F3 - 12. Advanced Currency Risk Management Flashcards
What is a money market hedge?
Fixing the future exchange rate, like with forward exchange contracts, by
- borrowing and lending on the money markets
- Using spot foreign exchange transactions
How does a money market hedge work for future payments in $?
- Borrow in £ now
- Convert to $ at spot
- Save in $ and earn interest
- Settle in $
- Pay back £ loan and interest
How does a money market hedge work for future receipts in $?
- Borrow in $ now
- Convert to £ at spot
- Save in £ and earn interest
- Use receipt to pay back $ loan
- Withdraw £ from deposit
What are currency futures?
Standardised (traded) contracts to buy a set amount of currency at a set rate for a set delivery date
How are currency futures settled?
- Calculate the gain or loss on futures, convert to home currency at spot rate
- Convert the amount of the transaction at spot rate and adjust by futures gain/loss
What are the 2 main pros of currency futures?
- Lock in a price, hedge downside
- Close out a futures position at any time
What are the 4 main cons of currency futures?
- Lose upside potential
- Standardised size (may under/over hedge)
- Basis risk (diff in dates)
- Need to post margin to the exchange
What are currency options?
An agreement involving a right, but not an obligation, to buy or sell a certain amount of currency at a set time for a set FX
What is the difference between an OTC and traded currency option?
OTC are tailored, traded are at standardised contract size
What is the main pro of FX options?
Protect from downside risk AND can benefit from upside
What are the 3 cons of FX options?
- Premiums can be expensive
- If traded, may under/over hedge
- Traded options not available in all currencies
What is the intrinsic value of an option?
The value that would be generated by exercising the option today, the difference between the spot price and the strike price of the option
What is the time premium value of an option?
Total option premium minus instrinsic value
What is arbitrage?
Arbitrage profit arises when a trader takes advantage of price differences between two markets - arbitrage disappears
