· TRANSACTION EXPOSURE (BUSINESS)

A transaction exposure arises whenever a company is committed to a foreign currency denominated transaction entered into before the change in exchange rate. Transaction exposure measures the effect of an exchange rate change on outstanding obligations which existed before the change, but were settled after the exchange rate change.

Transaction exposure, deals with changes in cash flows that result from existing contractual obligation due to exchange rate changes. In other words it refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations.

The level of transaction exposure depends on the extent to which a firm’s transactions are in foreign currency. In other words, the transaction in exposure will be more if the firm has more transactions in foreign currency.

Transaction risk is critical to an MNC’s due to the high variability in exchange rates. Transaction exposure has become an important function of International Financial Management as firms are now more frequently entering into financial & commercial contracts denominated in foreign currencies, judicious measurement & management of transaction exposure.

Temporal method

The temporal method is a modified version of the monetary/non-monetary method. The only difference is that,

· Under temporal method inventory is usually translated at the historical rate but it can be translated at the current rate if the inventory is shown in the balance sheet at market values. In the monetary/non-monetary method inventory items is always translated at the historical rate.

(Income statement items are normally translated at an average exchange rate for the period. However, cost of goods sold & depreciation are translated at historical rates.)

Current/Non-Current method

The current/non-current method is perhaps the oldest approach. No longer allowable under generally accepted accounting practices in the US. Its popularity gradually waned as other methods were found to give more meaningful results. Under the current/non-current method,

· All current assets & current liabilities of foreign affiliates are translated into the home currency at the current exchange rate while non-current assets & non-current liabilities are translated at historical rates.

· In the balance sheet, exposure to gains or losses from fluctuating currency values is determined by the net of current assets less current liabilities. Gains or losses on long-term assets & liabilities are not shown currently.

· Items in the income statement are generally translated at the average exchange rate for the period covered. However, those items that relate to revenue or expense items associated with non-current assets (such as depreciation changes) or long-term liabilities (amortization of debt discount) are translated at the same rate as the corresponding balance sheet items.

Monetary /Non-Monetary method

The monetary/non-monetary method differentiates between monetary & non-monetary items.

· Monetary items are those that represent a claim to receive or an obligation (responsibility) to pay a fixed amount of foreign currency unit, e.g. cash, accounts receivable, current liabilities, accounts payable & long-term debt.

· Non monetary items are those items that do not represent a claim to receive or an obligation to pay a fixed amount of foreign currency items e.g. inventory, fixed assets, long –term investments.

According to this method,

· All monetary items are translated at the current rate while non monetary items are translated at historical rates.

· Income statement items are translated at the average exchange rate for period (except for items such as depreciation & cost of goods sold (cogs) that are directly associated with non-monetary assets or liabilities. These accounts are translated at their historical rates.)

METHODS OF TRANSLATION

Four methods of foreign currency translation have been developed in various countries.

· The current rate method

· The monetary/non-monetary method

· The temporal method

· The current/non-current method

Current rate method

The Current rate method is the simplest & the most popular method all over the world. Under this method,

· All balance sheet & income items are translated at the current rate of exchange, except the stockholders’ equity.

· Income statement items, including depreciation & cost of goods sold (cogs), are translated at either the actual exchange rate on the dates the various revenues & expenses were incurred or at the weighted average exchange rate for the period.

· Dividend paid is translated at the exchange rate prevailing on the date the payment was made.

· The common stock account & paid –in-capital accounts are translated at historical rates.

· Gains or Losses caused by translation adjustment are not included in the net income but are reported separately & accumulated in a separate equity account known as Cumulative Translation Adjustment (CTA). CTA account helps in balancing the balance sheet balance since translation gains or losses are not adjusted through the income statement.

ADVANTAGE:

· The relative proportions of the individual balance sheet accounts remain the same & hence do not distort the various balance sheet ratios like the debt-equity ratio, current ratio, etc

· The variability in reported earnings due to foreign gains or losses is eliminated as the translation gain/loss is shown in a separate account – the CTA account.

