Unit 2 Derivatives FEM

Unit II
Derivatives
2.1 Meaning and types
2.2 Features of futures contracts
2.3 Features of options Contracts
2.4 Interest rate risk
2.5 Managing Interest rate risk
2.6 Exchange Risk
2.7 Transaction Exposure
2.8 Translation
2.9 Economic Exposure
2.10 Functions of Economic Exposure

2.1 Meaning and types

Introduction
Derivatives are financial instruments that derive their value from an underlying
asset. They have become an integral part of modern financial markets,
providing opportunities for risk management, speculation, and investment.
The concept of derivatives dates back centuries, but their usage and
complexity have evolved significantly over time.
The primary purpose of derivatives is to manage and mitigate risks associated
with price fluctuations of underlying assets.
For example, a farmer may use derivatives to protect against potential losses
due to fluctuating crop prices, while an investor may use derivatives to hedge
against changes in stock prices. By using derivatives, individuals and businesses
can transfer risk to other parties willing to accept it.

PESU 1
Unit 2 Derivatives FEM

Derivatives also offer opportunities for speculation and investment.

Traders can take positions on the anticipated price movements of underlying
assets, potentially profiting from market fluctuations. This speculative aspect
of derivatives trading attracts investors seeking to generate returns through
short-term trading strategies.
The most common types of derivatives are options, futures, swaps, and
forwards. Each derivative has its unique characteristics and is suited to
different risk management or investment objectives. Options provide the right,
but not the obligation, to buy or sell an asset at a predetermined price within a
specific time period. Futures contracts oblige parties to buy or sell an asset at a
future date and predetermined price. Swaps involve exchanging cash flows,
such as interest payments or currencies, between parties. Forwards are similar
to futures contracts but are typically traded over-the-counter and have
customizable terms.
In summary, derivatives are financial instruments whose value is derived
from underlying assets. They serve a vital role in risk management,
speculation, and investment, enabling individuals and businesses to hedge
against price fluctuations or seek profit opportunities. However, due to their
complexity and risks, a thorough understanding of derivatives and their
associated markets is essential for those engaging in derivative transactions.
Meaning

The term "derivatives" refers to financial instruments or contracts whose value

is derived from an underlying asset. These underlying assets can include
commodities, stocks, bonds, currencies, interest rates, or market indices.
Derivatives are used by individuals, businesses, and financial institutions to
manage or speculate on the price fluctuations of these underlying assets.

PESU 2
Unit 2 Derivatives FEM

Derivatives derive their value from the performance of the underlying asset,
rather than having intrinsic value of their own. They can be traded on various
organized exchanges or over-the-counter (OTC) between parties. Derivatives
are often categorized into several types, including options, futures, swaps, and
forwards.
Definition of Derivatives
A derivative is described as either the rate of change of a function, or the slope
of the tangent line at a particular point on a function.

Features of Derivatives

• Direct or exchange traded:

The derivatives contracts can be undertaken directly between the two
parties or through the particular exchange like financial futures contracts.
The exchange traded derivatives are quite liquid transaction costs in
comparison to tailor and have low made contracts.
Example of exchange traded derivatives are Dow Jons, S&P 500, Nikki 225,
NIFTY option, S&P Junior that are traded on New York Stock Exchange,
Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange
and so on.
• Related to notional amount:
In general, the financial derivatives are carried off-balance sheet. The size
of the derivative contract depends upon its notional amount. The notional
amount is the amount used to calculate the payoff.
For instance, in the option contract, the potential loss and potential
payoff, both may be different from the value of underlying shares,
because the payoff of derivative products differ from the payoff that
their notional amount might suggest.

PESU 3
Unit 2 Derivatives FEM

• Delivery of underlying asset not involved:

Usually, in derivatives trading, the taking or making of delivery of

underlying assets is not involved, rather underlying transactions are
mostly settled by taking offsetting positions in the derivatives
themselves. There is, therefore, no effective limit on the quantity of
claims, which can be traded in respect of underlying assets.
• May be used as deferred delivery:
Derivatives are also known as deferred delivery or deferred payment
instrument. It means that it is easier to take short or long position in
derivatives in comparison to other assets or securities. Further, it is
possible to combine them to match specific, i.e., they are more easily
amenable to financial engineering.
• Secondary market instruments:
Derivatives are mostly secondary market instruments and have little
usefulness in mobilizing fresh capital by the corporate world, however,
warrants and convertibles are exception in this respect.
• Exposure to risk:
Although in the market, the standardized, general and exchange traded
derivatives are being increasingly evolved, however, still there are so
many privately negotiated customized, over the counter (OTC) traded
derivatives are in existence. They expose the trading parties to
operational risk, count party risk and legal risk. Further, there may also
be uncertainty about the regulatory status of such derivatives.
• Off balance sheet item:

PESU 4
Unit 2 Derivatives FEM

Finally, the derivative instruments, sometimes, because of their balance

sheet nature, can be used to clear up the balance sheet. For example, a
fund manager who is restricted from taking particular currency can buy a
structured note whose coupon is tied to the performance of a particular
currency pair
Functions of derivatives

 Rate of change:
Derivatives represent the rate at which a function changes with respect to its
independent variable. For example, in physics, the derivative of the
displacement function with respect to time gives the velocity, which is the rate
of change of position.
 Slope of a curve:
The derivative of a function at a specific point gives the slope of the tangent
line to the curve at that point. This is useful for understanding the local
behavior of functions and analyzing their critical points.
 Optimization:
Derivatives help in finding the critical points (where the derivative is zero) of a
function, which are used to optimize the function. For example, finding the
maximum or minimum values of a function is achieved by analyzing its critical
points.
 Concavity and inflection points:
The second derivative of a function reveals its concavity (whether the curve is
bending upwards or downwards) and helps identify inflection points (where
the curve changes its concavity).
 Approximation:
Derivatives can be used to approximate functions and values. For instance,
linear approximations (using the tangent line) and higher-order
PESU 5
Unit 2 Derivatives FEM

approximations can help estimate the behavior of a function in a specific

region.
 Related rates:
In applied mathematics and physics, derivatives are used to solve problems
involving related rates. These are situations where the rates of change of
different variables are related through a common equation.
 Differential equations:
Derivatives are crucial in differential equations, which express the relationship
between a function and its derivatives. Differential equations have wide
applications in various scientific and engineering fields.
 Signal processing:
In signal processing, derivatives are used to analyze and process signals to
extract relevant information or remove noise.
 Finance and economics:
In finance and economics, derivatives play a vital role in calculating financial
risk, pricing options and futures contracts, and understanding the dynamics of
economic variables.
 Scientific modeling:
Derivatives are used extensively in scientific modeling to represent the
dynamics of systems and to study how changes in variables affect the overall
behavior.
Types of derivatives

1. Options: Options give the holder the right, but not the obligation, to buy or
sell an underlying asset at a predetermined price within a specified time
period. They can be further categorized as:
a. Call options: These provide the right to buy the underlying asset.
b. Put options: These provide the right to sell the underlying asset.
PESU 6
Unit 2 Derivatives FEM

2. Futures Contracts: Futures contracts are agreements to buy or sell an

underlying asset at a future date and a predetermined price. Unlike options,
futures contracts carry an obligation to fulfill the terms of the contract at the
specified time.

