Chapter 8 - Currency risk - exchange rates

Question 1

Currency Quotations

Answer 1

1. Impact on exporters if local currency strengthens (foreign currency weakens)
   * Exporters suffer if the foreign currency weakens because their revenue is in the foreign currency
2. Impact on importers if local currency weakens (foreign currency strengthens)
   * Importers suffer if the foreign currency strengthens because their costs are in the foreign currency

Question 2

Spot Rate:

Answer 2

The current rate available in the market today

Question 3

Forward Exchange Rate:

Answer 3

An exchange rate set for the exchange of currencies at some future date

Question 4

Spreads:

Answer 4

• Bid/ Offer spread = offering different exchange rates to exporters and importers, so that a bank can make a profit on the spread (the difference)

E.g = 1.9612 – 1.9618 A$ to the £

• 1.9612 A$ will be received by the importer when it sells to the bank
• 1.9618 A$ will be paid by the exported when it buys from the bank
• Remember = the company will always be offered the worst rate between the two by the bank

Question 5

Direct Rates:

Answer 5

The amount of domestic currency that is equal to one foreign unit of currency (£0.55 per $)

Question 6

Indirect Rates:

Answer 6

The amount of foreign currency that is equal to one domestic currency ($2 per £)
(Does not immediately tell you the value of the currency)

Question 7

Factors affecting the Spot Rate

Answer 7

• The exchange rate is determined primarily by supply and demand in the foreign exchange markets
• Demand comes from those who want to buy a currency and supply comes from those who want to sell it

Question 8

Reasons businesses would want to forecast exchange rate movements:

Answer 8

• Adverse movements may seriously impact receivable and payables values which means businesses will need to take exchange rate movements into account when making pricing decisions
• Longer-term exchange rate movements will influence investment appraisal decisions
• Future exchange rates can be forecasted using PPP and IRP

Question 9

Purchase Power Parity:

Answer 9

• Long term decline in the value of a foreign currency is caused by a foreign country having a higher rate of inflation than the domestic country
• PPP theory suggests that the impact of higher inflation is to decrease the purchasing power of the foreign exchange currency which over time will reduce its value on foreign currency markets

Question 10

PPP Formula:

Answer 10

S1 = S0 x ([ 1+rvar]) / ([1+r base])

Question 11

Interest Rate Parity:

Answer 11

• Difference between spot and forward rates reflects differences in interest rates
• If this were not so, then investors holding the currency with the lower interest rate would switch to the other currency, ensuring that they would not lose on returning to the original currency by fixing the exchange rate in advance at the forward rate
• If enough investors acted in this way, forces of demand and supply wold lead to a change in the forward rate to prevent such risk-free profit making
• The IRP principle links the foreign exchange markets & international money markets
• The IRP formula is the same as the PPP formula

Question 12

The Fisher Effect:

Answer 12

• Interest rate differentials between countries provide an unbiased predictor for future changes in spot exchange rates
• Currency of two countries with relatively high interest rates is expected to depreciate against currencies with lower interest rates, because higher interest rates are considered necessary to compensate for the anticipated currency depreciation
• The interest rate used in the IPR formula is the nominal(money) interest rate
• To adjust interest rate to get either money or real interest rate:
  (1 + r nominal) = (1 + r real) x (1 + inflation)

Question 13

Internal Hedging Techniques:

Answer 13

1. Invoicing in the company’s home currency
   * Transfers risk to customer/ supplier but may affect demand if product has some price elasticity
2. Matching receipts and payments
   * Facilitated by having an overseas bank account – does present some translation risk at reporting date
3. Matching assets and liabilities
   * Financing investments in overseas assets by using loan finance in the same currency
4. Leading and/or lagging
   * To take advantage of the benefits of either paying in advance or delaying payment to enjoy favourable movements in exchange rates
   * Opportunity cost should be taken into account – missing out on discounts for prompt payment & predicting exchange rates is inherently risky
5. Netting off inter-company balances, such as receivables and payables so only the net amount is transferred
   * Could be bi-lateral between two companies or multi-lateral if more than two is involved