Chapter 13 - Foreign Exchange Risk Flashcards
What is an exchange rate?
The price of a currency relative to another currency
what are factors affecting demand for the £?
- Uk exports
- non UK tourists holidaying in the UK
- Foreign direct investment
- Speculation
- Government intervention
What are the factors affecting supply of the £?
- UK imports
- UK tourists holidaying overseas
- UK investors buying overseas assets
- speculation
- government intervention
What are the different types of exchange rate systems?
- fixed exchange rates
- freely floating exchange rates
- managed floating exchange rates
What are fixed exchange rates?
where a government uses monetary policy and other methods to hold the rate steady
What are freely floating exchange rates?
no intervention by governments
What are managed floating exchange rates?
intervention to keep the value within a range
What is a floating exchange rate?
the authorities allow the forces of supply and demand to continuously change the exchange rates without intervention
If a currency depreciates what happens to the price (exchange rate)?
it falls, ‘getting weaker’ or ‘becoming less valuable’ e.g., £1 = $1.50 to £1 = $1.60
If a currency appreciates its exchange has what?
risen, ‘getting stronger’ or becoming more valuable e.g., £1 = $1.50 to £1 =$1.60
What is the base currency?
this is the ‘home’ currency. Currency that has a value of 1 in the quoted exchange rate
What is the counter currency?
this is the ‘other’, or ‘foreign’ currency to the home one, the one whose value varies.
What happens if one currency was to depreciate?
the other appreciates
What is a transaction risk?
the short term movement in rates before an individual transaction is settled
What is economic risk?
the long term transaction risk of exchange rate movement that affects international competitiveness
For an export company economic risk could occur because of what?
- the home currency strengthens against the currency in which it trades
- a competitor’s home currency weakens against the currency in which it trades
What is translation risk?
where the reported performance of an overseas subsidiary in home-based currency terms is distorted in financial statements because of a change in exchange rates
What is an exchange rate spread?
When banks dealing in foreign currency quote 2 prices for an exchange rate
What is the ‘lower price’ in relation to the exchange rate spread?
price at which the bank will sell the counter currency in exchange for the base currency. ‘The bank sells low’
What is the ‘higher price’ in relation to the exchange rate spread?
the price at which the bank will buy the counter currency in exchange for the base currency. ‘The bank buys high’
What is the spot market?
where you can buy and sell a currency now (immediate delivery)
What is the spot rate of exchange?
the exchange rate as of today
What is the forward market?
where you can buy and sell a currency at a fixed future date for a predetermined rate, by entering into a forward exchange contract
What is the purchasing power parity theory (PPPT)?
Claims that the rate of exchange between 2 currencies depends on the relative inflation rates within the respective countries.
What happens with the country with higher inflation rate?
will be subject to a depreciation of its currency
What is the formula to estimate expected future spot rates (provided in exam)?
S1 = So x (1 + hc) / (1 + hb)
What does S1 represent in the future spot rate formula?
represents the future spot exchange rate
What does So represent in the future spot rate formula?
represents the current spot exchange rate
What does hc represent in the future spot rate formula?
represents the inflation of the country with the counter currency
What does hb represent in the future spot rate formula?
represents inflation in the base country
what are the limitations of PPPT?
- the future inflation rates are estimates
- the market is dominated by speculative transactions
- government may intervene to manage exchange rates
what is the interest rate parity theory (IRPT)?
claims that the difference between the spot and the forward exchange rates is equal to the differential between interest rates available in the 2 countries
what is the forward rate?
a future exchange rate, agreed now, for buying or selling an amount of currency on an agreed date
The country with the higher interest rate see the forward rate for what?
for its currency subject to a depreciation
What is the formula for forward rates (provided in exam)?
Fo = So x (1 + ic) / (1+ ib)
What does Fo represent in the forward rates formula?
represents the current forward exchange rate
What does So represent in the forward rates formula?
represents the current spot exchange rate
What does ic represent in the forward rates formula?
represents the interest rate of the country with the counter currency
What does ib represent in the forward rates formula?
represents the interest rate in the base country
What are the limitations of forward rates?
- government controls on capital markets
- controls on currency trading
- intervention in foreign exchange markets
Taking measures to eliminate or reduce a risk is called what?
hedging the risk or hedging the exposure
What are some practical approaches of managing risk?
- Deal in home currency
- do nothing
- Leading
- Lagging
- Matching receipts and payments
- Netting
- Foreign currency bank accounts
- Matching assets and liabilities
Using a practical approach such as dealing in home currency reduces what?
competitiveness
Using a practical approach such as doing nothing may lead to what?
may end up better or worse off
Using a practical approach such as leading gives what movement?
if anticipate adverse movement in exchange rates
Using a practical approach such as lagging gives what movement?
if anticipate favourable movement in exchange rates
Using a practical approach such as matching receipts and payments leads to what?
net off to reduce exposure
What is a forwards contract?
a binding agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate
What are forward exchange contracts used for?
to hedge against transaction risk. Exchange made at pre-agreed forward rate
What are some advantages of forward exchange contracts?
- flexibility on amount and date
- straightforward
What are some disadvantages of forward exchange contracts?
- contractual commitment
- no opportunity to benefit from favourable rate movements
What is the practical approach of netting?
inter-company balances netted before payment
What is the practical approach of matching assets and liabilities?
pay for foreign asset and foreign currency loan
What is money market hedging?
Instead of waiting until the contract settlement date to make the currency exchange, currency is exchanged today
what are the 3 stages in a money market hedge?
Borrow
Translate
Invest
If it is a payment in regards to money market hedging what am I borrow and investing?
Borrow - Home currency
Invest - Foreign currency
Translate - Lower spread
If it is a receipt in regards to money market hedging what am I borrow and investing?
Borrow - foreign currency
Invest - home currency
Translate - higher spread
What is the calculation for finding the PV of a foreign currency deposit or borrowing?
take the future foreign currency value and divide by (1 + the applicable interest rate)
What is the first step in a money market hedge method?
- calculating the present value of a foreign currency deposit (for a payment) or a foreign currency borrowing (for a receipt)
What is the second step of the money market hedge?
Calculate the equivalent value in the home (base) currency
What is the third and last step of the money market hedge?
calculate the final value of the home currency borrowing or deposit
How do we calculate the final value of the home currency borrowing or deposit?
multiply the borrowed or deposited value by (1 + the applicable interest rate)
When a money market hedge is set up correctly, the exposure to changing exchange rates is reduced to what?
zero, because the currency exchange itself takes place today rather than on the settlement date
What are some features of futures contarcts?
- like a forward in that they fix the foreign currency rate and are binding
- are tradable on future exchanges
- are settled on three month cycles
- are for standardised amounts
- are priced at the exchange rate specified in the contract
What are 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
What do options provide?
extra flexibility - the opportunity to take advantage of favourable rate movements, but they come with a cost - a premium paid up front and spent whether the option is exercised or not.
Options may be what?
put - the right to sell currency at a particular rate
call - the right to buy currency at a particular rate
What is a premium?
An upfront fee payable to take out an option