3. Swaps: Swaps involve the exchange of one set of cash flows for another.
They are typically used to manage risks associated with interest rates,
currencies, or commodities. Some common types of swaps include:
4. Interest rate swaps: Parties exchange fixed and floating interest rate
payments.
Currency swaps: Parties exchange different currencies, typically for a specific
time period.
Commodity swaps: Parties exchange cash flows based on the price
fluctuations of a specific commodity.
5. Forwards: Forwards are similar to futures contracts, but they are typically
traded over-the-counter (OTC) rather than on organized exchanges. Forwards
involve an agreement to buy or sell an asset at a future date and a
predetermined price, but the terms of the contract are customized between
the buyer and seller.
6. Swaptions: Swaptions are options on interest rate swaps. They provide the
right, but not the obligation, to enter into an interest rate swap at a future
date or exercise the option to receive a fixed or floating rate.
7. Equity Derivatives: Equity derivatives are derivatives based on stocks or
stock indices. These include options and futures contracts on individual stocks
or market indices.
8. Credit Derivatives: Credit derivatives are used to manage credit risk
associated with debt instruments. They allow investors to transfer or hedge

PESU 7
Unit 2 Derivatives FEM

credit exposure. Common types include credit default swaps (CDS), which
provide insurance-like protection against credit events.

Advantages of Derivatives

1. Hedge Risks
Derivative trading lets you hedge your position in the cash market. For
example, if you buy a positional stock in the cash market, you can buy a Put
option in the derivative market. If the stock tumbles in the cash market, the
value of your Put option will increase. Hence, your losses will be minimal or nil.
2. Low Expenses
since derivative trading is primarily done to reduce risks, the charges are lower
compared to shares or debentures.
3. Transfer Risks
Unlike stock trading, derivative trading allows you to transfer the risks to all
stakeholders involved in the process. Hence, your risks reduce considerably.
Disadvantages of Derivatives

When invested with prior knowledge and extensive research, derivatives

trading may offer numerous benefits toward hedging or increasing profits.
However, these financial instruments are complex at their core and come with
certain disadvantages for the market entities.

● High Risk:
These instruments are market-linked and derive their value in real-time based
on the changing price of the underlying asset. Such prices depend on the
demand and supply factors and are volatile. The volatility exposes such
financial contracts to risk, forcing the entities to incur potentially huge losses.

PESU 8
Unit 2 Derivatives FEM

● Speculation:
A large part of the derivatives market follows a system of assumptions. Entities
speculate on the future price direction of the underlying asset and hope to
profit from the difference between the strike price and the exercise price.
However, if the speculation goes sideways, entities can incur losses.
● Counterparty Risk:
Although market entities can trade futures contracts through supervised
exchanges, they trade options contracts over the counter. It means there is no
defined system for due diligence with a possibility of the other party defaulting
on the payment or exercise promise. Hence, counterparty risk can expose
market entities to financial losses.

2.2 Features of futures contracts

Futures Contract

For investors trying to diversify their portfolios by investing in other asset

classes, derivative trading has shown to be extremely beneficial. Some people
favour options trading, while others prefer futures trading. However, due to
the intricacy of futures contracts, you must be familiar with all aspects of the
financial instrument.

What is a Futures Contract?

Forward and futures contracts are financial products that allow market players
to reduce or eliminate the risk of an asset's price fluctuations over time.

In two fundamental respects, a futures contract differs from a forward

contract: first, a futures contract is a legally binding agreement to purchase or

PESU 9
Unit 2 Derivatives FEM

sell a standardized asset on a certain date or during a specific month. Second, a

futures exchange is used to effectuate this transaction.

Futures contracts are essential for commodity producers, consumers, traders,

and investors since they are standardized and exchange-traded.

Futures Contract Explained

Futures are financial derivative contracts that obligate parties to transact the
asset at a pre-determined future date and also a price. The buyer needs to buy
or they sell needs to sell the underlying asset at a price - regardless of the
current market price at the date of expiration

Underlying assets are inclusive of physical commodities or other financial tools.

These contracts detail the quantity of the underlying asset and are
standardized to facilitate trading on a futures exchange.

Futures could be used for hedging and trade speculation.

Futures contracts and futures mean the same thing. Futures contract example -
you would hear someone say they had just bought oil futures, and that means
the same thing as an oil futures contract. When someone says futures
contract, they usually mean a specific type of future like oil, gold, bonds, or
S&P 500 index futures.

Futures contracts are also the most direct ways to invest in oil. The
terminology, futures, is more usual, and it is often utilized to the whole market
- such as, they are a futures trader.

Futures contracts are standardized, unlike a forward contract. Forwards are

quite similar to the types of agreements that lock in a future price in the

PESU 10
Unit 2 Derivatives FEM

present. But, the forwards are traded over the counter and also have
customizable terms that are arrived at between the counterparties.
Features of Futures Contracts

 A future contract could be of different types of asset classes. For instance,

there are futures for shares, commodities or currencies, indices, and more.
 These are standardized contracts, both in terms of quantity and quality. For
instance, a usual futures contract for oil is for 1000 barrels. This means to trade
10,000 barrels of oil, an investor would need to buy ten contracts.
 Investors need to deposit margin money to trade a futures contract. But, this
margin money is much less than the total value of the contract. This allows
investors to participate in the futures market even with a small sum of money.
 Apart from making profits, investors also use these contracts to hedge their
risk.

Types of Futures

Types of futures trading can be defined as the strategies that traders and
investors use to buy and sell futures contracts to make a profit or manage risk.

Most types of futures contracts are used for both hedging and speculation. For
example, manufacturers and consumers can use futures contracts to hedge
against price volatility and protect against potential losses. On the other hand,
traders and investors can use futures contracts to speculate on the direction of
livestock prices and make profits based on their expectations of future price
movements.

While there are many types of futures contracts, let's have a look at some of
them.

PESU 11
 Unit 2 Derivatives FEM

 Financial Futures

Financial future contracts are agreements between two parties to buy or sell an
underlying asset at a predetermined price and time in the future. Financial
futures contracts can be used by investors to hedge against potential losses,
speculate on future price movements, and gain exposure to different asset
classes. However, like any investment, financial futures trading carries risks and
investors should carefully consider their investment objectives and risk tolerance
before participating in financial futures trading.

 Currency Futures

A currency futures contract is a standardized agreement between two parties to

exchange a specified amount of one currency for another at a predetermined
exchange rate and a specific date in the future. Currency futures contracts are
used as a hedging tool by businesses and investors to manage their foreign
exchange risk. For example, an importer can enter into a currency futures
contract to buy a certain amount of foreign currency at a fixed price, thereby
locking in the exchange rate and protecting against potential losses from
currency fluctuations.

 Energy Futures

An energy futures contract is a financial derivative that allows investors and

businesses to buy or sell a certain amount of energy commodities, such as crude
oil, natural gas, heating oil, or gasoline, at a predetermined price and on a
specific date in the future.

 Metal Futures

PESU 12
 Unit 2 Derivatives FEM

A metal futures contract is a financial agreement between two parties to buy or

sell a specific quantity of metal, such as gold, silver, copper, or platinum, at a
predetermined price and on a specific date in the future.

 Grain futures

A grain futures contract is a financial agreement between two parties to buy or

sell a specific quantity of grains, such as wheat, corn, or soybeans, at a
predetermined price and on a specific date in the future.

 Livestock futures

A livestock futures contract is a financial agreement between two parties to buy

or sell a specific quantity of livestock, such as cattle, hogs, or feeder cattle, at a
predetermined price and on a specific date in the future.

