we have selected the topic " Cross rate transaction in exchange rate risk management" for our research project. In this topic we will identify that what is the exchange rate risk and what are the tools to mitigate this types of risk. we have used three main types of currencies to perform our research which are Pakistani rupee, Dollar and Euro. We have conducted different personal interviews at Karachi Forex markets and also fill out the questionnaires to conclude our research and finally we found that the hedging strategies are not being used thoroughly in our country. This is the evident from the fact that has been conducted by our consistent interviews and studies also.
We will be using three main tools and models to mitigate the exchange rate risks and debt portfolio management for the risk management system.
Value at risk (VAR)
Cost at risk (CAR)
Hedging techniques
We will be defining these tools in detail and check out the relationship with respect to the current market situation by different foreign exchange money changers and currency dealers and also we will conclude this with different types of exporter major will be the SMEs that how they use these techniques and tools to alleviate the risk and come up with their desire revenue.We will use these tools with different investors and buyers of long term debt financing that who they swap there transcations to gain the interest rate benefits and interest revenue.
Purpose:
As we all know that foreign exchange rates changes the value of firm's assets, liabilities, and cash flows therefore fluctuations in the currency markets have an impact on your overall imports and exports, incoming and outgoing payments and payments terms according to the foreign exchange rates risks so in order to minimize the risks and maximize the profit in any business, an individual will have to keep an eye on the exchange rates. So in this research, we will be discussing the ROLE OF THESE CROSS RATES TRANSACTIONS WHICH WILL IMPACT THE OVERALL BUSINESS OPERATIONs, FINANCIAL STABILITY AND PROFITABILITY MAXIMIZATION. This study will tell us about the Forex trading, tips and strategies that how and what to do when the exchange rates fluctuate and to optimize risk and return. We will also discussing the problems faced in the exchange rates transactions.
Background Study
We will conduct our proposed research across these above mentioned contexts with our three team members, each of which is responsible to perform several tasks on the roadmap. Each member will be assigned different role play in this research.
Our research will be based on the following key six (6) factors which influence the exchange rates. These key factors are as follows:
Differentials in Inflation
Differentials in Interest Rates
Current-Account Deficits
Public Debt
Terms of Trade
Political Stability and Economic Performance
Source: http://www.investopedia.com/articles/basics/04/050704.asp
Literature Review
According to the recent survey, there are a lot of Sme businessman who do not know what strategy to be followed to minimized the Forex risks how to capitalize their investments at the most profitable rate while minimizing the chance of loss in their portfolio management.
There are many research studies on the exchange rate risk management so far, for example.
http://www.swdsi.org/swdsi08/paper/SWDSI%20Proceedings%20Paper%20S108.pdf
http://www.earnforex.com/forex-articles#fundamental
But out research project will be highlighting those factors by which we can minimize the risk while doing the cross rate transactions between two or more currencies. Also we will be discussing the remedies of these types of transactions.
As we know that Exports and imports is the backbone of a country and play a vital role in the economy. If we export more and import less than it will directly effect the positive effect on the economy and in exports and imports, the importance of exchange rate cannot be denied as all the clearance, invoicing and payments made in the dollars $.so in order to analysis the cost analysis and to transfer the payments, we may be come up with gain in exchange rate or on the other hand loss may also be occurred. So the change in forex rate may induce the value of firm assets, liabilities, cash flows and outgoing and incoming payments in export and import fund.
Generally, the fluctuating Forex rate may affect the five below mentioned categories of the participants.
Consumers, including visitors of countries, tourists and immigrants
Businesses
Investors
Speculators
commercial banks, investment banks and central banks
We will be discussing all these five categories in detail in our project. Also we will be discussing the following factors:
Why manage your foreign exchange risk?
Where do these foreign exchange exposures come from?
Who should be concerned?
How exposed is your business?
What can you do to minimize the foreign exchange risks?
Transaction risk, the flow of cash risk is associated in this transaction risk which deals the effect of foreign exchange rate related to receivables pertaining to exporter and payable pertaining to importer and dividends. Any change in this will directly change the indenture of the quantity of the currency in the exchange rate firm.
2. Translation risk,translation risk is basically deals the financial statements risk pertaining to the exchange rate moves to the assessment of foreign indenture which measure the auxiliary measure the net assets and liabilities with respect to the exchange rate moves.the translation may be done at end of the exchange rate period or the average exchange rate which is sololy dependant on the rules and regulation of the company.
