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Financial Management ACCA > Chapter 19 - Currency risk management > Flashcards

Chapter 19 - Currency risk management Flashcards

1
Q

What are the three types of foreign exchange rate (or currency) risk?

A
  • Transaction
  • Translation
  • Economic
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2
Q

What is Transaction risk?

A

The gain or loss that arises when cash is converted following the settlement of a transaction

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3
Q

Give an example of Transaction risk

A

If you sell to the US and give the buyer 3 months to pay. The exchange rates can change in that time.

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4
Q

What is Translation risk?

A

The gain or loss that arises in financial statements when assets or liabilities are translated at the end of an accounting period.

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5
Q

Which type of currency risk is an accounting risk?

A

Translation

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6
Q

What is Economic risk?

A

The long term impact of exchange rate changes on the value of a business.

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7
Q

What is economic risk due to?

A

Strengthening and weakening of currencies over the long term

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8
Q

A currency is said to strengthen if it can…

A

buy more of another currency.

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9
Q

A currency is said to weaken if it can…

A

buy less of another currency

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10
Q

Is a strengthening currency a favorable or adverse risk for imports where payment is needed in another currency?

A

Favorable

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11
Q

Is a strengthening of a currency a favorable or adverse risk for exports where receipts arise in another currency

A

Adverse

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12
Q

What is the term given to the exchange rate for immediate conversion of cash from one currency into another.

A

Spot rate

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13
Q

What is the term given for the rate at which currency can be bought or sold on a future date using the forward
market.

A

Forward rate

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14
Q

What rate is used in a forward exchange contract?

A

Forward rate

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15
Q

What theory is below?

This theory suggests that exchange rate changes between two currencies (in the long term) depend on the relative inflation rates in those two currencies.

A

Purchasing Power Parity (PPPT)

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16
Q

What is the Purchasing power parity formula?

Its also in the formulae sheet

A

S1=S0 x (1+hc)/(1+hb)

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17
Q

What are S1, S0, hc and hb in the Purchasing power parity formula?

A 
S1 = the future expected spot rate
S0 = spot rate today
hc = inflation rate in the counter currency (the one that varies)
hb = inflation rate in the base currency (the one that is fixed)
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18
Q

What theory is below?

This theory suggests that the forward rate used in forward exchange contracts is based on interest rate
differentials. This means that it is based on the difference between interest rates between two different currencies

A

Interest Rate Parity (IRPT)

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19
Q

What is the interest rate parity formula?

Its also in the formulae sheet

A

F0=S0 x (1+ic)/(1+ib)

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20
Q

What are F0, S0, ic and ib in the interest rate parity formula?

A 
F0 = the forward rate or future expected spot rate
S0 = spot rate today
ic = interest rates in the counter currency (the one that varies)
ib = interest rates in the base currency (the one that is fixed)
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21
Q

What theory suggests…

The money rate of interest is made up of the real rate of interest and a premium because of inflation

A

The Fisher effect

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22
Q

What theory assumes…

That all countries will have the same real interest rate. What this means is that the difference in interest rates between two countries will be equal to the difference in inflation rates between two countries

A

International fisher effect

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23
Q

What theory states that…

The current forward rate is an unbiased predictor of the spot rate at that point in the future.

A

Expectations theory

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24
Q

What is it called when a foreign exchange rate dealer makes a profit when buying and selling currency?

A

Bid-offer spreading

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25
Q

What is the technique described below for managing currency risk?

This means that the currency risk arising is accepted. This might be suitable if the risk is deemed to be low.

A

Do nothing

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26
Q

What is the technique described below for managing currency risk?

A foreign bank account could be opened. Receipts could be deposited in the foreign bank account as and when they arise. Those receipts could then be used to make payments in the same foreign currency that arise on future dates.

A

Foreign bank accounts

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27
Q

What is the technique described below for managing currency risk?

The risk is effectively transferred to the other party to the transaction.

A

Invoice in home currency

28
Q

What is the technique described below for managing currency risk?

Receipts and payments in the same foreign currency and that arise at the same time are matched. A receipt is then used to partly make the payment.

A

Matching.

29
Q

What is the technique described below for managing currency risk?

This involves changing the timing of receipts or payments. Leading involves bringing forward a receipt or payment whereas lagging involves delaying a receipt or payment. This is done in order to convert at a more favourable exchange rate.

A

Leading and lagging

30
Q

What is the technique described below for managing currency risk?

If a company owns assets in a foreign currency the foreign exchange risk can be managed by borrowing in the same foreign currency. This means that if the asset loses value because of exchange rate changes the liability will also lose value.

A

Matching assets and liabilities

31
Q

What are the four main external hedging techniques?

