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INTRODUCTION: My Project Is EXCHANGE RATE RISK.

OBJECTIVES:

The objective of undertaking a project on EXCHANGE RATE RISK is to have in depth knowledge about exchange rate risk and risk management.

To know more about exchange rates especially about how they are determined. To know more about their types and how are they exposed. To know about how are exchange rates predicted and determined.

RESEARCH PROBLEM:

One of the most influencing and most critical limitations is that I am not trained for the research study and this is my first study. I tried hard to come at conclusion, but there is lack of expertise.

Another limitation is that there is lack of time. If I give more time then studies will be more effective.

The attitude of the research might be biased.

RATIONALE METHOD:

To provide a thorough knowledge of the concept of Exchange Rate Risk and its management.

To know the determinants of the exchange rate. To know the how markets get affected due to exchange rate risk.

RESEARCH METHODOLOGY The research-methodology adopted is mainly Non-doctrinal and descriptive. The sources of data include secondary sources like Articles, books and Journals.

CHAPTER SCHEME: EXCHANGE RATE HOW ARE EXCHANGE RATES PERDICTED AND DETERMINED EXCHANGE RATE RISK TYPES OF EXCHANGE RATE RISK MEASUREMENT OF THE RISK

CHAPTER 1 1.1 INTRODUCTION In finance, an EXCHANGE RATE (also known as a foreign-exchange rate, Forex rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveler's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash.

An exchange rate has a base currency and a counter currency. In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency. Most exchange rates use the US dollar as the base currency and other currencies as the counter currency. However, there are a few exceptions to this rule, such as the euro and Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar. Exchange rates for most major currencies are generally expressed to four places after the decimal, except for currency quotations involving the Japanese yen, which are quoted to two places after the decimal. Exchange rates can be floating or fixed. While floating exchange rates in which currency rates are determined by market force are the norm for most major nations, some nations prefer to fix or peg their domestic currencies to a widely accepted currency like the US dollar. Exchange rates can also be categorized as the spot rate which is the current rate or a forward rate, which is the spot rate adjusted for interest rate differentials

1.2 HOW ARE EXCHANGE RATES DETERMINED AND PREDICTED. Exchange rates are determined by the demand and supply for different currencies Three factors impact future exchange rate movements A countrys price inflation A countrys interest rate Market psychology

There are two schools of thought on predication (forecasting) 1. FUNDAMENTAL ANALYSIS: draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates. Fundamental analysis is about using real data to evaluate a security's value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security. A method of security valuation which involves examining the company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data.

2. TECHNICAL ANALYSIS: charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves. A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and

volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Technical analysts believe that the historical performance of stocks and markets are indications of future performance. In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, the technical analyst's decision would be based on the patterns or activity of people going into each store.

CHAPTER 2 2.1 EXCHANGE RATE RISK Exchange rate risk management is an integral part in every firms decisions about foreign currency exposure. Currency risk hedging strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications. Selecting the appropriate hedging strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered. The need for currency risk management started to arise after the break down of the Bretton Woods system and the end of the U.S. dollar peg to gold in 1973. The issue of currency risk management for non-financial firms is independent from their core business and is usually dealt by their corporate treasuries. Most multinational firms have also risk committees to oversee the treasurys strategy in managing the exchange rate (and interest rate) risk. This shows the importance that firms put on risk management issues and techniques. Conversely, international investors usually, but not always, manage their exchange rate risk independently from the underlying assets and/or liabilities. Since their currency exposure is related to translation risks on assets and liabilities denominated in foreign currencies, they tend to consider currencies as a separate asset class requiring a currency overlay mandate. A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 1989). In particular, it is defined as the possible direct loss (as a result of an unhedged exposure) or indirect loss in the firms cash flows, assets and liabilities, net profit and, in turn, its stock market value from an exchange rate move. To manage the exchange rate

risk inherent in multinational firms operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy and the available instruments to deal with these currency risks. The risk of an investment's value changing due to changes in currency exchange rates. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk". Exchange-rate risk is the risk of receiving less in domestic currency when investing in a bond that is in a different currency denomination than in the investor's home country. When investors purchase a bond that is designated in another currency other than their home countries, investors are opened up to exchange risk. This is because the payment of interest and principal will be in a foreign currency. When investors receive that currency, they have to go into the foreign currency markets and sell it to purchase their home currency. The risk is that their foreign currency will be devalued compared to the currency of their home countries and that they will receive less money than they expected to receive. As an example, suppose that a U.S. investor purchases a Euro denominated bond. When the interest payment comes due and if the Euro has declined in value compared to USD, the investor will receive less in USD than expected when he or she transacts in the foreign currency markets. In short, the investor will receive fewer Euros to purchase USD.

2.2 TYPES OF EXCHANGE RATE RISK

EXCHANGE RATE RISK

Transaction SHHERGHEIRGHEIRHEIUHAHERIPHGAIERHUPI Risk Economic Risk Translation Risk

Contingent Risk

TRANSACTION RISK: A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it.

ECONOMIC RISK: A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's market share position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influence the demand for a good in some country would also be an economic exposure for a firm that sells that good.

TRANSLATION RISK: A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiary /subsidiaries from foreign to domestic currency .While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments.

CONTINGENT RISK:

A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.

CHAPTER 4 4.1 MEASUREMENT OF THE RISK

Measuring currency risk may prove difficult, at least with regards to translation and economic risk. At present, a widely used method is the value-at-risk (VaR) model.

