Finance

When companies undertake global business, they take a risk since their business operations and investments are likely to be adversely effected by alterations in the exchange rates for dissimilar currencies. This type of risk is referred to as exchange rate risk. Increasingly, a number of business companies are scrambling for a share of international market, especially in third world countries, and putting funds in foreign stocks. However, all economies including the most developed, experience downturns once in a while. In the case of third world countries, currencies and economies may be moderately volatile due to factors, such as political turmoil as well as oil prices, thereby creating unstable environment for global market. These factors can greatly affect the cash flow, earnings, and balance sheet of several multinational companies in such developing nations. This report presents a wide definition and major types of exchange rate risk, discusses the measurement approaches used to measure the risk. It concludes by identifying that economic or operating exposure is likely to be most important in the long run.
Exchange rate risk refers to a risk which a firms performance will be affected due to exchange rate engagements. For instance, an international firm incurs direct and indirect loss when the host countrys exchange rate depreciates. Alternatively, this firm is able to do profit when the host countrys exchange rate appreciates. International companies need to intimately monitor their monetary operations as away of determining how they are exposed to the different types of exchange rate risk. Thus, financial managers ought to comprehend how to measure and manage their companys exposure to fluctuations in the exchange rate. This will assist them to determine whether or how to shield their multinational companies from a particular exposure. Firms could avoid exchange rate risk by exclusively doing business in their home countries, though for enormous businesses this stands out to be a difficult pragmatic proposition. Another realistic and practical alternative is to persist on utilizing ones own currency for each and every transaction. However, requesting or asking every customer to use Euro (for instance) is quite inflexible, a tall order, and forces the customers to take all the business risks, which may not go down well. A more logical, pragmatic, and rational way is for multinational companies managers to understand the basics of exchange rate risk in an attempt to reduce its adverse effect. Its a complicated issue, but its worth for companys management personnel to learn about the issue in order to act prudently on advice.
The major indicators of exchange rate risk are the relationships between inflation, exchange rates, and interest rates. The most substantial relationships are described as follows Purchasing power parity, in this particular concept it is assumed that in a stable market place, the relationships between exchange rates of dissimilar nations ought to be in similar ratio as the price of a fixed services and goods.  This implies that there is existing parity between exchange rates and the currencies purchasing power. There are several ways of expressing this concept, but most frequently  is that disparity in the rate of inflation is equivalent to the rate of alteration of exchange rate. Furthermore, the theory of international fisher effect suggests that disparities in interest rates between nations are anticipated to be offset by prospect alterations in exchange rates. For instance, if an investor earns an elevated interest rate in another nation, any benefits are offset by adverse exchange rate and this relationship is expressed as the interest rate differential is equivalent to the anticipated rate of alteration of exchange rate. Besides, unbiased forward rate theory proposes that forward exchange rate remains the most precise, accurate, and correct measure of anticipated prospect exchange rates. This is expressed in trouble-free terms as the forward exchange rate being equivalent to the anticipated exchange rate.
These exchange rate risk indicators aside, shielding a multinational company against exchange rate risk largely relies on vigilant monitoring. Factors, such as inflation, politics, consumer confidence, capital flow, and state of export and import markets together with several other social-economic conditions affect currency exchange rates. Furthermore, individual states or governments frequently take action in controlling the instability of currencies. These factors lead in exposure to 3 major exchange rate risk of transaction, translation, and economic. Translation risk (exposure) is a risk where changes in exchange rate will weaken a firms assets, income, liability, and equity. Therefore denomination of this risk is substantial, though experts suppose that actual assets are not easily affected by currency movement in any way. To protect the company against this risk, firm managers ought to undertake hedging technique in order to keep a close watch on any significant change on exchange rate. This sophisticated technique as well assists the fund managers in diversification of a firms holdings in dissimilar currencies.
Transaction exposure is another exchange rate risk, and refers to cash flows changes which emanates from accessible contractual obligations. This particular exchange rate risk in concerned with prospect cash flows following a contract agreement is a problem that often experienced by multinational firms in the international markets. Its not typically rational or logical to insist on advance payment from consumers and thus a technique referred to as factoring is normally utilized to reduce transaction risk. The technique comprises selling off firms international accounts receivable to a factoring value that then assumes on the responsibility for collections and credits. Factoring houses usually buy foreign accounts receivable at 90 to 95 percent of their original value, though the discount may be more than anticipated. Multinational companies frequently recover their losses via product price adjustment.
Apart from translation and transaction risks, there is economic risk (operating risk) that companies experience when dealing with international business and investments. It is a type of risk to unpredictable exchange rates that adversely impacts on a firms cash flow, foreign investments, and earnings. The degree to how a multinational firm is affected by economic risk is highly reliant on business and the nature of the firm. However, a number of companies frequently hedge against this type of exchange rate risk via foreign exchange market. Additionally, in economic exposure, international firms profits or gains will be wrinkled by changes in exchange rate as result of escalating costs. Many companies are much narrowed in actions to take in protecting themselves in this kind of circumstance. This risk is normally practical to the present value of prospect cash flow operations of a companys parent firm as well as overseas affiliates. Recognition of different kinds of exchange rate risk, together with their measurement, is imperative to strategic development and management of risks in a multinational company.
