10. FM - Managing risk: overseas trade Flashcards
Describe forward rates at a discount
More $ per £
So add
Currency is depreciated
Describe premium forward rates
Less $s per £
So subtract
So appreciates
What is the alternative to hedging currency exposure with a forward contract?
A company can use the money markets to lend or borrow, and achieve a similar result
How do you hedge a payment on a money market hedge
- Buy the PV of foreign currency amount today at the sport rate
( Like the firm making an immediate and certain payment in sterling)
May involve borrowing the funds to pay earlier than the settlement date - Foreign currency purchased is placed on deposit and accrues interest until the transaction date
- Deposit is then used to make the foreign currency payment
How do you hedge a receipt?
- If you are hedging a receipt, borrow the PV of the foreign currency amount today
Sell it at the spot rate
Results in an immediate and certain receipt in sterling
This can be inv until the date it was due - Foreign loan accuses interest until the transaction date
- Loan is then repaid with the foreign currency receipt
Describe a future
A standardised version of a forward
They are like forwards in that
- The company’s position is fixed but eh rate of exchange in the futures contract
- It is a binding control
However
- Futures are for standardised amounts
- Futures can eb traded on currency exchanges
because each contract is a standard amount and with a fixed maturity date, they may not cover the exact foreign currency exposure
How is foreign currency exposure dealt with with futures?
because each contract is a standard amount and with a fixed maturity date, they may not cover the exact foreign currency exposure
How do you determine whether to buy or sell futures?
Depends on whether the contract is dominated in sterling or in a foreign currency
The examine will give you contracts dominated in sterling, so the decision depends on what you will be doing with the sterling
How does a sterling futures contract work?
i.e. a contract size given in £
If a company is going to be buying currency in the future, then it will be selling sterling
Therefore it needs to SELL sterling contracts
If a company is going to be selling currency in the future, then it will be buying sterling. So needs to BUY sterling contracts
What happens if a sterling futures contract is for buying currency in the future?
If a company is going to be buying currency in the future, then it will be selling sterling
Therefore it needs to SELL sterling contracts
What happens if a sterling futures contract is for selling currency in the future?
If a company is going to be selling currency in the future, then it will be buying sterling. So needs to BUY sterling contracts
What is a transaction risk?
The risk tat an exchange rate will change between the transaction date and the subsequent settlement date i.e. it is the gain or loss arising on conversion
What does transaction risk primarily arise on?
On imports and exports
Give an example of how transaction risks occur on import and exports
A firm enters into a contract on 1 Jan to buy a piece of equip from US for $300k
Invoice is to be settled on 31 March
The exchange rate on 1st Jan is $1.6/£ therefore the firm expects the cost to be £187.5k
However, by 31st March, the £ may have
-> Strengthened to $1.75/£ in which case the cost will have fallen to £171,429 OR
-> depreciated to $1.45/£ in which case the cost has risen in £206,897
What is an economic risk
Is the variation in the value of the business (i.e. the PV of future cash flows) due to unexpected changes in exchange rates
It is a LT version of transaction risk
When can economic risk occurs for an export company
- Home currency strengthens against the currency in which is trades
- A competitor’s home currency weakens against the currency in which it trades
What is the solution for economic risk?
- A favoured, but LT solution is to diversify all aspects of the business internationally
What is a translation risk?
Where the reported performance of an overseas subsidiary in home based currency terms is distorted in consolidation financial statements because of a change in exchange rates
This is an accounting risk rather than cash based one
Is a translation risk an accounting risk or cash based risk?
Accounting risk
How are quoted exchange rates quoted?
Banking dealing in foreign currency quote 2 prices (a spread) for an exchange rate
- A lower ‘offer’ price
- A higher ‘bid’ price
What are the rates being offered if a dealer is quoting a price for US$/£ of 1.4325 - 1.4330
The lower rate, 1.4325, is the rate at which the dealer will SELL the variable currency (US dollar) in exch for the base currency (sterling)
The higher rate 1.4330, is the rate at which the dealer will buy the variable currency (US dollars) in exchange for the base currency (sterling)
The bank will always trade at the rate that is more favourable to itself
How do you know which exchange rate a banker will chose?
The bank will always trade at the rate that is more favourable to itself
TYu2: The US Dollar/ Sterling rate is quoted as 1.4325 - 1.4330
Comp A wants to buy $100k in exchange for sterling
What rate will the bank offer?
Comp A wants to buy $100k in exchange for sterling (so that the bank will be selling dollars)
- at the lower rate of 1.4235 the bank would sell $100k for £69,808
at the higher rate of 1.4330, the bank would sell $100k for £69,784
Clearly the bank would be better off selling at low rate
RULE = Banks sells low
Banks BUY high
What are the potential solutions for dealing with transaction risk?
Invoice in home currency
Leading and lagging
Matching
Foreign currency bank accounts
How does invoicing in the home currency protect against transaction risk?
