Chapter 14 - Foreign currency risk Flashcards
What is transaction risk?
The risk of foreign currency transactions having a variable value in domestic currency due to a change in rates
What format are spot rates presented in?
Buy - Sell
What are the different internal hedging techniques?
- Matching - assets and liabilities
- Leading - pay in advance
- Lagging - pay later
- Netting - receivables and payables
- Invoice in local currency
What are the characteristics of forward contracts?
- Fixed exchange rate arranged now for date set in future
- Customised - any date and amount
- OTC
What are the advantages of forward contracts?
- Simple
- Low set up costs
- Available
What are the disadvantages of forward contracts?
- Fixed date - inflexible
- Unattractive rate
- Counterparty risk
How does money market hedging work for receipts?
Set up a foreign currency loan
- Receive
- Borrow
- Sell - spot
- Invest
How does money market hedging work for payments?
Set up a foreign currency investment
- Pay
- Invest
- Buy - spot
- Borrow
What are the characteristics of currency futures?
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
What are the advantages of currency futures?
- For period of time
- Lower counterparty risk - futures exchange guarantees
What are the disadvantages of currency futures?
- Standard contract sizes - less suitable for small transactions
- Narrow range of currencies
- Basis risk
What are the characteristics of currency options?
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
What are the advantages of currency options?
- Valid for period of time
- Can be sold on if not needed
What are the disadvantages of currency options?
- Expensive - premium
- Large, standard contract sizes
- Narrow range of currencies
What are currency swaps?
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
How does balance of payments work?
Balance deficit (more currency being sold to pay for imports than is being bought for exports) results in a weakened currency
What does purchasing power parity theory suggest?
Relatively high inflation causes a weakening of the exchange rate
Is PPP theory true over short term or long term?
Long term
What are high interest rates associated with?
Weakening currencies
What is interest rate parity theory calculate?
Forward rates based on interest rate changes
What is translation risk?
Risk of changes in the domestic value of foreign assets and liabilities
What is economic risk?
Change in company value due to long-term exchange rate movements