Chp 9: Managing Currency Risk Flashcards
What are the five common methods of managing currency risk?
- Forward Contracts
- Money market hedges
- Currency futures
- Currency options
- Currency swaps
What are two advantages and two disadvantages of forward contracts?
Advantages
1. Flexibility of currency used, amount covered and time periods offered
2. Simple, no up-front transaction cost
Disadvantages
1. Fixed date agreement which must be fulfilled even if the transaction changes
2. Rate quoted may be unattractive
How do you treat forward rate ‘premiums’ and ‘discounts’?
Add on a discount to the spot exchange rate
Subtract a premium from the spot exchange rate
What are the four steps to hedging a foreign currency payment?
- Determine how much foreign currency needs to be invested now to pay the payment at a future date, include the added interest (lending rate)
- Determine how much of your home currency to borrow and how much interest (borrowing rate) will need to be paid on that
- Borrow at that given rate, immediately exchange it and deposit it with the foreign bank
- At the future date, pay the supplier with the foreign currency and pay off the home loan with home currency
What are the four steps to hedging a foreign currency receipt?
- Determine the amount to borrow in the foreign currency that, with interest (borrowing rate), would equal the amount to be received
- Convert the loan into the home currency
- Place it on deposit
- At the future date, pay off the foreign loan with the receipt and collect the home currency, that was deposited in the bank, with interest (lending rate)
What do buying and selling currency futures contracts mean?
Buying the futures contract means receiving the contract currency
Selling the futures contract means supplying the contract currency
What are the three steps to a currency futures hedge?
- Present - Contracts set in terms of buying and selling the contract choosing the closest standardised futures date after the transaction date. Convert the amount needed at the standardised futures rate
- Future - Complete the actual transaction on the spot market. Convert the amount needed at the spot rate
- Concurrently with step 2 - Close out the futures contract by doing the opposite of step 1. Calculate the net outcome. Work out the difference between the the rate used in step 1 and the futures rate, multiply by the amoutn received in step 1, then convert back into the currency needed for your loss or gain
If you make a profit on the spot, you should make a loss on the future
What are three advantages of currency futures?
- Transaction date flexibility
- Exchange regulated to risk is reduced
- Ease of buying and selling through a highly liquid market
What are four disadvantages of currency futures?
- Contracts not tailored to exact requirements
- Limited number of currencies traded
- The need to use a broker (incurs fees)
- The need to deposit and maintain a margin account
What are currency options?
Also known as exchange traded options
They give customers the right but not the obligation to buy (call) or sell (put) a fixed amoutn at a fixed rate on a fixed date
What are the three steps in a currency option hedge?
AKA exchange traded option hedge
- Setup the hedge - determine the contract date, whether it’s put or call, the stirke price to use and how many contracts needed. Then multiply the call figure (in the right decimals) x contract size x number of contracts
- Calculate the outcome if the option is exercised
- Calculate the net outcome, translating using the exchange rate and including the value of the premium
What two things do currency swaps enable a company to do?
- Manage currency risk - by swapping domestic debt into foreign debt you can match liabilities with assets
- Reduce borrowing costs - by taking out loans where there are interest rate advantages