- Insist all customers pay in your own home currency and pay for all imports in home currency
- This method transfers risk to other party
- But may not be commercial acceptable
How does lagging protect against transaction risk?
- If an importer expects that the currency it is due to pay will depreciate, it may attempt to delay the payment (lagging)
- This may be achieved by agreement or by exceeding credit terms
Note: strictly this is not hedging, it is speculation
How does leading protect against transaction risk?
- If another exporter expects that the currency it is due to receive will depreciate over the next few months, it may try and obtain payment immediately (i.e. leading)
- May be achieved by offering discount for immediate payment
Note: strictly this is not hedging, it is speculation
What is the difference between hedging and speculating?
Hedging: protecting yourself against adverse changes
Speculating: Betting on the exchange rate changing in your favour
How does matching protect against transaction risk?
- When a company has receipts and payments in the same foreign currency due at the same time it can simply match them off against each other
- If is then only necessary to deal on the forex markets for the unmatched portion of the total transactions
How does having foreign currency bank accounts protect against transaction risk?
- Where a firm has regular receipts and payments in the same currency, it may choose to operate a foreign currency bank account
- This operates as a permanent matching process
- The exposure to exchange risk is limited to the net balance on the account
What is the method for hedging with forwards
If we know that we are going to pay or receive currency in the future, we will agree to translate this currency at a rate agreed now (forward rate)
A forward contract is an obligation to accept or deliver a certain amount of a foreign currency on a certain date in the future
What is the number of contracts required for a sterling contract?
As usual, this will be transaction amount / contract size
However, when using sterling contracts, the contract side will be in £ but the transaction amount will be in currency
Therefore you need to convert the transaction amount into £ first (using the futures price)
When do sterling contracts need to be translated?
- if using sterling contracts, the futures prices will be given as currency per £ (e.g. $/£)
So prof/loss on the future will need to be translated at the spot rate on the transaction date
This will also be the case with the premium on an option as the premium is paid upfront, so it must be translated at the current spot rate
Define an option
Gives the right but not the obligation to buy or sell currency at some point in the future at a predetermined rat
What are the 2 options for an option, and when would you let them happen?
- Exercise option if favourable
- Let is lapse if the spot rate is more favourable, or there is no longer a need to exchange currency
What is the benefit of an option?
It eliminates downside risk
BUT allows participation in the upside
But this additional flexibility comes at a price
Why are options more expensive?
It eliminates downside risk
BUT allows participation in the upside
But this additional flexibility comes at a price
Can currency options be traded?
Yes, can either have tailor made OTC options or use traded currency options
How are OTC currency options dominated?
In foreign currency
How do you decide whether you need a currency put or call option?
You need to consider what you will be doing with the foreign currency (as it is generally denominated in foreign currency)
- If the company is going to be BUYING currency in the future, then it will need to buy a CALL option
- If the company is going to be SELLING currency in the future, then it will need to buy a PUT option
When do you need to buy a CALL option for currency options?
You need to consider what you will be doing with the foreign currency (as it is generally denominated in foreign currency)
- If the company is going to be BUYING currency in the future, then it will need to buy a CALL option
When do you need to buy a PUT option for currency options?
You need to consider what you will be doing with the foreign currency (as it is generally denominated in foreign currency)
- If the company is going to be SELLING currency in the future, then it will need to buy a PUT option
When do you need to buy traded option PUTS?
As for futures, the examiner will give you contracts denominated in STERLING, therefore if a company is going to be buying currency in the future, then it will be SELLING sterling
It therefore, needs to by PUTS
When do you need to buy traded option CALLS?
If the company is going to be selling currency in the future, then it will be BUYING sterling
Therefore it needs to buy CALLS
What does IRPT stand for?
Interest Rate Parity theory
What does Interest Rate Parity Theory claim?
Claims that the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the 2 currencies
What is the IRPT used for?
Used by banks to calculate the forward rate quoted on a currency
The formula is
Forward rate = Current spot rate x [(1 + if) / (1 + iuk)]
Where
if = foreign currency interest rate for the period
iuk = UK interest rate for the period
Does IRP hold true in practice?
Yes
There are no bargain interest rates to be had on loans/ deposits in one currency rather than another
However, where a gvmt imposes controls on currency trading, or otherwise intervenes in the currency markets, its effectiveness is limited
What does PPP stand for?
Purchase power parity
What does PPP claim?
Claims that the rate of exchange between 2 currencies depend on the relative inflation rates within the respective countries
What is PPP based on?
The Law of One Price
i.e. in equilibrium, identical goods must cost the same regardless of the currency in which they are sold
What is the impact of inflation on depreciation of currency
The higher the inflation, the greater the depreciation of the currency
How do you estimate expected future sport rates?
Apply the following formula
Forward rate = Current spot rate x [ (1+ inflf) / (1 + influk)
Where
inflf = expected foreign currency inflation rate for the period
influk = expected UK inflation rate for the period
Give some examples of risks that international trade increases
- Physical risk
- Trade risk
- Liquidity risk
- Credit risk
