5014 - Finance of International Trade - Managing Exchange Rate Volatility and Risk p99 - 116 Flashcards
(30 cards)
Exchange rates are volatile unless…
You are in a Fixed Exchange Rate Regime
Exchange Rate Volatility
Exchange rates can be volatile due to changes in demand and supply
Exchange Rate Risk: Transactions
Risk comes from movements in the exchange rate when paying or receiving a foreign currency. You may gain but you also may lose
Exchange Rate Risk: Translation
Risk comes from the translation of assets and liabilities held in countries with different currencies. The value currency in a country declines and so do would the value of the assets and liabilities in these countries. Only a book loss but looks bad to stakeholders as it is reduced profit. Only a cashflow gain or loss once realised and sold
Exchange Rate Risk: Economic
'’The risk that long-term movements in relative exchange rates will cause changes that place a company at a competitive disadvantage
Economic Exchange Rate Risk Example
A UK company is buying and selling in the UK. His competitor that also buys from Germany. The pounds value increases against the Euro, meaning the competitor how has access to cheaper goods because now a pound will buy more. This can happen when buying and selling
Internal Methods of Reducing or Eliminating Risk List
- Dont import/export
- Use export agents
- Invoice in GBP
- Invoice in stable currency like $
- Exchange rate variation clause
- Pricing Policies
- Switch the base of manufacturing
- Netting and Pooling
- Leading and Lagging
- Foreign currency account
- Foreign currency borrowing
External Methods of Reducing or Eliminating Risk List
- Forward Exchange contract
- Currency Options
- Foreign currency futures contract
- Currency swaps
Export Agents
To reduce risk you could sell to a UK agent who then exports, the downside of this is they will take a cut of profit
Invoice in Sterling
Eliminates risk for you but only really effective if have negotiating power
Invoice in Stable Currency like the Dollar
Reduces risk especially when dealing with countries with much more volatile currencies. May be beneficial to both parties in that case
Exchange Rate Variation Cause
This is a clause in a contract where the price changes if the exchange rates change. Both parties may be happy to agree this and share the risk
Pricing policies
Businesses can increase prices to cover the exchange rate changes, this is great if you can get away with it but not practical in competitive markets
Switch the Base of Manufacture
This involves manufacturing in the country of which you want to reduce the risk of exchange rates. So, if you sell in the US you could start manufacturing in the US so income and costs are in the same currency.
Netting and Pooling
Multinationals operate a central treasury department where they pool money and net off monies owed to and by subsidiaries in order to reduce transaction costs. They also borrow and lend from each other in different currencies
Leading and Lagging
- Lead means to rush to pay or encourage early payment if you think the rates will move against you
- Lag means delaying payments and receipts if you think the rates will be in your favour in the future
- Risky as you cant be certain about movement
Foreign Currency Accounts
Just like you can have a £ account in the UK you can also have one for $ and Euros etc, when you get payed in $ for example it would go to the dollar account and you can also pay in dollars from this account, avoiding the need to convert and making you able to exchange at a time best for you, say when exchange rates are favourable
Foreign Currency Borrowing
Say if you are due to receive $1 million in 6 months you face:
- Liquidity Risk - ability to wait 6 months and impact on cashflow, also may have interest / opportunity cost
- Default Risk - due to country risk, customer fails to pay you
- Exchange rate risk - how much will it be worth in 6 months time, how will that impact profit
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How to Reduce Risk with Foreign Currency Borrowing
Borrow in the foreign currency and convert to home currency, rather than waiting to find out the rate later, this means no liquidity risk and no exchange rate risk then pay the loan with the payment you receive later from the client. Still holds default risk
Interest of Currency Loans
Currency loan may be at a lower interest rate or higher than a UK Loan, each countries rates are different and the interest cost may be better than the exchange rate cost but have to consider interest rate parity
What are the four hedging products (derivatives) available?
- Forward Exchange Contract
- Currency Options
- Foreign Currency Futures Contract
- Currency Swaps
What are Derivatives?
A derivative is a product that is derived from something else, e.g. plastic comes from oil, the price of oil goes up, so the price of plastic goes up and vice versa
What are Financial Derivatives?
Contracts where the price (cost) of the contract is in some way derived from something else
Currency Derivatives
Contracts where the price (cost) is derived from exchange rates