Measurement of Exchange Rate Risk
After definition of various kinds of exchange rate risk which multinational companies are exposed to, a critical aspect of these firms remains how to measure these risks. The process is quite complicated and may perhaps prove difficult, especially with regards to economic and translation risk. Currently, the most utilized risk measurement method is the model of Value at Risk (VaR). Generally, VaR is referred to as the utmost loss for a specified risk over a specified time scope with z percent confidence. The Value at Risk calculation can be utilized in measuring a range of risks and thus assisting companies in risk management. However, this particular risk measuring model never defines what transpires to the exposure for (100-z) percent point of confidence, for instance in the worst case situation. Since the methodology never defines the utmost loss with 100 percent confidence. Thus, companies are frequently forced to come up with operational limits like stop loss orders or nominal amounts to complement VaR limits. In so doing firms are capable of reaching the highest probable risk measurement coverage.
Value at Risk calculation is mainly used by companies in estimation of foreign exchange riskiness resulting from a companys activities. This comprises foreign exchange position of companys assets, over a specified period of time under usual conditions. The calculation or measurement of risk by VaR model largely depends on three major parameters Holding period, which is the period of time over which the position of foreign exchange is planned to be held. The normal holding period is one day. The next parameter which Value at Risk rely on is the confidence level at which the anticipated estimation is planned to be made. The typical confidence levels range between 95 and 99 percent. The final parameter is the currency unit to be utilized for the purpose of Value at Risk denomination. Assuming a confidence level of x percent and a holding period of y days, the Value at Risk measures what will be at utmost loss (for instance, a market value decrease of a foreign exchange position) over y-days. If y days time period are not one of (100-x)  y-days, then these periods are the worst under usual conditions. Therefore, when a foreign exchange position contains one day Value at Risk of US20 million at 99 percent confidence level, the company ought to anticipate that, with a likelihood of 99 percent, the value of this position is likely to diminish by no more than US20 million in one day, given that normal conditions will exist during that one day. This implies that, a firm must anticipate that its foreign exchange rate position value will diminish by no more than US20 million of 99 confidence level out of 100 normal trading days.
To calculate Value at Risk, there exists a range of models. Among these models, the widely used ones include historian simulation which suggests that currency returns on a companys foreign exchange position will encompass the similar distribution as they had in the earlier period. Variance- covariance is yet another model that is widely used in VaR calculation. This mode suggests that currency returns on a companys foreign exchange position are always normally distributed and that the alteration in foreign exchange position value is linearly reliant on each and every current return of the company. Monte Carlo simulation being among the widely used model suggests or proposes that prospect currency returns will be distributed randomly.
Historical simulation is known to be the simplest Value at Risk model of calculation. This model comprises running the companys foreign exchange position across a set past, historical, or chronological exchange rate changes in order to capitulate loss distribution in foreign exchange position value. The significant benefit or advantage of this model is that it never suppose a normal distribution of firms currency returns, as it is properly documented that these currency returns are not typical but rather leptokurtic. The major setback historical simulation model is that Value at Risk calculation needs a huge database and thus computationally intensive. On other hand, a variance covariance model supposes that the change in firms foreign exchange position value is a linear amalgamation of every change in the values of foreign exchange positions. This therefore, implies that the entire currency return is linearly reliant on the individual currency returns. Another assumption of this VaR calculation model is that total currency returns are jointly normally distributed and thus for a 99 percent confidence interval, the value at risk can be measured or calculate as VaR (2.33 SP  MP) VP.
Where VP is the original value of the firms foreign exchange position. MP is an average of currency return on the companys total foreign exchange position that is a weighted mean of foreign exchange positions. SP is a standard deviation of currency return on the companys entire foreign exchange position, is a standard deviation of weighted change of variance covariance matrix of foreign exchange positions.
While variance covariance model permits a quick calculation of value at risk, its setbacks comprise restrictive postulations of a normal distribution of currency returns as well as a linear amalgamation of the total foreign exchange position. It should be noted, however, that this normality postulation could be relaxed.  Use of non normal distribution in place of normal distribution would increase the computational cost as a result of confidence interval estimation for any loss beyond the VaR. Monte Carlo simulation model normally shares the principal components with variance covariance calculation model along with random simulation components. Its main benefit is the capacity to handle all underlying distributions and more precisely evaluate the Value at Risk when non linear currency factors exist in firms foreign exchange position. Its serious disadvantage is the computationally rigorous process.
Economic Exposure Measurement
In measuring this risk an individual requires a workable and logical approach. Thus some of the practical approaches used in economic exposure measurement include regression analysis and regression equation. In regression analysis independent and dependent variable are involved in measuring the risk. Independent variable comprises of transformation in parent firms cash flow whereas dependent variable comprises mean nominal exchange rate change. Alternatively, regression equation approach of measurement is based on operational definition of economic risk and other risks experienced by a parent firm or its affiliates. For instance, a multinational company experiences exchange rate risk to an extent that variations in dollar value of cash flow unit is correlated with variations in nominal exchange rate.
CFt  a EXCHt  t. Where CFt is equal to CFt -CFt-1, and is the value of dollar of entire or total parent firm (affiliate) cash flow in t period. EXCHt  EXCHt - EXCHt-1, and is equal to the mean nominal exchange rate throughout period t,  stands for a random error term.
The output of this regression equation measure in that  coefficient measures the correlation of transformations in cash flows to changes in exchange rates. Therefore, a higher beta value indicates that there is greater economic exposure, since there is a higher  transformation of cash flow to exchange rate changes.
The concentration of most fund managers or accounting professions on the balance sheet impact of currency transformations has resulted into ignoring the imperative effect on prospect cash flows. International firms experiencing costs as well as selling products in overseas countries, their net impact of currency alterations may be less substantial in the long run. Finally, in order to measure the exchange rate risk appropriately, an individual ought to concentrate on inflation adjusted exchange rates rather than nominal exchange rates. The type of exposure that is likely to be most important in the long run is the operating exposure. Its also referred to as economic exposure and is mainly associated with the latent effect of exchange rate changes on the prospect firms cash flow.