Chapter 13 - Foreign Exchange Risk

Question 1

Transaction risk

Answer 1

1. The risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. The gain or loss arising on conversion.
2. Arises on any future transaction involving conversion between two currencies. Most commonly experienced between imports and exports.

Question 2

Economic risk

Answer 2

1. The variation in the value of the business (the PV of future cash flows) due to unexpected changes in exchange rates. It is the long term version of transaction risk.
2. For an export company, it could occur because
   - The home currency strengthens against the currency in which it trades.
   - A competitors home currency weakens against the currency in which it trades.

Question 3

Translation risk

Answer 3

1. Where the reported performance of an overseas subsidiary in home based currency terms is distorted in consolidated financial statements because of a change in exchange rates.

N.B. This is an accounting risk rather than a cash-based one.

2. The financial statements of overseas subsidiaries are usually translated into the home currency so that they can be consolidated into the group’s financial statements.
3. The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement.
4. Unless managers believe the company’s share price will fall as a result of a translation exposure loss in the company’s accounts, translation exposure will not normally be hedged. The company’s share price in an efficient market should only react to exposure that is likely to have an impact on cash flows.

Question 4

Purchasing Power Parity Theory (PPPT)

Answer 4

PPPT claims the rate of exchange between two currencies depends on the relative inflation rates within the respective countries (the law of one price).

Question 5

Depreciation and appreciation of a foreign currency

Answer 5

1. If a foreign currency depreciates, it is now worth less in our home currency.
   Receipt - adverse movement - will receive less in your home currency.
   Payment - favourable movement - will end up paying less in your home currency.
2. If a foreign currency appreciates, it is now worth more in our home currency.
   Receipt - favourable movement - will receive more in your home currency.
   Payment - adverse movement - will end up paying more in your home currency.

Question 6

Managing foreign currency risk

Answer 6

Practical approaches to managing foreign currency risk include

1. Deal in home currency
2. Do nothing
3. Leading
4. Lagging
5. Matching receipts and payments
6. Foreign currency bank accounts
7. Matching assets and liabilities

Question 7

A money market hedge

Answer 7

1. The money markets are markets for wholesale (large scale) lending and borrowing or trading in short-term financial instruments.
2. Used to lend or borrow instead of hedging a currency exposure with a forward contract.
3. Since forward exchange rates are derived from spot rates and money market interest rates, the end result from hedging should be roughly the same by either method.

Question 8

Hedging a payment

Answer 8

1. Buy the PV of the foreign currency amount today at the spot rate.
   - This is in effect an immediate payment in sterling.
   - May involve borrowing the funds to pay earlier than the settlement date.
2. The foreign currency purchased is placed on deposit and accrues interest until the transaction date.
3. The deposit is then used to make the foreign currency deposit.

Question 9

Hedging a receipt

Answer 9

1. Borrow the present value of the foreign currency amount today:
   - Sell it at the spot rate.
   - This results in an immediate result in sterling.
   - This can be invested until the date it was due.
2. The foreign loan accrued interest until the transaction date.
3. The loan is then repaid with the foreign currency receipt.