Financial Risk Management: Part 2_ M6 Flashcards
What are the main 4 hedges?
Futures and forwards very similar to each other just Futures Hedge deals with smaller/specific transaction amounts whereas Forwards deals with larger transaction amounts.
1. Futures - Smaller/specific Transactions (AR / sell derivatives to hedge the risk - AP buy derivatives to hedge the risk).
2. Forwards - Larger Transactions (AR / sell derivatives to hedge the risk - AP buy derivatives to hedge the risk).
3. Money Market Hedges
4. Currency option Hedges
What type of hedge derivatives are used to migate risk for short-term obligations?
A Forward Contract (used to mitigate risk of foreign receivable decreasing in value when due).
- The concern for the exporter is that the domestic currency will strengthen, which means the foreign receivable will translate into a lower amount received when it is converted into the domestic currency.
Put options are a short-term receivable hedging technique.
- The business has the option (not the obligation) to sell the collected amount of the foreign currency at the option (strike) price.
- If the option price is more than the exchange rate at the time of settlement, the business will exercise its option.
- If the option price is less than the exchange rate at the time of settlement, the business will allow the option to expire.
How to mitigate the risk from investing in foreign currency to pay A/P?
Investing foreign currency (in the buyer’s country)
- Mitigates the risk of a weakening of domestic currency relative to the strengthening of the foreign currency.
- You plan that your investment matures at the same time as your debt is due or to pay the debt off at a discount.
- If a company is receiving shipments and owes payment in a foreign currency, the concern is a weakening of the domestic currency relative to the foreign currency.
What is the most effective way to mitigate risk on foreign currency exchange rate fluctuations from import/export transactions?
Hold payables and receivables due in the same currency and amount.
What is some risk imposed by foreign exchange rates?
Payables denominated in a foreign currency when the domestic currency falls.
What situations produces a gain in foreign exchange situations?
- When payables are denominated in a foreign country, and the foreign country currency falls, this will produce a gain for the domestic country.
- Receivables denominated in a foreign currency when the foreign currency rises. This situation will produce a gain for the domestic country.
- Receivables denominated in a foreign currency when the domestic currency falls. This situation will also produce a gain for the domestic country.
What are the different exchange rate risk?
- Transaction risks associated with settlement of export transactions.
- Economic risks associated with the satisfaction of domestic expenses denominated in domestic currencies with imported revenues denominated in a foreign currency.
- Translation risk exist if a foreign investment or subsidiary translate in the books.
What is the impact on operations when the domestic currency appreciates vs. depreciates relative to foreign currency?
DOMESTIC CURRENCY APPRECIATES
- The domestic currency becomes more expensive relative to the foreign currency.
- Exports become more expensive to purchasers overseas, which means outflows decline.
- Imports become less expensive, which means inflows increase.
- The price of domestic goods relative to foreign goods increases.
DOMESTIC CURRENCY DEPRECIATES
- The domestic currency becomes less expensive relative to the foreign currency.
- Exports become less expensive, but imports become more expensive.
- The prices of domestic goods drop relative to foreign goods.
- A declining local currency implies that the domestic currency becomes less expensive relative to foreign currency.
- An investor would be more inclined to purchase domestically if the expectation was that the domestic dollar would strengthen relative to a foreign currency.
- Investors will want to purchase investments denominated in foreign currency when domestic inflation is higher (not lower) relative to the emerging market.
What happens when the foreign currency depreciates opposed to the domestic currency?
- As a foreign competitor’s currency becomes weaker, the product becomes less expensive in domestic currency.
- The less expensive product will increase demand and result in an advantage in the domestic market.
- It is better for domestic company when the value of the domestic currency weakens.
- A weak domestic currency makes domestic goods relatively less expensive than imported goods.
- Sales within domestic markets will deteriorate as the currency of foreign competitors deteriorates, making the domestic company’s goods more expensive.
- As a foreign competitor’s currency appreciates, sales within the domestic markets should also increase as goods manufactured domestically become less expensive.
What are some effects of fluctuating foreign currencies?
FOREIGN CURRENCY APPRECIATES
- If a domestic country has net cash inflows (receivables) of a foreign currency and the foreign currency appreciates, it will enjoy an economic gain .
- The domestic company will suffer an economic loss if it has net cash outflows (payabes) of a foreign currency and the foreign currency appreciates.
- When the foreign currency appreciates, the domestic currency depreciates
FOREIGN CURRENCY DEPRECIATES
- Domestic companies will enjoy an economic gain if it has net cash outflows (payables) with foreign currency and the foreign currency depreciates.
- When the foreign currency depreciates, the domestic currency appreciates.
- Domestic companies will suffer an economic loss if it has net cash inflows (receivables) of a foreign currency and the foreign currency depreciates.
What does highly leveraged mean?
- The client is heavily utilizing debt in the capital structure.
- If prime interest rates (the rates that banks charge their most creditworthy customers) rise, debt becomes more expensive, which will have a significant impact on the bottom line.
What are techniques to mitigate exchange rate risk for long-term foreign transactions?
Best Strategy
Hold payables and receivables due in the same currency and amount.
CURRENCY SWAP
Two firms with coincidental needs for international currencies may agree to swap currencies collected in a future period at a specified exchange rate.
PARALLEL LOAN
Two firms may mitigate their transaction exposure to long-term exchange rate loss by exchanging or swapping their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date.
LONG-TERM FORWARD CONTRACT
Long-term forward contracts are set up to stabilize transaction exposure over long periods.
what does it mean for FCU to fluctuate from smaller to larger compared to domestic static rate?
$2.57 FCU to $3.15 FCU compared to domestic $1.00
- The foreign currency lost value relative to the U.S. dollar, which causes the company’s investment to decline.
- Means FCU loosing value It now takes $3.15 FCU to 1.00 US Dollars vs. only $2.57 FCU to $1.00.
What are the factors that determines exchange rates?
- Inflation.
- Interest rates.
- Trade restrictions.
What are the effects on exchange rates when inflation is UP?
- Reduces the purchasing power of the inflated currency, which means there is less demand for the inflated currency, and more demand for the other currency.
- Weakens the inflated currency in relation to the other currency.
- Makes inflated currency country products more expensive and reduces demand for them.
