Chapter 10

Question 1

How do we quote exchange rates?

Answer 1

Current price of USD in GBP - spot price may be displayed as $1.2543 - $1.2594

Means if we want to sell USD for GBP, we will use a rate of $1.2594 to £1

Whereas if we want to buy USD we use $1.2543

WE ALWAYS LOSE OUT

Question 2

What are the three different types of currency risk?

Answer 2

Transaction: a risk a business is exposed to when it enters into a short term transaction involving credit in a non native currency (changes in FX rates before settlement could lead to the business either losing or gaining)

Economic: refers to longer term risk a business is exposed to by trading in a particular foreign currency (changes in FX rate may make it less able to compete against rivals)

Translation: danger of a business generating accounting losses when translating the results of overseas subsidiaries

Question 3

What six factors should we consider when considering if to hedge?

Answer 3

Costs: how much will hedge cost, does risk warrant cost?

Exposure: is our exposure material?

Attitude to risk: are we risk seeking or averse (hedge)?

Portfolio effect: what is the overall position for the company as a whole?

Shareholders: are they diversified internationally? If so don’t hedge

Insolvency and cost of capital: hedging should reduce volatility of cash flows and hence cost of capital

Question 4

What are the four ways of reducing direct risk not involving derivative methods

Answer 4

Invoice currency: invoice foreign customers in domestic currency. Pushes risk on to customer but may prove unpopular

Match receipts and payments; set up foreign currency bank account and can ensure it has to only hedge its net foreign currency position - proves easier and cheaper than separately hedging each transaction

Match assets and liabilities : try find high value foreign assets with foreign borrowing (so that c your interest payments are also in a foreign currency). This will decrease net foreign currency exposure

Leading and lagging: may lead in a payment to a foreign supplier if you fear the foreign currency will strengthen. May lag on a payment to a foreign supplier if you think the foreign currency will weaken.

Question 5

What is a forward exchange contract?

Answer 5

Binding agreement to buy or sell an amount of one currency in the future for a set price in another currency, agreed today.

Can be used to eliminate transaction risk of future foreign currency payment to a supplier or receipt from customer

FX forwards are either quoted as discounts or premiums on the spot price.

ADDIS (add discount, deduct premium)

Question 6

What are the pros and cons of forward exchange contracts?

Answer 6

Pros:

Lock in price hedging downside risk

Tailored to investor so won’t be over or under hedged

Cons:

Investor loses upside potential

Difficult to unwind the hedge so we must satisfy the contract even if our foreign customer doesn’t pay on time

Question 7

What are option forward exchange contracts?

Answer 7

Are forward exchange contracts where the customer has the option to call for the performance of the contract over a set date range.

Question 8

What is interest rate parity - how the forward rates are set?

Answer 8

Uses nominal interest rates in two counties and the spot exchange rate to:

Determine fair forward exchange rate

Predict the future expected spot rate.

Basic idea: if an investor should be in the same position is they do either of the following:

Exchange GBP for USD, deposit the dollars in a US bank account for a set period then use an FX forward to convert back to sterling

Deposit the sterling in a uk bank account for a set period.

Question 9

How do you use the interest rate parity to set forward rates?

Answer 9

Future expected spot exchange rate:

Spot rate x (1+hf)/(1+huk) = expected future spot rate

Question 10

What are currency futures?

What are the hedging steps?

Answer 10

Standardised traded contracts to buy a set amount of currency at a set rate for a standardised delivery date in future.

Don’t lead to any currencies being swapped, only a net gain or loss in the currency in which the price is quoted.

Set up:

If hedging an expected USD receipt - want to sell USD, buy GBP so buy GBP futures

Choose maturity date (as close to receipt as possible but not before)

Calculate number of contracts = ($ receipt / futures rate)/ 62,500

Outcome of hedge:

Close out futures by selling same number of contracts - gain or loss on futures

(Sell rate - buy rate) x # contracts x £62,500

Convert the bet of the $ receipt and the gain/ loss on the future to £ using the spot rate (at the $ receipt date)

Question 11

What are the pros and cons of currency futures?

Answer 11

Pros:

They attempt to lock in a price, hedging downside risk

Can close out position at any time (more flexible than forwards)

Cons:

The investor loses any upside potential

Standardised contracts so may over/under hedge

Basis risk (difference between spot rate and futures rate before futures maturity date) may lead to hedge not being 100% efficient.