 Food and Fiber Future Contracts

Food and fiber futures contracts are financial agreements between two parties
to buy or sell a specific quantity of agricultural products, such as cotton, sugar,
cocoa, coffee, and various types of grains, at a predetermined price and on a
specific date in the future.

Pros & Cons of Future Contracts

Pros:
 Hedging: Futures contracts are often used as a hedging tool by investors to
reduce their exposure to market volatility. By locking in a price today, investors
can protect themselves against future price fluctuations.
 Liquidity: Futures markets are highly liquid, meaning that there are a large
number of buyers and sellers, and it is easy to enter and exit positions.

PESU 13
 Unit 2 Derivatives FEM

 Leverage: Futures contracts allow investors to control a large amount of the

underlying asset with a relatively small amount of capital. This can amplify
returns but also increases risk.
 Transparency: Futures contracts are standardized and traded on exchanges,
making the pricing and terms of the contract transparent to all market
participants.
Cons
Risk: Futures contracts are highly leveraged instruments and can be very risky. A
small price movement in the underlying asset can result in a large gain or loss in
the value of the futures contract.
Margin requirements: To trade futures, investors must post a margin, which is a
percentage of the contract value. Margin requirements can be high, and
investors may need to maintain a certain level of margin in their accounts to
keep their positions open.
Counterparty risk: Futures contracts are essentially agreements between two
parties, and there is always a risk that one party may not fulfill obligations.
Limited flexibility: Futures contracts are standardized, meaning that investors
cannot customize the terms of the contract. This can be a disadvantage for
investors who have specific needs or strategies.
2.3 Options Contracts
Option contract

In option contract is a type of financial derivative that gives the holder (buyer)
the right, but not the obligation, to buy or sell an underlying asset at a
predetermined price within a specified time period. The underlying asset can
be a stock, bond, commodity, currency, or market index.

There are two types of option contracts:

PESU 14
Unit 2 Derivatives FEM

Call Option: A call option gives the holder the right to buy the underlying asset
at the predetermined price, known as the strike price, before or on the
expiration date of the option. The buyer of a call option anticipates that the
price of the underlying asset will rise, allowing them to profit by exercising the
option and buying the asset at a lower strike price than the market price.

Put Option: A put option gives the holder the right to sell the underlying asset
at the strike price before or on the expiration date. The buyer of a put option
expects the price of the underlying asset to decline, allowing them to profit by
exercising the option and selling the asset at a higher strike price than the
market price.

Features of an option contract

1. Premium or down payment:
The holder of this type of contract must pay a certain amount called the
‘premium’ for having the right to exercise an options trade. In case the holder
does not exercise it, s/he loses the premium amount. Usually, the premium is
deducted from the total payoff, and the investor receives the balance.
2. Strike price:
This refers to the rate at which the owner of the option can buy or sell the
underlying security if s/he decides to exercise the contract. The strike price is
fixed and does not change during the entire period of the validity of the
contract.
3. Contract size:
The contract size is the deliverable quantity of an underlying asset in an
options contract. These quantities are fixed for an asset. If the contract is for
100 shares, then when a holder exercises one option contract, there will be a
buying or selling of 100 shares.

PESU 15
Unit 2 Derivatives FEM

4. Expiration date:
Every contract comes with a defined expiry date. This remains unchanged until
the validity of the contract. If the option is not exercised within this date, it
expires.
5. Intrinsic value:
An intrinsic value is the strike price minus the current price of the underlying
security. Money call options have an intrinsic value.
6. Settlement of an option:
There is no buying, selling or exchange of securities when an options contract
is written. The contract is settled when the holder exercises his/her right to
trade. In case the holder does not exercise his/her right till maturity, the
contract will lapse on its own, and no settlement will be required.
7. No obligation to buy or sell:
In case of option contracts, the investor has the option to buy or sell the
underlying asset by the expiration date. But he is under no obligation to
purchase or sell. If an option holder does not buy or sell, the option lapses.

Advantages of options

• Leverage.
Options allows to employ considerable leverage. This is an advantage to
disciplined traders who know how to use leverage.
• Risk/reward ratio.
Some strategies, like buying options, allows you to have unlimited upside with
limited downside.
• Unique Strategies.
Options allow you to create unique strategies to take advantage of different
characteristics of the market - like volatility and time decay.

PESU 16
Unit 2 Derivatives FEM

• Low capital requirements.

Options allow you to take a position with very low capital requirements.
Someone can do a lot in the options market with $1,000 but not so much with
$1,000 in the stock market.

Disadvantages of options
 Complex:
Options trading can be very complex as it involves three decisions, direction,
time, and price. Traders must consider all three things before implementing an
option strategy.
 Additional hurdle:
In India, one needs to open a demat account and trading account to trade
shares. Though the same demat account works for options trading, there is an
additional hurdle which is a compulsion. SEBI mandates all investors to sign the
options trading agreement, which lists all risks involved in options trading.
 Uncertainty of gains:
Every option strategy works on future expectations and assumptions. The
trader earns profits only if the share prices move in a direction as predicted by
the trader. Else, the chances of making losses are high.
 Trading fees and commissions:
Compared to equities, trading fees and commissions are high in the case of
options trading. The more complex the strategy, with more calls and puts, the
higher the expenses.
 Tax:
All gains in options trading are short-term gains and are taxable as per the
short-term capital gains tax rate, which is 15%. Hence, the trader loses a part
of the gains in the form of taxes.

PESU 17
Unit 2 Derivatives FEM

2.4 Interest rate risk

Interest rate risk

Interest rate risk is the probability of a decline in the value of an asset resulting
from unexpected fluctuations in interest rates. Interest rate risk is mostly
associated with fixed-income assets (e.g., bonds) rather than with equity
investments. The interest rate is one of the primary drivers of a bond’s price.

Interest rate risk refers to the potential impact of changes in interest rates on
the value of financial instruments, particularly fixed-income securities such as
bonds, loans, and other debt instruments. It is the risk that the value of these
instruments will fluctuate due to shifts in interest rates.

Types of Interest Rate Risk

There are various types of interest rate risk that firms need to consider when
managing their financial risks. These risks can arise from mismatches in the
repricing of assets and liabilities, changes in the shape of the yield curve, and
other factors.

1. Reprising Risk

Repricing risk is the risk of changes in interest rates affecting the net interest
income of a firm. This risk arises when there is a mismatch between the
repricing of assets and liabilities, which can lead to fluctuations in net interest
income.

For example, if a bank has more liabilities repricing in the short term compared
to its assets, it faces the risk that an increase in interest rates will lead to
higher interest expenses without a corresponding increase in interest income.
This can result in reduced profitability and financial stability.

PESU 18
Unit 2 Derivatives FEM

2. Yield Curve Risk

Yield curve risk refers to the potential for losses resulting from changes in the
shape of the yield curve, which represents the relationship between interest
rates and the time to maturity of financial instruments. This risk can affect the
value of a firm's interest-sensitive assets and liabilities. A change in the yield
curve's shape, such as a flattening or steepening, can affect the relative values
of assets and liabilities with different maturities. This can lead to changes in
the firm's net interest income and potentially result in financial losses.

3. Basis Risk

Basis risk is the risk that arises when the interest rates of different financial
instruments or indexes do not move in perfect correlation. This risk can affect
firms that use hedging strategies to manage their interest rate risk.

