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FM - Financial Management > Chapter 13 - Foreign Exchange Risk > Flashcards

Chapter 13 - Foreign Exchange Risk Flashcards

1
Q

What is an exchange rate?

A

The price of a currency relative to another currency

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2
Q

what are factors affecting demand for the £?

A
  • Uk exports
  • non UK tourists holidaying in the UK
  • Foreign direct investment
  • Speculation
  • Government intervention
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3
Q

What are the factors affecting supply of the £?

A
  • UK imports
  • UK tourists holidaying overseas
  • UK investors buying overseas assets
  • speculation
  • government intervention
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4
Q

What are the different types of exchange rate systems?

A
  • fixed exchange rates
  • freely floating exchange rates
  • managed floating exchange rates
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5
Q

What are fixed exchange rates?

A

where a government uses monetary policy and other methods to hold the rate steady

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6
Q

What are freely floating exchange rates?

A

no intervention by governments

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7
Q

What are managed floating exchange rates?

A

intervention to keep the value within a range

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8
Q

What is a floating exchange rate?

A

the authorities allow the forces of supply and demand to continuously change the exchange rates without intervention

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9
Q

If a currency depreciates what happens to the price (exchange rate)?

A

it falls, ‘getting weaker’ or ‘becoming less valuable’ e.g., £1 = $1.50 to £1 = $1.60

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10
Q

If a currency appreciates its exchange has what?

A

risen, ‘getting stronger’ or becoming more valuable e.g., £1 = $1.50 to £1 =$1.60

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11
Q

What is the base currency?

A

this is the ‘home’ currency. Currency that has a value of 1 in the quoted exchange rate

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12
Q

What is the counter currency?

A

this is the ‘other’, or ‘foreign’ currency to the home one, the one whose value varies.

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13
Q

What happens if one currency was to depreciate?

A

the other appreciates

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14
Q

What is a transaction risk?

A

the short term movement in rates before an individual transaction is settled

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15
Q

What is economic risk?

A

the long term transaction risk of exchange rate movement that affects international competitiveness

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16
Q

For an export company economic risk could occur because of what?

A
  • the home currency strengthens against the currency in which it trades
  • a competitor’s home currency weakens against the currency in which it trades
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17
Q

What is translation risk?

A

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

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18
Q

What is an exchange rate spread?

A

When banks dealing in foreign currency quote 2 prices for an exchange rate

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19
Q

What is the ‘lower price’ in relation to the exchange rate spread?

A

price at which the bank will sell the counter currency in exchange for the base currency. ‘The bank sells low’

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20
Q

What is the ‘higher price’ in relation to the exchange rate spread?

A

the price at which the bank will buy the counter currency in exchange for the base currency. ‘The bank buys high’

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21
Q

What is the spot market?

A

where you can buy and sell a currency now (immediate delivery)

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22
Q

What is the spot rate of exchange?

A

the exchange rate as of today

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23
Q

What is the forward market?

A

where you can buy and sell a currency at a fixed future date for a predetermined rate, by entering into a forward exchange contract

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24
Q

What is the purchasing power parity theory (PPPT)?

A

Claims that the rate of exchange between 2 currencies depends on the relative inflation rates within the respective countries.

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25
Q

What happens with the country with higher inflation rate?

A

will be subject to a depreciation of its currency

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26
Q

What is the formula to estimate expected future spot rates (provided in exam)?

A

S1 = So x (1 + hc) / (1 + hb)

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27
Q

What does S1 represent in the future spot rate formula?

A

represents the future spot exchange rate

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28
Q

What does So represent in the future spot rate formula?

A

represents the current spot exchange rate

29
Q

What does hc represent in the future spot rate formula?

A

represents the inflation of the country with the counter currency

30
Q

What does hb represent in the future spot rate formula?

A

represents inflation in the base country

31
Q

what are the limitations of PPPT?

A
  • the future inflation rates are estimates
  • the market is dominated by speculative transactions
  • government may intervene to manage exchange rates
32
Q

what is the interest rate parity theory (IRPT)?

A

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

33
Q

what is the forward rate?

