CU-BBA-SEM-IV-Treasury Management

d. Financial risks 3. _______________is associated with an enterprise's ability to convert an asset or security into cash to prevent a loss. a. Liquidity risk b. Operational risk c. Compliance risk d. Financial risks 4. The goal of FX risk management is to _____________ the potential of incurring currency losses caused by exchange rate movements. a. Minimise b. Maximise c. Optimize d. Balance 5. Mention the stakeholders of the company a. Shareholders, b. Rating agencies c. Regulators, d. All of these Answers 1-a, 2-d, 3-a, 4-a, 5-d 6.13 REFERENCES Reference books  Chapman, C., & Ward, S. (1997): Project risk management. JOHN WILEY & Sons.  Courtney, H., Kirkland, J., and Viguerie, P. (1997): Strategy under uncertainty. Harvard Business Review. November/ December Textbooks  Knight, F. H. (1921): Risk, Uncertainty, and Profit. Houghton Mifflin Company. 101 CU IDOL SELF LEARNING MATERIAL (SLM)

 Peter Romilly, P. (2007): Business and climate change risk: a regional time series analysis. Journal of International Business Studies.  Ephraim Clark, E., Marois, B. (1996): Managing Risk in International Business. Intl Thomson Business Press.  Oetzel, J.M., Bettis, R.A. and Zenner, M. (2001): Country Risk Measures: How Risky Are They? Journal of World Business Websites  http://www.slideshare.net/sreenath.s/evolution-of-hrm  www.articlesbase.com/training-articles/evolution-of-human-resource- management- 1294285.html  http://www.oppapers.com/subjects/different-kinds-of-approaches-to-hrm- page1.html 102 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 7: FINANCIAL RISK 103 STRUCTURE 7.0 Learning objectives 7.1 Introduction 7.2 Meaning of financial risk 7.3 Types of financial risk 7.4 Market Risks 7.4.1 Types of Market Risks 7.4.2 Measures of Market Risks 7.4.3 Regulations of Market Risks 7.4.4 Strategy to reduce market risk 7.5 Credit Risk 7.5.1 Credit risk analysis 7.5.2 Credit risk ratio 7.5.3 Counter party credit risk 7.5.4 Credit rating 7.5.5 Credit risk transfer 7.5.6 Mitigation of credit risk 7.6 Liquidity Risk 7.6.1 Reasons for liquidity risks 7.6.2 Types of liquidity risks 7.6.3 Measures to assess the liquidity of various assets 7.6.4 Relevant ratios to measure liquidity risk 7.6.5 Ways to manage liquidity risk 7.7 Legal Risk 7.7.1 Types of legal risks 7.7.2 Mitigation of legal risks 7.8 Operational risk 7.9 Summary CU IDOL SELF LEARNING MATERIAL (SLM)

7.10 Key words 7.11 Learning Activity 7.12 Unit end questions 7.13 References 7.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Identify financial risks  Find out the causes and mitigation of market risks  Discuss the credit risks  Describe the Liquidity risks and Legal risks  Recall the operational risk 7.1 INTRODUCTION Financial markets face financial risk due to various macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations. Individuals face financial risk when they make decisions that may jeopardize their income or ability to pay a debt they have assumed. The probability that some event will cause an undesirable outcome on the financial health of the business. 7.2 MEANING OF FINANCIAL RISK Financial risk is the possibility of losing money on an investment or business venture. Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk. Financial risk is a type of danger that can result in the loss of capital to interested parties. 7.3 TYPES OF FINANCIAL RISKS There are 5 main types of financial risk:  Market risk,  Credit risk,  Liquidity risk,  Legal risk and  Operational risk 104 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 7.1 Financial risk 7.4 MARKET RISK Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. Figure 7.2 Market risk 105 CU IDOL SELF LEARNING MATERIAL (SLM)

Market risk is the risk of change or decrease in the value of investments due to changes in uncontrollable market factors. These market factors can be recession or depression, changes in government policies affecting key interest rates, natural calamities, and disasters, political unrest, terrorism, etc. It is also known as systematic risk. 7.4.1 Types of market risk  Interest rate risk: Central Government changes rates by change n its monetary policy  Equity risk: It is risk of the possibility of changes in the prices of stocks and stock indices  Currency risk: It arises from exchange rate fluctuations that occur between different currencies.  Commodity risk: commodities price changes in international markets. arises when essential  Margining risk: It arises out of unfavourable margin calls covering a position.  Country risk: Such as political environment and stability, fiscal deficit levels, government rules 7.4.2 Measure of market risk Market risk is measured for a time period of one year or less. There are two methods to measure the marker risk. They are following under: 1. VAR method The best measure of market risk is the value-at-risk or VAR method. It is a statistical method for managing risk. To estimate the probability of the loss, with a confidence interval, we need to define the probability distributions of individual risks. The focus in VAR is clearly on downside risk and potential losses. Its use in banks reflects their fear of a liquidity crisis, where a low-probability catastrophic occurrence creates a loss that wipes out the capital and creates a client exodus. There are three key elements of VaR – a specified level of loss in value, a fixed time period over which risk is assessed and a confidence interval. Thus, we could compute the VAR for a large investment project for a firm in terms of competitive and firm-specific risks and the VAR for a gold mining company in terms of gold price risk. 2. Beta coefficient CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital. Beta is used in this model. Sometimes it refers to volatile when it is equal to one, when it is greater than one then it is more volatility and if it is lesser than investment it denotes less volatile than market. 106 CU IDOL SELF LEARNING MATERIAL (SLM)

7.4.3 Regulations for market risk There are a few regulations too with regards to disclosure of the market risk of investments. The Securities and Exchange Commission makes it compulsory for companies to disclose their market risk exposure in a section in all annual reports submitted on Form 10-K. It requires the companies to disclose their exposure to financial markets and how volatility in the markets will impact them. 7.4.4 Strategy to reduce market risk Risk is primarily the probability of a bad event happening or a good event not happening. Thus, risk to an investor in the financial market context refers to the possibility Concentration risk is the risk that trader run when he is entirely or substantially invested in one theme or sector. If something goes wrong with the sector, the entire portfolio may go for a loss. The answer to concentration risk is diversification. The trader don’t have control over how the company performs, but he have control over which stocks/themes he want to be invested in. Tweak your portfolio to mitigate interest rate risk Interest risk and inflation risk are related because normally higher inflation leads to higher interest rates. This impacts equities and bonds. When rates are cut, bond prices go up, which improves the NAV of bond funds. Even in case of equities, lower rates discount the future cash flows at a lower rate and boosts valuation. The reverse holds when rates rise. If the trader is invested in bonds, he can shift maturities and if the trader is in equities, he need to tweak your exposure to rate-sensitive sectors such as banks, NBFCs, auto, and realty. Hedge your portfolio against currency risk You may wonder why currency risk would impact your rupee portfolio. The problem is that the companies that you invest in are vulnerable to currency risk and that spills over to your returns. For example, IT, pharma, and auto ancillaries are essentially export-oriented and benefit from a strong dollar. Sectors such as capital goods, power, and telecom are importers and benefit from a stronger rupee. When you create your portfolio, keep a mix of dollar defensives and rupee defensives to hedge your risk. Go long-term for getting through volatility times The bad news is that whether the trader is invested in bonds or equities, he cannot escape volatility. He can manage volatility by taking a long-term and systematic approach. When he play the market as a short-term trader, volatility hits him really hard. From a long-term perspective, volatility in equities tend to even out over time. Further, a systematic or phased approach helps even out volatility. Stick to low impact-cost names to beat liquidity risk 107 CU IDOL SELF LEARNING MATERIAL (SLM)

Liquidity risk arises when you are unable to exit or enter a particular stock within trader price range. This problem becomes more profound when the markets become volatile. In a crashing market, liquidity may be hard across all stocks. However, in normal market conditions, the trader can avoid this risk by sticking to the low impact-cost stocks. Fight horizon risk arising out of assets-liability mismatch This is a risk that has nothing to do with market conditions, but more to do with trader own investment decision. IL&FS is today in a crisis because it borrowed short-term money and lent to infrastructure projects. This is the best example of horizon risk on a very large scale. If you invest in equities for a goal that is just three years away, the trader could very well end up in trouble. The answer lies in structuring investments as per the horizon of trader liabilities. Triumph over reinvestment risk In mutual funds, the trader can opt for growth plans and in equities, go for low-dividend and high-growth companies. In addition, there is also geopolitical risk, which normally gets factored in volatility risk of a stock or the market. 7.5 CREDIT RISK Credit risk is the risk of non-payment of a loan by the borrower. In other words, it can define it as the risk that the borrower may not repay the principal amount or the interest payments associated with it (or both) partly or fully. This results in the loss for the lender in the form of disruption of cash flows and increased collection cost. It can be a result of any of the following reasons – poor cash flows of the borrower making it difficult to pay the interest and the principal amount, rising interest rates in case of floating interest rate loans, change in market conditions, business failure, unwillingness to repay, etc. 7.5.1 Credit risk analysis For assessing the credit risk, borrower’s credit history, his asset-holding, capital, his overall financial strength, his ability to repay the debt, the probability of default by the borrower during the tenure of payment etc. are some of the important factors to consider. 7.5.2 Credit risk ratio Its ratio is calculated as a percentage or likelihood that lenders will suffer losses due to the borrower’s inability to repay the loan on time. It acts as a deciding factor for making investments or for taking lending decisions. Generally, banks and lenders classify credit risk as high, medium or low based on the credit rating model designed for the internal use of the company. Many companies (banks/lending institutions/private lenders) follow the credit rating reports of renowned credit rating agencies. 108 CU IDOL SELF LEARNING MATERIAL (SLM)

