Foreign Currency Risk (2) Flashcards
What is a forward contract?
A contract with a bank fixing the exchange rate on a specific amount of FX receivable or payable at a future date at an exchange rate agreed now
Another name for a forward contract
OTC contract
What is the purpose of a forward contract?
Fix and exchange rate now for settlement of a transaction at a future date
What does a forward contract remove?
Uncertainty at what exchange rate will be at their future date
What is currency risk?
A two-way risk
Why is a forward contract a two-way risk?
Company can hedge against the risk of an adverse movement in spot exchange up to date of settlement, but loses the opportunity to gain from a favourable movement in spot rate
How are forward contracts arranged?
Directly with a bank and sometimes referred to as OTC
Advantages of forward rates?
Simple
Low or zero up-front costs
Available for many currencies
Disadvantages of forward rates
Fixed date
Unattractive rate
Counter-party risk
What is a foreign currency receipt (export)
It is possible to manufacture a forward rate by using spot exchange rate and money market lending or borrowing
How can exchange rate risk be eliminated when foreign currency revenue is expected (export)
Borrowing foreign currency today, converting funds into domestic at today’s spot rate
Using future revenue to repay foreign currency loan
What is meant by money-market hedging?
Involves a short-term loan in a foreign currency
First step in creating a money market hedge for a receipt?
identify loan repayment required in the future
Second step in creating a money market hedge for a receipt?
Calculate amount that needs to be borrowed today in the foreign currency using interest rate provided
Third step in creating a money market hedge for a receipt?
Covert this immediately to domestic (home) currency at the spot rate. Place this deposit in the home currency
Fourth step in creating a money market hedge for a receipt?
Include interest earned on deposit in the home currency, using interest rate provided
How can foreign currency payable eliminate exchange rate risk?
Withdrawing funds from domestic currency and putting them in on deposit in foreign currency
Using foreign funds to pay foreign currency expense in the future
First step in creating a money market hedge for an expense?
Identify cash required to pay the foreign currency expense
Second step in creating a money market hedge for an expense?
Using interest rate provided, calculat the amount that needs to be invested today in foreign currency
Third step in creating a money market hedge for an expense?
Convert immediately to home currency at the spot rate
Fourth step in creating a money market hedge for an expense?
Include cost of borrowing in domestic country to compare to a forward contract
What is money market hedging unlikely to deliver?
A significantly different outcome from that delivered by a forward contract
What may money market hedging likely improve?
If it is used by an exporter with a cash flow deficit (saved overdraft interest) or importer with a cash flow surplus (interest on cash flow surplus less than cost of borrowing)
When money market hedging less than a forward contract?
Likely to be more time-consuming than a forward contract and could involve issue costs as borrowing is involved