Foreign Exchange and Hedging Strategies Flashcards
What is the foreign exchange market?
Where pairs of currencies can be bought and sold in exchange for one another i.e. £, $ and euros.
What is a FX rate?
The number of foreign currency units per unit of the domestic currency.
i.e. if the US Dollar Sterling ($/£) rate is 1.6000 then $1.6 (foreign) is equivalent to £1 (domestic)
How do you convert a domestic currency amount to the foreign currency?
Multiply by the FX rate.
i.e. £10,000 = £10,000 x 1.6 = $16,000.
How do you convert a foreign currency amount to the domestic currency?
Divide by the fx rate.
i.e. $16,000 = 16,000/1.6 = £10,000
What is the 7 types of terminology within a FX Rate structure? (slide 4).
- Offer - the dealing rate when buying the domestic currency and selling the foreign currency.
- Pm - the premium of the spot rate over the forward rate (in pips)
- ds - the discount of the spot rate to the forward rate (in pips)
- Bid - the dealing rate when selling the domestic currency and buying the foreign currency
- £/$ - US Dollars (foreign) per UK Pound (domestic)
- Spot - the rate for dealing today and settling today
- Foward – the rate for dealing today but settling in the future
How do you calculate forward rates? (slides 5-6)
- deduct premiums (pm) from the spot rate
2. Then add discounts (ds) to the spot rate
What are FX rates in the long term?
Determined by relative levels of national economic growth which will ultimately impact on Inflation rates; and Interest rates.
What are Fx rates in the short term?
Volatile and Unpredictable
What 3 types of foreign exchange risks are companies exposed to?
- Economic risk - All companies
- Translation risk - Companies which have overseas assets and/or liabilities.
- Transaction risk - Companies which import and/or export.
What is economic risk?
The risk that a significant and permanent FX rate movement will adversely and permanently affect a company’s competitive position
What happens when the domestic currency is devalued? economic risk) (weakened)
Exporters benefit but importers suffer.
What happens when the domestic currency is revalued? economic risk) (strengthened)
importers benefit but exporters suffer.
What can economic risk NOT be?
Avoided even if the company trades purely in its domestic economy
Eliminated, only reduced by having a global spread of operations
What types of companies does translation risk affect?
Companies with overseas assets and/or liabilities.
What happens to these assets/liabilities when dealing with translation risk?
Have to be translated to the domestic currency at the spot rate prevailing at the financial year end (balance sheet date)
Where does this translation risk arise from?
From FX rates moving between balance sheet dates and changing the net asset value of the company.
How can translation risk be reduced?
By matching overseas assets and liabilities (i.e. borrowing overseas to fund overseas projects)
Who does transACTION risk affect?
Importers and exporters taking/giving trade credit.
How can transAction arise?
From the FX rate moving between the order date and the settlement date.
Order date - the date that the company agrees to buy/sell goods in a foreign currency; and
Settlement date - the date that the company pays for/is paid for goods in the foreign currency
What types of fx rate movements are within the transACTION risk?
- Adverse - real cash losses in the domestic currency (i.e. lower than expected sales revenues for exporters)
- Favourable - real cash gains in the domestic currency (i.e. lower than expected costs for importers)
How can you reduce transACTION risk?
Hedge it.
How do you manage FX Transaction Risk? (slide 15)
On the day that a company receives an export order or places an import order it can either take no action and accept the FX transaction risk or
Take action to reduce/eliminate the FX transaction risk by employing Internal strategies; and/or External hedging strategies.
What are the Internal strategies to TransACTIONrisk?
- Request settlement in domestic currency.
2. Matching and netting when a company is a regular importer and exporter.
What happens when you request a settlement in domestic currency? (Internal strategy of transACTION risk).
Transfers all FX transaction risk to customer / supplier as there are no transaction costs; BUT it’s only possible if there is high bargaining power. This is because you may not be able to agree a fair exchange rate.
Why do importer/ exporter companies match and net? (slide 16).
Match foreign currency receipt and payment dates
Net foreign currency receipts and payment amounts
Hedge net exposure
How 4 markets can the FX transaction risk be hedged?
- Forward market (physical)
- Money market (physical)
- Currency futures market (derivative)
- Currency options market
(derivative)
What 5 hedging implications should companies consider when deciding their hedging strategy?
- Availability - can the exposure be hedged?
- Cost: Implicit (domestic currency payment / receipt)
Explicit (hedge set-up costs) - Flexibility - can the hedge be altered in the future if required?
- Efficiency - can a perfect hedge be achieved which exactly matches the exposure (amount and date)?
- Complexity - the pricing mechanisms in derivative markets are more complex than in physical markets
How do importer companies set up when they are doing a money market hedge?
Borrow in domestic money market, buy foreign currency in the spot market and lend in foreign money market
How do exporter companies set up when they are doing a money market hedge?
Lend in domestic money market, sell foreign currency in the spot market and borrow in foreign money market
What is the 2 advantages if a money market hedge?
- Perfect hedge can be achieved to eliminate FX transaction risk
- Flexibility – can be unwound or rolled-forward easily
What are the 2 disadvantages of a money market hedge/?
- Higher transaction costs than forwards
2. Need access to the foreign money market
FORWARD VS MONEY MARKET HEDGE EXAMPLE (SLIDES 21 - 26)
must learn this john
How do you set up hedges with currency futures?
Buy or sell one or more currency future contracts on order date and close position on settlement date - If the FX rate movement is adverse then gain in value of the futures position will offset the underlying currency losses and vice versa.
What is the 3 advantages of hedging with currency FUTURES?
- Lowest cost derivative
- High market liquidity – can hedge large exposures quickly
- Flexible – can unwind or roll-forward in the market
What is the 2 disadvantages of hedging with currency FUTURES?
- Currency futures only available for major currency pairs
- Futures only trade on exchanges so contracts have standardised size and thus may not be possible to achieve a perfect hedge
How do you set up hedges with currency OPTIONS?
- Buy or sell one or more currency options on the order date either: on exchange (cheaper but only certain pairs and hedge efficiency issues) or
over-the-counter (More expensive but any pair and perfect hedge possible) - Close position (or exercise option) on the settlement date
What is an advantage of hedging with currency OPTION?
Options cap rather than fix prices which means it protects against adverse FX rate movements; and
offers some benefit from favourable FX rate movements.
What are the 3 disadvantages of hedges with a Currency OPTION?
- Most expensive hedging method
- Less liquidity than futures markets
- Complex pricing mechanism introduces additional risks
What is the 3 upsides of hedging FX transACTION risk? (Hedging debate)
- Reduces the risk of corporate failure
- Reduces the volatility of cash flows
- Reduces the cost of capital; which should increase shareholder wealth on balance.
