Unit 5: Exchange Risk

Exchange Risk vs Exchange Exposure

Simple Difference

Risk = Uncertainty of loss. Exposure = The extent to which a company or person is vulnerable to risk.

Example: An Indian company has to pay $10,000 in 30 days. If USD/INR moves unfavorably, it faces exchange risk. The $10,000 is the exchange exposure.

Transaction Exposure

Example: You sold goods to a US buyer and will receive $20,000 in 2 months. If the USD weakens, you will receive fewer INR. This is transaction exposure.

Managing Transaction Exposure

There are two main strategies

• Internal Hedging (e.g., leading/lagging payments, netting)
• External Hedging (using financial instruments)

External Hedge: Forward Contract Hedge

Example: An Indian importer agrees to buy $50,000 worth of goods in 3 months. He fears the USD may appreciate. He enters a forward contract to buy $50,000 at ₹84/USD. Even if the market moves to ₹86/USD, he still pays only ₹84/USD → loss avoided.

Summary Table

Money Market Hedge (External Hedge)

Example: Hedging a Payable An Indian company has to pay $10,000 in 3 months. Fearing USD will rise, it: Today: Buys $10,000 at spot rate using a rupee loan, or by converting own INR to USD and depositing in US bank. After 3 months: Pays $10,000 using deposit; repays INR loan (if borrowed).

Risk Avoided: Any USD appreciation is irrelevant — payment is pre-arranged.

Hedging with Futures and Options

A. Futures Contract Hedge

Example: You must pay $10,000 in 3 months. You buy USD futures today at ₹84/USD. Even if the rate becomes ₹86, you gain ₹2 in the futures market, offsetting the higher cost.

B. Options Contract Hedge

Example: You expect to receive $10,000. You buy a put option at ₹84/USD. If rate falls to ₹82/USD, you sell at ₹84, avoiding loss. If rate is ₹85, you ignore the option and sell at market rate.

Internal Hedge (Natural Hedging Techniques)

Examples: Leading: Pay early if foreign currency is expected to rise. Lagging: Delay payment if currency is expected to fall. Netting: A company has to pay $10,000 and receive $8,000 → net exposure = $2,000 only.

Translation Exposure (Accounting Exposure)

Example: A US-based company has a UK subsidiary. The subsidiary's GBP profits must be converted to USD for reporting. If GBP weakens, USD profit appears lower → translation loss.

Key Features of Translation Exposure

Summary Table

Methods of Translation

Used to convert foreign subsidiary’s financial statements into parent company’s currency for reporting.

Managing Translation Exposure

 Economic Exposure (Operating Exposure)

Managing Economic Exposure

Interest Rate Risk

Managing Interest Rate Risk

Summary Table