7.5.3 Counter party credit risk Counterparty credit risk is the risk that a counterparty (i.e. another party of the contract) will not fulfill his financial obligation mentioned in the contract. It is also known as default risk. High counterparty risk requires a high-interest payment and vice versa. 7.5.4 Credit rating Based on its assessment, a credit rating is assigned to the borrower. These ratings are assigned by the credit rating agencies like Standard & Poor’s (S&P), Moody’s Investors Services, Fitch Ratings, CRISIL, CARE, etc. A high credit rating denotes high chances of recovery of the loan and a low credit rating denotes that there might be a trouble in the recovery of the loan from the borrower, based on his past performance, or bad credit risk associated with his name, low credit score, etc. Like for example, AAA or AA+ rating given by S&P means there is very low or almost no risk of default. Similarly, D or CCC or CC rating means there is a high risk of default by the borrower 7.5.5 Credit risk transfer Credit risk transfer is a credit risk management strategy whereby the risk is transferred from one party to another. This can be done by taking credit risk insurance, financial guarantee, etc. 7.5.6 Mitigation of credit risk To mitigate or reduce the it, lenders often perform a credit check on the borrower, take security from the borrower, take a guarantee from the third party, ask the borrower to take required insurance, etc. In order to select the right way of mitigating credit risk, proper credit risk assessment is important. 7.6 LIQUIDITY RISK Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM). It can affect the entire financial ecosystem and even the global economy. Example of Liquidity Risk Inability to meet short-term debt due to exceptional losses or damages during Operations. Unable to meet proper funding within a specific time-frame. The rise of material causes rises in manufacturing expense for the concern. 7.6.1 Reasons for liquidity risk There are many causes of liquidity risk liquidity risk actually arises when the one party wants to trading an asset cannot do it because in the market no one wants to trade that asset .The 109 CU IDOL SELF LEARNING MATERIAL (SLM)

persons who are about to hold or currently hold the asset and want to trade that asset then liquidity risk become partial important to them as it affects their ability to do business. From drop of price to zero is very different from that appearance of liquidity risk. In the case when the assets price drop to zero then market said that asset is valueless. On the other hand when one party found that the other party is not interested in buying and selling of an asset then it became a big problem for the participant of a market to find the other interested party. So we can say that in the emerging markets or low volume markets the risk of liquidity is higher. Due to uncertain liquidity the liquidity risk is known as a financial risk. When the credit rating falls the institution may lose its liquidity, in this way rapid unexpected cash outflows, or as a result of this happening the counterparties may avoid the business of buying and selling with or borrowing the loan to the institutions. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. The firm is also seen to the risk of liquidity when the markets in they depend are under the liquidity loss. Liquidity risks tend 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. Let us suppose a firm has a cash flows offsetting on a given day of with two different counter parties. If the counter party do not make the payment and become a payment defaults. In this way firm will have to make the cash from some other sources in order to make payment. Credit risk is the risk arises due to the liquidity. A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example-the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. As compared to the risks like market, credit and other risks the liquidity risk is also has to be managed. It is impossible to isolate the liquidity risk because it has the tendency to compound the other risks overall the most simple circumstances. Liquidity risk does not exist in the comprehensive metrics. In order to assessed the liquidity risk the certain techniques of asset liability management can be applied on a day by day basis. A simple test is conducted for the liquidity risk in ordered to see the net cash flows. Any day which shows a sizeable negative cash flow is of concern. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization’s cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps 110 CU IDOL SELF LEARNING MATERIAL (SLM)

 Gap between demand and supply  Depends on the type of asset  Cash flow constraints 7.6.2 Types of liquidity risk 1. Funding liquidity risk 2. Market liquidity risk The other types of liquidity risks are:  Widening bid/offer spread  Making explicit liquidity reserves  Lengthening holding period for Vary calculations  Funding liquidity – Risk that liability:  Cannot be met when they fall due  Can only be met at an uneconomic price  Can be name-specific or systemic 7.6.3 Measures to assess the liquidity of various assets 1. Bid-ask spread: The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product’s mid-price can be used. The smaller the ratio the more liquid the asset is. This spread is comprised of operational costs, administrative and processing costs as well as the compensation required for the possibility of trading with a more informed trader. 2. Depth of the market: It refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price. 3. Immediacy: it refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost. 4. Resilience: The fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time. 111 CU IDOL SELF LEARNING MATERIAL (SLM)

7.6.4 Relevant ratios to measure liquidity risk Current Ratio The calculation of the current ratio is done by dividing the current assets by the company’s current liabilities. This ratio gives an indication of the comfort level of the company in meeting its short-term liabilities, with the available quantum of current assets. Naturally, the higher the ratio, the higher would be the comfort level of the company. And that means the company will have no issue in discharging its current obligations. Similarly, a low ratio or a ratio less than one will mean that the current assets are not adequate enough to meet its current liability requirements. Quick Ratio The quick ratio is another form of the current ratio, but it includes only highly liquid assets in the category of current assets. These assets include cash, marketable securities, and accounts receivables. Therefore, the sum of these highly liquid assets is divided by the total current liabilities of the company to find out the ratio. A higher current ratio indicates that The Company is in a good position to meet its current financial obligations and vice-versa. Interest Coverage Ratio This ratio measures how capable a company is to pay off the interest on its outstanding loans by its earnings before interest and taxes. The calculation for the Interest coverage ratio is done by dividing the company’s EBIT by its total interest obligations. A high ratio will mean that the company is in a good position and there is negligible liquidity risk or failure to pay interest on time. On the other hand, a low-interest coverage ratio will imply that the company earns barely enough to meet its interest expenses, and hence, its liquidity position is not very good and interest payment sometimes may delay. 7.6.5 Ways to manage liquidity risk Effective cash flows Proper estimation and forecasting of cash flow can help a business to effectively plan its liquidity requirements. It can plan its expenses in accordance with the estimated future cash flows and avoid any period of trouble. Keeping a Track of Liquid Assets A company or an investor should keep proper track of its liquid assets in hand. This will help it to determine its liquidity position to successfully meet a case of an urgent need. Also, it should know before-hand the proper markets and channels through which it can liquidate its assets quickly in times of emergency. Investment Management 112 CU IDOL SELF LEARNING MATERIAL (SLM)

A business or an investor should keep sufficient investments in liquid assets first. And then go for illiquid assets like land, buildings, etc. This will help it to raise cash in times of urgency without suffering big losses. Also, a well-diversified portfolio is important to be able to handle setbacks if any particular investment fails. Managing and Reducing Leverage High debt obligations can cause liquidity risks for a company or individual. Hence, leveraging should be properly managed and controlled. And over-reliance on debt should not be there. Lower leverage means a reduced quantum of liabilities. And it will lead to curtailing the company’s liquidity risk. 7.7 LEGAL RISK Legal risk is the risk of financial or reputational loss that can result from lack of awareness or misunderstanding of, ambiguity in, or reckless indifference to, the way law and regulation apply to your business, its relationships, processes, products and services. There are three steps to identify legal risks: Step 1: Find sources of legal risk. The primary sources of legal risk are contracts, regulations, litigation, and structural changes. Step 2: Recognize potential and actual risks Step 3: Record risks in a risk register. 7.7.1 Types of Legal Risks Regulatory Risks turning into legal risks These are the risks that arise out of regulations and laws that govern a business organization or the market in which it operates. Every country and the government lays down certain laws and regulations for the proper operations of the businesses. And all the businesses have to comply with those rules and regulations of the land. Moreover, any Non-compliance can have serious consequences for any organization. For example, a business can face strict penalties and even closure in case of non-compliance with regulations with regard to taxation. Risks with regards to contracts Businesses have to enter into contracts almost on daily basis. Hence, a business organization faces contractual risk on a daily basis. These risks pertain to its contractual obligations with the third parties. A business can face legal risks and hurdles in case of non-fulfillment of these very contracts. Failure to deliver goods and services within the agreed deadlines as per the contract is a contractual risk. Also, failure to deliver goods and services completely, deficiency in the provision of service, quality issues, etc. are all contractual risks that a business faces. 113 CU IDOL SELF LEARNING MATERIAL (SLM)