DISADVANTAGE

· The various items in the balance sheet which are recorded at historical costs are translated back into $ at a different rate.

MEASUREMENT OF TRANSLATION EXPOSURE

Translation exposure measures the effect of an exchange rate change on published financial statements of a firm.

· Assets & liabilities that are translated at the current exchange rate are considered to be exposed (uncovered) as the balance sheet will be affected by fluctuations in currency values over time.

· Assets & liabilities that are translated at a historical exchange rate will be regarded as not exposed as they will not be affected by exchange rate fluctuations.

· So, the difference between exposed assets & exposed liabilities is called translation exposure.

Translation exposure = Exposed assets- Exposed liabilities (change in the exchange rate)

Under the generally accepted US accounting principles, the net monetary asset position of a subsidiary is used to measure its parent’s foreign exchange exposure. The net monetary asset position is monetary assets such as cash & accounts receivable minus monetary liabilities such as accounts payable & long-term debt.

The translation of gains & losses does not involve actual cash flows – these gains or losses are purely on paper i.e. they are of an accounting nature.

STEPS for measuring translation exposure are:

1. Determine functional currency.

2. Translate using temporal method recording gains/losses in the income statement as realized

3. Translate using current method recording gains/losses in the balance sheet & as realized

4. Consolidate into parent company financial statements.

TYPES OF RISK EXPOSURE

There are mainly three types of foreign exchange exposures

• Translation exposure
• Transaction exposure
• Economic exposure

· TRANSLATION EXPOSURE (TRANSFORMATION)

Accounting exposure, also known as translation exposure, it is the level to which a firm’s foreign currency denominated financial statements is affected by exchange rate changes. All financial statements of a foreign subsidiary have to be translated into the home currency for the purpose of finalizing the accounts or to compare financial results for any given period.

(If a firm has subsidiaries in many countries, the fluctuations in exchange rate will make the assets valuation different in different periods. The changes in asset valuation due to fluctuations in exchange rate will affect the group’s asset, capital structure ratios, profitability ratios, solvency ratios etc.)

As investors all over the world are interested in home currency values, the foreign currency balance sheet & income statement are restated in the parent country’s reporting currency.

FOR EXAMPLE: foreign affiliates of US companies must restate the franc, sterling or mark statements into US $ so that the foreign values can be added to the parent US $ denominated balance sheet & income statement. This process is called “translation”.

Foreign exchange risk is the possibility of gain or loss to a firm that occurs due to unexpected changes in exchange rate. Exchange rates are considered by MNC’s as crucially important factor affecting their profitability. Because exchange rate fluctuations directly impact the sales revenue of firms exporting goods & service. Future payments in a foreign currency carry the risk that the foreign currency will depreciate in value before the foreign currency payment is received & is exchanged into Indian rupees.

For example, if an Indian firm imports goods & pays in foreign currency (says dollars), its outflow is in dollars, and thus it is exposed to foreign exchange risk. If the value of the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay more domestic currency to get the required amount of foreign currency.

Foreign exchange risks, therefore, pose one of the greatest challenges to a multinational company. These risks arise because MNC’s operate in multiple currencies. Infact, many times firms who have a diversified portfolio find that the negative effect of exchange rate changes on one currency are offset by gains in others i.e. exchange risk is diversifiable.

The beginning of the floating exchange rate regime, since the early 1970’s, has sharp the interest of MNC’s in developing techniques & strategies for foreign exchange exposure management. The primary goal is to protect corporate profits from the negative impact of exchange rate fluctuations.

FOREIGN EXCHANGE RISK EXPOSURE

The foreign exchange market consists of the spot market & the forward or futures market.

· The spot market deals with foreign exchange delivered within 2 business days or less. Transactions in the spot market quote rates of exchange prevalent at the time the transactional took place. Typically , a bank will quote a rate at which it is willing to buy the currency (bid rate) & a rate at which it will sell a currency (offer rate) for delivery of the particular currency.

