Ch.10 - Managing financial risk: Overseas trade

Question 1

What is transaction risk?

Answer 1

• risk that an exchange rate will change between the transaction date and the subsequent settlement date
• arises primarily on imports and exports

Question 2

What is economic risk?

Answer 2

• variation in the value of business due to unexpected changes in exchange rates
• favoured, but long term solution is to diversify all aspects of the business internationally

Question 3

What is translation risk?

Answer 3

• where the reported performance of an overseas subsidiary in home-based currency terms is distorted because of a change in exchange rates

Question 4

How can business manage transaction risk?

Answer 4

1. invoice in home currency
2. leading and lagging (discount for immediate payment, delaying payments) - not hedging, ONLY speculation
3. matching (receipts and payments in the same foreign currency due at the same time)
4. foreign currency bank accounts (permanent matching process)

Question 5

In what currency are futures and traded options denominated?

Answer 5

Denominated in Sterling. Therefore, if buying foreign currency, selling sterling, buying PUT option.

Question 6

What is interest rate parity theory?

Answer 6

The difference between the spot and future exchange rates is equal to the differential between interest rates available in the two countries.

Current spot rate * [(1+If)/(1+Iuk)] = Forward rate

Question 7

What is purchasing power parity (PPP)?

Answer 7

The rate of exchange between two currencies depends on the relative inflation rates within respective countries. Based on the Law of One Price.

Current spot rate * [(1+INFf)/(1+INFuk)] = Forward rate