Chapter 9 - Currency risk management - TO FINISH Flashcards
What is an exchange rate?
Expressed in terms of the quanity of one currency that can be exchanged for one unit of the other currency. It can be thought of as the price of a currency
What are direct quotes?
One unit of foreign currency = its value in home currency
What are indirect quotes?
One unit of home currency = its value in foreign currency
What is a spot rate?
Rate given for a transaction with immediate delivery
What is a cross rate?
Using a different currency exchange rate to find the exchange rate of the currency required
What are the reasons for forecasting exchange rates?
Foreign debtor and creditor balances
Working capital
Pricing
Investment appraisal
Consolidation of foreign subsidiaries
What is purchasing power parity?
‘Law of one price’
Country with higher inflation will suffer a fall in the value of its currency
Assumes rates are quoted as indirect quotes
What are the limitations of purchasing power parity theory?
Future inflation rates may not be accurate
Speculation
Government Intervention
What is interest rate parity?
Difference between spot and forward rates is equal to the differential between interest rates available in the two countries
Both countries have the same real interest rate
Country with higher interest rates will suffer a fall in the value of its currency
Assumes rates are quoted as indirect quotes
What is arbitrage?
Practice whereby traders look to make profits by finding small inefficiencies in markets allowing them to buy currency cheaply on one market and then immediately sell it on a different market.
What are the limitations of interest rate parity theory?
Controls on capital markets
Controls on currency trading
Government intervention
What are the three types of risk exposure?
Transaction risk
Economic risk
Translation risk
What is transaction risk?
Risk of exchange rates changing before the settlement date of a transaction
What is economic risk?
Risk that long-term adverse movements in exchange rates make the company less competitive internationally
What is translation risk?
Risk of exchange rate movements between one year and the next causing fluctuations in values of foreigh currency assets and liabilities in consolidated accounts
What are some internal methods of currency risk management?
Home currency
Leading/lagging
Matching/netting
Countertrade
What is the home currency method?
Passes risk to other party
Unlikely to be commercially acceptable
What is the leading/lagging method?
Speed up/delay payment depending on expectations of exchange rate movement
Problem predicting movements
What is the matching/netting method?
Match/net off transactions in the same currency
Easier if use foreign bank accounts
What is the countertrade method?
Avoid using currency and exchange products of equivalent value
What is a forward contract?
A binding agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate
What are the features and operations of forward contracts?
Forward contracts are a commitment, and as a result they have to be honoured even if the rate in the contract is worse than the rate in the market.
Forward contract rates are often quoted as an adjustment to the spot rate:
- add a discount
- subtract a premium
What are the advantages of forward contracts?
Simple
Low transaction costs
Fix the exchange rate
Tailored
What are the disadvantages of forward contracts?
Contractual commitment
Lose upside potential
Forward markets banned in some countries e.g. China, Russia, India, Brazil
What are the basic ideas of money market hedges?
Avoid future (uncertain) exchange rate by making exchange now at (known) spot rate
Use interest rates to create assets and liabilities that ‘mirror’ the future assets and liabilities
What is the operation of money market hedges?
- Borrow
- Convert
- Deposit
- Future transaction date
How do we calculate a money market hedge?
Always start with the future foreign cash flow.
E.g. to hedge a payment in a foreign currency:
- Calculate foreign deposit as the PV of the future payment
- Then calculate how much home currency you need to borrow
E.g. to hedge a receipt in a foreign currency
- Calculate foreign borrowing as the PV of the future receipt
- Then convert into home currency and place on deposit
What are the advantages of a money market hedge?
No currency risk
Fairly low transaction costs
Offers flexibility
May be able to use when forward contracts not available
What are the disadvantages of a money market hedge?
Complex
May be difficult to get overseas loan
A company with a large overdraft may struggle to borrow funds now
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