11. Risk Management and Currency Risk Flashcards
What is financial risk?
The risk of future financial conditions being different to those expected
What are the 4 types of financial risk?
- Currency risk (exchange rates)
- Interest rate risk
- Credit risk - risk of non payment
- Political risk
What are the 3 approaches to managing credit risk?
- Credit control policies
- Non-recourse debt factoring (selling receivables)
- Insurance
What is political risk?
Risk that action by a foreign government will affect the position of a company
What are the 6 actions a government might take to prevent exploitation of its country by mulitnationals?
- Quotas on international company trade
- Tariffs on imports
- Non tariff barriers (e.g. extra checks)
- Restrictions
- Nationalisation
- Minimum resident shareholding quotas
What are the 3 strategies for managing political risks?
- Negotiations with host government
- Overseas/ outsourced production strategies
- Management structure (JVs with domestic)
What is a spot rate?
Exchange rate right now
When a £ for $ exchange rate is quote $X - $Y : £1, what do X and Y represent?
We can buy $X for £1, and sell $Y for £1
What is the trick for remembering which of $X - $Y : £1, represent buying and selling $?
We always lose out - sell rate will always be higher than the buy rate, meaning we receive less £ for $ when selling and have to pay more £ for $ when buying
What is a tick?
£/$ 0.0001 movement in foreign currency
When a £ for $ exchange rate is quote $X - $Y : £1, what is the spread in ticks?
Y - X
If the £ strengthens against the $, what does that mean for the $X - $Y : £1 exchange rate?
X and Y become higher - the £ can buy more of the $ than before
If the $ weakens against the £, what does that mean for the $X - $Y : £1 exchange rate?
X and Y become higher - you need more $ to buy £
What is the cross rate?
The exchange rate between two currencies being use to calculate the exchange rate between those two currencies and a third
What are the 3 types of currency risk?
- Transaction risk (changes in FX on short term credit transactions)
- Economic risk (long term risk of trading with particular foreign countries)
- Translational risk (generating accounting losses when translating foreign assets into functional currency)
What is the balance of payments?
The difference between a country’s overseas earnings and spending
What does a surplus balance of payments mean, and what does it mean for currency movement?
The country is exporting more than it imports, and so the currency will strengthen as demand for it increases
What does a defecit balance of payments mean, and what does it mean for currency movement?
The country is importing more than it exports, and so the currency will weaken as more of it used to buy foreign currency for imports
What is purchasing power parity theory (PPP)?
A basket of goods traded in one country will cost the same no matter where it is traded (the law of one price)
What is the consequence of PPP theory?
Purchasers should be indifferent between buying goods in the UK in £ or the US in $
How does PPP argue that FX rates between two countries are influenced by inflation rates?
- If inflation is lower in country X, then buyers in country Y will seek to buy their goods in X
- X buyers will buy Y$ in order to buy in Y
- The Y$ will then strengthen
What is the relationship between inflation and currency strength according to PPP theory?
The country with the higher inflation rate should see its currency weaken
What is the equation for calculating the predicted future spot rate according to PPP theory?
Current Spot x (1 + inflation of variable)/(1 + inflation of fixed)
What is interest rate parity theory (IRP)?
A fair forward exchange rate can be determined using the current spot rate and the nominal interest rates in the two countries?
What is an FX forward contract?
A contract that allows two parties to agree today an exchange rate at which to transact at some point in the future
What does IRP state should be equivalent for an investor in country X?
- Exchange X$ for Y$, deposit Y$ in a bank in country Y (gathering interest at y%) and then convert back to $X
- Deposit X$ in a bank in country X (gathering interest at x%) for the same period
What is the equation for calculating the fair forward exchange rate according to IRP theory?
Current Spot x (1 + interest of variable)/(1 + interest of fixed)
What is the international Fisher effect?
The only reason that nominal interest rates in two different countries are different is due to the differing levels of inflation (i.e. the real interest rats in each country are equal)
What is expectations theory?
The forward rate using IRP theory is an unbiased predictor of the future expected spot rate using PPP theory
What are 3 factors other than interest and inflation causing currency fluctuations?
- Political stability
- Debt ratings
- Government policies
What are the 3 benefits of using internal hedging techniques?
- Simpler
- Cheaper
- Useful for large volumes of small FX transactions
What are the 6 methods of internal hedging?
- Invoice customers in domestic currency (pass risk)
- Match receipts and payments in a foreign bank account (only at risk on net position)
- Match assets and liabilities (fund foreign assets with foreign borrowing)
- Leading and lagging
- Countertrade
- Multilateral netting (netting centre to settling intra-group transactions)
What is leading and lagging?
The deliberate acceleration or delaying of payments due in a foreign currency in order to take advantage of an expected change in currency exchange rates
- Lead if you expect the foreign currency to strengthen
- Lag if you expect the foreign currency to weaken
When are external hedging techniques most useful?
When hedging the risk of large, one off foreign transaction
What are the 4 types of external hedging techniques?
- Forward exchange contracts
- Money market hedged
- FX options
- Currency futures
What are FX forwards?
Binding agreements to buy or sell an amount of one currency in the future for a set price in another currency
What type of currency risk are FX forwards used to eliminate?
Transaction risk
How are discounts and premiums treated when applied to spot prices in an FX forward?
- Add a discount
- Deduct a premium
Is the spread for a forward contract larger or smaller than the spread for the spot?
ALWAYS larger
What are the 2 pros of an FX forward?
- Lock in the price, hedging downside risk
- Tailored to the investor (so won’t be over/under hedged)
What are the 2 cons of an FX forward?
- Lose upside potential
- Difficult to unwind as there is no secondary market, so must satisfy
