidiary has real estate, inventories and cash valued at, 1000000, 200000
and 150000 pound respectively. The spot rate is Rs. 52 per pound sterling by
the close of the financial year these have changed to 950000 pounds, 205000
pounds and 160000 pounds respectively. However during the year there has
been a drastic depreciation of pound to Rs. 47. If the parent is required to
translate the subsidiary’s balance sheet from pound sterling to Rupees at the
current exchange rate, it has suffered a translation loss. The translation value
of its assets has declined from Rs. 70200000 to Rs. 61805000. Note that no cash
movement is involved since the subsidiary is not to be liquidated. Also note
that there must have been a translation gain on subsidiary’s liabilities, ex.
Debt denominated pound sterling.

12. Contingent Exposure

The principle focus is on the items which will have the impact on the
cash flows of the firm and whose values are not contractually fixed in foreign
currency terms. Contingent exposure has a much shorter time horizon.
Typical situation giving rises to such exposures are
a. An export and import deal is being negotiated and quantities and
prices are yet not to be finalized. Fluctuations in the exchange rate
will probably influence both and then it will be converted into
transactions exposure.
b. The firm has submitted a tender bid on an equipment supply
contract. If the contract is awarded, transactions exposure will arise.
c. A firm imports a product from abroad and sells it in the domestic
market. Supplies from abroad are received continuously but for
marketing reasons the firm publishes a home currency price list
which holds good for six months while home currency revenues
 may be more or less certain, costs measured in home currency are
exposed to currency fluctuations.

In all the cases currency movements will affect future cash flows.

13. Competitive exposure

Competitive exposure is the most crucial dimensions of the currency
exposure. Its time horizon is longer than of transactional exposure – say
around three years and the focus is on the future cash flows and hence on
long run survival and value of the firm. Consider a firm, which is involved in
producing goods for exports and /or imports substitutes. It may also import a
part of its raw materials, components etc. a change in exchange rate gives rise
to no. of concerns for such a firm, example,
1. What will be the effect on sales volumes if prices are maintained? If
prices are changed? Should prices be changed? For instance a firm
exporting to a foreign market might benefit from reducing its foreign
currency priced to foreign customers. Following an appreciation of
foreign currency, a firm, which produces import substitutes, may
contemplate in its domestic currency price to its domestic customers
without hurting its sales. A firm supplying inputs to its customers who
in turn are exporters will find that the demand for its product is
sensitive to exchange rates.
2. Since a part of inputs are imported material cost will increase following
a depreciation of the home currency. Even if all inputs are locally
purchased, if their production requires imported inputs the firms
material cost will be affected following a change in exchange rate.
3. Labour cost may also increase if cost of living increases and the wages
have to be raised.
 4. Interest cost on working capital may rise if in response to depreciation
the authorities resort to monetary tightening.
5. Exchange rate changes are usually accompanied by if not caused by
difference in inflation across countries. Domestic inflation will increase
the firm’s material and labour cost quite independently of exchange rate
changes. This will affect its competitiveness in all the markets but
particularly so in markets where it is competing with firms of other
countries
6. Real exchange rate changes also alter income distribution across
countries. The real appreciation of the US dollar vis-à-vis deutsche
mark implies and increases in real incomes of US residents and a fall in
real incomes of Germans. For an American firm, which sells both at
home, exports to Germany, the net impact depends upon the relative
income elasticities in addition to any effect to relative price changes.

Thus, the total impact of a real exchange rate change on a firm’s sales,
costs and margins depends upon the response of consumers, suppliers,
competitors and the government to this macroeconomic shock.

In general, an exchange rate change will effect both future revenues as

well as operating costs and hence exchange rates changes, relative inflation
rates at home and abroad, extent of competition in the product and input
markets, currency composition of the firm’s costs as compared to its
competitors’ costs, price elasticities of export and import demand and supply
and so forth.
 Descriptive
1. What is currency risk? Enumerate the different types of currency risks
with examples.
Ans. Currency risk arises due to exposures explained in concepts 10 to 13

