Exam 2 Flashcards
Law of 1 price
A freely traded asset with no trade restrictions should have same price in foreign and domestic markets
Assumptions of 1 Price
- Free Trade/No trade restrictions
- Perfect substitutions of goods and services
- No transaction costs
Absolute Purchasing Power Parity
- Exchange rates between countries is the ratio of price levels between those countries
- Based on a basket of goods
- Must have the same or similar basket of essential goods and the goods have similar weights
Relative Purchasing Power Parity
The change in ER over a period is the relative change in prices between the two countries over that same period
International Fischer Effect
○ Change in foreign currency exchange rates are based on interest rate differentials between countries
○ Spot rates should change in an equal amount and in an opposite direction to the interest rate differential between coutnries
Interest Rate Parity
- The interest rate differentials between counties is equal to and inversely related to the differential between the forward and spot exchange rates.
- Interest rates are quoted on an annual basis, and must be changed to the time frame you care about
Covered Interest Arbitrage
Created when forward contract exploits interest rate differentials between countries
CIA Process
- Calculate Forward Discount or Premium
- Calulate Delta IR
- Determine which rule
- Calculate Investment returns
CIA Rules
- IF F is premium and F∆IR, Invest in lower IR
- IF F is discount and -F>∆IR, Invest in Higher IR
- IF F is discount and -F
Transaction Exposure:
The risk of loss arising from the effect of changes in foreign exchange rates on the settlement of a contract which originated prior to the change
Sources of Transaction Exposure
○ Commercial Activity - trading of goods and services on account or on credit where price quotes or settlements are required in a foreign country
○ Credit Financing Arrangement - Borrowing or lending in a foreign currency or requiring repayment in a foreign currency
○ Financial Position - Acquiring assets or liabilities that are denominated in a foreign currency
Types of Hedging for Transaction Exposure
○ Risk management tool to manage FX exposure
○ Utilizing a position to offset the risk of loss likely to arise from realization of an exposure
○ The risk of loss relating to the FX transaction exposure and the hedging transaction are negatively correlated
Translation Exposure
○ The risk exposure to consolidated earnings and capital from changes in exchange rates since translation, all else equal
○ Converting/ restating the financial statements of a subsidiary which is denominated in a foreign currency to the parent’s company reporting currency
§ To produce a set of consolidated financial statements
§ Performance assessment and comparison of subsidiaries.
Functional Currencie
is the primary currency used in the entity’s operations or the environment in which it operates
Reporting Currency
is the currency in which the financial statements are prepared
Current Exchange Rate
is the spot exchange rate at balance sheet reporting date
Historical Exchange Rate
Is the spot exchange rate at transaction date
Restatement Process:
- Determine the functional currency
2. Convert financial statements from functional currency to reporting currency
3. Record gains and losses on the translation o currencies
Methods of restatement - Income Statement
○ Revenues and expenses - Spot rate @ incurrence or weighted average rate
○ Gains/Losses - Spot Rate @ incurrence or weighted average rate
○ Difference - None
- Methods of restatement - Balance Sheet
○ Monetary Assets - Spot rate at the balance sheet date
○ Nonmonetary assets - Spot rate at the balance sheet date
○ Liabilities - Spot rate at the balance sheet date
○ Equity - Historical cost
○ Difference - included in other comprehensive income
Balance sheet hedge
requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet
§ Net translation exposure will be zero
§ Cost of balance sheet hedge depends on relative borrowing costs
§ Are a compromise in which the denomination of balance sheet accounts is altered, sometimes at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.
Operating Exposure
- The sensitivity and impact on firm value resulting from unexpected changes in foreign exchange rates
General Process to Calculate Operating exposure decisions
- Calculate the Value of the firm in USD at the current ER
- Calculate the value of the firm in USD at the “new” ER
- Calculate the operating loss or gain
NOPAT
EBIT x (1-t)
OCF
NOPAT + Depreciation
Matching cash flows
○ Match CF, same amount, same currency, for same period of time
○ MM or balance sheet hedge
Risk-Sharing Agreements
○ Both parties agree to share their foreign exchange gains and losses
Back-to-Back loans
MNE in different countries borrow from each other in their respective currencies.
Currency Swap
MNEs in different countries exchange cash flows in their respective currencies.
Contractual hedge
MNEs can utilize currency options to manage their operating exposure.