· The forward market is for foreign exchange to be delivered in 3 days or more. In quoting the forward rate of currency, a bank will quote a bid & offer rate for delivery typically 1, 2, 3, or 6 months after transaction date.

Determining The Amount Of Available Capital

The available capital is the current value of the assets current value of the liabilities. If all the assets and liabilities are traded, their values are simply the price at which they are traded. If the assets include assets, which are not traded frequently, then the reasonable value for those assets can be assigned.

Reasonable Value of Assets = Nominal Value - (Specific & General provision)

Nominal Value is the total amount owed to the bank. The specific provisions is the amount that is expected to be unpaid by customers who are already in financial trouble. The general provisions is the amount that is expected to be unpaid by other customers, who get in trouble over the next years.

Capital = Nominal Assets Value – provisions – liabilities.

In short run the board of director can also increase the capital by issuing more share without creating any outside liabilities and in long run it increase capital through accumulation of retained earning by not paying dividends to share holders at required rate.

Allocating Risk Limits To Each Business Unit/ Segment With In The Bank: After determining the target debt rating and amount of available capital, the bank’s total risk capacity is fixed.

Risk Capacity = Probability of default X Available Capital

The bank can decide total risk capacity in different segment of its business like trading, credit cards and corporate lending. The bank must consider the expected return from each unit and the diversification of the risk between different segments. The risk capacity is allocated by giving each business unit a limit on the amount of risk it can take. This limit may be in terms of risk capital or in more familiar terms, such as the total amount of loans it can give.

Analysis of risk

Analysis of Risk (Measurement of Risk):

It includes following methods:

Random Variables & Probability Distribution

Random Variables: Random Variable is variable whose out come is uncertain. For example, if a coin is to be flipped and the variables x is defined to be to be equal to Rs. 1 if heads appears and Rs. –1 if tails appears. Then prior to the coin flip, the value of x is unknown; that is x is random variables. Once the coin has been flipped and the outcome revealed, the uncertainty about x is revealed, because the value of x is then known.

Probability Distribution: It identifies all the possible outcomes for the random variables and the probability of the outcomes. Probability distribution indicates the proportion of expected outcome to the total out come. So, in this above example, the probability of appearing of heads and tails will be .5 in each case. Because there are only two expected out comes.

Types of liquidity risk

Liquidity risk can also be classified in to two parts.

Ø Assets Liquidity Risk

Ø Funding Liquidity Risk

Assets Liquidity Risk/ Market/ Product Liquidity Risk: It arises when a transaction cannot be conducted at prevailing market prices due to the size of the position related to normal trading lots. It can be managed by setting limits on certain markets or products and by means of diversification.

Funding Liquidity Risk: It is also known as cash flow risk, refer to the inability to meet payments obligations, which may force early liquidation, thus transforming paper losses in to realize losses. This especially a problem for portfolio that are leveraged and subject to margin calls from the lenders. Cash flow risk interacts with product liquidity risk if the portfolio contains illiquid assets that must be sold at less than fair market value.

Liquidity risk

liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

Causes of Liquidity Risk
Liquidity risk' arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.
Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found higher in emerging markets or low-volume markets.
Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

What is operational risk

Operational Risks: It arises from human & technical errors or accidents. This includes fraud, management failure and inadequate procedures & controls. Technical errors may be due to breakdowns in information, transaction processing, and settlement systems or any other problem in back office operations, which deals with the recording of transactions and reconsolidation of individual trades with the firms aggregate position.

It can also lead to market & credit risk, like if the settlements fail than it will create market risk & credit risk, since the cost may depend on movements in the market price.

The best protection against operational risks consists of redundancies of systems, clear separation of responsibilities with strong internal control and regular contingency planning.

What is Credit Risk

It originates from the fact that counter parties may willing or unable to fulfill their contractual obligations. Its effect is measured by the cost of replacing cash flows if other party defaults.

Credit risk should be defined as the potential loss in mark to market value that may incur due to occurrence of credit events. A credit event occurs when there is a change in the counter party’s ability to perform its obligation.

