Financial Risk Management Pt. 2 Flashcards
Circumstances that give rise to changes in exchange rates are generally divided between:
trade-related factors (including differences in inflation, income, and government regulation) & financial factors (including differences in interest rates and restrictions on capital movements between companies)
Trade factor (relative inflation rates)
when domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their money; the increase in demand for foreign currency forces the value of the foreign currency to rise in relation to the domestic currency, thereby changing the rate of exchange between the domestic and foreign currency
Trade factor (relative income levels)
as income increases in one country relative to another, exchange rates change as a result of increased demand for foreign currencies in the country in which income is increasing
Trade factor (government controls)
various trade and exchange barriers that artificially suppress the natural forces of supply and demand affect exchange rates
Financial factors (relative interest rates and capital flows)
interest rates create demand for currencies by motivating either domestic or foreign investments; the forces of supply and demand create changes in the exchange rate as investors seek fixed returns; the effect of interest rates is directly affected by the volume of capital that is allowed to flow between countries
What is transaction exposure?
the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates
it is generally measured in two steps: project foreign currency inflows and outflows & estimate the variability (risk) associated with the foreign currency
What is economic exposure?
the potential that the present value of an organization’s cash flows could increase or decrease as a result of changes in the exchange rates
What is currency appreciation/depreciation?
it refers to the strengthening/weakening of a currency in relation to other currencies
for currency appreciation, as a domestic currency appreciates* in value or becomes stronger, it becomes more expensive in terms of a foreign currency; as a currency appreciates, the volume of the outflows tends to decline as domestic exports become more* expensive; however, the volume of inflows tends to increase* as foreign imports become less* expensive
- = the opposite holds true for currency depreciation
What is translation exposure?
the risk that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in the exchange rates
degree of foreign involvement: translation exposure increases as the proportion of foreign involvement by subsidiaries increases
locations of foreign investments: the more stable the exchange rate, the lower the translation risk and vice versa
What is hedging?
a financial risk management technique in which an organization, seeking to mitigate the risk of fluctuations in value, acquires a financial instrument that behaves in the opposite manner from the hedged item
it is a process of reducing the uncertainty of the future value of a transaction or position by actively engaging in various derivative instruments
What is net transaction exposure?
it considers the effect of transaction exposure on the entity taken as a whole rather than on individual subsidiaries
What is a futures hedge?
it entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date; tend to be used for smaller transactions
AP application: a futures contract to buy the foreign currency at a specific price at the time the account payable is due will mitigate the risk of a weakening domestic currency
AR application: a futures hedge contract to sell the foreign currency received in satisfaction of the receivable at a specific price at the time the accounts receivable is due will mitigate the risk of a strengthening domestic currency
What is a forward hedge?
similar to a futures hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point; however, it is for larger transactions (contracts between businesses and commercial banks)
futures hedge = particular transaction
forward hedge = anticipates a company’s needs to either buy or sell a foreign currency at a particular point
AP application: a forward hedge contract to buy the foreign currency at a specific price at the time accounts payable are due for an entire subsidiary will mitigate the risk of a weakening domestic currency
AR application: a forward hedge contract to sell the foreign currency received in satisfaction of the receivables at a specific price at the time the accounts receivable are due or on the monthly cycle of a particular subsidiary will mitigate the risk of a strengthening domestic currency
What is a money market hedge?
it uses international money markets to plan to meet future currency requirements; it uses domestic currency to purchase a foreign currency at current spot rates and invest them in securities times to mature at the same time as related payables
money market hedge payables (excess cash): first with excess cash use money market hedges to lock in the exchange rate associated with the foreign currency needed to satisfy payables when they come due
money market hedge payables (borrowed funds): firms that do not have excess cash follow the same basic procedure for a money market hedge on payables, except that they first borrow funds domestically and invest them internationally to satisfy the payable denominated in a foreign currency
money market hedge receivables: a money market hedge used for receivables denominated in foreign currencies effectively involves factoring receivables with foreign bank loans; borrowed foreign currency amounts are converted into the domestic currency
What are currency option hedges?
they use the same principles as forward hedge contracts and money market hedge transactions; however, instead of requiring a commitment to a transaction, the currency option hedge gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge, depending on which result is most favorable
Payables: a call option (an option to buy) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for payables; the business has the option (not the obligation) to purchase the security at the option (strike or exercise) price; although option premiums are used to compute any net savings associated with option transactions, they are a sunk cost and are irrelevant to the decision to exercise the options
Receivables: a put option (an option to sell) is the currency option hedge used to mitigate the transaction exposure associated with exchange rate risk for receivables; the business has the option (not the obligation) to sell the collected amount of the foreign currency from the receivable at the option (strike or exercise) price; although premiums are used to compute any net preserved value associated with option transactions, they are a sunk cost and irrelevant to the decision to exercise the options
