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Finance 2 > FOREIGN CURRENCY RISK / INTEREST RATE RISK > Flashcards

FOREIGN CURRENCY RISK / INTEREST RATE RISK Flashcards

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1
Q

What international exposure do most firms have?

A
  • Sales
  • Suppliers
  • Competitors
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2
Q

What international exposure do multinationals or international corporations have?

A
  • FOREX
  • Differing interest rates
  • Differing accounting methods
  • Different tax rates
  • Differing government intervention / regulation
  • Cultural and social differences.
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3
Q

What kind of market are FOREX markets?

A

OTC markets - over the counter markets
A decentralised market, without a central physical location, where market participants trade with one another through various communication modes such as telephone, email and proprietary electronic trading systems.

In an OTC market, dealers act a market makers by quoting price at which they will buy and sell a security or currency. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected.

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4
Q

Who are the participants in FOREX markets?

A
  • Importers
  • Exporters
  • Portfolio managers
  • FOREX brokers
  • Traders
  • Speculators
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5
Q

What motives are there for investing in foreign markets?

A
  • Economic conditions
  • Exchange rate expectations
  • International diversification
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6
Q

What are the motives for providing credit in foreign markets?

A
  • High foreign interest rates
  • Exchange rate expectations
  • International diversification
  • Crises
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7
Q

What are the motives for borrowing in foreign markets?

A
  • Exchange rate expectations

- Low interest rates

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8
Q

What are the three exchange rate systems?

A
  • Fixed exchange rates
  • Freely floating exchange rates
  • Managed floating exchange rates
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9
Q

FIXED EXCHANGE RATES

A
  • Fixed against a single identified currency

- Fixed against a basket of currencies

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10
Q

FREELY FLOATING EXCHANGE RATES

A

Also known as a “clean float”

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11
Q

MANAGED FLOATING EXCHANGE RATES

A

Also known as a “dirty float”

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12
Q

What are the attributes of banks that provide foreign exchange?

A
  • Competitiveness of quote
  • Special relationships with the bank
  • Speed of execution
  • Advice about current market conditions
  • Forecasting advice
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13
Q

How is currency converted using exchange rates?

A

Achieved by either dividing or multiplying.

If currency conversion is seen as the source currency (“from”) to a destination currency (“to”), then in the exchange rate quote, if the source currency is on the left one divides, if the source currency is on the right, we multiply.

e.g. Conversion from: (Source) £100
To (destination):
USD
Exchange rate:
$1.85:£1
Operation:
MULTIPLY
Converted value:
£100*1.85 = $185
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14
Q

DIRECT QUOTES

A

The number of units of home currency for one of the foreign currency.

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15
Q

INDIRECT QUOTES

A

The number of units of foreign currency for one unit of the home currency.

Indirect quotation = 1 / direct quotation

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16
Q

BID

A

Buy

17
Q

ASK

A

Sell

18
Q

What is the bid/ask spread

A

= ask rate - bid rate / ask rate

%

19
Q

CROSS RATES

A

Quoting currencies in terms of four major currencies:

  • GBP
  • USD
  • JPY
  • EUR
20
Q 
Cross rate example:
UK - £1
=
Australia:
A$2.30:£1
=
Mexico:
20 New Pesos:£1
What is the cross rate?
A

A$2.30 = 20 New Pesos (both worth £1)

Divide both sides by 2.3

A$1 = 20 New Pesos:£1 / A$2.30: £1

Cross rate = 8.70 New Pesos:A$1

21
Q

TRIANGULAR ARBITRAGE

A

Trading out of the Home Currency -> 2nd currency -> 3rd currency -> home currency

The purpose is to earn an arbitrage profit via trading from the 2nd to the 3rd currency when the direct exchange rate between the two is not in alignment w/ the cross exchange rate.

22
Q

Triangular arbitrage example:
$ —- Bank A: €0.7638:$ —-> € ——- Bank B: €1.1704:£ —-> £ ——Bank C: £1.5400:$ —–> $

Is there an arbitrage profit opportunity here?

A

$5,000,000 * 0.7638 = €3,819,000
€3,819,000 / 1.1705 = £3,262,708
£3,262,708 * 1.5400 = $5,024,570
$5,024,570 - 5,000,000 = $24,570 Arbitrage profit

23
Q

FORWARD MARKET

A

Involves contracting today for the future purchase or sale of foreign currency.
Standard periods of quotes are: 1 mo., 3mo., 6mo., 9mo., and 1 year
Very good bank customers obtain rates > 1 year

24
Q

What is the difference with international capital budgeting to normal capital budgeting?

A
  • Process is more complex
  • Increased risk of cross-border projects
  • Difficulties in the appraisal process
25
Q

What factors should be considered in multinational capital budgeting?