2. Discuss the exposure and risk occurring due to the changes in

a) Interest rates
b) Exchange rates
Ans.
a) Interest rate uncertainty exposes a firm to the following kinds of risks:
1. If the firm has borrowed on a floating rate basis, at very reset date, the
rate for the following period would be set in line with the market rate.
The firm’s future interest payments are therefore uncertain. An increase
in rates will adversely affect the cash flows.
2. Consider a firm, which wants to undertake a fixed investment project.
Suppose it requires foreign currency financing and is forced to borrow
on a floating rate basis. Since its cost of capital is uncertain, an
additional element of risk is introduced in project appraisal.
3. On the other hand, consider a firm, which has borrowed on a fixed rate
basis to finance a fixed investment project. Subsequently inflation rate
in the economy slows down and the market rate of interest declines.
The cash flows from the project may decline as a result of the fall in the
rate of inflation but the firm is logged into high cost borrowing.
4. A fund manager expects to receive a sizable inflow of funds in three
months to be invested in five –year interest rate will have declined thus
reducing the return on his investments.
5. A bank has invested in a six-month loan at 18% and financed it by
means of a three-month deposit at 16.5%. At the end of three months it
 must refinance its investment. If deposits rates go up in the mean while
its margin will be reduced or may even turn negative.
6. A fund manager is holding a portfolio fixed income securities such as
government and corporate bonds. Fluctuations in interest rates expose
into two kinds of risks. The first is that the market value of his portfolio
varies inversely with interest rates. This is the risk of capital gains or
losses. Secondly he receives periodic interest payments on his holdings,
which have to be reinvested. The return he can obtain on these
reinvestments in uncertain.

In each of these cases, an adverse movement in interest rates hurts the

firm by either increasing the cost of borrowing or by reducing the return on
investment or producing capital losses on its assets portfolio. During the early
80’s investor’s preferences shifted towards floating rate instruments thus
exposing borrowers to substantial interest rate risks.
For most Indian companies the idea of interest rate risk is relatively
new. In an environment of administered rates and fragmented,
compartmentalized capital markets, neither investors nor borrowers felt the
need to worry fluctuations in interest rates.
With increasing resort to external commercial borrowings, Indian
companies have had to recognize and learn to manage interest rate risk. Also,
the Indian financial system is gradually moving in the direction of market
determined interest rate risk. Also, the Indian financial system is gradually
moving in the direction of market determined interest rates. During the last
few years the environment has changed drastically. In particular, the steep
rise in interest rates during 1995-1996 has led to the painful realization that
careful management of the interest rate risk is crucial to a firm’s financial
health.
Ans. 2. b) Same as descriptive question no. 1

3. Discuss the available tools to manage risk involved due to fluctuations in

exchange rates and interest rates.
Ans.
A firm may be able to reduce or eliminate currency exposure by means
of internal and external hedging strategies.
♦ INTERNAL HEDGING STARTEGIES
 Invoicing
A firm may be able to shift the entire risk to another party by invoicing
its exports in its home currency and insisting that its imports too be invoiced
in its home currency, but in the presence of well functioning forwards markets
this will not yield any added benefit compared to a forward hedge. At times,
it may diminish the firm’s competitive advantage if it refuses to invoice its
cross-border sales in the buyer’s currency.
In the following cases invoicing is used as a means of hedging:
1. Trade between developed countries in manufactured products is
generally invoiced in the exporter’s currency.
2. Trade in primary products and capital assets are generally invoiced in a
major vehicle currency such as the US dollar.
3. Trade between a developed and a less developed country tends to be
invoiced in the developed country’s currency.
4. If a country has a higher and more volatile inflation rate than its trading
partners, there is a tendency not to use that country’s currency in trade
invoicing.
Another hedging tool in this context is the use of “currency cocktails”
for invoicing. Thus for instance, British importer of fertilizer from Germany
can negotiate with the supplier that the invoice is partly in DEM & partly in
Sterling. This way both the parties share exposure. Another possibility is to
use one of the “standard currency baskets” such as the SDR or the ECU for
invoicing trade transactions.
Basket invoicing offers the advantage of diversification and can reduce
the variance of home currency value of the payable or receivable as long as
there is no perfect correlation between the constituent currencies. The risk is
reduced but not eliminated. Also, there is no way by which the exposure can
be hedged since there is no forward markets I these composite currencies. As
a result, this technique has not become very popular.
 Netting and Offsetting:
A firm with receivables and payables in diverse currencies can net out
its exposure in each currency by matching receivables with payables. Thus a
firm with exports to and imports from say Germany need not cover each
transaction separately; it can use a receivable to settle all or part of a payable
and take a hedge only for the net DEM payable or receivable. Even if the
timings of the two flows do not match, it might be possible to lead or lag one
of them to achieve a match.
To be able to use netting effectively, the company must have
continuously updated information on inter-subsidiary payments position as
well as payables and receivables to outsiders. One way of ensuring efficient
information gathering is to centralise cash management.
 Leading and lagging: Another internal way of managing transactions
exposure is to shift the timing of exposures by leading or lagging
payables and receivables. The general rule is lead, i.e. advance payables
and lag, i.e. postpone receivables in “strong” currencies and,
conversely, lead receivables and lag payables in weak currencies.
Simply shifting the exposure in time is not enough; it has to be
combined with a borrowing/lending transaction or a forward
transaction to complete the hedge.
Both these tools exist as a response to the existence of market imperfections.
♦ External Tools
A. Using hedging for forwards market:
In the normal course of business, a firm will have several contractual
exposures in various currencies maturing at various dates. The net exposure
in a given currency at a given date is simply the difference between the total
inflows and the total outflows to be settled on that date. Thus suppose ABC
Co. has the following items outstanding:
Item Value Dates to maturity
1.USD receivable 800,000 60
2.NLG payable 2,000,000 90
3.USD interest payable 100,000 180
4.USD payable 200,000 60
5.USD purchased forward 300,000 60
6.USD loan installment due 250,000 60
7.NLG purchased forward 1,000,000 90

