Exchange Risk Analysis - Assignment Example

Running Header: Exchange Risk Analysis Student’s Name: Instructor’s Name: Course code: Date of Submission: Introduction Risk analysis in foreign exchange market refers to the uncertainty of predicted cash flows in the future andinconsistency in stock returns. It also entails analysis of existing statistics to evaluate the probability of business success or failure and probable economic states in the future. The main aim of the analysis is to minimize unforeseen negative impacts in the future. In a broader perspective, an exchange rate risk implies the effect of unforeseen and unexpected changes in the rate of foreign exchange on the real value of an organization or company (Wang, Peijie, 2005). From this point of view, exchange rate risk is directly equal to the loss due to unmanaged exposure of organizations to risks or indirect losses in the organization’s cash flows, net profit, stock market value, assets, and liabilities. Therefore, considering this point, every organization need to manage its exposure to risks by determining the specific kinds of risks exposed to and determining efficient strategies to encounter these currency risks. Exchange rate risk usually affects multinational companies that deal with export and imports of goods and services. In some other cases, the exchange risk can also affect investors that concentrate their businesses in international investments. For example, in the case of converting money from one currency to anothercurrency for investment purposes, any changes in the currency exchange rate will result in increase or decrease in the value of the currency when converted back to its original money when exchange rate fluctuates. Objectives of Risk Management Exchange rate risk analysis forms an integral part and takes center stage in an organization’s decision-making on foreign exchange. The decisions made here aims at formulating strategies of identifying currency risks, strategies to eliminate the identified risks, and the requirement of understanding of how exchange rate risk would affect operations of agents and subsidiaries and techniques to encounter consequent exchange risk implications. Therefore, almost all sorts of multinational businesses require a vivid risk analysis program. Analyzing risks, measuring them, and formulating strategies to manage them are crucial activities for every company and organization to reduce their vulnerabilities of encountering major changes in the exchange rate markets. This would affect the profit margins and value of assets of the organization exposed to such changes in foreign exchange rates (Pilbeam, Keith, 2006). Selecting the most appropriate and efficient strategies to manage exchange rate risks is a daunting task for most organizations because of the complexities and complications that come with accurate measurement of current risk exposure and making the right decisions on the appropriate levels of risk exposure for analysis. Types of Exchange Rate Risks There are three major types of exchange rate risks facing most organizations across the globe. They include transaction risks, translation risks, and economic risks. The difference in the three risks is the degreeof their effects of unexpected changes in the exchange rates on the value of an organization. Transaction risks involve cash flow risks and entail the impact of exchange rate changes on organization’s transactional account. Risk exposure in this case involves receivables such as export contracts, payables such as import contracts, and repatriation of dividends. In any of these contracts, a change in exchange rate in the currency of any given denomination will definitely lead to exposure of an organization to direct transactional exchange rate risk. Translation exposure refers to accounting exposure. It measures the impact of changes in exchange rate on the financial statements of the group of company. By large extend, this type of exchange risk impacts on organization’s balance sheet exchange risk, valuation to foreign subsidiaries, and consolidation of those subsidiaries in the balance sheet of the mother company. To assess translational exposure is measuring the exposure of net assets to probable changes in exchange rates. To have a clear analysis of this type of exposure, most organizations do their translations either at the end-of-period exchange rate or in other cases at average exchange rate of the entire period (Eun, Cheol S., et al., 2011). The choice of either of the two will largely depend on the regulations likely to affect the mother company. By doing so enables organizations to consolidate their financial statements from foreign subsidiaries to the mother company’s financial statements. Therefore, while financial statements translations are conducted at an average exchange rate over the entire period, exposure of balance sheets in foreign subsidiaries may not apply. Therefore, translations of foreign subsidiaries balance sheets are usually at the present exchange rate during consolidation. Finally, economic risks reflect the risk of organization’s current value in relation to forthcoming operating cash flows due to changes and fluctuation in the exchange