3. Economic risk, it reflects the present value of the future cash flows of the financial statements with respect to the flows of the exchange rate risk. It is applied on the present value of future cash flows operation which reflects basically the risk to the firm's present value of future operating cash flows from exchange rate movements.
WHAT IS FOREIGN EXCHANGE
Foreign exchange is basically the currency which is being used outside the host country for transactions for example in USA Dollar is used, in Saudi Arabia; Riyal is used and so on.
WHAT IS RISK
Risk is basically the scarcity of the resources which may be occur by any upcoming uncertain event in the three main areas Like transactions, translation and economical. Risk cannot be ignore or eliminated but it can be minimized or mitigation by different types of tactical resolution and strategies followed by the steps.
WHAT IS THE FOREIGN EXCHANGE RISK.
Foreign exchange risk is highly applicable in the business where dealing with two or more different currencies are being used in the transactions like in the export firms normally the payments and invoices are made using Dollar (if we export in USA or other country where Dollar is used) so in order to get the payment we need to know the complete know how about the exchange rate of Dollar like for example if company A is situated in Pakistan and Company B is situated in California USA.now if company A wants to export its goods like printed fabric to company B than it needs to make the invoice in dollar amount so the Company B can Cost the per unit cost out and be bale to sell the goods in their country now for example we this dealing was being done the exchange rate was for example 85.6 means I USD is equal to 85.6 PKR or alternatively 85.6 PKR is equal to 1 USD.if the invoice is made for 1000 USD than in PKR the amount is 1000 x 85.6 = 85600 PKR,the company A will send the bill to Company B and then Company B now want s to make payment to Company A but at the time of payment the exchange rate was 85.25 which means that 1 USD is equal to 85.25 PLR or alternatively 85.25 PKR is equal to 1 USD now if Company B makes payment to Company A 1000 USD than as Company A is situated in Pakistan they needs to encash it out in Pakistani currency PKR so when they swap it in Forex company they transfer them into the current exchange rate which is 85.25 and give him PKR 1000 x 85.25 = 85250.
Now see at the time of shipment the exchange rate was 85.6 and a the time of payment the exchange rate was 85.25 the difference is (85.6 - 85.25) 0.35 and the difference in total PKR 350.
Now assume that in this only one transaction the Company A will definitely Lose PKR 350 and Company A will definitely gain the same amount.
This risk of scarcity is called the foreign exchange rate risk which can be minimized or mitigate by several strategies and tactical tools.
WHAT IS VALUE AT RISK (VAR)?
This model of estimation was firstly defined by JPMorgan Bank in 1990s and now it is more commonly used to estimate the tendency of the risk used for debt management, assets management, exchange rate risk and portfolio management.Value at risk is the broad term used to estimate the risk of the assets or the portfolio of the assets that how much the value of the assets will be decreased over a certain time period (usually time horizon is from 1 day to 10 days), it is a general term which is being used by all over the world to measure the tendency that how much the asset will be risky in order to hold it in future. It is a statistical analysis based on the past history to check out that how the value of the particular currency deviate from one arte to other, what is the tendency and how often this rate is increase or decrease and by what percentage?
In result, it will give us the estimated answer that in this assets, the chance of losing is X percentage that the chance of this portfolio will lose Y dollar in the certain time horizon.
In the general term, VAR check out the probability and the confidence level to measure the risk using the following three different models in the it, which are as follows:
Variance- co variance approach.
Historical simulate
Monte carlo method
VARIANCE CO VARIANCE APPROACH
in this approach we simply estimate the two factors which are the most important factors to estimate and measure the risk on the portfolio and the exchange rate risk management, in which we take the average exchange rate or the expected exchange rate and the standard exchange rate and plot the curve
After this plotting the curve we actually know that where the values lies between the 95% or (100 - 95%) 5% lies under the curve and see the actual impact on the exchange rate.
HISTORICAL SIMULATION
In this approach we analysis the past historical data putting them in order from worst to best. We assume that the history repeat itself.
We put all the data like the exchange rate in the histogram and critically analyze our expected rate. We see the chance of occurrence in this histogram as well.
VAR (Value at Risk)
It is always difficult to measure currency risk. One model of calculation that we have come up with is the (VAR) Value at Risk model. In a VAR Model we calculate the Maximum Loss. Keeping in mind the exposure that we are given and certain time period on horizon we take the Z % confidence level.