Its net exposure in USD at 60 days is:

(800,000+300,000)-(200,000+250,000)=+USD 650,000
Whereas it has a net exposure in NLG of –1,000,000 at 90 days.
The use of forward contracts to hedge transactions exposure at a single
date is quite straightforward. A contractual net inflow of foreign currency is
sold forward and a contractual net outflow is bought forward. This removes
all uncertainty regarding the domestic currency value of the receivable or
payable. Thus in the above example, to hedge the 60 day USD exposure, ABC
Co. can sell forward USD 650,000 while for the NLG exposure it can buy NLG
1,000,000 90 day forward.
What about exposures at different date? One obvious solution is to
hedge each exposure separately with a forward sale or purchase contract as
the case may be. Thus in the example, the firm can hedge the 60 day USD
exposure with a forward sale and the 180 day USD exposure with a forward
purchase.

B. Hedging with the money market:

Firms, which have access to international money markets for short-term
borrowing as well as investment, can use the money market for hedging
transactions exposure.
E.g.: Suppose a German firm ABC has a 90 day Dutch Guilder
receivable of NLG 10,000,000. It has access to Euro deposit markets in DEM as
well as NLG. To cover this exposure it can execute the following sequence of
transactions:
1. Borrow NLG in the euroNLG market for 90 days.
2. Convert spot to DEM.
3. Use DEM in its operations, e.g. to pay off a short-term bank loan or
finance inventory.
4. When the receivable is settled, use it to pay off the NLG loan.
Suppose the rates are as follows:
NLG/DEM Spot: 101025/35 90day forward: 1.1045/65
EuroNLG interest rates: 5 1/4/5 ½
EuroDEM interest rates: 4 3/4/5.00
Comparing the forward cover against the money market cover. With
forward cover, each NLG sold will give an inflow of DEM (1/1.064)= DEM
0.9038, 90 days later. The present value of this (at 4.74%) is
0.9038/[1+ (0.0475/4)]= DEM 0.8931
To cover using the money market, for each NLG of receivable, borrow
NLG 1/[1+ (0.055/4)]
= NLG 0.9864, sell this spot to get DEM (0.9864/1.1035)
=DEM 0.8939
 Pay off the NLG loan when the receivables mature. Thus the money
markets cover; there is a net gain of DEM 0.0008 per NLG of receivable or
DEM 8000 for the 10 million-guilder receivable.
Sometimes the money market hedge may turn out to be the more
economical alternative because of some constraints imposed by governments.
For instance, domestic firms may not be allowed access to the Euromarket in
their home currency or non-residents may not be permitted access to domestic
money markets. This will lead to significant differentials between the
Euromarket and domestic money market interest rates for the same currency.
Since forward premia/ discounts are related to Euromarket interest
differentials between two currencies, such an imperfection will present
opportunities for cost saving.
E.g. A Danish firm has imported computers worth $ 5 million from a US
supplier. The payment is due in 180 days. The market rates are as follows:
DKK/USD Spot: 5.5010/20
180 days forward: 5.4095/ 5.4110
Euro $: 9 1/2/ 9 ¾
Euro DKK: 6 1/4/ 6 ½
Domestic DKK: 5 1/4/ 5 ½
The Danish government has imposed a temporary ban on non-residents
borrowing in the domestic money market. For each dollar of payable, forward
cover involves an outflow of DKK 5.4110, 180 days from now. Instead for each
dollar of payable, the firm can borrow DKK 502525 at 5.5%, acquit $ 0.9547 in
the spot market and invest this at 9.50% in a Euro $ deposit to accumulate to
one dollar to settle the payable. It will have to repay DKK 5.3969 [=5.2525*
1.0275], 180 days later. This represents a saving of DKK 0.0141 per dollar of
payable or DKK 70,500 on the $5 million payable.
From the above example it is clear that from time to time cost saving
opportunities may arise either due to some market imperfection or natural
market conditions, which an alert treasurer can exploit to make sizeable gains.
Having decided to hedge an exposure, all available alternatives foe executing
the hedge should be examined.