For instance, a firm may use interest rate swaps to hedge its exposure to
fluctuations in interest rates. However, if the reference rates used in the swap
agreement do not move in perfect correlation with the firm's actual interest
rate exposure, it may still face financial losses due to basis risk.

4. Optionality Risk

Optionality risk is the risk associated with embedded options in financial

instruments, such as callable bonds or mortgages with prepayment options.
The presence of these options can affect the value of the instrument and
create uncertainty regarding future cash flows.

For example, if interest rates decline, borrowers may choose to prepay their
mortgages, causing the lender to receive lower interest income than

PESU 19
Unit 2 Derivatives FEM

anticipated. This can lead to financial losses for the lender and impact the
overall value of its interest-sensitive assets.

Concept of Interest rate risk

It refers to the potential impact of fluctuations in interest rates on the

value of an investment or the profitability of a financial institution. It is a
significant risk faced by both investors and financial institutions, and it arises
from the fact that interest rates can change over time.

The concept of interest rate risk can be understood from two perspectives:

1. Fixed-income investments: Interest rate risk primarily affects fixed-income

securities such as bonds, notes, and other debt instruments. When interest
rates rise, the value of existing fixed-rate bonds decreases because the rates
offered by newly issued bonds become more attractive. Conversely, when
interest rates fall, the value of existing fixed-rate bonds increases because they
offer higher interest rates than newly issued bonds. Therefore, the market
value of fixed-income investments is inversely related to changes in interest
rates.

2. Financial institutions: Interest rate risk also impacts financial institutions

such as banks and other lending institutions. These institutions often have
mismatched maturities in their assets and liabilities. For example, they may
have longer-term loans with fixed interest rates (assets) and shorter-term
deposits or borrowings (liabilities) that are subject to interest rate fluctuations.
If interest rates rise, the cost of funding for financial institutions may increase,
squeezing their net interest margin. Conversely, if interest rates fall, the
interest income generated from assets may decrease.

PESU 20
Unit 2 Derivatives FEM

Pros of Interest Rates

There are some upsides to rising rates:

 More interest for savers.

Banks typically increase the amount of interest they pay on deposits over time
when the Federal Reserve raises interest rates. Fixed income securities tend to
offer higher rates of interest as well.
 Payouts increase.
Regular benefits and entitlement payments such as Social Security are indexed
to inflation and these will rise with higher interest rates.
 Inflation may subside.
One of the main factors driving the Federal Reserve to push interest rates up is
concern over inflation, which is at a 40-year high. Consumer prices in
November 2022 were 7.1% higher than they were in October of the previous
year. Higher interest rates could tamp inflation, leading to lower prices on
everything from gasoline to houses.
 A stronger dollar.
Higher interest rates typically lead to a strong dollar, which could lower the
price of imported goods and also make it cheaper for Americans traveling
overseas.

Cons of Interest Rates

 New loans will cost more.

Just as banks are paying more in interest to depositors, they’re charging more
to borrowers. Rates on a 30-year mortgage, for example, surged past 6% in
September, nearly double their rate a year ago.

PESU 21
Unit 2 Derivatives FEM

Payments will go up on adjustable-rate loans. New loans aren’t the only debt
that’s costing more. Interest rates on existing, adjustable-rate loans, such as
credit cards, are also increasing.

 Home equity may decline.

Home equity makes up a large portion of many Americans’ net worth. As rising
interest rates make owning a house less affordable, home prices start to go
down, which could lower the value of your home equity – and your net worth.

 There’s a higher chance of a recession.

While the Fed is increasing rates in an effort to rein in inflation, there’s a

chance that its efforts will push the economy into a recession. (Some
economists believe that the economy entered one earlier in 2022.)

 Stock market volatility may continue.

Concerns about the higher cost of doing business and the chance for a
potential recession have weighed on the stock market, leading to increased
volatility over the past several months. While investors may have already
priced some interest rate increases into stock valuations, uncertainty about
how high rates will go means that volatility will likely endure.

Measurement of Interest Rate

Measuring and assessing interest rate risk is essential for effective risk
management. Various methods can be used to quantify the potential impact of
interest rate fluctuations on a firm's financial position and performance.

PESU 22
Unit 2 Derivatives FEM

 Gap Analysis

Gap analysis is a commonly used method for measuring interest rate risk. It
involves comparing the repricing of assets and liabilities within specified time
periods, which helps identify potential mismatches that could affect a firm's
net interest income.
Using gap analysis, firms can assess their exposure to repricing risk and
develop strategies to mitigate the potential impact of interest rate changes.

 Duration Analysis

Duration analysis is another method for assessing interest rate risk, focusing on
the sensitivity of a firm's assets and liabilities to changes in interest rates.

Duration measures the weighted average time until an instrument's cash flows
are received, which can help estimate the potential impact of interest rate
changes on the value of assets and liabilities.

 Simulation Analysis

Simulation analysis involves using computer models to estimate the potential

impact of various interest rate scenarios on a firm's financial position and p
Interest Rate Risk Management Techniques

Firms can employ various techniques to manage their interest rate risk
exposure, including asset and liability management (ALM), hedging strategies,
diversification, and duration matching.

PESU 23
Unit 2 Derivatives FEM

Interest Rate Risk Management Techniques

 Asset and Liability Management (ALM)

ALM is a comprehensive approach to managing a firm's interest rate risk by

aligning the maturities and reprising characteristics of its assets and liabilities.

This approach aims to maintain a balance between interest-sensitive assets

and liabilities, which can help mitigate the impact of interest rate changes on
net interest income and the firm's financial stability.

 Interest Rate Hedging Strategies

Interest rate hedging strategies involve the use of financial instruments, such
as interest rate swaps, futures and options, to mitigate the potential impact of
interest rate changes on a firm's financial position and performance.

 Diversification of Assets and Liabilities

Diversification involves spreading a firm's investments across a range of assets

and liabilities with different interest rate sensitivities, which can help reduce
the overall exposure to interest rate risk.

 Duration Matching

Duration matching involves aligning the duration of a firm's assets and

liabilities to reduce its sensitivity to interest rate fluctuations.

By matching the duration of interest-sensitive assets and liabilities, firms can

minimize the potential impact of interest rate changes on the value of their
portfolios.

PESU 24
Unit 2 Derivatives FEM

 Interest Rate Risk Regulation and Supervision

Regulatory frameworks and supervisory authorities play a crucial role in

ensuring that firms effectively manage their interest rate risk exposure.

This section will discuss the regulatory framework, the role of central banks
and supervisory authorities, and the Basel III framework's impact on interest
rate risk management.

 Regulatory Framework

The regulatory framework for interest rate risk management consists of rules,
guidelines, and standards that govern the management of interest rate risk by
financial institutions and other firms.

2.5 Managing Interest rate risk

Interest rate risk refers to the current or prospective risk to the bank’s capital
and earnings arising from adverse movements in interest rates that affect the
bank are banking book positions. When interest rates change, the present
value and timing of future cash flows change.
Managing interest rate risk, investors and financial institutions employ various
strategies:

1. Hedging: Hedging involves using financial instruments such as interest rate

swaps, futures, or options to offset potential losses resulting from interest rate
movements. By taking offsetting positions, investors or financial institutions
can mitigate the impact of interest rate changes.

2. Duration matching: Duration is a measure of a bond's sensitivity to changes

in interest rates. Investors can manage interest rate risk by matching the
duration of their fixed-income investments with their investment time horizon.

PESU 25
Unit 2 Derivatives FEM

This helps ensure that the investments are less affected by interest rate
fluctuations.