Non-contractual risks There are risks that can arise for a business even without being a part of any contract with a third party. A competitor may infringe an organization’s patents and copyrights, or launch a similar product like the one a company is offering. The situation can be the opposite too. Other companies can file a lawsuit against a company. This can be for matters such as trademarks, patents, and copyright infringement. Also, a company may face cases and lawsuits for harm or loss caused to a consumer. This may be due to a faulty product, or a damaged product. For example, many times cosmetic companies face lawsuits by a consumer for harm caused by the company’s cosmetic products. The harm may be totally unintentional and just a one-off case out of millions of products sold. It may still cause a significant loss to the company. It may have to pay a huge compensation amount. Also, it may lead to a loss of reputation and brand image. Compliance risk Compliance risks are those risks that pertain to the various compliances that a business is subject to. These compliances may be with regards to its internal policies and practices. It may be regarding external policies and statutes of the government and other statutory bodies. Risk of disputes A business faces regular disruptions due to multiple disputes. These may be with customers, employees, or other stakeholders. It should deal cautiously with such disputes. Mishandling can result in the filing of cases and litigations by the aggrieved party. This can pose risk to a business and cause undue loss to it in terms of wastage of time to deal with such litigations. Also, the expense the business will incur to fight such cases can be very heavy. 7.7.2 Mitigation of Legal Risks Corporate governance The legal department in a business organization should ensure strong and ethical corporate governance within the organization. It should make sure that the business conducts ethical and legal transactions and practices that reduce the legal risks to the minimum. The management should ensure that there is a proper system in place for day-to-day activities like consumer dealing, grievances handling, taxation, and statutory compliances, efficient and active paperwork handling and documentation, etc. After putting a proper structure in place, threats that can pose a legal risk in the organization need to be identified. Hence, instances and loopholes that may allow fraud, thefts, unlawful and unethical activities need to be checked to the best possible extent. Measures like internal audits and controls, awareness programs, etc. can help to keep a check on such activities. Assets 114 CU IDOL SELF LEARNING MATERIAL (SLM)

A business needs to protect its tangible and intangible assets from any damage, thefts, wastages, and breakdowns. It should ensure no harm is caused by its assets to any person, employee, agency or institution both internally and externally. This will help to keep any possibility of legal risk by way of claims to damages, penalties, legal suits, etc. to the minimum. Regulations and controls Any organization needs to ensure that it complies with all the possible rules and regulations of the government and the statutory bodies that govern it. It should adhere to the laws and statutes of the land to minimize any possibility of legal risks. Strict compliance measures, policies, and protocols should be put in place. Management and concerned departments should ensure compulsory adherence to them throughout the organization. Non-compliance with regulations can result in economic loss to an organization and may be harmful to its future too. Any changes in the work pattern or line of activities should only be incorporated after a thorough examination of compliances and regulations. Contractual fulfillment Management should ensure efficient handling of each and every contract and ensure their successful completion. Non-completion and delivery on time may pose legal risks to the organization. Moreover, the organization must ensure an error-free production process. That will avoid any chance of faulty product reaching the client or consumer. The chances of manual mistakes, overburdening of employees and resources, inability to deliver due to shortages or defects, etc. should be brought down to the minimum possible levels. Managers should be well informed about the company’s production and delivery potential and schedule. All this can bring down the legal risks considerably. Disputes and conflicts There should be an appropriate dispute and grievance redressal body in the organization. This will provide an appropriate forum to stakeholders such as employees, suppliers, and consumers to approach it in case of any grievance or dispute. The management should ensure there is no unnecessary litigation or claims on the company and legal risk, if any, are always in control. Also, this will ensure no damage is done to its business relations with customers and suppliers, and there are no employee grievances as well. This will help in building goodwill and saving a lot of valuable time and resources on legal risks. 7.8 OPERATIONAL RISK Operational risk is \"the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events (including legal risk), differ from the expected losses\" 115 CU IDOL SELF LEARNING MATERIAL (SLM)

Operational risk (OR) is the risk of loss due to errors, breaches, interruptions or damages either intentional or accidental caused by people, internal processes, systems or external events. For example, an error or fraud in a bank's credit-underwriting process can cause the bank's credit costs to rise. The term operational risk management ( ORM) is defined as a continual cyclic process which includes risk assessment, risk decision making, and implementation of risk controls, which results in acceptance, mitigation, or avoidance of risk. 7.9 SUMMARY  Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk. Financial risk is a type of danger that can result in the loss of capital to interested parties.  Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets.  Credit risk monitoring has become very important in order to know the creditworthiness of an individual or an organization  Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM)  Legal risks are part and parcel of the business. It cannot avoid it but all attempts should be made to mitigate or minimize these. Because the outcome of these risks could be far-reaching in terms of financial, operational, goodwill, and more. A well prepared and awakened legal department can help the organization to take care of this aspects  Operational Risk: This type of risk arises out of operational failures such as mismanagement or technical failures. 7.10 KEYWORDS  Risk can be referred to like the chances of having an unexpected or negative outcome  An interest rate refers to the amount charged by a lender to a borrower for any form of debt.  Credit rating: A credit rating is a measurement of a person or business entity's ability to repay a financial obligation based on income and past repayment histories. Usually 116 CU IDOL SELF LEARNING MATERIAL (SLM)

expressed as a credit score, banks and lenders use a credit rating as one of the factors to determine whether to lend money.  Current assets: easily convertible into cash within a year or less than a year.  Legal constraints: Legal constraints are legal laws that control the media sector and it's important that these laws are followed or you could be fined and investigated by the police  Operational risk (OR) is the risk of loss due to errors, breaches, interruptions or damages either intentional or accidental caused by people, internal processes, systems or external events.  Compliance risk – It is the risk pertaining to internal and external processes. 7.11 LEARNING ACTIVITY 1. How does credit risk arise? ___________________________________________________________________________ ___________________________________________________________________________ 2. How can the trader reduce risk in forex? ___________________________________________________________________________ ____________________________________________________________________ 7.12 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. List out the types of marketing risks. 2. What is credit risk transfer? 3. Mention the types of liquidity risk 4. What are current assets? 5. What are the ways to manage liquidity risk? 6. How you mitigate the operational risk. Long Questions 1. What is a financial risk? Explain. 2. Identify the causes for market risk. 3. What do you mean by credit rating? Explain. 117 CU IDOL SELF LEARNING MATERIAL (SLM)

4. Give the relevant ratios to measure liquidity risks 5. How will you measure the marketing risks? 6. How to mitigate the legal risk. Discuss. B. Multiple Choice Questions 1. ------------------------risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets a. Market risk b. Interest rate risk c. Liquidity risk d. Legal risk 2. Current assets means------ a. Convertible into cash within a years b. Convertible into cash within 3 years c. Convertible into cash within 5years d. Convertible into cash within 10 years 3. An ------ rate refers to the amount charged by a lender to a borrower for any form of debt a. Bank rate b. Swap rate c. Currency rate d. Interest rate 4. Financial risks include a. Interest rate b. Bank rate c. Vendor rate d. Current rate 118 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Systematic risk is also known as a. Credit risk b. Market risk c. Liquidity risk d. Operational risk Answers 1-a, 2-a, 3-d. 4-a 5-c 7.13 REFERENCES References books  Rajiv Srivastava and Anil Misra, Financial Management, Oxford university press.  S.N.Maheswari Financial Management, Sultan Chand, New Delhi Textbooks  Punidavathi pandiyan. Financial Management. Mumbai: Himalaya Publishing House.  I.M.Pandey, Financial Management, Pearson  Essentials of financial management, Pearson Websites  https://efinancemanagement.com/sources-of-finance/cred  https://www.indiainfoline.com/article/news-personal-finance/8-ways-to-mitigate- market-risks-and-make-the-best-of-your-investments-118101900122_1.html  https://www.google.com/search?sxsrf=ALeKk03- OH4OnQzRjoPpjJFsxfvwVmk5ZA:1625469522783&source=univ&tbm=isch&q=cre dit+risk+images&sa=X&ved=2ahUKEwivg_7rscvxAhVr7XMBHeeVB_wQ7Al6BA gF  https://www.wallstreetmojo.com/credit-risk-examples/ 119 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 8: ENTERPRISE AND FOREX RISK 120 MANAGEMENT STRUCTURE 8.0 Learning Objectives 8.1 Introduction-ERM 8.2 Purpose of ERM 8.3 Responsible for ERM 8.4 Requirement for effective ERM 8.5 Significance of ERM 8.6 Forex Risk Management. 8.6.1 Importance of forex risk management 8.6.2 Fundamentals of forex risk management 8.7 Risk of forex fluctuations 8.7.1 causes of forex fluctuations 8.8 Forex rates 8.9 Types of forex rates 8.9.1 Difference between fixed exchange rate and flexible exchange rate 8.10 Increased forex risk affects business 8.11 Forex affects economy 8.12Global events affect the forex market 8.13 Impact of forex risk fluctuations in global millieu 8.14 Summary 8.15 Keywords 8.16 Learning Activity 8.17 Unit End Questions 8.18 References 8.0 LEARNING OBJECTIVES After studying this unit, you will be able to: CU IDOL SELF LEARNING MATERIAL (SLM)