Must post margin (collateral) to the exchange

Question 12

What are the two problems when using bitcoin for international transactions?

Answer 12

Exchangability: likely only to be exchanged for a narrow range of major currencies

Price volatility: rates are extremely volatile.

Question 13

What is a money market hedge?

Answer 13

Instead of using forwards and futures, we use the following to hedge our transaction risk exposure by fixing an effective forward exchange rate:

Borrowing and lending on money markets

Spot foreign exchange transactions.

For example if a company is expecting to make a future dollar payment:

It borrows money now in sterling

Immediately converts the sterling to dollars (at current spot rate) and deposits it in an interest bearing account such that at the date of payment it will have enough dollars to make the payment

Company then pays back sterling loan - the amount of sterling to be paid back will be known on the outsid, hence total sterling cost is fixed at the outset.

If expecting a receipt:

Borrow now in foreign currency, convert to sterling at spot and deposit sterling in an interest bearing account.

Question 14

Pros and cons of MMH?

Answer 14

Pros:

Attempt to lock in price hedging downside risk

Tailored to investor so won’t be over or under hedged

Cons:

Investor loses upside potential

Difficult to unwind hedge

Unlikely to be cheaper than using a forward and it is greater admin and effort

Question 15

How do you choose a hedging method?

Answer 15

Cheapest method should be chosen

Question 16

What is a currency option?

What do they protect against?

What are OTC currency option?

Answer 16

Is an agreement involving a right but not an obligation to buy/sell a certain amount of currency at a stated rate of exchange at some time in the future.

Protect against adverse movements in the exchange rate while allowing the investor to take advantage of favourable exchange rate movements.

OTC: allow you to pay a premium now and buy a tailored option to;

-buy (call) or sell (put) a set amount of currency
- at a set price (in another currency)
- at a future date

Question 17

What are the hedging steps for a OTC currency option $ receipt?

Answer 17

Setup hedge:

As expected $ receipt, we will want to sell $ hence we need an option to buy a put option on $

Choose strike price (based on minimum £ you want to receive)

Pay premium in £

Outcome of hedge:

If dollar weakens to worse than strike price, exercise options and convert $ to £ at strike price

If dollar strengths to better than strike price, let option lapse and convert the $ to £ at spot price

Question 18

What are traded currency options?

What are the hedging steps?

Answer 18

A company wishing to purchase an option to buy/sell sterling can use traded options (on stock exchanges)

These options are standardised with standard maturity dates and contract sizes

Contract sizes quoted in sterling

Premiums quoted in cents

If exercised they will not lead to currencies being exchanged, rather a gain/loss in the foreign currency

When trying to determine whether to use a put or call, think “what do I want to do with £” if you want to buy then buy a call, and if you want to sell then buy a put

Setup:

As expecting $ receipt, want to sell $ and buy £, so buy a call option on £

Choose strike price and maturity date

Calculate # contracts needed : ($ receipt/strike price)/£31250

Pay premium in $: = # contracts x premium (cents) /100 x£31,250

Need to pay this in $ so must buy $ at spot to do so

Outcome:

If dollar weakens to worse than strike price, exercise options:
Gain on option = (spot -strike) x # contracts x £31,250

This is a gain in $ so add to the $ receipt and convert the total to £ at the spot rate

If dollar strengthens to better than strike price, let option lapse: convert the $ to £ at the spot price

Question 19

What are the pros and cons of traded currency options?

Answer 19

Pros:

Protect from downside risk and allows buyer to benefit from upside

Cons:

Option premium can be expensive and must be paid upfront

If traded, may over/under hedge due to standardised contracts

If traded, not available in all currencies

Question 20

In an exam questions as to whether to hedge or not, what should be considered?

Answer 20

• comparison of sterling value of payment/receipt at the earlier / current / future predicted spot rates. How volatile are exchange rates and is there a trend? Greater volatility = greater reason to hedge

What does the forward rate suggest? For example if a future $ receipt is expected and the dollar is trading at a discount in the forward market (more $ to £) then we should be concerned that this may predict a weakening of the $ causing us to hedge.

Compare results of different hedging options: list hedges in order of outcome and discuss price and cons of each. Consider directors attitudes to risk . If they are risk seekers they may choose not to hedge in order to preserve 100% of the upside