5014 - Finance of International Trade - Managing Exchange Rate Volatility and Risk p99 - 116

Question 1

Exchange rates are volatile unless…

Answer 1

You are in a Fixed Exchange Rate Regime

Question 2

Exchange Rate Volatility

Answer 2

Exchange rates can be volatile due to changes in demand and supply

Question 3

Exchange Rate Risk: Transactions

Answer 3

Risk comes from movements in the exchange rate when paying or receiving a foreign currency. You may gain but you also may lose

Question 4

Exchange Rate Risk: Translation

Answer 4

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

Question 5

Exchange Rate Risk: Economic

Answer 5

'’The risk that long-term movements in relative exchange rates will cause changes that place a company at a competitive disadvantage

Question 6

Economic Exchange Rate Risk Example

Answer 6

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

Question 7

Internal Methods of Reducing or Eliminating Risk List

Answer 7

1. Dont import/export
2. Use export agents
3. Invoice in GBP
4. Invoice in stable currency like $
5. Exchange rate variation clause
6. Pricing Policies
7. Switch the base of manufacturing
8. Netting and Pooling
9. Leading and Lagging
10. Foreign currency account
11. Foreign currency borrowing

Question 8

External Methods of Reducing or Eliminating Risk List

Answer 8

1. Forward Exchange contract
2. Currency Options
3. Foreign currency futures contract
4. Currency swaps

Question 9

Export Agents

Answer 9

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

Question 10

Invoice in Sterling

Answer 10

Eliminates risk for you but only really effective if have negotiating power

Question 11

Invoice in Stable Currency like the Dollar

Answer 11

Reduces risk especially when dealing with countries with much more volatile currencies. May be beneficial to both parties in that case

Question 12

Exchange Rate Variation Cause

Answer 12

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

Question 13

Pricing policies

Answer 13

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

Question 14

Switch the Base of Manufacture

Answer 14

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.

Question 15

Netting and Pooling

Answer 15

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

Question 16

Leading and Lagging

Answer 16

• 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

Question 17

Foreign Currency Accounts

Answer 17

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

Question 18

Foreign Currency Borrowing

Answer 18

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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Question 19

How to Reduce Risk with Foreign Currency Borrowing

Answer 19

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

Question 20

Interest of Currency Loans

Answer 20

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

Question 21

What are the four hedging products (derivatives) available?

Answer 21

• Forward Exchange Contract
• Currency Options
• Foreign Currency Futures Contract
• Currency Swaps

Question 22

What are Derivatives?

Answer 22

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

Question 23

What are Financial Derivatives?

Answer 23

Contracts where the price (cost) of the contract is in some way derived from something else

Question 24

Currency Derivatives

Answer 24

Contracts where the price (cost) is derived from exchange rates

Question 25

Interest Rate Derivatives

Answer 25

Contracts where their price is derived from Interest Rates

Question 26

Commodity Derivatives

Answer 26

Contracts where the price is derived from a commodity like oil, gold, wheat and so on

Question 27

Types of Derivatives: Forwards

Answer 27

Todays price or exchange rate to be executed in the future. Differs from futures as forwards are private and customizable

Question 28

Types of Derivatives: Futures

Answer 28

Same as a forward but standardized terms and traded on an exchange and prices settled on a daily basis

Question 29

Types of Derivatives: Options

Answer 29

Same as forwards but you can opt - no obligation to trade

Question 30

Types of Derivatives: Swaps

Answer 30

Basically what you think it is