 Analyse the ERM.  Find out the requirements for effective ERM  Discuss the importance of forex risk management  Explain the causes of forex fluctuations  Describe the impact of forex fluctuations in global milieu. 8.1 INTRODUCTION Enterprise risk management (ERM) is the process of identifying and addressing methodically the potential events that represent risks to the achievement of strategic objectives, or to opportunities to gain competitive advantage. The framework emphasizes entity wide risk management across four objectives: strategic, operations, reporting, and compliance. Enterprise Risk Management (ERM) is important because its success determines the health and life of the business enterprise. Therefore, they identify that risk and address it by developing multiple sources so reducing that particular risk. 8.2 PURPOSE OF ERM Enterprise risk management (ERM) is a firm-wide strategy to identify and prepare for hazards with a company's finances, operations, and objectives. ERM allows managers to shape the firm's overall risk position by mandating certain business segments engage with or disengage from particular activities. The framework emphasizes entity wide risk management across four objectives: strategic, operations, reporting, and compliance. 8.3 RESPONSIBLE FOR ERM Everyone in the organization plays a role in ensuring successful enterprise-wide risk management but management bears the primary responsibility for identifying and managing risk and for implementing ERM in a structured, consistent, and coordinated approach. 8.4 REQUIREMENTS FOR EFFECTIVE ERM  Risk appetite,  Risk measurement,  Culture and governance,  Data management,  Risk controls, 121 CU IDOL SELF LEARNING MATERIAL (SLM)

 Scenario planning and  Stress testing These are among the critical components of a successful enterprise risk management program. 8.5 SIGNIFICANCE OF ERM  Companies often start new endeavours to explore business opportunities. But there is an uncertainty whether the companies would take the opportunities or not. As every endeavour comes with an associated risk, therefore having the enterprise risk management solutions is necessary.  Companies have to increase the capability of risk-taking to handle all the opportunities, which keep knocking at their doors. With the right Risk Management Solutions, it becomes possible for the organizations to identify and analyse the risks. And therefore they can decide which risk is worth to take.  Projects can directly control opportunities and risks within the remit. Therefore, the performance of the project entirely depends on all the obstacles that are thrown up by the organization or enterprise and other outside influences that are outside the control of project management.  Enterprise Risk Management is necessary as the success of this system decides the endurance and vitality of the company. In case a company fails to identify the risks to the existence, this would be ill-prepared to face all the risk events. For instance, businesses that depend on the sole source supplier are at big risk. This is why it is necessary to identify the risk and then address that by developing various sources to decrease that specific.  Last but not least, Enterprise Risk Management Solutions are also helpful in institutionalizing the procedures of risk management in every company by standardizing the methodology, tools and the company procedures in monitoring the risks of an individual project. It is necessary to ensure that the effects of individual project failures should be appropriately addressed.  To excel in ERM 122 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 8.1 ERM 8.6 FOREX RISK MANAGEMENT The forex market allows participants, including banks, funds, and individuals, to buy, sell or exchange currencies for both hedging and speculative purposes. In the forex market risk is comparatively greater than other market Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. The three types of foreign exchange risk include transaction risk, economic risk, and translation risk. Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets. To minimize the forex risk, the trader must take the forex risk management strategy to avoid the losses. Forex risk management enables the trader to implement a set of rules and measures to ensure any negative impact of a forex trade is manageable. An effective strategy requires proper planning from the outset, since it's better to have a risk management plan in place before the trader actually start trading Forex risk management comprises individual actions that allow traders to protect against the downside of a trade. More risk means higher chance of sizeable returns – but also a greater chance of significant losses. Therefore, being able to manage the levels of risk to minimize loss, while maximizing gains, is a key skill for any trader to have. The traders do this by Risk management. It can include establishing the correct position size, setting stop losses, and controlling emotions when entering and exiting positions. Implemented well, these measures can prove to be the difference between profitable trading and losing it all. 8.6.1 Importance of forex risk management Good forex risk management can bring the company the following benefits: Better protection for the company in cash flow and profit margins, deeper understanding of how forex fluctuations affect the balance sheet, increased borrowing capacity, leading to faster growth and a stronger competitive edge. 123 CU IDOL SELF LEARNING MATERIAL (SLM)

Exchange rate risk cannot be avoided altogether when investing overseas, but it can be mitigated considerably through the use of hedging techniques. The easiest solution is to invest in hedged investments such as hedged ETFs. The fund manager of a hedged ETF can hedge forex risk at a relatively lower cost. 8.6.2 Fundamentals of forex risk management In the digital trading sudden risk can become completely out of control, in part due to the speed at which a transaction can take place. Many traders face issues. Hence, they might turn to online trading as a form of gambling rather than approaching trading as a professional business that requires proper speculative habits. Speculating as a trader is not gambling. The difference between gambling and speculating is risk management Appetite for Risk Working out the appetite for risk is central to proper forex risk management. Traders should ask: How much am I willing to lose in a single trade? This is particularly important for the most volatile currency pairs, such as certain emerging market currencies. Also, liquidity in forex trading is a factor that affects risk management, as less liquid currency pairs may mean it is harder to enter and exit positions at the price you want. If the trader don’t know how much they are comfortable with losing, their position size may end up too high, resulting in losses that may affect their ability to take on the next trade – or worse Position Size Selecting the right position size, or the number of lots the trader take on a trade, is important as the right size will both protect both their account and maximize opportunities. To select the position size, trader need to work out their stop placement, determine their risk percentage and evaluate their pip cost and lot size. Stop Losses This fundamental point is the price at which the trader breaks even if the market cuts him out at that point. Once the trader protected by a break-even stop, his risk has virtually been reduced to zero, as long as the market is very liquid and he know his trade will be executed at that price. The trader should understand the difference between stop orders, limit orders and market orders. Using stop loss orders – which are placed to close a trade when a specific price is reached – is another key concept to understand for effective risk management in forex trading. Knowing the point in advance at which the trader want to exit a position means , then the trader can prevent potentially significant losses. 124 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 8.2 Market risk A market order is an instruction to buy or sell a security immediately at the current price. A limit order is an instruction to buy or sell only at a price specified by the investor. Market orders are best used for buying or selling large-cap stocks, futures, or ETFs. A limit order is preferable if buying or selling a thinly traded or highly volatile asset. The market order is the most common transaction type made in the stock markets. It is the default choice in most online broker transaction pages. Leverage Leverage in forex allows traders to gain more exposure than their trading account might otherwise allow, meaning higher potential to profit, but also higher risk. Leverage should, therefore, be managed carefully. Controlling Your Emotions It’s important to be able to manage the emotions of trading when risking traders’ money in any financial market. Letting excitement, greed, fear or boredom affect traders’ decisions may expose to undue risk. The traders should maintain a forex trading journal or log can help to refine their strategies based on prior data – and not on their feelings. 8.7 RISK OF FOREX FLUCTUATIONS Foreign exchange risk arises when a company engages in financial transactions denominated in a currency other than the currency where that company is MNC. If a currency's value fluctuates between when the contract is signed and the delivery date, it could cause a loss for one of the parties. 125 CU IDOL SELF LEARNING MATERIAL (SLM)

Currencies fluctuate based on supply and demand. Most of the world's currencies are bought and sold based on flexible exchange rates, meaning their prices fluctuate based on the supply and demand in the foreign exchange market. The fluctuation of a country's currency can have a far-reaching impact on the country's economy, consumers, businesses and remittance inflows. This means that whether a country's currency appreciates or depreciates, it will have both positive and negative impacts on a country's economy, depending on the sector. The best way to protect foreign returns is to invest in mutual funds or exchange-traded funds that are hedged, says Boyle. These funds usually use sophisticated investments like futures and options to hedge the currency risk of a bond or equity, and reduce losses. 8.7.1 Causes of forex fluctuations A high demand for a currency or a shortage in its supply will cause an increase in price. ... A currency's supply and demand are tied to a number of intertwined factors including the country's monetary policy, the rate of inflation, and political and economic conditions. Factors that Affect Foreign Exchange Rates are  Inflation Rates. Changes in market inflation cause changes in currency exchange rates.  Interest Rates.  Country's Current Account / Balance of Payments.  Government Debt  Terms of Trade.  Political Stability & Performance. ...  Recession  Speculation. The major causes for forex fluctuations are Trade Movements: Any change in imports or exports will certainly cause a change in the rate of exchange. If imports exceed exports, the demand for foreign currency rises; hence the rate of exchange moves against the country. Conversely, if exports exceed imports, the demand for domestic currency rises and the rate of exchange moves in favour of the country. Capital Movements: International capital movements from one country for short periods to avail of the high rate of interest prevailing abroad or for long periods for the purpose of making long-term investment abroad. Any export or import of capital from one country to another will bring about a change in the rate of exchange. 126 CU IDOL SELF LEARNING MATERIAL (SLM)

