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P3 > Chapter 12 - Currency risk managment > Flashcards

Chapter 12 - Currency risk managment Flashcards

1
Q

What is spot rate?

A

This is the rate given for a transaction with immediate delivery. In practice this means it will be settled within two working days.

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2
Q

What is the spread concerning banks?

A

Banks do not operate wholly for the greater good; in fact they wish to make a profit out of the deal. This means that they need to earn a margin or spread on the deal, as well as commission and fees.

e.g. 1 GBP = 1.5500-1.4500 USD
The rate at which the bank will sell the variable currency in exchange for the base currency (GBP) is 1.4500 USD.
The rate at which the bank will buy USDs in exchange for GBPs is 1.5500 USD.

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3
Q

Assume that the spread is GBP 1 = USD 1.5500 - 1.4500. Consider the situations of three UK based companies:

A C Ltd imports good from Texas to the value of USD 100,000. Payment is cash on delivery; what is the cost in sterling of this purchase?
B B Plc exports goods to California valued at USD50,000. Receipt payment is immediate on delivery of the goods; what is the value of GBP received?
C P Ltd wishes to buy a product from US that is for sale in the UK at GBP12 each; at what dollar price must it purchase the product?

A

A 68,966GBP
B 32,260GBP
C 17.4USD

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4
Q

The exchange rate for USD/GBP is USD1.4417/GBP1 and the exchange rate for EUR/GBP is 1.1250.

How many dollars are there to the Euro?

A

1.2815

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5
Q

A US company has to pay EUR100,000 for a machine. You have the following information:

GBP/EUR = 1.5300
GBP/USD = 1.8700

What is the cost of the machine in dollars?

A

122,222USD

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6
Q

List some of the reasons why foreign exchange rate has to be forecasted

A
  • Foreign Debtor and Creditor balances
  • Working capital
  • Investment appraisal of foreign subsidiaries
  • Pricing
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7
Q

What is PPPT?

A

Theory of Purchasing Power Parity suggests that the rate of exchange will be directly determined by the relative rates of inflation suffered by each currency. If one country suffers a greater rate of inflation than another, its currency should be worth less in comparative terms.

The basis of PPP is the ‘Law of One Price’:

  • Identical goods must cost the same regardless of the currency in which they are sold.
  • If this is not the case, then arbitrage will take place until a single price is charged.
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8
Q

What is the formula for PPPT?

A

Future spot rate = Current spot rate x ((I + rate of inflation in the foreign currency) / (I + rate of inflation in the home currency))

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9
Q

The USD and GBP are currently trading at GBP/USD = 1.7200. Inflation in US is expected to grow at 3% pa, but at 4% pa in the UK.

What is the future spot rate in a year’s time?

A

1.7200 x (1.03/1.04) = 1.7035

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10
Q

What are the issues with PPPT?

A
  • In many markets it is apparent that the suppliers or manufacturers charge what the market will bear, this differing from one market to another
  • The costs of physically moving some products from one place to another mean that there will always be a premium in some markets in relation to another
  • Differing taxation regimes may dramatically affect the costs of a product in each market to limit the amount of arbitrage that occurs
  • manufacturers may be able to successfully differentiate products in each market to limit the amount of arbitrage that occurs
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11
Q

Why PPPT may not be a good predictor of future spot rate?

A
  • Future inflation rates are only an estimate and often cannot be relied upon to be accurate
  • The market is dominated by speculation and currency investment rather than trade in physical goods
  • Government intervention in both direct (e.g. management of exchange rates) and indirect ways (e.g. taxation policies) can nullify the impact of PPPT.
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12
Q

Explain IRPT

A

Interest rate parity theory claims that the difference between the spot rate and the forward exchange rates is equal to the differential between interest rates available in the two currencies. The forward rate is a future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date.

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13
Q

What is the rule of IRPT?

What is the formula for IRPT?

A

IRPT predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation.
Formula for IRPT is al follows:
Forward rate = Current spot rate x ((I+money risk-free rate of interest for the foreign currency) / (I+ money risk-free rate for interest for the home currency)

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14
Q

A treasurer can borrow in CHF at a rate of 3% pa or in the UK at a rate of 7% pa. The current rate of exchange is GBP1/CHF10

What is likely rate of exchange in a year’s time?

A

GBP/CHF=9.6262CHF

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15
Q

What is the limitation for IRPT?