The VaR methodology can be used to measure a variety of types of risk, helping firms in their risk management.

The VaR measure of exchange rate risk is used by firms to estimate the riskiness of a foreign exchange position resulting from a firms activities, including the foreign exchange position of its treasury, over a certain time period under normal conditions.

VALUE-AT-RISK (VaR)

Value at risk is one of the most common methods used in Risk Measurement. There are several methods to measure VaR, three basic methods are: the parametric method, historical simulation and Monte Carlo simulation. One of the most important risk factors is the risk of exchange rate fluctuations which has very large impact on the performance of banks and the economy. Because of high sensitivity in banking operations such as monetary, financial and currency exchange operations as well as sensitivity to international fluctuations and also due to the significant impact of exchange rate fluctuations on the country's economy, therefore banks as the main pillar of the country's economy influenced with exchange rate fluctuations and therefore highly insists on calculating relevant risks for measuring capital required to cover to prevent large losses or even bankruptcy. Banks use various methods and tools to calculate the relevant risks, in which

each method has its own advantages and disadvantages. As proposed in 1995 and 1996 by the Basle Committee on Banking Supervision, banks are now allowed to calculate capital requirements for their trading books and other involved risks based on a VaR concept and in Basel committee VaR is recognized as the most comprehensive benchmark for risk measurement. Value at risk is one of the most common methods used in Risk Measurement. There are several methods to measure VaR, three basic methods are: the parametric method, historical simulation and Monte Carlo simulation. One of the most important risk factors is the risk of exchange rate fluctuations which has very large impact on the performance of banks and the economy. Because of high sensitivity in banking operations such as monetary, financial and currency exchange operations as well as sensitivity to international fluctuations and also due to the significant impact of exchange rate fluctuations on the country's economy, therefore banks as the main pillar of the country's economy influenced with exchange rate fluctuations and therefore highly insists on calculating relevant risks for measuring capital required to cover to prevent large losses or even bankruptcy. Banks use various methods and tools to calculate the relevant risks, in which each method has its own advantages and disadvantages. As proposed in 1995 and 1996 by the Basle Committee on Banking Supervision, banks are now allowed to calculate capital requirements for their trading books and other involved risks based on a VaR concept and in Basel committee VaR is recognized as the most comprehensive benchmark for risk measurement. VaR is an estimate of the worst possible loss (i.e., the decrease in the market value of a foreign exchange position) an investment could realize over a given time horizon, under normal market conditions (defined by a given level of confidence).

THE VAR CALCULATION DEPENDS ON 3 PARAMETERS:

The holding period, i.e., the length of time over which the foreign exchange position is planned to be held. The typical holding period is 1 day.

The confidence level at which the estimate is planned to be made. The usual confidence levels are 99 percent and 95 percent.

The unit of currency to be used for the denomination of the VaR.

As proposed by the Basle Committee on Banking Supervision, banks are now allowed to calculate capital requirements for their trading books and other involved risks based on a VaR concept and in Basel committee VaR is recognized as the most comprehensive benchmark for risk measurement.

BEST PRACTICES FOR EXCHANGE RATE RISK MANAGEMENT

For their currency risk management decisions, firms with significant exchange rate exposure often need to establish an operational framework of best practices.

These practices or principles may include:

1. Identification of the types of exchange rate risk that a firm is exposed to and measurement of the associated risk exposure. This involves determination of the transaction, translation and economic risks, along with specific reference to the currencies that are related to each type of currency risk. In addition, measuring these currency risks-using various models (e.g. VaR)-is another critical element in identifying hedging positions.

2. Development of an exchange rate risk management strategy. After identifying the types of currency risk and measuring the firms risk exposure, a currency strategy needs to be established on how to deal with these risks. In particular, this strategy should specify the firms currency hedging objectiveswhether and why the firm should fully or partially hedge its currency exposures. Furthermore, a detailed currency hedging approach should be established. It is imperative that a firm details the overall currency risk management strategy on the operational level, including the execution process of currency hedging, the hedging instruments to be used, and the monitoring procedures of currency hedges.

3. Creation of a centralized entity in the firms treasury to deal with the practical aspects of the execution of exchange rate hedging. This entity will be responsible for exchange rate forecasting, the hedging approach mechanisms, the accounting procedures regarding currency risk, costs of currency hedging, and the establishment of benchmarks for measuring the performance of currency hedging. (These operations may be undertaken by a specialized team headed by the treasurer or, for large multinational firms, by a chief dealer.)

4. Development of a set of controls to monitor a firms exchange rate risk and ensure appropriate position taking. This includes setting position limits for each hedging instrument, position monitoring through mark-to-market valuations of all currency positions on a daily basis (or intraday), and the establishment of currency hedging benchmarks for periodic monitoring of hedging performance (usually monthly).

5. Establishment of a risk oversight committee. This committee would in particular approve limits on position taking, examine the appropriateness of hedging instruments and associated VaR positions, and review the risk management policy on a regular basis. Managing exchange rate risk exposure has gained prominence in the last decade, as a result of the unusual occurrence of a large number of currency crises. From the corporate

managers perspective, currency risk management is increasingly viewed as a prudent approach to reducing a firms vulnerabilities from major exchange rate movements. This attitude has also been reinforced by recent international attention on both accounting and balance sheet risks

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