Foreign Exchange Exposure and Risk Management
This domain tests the three exposures, the parities linking spot, forward and interest rates, and the arithmetic of choosing between forward, money-market and option hedges.
Exposures and parities
Transaction exposure is committed foreign-currency cash flow. Translation (accounting) exposure is restatement of a foreign subsidiary's assets and liabilities. Economic exposure is the effect of rate changes on future competitiveness and value. Covered interest parity: F/S = (1 + ih)/(1 + if), so the forward premium approximates the interest differential. PPP explains long-run spot movement through inflation differentials.
Hedging arithmetic
An importer buys foreign currency at the bank's ask; an exporter sells at the bid. A money-market hedge borrows domestic currency now, converts at spot, invests in the foreign currency and repays from the eventual payable or receivable.
Worked example
An importer owes USD 1,00,000 in three months. Spot 83.00/83.10; three-month forward 83.40/83.55. Forward cost = 1,00,000 × 83.55 = ₹83,55,000. Money market: INR 8% p.a., USD 5% p.a. PV of the liability = 1,00,000/1.0125 = USD 98,765.43; converted at ask 83.10 = ₹82,07,407 borrowed; repay ×1.02 = ₹83,71,555. The forward is cheaper by ₹16,555, so hedge forward.
Traps
Using the mid-rate when the bank deals at bid/ask; annualising a three-month rate by ×4 rather than applying the period rate; hedging translation exposure as if it were transactional; ignoring option premium when comparing with a forward; assuming PPP holds over months rather than years.