Stock Exchange Operations: These include granting of loans, payment of interest on foreign loans, repatriation of foreign capital, purchase and sale of foreign securities e c., which influence demand for foreign funds and through it the exchange rates. For instance, when a loan is given by the home country to a foreign nation, the demand for foreign money increases and the rate of exchange tends to move unfavorably for the home country. But, when foreigners repay their loan, the demand for home currency exceeds its supply and the rate of exchange becomes favorable. Speculative Transactions: These include transactions ranging from anticipation of seasonal movements in exchange rates to the extreme one, viz., flight of capital. In periods of political uncertainty, there is heavy speculation in foreign money. There is a scramble for purchasing certain currencies and some currencies are unloaded. Thus, speculative activities bring about wide fluctuations in exchange rates. Banking Operations: Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue letters of credit, accept foreign bills of exchange, take up arbitrage, etc. These operations influence the demand for and supply of foreign exchange, and hence the exchange rates. Monetary Policy: An expansionist monetary policy has generally an inflationary impact, while a constructionist policy tends to have a deflationary inflation. Inflation and deflation bring about a change in the internal value of money. This reflects in a similar change in the external value of money. Inflation means a rise in the domestic price level, fall in the internal purchasing power of money, and hence a fall in the exchange rate. Political Conditions: Political stability of a country can help very much to maintain a high exchange rate for its currency; for it attracts foreign capital which causes the foreign exchange rate to move in its favour. Political instability, on the other hand, causes a panic flight of capital from the country hence the home currency depreciates in the eyes of foreigners and consequently, its exchange value falls. 8.8 FOREIGN EXCHANGE RATES  In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in terms of another currency. 127 CU IDOL SELF LEARNING MATERIAL (SLM)

 An exchange rate is the rate at which one currency can be exchanged for another between nations or economic zones. It is used to determine the value of various currencies in relation to each other and is important in determining trade and capital flow dynamics.  Currency prices can be determined in two main ways: a floating rate or a fixed rate. A floating rate is determined by the open market through supply and demand on global currency markets. Therefore, most exchange rates are not set but are determined by on-going trading activity in the world's currency markets. 8.9 TYPES OF FOREX RATES There are two kinds of exchange rates: flexible and fixed. Flexible exchange rates change constantly, while fixed exchange rates rarely change. A fixed exchange rate is a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band. Fixed rates provide greater certainty for exporters and importers. Fixed rates also help the government maintain low inflation, which, in the long run, keep interest rates down and stimulates trade and investment. Disadvantages of Fixed Exchange Rates Developing economies often use a fixed-rate system to limit speculation and provide a stable system. A stable system allows importers, exporters, and investors to plan without worrying about currency moves. However, a fixed-rate system limits a central bank's ability to adjust interest rates as needed for economic growth. A fixed-rate system also prevents market adjustments when a currency becomes over or undervalued. Effective management of a fixed-rate system also requires a large pool of reserves to support the currency when it is under pressure. An unrealistic official exchange rate can also lead to the development of a parallel, unofficial, or dual, exchange rate. A large gap between official and unofficial rates can divert hard currency away from the central bank, which can lead to forex shortages and periodic large devaluations. These can be more disruptive to an economy than the periodic adjustment of a floating exchange rate regime. A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate. 128 CU IDOL SELF LEARNING MATERIAL (SLM)

Floating exchange rates mean that currencies change in relative value all the time. For example, one U.S. dollar might buy one British Pound today, but it might only buy 0.95 British Pounds tomorrow. The value \"floats.\" 8.9.1 Differences between fixed exchange rate and fluctuating rate A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly. The major difference between floating and fixed interest rate is that the floating interest rate works out to be cheaper than the fixed one. For instance, if the fixed rate of interest in 15% and the floating interest rate is 12.5%, the borrower ends up saving a lot of money, even when the interest rate rises by 2. 8.10 INCREASED FOREX RISK AFFECT BUSINESS Increased forex has a negative effect on a business. It ensures that governments do not expand the monetary supply too rapidly, thus causing high price inflation. Was worth less. Exchange rate volatility can also have an effect on competition. Depreciation of the local currency makes the cost of importing goods more expensive, which could lead to a decreased volume of imports. Domestic companies should benefit from this as a result of increased sales, profits and jobs. 8.11 FOREX EXCHANGE AFFECT ECONOMY Exchange rates directly impact international trade. Low exchange rates support tourism and the export economy. At that point, domestic goods become less expensive for foreign buyers. Consumers then have more purchasing power to spend on imported goods. Foreign exchange identifies the process of converting domestic currency into international banknotes at particular exchange rates. These transactions present distinct ramifications for the global economy. Foreign exchange rates affect international trade, capital flows and political sentiment. Identification Foreign exchange rates describe valuations for domestic currency, which describe the economic and political standing of your home nation. Low exchange rates may signal recession and political instability. Alternatively, strong exchange rates often serve as an indicator of favorable commercial conditions for a particular country. Exchange rates directly impact international trade. Low exchange rates support tourism and the export economy. At that point, domestic goods become less expensive for foreign buyers. Domestic consumers, however, prefer higher exchange rates. Consumers then have more purchasing power to spend on imported goods. 129 CU IDOL SELF LEARNING MATERIAL (SLM)

Features Foreign exchange rates influence capital flows, or investment funds that move into and out of a country. Nations with rapidly deteriorating currency values are less attractive to foreign investors. At that point, foreigners liquidate their stocks, bonds, and real estate, because these assets are losing purchasing power relative to competing investments in other currencies and countries. International savers prefer to purchase investments in countries that feature stable and appreciating exchange rates. Foreigners are more comfortable making overseas financial commitments when they feel that value will be preserved--as international profits are eventually converted back into their home currency. Considerations Foreign exchange rates carry important political implications. Citizens may point to unfavorable exchange rates and trade imbalances as signs that politicians currently in office are mismanaging the economy. Voters will then agitate for economic reforms and changes in leadership. Politicians may react by proposing domestic tax cuts, while legislating for import duties and quotas designed to protect the economy at home. Benefits The orderly dissemination of exchange rates through organized currency markets leads to increased globalization. Globalization refers to the integration of separate nations, regions and cultures within the world economy. This trend improves the spread of technological innovations, expands markets and creates jobs for the international labor pool. Globalization contains inflation--because the increased competition for jobs and market share places downward pressure on prices. Risks Globalization is associated with contagion, or the spread of financial panic and recession throughout the world. For example, the value of the Mexican peso may collapse due to sovereign default and credit crisis in that country. International investors would then quickly liquidate their Mexican asset holdings. The fallout from Mexico reaches global proportions as savers speculate that all institutions doing business within Mexico are in jeopardy of bankruptcy. Foreigners are then likely to sell off all asset holdings, irrespective of geographic origin, to meet financial obligations and avoid potential losses. The selling pressure causes worldwide asset values to crash. 8.12 GLOBAL EVENTS AFFECT THE FOREX MARKET Political Impact on Currency Prices A political election a common event in almost every nation can have a large impact on a country's currency. Elections can be viewed by traders as an isolated case of potential political instability and uncertainty, which typically equates to greater volatility in the value 130 CU IDOL SELF LEARNING MATERIAL (SLM)

of a country's currency. In most situations, forex participants will simply keep an eye on pre- election polls to get a sense of what to expect and see if there will be any changes at the top. That's because a change in government can mean a change in ideology for the country's citizens, which usually equates to a different approach to monetary or fiscal policy, each serving as big drivers of a currency's value. Additionally, political parties or individuals who are seen as more fiscally responsible or concerned with promoting economic growth tend to boost a currency's relative value. For instance, an incumbent who is seen as a \"pro economy\" that is in danger of losing their position of power may lead to currency drops for fears of limited future economic growth and predictability. Another circumstance of great importance is an unexpected election. Whether it comes via a non-confidence vote, corruption scandals, or other situations, unplanned elections can wreak havoc on a currency. For example, cases of upheaval among citizens that result in protests or work stoppages can cause great uncertainty in countries and increased political instability. Even in cases where an autocratic government is being challenged in favor of a new, more democratic, and economically open-minded government, forex traders don't like the uncertainty. Political instability has a tendency to outweigh any positive outcomes from a new government in the short run, and related currencies will usually suffer losses. However, basic valuation factors and principals will once again apply, and currencies should settle at or around a rate indicative of the country's economic growth prospects over the long term. Impact of Natural Disasters on Currency Prices The fallout from a natural disaster can be catastrophic for a country. Earthquakes, floods, tornadoes, and hurricanes harm a country's citizens, morale, and infrastructure. Additionally, such disasters will also have a negative effect on a nation's currency. The loss of life, damage to major factories and distribution centers, coupled with the uncertainty that inevitably comes with natural disasters, are all bad news for a currency. Infrastructure damage is also a key concern when it comes to the impact of natural disasters. The fact that basic infrastructure is the backbone of any economy breaks in that infrastructure can severely limit the economic output of a region. Furthermore, the additional costs that are incurred to clean up and rebuild after a disaster take away from government and private spending that could have been used towards economically advantageous ventures, rather than towards patching up a break in the value chain from damages in infrastructure. Add to this a probable decrease in consumer spending due to the economic uncertainty and a possible loss of consumer confidence, and any economic strengths can be turned into economic weaknesses. In all, a natural disaster will almost surely negatively affect a nation's currency. 131 CU IDOL SELF LEARNING MATERIAL (SLM)