A

The only limitation on the universal applicability of this relationship will be due to government intervention. These may arise in a number of ways including the following:

  • Controls on capital markets - the government may limit the range and type of markets within their financial services system.
  • Controls on currency trading - These may be in the form of a limit on the amount of currency that may be taken out of a country or the use of an ‘official’ exchange rate that does not bear any relation to the ‘effective’ rate at which the markets wish to trade.
  • Government intervention in the market - The government may attempt to control or manipulate the exchange rate by buying or selling their own currency.
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16
Q

What is International Fisher Effect?

A

The international Fisher Effect claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange. The international Fisher Effect assumes that all countries will have the same real interest rate, although nominal or money rates may differ due to expected inflation rates.
Thus the interest rate differential between two countries should be equal to the expected inflation differential. Therefore, countries with higher expected inflation rates will have higher nominal interest rates, and vice versa.

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17
Q

What is the formula for IFE?

A

(1 + nominal rate) = (1 + real rate) x (1+ inflation rate)

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18
Q

One-year money market interest rate in the UK are 5.06%. Inflation in the UK is currently running at 3% per annum. What is the real rate?

A

The real one-year interest rate in the UK can be calculated as follows:

1.0506 = (1 + real rate) x (1.03)
1 + real rate = 1.0506/1.03 = 1.02
Real rate = 1.02 - 1 = 2% per year

The nominal or market interest rates in any country must be sufficient to reward investors with a suitable real return plus an additional return to allow for the effects of inflation.

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19
Q

If the interest rate on USD deposits is 8%, the interest rate on EUR deposits is 5%, and the spot rate is USD/EUR0.9200, what is the one year forward rate predicted to be if interest rate parity holds?

A USD/EUR0.9463
B USD/EUR1.0567
C USD/EUR0.8944
D USD/EUR1.1180

A

C

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20
Q

What is Arbitrage?

A

Arbitrage is the simultaneous purchase and sale of a security in different markets with the aim of making a risk-free profit through the exploitation of any price differences between the two markets.

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21
Q

A speculator can buy USD2 for GBP1, sell one EUR for GBP0.8 and can sell USD for USD1.50EUR1. There is GBP1,000,000 available to invest for the purpose of making a profit.

What is the possible profit using arbitrage opportunities?

A

GBP66,700

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22
Q

What are the stages in financial risk management?

A

Essentially these are same as in any risk management process:

  1. Identify risk exposures
  2. Quantify risk exposures
  3. Decide whether hedge or not
  4. Implement and monitor hedging program
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23
Q

What are the benefits of hedging?

A
  • Hedging can provide certainty of cash flows which will assist in the budgeting process
  • Risk will be reduced, and hence management may be more inclined to undertake investment projects
  • Reduction in the probability of financial collapse (bankruptcy)
  • Managers are often risk-averse since their job is at risk. If a company has a policy of hedging it may be perceived as a more attractive employer to risk-averse managers
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24
Q

What are the arguments agains hedging?

A
  • shareholders have diversified their own portfolio, thus further hedging by the business may harm shareholders’ interests
  • transaction costs associated with hedging can be significant
  • lack of expertise within the business, particularly with regards to use of derivative instruments
  • complexity of accounting and tax issues associated with the use of derivatives.
25
Q

What is derivatives?

A

A derivative is a financial instrument whose value depends on the price of some other financial asset or underlying factor (such as gold, oil, interest rates or currencies)

Derivatives have the following uses:

  • Hedging
  • Speculation
  • Arbitrage
26
Q

What are the functions of treasury?

A

The treasury function exists in every business, though in a small business it may be absorbed into the accounting or company secretarial work. The main functions of treasury are:

  • managing relationships with the banks - regarding the investment of surplus cash or making arrangements to allow deficits of cash or to arrange hedging
  • working capital and liquidity management - to ensure that sufficient but not excessive amount of cash are available on a daily basis to fund inventory, payables and receivables
  • long-term funding management - providing cash for longer term investments such as non-current assets or arranging mortgages / debentures
  • currency management - dealing with all currencies which entail both internal and external hedging techniques, sourcing currencies, managing foreign currency bank accounts
27
Q

Treasury function can be Profit/cost centre. Explain

A

Advantages of operating as a profit centre, as opposed to cost centre include:

  • a market rate is charged to business units throughout the entity, economically as possible.
  • the treasurer is motivated to provide services as efficiently and economically as possible.

