F3: Hedging FX Exposure Flashcards
What is the Balance-of-Payments (BoP) statistic?
BoP tracks a country’s inflows and outflows of goods, services, and capital.
What does a fixed exchange rate system mean?
1: Forges a direct link between inflation differentials and employment levels
2: The DKK has a peg to the EUR so there is no free floating in the exchange rates
3: The risk about the peg system is that the underlying economic conditions may not justify a certain price
What does a floating exchange rate system mean?
1: Allows exchange rates to adjust for inflation differences
2: Allows employment levels and wages to equalize through the exchange rate mechanism
What are the two elements of risk related to FX that is interesting in IB?
1: The long-term changes in exchange rates. This is because firms invest over a long time horizon in other countries and as a consequence they have cash outflows in the beginning at one exchange rate and cash inflows later in time at another exchange rate. The later exchange rate may be very different from the exchange rate in the beginning
2: Short-term variations in exchange rates. Some exchange rates fluctuate quite a bit in the short term
Why is FOREX risk a challenge for MNCs?
Currency risk: The risk of unexpected changes in foreign exchange rates
Exposure to currency risk: MNCs has an exposure to FX risk when the value of assets or liabilities can change with changes in FX rates
Export: If you are a US firm that wants to sell its product in India in which currency (USD/INR) do you sell the (10 USD) product?
1: The INR has depreciated a lot relative to the USD. So if you sell the product in INR the price will increase a lot for the local population. If you sell the product in INR, and the INR has depreciated, then the company will receive a lot less for the product
2: The firm has to look at price elasticity of demand. If the product has a high elasticity of demand it will be best to price it in local currency and if it has a low elasticity of demand it will be best to price it in the home currency
Set up production in India: What is the issue?
Since costs and revenue is in INR we don’t have a FX risk (natural hedge) and there is no problem relating to which currency the product should be priced in. However, the problem arises when revenue has to be expropriated to the US.
If we want to expatriate 5.000.000 USD in INR in 2015 we will still have to use an exchange rate, and we will get fewer USD pr. INR than we would have in 1980 because INR has depreciated
Export or set up local production?
This is a strategic decision. If we just want access to the Indian market it will be best to just export, but if we want to use the Indian market as a springboard for other Asian markets it will be better to set up local production because in that case the repatriation of profits to USD won’t be that important because we’re planning to re-invest the money in the local region and therefore we don’t face a high FOREX risk
What is the law of one price and what upholds it?
The law of one price is the principle that equivalent assets sell for the same price
The law of one price is upheld by the no-arbitrage condition that refers to an absence of arbitrage opportunities, so that the law of one price holds within the bounds of transaction costs
Because of the law of one price and no-arbitrage condition we can assume that there is only one price and we can use this to predict what the price will be over time
When is the law of one price not applicable?
Seldom holds for non-traded assets
Can’t compare assets that vary in quality
May not be precise when there are market frictions
What is the interest rate parity?
The interest rate parity is a formula that tells us that 1 + the USD interest rate needs to be the same as the expected future exchange rate multiplied by 1 + the EUR interest rate
What are the characteristics of forwards?
Forwards are a pure credit instrument
Forwards are a zero-sum game, so that one party always has an incentive to default
Forward are normally tailor made and not standardized
What are the characteristics of futures?
Futures are contracts
A futures exchange clearinghouse takes one side of every transaction (and makes sure that its exposures cancel one another)
Initial and maintenance margins ensure settlement
Futures are standardized and are traded on an exchange
Differences between forwards and futures
Futures contracts are like a bundle of consecutive one-day forward contracts
Futures and forwards are nearly identical in their ability to hedge risk
The biggest difference between a forward and a futures contract is daily marking-to-market
Forward contracts can be tailored to match the underlying exposure and thus they can provide a perfect hedge of a transaction exposure to currency risk
Exchange-traded futures contracts are standardized and will not provide a perfect hedge if they do not match the underlying exposure’s 1) maturity 2) currency and 3) contract size
What are options?
An option is an agreement giving the option holder (buyer or owner) the right to buy (call) or sell (put) an underlying asset at a specified price, on (or perhaps before) a specified date
How is the one-year forward exchange rate for EUR/DKK calculated if the annual interest rate in the Eurozone is 10%, the annual interest rate in Denmark is 16% and the spot rate for EUR/DKK is 13?
See below
Which of the following statements about real and nominal exchange rates are correct?
The correct answers are (b), (d) and (e)
Which of the following statements about the distinction between currency forward and cur- rency future contracts are correct?
The correct answers are (a), (c), (d) and (e)
Which of the following statements about the choice between currency forward and currency future contracts are correct?
The correct answers are (a), (d) and (e)