A
  • Exchange rate fluctuations
  • Inflation
  • Financing arrangements
  • Blocked funds/ restrictions of remittances
  • Uncertain salvage value
  • Impact of project on prevailing cash flows
  • Real options
  • Political factors
  • Tax laws
26
Q

What are the three types of exchange rate exposure?

A
  • Transaction risk
  • Economic risk
  • Translation risk
27
Q

TRANSACTION RISK

A

Risk of an exchange rate changing between the transaction date and the subsequent settlement date.

  • Cash inflows
  • Cash outflows

Extent of transaction risk:

  • Standard deviation of foreign cash flows
  • Currency variability
  • Currency correlations
  • Multi-currency exposures
  • Value-at-risk (VaR)
28
Q

Transaction risk example
Assume the exchange rate is $1.50:£1, if the value of the £ increases by 20%:
a) calculate the impact of this on a UK exporter due to receive $200,000 from a US customer.
b) calculate the impact of this on a UK importer due to pay $200,000 to a supplier.

A 
a) 20% increase =  1.8
$1.50:£1
$200,000/1.5 = £133,333
$200,000/1.8 = £111,111
133,333 - 111,111 = £22,222 LOSS

b) $200,000/1.5
= £133,333
$200,000/1.8 = £111,111
£133,333 - £111,111 = £22,222 GAIN

29
Q

ECONOMIC RISK

A

The variation in the value of the business due to unexpected changes in exchange rates.

  • Degree to which future cash flows are influenced
  • This in turn influences firm value

INCLUDES:

  • Transaction exposure
  • Indirect effects on revenue and costs.

Firms may have no transaction risk but may be influenced with economic risk.

30
Q

TRANSLATION RISK

A

MNC’s create financial statements by consolidating all of the individual subsidiaries/units financial statements.

  • Conversion from local -> parent firm’s currency.
  • -Changing exchange rates over time -> “translation” into a different currency
  • Affected by changes in exchange rate movements.

Cash flow perspective
Stock price perspective

31
Q

What are the determinants of translation exposure?

A
  • Proportion of business conducted by foreign subsidiaries/units
  • Location of foreign business subsidiaries/units
  • Accounting methods used - weighted average exchange rate is used.
32
Q

Examples of translation exposure of MNCs

A
  • 2000/1 - euro weakness: DuPont, Colgate-Palmolive, Gillette, Goodyear and Mcdonalds
  • 2002/3 - Euro strength: IBM and Colgate-Palmolive
  • 2004/5 - VW, BMW and Adidas-Salomon
33
Q

INTEREST RATE RISK

A

The potential loss from unexpected changes in interest rates which can significantly alter a bank’s profitability and market value of equity.

Firms need to borrow in order/borrow as part of their operations.
Changes in interest rates create risks for MNCs.

34
Q

FIXED RATE OF INTEREST

A
  • Standardised rates
    e. g. 5% for duration of the instrument
  • Generally corporate bonds.
35
Q

FLOATING (VARIABLE) RATE OF INTEREST

A

Also known as an adjustable rate of interest
E.g. LIBOR, LIBOR +2%
Generally short term borrowing (money markets/banks)

36
Q

Interest rate risk example:
Suppose your firm borrows £1,000,000 for one year. Which would you prefer?
• Fixed rate of 5% EAR
• Floating rate of LIBOR +2% EAR?
Note: the annualized LIBOR rate for the first six months is 2.3% and 3.25%
for the 2nd half of the year.

A

Fixed rate
5% * 1,000,000 = 50,000

LIBOR (6 mo1) = (2% + 2%/2) * 1,000,000
=21,500

LIBOR (6mo2) = (3.25% + 2%) * 1,000,000 = 26,750

21,500 + 26,750 = £47,750

37
Q

What are the types of interest rate risk?

A
  1. Gap exposure

2. Basis risk

38
Q

GAP EXPOSURE

A

Gap analysis - allocate assets, liabilities according to repricing/maturity buckets which are sensitive to interest rate changes.

Two types:
- Negative gap: When more interest sensitive liabilities maturing at a certain time, than it has interest sensitive assets maturing at the same time.

  • Positive gap: Is when interest sensitive assets maturing at a particular time exceeds the amount of interest sensitive liabilities maturing at the same time.
39
Q

BASIS RISK

A

Difference between the futures price and the spot price.
Basis risk = Futures price - Spot price

RISK: Assets and liabilities set with reference to variable rates, but the variable rates are set to different benchmarks:
- Deposits linked to one-month LIBOR
-Borrowings may be based on the 12-month LIBOR
These rates are unlikely to move in line with each other.

Finance 2 (10 decks)

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