Effect of War on Currencies Unlike a currency war, wherein countries actively attempt to devalue their currencies to aide their domestic economies in global export trading, a physical war can be far more devastating to a country's economy. Much like a natural disaster, the impact of war is brutal and widespread. Similar to disasters, the damage of war to infrastructure deals a huge blow to a nation's short-term economic viability, costing citizens and governments billions of dollars. History has shown than war rebuilding efforts must often be financed with cheap capital resulting from lower interest rates, which inevitably decrease the value of domestic currency. There is also a huge level of uncertainty surrounding such conflicts on future economic expectations and the health of affected nations. Thus, nations that are actively at war experience a higher level of currency volatility compared to those not engaged in conflict. Some economists believe that there is a potential economic upside to war. War can kick-start a fledgling economy, especially its manufacturing base when it is forced to concentrate its efforts on war time production. For instance, the U.S. entry into World War II following the attacks on Pearl Harbor helped pull the country out of the grips of the Great Depression. While there is some historical precedent for this viewpoint, most would agree that an improved economy at the cost of human lives is a very poor trade-off 8.13 IMPACT OF FOREX RISK FLUCTUATIONS IN GLOBAL MILIEU When exchange rates change, the prices of imported goods will change in value, including domestic products that rely on imported parts and raw materials. Exchange rates also impact investment performance, interest rates and inflation - and can even extend to influence the job market and real estate sector. A high-quality investment in another nation may lose money because that country's currency declined. Foreign-denominated debt used to purchase domestic assets has also led to bankruptcies in many emerging market economies. 8.14 SUMMARY  The chapter consist of two parts: Enterprise Risk Management & Forex risk management:  Enterprise risk management is a process, effected by an entity's board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance etc. 132 CU IDOL SELF LEARNING MATERIAL (SLM)

 The framework emphasizes entity wide risk management across four objectives: strategic, operations, reporting, and compliance.  Risk is inherent in every trade you take, but as long as trader can measure risk he can manage it... With a disciplined approach and good trading habits, taking on some risk is the only way to minimize the risk.  Good forex risk management can bring the company the following benefits: Better protection for your cash flow and profit margins. Deeper understanding of how FX fluctuations affect the balance sheet. Increased borrowing capacity, leading to faster growth and a stronger competitive edge.  Currency prices can be determined in two main ways: a floating rate or a fixed rate. A floating rate is determined by the open market through supply and demand on global currency markets. Therefore, most exchange rates are not set but are determined by on-going trading activity in the world's currency markets. 8.15 KEYWORDS  Exchange rate risk: It is also known as currency risk, is the financial risk arising from fluctuations in the value of a base currency against a foreign currency in which a company or individual has assets or obligations.  Market Order: market order is an instruction to buy or sell a security immediately at the current price.  Limit order: It is an instruction to buy or sell only at a price specified by the investor.  Monetary Policy- It refers to government policy relating to money supply. The currency notes are supplied by RBI through commercial banks.  Foreign exchange risk: It refers to the losses that an international financial transaction may incur due to currency fluctuations. 8.16 LEARNING ACTIVITY 1. What companies will use ERM? Discuss ___________________________________________________________________________ ___________________________________________________________________________ 2. How can the trader reduce risk in forex? ___________________________________________________________________________ ____________________________________________________________________ 133 CU IDOL SELF LEARNING MATERIAL (SLM)

8.17 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is ERM? 2. Define forex market. 3. State any two importance of forex risk management 4. Who is responsible for ERM? 5. Mention the difference between fixed exchange rate and flexible exchange rate. 6. How the increased fluctuations in exchange rate affects the business? Long Questions 1. Discuss the fundamentals of ERM. 2. Identify the causes of forex fluctuations. 3. Bring out the significance of forex risk management. 4. Give the overview of forex rates system. 5. Describe the global events affects which affects the forex market in detail. 6. Analyse the major risks in forex market. B. Multiple Choice Questions 1. The net potential gain or loss likely to arise from exchange rate changes is- a. Exchange exposure b. Exchange risk c. Profit/loss on foreign exchange d. Exchange difference 2. The exchange loss/gain due to transaction exposure is reckoned on- a. Entering into a transaction in foreign exchange b. Quoting a price for a foreign currency transaction c. Conversion of foreign currency into domestic currency d. Entry in the books of accounts 3. Maintaining a foreign currency account is helpful to- 134 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Avoid transaction cost b. Avoid exchange risk c. Avoid both transaction cost and exchange risk d. Avoid exchange risk and domestic currency depreciation 4. The following is not a sale transaction of foreign exchange: a. Issue of a foreign demand draft b. Payment of an import bill c. Realization of an export bill d. None of these 5. India’s foreign exchange rate system is? a. Free float b. Managed float c. Fixed. d. Fixed target of band Answers 1-b, 2-c, 3-c, 4-c, 5-b 8.18 REFERENCES References books  Rajiv Srivastava and Anil Misra, Financial Management, Oxford university press.  S.N.Maheswari Financial Management, Sultan Chand, New Delhi Textbooks  Punidavathi pandiyan. Financial Management. Mumbai: Himalaya Publishing House.  I.M.Pandey, Financial Management, Pearson  Essentials of financial management, Pearson Websites 135 CU IDOL SELF LEARNING MATERIAL (SLM)

 https://keydifferences.com/ddifference-between-treasury-management-and-financial- management.html  https://yourbusiness.azcentral.com/importance-treasury-management-26921.html  https://www.accountingtools.com/articles/2017/5/15/treasury-functions  https://www.coupa.com/blog/treasury/cash-management-and-role-treasury  https://www.google.com/search?q=function+s+of+tresury&oq=function+s+of+tresury +&aqs=chrome..69i57.8486j0j7&sourceid=chrome&ie=UTF-8  google.com/search?q=perspectives+of+treasury+management&biw=1536&bih=754& sxsrf=ALeKk01QDYA2KSBQcbNM3YlfQUbyy_fbYw%3A1625395058894&ei=co _hYOuMNpuprtoP1rW50Ag&oq 136 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 9: FOREIGN EXCHANGE RISKS 137 STRUCTURE 9.0 Learning Objectives 9.1 Introduction 9.2 Foreign exchange risk 9.2.1 Concept of foreign exchange risk 9.3 Types of foreign exchange risks. 9.4 Strategy for managing transaction risks 9.4.1 Measurement of translation exposure 9.4.2 Advantage of transaction risk management 9.5 Strategy to manage the translation risks 9.5.1 Measurement of translation exposure 9.6 Strategy to manage the economic risk 9.6.1 Effects of economic exposure 9.6.2 Operational risk and currency mitigation. 9.7 Mitigation of foreign exchange risks 9.7.1 Transact in home currency 9.7.2 Build protection 9.7.3 Forex hedging 9.7.4 Hedging arrangements via financial instruments 9.8 Summary 9.9 Keywords 9.10 Learning Activity 9.11 Unit End Questions 9.12 References 9.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain the meaning of forex CU IDOL SELF LEARNING MATERIAL (SLM)

