Chapter 10 Managing financial risk: overseas trade Flashcards
1.1 Foreign exchange risk
Transaction risk is the risk that an exchange rate will change between the transaction date and the subsequent settlement date. It arises primarily on imports and exports.
Economic risk is the variation in the value of the business due to unexpected changes in exchange rates. It is the long-term version of transaction risk. For an export company it could occur because the home currently strengthens against the currency in which it trades or a competitor’s home currency weakens against the currency in which it trades.
Translation risk is where the reported performance of an overseas subsidiary in home-based currency terms is distorted in the financial statements because of a change in exchange rates. This is an accounting risk not a cash risk.
2.1 Exchange rates
Banks dealing in foreign currency quote two prices for an exchange rate.
- The lower rate is the rate at which the dealer will sell the variable currency in exchange for the base currency
- The higher rate is the rate at which the dealer will buy the variable currency in exchange for the base currency
3.1 Managing transaction risk solutions
A company should eliminate or reduce the currency risk when it is significant. Solutions include:
- Invoice in home currency: this transfers risk to other parties but may not be commercially acceptable
- Leading and lagging: if an exporter expects that the currency it is due to receive will depreciate over the next months it may try to obtain payment immediately. This is achieved by offering a discount for immediate payment. If an importer expects the currency, is it due to pay will depreciate it may attempt to delay payment via exceeding credit terms.
- Matching: when a company has receipts and payments in the same foreign currency due at the same time, it can match the against each other. Only necessary to deal on the forex markets for the unmatched portion of the total transactions
- Foreign currency bank accounts: where a firm has regular receipts and payments in the same currency, it may choose to operate a foreign currency bank account. This operates a permanent matching process, the exposure to exchange risk is limited to the net balance on the account
4.1 Hedging with forwards
A forward contract is an obligation to accept or deliver a certain amount of a foreign currency on a certain date in the future. It can be arranged for any amount of any currency on any date.
Quoted forward rates: quoted as a premium or a discount on the spot rate. Forward rates at a discount add more $s per £ and the currency is depreciated. A premium subtracts less $s per £, as the currency is appreciated.
5.1 A money market hedge
A company could use the money markets to lend or borrow, instead of hedge currency exposure with a forward contract.
Hedging a payment: buy the present value of foreign currency amount today at the pot rate (like the firm making an immediate and certain payment in sterling and may involve borrowing the funds to pay earlier than the settlement date). The foreign currency purchased is placed on deposit and accrues interest until the transaction date and the deposit is then used to make the foreign currency payment.
Hedging a receipt: borrow the present value of the foreign currency today (sell at the spot rate, this results in an immediate and certain receipt in sterling and can be invested until date its due). The foreign loan accrues interest until the transaction date and the loan is then repaid with the foreign currency receipt.
6.1 Hedging with futures
Futures are the standardised version of forwards. They are similar to forwards in that the company’s position is fixed by the rate of exchange in the futures contract and it is a binding contract. However, futures are for standardised amounts and can be traded on currency exchanges. As the contract is for a standard amount and with a fixed maturity date, they may not cover the exact foreign currency exposure.
Whether to buy or sell futures depends on if the contract is denominated in sterling or the foreign currency. If a company is buying currency in the future, then it will be selling sterling and therefore needs to sell sterling contracts. If it is selling currency in the future, then it will be buying sterling, so therefore needs to buy sterling contracts.
the number of contracts is the transaction amount divided by the contract size. When using sterling contracts. The contract size will be in £ but the transaction amount will be in currency. Therefore, you need to convert the transaction amount into £ first (using the futures price).
If using sterling contracts, the futures prices will be given as currency per £, therefore the profit or loss on the future will need to be translated at the spot rate on the transaction date. This will also be the case with the premium on an option. Because a premium is paid up front, it must be translated at the current spot rate.
7.1 Currency options
Options give the right but not the obligation to buy or sell currency at some point in the future at a predetermined rate. A company can therefore exercise the option or let it lapse (if the spot rate is more favourable and there is no longer a need to exchange currency).
The option eliminates downside risk buy allows participation in the upside. The additional flexibility means a premium must be paid to purchase an option. A company may buy a tailor-made OTC option or use traded currency options.
OTC options: these are generally denominated in a foreign currency. If a company is buying currency in the future, it will need to buy a call option. If they are selling currency, then it will need to buy a put option.
Traded options: examiners will give contracts denominated in sterling, if a company is going to be buying currency in the future, then it will sell sterling, so needs to buy a put option.
8.1 Cryptocurrency
This is a digital currency using cryptography to make sure payments are sent and received. They are useful for transactions involving foreign currency, as both parties can agree to settle the transaction with a cryptocurrency rather than using foreign currency hedging techniques. This does present two key problems:
- Exchangeability: can exchange for a narrow range of major currencies
- Price volatility: exchange rates extremely volatile, there are opportunities to hedge this risk.
Forward contracts: tailored to individual and allow a business to hedge the value of a cryptocurrency in advance. A spread of rates are given in the exam, and we need to select the correct rate for the transaction as the bank will offer the least attractive rate for the business.
Futures contracts: Bitcoin futures are standardised contracts that can be traded on an exchange, to protect against future changes in the value of Bitcoin. For a payment in Bitcoin the company is concerned the price will rise and therefore buy futures today. For a receipt the company is concerned the price will fall and will sell futures today. Bitcoin futures are in a standardised size, the number of contracts is the transaction divided by the standard size.
9.1 Why exchange rates fluctuate
Purchasing power parity (PPP) claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries. PPP is based on the law of one price. In equilibrium identical goods must cost the same regardless of the currency in which they are sold. The country the higher inflation will be subject to a depreciation of its currency. To estimate the expected future spot rates, apply the formula:
Future spot rate = current spot rate x (1 + inflf) / (1 + influk)
Inflf is the expected foreign currency inflation rate for the period and influk is the expected UK inflation rate for the period.
Interest rate parity theory claims the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies. This is used by banks to calculate the forward rate quoted on a currency, the formula is:
Forward rate = current spot rate x (1 + if) / (1 + iuk)
If is the foreign currency interest rate for the period and iuk is the UK interest rate for the period
There are no bargain interest rates to be had on loans/deposits in one currency rather than another. However, where a government imposes controls on currency trading, or otherwise intervenes in the currency markets, its effectiveness is limited.
10.1 Risks of overseas trade
International trade increases the degree to which a firm faces physical, trade, liquidity and credit risk.
