Chapter 14 - Foreign currency risk

Question 1

What is transaction risk?

Answer 1

The risk of foreign currency transactions having a variable value in domestic currency due to a change in rates

Question 2

What format are spot rates presented in?

Answer 2

Buy - Sell

Question 3

What are the different internal hedging techniques?

Answer 3

• Matching - assets and liabilities
• Leading - pay in advance
• Lagging - pay later
• Netting - receivables and payables
• Invoice in local currency

Question 4

What are the characteristics of forward contracts?

Answer 4

• Fixed exchange rate arranged now for date set in future
• Customised - any date and amount
• OTC

Question 5

What are the advantages of forward contracts?

Answer 5

• Simple
• Low set up costs
• Available

Question 6

What are the disadvantages of forward contracts?

Answer 6

• Fixed date - inflexible
• Unattractive rate
• Counterparty risk

Question 7

How does money market hedging work for receipts?

Answer 7

Set up a foreign currency loan

• Receive
• Borrow
• Sell - spot
• Invest

Question 8

How does money market hedging work for payments?

Answer 8

Set up a foreign currency investment

• Pay
• Invest
• Buy - spot
• Borrow

Question 9

What are the characteristics of currency futures?

Answer 9

Contract to purchase or sell standard quantity of currency by agreed future date at specified exchange rate

• Fixed rate
• Standard amount
• Margin paid up front
• Separate from actual transaction
• Has to be exercised
• Expires quarter ends

Question 10

What are the advantages of currency futures?

Answer 10

• For period of time

- Lower counterparty risk - futures exchange guarantees

Question 11

What are the disadvantages of currency futures?

Answer 11

• Standard contract sizes - less suitable for small transactions
• Narrow range of currencies
• Basis risk

Question 12

What are the characteristics of currency options?

Answer 12

A right to buy (call) or sell (put) a quantity of a currency in exchange for another, at a specific rate on or before expiry date.

• Exchange traded / OTC
• Premium up front
• Like insurance policy
• Doesn’t need to be exercised

Question 13

What are the advantages of currency options?

Answer 13

• Valid for period of time

- Can be sold on if not needed

Question 14

What are the disadvantages of currency options?

Answer 14

• Expensive - premium
• Large, standard contract sizes
• Narrow range of currencies

Question 15

What are currency swaps?

Answer 15

Agreement in which two organisations agree to exchange payments on different terms

• Used to restructure currency base of liabilities
• Reduces exchange rate exposure over long temr

Question 16

How does balance of payments work?

Answer 16

Balance deficit (more currency being sold to pay for imports than is being bought for exports) results in a weakened currency

Question 17

What does purchasing power parity theory suggest?

Answer 17

Relatively high inflation causes a weakening of the exchange rate

Question 18

Is PPP theory true over short term or long term?

Answer 18

Long term

Question 19

What are high interest rates associated with?

Answer 19

Weakening currencies

Question 20

What is interest rate parity theory calculate?

Answer 20

Forward rates based on interest rate changes

Question 21

What is translation risk?

Answer 21

Risk of changes in the domestic value of foreign assets and liabilities

Question 22

What is economic risk?

Answer 22

Change in company value due to long-term exchange rate movements