CH10 - FX Risk Flashcards
Transaction Risk
- The change in exchange rate between the time a contract is entered and the date of settlement - Gain or loss arising on conversion
- E.g. US company enters an agreement when exchange rate is: £0.93=$1
- Base currency USD depreciates to £0.89=$1 and therefore has to pay more
Economic risk
- Long term version of transaction risk - affects competitiveness
- If your home currency strengthens (OR COUNTER CURRENCY WEAKENS), to keep the same margin, you will need to raise your price, as the home currency is converted into a higher counter currency
- Or if you keep the same selling price, you will make less profit
Translation risk
- Financial statements of subsidiaries translated into home currencies
- If home currency depreciates (I have to use more home currency to buy the counter currency) then the value of that subsidiary lessens.
- Gains/Losses usually unrealised so many firms don’t hedge
Dealing with FX Risk – Internally
Matching
Using same currency to net off receipts and payments
Only then deal with FX risk on the unmatched portion of transactions
Invoice in home currency
Passes the risk onto the customer. Only achievable in monopoly otherwise customers go to competitors
Leading and lagging
Hard to guess which way FX will go
If Importer (payment) expects currency to depreciate – delay payment by agreement or exceeding credit terms
If exporting (receiving) expects that currency will depreciate – will try to obtain payment immediately through discount
Or do nothing
Forward - Simple Contract
Locked into the forward. Ignore any other rates e.g. Spot
Most frequently used, simply – OTC so can be matched exactly/
With a spread, remember bank sells low, buys high. Company will make the less money. DIVIDE by the lower
Contractual commitment – no cover if customer doesn’t paye, no benefit to gain from the upside if currency depreciates. Only good for main currencies.
Synthetic FX Agreements (SAFEs) – The counter party pays the difference
Can combine with a SWAP
Money market Hedges - Payment & Receipt
Avoid future exchange rate uncertainty by making the exchange at today’s spot rate and then reconverting.
If receiving USD, Euro is the foreign
Payments
1. Divide by the foreign currency DEPOSIT rate
2. Translate to HOME currency at a LOWER SPOT rate
3. Multiply by home currency BORROWING rate
Receipt
1. Divide the receipt by the foreign currency BORROWING rate
2. Translate to HOME currency at SPOT rate - HIGHER of spread
3. Multiply by the home company DEPOSIT rate
Futures - Step 1
Figure out if buy or sell
If Contract size (CC) is euros and payment in USD, we are selling Euros to buy USD. SELL. Expiry will be one the one closest after date of receipt
Futures - Step 2
Find out how many contracts
Amount to be received
DIVIDED BY
Futures price NOW IF contract currency different to receipt currency
DIVIDED BY
Contract size
EQUALS amount of contracts
E.g. $12m USD/1.3350 Future NOW = EUR8.99m/ 200k = 45 contracts
Futures - Step 3
Contact exchange to state the hedge = Sell 45 December futures at a price of $1.3350/EUR1
Futures - Step 4
Calculate P&L
Sell at 1.3350 – Future price NOW
Close out and buy at 1.3240 – Future price FUTURE
Difference is 0.011 per EUR1
45 contractsEUR200,000gain or loss Difference = $99k Gain
You always want to buy low/sell high, or sell high/buy low. If selling low buying high – you make a loss
Futures - Step 5
Transaction at spot rate for closure.
Amount of currency needed ($12m)-gain or loss/1.3190 SPOT Rate Future
Basis and Basis Risk
Spot Rate minus Futures Rate. Basis on expiry date always 0 as the closer we get to expiry it will reduce as future becomes the spot
Basis Risk – assuming the basis will always fall in a linear pattern
Basis Risk How to - If not given futures price in future
Compare Spot Price now and in future and calculate the basis reduction expected:
E.g. 5 Month Expiry Future price now of 0.7300 at a sell – Remember sell low
Now In 4 months
Spot 0.7343 0.7337
Future 0.7300 0.7328
0.7343 Minus 0.7300 = 0.0043 / 5 months expiry = 0.0009
0.7337-0.0009 = 0.7328
Lock in = Or Future RATE NOW + Unexpired Basis * Initial remittance value = will get you the same
Options How To - Similar to Futures - Remember change to Ex price
- Define Put/Buy. Choose exercise price. Remember if the put is 12.40 this is $0.1240 + $1.50 exercise price
- Find amount of contracts – the spot rate changes from Futures Price NOW to Exercise Price
- Calculate the premium – premium valuecontract sizecontracts required. Convert to home currency using spot rate now
- Decide on exercising or lapsing. If puts, sell high. If calls, buy low
- Calculate net payments
Options = contract size multiplied by contracts
Remainder = Remittance value MINUS (Options taken value*exercise price)
Remember if receipt – the premium is always a minus!
FX Swaps
- Buy at Swap rate (-)
- Swap back at the same Swap rate (+)
- Sell back at higher rate – Often forward
- Interest on initial based on current borrowing rate
- Swap fee based on initial value
Currency Swaps
Swapping interest rate commitments on borrowings in different countries
1. Each company is borrowing their amount needed at the other companies borrowing rate.
Netting & Matching
Do Paid To as the Y Axis, Paid by as the X Axis
Forwards, Futures, Hedges, Swaps, Options
Forward – Locking into a future FX rate, no upside if the currency depreciates, but locked against currency appreciation.
Future – Company expects to receive US$, company bets the currency will depreciate, if it wins, it cancels out the loss, if it loses, US$ Strengthens and cancels out the loss from the bet.
Both very similar except Futures are trades on exchange, take place in 3 monthly cycles and standardized amounts.
Hedges – Taking the exchange rate now and lock in for a future date
Swap – Converting using todays exchange rate, e.g. USD to Peso, also taking out a loan in USD to buy the same amount of Peso, in one years time swapping back the first set of Pesos for USD
Options – Optional Futures