The main disadvantages are:

  • the profit concept brings the temptation to speculate and take excessive risk
  • management time can be wasted on discussions about internal charges for the treasury activities
  • additional administrative costs will be incurred
28
Q

Explain difference between Centralised and decentralised treasury

A

Many large companies operate a centralised treasury function, which has merits and limitations.
Risks associated with centralised treasury include:
- a lack of motivation towards managing cash in the subsidiaries, since any cash that is received is swept up to head office to be managed from the group’s perspective
- the risk that, should head office commit some error in their treasury operations, the financial health of the whole group could be placed in jeopardy.

Risks associated with decentralised activity are:

  • that one company might pay large overdraft interest costs, while another cash balances in hand earning low interest rates.
  • the risk of not generating the profits for the group that would be earned if the group funds were actively managed by a treasury operation seeking profits rather than individual executives just seeking to minimise costs.
29
Q

There are methods for currency risk management. Which?

A
  1. Internal methods
    - Invoice in home currency
    - Leading/lagging payments
    - Offsetting - matching, netting and pooling
    - Countertrade
  2. External methods
    - Forward
    - MMH
    - Futures
    - Options
    - Swaps
30
Q

What are the issues with invoicing in home currency?

A
  • the customers and suppliers may not be prepared to accept all the currency risk and therefore they will not trade with the business.
  • the other parties may not be prepared to accept the same prices and will require discounts on sales or premiums on purchases
  • there are other ways of hedging risks that mean that the risk transacting in foreign currency is acceptable
31
Q

What are the problems with leading and lagging?

A
  • Early payment will cost a company in interest foregone on the funds that have been disbursed early
  • The payee will not be happy that payment may become overdue, especially if the currency is expected to fall
  • it requires the company to take a view on exchange rates i.e. speculate. There is a risk that the company will be wrong.
32
Q

For netting to be successful participants must agree on a number of issues. What are those?

A
  • Currencies - which currencies will be used for invoicing? They may be the buyer’s, the seller’s or a third currency
  • Credit period - ideally all participants should have the same credit periods but there may be variations for those participants who are long or short of funds.
  • Settlement dates - the netting settlement dates and the netting cycle timetable must be known by all the participants and adhered to. Netting periods must also be decided e.g. weekly, monthly and etc.
  • Exchange rates - the exchange rates to be used in the netting must be agreed. Will it be spot or forward rates, mid at 11 00 am or some budgeted in house rate? Rates should be ‘arms length’ as there would be potential tax issues otherwise.
  • Conflict resolution - Multilateral netting may be payment driven, receivables driven or both. Either way disagreements will arise as to who owes what to whom so a process for sorting these issues out so that the items may be included in the netting will need to be in place. If not resolved then items may have to be pulled from the netting process.
  • Management - will it be a bespoke system or bank managed
33
Q

Forward contract rates are often quoted at a premium or discount to the current spot rate. Explain

A
  • A discount means that the currency being quoted (the dollar) is expected to fall in value in relation to the other currency (sterling). If a currency falls in value then you need more of that currency to buy a single unit of other. A discount is often to referred to as ‘dis’ and premium as ‘prem’.
  • A premium is vice versa to discount
34
Q

Calculate the forward contract bid and offer prices in the following situation:

(i) The current spot rate is GBP1=USD1.5500 - 1.4500 and, one month forward rate is quoted at 0.55 - 0.50 c dis
(ii) The current spot rate is GBP1=EUR1.7150 - 1.6450 and, one month forward rate is quoted at 0.68 - 0.75 c pm

A

(i) Add a discount to get the forward rate:
Spot rate 1.5500 - 1.4500
Add disc 0.0055 0.0050
Forward rate = 1.5555 - 1.4550

(ii) Subtract premium to get the forward rate:
Spot rate 1.7150 - 1.6450
Subtract prem (0.0068) (0.0075)
Forward rate = 1.7082 - 1.6375

35
Q

EEFS Ltd (a UK company) sold goods to the value of USD 2.0 million Receipt is due in 90 days.

The current spot rate is GBP1 = USD 1.5430 - 1.5150

There is a three-month discount forward of 2.5 cents - 1.5 cents

What is the amount of sterling that EEFS Ltd will receive under the forward contract?

A

Current spot rate 1.5430 - 1.5150
Add discount 0.0250 - 0.0150
Forward rate = 1.5680 - 1.5300

2,000,000 / 1.5680 = 1,275,500 GPB

36
Q

What are the advantages of forward contracts?

A
  • Are simple, and so have low transaction costs;
  • Can be purchased from a high street bank
  • Fix the exchange rate;
  • Are tailored, so are flexible to amount and delivery period
37
Q

What are the disadvantages of forward contracts?