rate. This type of risk entails the implications of fluctuations in exchange rates domestic sales and exports and operating expenses such as production costs and costs of imports. It usually applies to the present value of forthcoming cash flows operation of the organization’s mother company as well as its foreign subsidiaries. Measuring Exchange Rate Risk Measuring exchange rate risk may be a difficult activity, especially with translation risk and economic risk (Holton, 2003). Presently, the most common method applied by most firms to measure exchange rate risk is the value-at-risk model (VaR) (Lam, J., 2003). value at risk implies to the maximum loss suffered by an organization for a given time with z% confidence. The importance of the VaR model is its efficiency in measuring a variety of types of risks. However, the model fails to demonstrate and explain what happens between the points of confidence from (100-z) %. This implies that it does not explain the worst-case scenario.Therefore, since the model fails to explain an organization’s maximum loss at 100% confidence, organizations formulate strategies for operational limits. Such strategies include nominal amounts to supplement VaR limits in order for the organization to reach the highest possible coverage (Van Deventer et, al, 2004). Value-at-Risk Calculations Most organizations apply this model to estimate riskiness of fluctuations in foreign exchange because of their organizations activities. The model depends on three major parameters as discussed below. The holding period, this implies to the length of time that the organization planned to hold foreign exchange position. Conventionally, this period is 1 day. The confidence level refers to the level at which the organization planned the estimate. Usually, these levels are 95% and 99%. Finally,VaR calculations also depend on the unit of currency used. Managing Exchange Rate Risks In international business, hedging exchange rate risks calls for the use of various risk management strategies that will greatly depend on the size of an organization and its prevalence of specific types of risks (Allen, 2003). The most complicated type of risk to manage is the transaction one as it entails cash flows. However, the best practices for managing exchange rate risks identifying the types of risk, measuring the risk using appropriate models as VaR, developing an exchange rate management strategy, coming up with asset controls to monitor organization’s exchange rate risks, and finally forming an oversight committee to manage exchange rate risks.Most organizations engage in management strategies such as buy/sell currency forward, reduce/increase W.C, tightening credit, borrowing locally, delaying payments, and speeding up Div. fees (Lam, J., 2003). Conclusion From the above analysis, every multinational organization faces exposure to risks from changes in foreign exchange rates. This affects the value of organization’s assets, liabilities, and the general value of the organization in the market. Therefore, foreign exchange risk analysis and management forms a crucial part of an organization’s decision-making on unforeseen foreign exchange changes. Therefore, foreign exchange risk exposure is a matter concerning every multinational company and is a sensitive issue concerning real local currency value of assets, liabilities, and operating incomes in line with unforeseen changes and fluctuations in exchange rates. Typically, measurement of foreign exchange risk by the variance of the domestic currency value calls for the most effective methods such as VaR model to assess the level of risk exposure to any organization. Measuring and managing foreign exchange risks are very crucial functions of an organization in their quest to minimize their vulnerability to major changes resulting from fluctuations in foreign exchange rates. The main source of these vulnerabilities arise from the organization’s engagement in international investments and operations where any changes in exchange rates would result certain effects in the organization’s profit margins, value of assets, and liabilities. In managing risks, organizations utilize many management strategies that depend on the size of the organization and the type of the risks exposed to. Most of these strategies become a bit complicated as they address translation, transaction, and economic risks simultaneously. Reference Allen, S., (2003).Financial Risk Management. A practioner’s Guide to Managing Market and Credit Risk. New Jersey, John Willey and Sons Eun, Cheol S., et al., (2011). International Financial Management, 6th Edition. New York, NY: McGraw-Hill/Irwin Holton, G. A., (2003). Value-at-Risk: Theory and Practice. San Diego: California, Academic Press Lam, J., (2003). Enterprise Risk Management: From Incentives to Controls. New Jersey: California, John Wiley and Sons Pilbeam, Keith (2006). International Finance, 3rd Edition. New York, NY: Palgrave Macmillan Van Denveter et al., (2004). Advanced Financial Risk Management: Tools and Techniques for Integrated Rate Risk Management. New Jersey, John Wiley and Sons Wang, Peijie (2005). The Economics of Foreign Exchange and Global Finance. Berlin, Germany: Springer Read More