C. Hedging with Currency Options:

Currency options provide a more flexible means to cover transactions
exposure. A contracted foreign currency outflow can be hedged by
purchasing a call option (or selling a put option) on the currency while an
inflow can be hedged by buying a put option. (Or writing a call option. This is
a “covered call” strategy).
Options are particularly useful for hedging uncertain cash flows, i.e.
Cash flows those are contingent on other events. Typical situations are:
a. International tenders: Foreign exchange inflows will materialise only if
the bid is successful. If execution of the contract also involves purchase
of materials, equipments, etc. from third countries, there are contingent
foreign currency outflows too.
b. Foreign currency receivables with substantial default risk or political
risk, e.g. the host government of a foreign subsidiary might suddenly
impose restrictions on dividend repatriation.
c. Risky portfolio investment: A funds manager say in UK might hold a
portfolio of foreign stocks/bonds currently worth say DEM 50 million,
which he is planning to liquidate in 6 months time. If he sells Dem 50
million forward and the portfolio declines in value because of a falling
German stock market and rising interest rates, he will find himself to be
over insured and short in DEM.
E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on
September 1. The market rates are as follows:
DEM/GBP Spot: 2.8175/85
90-day Swap points: 60/55
 September calls with a strike of 2.82 (DEM/GBP) are available for a
premium of 0.20p per DEM. Evaluating the forward hedge versus purchase of
call options both with reference to an open position.
i. Open position: Suppose the firm decides to leave the payable
unhedged. If at maturity the pound sterling/ DEM spot rate is St.,
the sterling value of the payable is (5,00,000) St.
ii. Forward hedge: If the firm buys DEM 5,00,000 forward at the offer
rate of DEM 2.8130/PS or PS0.3557/ DEM, the value of the payable
is PS (5,00,000 * 0.3557)=PS 1,77,850.
iii. A Call option: Instead the firm buys call options on DEM 5,00,000 for
a total premium expense of PS 1000.
At maturity, its cash outflow will be
PS [(5,00,000)St +1025] for St<= 0.3546
and PS[5,00,000)(0.3546)+1025]
= PS 178325 for St>=0.3546.
Here it is assumed here that the premium expense is financed by a
90 day borrowing at 10%.

D. Hedging with currency futures:

Hedging contractual foreign currency flows with currency futures is in
many respects similar to hedging with forward contracts. A receivable is
hedged by selling futures while a payable is hedged by buying futures.
A futures hedge differs from a forward hedge because of the intrinsic
features of future contracts. The advantages of futures are, it easier and has
greater liquidity. Banks will enter into forward contracts only with
corporations (and in rare cases individuals) with the highest credit rating.
Second, a futures hedge is much easier to unwind since there is an organized
exchange with a large turnover.
 A firm may be able to reduce or eliminate interest rate exposure by
mean of following hedging strategies.

 Forward rate Agreements:

A FRA is an Agreement between two parties in which one of them (The
seller of FRA), contracts to lend to other (Buyer), a specified amount of funds,
in a specific currency, for a specific period starting at a specified future date,
at an interest rate fixed at the time of agreement. A typical FRA quote from a
bank might look like this:
USD 6/9 months: 7.20 – 7.30% P.a.
This is to be interpreted as follows.
 The bank is willing to accept a three month USD deposit starting six
months from now, maturing nine months from now, at an interest rate
of 7.20% P.a. (Bid Rate).
 The bank is willing to lend dollars for three months, starting six months
from now at a interest rate of 7.30% P.a. (Ask Rate).
The important thing to note is that there is no exchange of principal
amount.
 Interest rate futures:
Interest rate futures are one of the most successful financial innovations
in recent years. The underlying asset is a debt instrument such as a treasury
bill, a bond, and a time deposit in a bank and so on. For e.g. the International
Monetary Market (a part of Chicago Mercantile Exchange) has a futures
contract on US government treasury bills, three-month Eurodollar time
deposits and US treasury notes and bonds. The LIFFE has contracts on
Eurodollar deposits, sterling time deposits and UK government bonds. The
Chicago Board of Trade offers contracts on long-term US treasury bonds.
Interest rate futures are used by corporations, banks and financial
institutions to hedge interest rate risk. A corporation planning to issue
commercial paper for instance can use T-Bill futures to protect itself against an
increase in interest rate. A corporate treasurer who expects some surplus cash
in near future to be invested in short-term instruments may use the same as
insurance against a fall in interest rates. A fixed income fund manager might
use bond futures to protect the value of her fund against interest rate
fluctuations. Speculators bet on interest rate movements or changes in the
term structure in the hope of generating profits.

 Interest Rate Swaps:

A standard fixed-to-floating interest rate swap, known in the market jargon as
a plain vanilla coupon swap (also referred to as “exchange of borrowings”) is
an agreement between two parties in which each contracts to make payments
to the other on particular dates in the future till a specified termination date.
One party, known as the fixed ratepayer, makes fixed payments all of which
are determined at the outset. The other party known as the floating ratepayer
will make payments the size of which depends upon the future evolution of a
specified interest rate index (such as the 6-month LIBOR). The key feature of
this is:
The Notional Principal:
The fixed and floating payments are calculated if they were interest payments
on a specified amount borrowed or lent. It is notional because the parties do
not exchange this amount at any time; it is only used to compute the sequence
of payments. In a standard swap the notional principal remains constant
through the life of the swap.

 Interest rate Options:

A less conservative hedging device for interest rate exposure is interest rate
options. A call option on interest rate gives the holder the right to borrow
funds for a specified duration at a specified interest rate, without an
obligation to do so. A put option on interest rate gives the holder the right to
invest funds for a specified duration at a specified return without an
obligation to do so. In both cases, the buyer of the option must pay the seller
an up-front premium stated as a fraction of the face value of the contact.
As interest rate cap consists of a series of call options on interest rate or
a portfolio of calls. A cap protects the borrower from increase in interest rates
at each reset date in a medium-to-long-term floating rate liability. Similarly,
an interest rate floor is a series or portfolio of put options on interest rate,
which protects a lender against fall in interest rate on rate dates of a floating
rate asset. An interest rate collar is a combination of a cap and a floor.

4.

5. Explain the importance and relevance of hedging in foreign exchange

market.
Ans.
Foreign Exchange Market
The foreign exchange market is the market in which currencies are
brought and sold against each other. It is the largest market in the world.
Foreign exchange market is an over the counter market. This means there is
no single market place or an organized market place or an organized
exchange (like a stock exchange) where traders meet and exchange currency.
The traders sit in the offices (foreign exchange dealing rooms) of major
commercial banks around the world and communicate with each other
through telephones, telex, computer terminals and other electronic means of
communication.
Hedging:
Hedging means a transaction undertaken specifically to offset some
exposure arising out of the firm’s usual operations. In other words, a
transaction that reduces the price risk of an underlying security or commodity
position by making the appropriate offsetting derivative transaction.
Different types of exposures
Refer to concept questions 10 to 13.
Conclusion
Hence after looking at the different types of exposures, traders faces it is
very clear that Hedging with the help of derivatives will ensure a safe
transaction in Foreign exchange market.

6. Is it possible to hedge the foreign exchange risk in the forwards market?

Ans. It is not possible to hedge forex risk fully.
This is so because as long as there exists currency as a medium of
exchange the person holding the currency is exposed to different types of
risks e.g. political, financial, …
This can be explained with the help of example of an Indian exporter. If
he has contracted for exports worth 1000 USD and the spot rate was 45 Rs./$
for a period of 6months with a co. in USA. He would receive his payments 6
months from now, the commercial risk involved here is with respect to the
fluctuations in exchange rates. If the rates 6 months from now become 50 Rs/$
then he would receive 50000 USD i.e. he incurs a profit of 5000 USD and vice a
versa when the value of Rs. appreciate.
In above case, if we hedge our position the cash flow would be certain,
but still we have Rs. i.e. a currency in our hand with which risk prevails.
Here comes in the political risk i.e. even when the Indian exporter has
the home currency. In case the country’s economy crashes the currency will
loose all it value throughout the world.
Thus, with the help of above e.g. it can be proved that as long as
currency is involved we have risk.
7. Explain with an example how to cover exchange risk in the forwards
market.
Ans. Please refer to answer 3 (A)