The VAR can measure many types of risks but the VAR Model has a deficiency in the sense that it doesn't calculate the worst case scenario since that is the exposure for (100- Z) % confidence. Therefore as due to the confrontation of the maximum loss not being derived as it's nearly close to impossible so the companies that use the VAR Model normally set operational limits which in this case may be a stop at loss order or at particular amounts:
There are 3 parameters on which the VAR calculation depends on:
The holding period:
The length of time in which we are going to keep the amount in hands to be swap; normally we acquire it as 1 day.
The confidence level:
This is the Z level of confidence one which we effort on. The Confidence levels that we take are 95% and 99% as we discussed before that we don't go for 100% as it is not possible to absolutely finish the risk but it is probable to lessen the risk.
The Unit of currency:
The unit of currency, which we are using for quantity.
Formula:
Let x= days ; y= Confidence level
If x= 1 & y=99, Then
(100-99) % - 1 = 99%
The VAR can be calculated by many models:
The Historical Simulation :
The return of the currency that firm gets is based on almost the same date as was bereavement with in the past.
The Variance - Co Variance Model:
The return of the currency of a firm is normally scattered and is similarly addiction on all the currency return returns for the value of the foreign exchange that we are dealing with.
Monte Carlo Simulation:
This deals with the randomly distribution of the currency returns that are expected for future.
VAR= - Vp ( Mp + 2.33 x Sp)
Where Vp is the initial Value
Mp is the mean of the currency return and is basically the weighted average of the individual foreign exchange.
Sp is the deviation of the currency return.
Problem Statement
What are the factors that contribute to the exchange rate risk management and how to get minimized the risk with and without the new reserve currency.
Benefits of the Study
This will help students develop a broader horizon as well as will benefit the investors
Scope of Research
In the scope of the study we will find out what are the factors that come into play when we are dealing with the cross rate transactions in exchange rate risk management and what are the remedies and how it can be tackled.
Research Methodology
This is a descriptive research as well as a causal one as we will be concerned with the cause and effect as well. The research will be conducted based on the data available from the secondary resources as well as the replies that we get through our primary data that will be received via students, foreign exchange dealers and invertors through interviewing and questionnaires.
Sampling Method
The sample method will be on that of the collection from students, foreign exchange dealers and invertors.
Research Limitation
The sample shall provide accurate answer.
The Time Factor is also one of the limitations as we need to complete it in a given framework of time.
Solution:
Based on our research and this studies, we have come up with the result after analyzing the questionnaires and having the personal meeting and interviewing with SME Exporter we have identified that most of the investors, business man, SME Sector business man, exporter and debtors plus the money changer and marketer they are not using the VAR model thoroughly as they should have to do the reason behind this is that most of them are unaware about the VAR and CAR model but they are using some part of it by default as we describe earlier which is based on the past historic exchange rate. We have also found that some of the SME sector business man is using the pre determined historic simulated exchange rate based on their past preserved experience.
Following are our analysis regarding the SDR analysis which is also based on the interviews and data gathered with our questionnaires
Adoption of a new reserve currency, 2 reformed and unstructured SDR.
The SDR will be rehabilitated.
Transmission weight age of different component (Currencies to the reformed SDR).
The principles will be :-
Equity
Proportionate Representation of all major developed and developing economics of all regions.
Diversification of risks associated with having a single Country's currency as a preserve currency.
To unshackle from the ascendancy of a single currency.
Including:
Observation authenticity.
Inclusion of Yuan and Russian Ruble bearing in mind the size of the economies.
Inclusion of Swiss Frank as nature of Swiss economy.
Name of the Currency : Bancor
This is named after John Maynard Keynes, who gave idea of multinational currency.
extent:
USA : 37%
Euro : 23 %
Swiss: 12%
Yuan: 18%
Ruble: 10%
100%
Dollar not able to keep unwavering value share therefore
Dollar is positioned first at 62 %
Euro is positioned second 27 %
Contemporary Asian Economics confine 47% of the market.
The Risk can't be eliminated but can be tone down and we understand by SDR it can be achieved.
Due to the systematic Risks. A Country will facade the interest rate alarm or the depreciation of currency, hence it imparts the imports and Exports as the transactions are normally done in Dollars.