A
  1. Forward exchange contracts
  2. Money market hedge
  3. Futures (a type of derivative)
  4. Options (a type of derivative)
32
Q

Is a forward exchange contract legally binding?

A

Yes

33
Q

What is a forward exchange contract for?

A

For the purchase or sale of a specified amount of foreign currency on a future date

34
Q

What is done to the forward rate when the contract is made in a forward exchange contract?

A

It is fixed

35
Q

What are the three advantages of forward exchange rate contracts?

A

▪ Fixes the rate and therefore eliminates adverse exchange rate movements
▪ Tailor made and therefore flexible in terms of the amount hedged and the settlement date
▪ Relatively simple and easy to arrange

36
Q

What are the two disadvantages of forward exchange rate contracts?

A

▪ Cannot take advantage of favourable exchange rate movements

▪ Legally binding, and therefore if the underlying transaction falls through then
the company using the forward contract is still obliged to complete the exchange of currency under the terms of the forward contract

37
Q

What is described below?

This involves borrowing in one currency, converting the borrowed money into another currency, and then putting the money on deposit until the time the transaction is completed.

A

Money Market Hedge

38
Q

Hedging a foreign currency payment

The physical process is as follows:

A

Step 1 – Borrow an appropriate amount in the home currency today
Step 2 – Convert the amount from the home currency into the foreign currency today
Step 3 – Put the amount in the foreign currency on deposit in a foreign currency bank account
Step 4 – Make the payment out of the foreign currency bank account

39
Q

Hedging a foreign currency receipt

The physical process is as follows:

A

Step 1 – Borrow an appropriate amount in the foreign currency today
Step 2 – Convert the amount borrowed from the foreign currency into the home currency today
Step 3 – Put the amount in the home currency on deposit in a home currency bank account
Step 4 – When cash is received from the customer use this to repay the foreign currency borrowings

40
Q

What type of contract is a future?

A

A derivative contract

41
Q

The value of the futures contract is derived from what?

A

The value of something else (e.g. shares or the exchange rate)

42
Q

Are futures contracts binding?

A

Yes

43
Q

What do futures and forward contacts protect against?

A

Adverse exchange rate movements

44
Q

What are futures quantities only allowed in?

A

Standard amounts (25k, 50k, 75k)

45
Q

When do settlement of futures contracts take place?

A

At the end of March, June, September and December

46
Q

Where are futures traded?

A

On the futures exchange

47
Q

What do futures provide more flexibility with compared to forward contracts?

A

The date upon which they need to be used

48
Q

What do futures require?

A

A margin to be deposited with a futures dealer

49
Q

What does a futures hedge not always give?

A

A perfect result in terms of the amount received or paid

50
Q

What type of contract is an option?

A

Derivative contract

51
Q

What does a currency option give the holder?

A

The right, but not the obligation, to buy (call) or sell (put) foreign currency at a specific exchange rate on a future date

52
Q

How might an option be traded?

A

On an exchange (traded option) or may be negotiated with a bank (negotiated option)

53
Q

What can a holder of an option do with it?

A

Can ‘exercise’ the option or allow the option to ‘lapse’

54
Q

What is the appeal of an option?

A

The holder to protect against adverse exchange rate movements whilst, at the same time take advantage of favourable exchange rate movements

55
Q

What is the most expensive hedging technique?

A

Options

56
Q

Does the holder of an option have to pay the premium if they do not exercise the option?

A

Yes

57
Q

Does translation risk effect shareholder wealth?

A

No

58
Q

What film do futures remind you of?

A

The big short

59
Q

Who is likely to use futures?

A

Speculators

60
Q

Whats the rule for banks buying and selling currency?

A

Banks buy high, banks sell low

61
Q

What is PPPT based on?

A

The law of one price

62
Q

What does PPPT claim?

A

That the exchange rate movements between two countries depends on the relative inflation rates within those countries.

63
Q

What are the 3 limitations of PPPT?

A
  • Future inflation rates are only estimates
  • Market dominated by speculative transactions (98%) so PPPT breaks down
  • Government intervention may defy forces pressing towards PPPT
64
Q

What does IRPT claim?

A

That the difference between the spot and the forward rates is equal to the differential between interest rates available in the two countries.

65
Q

What are the 3 limitations of IRPT?

A
  • There are government controls on capital markets
  • There are controls on currency trading
  • Intervention for foreign exchange markets
66
Q

What does the Fisher effect assume?

A

That the interest rates between two countries provide an unbiased predictor of future changes on the spot rate.

67
Q

What does expectations theory claim?

A

That the current forward rate is an unbiased predictor of the spot rate at that point in the future.

Financial Management ACCA (26 decks)

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