Chapter 9 Flashcards
Definition of exchange rate
Expressed in terms of the quanity of one currency that can be exchanged for one unit of the other currency
Direct quotes
One unit of foreign currency = its value in home currency
Indirect quotes
One unit of home currency = its value in foreign currency
What is the spot rate?
Rate given for a transaction with immediate delivery
Reasons for forecasting exchange rates
Foreign debtor and creditor balances
Working capital
Pricing
Investment appraisal
Consolidation of foreign subsidiaries
Two theories to help predict foreign exchange rate movements
Purchasing power parity
Interest rate parity
Purchasing price parity
Law of one price
Country with higher inflation will suffer a fall in the value of its home currency
Assumes rates are quoted as indirect quotes
Limitations of purchasing power parity
Future inflation rates may not be accurate
Speculation
Government intervention
Interest rate parity
Difference between spot and forward rate is equal to differential between interest rates available in two currencies
Both countries have the same real interest rate
Country with higher inflation rate will suffer a fall in the value of its currency
Assumes rates are quoted as indirect quotes
Limitations of interest rate parity
Controls on capital markets
Controls on currency trading
Government intervention
Internal methods of currency risk management
Home currency
Leading/Lagging
Matching/Netting
Countertrade
Home currency
Passes risk to other pary
Unlikely to be commercially acceptable
Leading/Lagging
Speed up/delay payment depending on expectations of exchange rate movement
Matching/Netting
Match/net off transactions in the same currency
Easier if use foreign bank accounts
Countertrade
Avoid using currency and exchange products of equivalent value
Definition of forward contract
Binding agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate
Advantages of forward contracts
Simple
Low transaction costs
Fix the exchange rate
Tailored
Disadvantages of forward contracts
Contractual commitments
Lose upside potential
Forward markets banned in some countries
Basic ideas of money market hedges
Avoid future exchange rate by making exchange now
Use interest rates to create assets and liabilities that ‘mirror’ the future assets and liabilities
Advantages of money market hedges
No currency risk
Fairly low transaction costs
Offers flexibility
May be able to use when forward contracts not available
Disadvantages of money market hedges
Complex
May be difficult to get overseas loan
A company with a large overdraft may struggle to borrow funds now
Reasons why hedge may not be perfectly efficient
Rounding the number of contracts
Closing out before expiry date
Advantages of currency futures
Effectively ‘fix’ the exchange rate
No transaction costs
Tradable
Disadvantages of currency futures
Require up front margin payments
Not for precise tailored amounts
Definition of currency options
Right, but not an obligation, to buy or sell a currency at exercise price on a future date
Features and operation of currency options
If favourable movements in rates the company will allow the option to lapse. The right will only be exercised to protect against an adverse movement
Writer of option will charge a non-refundable premium
Two types of options
Call option gives holder right to buy the underlying currency
Put option gives holder the right to sell the underlying option
Advantages of currency options
Can benefit it rates move favourably
Many choices of strike prices, dates and premiums
Can be allowed to lapse if not required
Disadvantages of currency options
High up-front premium costs
Traded options are not for precise tailored amounts
Intrinsic value
Difference between exercise price of the option and current market value of the product
Option with this is knows as ‘in the money’
Time value
Difference betweent the actual premium and the intrinsic value
Out of money meaning
Strike price is less favourable than the current spot rate