Credit risks can be of following two types-

Ø Sovereign Risk

Ø Settlement Risk

Sovereign Risk: It occurs like when countries impose foreign exchange controls that make it impossible for counter parties to honour their obligation. This type of risk is country specific.

Settlement Risk: It occurs when two payments are exchanged the same day. This risk arises when the counter party may default after institution already made its payments. Settlement risk is very real for foreign exchange transaction, which involves exchange of payments in different currencies at different times.

Credit risk is controlled by credit limits or notional, current & potential exposures and increasingly, credit enhancement features such as requiring collateral of marking to market.

Market Risks

It arises from movements in the level of market prices. It can be measured in two forms.

ü Absolute Risk

ü Relative Risk

Absolute Risk: It is measured in terms of relevant currency. It focuses on the movement of total return.

Relative Risk: It is measured in terms of related Bench Mark Index. It has emphasis on the deviation from index.

The market risk can be classified in to two following categories.

Ø Directional Risks

Ø Non-Directional Risks

Directional Risks: It involves exposures to the direction of movements in the financial variables, such as stock prices, interest rates, exchange rates & commodity prices. These exposures are measured by linear approximation such as beta for exposure to stock market movements.

Non-Directional Risks: It involves remaining risks, which consist of non-linear exposures to hedged position. Second order or quadratic exposures are measured by convexity when dealing with interest rates and gama when dealing with options.

Financial Risk Management

It refers to the design & implementation of procedure for controlling financial risks. Technological changes have arises from advances on two fronts.

Ø Physical Equipment

Ø Financial Theory

Physical Equipment: The availability of cheaper communications & computing power has led to innovations such as global 24 hours trading and online risk management systems.

Financial Theory: Modern finance theory has allowed institution to create price & control the risks of news financial instruments.

Types of Financial Risks:

1. Market Risks
2. Credit Risks
3. Operational Risks
4. Liquidity Risks

Risk Management in Banks

If a bank takes more risk it can expect to make more money, but the greater risk also increases the NPAs (Non Performing Assets) and looses its business badly which can force it to go out from business. There should be following two objective before the banks-

Ø To generate profit

Ø To stay in business

The function of risk management in banks is –

Ø To ensure that the total risk being taken is matched to the bank’s capacity for absorbing losses in case things go wrong.

Ø To help the CEO (Chief Executive Officer) direct the scare resources of capital to the opportunities that are expected to create the maximum return with the minimum risk.

Risk Management at Macro level: Like other banking functions risk, is also looked after by board of directors of the banks. The board has to maintain the balance between shareholder’s & debt-holder’s desires of taking risk. Apart from this it has to take in to account perception of rating agencies, regulators and its own desire to stay in business.

The board can oversee the three key functions of risk management.

Ø Determining the target debt rating.

Ø Determining the amount of available capital

Ø Allocating risk limits to each business unit/ segment with in the bank.

what are the sources of risk

Human Created: Business cycles, Inflation, Change in the government policies & wars.

Unforeseen Natural Phenomena: Disturbance in the weather like flood, drought, Cyclones & Earthquakes.

Other Sources: Long term economic growth, technological innovation that render existing technology obsolete.

Government Rules & Regulations: When the Government bans something or imposes some heavy duties & taxes on the turnover; it leads to decrease in the demand of goods & services.

Foreign Exchange Rate: It creates imbalances in the balance of payment as well as make favorable or unfavorable in the net business (export & Import) of goods & services from aboard.

What is risk identification

Risk Identification: It means to identify the sources & reasons of expected losses. There are various methods of identifying exposures. For examples, comprehensive checklist of common risk exposures can be obtained from risk management consultants & other sources. Loss exposures can also be identified through analysis of firm’s financial statements, discussions with managers through the firm, surveys of employees & discussion with the risk management consultant & insurance agents. Regardless of the specific method used, risk identification requires an overall understanding of business & specific legal & regulatory factors that affects the business.

One method of identifying individual exposures is to analyze the source & uses of funds in the present and planned for the future. Potential events that decrease in availability of funds or increase in the uses of funds represent risk exposures.