 Discuss the concept of foreign exchange risk  Analyse the mitigation of Transaction risk  Describe the strategies to minimize the translation risk  Identify the strategy for economic risk  Enumerate the mitigation of foreign exchange risks 9.1 INTRODUCTION Foreign exchange, or forex, is the conversion of one country's currency into another. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. The foreign exchange market (or FX market) is the mechanism in which currencies can be bought and sold. A key component of this mechanism is pricing or, more specifically, the rate at which a currency is bought or sold. The risk is involved in forex market. Risk is inherent in every trade, but as long as the trader can measure risk he can manage it. With a disciplined approach and good trading habits, taking on some risk is the only way to generate good rewards. All traders have to take responsibility for their own decisions. In trading, losses are part of the norm, so a trader must learn to accept losses as part of the process. Losses are not failures. However, not taking a loss quickly is a failure of proper trade management. Usually a trader, when his position moves into a loss, will second guess his system and wait for the loss to turn around and for the position to become profitable. This is fine for those occasions when the market does turn around, but it can be a disaster when the loss gets worse. The best way to objectify the trading is by keeping a journal of each trade, noting the reasons for entry and exit and keeping score of how effective system is. This helps the system provides a reliable method in stacking the odds in trader favuor. 9.2 FOREIGN EXCHANGE RISK Exchange rate risk, also known as currency risk, is the financial risk arising from fluctuations in the value of a base currency against a foreign currency in which a company or individual has assets or obligations. It is caused by the effect of unexpected currency fluctuations on a company's future cash flows and market value and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company's competitive position, even if it does not operate or sell overseas. 138 CU IDOL SELF LEARNING MATERIAL (SLM)

9.2.1 Concept of forex risk The risk occurs when a company engages in financial transactions or maintains financial statements in a currency other than where it is headquartered. For example, a company based in Canada that does business in China – i.e., receives financial transactions in Chinese yuan – reports its financial statements in Canadian dollars, is exposed to foreign exchange risk. The financial transactions, which are received in Chinese yuan, must be converted to Canadian dollars to be reported on the company’s financial statements. Changes in the exchange rate between the Chinese yuan (foreign currency) and Canadian dollar (domestic currency) would be the risk, hence the term foreign exchange risk. Foreign exchange risk can be caused by appreciation/depreciation of the base currency, appreciation/depreciation of the foreign currency, or a combination of the two. It is a major risk to consider for exporters/importers and businesses that trade in international markets. 9.3 TYPES OF FOREIGN EXCHANGE RISKS The three types of foreign exchange risk include: Transaction risk Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options. For example, a Canadian company with operations in China is looking to transfer CNY600 in earnings to its Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6 CNY, and the rate subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100 (CNY600/6) would instead of CAD86 (CNY600/7). Economic risk Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations. For example, a Canadian furniture company that sells locally will face economic risk from furniture importers, especially if the Canadian currency unexpectedly strengthens. Translation risk Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is 139 CU IDOL SELF LEARNING MATERIAL (SLM)

higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency. For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces translation risk, as the subsidiary’s financial performance – which is in Chinese yuan – is translated into Canadian dollar for reporting purposes. 9.4 STRATEGY FOR MANAGING TRANSACTION RISK Meaning Figure 9.1 Strategy for Managing Transaction Risk Transaction risk will be greater when there exists a longer interval from entering into a contract or trade and settling it. Transaction risk can be hedged through the use of derivatives like forwards and options contracts to mitigate the impact of short-term exchange rate moves. This is the simplest kind of foreign currency exposure and, as the name itself suggests, arises due to an actual business transaction taking place in foreign currency. The exposure occurs, for example, due to the time difference between an entitlement to receive cash from a customer and the actual physical receipt of the cash or, in the case of a payable, the time between placing the purchase order and settlement of the invoice. A lot of it can be understood from the practices of central banks, especially investment banks, who are heavily involved in multiple currency dealings daily. These banks have formal programs in place to combat transactional risk. These risks are usually synced with credit risk and market risk, which are centralized to institute and administer command over the entire structure of risk operations. There may not be a consensus in terms of who in the organization assumes the job of determining 140 CU IDOL SELF LEARNING MATERIAL (SLM)

transactional risk; however, most commonly, a country risk committee or credit department does the task. Banks typically assign a country rating that encompasses all types of risk, including currency lending, locally and abroad. Important to note is that these ratings, especially ‘transactional risk rating,’ goes a long way in determining a cap and exposure limits every market deserves, keeping in mind the companies policies. For example; A British Company is repatriating profits to the U.K. from its business in France. It will have to get Euro earned in France converted to British Pounds. The company agrees to enter into a spot transaction to achieve this. Generally, there is a time lag between the actual exchange transaction and settlement of the transaction; as such, if the British pound appreciates as compared to Euro, this company will receive lesser pounds than what was agreed to. Figure 9.2 Transaction Risk 9.4.1 Mitigation of Transaction Risk Banks susceptible to transactional risk indulge in various hedging strategies through different money market and capital market instruments, which mainly include currency swaps, currency futures, and options, etc. Each hedging strategy has its own merits and demerits, and firms make choices from a plethora of available instruments to cover their forex risk that best suits their purpose. For example a firm’s risk mitigation attempt by buying a forward contract. A firm may enter into a currency forward deal where it locks the rate for the period of the contract and gets it settled at the same rate. By doing this firm is almost certain of the quantum of the cash flow. 141 CU IDOL SELF LEARNING MATERIAL (SLM)

This helps encounter the risk faced by rate fluctuations and brings in more excellent stability in decision making. A company can also enter into a futures contract promising to buy/sell a particular currency as per the agreement; in fact, futures are more credible and are highly regulated by the exchange, which eliminates the possibility of default. Options hedging is also a perfect way of covering rate risks, as it demands only a little upfront margin and curtails the downside risk to a great extent. The best part about the options contract and the main reason they are preferred is that they have unlimited upside potential. Additional, they are a mere right, not an obligation, unlike all the others. A few operational ways through which banks attempt to mitigate Transaction risk; Currency invoicing, which involves billing the transaction in the currency that is in the companies favor. This may not eradicate exchange risk; however, it shifts the liability to the other party. A simple example is an importer invoicing its imports in the home currency, which shifts the fluctuation risk onto the shoulder of the exporter. A firm may also use a technique called as leading and lagging in hedging the rate risk. Let’s say a firm is liable to pay an amount in 1 month and is also set to receive an amount (probably similar) from another source. The firm may adjust both the dates to coincide. They are thereby avoiding the risk altogether. Risk sharing: The parties in the trade can agree to share the exposure risk through Mutual understanding. A company can also avoid assuming any exposure by dealing only and only in home currency. 9.4.2 Advantages of transaction risk management A sound transaction risk mitigation program includes and thereby promotes,  A comprehensive inspection by decision-makers  Country risk and exposure policies for different markets at the same time supervise political instabilities.  Regular back testing on assets and liabilities denominated in foreign currencies  Orderly supervision of various economic factors in different markets  Suitable internal control and audit provisions 9.5 STRATEGY TO MANAGE THE TRANSLATION RISK 142 Translation Exposure CU IDOL SELF LEARNING MATERIAL (SLM)

This is the translation or conversion of the financial statements (such as P&L or balance sheet) of a foreign subsidiary from its local currency into the reporting currency of the parent. This arises because the parent company has reporting obligations to shareholders and regulators which require it to provide a consolidated set of accounts in its reporting currency for all its subsidiaries. Translation exposure (also known as translation risk) is the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes. For example, if FMCG major Unilever reports a consolidated financial statement for its US, UK, and Europe subsidiary, it will face translation risk. 9.5.1 Measurement of Translation Exposure Translation exposure can often depict a distorted representation of a company’s international holdings if foreign currencies depreciate considerably compared to the home currency. Accountants can choose among several options while converting the values of foreign holdings into domestic currency. They can choose to convert at the current exchange rate or at a historical rate prevalent at the time of occurrence of an account. Whichever rate they choose, however, needs to be used consistently for several years, in accordance with the accounting principle of consistency. The consistency principle requires companies to use the same accounting techniques over time to maintain uniformity in the books of account. In case a new technique is adopted, it should be mentioned clearly in the footnotes of the financial statements. Consequently, there are four methods of measuring translation exposure: 143 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 9.3 Methods of Translation Exposure 1. Current/Non-current Method The values of current assets and liabilities are converted at the exchange rate that prevails on the date of the balance sheet. On the other hand, non-current assets and liabilities are converted at a historical rate. Items on a balance sheet that are written off or converted into cash within a year are called current items, such as short-term loans, bills payable/receivable, and sundry creditors/debtors. Any item that remains on the balance sheet for more than a year is a non-current item, such as machinery, building, long-term loans, and investments. 2. Monetary/Non-monetary Method All monetary accounts are converted at the current rate of exchange, whereas non-monetary accounts are converted at a historical rate. Monetary accounts are those items that represent a fixed amount of money, either to be received or paid, such as cash, debtors, creditors, and loans. Machinery, buildings, and capital are examples of non-monetary items because their market values can be different from the values mentioned on the balance sheet. 3. Current Rate Method The current rate method is the easiest method, wherein the value of every item in the balance sheet, except capital, is converted using the current rate of exchange. The stock of capital is evaluated at the prevailing rate when the capital was issued. 4. Temporal Method 144 CU IDOL SELF LEARNING MATERIAL (SLM)