A
  • A potential credit risk since the company is contractually bound to sell a currency, which it may not have received from its customer;
  • No upside potential
38
Q

The spot rate for Swiss franc is GBP1/CHF 1.6734 - 1.6802
The three month forward premium is 0.0200 - 0.0250

If you wanted to sell your CHF forward what exchange rate would you receive from the bank?

A
  1. 6734 - 0.0200 = 1.6534
  2. 6802 - 0.0250 = 1.6552

GBP1/CHF 1.6534 - 1.6552
The bank would sell GBP at 1.6552

39
Q

What is the MMH?

A

The money market are markets for wholesale (large-scale) lending and borrowing, or trading in short-term financial instruments. Many companies are able to borrow or deposit funds through their bank in the money markets.

40
Q

A UK company is due to receive USD 12,000 in 6 months time from a customer. The USD/GBP forward rate is 1.9550 - 1.9600 and the spot rate is 1.9960 - 1.9990.
Interest rates in the US to borrow are 12% and to lend are 11%. In the UK interest to borrow are 11% and to lend are 10%. If the company chooses to use a MMH, how much will they receive in GBPs in 6 months time?

A

The company should borrow from the bank just enough to end up owing exactly USD12,000
12000/1.06 = USD11,321
They should convert this into GBP at spot
11,321/1.9990 = GBP5,663
They should then invest this for 6 months in the UK
End up with 5,663 x 1.05 = GBP 5,946 (fixed, certain sum)

41
Q

DD Ltd (a UK company) is required to make a payment of EUR 1.3 million in 6 months’ time. The company treasurer has established the following rates going forward:

Spot rate GBP1 = EUR 1.5095 - 1.5050
Six month GBP1 = EUR 1.5162 - 1.4895

Money market rates (pa)
Loan Deposit
Euro 4.0% 2.5%
Sterling 4.6% 3.1%

Required: What is the GBP of making the payment using:

(a) money market hedge
(b) a forward contract hedge?
(c) re perform the contract and MMH assuming that the business will receive EUR 1.3 million in 6 months’ time.

A

(a) The MMH to pay EUR in 6 months’ time requires DD Ltd to borrow in GBP, translate to EUR and deposit in EUR.
A payment of EUR 1.3 million in 6 months (only 1.25% interest) will require a EUR deposit now of (EUR 1.3 million / 1.0125) = EUR 1,283,951. This means that with a spot rate of 1.5050 the GBP loan will need to be GBP 853,124.

The loan of GBP 853,124 will increase over the 6 months to the date of repayment by 2.3% and will therefore be GBP 872,746. The cost therefore GBP 872,746.

(b) The forward contract will use the six month forward rate of 1.4895 for buying EUR. The cost is therefore (EUR 1,300,000 / 1.4895) = GBP 872,776.
There is virtually no difference between the two methods. This is expected because any significant difference would mean that profit could be made simply by converting one currency into another.

(c) Under MMH the company would borrow EUR now, translate into GBP and deposit for 6 months.

The borrowing would be EUR 1,300,000 / 1.02 = EUR 1,274,510. This would translate now into 1,274,510 / 1.5095 = GBP 844,326.
By growth for interest for 6 months this becomes GBP 857,413.
The forward contract would give: EUR 1,300,000 / 1.5162 = GBP 857,407

42
Q

What are the advantages and disadvantages of MMH?

A

Advantages:

  • Ensure there is no currency risk because exchange takes place today.
  • Have fairly low transaction costs.
  • Offer flexibility (especially if customer delays payment).

Disadvantages:

  • They are complex
  • It may be difficult to get an overseas loan in the case of a foreign currency receipt.
43
Q

There is a three step process which can be followed to answer a futures question. What are those?

A 
Step 1. Set up:
- Do we initially buy or sell futures?
- Which expiry date should be chosen?
- How many contracts?
Step 2. Contract exchange - pay the initial margin and wait until the transaction/settlement date.
Step 3. Closing out
44
Q

What are the advantages and disadvantages of currency futures contracts?

A

Advantages:

  • Offer an effective ‘fixing’ of exchange rate
  • Have no transaction costs
  • Are tradable

Disadvantages:

  • A foreign futures market must be used for GBP futures;
  • They require up front margin payments
  • They are no usually for the precise tailored amounts that are required
45
Q

A UK company sells goods to a US company to the value of $2,650,000 in August. It is now June and spot is $1.9800/GBP. A June futures contract is quoted as $1.9790. A September futures contract is quoted as $1.9000. Sterling futures are traded in contracts of GBP62,500. The UK company always buys the minimum number of contracts, being prepared to leave un-hedged any small residual amount.