3. Diversification: Spreading investments across different types of fixed-

income securities, maturities, and issuers can reduce interest rate risk.
Diversification helps offset losses from some investments with gains from
others, potentially reducing the overall impact of interest rate changes.

4. Active monitoring: Investors and financial institutions should closely

monitor interest rate movements and economic indicators to make informed
decisions. By staying updated on market conditions, they can adjust their
investment or lending strategies accordingly.

Highest Interest Rate Risk

Even though all kinds of interest rate risk can have negative effects, specific
circumstances may put investors, borrowers, and financial institutions in the
greatest danger of interest rate exposure.

 Long-Term Bond – Interest rate risk poses a significant threat to investors

who hold long-term bonds. Long-term bonds often lose more value when
interest rates rise than short-term bonds, which increases the possibility of
capital losses.
 Fixed Rate Loans – Borrowers with fixed-rate loans may face the highest
interest rate risk when interest rates decline. While they continue to make the
same loan payments, they can be paying more interest than borrowers on
variable-rate loans.
 Interest Rates Swaps – Financial institutions that engage in interest rate
swaps, a type of derivative contract, can also face a high level of interest rate

PESU 26
Unit 2 Derivatives FEM

risk. If interest rates change in an unfavorable way, the bank may incur
significant losses.

Cause of Interest Rate Risk

 Monetary Policy – Interest rates are affected by monetary policy decisions

made by central banks, such as the Federal Reserve. When the Federal Reserve
raises interest rates to control inflation, the value of fixed-income securities
falls, and investors may face losses. On the other hand, when the Federal
Reserve reduces interest rates to boost the economy, the value of fixed-
income securities increases, and investors may profit from higher
returns.
 Inflation – Another element that has an impact on interest rates is inflation.
The Federal Reserve may increase interest rates in order to reduce inflation
when it is high. When inflation is low, on the other hand, the Federal Reserve
may decrease interest rates to boost the economy.
 Economic Growth – Growth in the economy has an impact on interest rates
as well. Credit is in higher demand and interest rates go up while the economy
is expanding. On the other hand, when the economy is in a recession, loan
demand declines, and interest rates drop.

Effects of Interest Rate Risk

Interest rate risk can have varying effects on financial institutions, borrowers,
and investors. Some of the potential effects include

 Impact on Financial Institutions – Changes in interest rates can directly

impact a bank’s profitability. If a bank has more liabilities than assets that are

PESU 27
Unit 2 Derivatives FEM

sensitive to interest rates, an increase in rates could result in higher interest

expenses and lower net interest revenue.
 Impact on Borrowers – For borrowers, a rise in interest rates can increase the
cost of borrowing, making it more expensive to service existing debt or take on
new loans. Conversely, a decline in interest rates can make borrowing more
affordable.
 Impact on Investors – When interest rates rise, investors who hold bonds or
other fixed-income instruments run the danger of suffering capital losses as
the market value of their holdings falls. Additionally, the yield and overall
return of fixed-income portfolios can be impacted by changes in interest
rates.
 Market Volatility – Interest rate risk can increase market volatility, leading to
fluctuations in stock prices, currency exchange rates, and other financial
instruments.

Functions of Interest rate Risk Management

I. Authority and Organization:

System Risk Management (SRM) is responsible for administering Sections

16.865 and 20.865, 895.46 and 893.82 of the State of Wisconsin Statutes. This
includes establishing policies and guidelines for risk management programs
throughout the twenty-six institutions of the UW System to ensure that the
basic objective of risk management — the preservation of System assets (both
human and physical) by the minimization of loss at all institutions — is met at
the least possible cost to the System and the State.

PESU 28
Unit 2 Derivatives FEM

II. Background:

Risk management is the process of identifying, measuring and treating

property, liability, income, and personnel exposures to loss.

III. Policy:

It is the policy of the University of Wisconsin System to preserve the assets of

the institution and protect the physical well-being of students, employees, and
the general public involved in activities occurring both on and off campus.
Preservation of assets and protection of personnel is a responsibility of each
institution. Institutions must, therefore, learn to manage those exposures to
risk which could destroy or deplete their assets or cause harm to persons.

Five basic steps in managing the exposures to loss are as follows:

Identification of loss exposures can be achieved before a loss occurs through

the use of surveys of operations, inspection of facilities, and questionnaires.
The institution risk manager must analyze the variety of property, liability,
income, and personnel exposures at the institution.

Measurement of loss exposures through analysis of the probable frequency

and severity of loss can help to reduce the uncertainty involved and lead to
corrective action.

2.6 Exchange Risk

Foreign exchange risk is the chance that a company will lose money on
international trade because of currency fluctuations. Also known as currency
risk, FX risk and exchange rate risk, it describes the possibility that an
investment’s value may decrease due to changes in the relative value of the

PESU 29
Unit 2 Derivatives FEM

involved currencies. It affects investors and any business involved in

international trade. The risk occurs when a contract between two parties
specifies exact prices for goods or services as well as delivery dates.

Types of Foreign Exchange Risk

There are three main types of foreign exchange risk, also known as foreign
exchange exposure: transaction risk, translation risk, and economic risk. A
fourth – jurisdiction risk – arises when laws unexpectedly change in the
country where the exporter is doing business. This is less common and exists
primarily in unstable countries.

1. Transaction Risk
Occurs when a company buys products from a supplier in another country, and
price is provided in the supplier’s currency. If the supplier’s currency
appreciates vs. the buyer’s currency, the buyer will have to pay more in its
base currency to meet the contracted price.
The risk of transaction exposure typically impacts one side of a transaction: the
business that completes the transaction in a foreign currency. The company
receiving or paying a bill using its home currency is not subjected to the same
risk. While a high level of exposure to exchange rates can lead to major losses,
savvy finance professionals hedge or mitigate those risks.
2. Translation Risk
Refers to how a foreign exchange transaction will impact financial reporting;
i.e., the risk that a company’s equities, assets, liabilities or income will change
in value as a result of exchange rate changes.
This risk occurs because subsidiaries of a parent company in another country
denominate their currency in the countries where they are located. The parent

PESU 30
Unit 2 Derivatives FEM

company faces potential losses when it must translate the subsidiaries’

financial statements into its own country’s currency.
3. Economic Risk
Also known as operating exposure, this refers to the impact on a company’s
market value from exposure to unexpected currency fluctuations. This can
affect a company’s future cash flows, foreign investments and earnings.

Cause Exchange Rate Risk

Exchange rate risk refers to the possibility of losses in international financial

transactions due to fluctuations in the value of currency. These fluctuations
can be caused by many different local and global factors, including:

 Trading activity within the forex market or other markets.

 Economic news.
 Political news.
 Other global news.
 Weather events, like storms, flooding, and droughts.

Dealing with transaction risks

Assuming that the business does not want to tolerate exchange rate risks (and
that could be a reasonable choice for small transactions), transaction risk can
be treated in the following ways:

 Invoice. Arrange for the contract and the invoice to be in your own currency.
This will shift all exchange risk from you onto the other party. Of course, who
bears the risk will be a matter of negotiation, along with price and other
payment terms. If you are very keen to get a sale to a foreign customer you
might have to invoice in their currency.
PESU 31
Unit 2 Derivatives FEM

 Netting. If you owe your Japanese supplier ¥1m, and another Japanese
company owes your Japanese subsidiary ¥1.1m, then by netting off group
currency flows your net exposure is only for ¥0.1m. This will really only work
effectively when there are many sales and purchases in the foreign currency.
 Matching. If you have a sales transaction with one foreign customer, and
then a purchase transaction with another (but both parties operate with the
same foreign currency) then this can be efficiently dealt with by opening a
foreign currency bank account.