The temporal method is similar to the monetary/non-monetary method, except in its treatment of inventory. The value of inventory is generally converted using the historical rate, but if the balance sheet records inventory at market value, it is converted using the current rate of exchange. In each of the methods used above, there is a mismatch between the total values of assets and liabilities after conversion. While calculating income and net profit, variations in exchange rates can distort the amounts to a great extent, which is why accountants often use hedging to do away with this risk. 9.6 STRATEGY TO MANAGE THE ECONOMIC RISK Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations. Economic risk, which reflects basically the risk to the firm's present value of future operating cash flows from exchange rate movements. In essence, economic risk concerns the effect of exchange rate changes on revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports). 9.6.1 Effects of Economic Exposure Since unanticipated rate changes affect a company’s cash flows, economic exposure can result in serious negative consequences for the company’s operations and profitability. A stronger foreign currency may make production inputs more expensive, causing decreased profits. Furthermore, economic exposure can undermine the company’s competitive position. For example, if the local currency strengthens, local manufacturers will face more intense competition from foreign manufacturers whose products will become cheaper. 9.6.2 Operational and currency risk There are two main strategies to mitigate economic exposure: operational and currency risk mitigation. Operational strategy Operational strategy is aiming to adjust or change the current company’s operations to prevent possible risks associated with future currency fluctuations. The operational mitigation strategy may involve the following steps: Diversification of production facilities and markets of products: The expansion of operating facilities and sales to a mixture of markets. 145 CU IDOL SELF LEARNING MATERIAL (SLM)

Sourcing flexibility: A company considers the acquisition of its key inputs from different regions. Diversification of financing: A company may seek financing from capital markets in different regions. Currency risk mitigation strategy The main goal of the currency risk mitigation strategy is to minimize or eliminate economic exposure through hedging. Some of the currency risk mitigation strategies are: Matching currency flows: A company matches the foreign currency outflows with foreign currency inflows. Currency risk-sharing agreements: A company enters into a currency risk-sharing agreement with its supplier/customer. According to this agreement, the sale/purchase contract is executed at a predetermined price. Thus, both parties share the potential currency risk. Currency swaps: A company can use currency swaps to obtain the required cash flows in foreign currency at the desired exchange rate. The counterparties will exchange the interest and principal in one currency for the same in another currency at fixed dates until the maturity of the swap. Figure 9.4 Operational and currency risk 146 9.7 MITIGATION OF FOREIGN EXCHANGE RISKS Some of the factors helpful to mitigate the risk  Transaction in home currency CU IDOL SELF LEARNING MATERIAL (SLM)

 Build Protection  Foreign Exchange Hedging  Hedging Arrangements via Financial Instruments 9.7.1 Transact in Home Currency Most of the small and medium may be able to transact in only one currency. For example, a US company may be able to insist on invoicing and payment in USD even when operating abroad. This passes the exchange risk onto the local customer/supplier. In practice, this may be difficult since there are certain costs that must be paid in local currency, such as taxes and salaries, but it may be possible for a company whose business is primarily done online. This may take into consideration whether transaction must be in own currency or not 9.7.2 Build Protection Many companies managing large infrastructure projects, such as those in the oil and gas, energy, or mining industries are often subject to long-term contracts which may involve a significant foreign currency element. These contracts may last many years and the exchange rates at the time of agreeing to the contract and setting the price may then fluctuate and jeopardize profitability. It may be possible to build foreign exchange clauses into the contract that allow revenue to be recouped in the event that exchange rates deviate more than an agreed amount. This obviously then passes any foreign exchange risk onto the customer/supplier and will need to be negotiated just like any other contract clause. These can be a very effective way of protecting against foreign exchange volatility but does require the legal language in the contract to be strong and the indices against which the exchange rates are measured to be stated very clearly. These clauses also require that a regular review rigor be implemented by the finance and commercial teams to ensure that once an exchange rate clause is triggered the necessary process to recoup the loss is action. 9.7.3 Foreign Exchange Hedging Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging strategies typically involve derivatives, such as options and futures contracts. A natural foreign exchange hedge occurs when a company is able to match revenues and costs in foreign currencies such that the net exposure is minimized or eliminated. For example, a US company operating in Europe and generating Euro income may look to source product from Europe for supply into its domestic US business in order to utilize these Euros. This is an example which does somewhat simplify the supply chain of most businesses, but I have seen this effectively used when a company has entities across many countries. 147 CU IDOL SELF LEARNING MATERIAL (SLM)

However, it does place an extra burden on the finance team and the CFO because, in order to track net exposures, it requires a multiple currency P&L and balance sheet to be managed alongside the traditional books of account. 9.7.4 Hedging Arrangements via Financial Instruments  Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one's ownership of an entity.  A primary instrument is a financial investment whose price is based directly on its market value. Primary instruments include cash-traded products like stocks, bonds, currencies, and spot commodities.  Financial instruments are contracts for monetary assets that can be purchased, traded, created, modified, or settled. Basic examples of financial instruments are cheques, bonds. Stocks. Two of the most common asset classes for investments are, securities. Hedging Arrangements via Financial Instruments The most complicated, risk is through the use of hedging arrangements via financial instruments. The two primary methods of hedging are through a forward contract or a currency option. Forward exchange contracts. A forward exchange contract is an agreement under which a business agrees to buy or sell a certain amount of foreign currency on a specific future date. By entering into this contract with a third party (typically a bank or other financial institution), the business can protect itself from subsequent fluctuations in a foreign currency’s exchange rate. The intent of this contract is to hedge a foreign exchange position in order to avoid a loss on a specific transaction Currency options. Currency options give the company the right, but not the obligation, to buy or sell a currency at a specific rate on or before a specific date. They are similar to forward contracts, but the company is not forced to complete the transaction when the contract’s expiration date arrives. Therefore, if the option’s exchange rate is more favorable than the current spot market rate, the investor would exercise the option and benefit from the contract. If the spot market rate was less favorable, then the investor would let the option expire worthless and conduct the foreign exchange trade in the spot market. This flexibility is not free and the company will need to pay an option premium 9.8 SUMMARY  Foreign exchange risk refers to the risk that a business’ financial performance or financial position will be affected by changes in the exchange rates between currencies. 148 CU IDOL SELF LEARNING MATERIAL (SLM)

 The three types of foreign exchange risk include transaction risk, economic risk, and translation risk.  Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets.  To manage the risk, Risk per trade should always be a small percentage of your total capital. A good starting percentage could be 2% of your available trading capital. So, for example, if you have $5000 in your account, the maximum loss allowable should be no more than 2%. With these parameters your maximum loss would be $100 per trade.  Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.  Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.  Translation exposure is a kind of accounting risk that arises due to fluctuations in currency exchange rates.  Converting the values of holdings of a foreign subsidiary into the domestic currency of the parent company can lead to inconsistencies if exchange rates change continuously.  There are four methods of measuring translation exposure: Current/Non-current, Monetary/Non-monetary, Current Rate, and Temporal methods. 9.9 KEYWORDS  Forward market: a contract is agreed to buy or sell a set amount of a currency at a specified price, at a set date in the future or within a range of future dates  Futures market: a contract is agreed to buy or sell a set amount of a currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding  Currency: It is a medium of exchange for goods and services  Exchange rate: It is the rate at which one national currency will be exchanged for another. 149 CU IDOL SELF LEARNING MATERIAL (SLM)

 Currency Swap: A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency  Financial instruments: These are assets that can be traded, or they can also be seen as packages of capital that may be traded  Currency option (also known as a forex option): It is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. 9.10 LEARNING ACTIVITY 1. Company A, based in Canada, recently entered into an agreement to purchase 10 advanced pieces of machinery from Company B, which is based in Europe. The price per machinery is €10,000, and the exchange rate between the euro (€) and the Canadian dollar ($) is 1:1. A week later, when Company A commits to purchasing the 10 pieces of machinery, the exchange rate between the euro and Canadian dollar changes to 1:1.2. Is it an example of transaction risk, economic risk, or translation risk? ___________________________________________________________________________ _____________________________________________________________________ 2. Company A, based in Canada, reports its financial statements in Canadian dollars but conducts business in U.S. dollars. In other words, the company makes financial transactions in United States dollars but reports in Canadian dollars. The exchange rate between the Canadian dollar and the US dollar was 1:1 when the company reported its Q1 financial results. However, it is now 1:1.2 when the company reported its Q2 financial results. Is it an example of transaction risk, economic risk, or translation risk? ___________________________________________________________________________ _____________________________________________________________________ 9.11 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Give the meaning of foreign exchange. 2. Define Forex risk 3. How will you measure the translation exposure 4. Recall the effects of economic exposure 150 CU IDOL SELF LEARNING MATERIAL (SLM)