Chapter 9 - Currency risk management - TO FINISH

Question 1

What is an exchange rate?

Answer 1

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

Question 2

What are direct quotes?

Answer 2

One unit of foreign currency = its value in home currency

Question 3

What are indirect quotes?

Answer 3

One unit of home currency = its value in foreign currency

Question 4

What is a spot rate?

Answer 4

Rate given for a transaction with immediate delivery

Question 5

What is a cross rate?

Answer 5

Using a different currency exchange rate to find the exchange rate of the currency required

Question 6

What are the reasons for forecasting exchange rates?

Answer 6

Foreign debtor and creditor balances
Working capital
Pricing
Investment appraisal
Consolidation of foreign subsidiaries

Question 7

What is purchasing power parity?

Answer 7

‘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

Question 8

What are the limitations of purchasing power parity theory?

Answer 8

Future inflation rates may not be accurate
Speculation
Government Intervention

Question 9

What is interest rate parity?

Answer 9

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

Question 10

What is arbitrage?

Answer 10

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.

Question 11

What are the limitations of interest rate parity theory?

Answer 11

Controls on capital markets
Controls on currency trading
Government intervention

Question 12

What are the three types of risk exposure?

Answer 12

Transaction risk
Economic risk
Translation risk

Question 13

What is transaction risk?

Answer 13

Risk of exchange rates changing before the settlement date of a transaction

Question 14

What is economic risk?

Answer 14

Risk that long-term adverse movements in exchange rates make the company less competitive internationally

Question 15

What is translation risk?

Answer 15

Risk of exchange rate movements between one year and the next causing fluctuations in values of foreigh currency assets and liabilities in consolidated accounts

Question 16

What are some internal methods of currency risk management?

Answer 16

Home currency
Leading/lagging
Matching/netting
Countertrade

Question 17

What is the home currency method?

Answer 17

Passes risk to other party
Unlikely to be commercially acceptable

Question 18

What is the leading/lagging method?

Answer 18

Speed up/delay payment depending on expectations of exchange rate movement
Problem predicting movements

Question 19

What is the matching/netting method?

Answer 19

Match/net off transactions in the same currency
Easier if use foreign bank accounts

Question 20

What is the countertrade method?

Answer 20

Avoid using currency and exchange products of equivalent value

Question 21

What is a forward contract?

Answer 21

A binding agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate

Question 22

What are the features and operations of forward contracts?

Answer 22

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

Question 23

What are the advantages of forward contracts?

Answer 23

Simple
Low transaction costs
Fix the exchange rate
Tailored

Question 24

What are the disadvantages of forward contracts?

Answer 24

Contractual commitment
Lose upside potential
Forward markets banned in some countries e.g. China, Russia, India, Brazil

Question 25

What are the basic ideas of money market hedges?

Answer 25

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

Question 26

What is the operation of money market hedges?

Answer 26

1. Borrow
2. Convert
3. Deposit
4. Future transaction date

Question 27

How do we calculate a money market hedge?

Answer 27

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

Question 28

What are the advantages of a money market hedge?

Answer 28

No currency risk
Fairly low transaction costs
Offers flexibility
May be able to use when forward contracts not available

Question 29

What are the disadvantages of a money market hedge?

Answer 29

Complex
May be difficult to get overseas loan
A company with a large overdraft may struggle to borrow funds now

Question 30

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