 Leading and lagging. Let’s imagine you are planning to go to Spain and you
believe that the euro will strengthen against your own currency. It might be
wise for you to change your spending money into euros now. That would be
‘leading’ because you are changing your money in advance of when you really
need to. Of course, the euro might weaken and then you’ll want to kick
yourself, but remember: managing transaction risk is not about maximising
your income or minimising your expenditure, it is about knowing for certain
what the transaction will cost in your own currency.

Foreign Exchange Risk Management Policy

 Senior management of the branch should be aware of the foreign exchange

risk policy of the bank and any reporting and monitoring requirements with
which it must comply. The policy should be reviewed on a regular basis by
senior management, normally at least annually, to ensure that it remains
appropriate.
 The foreign exchange risk management policy should take into account the
nature of the branch’s business and the various types of foreign exchange risk
that arise from it.

PESU 32
Unit 2 Derivatives FEM

Procedures and Systems

The Authority requires branches to monitor their foreign exchange risk on a

frequent and timely basis. The Authority would expect branches that assume
any foreign exchange risk to be in a position to measure their positions on an
on-going basis and to report to management daily. This requires:

 A clear allocation of the responsibility for measuring and reporting foreign

exchange risk within the group.

 The maintenance of reliable systems that can produce accurate reports

promptly
 Active senior management involvement in, and clearly allocated
responsibility for, foreign exchange risk reporting
 Regular reporting to/from the branch time in the future at an agreed
exchange rate (the forward rate).

2.7 Transaction Exposure

Transaction exposure refers to the risk that arises from the potential impact of
exchange rate fluctuations on specific international transactions or contracts. It
is a type of foreign exchange risk that affects companies engaged in cross-
border trade or individuals involved in international transactions.
Transaction exposure can affect both importers and exporters.
Importers face transaction exposure when they have to pay for goods or
services in a foreign currency. If their domestic currency strengthens against
the foreign currency, the cost of imports in terms of the domestic currency
may increase. Exporters, on the other hand, face transaction exposure when
they receive payment in a foreign currency. If their domestic currency
strengthens, the amount received in the domestic currency may decrease.

PESU 33
Unit 2 Derivatives FEM

Measuring
Measuring transaction exposure involves quantifying the potential impact of
exchange rate fluctuations on specific international transactions. The goal is to
assess the potential gains or losses that could arise from currency movements
and determine the level of risk involved.
Methods used to measure transaction exposure:
1. Direct Currency Quotation: One way to measure transaction exposure is by
using direct currency quotation. This involves expressing the value of the
transaction in the domestic currency and the foreign currency. By comparing
the domestic currency value before and after exchange rate movements, the
gain or loss can be calculated.
2. Sensitivity Analysis: Sensitivity analysis involves evaluating the potential
impact of different exchange rate scenarios on the transaction. By simulating
various exchange rate movements, a company or individual can assess the
range of potential outcomes and quantify the associated gains or losses.
3. Value at Risk (VaR): VaR is a statistical measure used to estimate the
maximum potential loss within a certain confidence level. To measure
transaction exposure using VaR, historical exchange rate data and statistical
models are used to calculate the potential loss at a specified confidence level
(e.g., 95% confidence level).
4. Scenario Analysis: Scenario analysis involves considering specific scenarios
of exchange rate movements and analyzing the impact on the transaction.
Various scenarios, such as a 10% depreciation or appreciation of the foreign
currency, can be evaluated to estimate the potential gains or losses.
5. Monte Carlo Simulation: Monte Carlo simulation is a technique that
involves generating multiple random simulations of exchange rate movements
and evaluating the resulting impact on the transaction. By running numerous

PESU 34
Unit 2 Derivatives FEM

simulations, the range of potential outcomes and the associated probabilities

can be estimated.
6. Regression Analysis: Regression analysis can be used to measure transaction
exposure by analyzing historical data on exchange rates and transaction values.
By determining the correlation between exchange rate movements and
transaction values, the potential impact of future exchange rate movements
on the transaction can be estimated.
Borrowing and lending activities can have implications for transaction
exposure, particularly when they involve foreign currencies. Here's how
borrowing and lending can impact transaction exposure and some strategies to
manage it:
Borrowing in Foreign Currency:
A company borrows funds in a foreign currency; it exposes itself to
transaction risk if its domestic currency strengthens against the borrowed
currency. This is because the repayment amount in the domestic currency will
increase, leading to potential losses. To manage this exposure:
a. Natural Hedging: If a company has foreign currency revenues or assets, it
can use those funds to repay the foreign currency borrowing. This approach
offsets the transaction exposure by aligning the currency inflows with the
currency outflows.
b. Currency Swaps: Companies can enter into currency swap agreements
where they exchange the foreign currency debt for a debt denominated in
their domestic currency. This allows them to eliminate the transaction
exposure associated with the foreign currency borrowing.
c. Forward Contracts: Companies can use forward contracts to hedge the
future repayment obligations by fixing the exchange rate at which they will
convert their domestic currency into the foreign currency for debt repayment.

PESU 35
Unit 2 Derivatives FEM

Lending in Foreign Currency:

A company lends funds in a foreign currency, it exposes itself to
transaction risk if the borrower's domestic currency strengthens against the
lent currency. This can affect the repayment value in the lender's domestic
currency. To manage this exposure:
a. Currency Swaps: Lenders can enter into currency swap agreements to
exchange the foreign currency loan proceeds for a loan in their domestic
currency. By doing so, they can eliminate the transaction exposure associated
with the foreign currency lending.
b. Credit Risk Assessment: Lenders should carefully assess the
creditworthiness of the borrower and consider the potential impact of
exchange rate fluctuations on the borrower's ability to repay the loan. This
helps mitigate the risk of non-repayment due to adverse currency movements.
c. Loan Terms and Covenants: Lenders can incorporate clauses in loan
agreements that allow for adjustments or repayment modifications in the
event of significant currency fluctuations. These provisions help address the
potential impact of exchange rate movements on the loan's repayment value.
d.Currency Diversification: Companies engaged in borrowing and lending
activities can consider diversifying their currency exposure. By borrowing or
lending in multiple currencies, they reduce their concentration of risk in a
single currency. This strategy allows for potential offsets if one currency
strengthens while another weakens.
e.Monitoring and Hedging: Regular monitoring of exchange rate movements
and economic indicators is essential for companies involved in borrowing and
lending activities. By staying informed, companies can assess the potential
impact of exchange rate fluctuations on their transaction exposures and take

PESU 36
Unit 2 Derivatives FEM

timely hedging measures, such as entering into hedging contracts or adjusting

borrowing or lending strategies.
2.8 Translation
Translation Exposure is defined as the risk of fluctuation in the exchange
rate that may cause changes in the value of the company’s assets, liabilities,
income, and equities and is usually found in multinational companies as their
operations and assets are based in foreign currencies. At the same time, its
financial statements are consolidated in domestic currency. Therefore, many
companies prefer to hedge such risks in the best possible way.
Methods to Measure Translation Exposure
1. Current/Non-Current Method
In this method, current assets and liabilities are valued at the currency
rate, while non-current assets and liabilities are valued per the historical rate.
All amounts from income statements are valued based on the currency
exchange rate. In some cases, an approximated weighted average can be used
if there are no significant fluctuations over the financial periods.
Company XYZ is a US Company that has a subsidiary in Europe. Since the
operating currency in Europe is the EURO.