How many contracts should be bought?

A

22

46
Q

There are two types of option. Call and put. Explain difference

A

A call option gives the holder the right to buy the underlying currency

A put option gives the holder the right to sell the underlying currency.

47
Q

A UK exporter is due to receive USD 25 million in 3 months’ time. Its bank offers a 3 month dollar put option on USD 25 million at an exercise price of GBP/USD 1.5000 at a premium cost of GBP 300,000.

Show the net GBP receipt if the future spot is either USD 1.6000 or USD 1.4000

A

25,000,000 / 1.5000 = 16,666,670 GBP - 300,000 = 16.366,670 GBP.

25,000,000 / 1.6 = 15,625,000 GBP
25,000,000 / 1.4 = 17,857,140 GBP

48
Q

What are the advantages and disadvantages of currency options?

A

Advantages:
- They offer the perfect hedge (downside risk covered, can participate in upside potential
- They are many choices of strike price, dates, premiums and etc
- The option can be allowed to lapse if the future transaction does not arise
Disadvantages:
- Traded sterling currency options are only available in foreign currency
- There are high up-front premium costs

49
Q

A company is due to receive USD 3 million in 3 months’ time.
The spot rate is USD 1.9500/GBP but the company is worried that the USD will weaken. They have been offered a three month put option on USD at USD 1.9700/GBP, costing USD 0.02 per GBP.
If the company chooses to buy and then exercise the option, what is the net receipt in GBP?

A

The GBP received upon exercise will be 3,000,000/1.9700 = GBP 1,522,843.
The cost of the option will be 0.02 x 1,522,843 = USD 30,457.
At spot cost in GBP is 30,457/1.9500 = GBP 15,619.
Therefore the net receipt will be 1,522,843 - 15,619 = GBP 1,507,224

50
Q

Which of the following are characteristics of an ‘over the counter option’ as compared to an ‘exchange traded option’?

A Can be customised to meet the customer’s needs in term of amount and duration
B Settlement at maturity
C Easy to liquidate the position
D Potential to benefit from favourable exchange rate changes.

A

A B D

51
Q

The basic principle of the Black-Scholes model is that the market value, or price, of a call option consists of two key elements. What are those?

A
  • The intrinsic value of the option

- The time value of the option

52
Q

What are the limitations to Black-Scholes model?

A
  • It assumes that the risk-free interest rate is know and is constant throughout the option’s life
  • The standard deviation of returns from the underlying security must be accurately estimated and has to be constant throughout the option’s life. In practice standard deviation will vary depending on the period over which it is calculated; unfortunately the model is very sensitive to its value.
  • It assumes that there are no transaction costs or tax effects involved in buying or selling the option or the underlying item
53
Q

Which of the following is not a factor upon which an option value depends?

A The current share price
B The standard deviation of return on underlying share
C The time expiration of the option
D The number of shares in issue

A

D

54
Q

Which of the following would decrease the intrinsic value of a put option? Select all that apply

A An increase in the time to expiry
B A decrease in the market value of the share
C A decrease in the volatility value of the share
D A decrease in the strike price

A

D

55
Q

Which of the following will increase the value of a call option? Select all that apply

A An increase in the strike price
B An increase in the time to expiry
C A decrease in the volatility of the share
D A decrease in the market value of the share

A

B

56
Q

SW Plc is a UK company looking to expand in to the USA. It wants to raise USD 20 million at a variable interest rate. It has been quoted the following:

USD LIBOR + 60 points
GBP 1.2%

AP Inc is an American company looking to refinance an existing loan of GBP 18 million at a fixed rate. It can borrow at the following rates:

USD LIBOR + 50 points
GBP 1.5%
The current spot rate is USD 1 = GBP 0.9

Calculate the saving made by both companies if they enter into the currency swap

A

Savings for SW = $20,000
Savings for AP = GBP 54,000

Check page 759 for answer

57
Q

Which of the following is an external hedging technique? Select all that apply

A A forward contract
B A MMH
C Pooling
D A futures contract

A

A B D

58
Q

A UK company has sold goods to a Danish company and will receive 300 Danish Kroner in 3 moths time. Which of the following would hedge its position?

A Selling a call option on Kroner
B Buying a put option on Kroner
C Using the forward market to buy Kroner at the 3 month forward rate
D Buying Danish Kroner futures

A

B

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