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  3. Lecture International finance: An analytical approach (3/e): Chapter 12 - Imad A. Moosa

Lecture International finance: An analytical approach (3/e): Chapter 12 - Imad A. Moosa

Chapter 12 - Foreign exchange risk and exposure. In this chapter, the learning objectives are: To define risk and exposure; to elaborate on the concept of value at risk (VAR); to distinguish among transaction, economic and translation exposure;… Chapter 12 Foreign Exchange Risk and Exposure Objectives • To define risk and exposure • To elaborate on the concept of value at risk (VAR) • To distinguish among transaction, economic and translation exposure Copyright 2010 McGraw-Hill Australia Pty Ltd

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  1. Chapter 12 Foreign Exchange Risk and Exposure
  2. Objectives • To define risk and exposure • To elaborate on the concept of value at risk (VAR) • To distinguish among transaction, economic and translation exposure Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-2
  3. Definitions of risk • The chance of bad consequence, loss, etc. (The Concise Oxford Dictionary) • The possibility of loss, injury, disadvantage or destruction (Webster’s Dictionary) (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-3
  4. Definitions of risk (cont.) • The origin of the word ‘risk’ is either the Arabic risq or the Latin risicum (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-4
  5. Definitions of risk (cont.) • In finance, a distinction is made between risk and uncertainty • In finance, risk is measured by the dispersion around the mean value of the rate of return, the cost of borrowing, the value of assets and liabilities, etc. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-5
  6. FX risk • FX risk arises because of uncertainty about the future spot exchange rate • It refers to the variability of the domestic currency value of certain items resulting from the variability of the exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-6
  7. Rate of return Vt 1 R V 1 Vt V SV R (1 S )(1 V ) 1 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-7
  8. Measuring risk: probability distribution n E ( R) pi ( Ri ) i 1 2 n 2 ( R) pi Ri E ( R) i 1 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-8
  9. Measuring risk: historical data 1 n R Rt n t 1 1 n 2 (R) ( Rt R )2 n 1 t 1 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-9
  10. Measurement of VAR • Measurement unit (e.g. AUD) • Time horizon (one day, one week, etc.) • Probability (1-5%) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-10
  11. Implementation of VAR analysis • Parametric (analytical) approach • Historical approach • Simulation approach Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-11
  12. The parametric approach • The approach is based on the assumption of the normality of rates of return (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-12
  13. The parametric approach (cont.)   Per cent of  Lowest r  Highest r  Probability  VAR  Observations  68  r   r   16.0  K (r )   90  r 1.65   r 1.65   5.0  K (r 1.65 )   95  r 1.96   r 1.96   2.5  K (r 1.96 )   98  r 2.33   r 2.33   1.0  K (r 2.33 )   99  r 3   r 3   0.5  K (r 3 )     Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-13
  14. The historical approach • VAR with a certain probability is calculated from the lower nth percentile of historical observations on the rate of return Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-14
  15. The simulation approach • VAR with certain probability is calculated from the lower nth percentile of simulated observations on the rate of return • Observations are generated from Monte Carlo simulation by specifying a probability distribution and its parameters Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-15
  16. VAR: pros • It is simple • It is suitable for risk-limit setting and performance measurement • It can take account of complex movements Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-16
  17. VAR: cons • It can be misleading • VAR estimates are highly sensitive to the underlying assumptions • It cannot cope with sudden or sharp changes Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-17
  18. VAR: conclusion • VAR is useful but it should be handled with care and used in conjunction with other measures of risk • Confidence in VAR has been undermined by the global financial crisis as the VAR models used by financial institutions failed to predict the losses that they actually endured Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-18
  19. Exposure • Risk measures the probability and magnitude of deviation from some expected outcome • Exposure is a measure of the sensitivity of what is at risk to the source of risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-19
  20. FX exposure • Exposure to FX risk is a measure of the sensitivity of the domestic currency value of FX items to changes in the exchange rate • Sometimes it is defined as the amount at risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 12-20
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