PESU 37
Unit 2 Derivatives FEM

2. Monetary/Non-Monetary Method
In this method, all monetary accounts in balance sheets such as
Cash/Bank and bills payable are valued at the current rate of foreign exchange,
while remaining non-monetary items in the balance sheet and shareholder’s
equity are calculated at the historical rate of foreign exchange when the
account was recorded.

PESU 38
Unit 2 Derivatives FEM

3. Temporal Method
In this method, current and non-current accounts that are monetary on
the balance sheet are converted at the current foreign exchange rate. In
addition, non-monetary items are converted at historical rates. For example,
all accounts of a foreign subsidiary company are converted into the parent
company’s domestic currency. The basis of this method is items are translated
in a way they are carried as per the firm’s books to date.

4. Current Rate Method

By this method, all items in the balance sheet except shareholder’s
equity are converted at the current exchange rate. In addition, all items in
income statements are converted at an exchange rate at their occurrence.

PESU 39
 Unit 2 Derivatives FEM

Differences between Translation Exposures vs. Transaction Exposure

Difference Translation Exposure Transaction Exposure

The risk involved due to changes

The risk involved in reporting
in the exchange rate, which
consolidated financial
Definition affects the cash flow movement
statements due to fluctuation in
arises in the company’s daily
exchange rates;
operations.

Legal Requirements and

Area Managing daily operations;
accounting issues;

It only occurs while consolidating The parent company does not

Foreign
financial statements of parent require having a foreign
Affiliate/Subsidiary
company and subsidiary or subsidiary for transaction
foreign affiliate. exposure.

Profit or Loss The result of Translation The result of transaction

PESU 40
 Unit 2 Derivatives FEM

Difference Translation Exposure Transaction Exposure

exposure is notional profit or exposure is realized profit and

loss. loss.

By the end of every quarter of

It only arises at a time of
the financial year
Occurrence transaction involving foreign
while consolidating financial
currency.
statements.

Since it Directly affects the cash

The value of the company is not flows of the company, it
Value Impact
affected. changes the value of the
company.

Translation exposure is more

concepts instead of an actual Since Transaction exposure
impact on the value of the affects cash flows, it affects the
company. Hence it does not tax payments of the company.
Tax
affect tax payment and does not Provides benefits in case of loss
provide any benefits in case of due to changes in the exchange
loss in terms of fluctuation in the rate
exchange rate.

Functions of Translation exposure

Financial Reporting:

Translation exposure is primarily concerned with how changes in exchange

rates affect the reported financial performance and financial position of a
multinational corporation. Companies with foreign subsidiaries have to convert
their subsidiaries' financial statements into the parent company's reporting
currency for consolidated financial reporting. Fluctuations in exchange rates
can lead to changes in revenue, expenses, assets, liabilities, and equity, which
in turn affect the financial ratios and overall financial health of the company.

PESU 41
Unit 2 Derivatives FEM

Risk Management:

Companies with significant international operations are exposed to exchange

rate fluctuations, which can impact their financial results. By understanding
and managing translation exposure, companies can take steps to mitigate the
potential negative effects of exchange rate movements. This might involve
using financial instruments such as currency forwards, options, and swaps to
hedge against unfavorable exchange rate changes.

Investor Relations:

Changes in reported financial results due to translation exposure can influence

investors' perceptions of a company's performance and stability. Companies
need to communicate clearly about the impact of translation exposure on their
financial statements to avoid misunderstandings and manage investor
expectations.

Strategic Decision-Making:

Understanding translation exposure is crucial for making informed strategic

decisions related to foreign investment, expansion, and divestiture. Companies
need to evaluate potential risks and benefits when deciding to enter or exit
foreign markets, acquire or divest foreign subsidiaries, or undertake other
international business activities.

Performance Evaluation and Compensation:

For multinational companies, performance evaluation of subsidiaries is

complex due to translation exposure. Managers of foreign subsidiaries may be
compensated based on local currency financial results, which can be distorted
by exchange rate fluctuations during translation. Companies must design

PESU 42
Unit 2 Derivatives FEM

compensation structures that align with the parent company's overall financial
goals while accounting for translation exposure.

Capital Budgeting:

When making investment decisions in foreign markets, companies need to

incorporate the potential impact of translation exposure on future cash flows.
Changes in exchange rates can affect the value of repatriated earnings, interest
payments, and other financial obligations, thus influencing the attractiveness
of foreign investment opportunities.

Tax Implications:

Translation exposure can also affect tax liabilities. Exchange rate fluctuations
can impact the value of profits and assets when translated to the parent
company's reporting currency, potentially leading to tax implications in various
jurisdictions.

Credit Ratings and Financing Costs:

Fluctuations in financial ratios due to translation exposure can influence a

company's creditworthiness and, consequently, its borrowing costs. Rating
agencies and lenders consider a company's financial stability and performance
when determining credit ratings and financing terms.

Limitations of Translation exposure

Volatile Exchange Rates:

Exchange rates can be highly volatile and unpredictable. Fluctuations in

exchange rates can lead to significant variations in the reported financial
results of a company's foreign subsidiaries. This can create challenges in
accurately assessing the true underlying performance of the subsidiaries.
PESU 43
Unit 2 Derivatives FEM

Distorted Financial Ratios:

Translation exposure can distort key financial ratios used for performance
evaluation, credit assessment, and strategic decision-making. This distortion
can make it difficult to compare the financial performance of different
subsidiaries or assess the overall financial health of the multinational company.

Inaccurate Performance Assessment:

Translation exposure can make it challenging to accurately assess the

performance of individual foreign subsidiaries. For example, a subsidiary may
experience positive operational performance in its local currency, but when
translated into the parent company's reporting currency, the performance may
appear negative due to adverse exchange rate movements.

Lack of Cash Flow Impact:

Translation exposure mainly affects the reported financial statements, not the
actual cash flows of the company. Exchange rate fluctuations impact balance
sheet items like assets, liabilities, and equity, but they don't necessarily directly
affect the company's ability to generate cash.

Hedging Complexity:

Hedging translation exposure can be complex and expensive. Using financial

instruments like currency forwards or options to hedge against exchange rate
risk requires expertise and may not always provide perfect protection against
adverse movements.

PESU 44
Unit 2 Derivatives FEM

Overemphasis on Short-Term Results:

Companies might focus too much on short-term results due to translation

exposure, as fluctuations in exchange rates can lead to dramatic changes in
reported financial performance. This emphasis on short-term fluctuations
could detract from the long-term strategic goals of the company.

Difficulty in Forecasting:

Predicting future exchange rate movements is notoriously challenging.

Companies may find it difficult to accurately forecast exchange rates, making it
harder to plan for potential translation exposure risks.

Complex Accounting Rules:

Accounting for translation exposure involves complying with complex

accounting rules, such as those outlined in International Financial Reporting
Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). These
rules can introduce subjectivity and judgment into the translation process.

Impact on Debt Covenants:

For companies with debt covenants tied to certain financial ratios, translation
exposure can lead to violations of these covenants during periods of significant
exchange rate fluctuations. This can trigger financial penalties or other
negative consequences.

