Chapter 9 - Managing Currency Risk Flashcards
1
Q
What is forward contracts?
A
- Forward contract = agreement to exchange different currencies at a specific future date and at a specific rate
- Forward contracts are used to hedge transaction exposure
- The trader will therefore know in advance how much local currency they will receive/ pay
- Forward rates are set by banks & usually calculated using IRP
2
Q
Advantages of Forward Contracts:
A
- Arranged over the counter (OTC) so are flexible in terms of:
* Currencies available
* Amounts covered
* Contract periods offered (usually 24 months) - Simple & no up-front transaction cost
3
Q
Disadvantages of Forward Contracts:
A
- Fixed date arrangements so if the transaction being hedged changes (e.g. late payment) the contract must still be fulfilled
- Rate quoted may be unattractive
4
Q
Quotation of forward rates:
A
- If not given a forward rate in the Q, may have to calculate by adjusting the spot rate by either a discount or a premium
- The effect of discount/ premium is to widen the bid/offer spread
- Bank will quote a larger spread as:
* Forward rate = 1.2937 – 1.2947 or 1.2942 +/- 0.0005
* Can also be quoted as adjustment to the spot = 1.2947 – 1.2952 with 3-month forward 0.0010 – 0.0005 premium
* Subtract a premium or add a discount
5
Q
Forward Option Contract:
A
- Offers same arrangement as a fixed forward contract expect the exercise dates can be chosen
6
Q
Money Market Hedge:
A
- Money market hedge = manufacture a forward rate by using the spot rate and money market lending/ borrowing rate
- Money market rates can be quoted in an annual % or in the form of LIBOR 4 ½ - 4 ¼ (4.25% p.a. on deposits and 4.5% p.a. on loans)
7
Q
Hedging payments:
A
- Borrow the appropriate amount in home currency now
- Convert the home currency to foreign currency immediately
- Put the foreign currency on deposit in a foreign currency bank account
- When the time comes to pay the creditor = pay the creditor out of the foreign currency bank account and repay the home country loan account
* Effect is exactly the same as using a forward contract & will cost the same amount
* If results from money market hedge were very different, speculators could make money without taking a risk – therefore market forces ensure they deliver the same results
8
Q
Hedging receipts:
A
- Borrow an appropriate amount in the foreign currency today
- Convert it immediately to the home currency
- Place it on deposit in the home currency
- When the debtor’s cash is received = repay the foreign currency loan & take the cash from the home currency deposit account
9
Q
Currency Futures
A
- Currency futures have a similar impact as forward contracts and also intends to fix the outcome of a transaction
- Currency future = standardised contract to buy/sell a fixed amount of currency at a fixed rate at a future date
* Buying the futures contract = receiving the contract currency
* Selling the futures contract = suppling the contract currency - Unlike forward contracts this is achieved by entering into a futures contract that is separate from the actual transaction and operates in such a way that if you make a loss in the spot market, you will expect to make a profit in the futures market
* Gain/loss of a futures contract derives from future exchange rate movements – so futures is a derivative
10
Q
Features of currency futures:
A
- Mainly available from the US markets
- Each contract fixes the exchange rate on large, std amount of currency
- Contracts normally expire at the end of each quarter but can be used on any date up to the expiry date
- Smaller range of currencies are traded on futures market compared to forward market
- Futures have less credit risk than forward contracts as organised exchanges has clearing houses that guarantee that all traders in the market will honour their obligations
11
Q
Steps in a futures hedge:
A
- Now = determine:
a) type of contract (buy/sell),
b) future rate AFTER completion of transaction
c) number of contracts (amount / contract price /125 000) - In the future = calculate actual transaction using spot rate
- At the same time as step 2 = calculate the net outcome
a) calculate difference between future rates
b) difference x 125000 x no of contracts
c) actual transaction + difference amount
12
Q
Ticks:
A
- Tick = smallest movement in the exchange rate which is normally quoted on the futures market to 4 decimal places
- E.g. if a futures contract is for £125,000 every 0.0001 movement will give a $12.5 profit/loss which is the tick size
- If the futures exchange rate has moved in your favour by 0.0030 this will be 30 ticks x $12.50 = $375 per contract
13
Q
Margin:
A
- Futures exchanges require market participants to pay a deposit/ margin when undertaking a transaction
- Each day any profit/loss on client’s position (variation margin) is debited/credited to this account so losses are not allowed to build up
- Marking to market = process of settling the gains/losses on futures contracts at the end of each trading day
- If losses are made that reduce the account below maintenance margin the investor will be required to restore the margin account to the maintenance level
- Margin is returned when the contract is closed out
- Margin is paid in and out at the spot rate
- Futures calculation may have to be adjusted for the differences between the amount paid in and paid out
14
Q
Advantages of currency futures:
A
- Transaction date flexibility because the future can be closed out at any time up to the settlement date
- Exchange regulated market so counter party risk is reduced
- Ease of buying & selling contracts through highly liquid market
15
Q
Disadvantages of currency futures:
A
- Contracts cannot be tailored to exact requirements
- Limited number of currencies traded
- Need to use broker (fees)
- Need to deposit & maintain margin account