A

a future exchange rate, agreed now, for buying or selling an amount of currency on an agreed date

34
Q

The country with the higher interest rate see the forward rate for what?

A

for its currency subject to a depreciation

35
Q

What is the formula for forward rates (provided in exam)?

A

Fo = So x (1 + ic) / (1+ ib)

36
Q

What does Fo represent in the forward rates formula?

A

represents the current forward exchange rate

37
Q

What does So represent in the forward rates formula?

A

represents the current spot exchange rate

38
Q

What does ic represent in the forward rates formula?

A

represents the interest rate of the country with the counter currency

39
Q

What does ib represent in the forward rates formula?

A

represents the interest rate in the base country

40
Q

What are the limitations of forward rates?

A
  • government controls on capital markets
  • controls on currency trading
  • intervention in foreign exchange markets
41
Q

Taking measures to eliminate or reduce a risk is called what?

A

hedging the risk or hedging the exposure

42
Q

What are some practical approaches of managing risk?

A
  • Deal in home currency
  • do nothing
  • Leading
  • Lagging
  • Matching receipts and payments
  • Netting
  • Foreign currency bank accounts
  • Matching assets and liabilities
43
Q

Using a practical approach such as dealing in home currency reduces what?

A

competitiveness

44
Q

Using a practical approach such as doing nothing may lead to what?

A

may end up better or worse off

45
Q

Using a practical approach such as leading gives what movement?

A

if anticipate adverse movement in exchange rates

46
Q

Using a practical approach such as lagging gives what movement?

A

if anticipate favourable movement in exchange rates

47
Q

Using a practical approach such as matching receipts and payments leads to what?

A

net off to reduce exposure

48
Q

What is a forwards contract?

A

a binding agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate

49
Q

What are forward exchange contracts used for?

A

to hedge against transaction risk. Exchange made at pre-agreed forward rate

50
Q

What are some advantages of forward exchange contracts?

A
  • flexibility on amount and date
  • straightforward
51
Q

What are some disadvantages of forward exchange contracts?

A
  • contractual commitment
  • no opportunity to benefit from favourable rate movements
52
Q

What is the practical approach of netting?

A

inter-company balances netted before payment

53
Q

What is the practical approach of matching assets and liabilities?

A

pay for foreign asset and foreign currency loan

54
Q

What is money market hedging?

A

Instead of waiting until the contract settlement date to make the currency exchange, currency is exchanged today

55
Q

what are the 3 stages in a money market hedge?

A

Borrow
Translate
Invest

56
Q

If it is a payment in regards to money market hedging what am I borrow and investing?

A

Borrow - Home currency
Invest - Foreign currency
Translate - Lower spread

57
Q

If it is a receipt in regards to money market hedging what am I borrow and investing?

A

Borrow - foreign currency
Invest - home currency
Translate - higher spread

57
Q

What is the calculation for finding the PV of a foreign currency deposit or borrowing?

A

take the future foreign currency value and divide by (1 + the applicable interest rate)

57
Q

What is the first step in a money market hedge method?

A
  • calculating the present value of a foreign currency deposit (for a payment) or a foreign currency borrowing (for a receipt)
57
Q

What is the second step of the money market hedge?

A

Calculate the equivalent value in the home (base) currency

58
Q

What is the third and last step of the money market hedge?

A

calculate the final value of the home currency borrowing or deposit

59
Q

How do we calculate the final value of the home currency borrowing or deposit?

A

multiply the borrowed or deposited value by (1 + the applicable interest rate)

60
Q

When a money market hedge is set up correctly, the exposure to changing exchange rates is reduced to what?

A

zero, because the currency exchange itself takes place today rather than on the settlement date

61
Q

What are some features of futures contarcts?

A
  • 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
62
Q

What are currency options?

A

Options give the right but not the obligation to buy or sell currency at some point in the future at a predetermined rate

63
Q

What do options provide?

A

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.

64
Q

Options may be what?

A

put - the right to sell currency at a particular rate
call - the right to buy currency at a particular rate

65
Q

What is a premium?

A

An upfront fee payable to take out an option

FM - Financial Management (19 decks)

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