Inconsistent Reporting Periods:

Different countries may have different reporting periods and fiscal years,
which can complicate the process of consolidating financial statements and
applying consistent translation methods.

PESU 45
Unit 2 Derivatives FEM

2.9 Economic Exposure

Economic exposure is the toughest to manage because it requires

ascertaining future exchange rates. However, economists and investors can
take the help of statistical regression equations to hedge against economic
exposure. There are various techniques that companies can use to hedge
against economic exposure. Five such techniques have been discussed in this
chapter.

It is difficult to measure economic exposure. The company must accurately

estimate cash flows and the exchange rates, as transaction exposure has the
power to alter future cash flows while fluctuation of the currency exchange
rates occur. When a foreign subsidiary gets positive cash flows after it corrects
for the currency exchange rates, the subsidiary’s net transaction exposure is
low.

Economic exposure mitigation strategies: Companies mitigate economic

exposure through:

1. Operational strategy

Involves diversifying production facilities, sources of financing, and end

product markets. In this way, the effects of changes in exchange rates can
offset each other to some degree if several different currencies are
involved.

 Diversification of supply and operations. For raw materials, for

example, companies should have alternative suppliers to source raw
materials from abroad. Suppose the raw materials’ price from the
leading supplier becomes more expensive due to the exchange rate

PESU 46
Unit 2 Derivatives FEM

depreciation. In that case, they can switch to alternative suppliers. The

same is true for production facilities.

 Access financing in different currencies. For example, companies

borrow in the main currency that is the source of their revenue. Thus,
the effect of currency fluctuations on revenue partially offsets the effect
on interest payments.

 Diversification of sources of revenue. If the company sells products in

several countries, they get different currencies. It reduces risk exposure
in one particular currency.

2. Currency risk mitigation strategy.

The currency risk mitigation strategy has several alternatives. The
company matches cash outflows and cash inflows with the same currency. For
example, suppose an Indonesian company has significant revenue in US
dollars. In that case, it should compensate for this by borrowing in US dollars. If
the rupiah appreciates, sales will weaken due to higher prices in the US
market.

Economic Exposure – product decisions

Economic exposure can significantly influence a company's product

decisions, as changes in exchange rates can impact the competitiveness,
profitability, and market demand for products. Here are some ways economic
exposure affects product decisions:

1. Pricing Strategy: Exchange rate fluctuations can directly impact the cost
structure of a company, especially if it relies on imported raw materials or
components. When the local currency depreciates, the cost of imported inputs
increases, which may lead to higher production costs. In such cases, companies

PESU 47
Unit 2 Derivatives FEM

may need to adjust their pricing strategy to reflect the higher costs or explore
alternative sourcing options to mitigate the impact.

2. Market Selection: Economic exposure can influence the selection of target

markets for product expansion. A company may evaluate the potential impact
of exchange rate fluctuations on its products in different markets. If a market is
characterized by high volatility in exchange rates or a history of significant
currency depreciation, the company may approach that market with caution or
develop specific strategies to mitigate the risks.

3. Product Localization: Economic exposure may prompt companies to

consider localizing their products in specific markets. By establishing local
production facilities or sourcing inputs locally, companies can reduce their
exposure to exchange rate fluctuations. This localization strategy can help
maintain cost competitiveness and enhance market penetration in the face of
currency volatility.

4. Product Design and Features: Economic exposure can influence product

design decisions to enhance market appeal. For example, if a company's
products become more expensive due to a stronger local currency, it may
consider product redesign to increase value or differentiate itself from
competitors. This could involve incorporating additional features, improving
quality, or targeting niche markets to justify a higher price point.

5. Competitor Analysis: Economic exposure necessitates monitoring and

analyzing the activities of competitors in different markets. Exchange rate
fluctuations can impact the prices and competitiveness of rival products.
Companies must assess the potential impact of exchange rate movements on

PESU 48
Unit 2 Derivatives FEM

their competitors and adjust their product decisions accordingly, such as by

offering competitive pricing or differentiating their products.

6. Marketing and Promotion: Economic exposure can influence marketing and

promotional strategies for products in different markets. Companies may need
to adapt their marketing messages to address potential concerns related to
exchange rate fluctuations. Highlighting price stability, long-term value, or local
production may be relevant to attract customers in markets where exchange
rate volatility is a concern.

7. Forecasting and Scenario Planning: Economic exposure requires companies

to incorporate exchange rate forecasts and scenario planning into their
product decisions. By assessing potential exchange rate scenarios, companies
can evaluate the impact on costs, pricing, demand, and profitability. This helps
in making informed product decisions and developing strategies to mitigate
economic risks.

Functions of Economic Exposure

Strategic Decision-Making:

Economic exposure plays a crucial role in strategic decision-making for

multinational corporations. When evaluating investment opportunities,
expansion into new markets, or divestiture of assets, companies need to
consider the potential impact of exchange rate fluctuations on future cash
flows and profitability. Economic exposure helps companies make informed
decisions about where and how to allocate resources.

PESU 49
Unit 2 Derivatives FEM

Pricing and Market Positioning:

Exchange rate fluctuations can affect a company's competitiveness in

international markets. Economic exposure influences decisions about pricing
strategies and market positioning. Companies need to assess how changes in
exchange rates could impact their cost structure, pricing power, and market
share.

Supply Chain Management:

Economic exposure can influence a company's supply chain decisions.

Fluctuations in exchange rates can affect the cost of raw materials,
components, and finished goods. Companies may need to adjust their sourcing
strategies or negotiate with suppliers to mitigate potential adverse effects on
profitability.

Hedging and Risk Management:

Managing economic exposure involves identifying and hedging against

potential risks arising from exchange rate fluctuations. Companies may use
financial derivatives, such as currency forwards, options, and swaps, to hedge
their exposure to currency risk. Effective risk management helps stabilize cash
flows and protect profitability.

Cash Flow Forecasting:

Economic exposure requires companies to develop accurate cash flow

forecasts that incorporate the potential impact of exchange rate changes.
These forecasts help companies anticipate potential challenges, allocate
resources effectively, and ensure they have the necessary liquidity to meet
financial obligations.

PESU 50
Unit 2 Derivatives FEM

Debt Management:

Companies with foreign currency-denominated debt or financial obligations

need to manage their exposure to exchange rate risk. Fluctuations in exchange
rates can impact the cost of servicing debt, leading to increased interest
expenses. Effective economic exposure management helps companies assess
their ability to meet debt obligations in different currency environments.

Investor Relations:

Transparent communication about economic exposure and its potential impact

on future financial performance is crucial for maintaining positive investor
relations. Investors and stakeholders need to understand how exchange rate
fluctuations may affect a company's earnings and value over time.

Mergers and Acquisitions:

When considering mergers, acquisitions, or joint ventures, companies need to

assess the economic exposure of both parties involved. Exchange rate
fluctuations can impact the valuation of assets and liabilities, as well as the
potential synergies and risks associated with the transaction.

Risk Assessment and Mitigation:

Economic exposure analysis helps companies identify potential vulnerabilities

and assess the impact of currency risk on different aspects of their operations.
This allows companies to implement proactive measures to mitigate risks and
enhance their overall risk management strategy.

Long-Term Financial Planning:

Economic exposure considerations are essential for long-term financial

planning and setting corporate goals. By factoring in potential exchange rate
PESU 51
Unit 2 Derivatives FEM

fluctuations, companies can establish realistic growth targets and financial

expectations for the future.

PESU 52