8. What factors determine the value of an option?

Ans. The factors are
a. Maturity of an option: higher the price higher the value of an option

and vice a versa

b. Spot price of underlying assets:
c. Strike price of underlying assets:
d. Interest rate structure in the market: higher the interest rate
structure in the market higher the value of an option and vice a versa
e. Volatility: higher the volatility in the market higher the value of an

option and vice a versa. This is so because higher the volatility in the
market, higher the potential for earning more, thus the buyer of an
option has to pay more premium.

9. Explain with examples how options are used to cover exchange risks?
Ans. Currency options provide corporate treasurer another tool for hedging
foreign exchange risks arising out of firms operations. Unlike forward
contract, options allow the hedger to gain from favorable exchange rate
movements, while been unprotected from unfavorable movements. However
forward contracts are costless while options involve up front premium cost.
a) Hedging a Foreign Currency with calls.
In late February an American importer anticipates a yen payment of
JYP 100 million to a Japanese supplier sometime late in May. The current
USD/JYP spot is 0.007739 (which implies a JYP/USD rate of 129.22.). A June
yen call option on the PHLX, with strike price of $0.0078 per yen is available
for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen contract
is for JPY 6.25 million. Premium per contract is therefore: $(0.000108 *
6250000) = $675.
The firm decides to purchase 16 calls for a premium of $10800 .In addition
there is a brokerage fee of $20 per contract. Thus the total expense in buying
the option is $11,120.The firm has in effect ensured that its buying rate for yen
will not exceed $0.0078+ $(11120/100,000,000)= $0.0078112 per yen.
The price the firm will actually end up paying for yen depends on the
spot rate at the time of payment .For further clarification the following 2 e.g.
are considered:
1. Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late May when
the payment becomes due .The firm will not exercise its options. It can
sell 16 calls in the market provided the resale value exceeds the
brokerage commission it will have to pay. (The June calls will still have
some positive premium) .It buys yen in the spot market .In this case the
price per yen it will have paid is $0.0075 + $0.0000112 - ${(Sale of value
options – 320) /100000000}
If the resale value of the options is less than $320, it will simply let the
options lapse .In this case the effective rate will be $0.0075112 per yen or
yen 133.13 per $. It would have been better to leave the payable
uncovered. The forward purchase at $0.0078 would have fixed the rate
at that value and would be worse than the option.
2. Yen appreciates to $0.08
Now the firm can exercise the options and procure the yen at the strike
price of $0.0078.In addition, there will be transaction cost associated
with the exercise. Alternatively, it can sell the option and buy the yen in
the spot market. Assume that June yen calls are trading at $0.00023per
yen in late May. With the latter alternative, the dollar will be $800000-
 $(0.00023 * 16* 6250000)+ $320= $777320. Including the premium, the
effective rate the firm has paid is $(0.0077732+0.0000112) = $0.0077844.

b) Hedging a receivable with a put option

A German chemical firm has supplied goods worth Pound 26 million to
a British customer. The payment is due in two months. The current
DEM/GBP spot rate is 2.8356 and two month forward rate is 2.8050. An
American put option on sterling with 3 month maturity and strike price of
DEM 2.8050 is available in the inter bank market with a premium of DEM 0.03
per sterling. The firm purchases a put option on pound 26 million .The
premium paid is DEM (0.03 * 26000000) = DEM 780000. There are no other
costs.
Effectively the firm has put a floor on the value of its receivable at
approximately DEM 2.7750 per sterling (= 2.8050-0.03). Again two e.g. are
considered:
1. The pound sterling depreciates to DEM 2.7550 .The firm exercises its
put option and delivers pound 26 million to the bank at the price of
2.8050. The effective rate is 2.7750. It would have been better off with a
forward contract.
Sterling appreciates to DEM 2.8575. The option has no secondary market and
the firm allows it to lapse. It sells the receivable in the spot market. Net of the
premium paid, it obtains an effective rate of 2.8275, which is better than
forward rate. If the interest forgone on premium payment is accounted for,
the superiority of the option over the forward contract will be slightly
reduced.
10. Write a short note on currency swaps
Ans. Please refer to concept answer 8
11. What types of exchange exposure in a multinational enterprise subject
to?
Ans. Please refer to descriptive answer 1