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Corporate Finance Revision > Foreign Exchange and Hedging Strategies > Flashcards

Foreign Exchange and Hedging Strategies Flashcards

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1
Q

What is the foreign exchange market?

A

Where pairs of currencies can be bought and sold in exchange for one another i.e. £, $ and euros.

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2
Q

What is a FX rate?

A

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)

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3
Q

How do you convert a domestic currency amount to the foreign currency?

A

Multiply by the FX rate.

i.e. £10,000 = £10,000 x 1.6 = $16,000.

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4
Q

How do you convert a foreign currency amount to the domestic currency?

A

Divide by the fx rate.

i.e. $16,000 = 16,000/1.6 = £10,000

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5
Q

What is the 7 types of terminology within a FX Rate structure? (slide 4).

A
  1. Offer - the dealing rate when buying the domestic currency and selling the foreign currency.
  2. Pm - the premium of the spot rate over the forward rate (in pips)
  3. ds - the discount of the spot rate to the forward rate (in pips)
  4. Bid - the dealing rate when selling the domestic currency and buying the foreign currency
  5. £/$ - US Dollars (foreign) per UK Pound (domestic)
  6. Spot - the rate for dealing today and settling today
  7. Foward – the rate for dealing today but settling in the future
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6
Q

How do you calculate forward rates? (slides 5-6)

A
  1. deduct premiums (pm) from the spot rate

2. Then add discounts (ds) to the spot rate

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7
Q

What are FX rates in the long term?

A

Determined by relative levels of national economic growth which will ultimately impact on Inflation rates; and Interest rates.

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8
Q

What are Fx rates in the short term?

A

Volatile and Unpredictable

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9
Q

What 3 types of foreign exchange risks are companies exposed to?

A
  1. Economic risk - All companies
  2. Translation risk - Companies which have overseas assets and/or liabilities.
  3. Transaction risk - Companies which import and/or export.
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10
Q

What is economic risk?

A

The risk that a significant and permanent FX rate movement will adversely and permanently affect a company’s competitive position

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11
Q

What happens when the domestic currency is devalued? economic risk) (weakened)

A

Exporters benefit but importers suffer.

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12
Q

What happens when the domestic currency is revalued? economic risk) (strengthened)

A

importers benefit but exporters suffer.

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13
Q

What can economic risk NOT be?

A

Avoided even if the company trades purely in its domestic economy

Eliminated, only reduced by having a global spread of operations

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14
Q

What types of companies does translation risk affect?

A

Companies with overseas assets and/or liabilities.

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15
Q

What happens to these assets/liabilities when dealing with translation risk?

A

Have to be translated to the domestic currency at the spot rate prevailing at the financial year end (balance sheet date)

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16
Q

Where does this translation risk arise from?

A

From FX rates moving between balance sheet dates and changing the net asset value of the company.

17
Q

How can translation risk be reduced?

A

By matching overseas assets and liabilities (i.e. borrowing overseas to fund overseas projects)

18
Q

Who does transACTION risk affect?

A

Importers and exporters taking/giving trade credit.

19
Q

How can transAction arise?

A

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

20
Q

What types of fx rate movements are within the transACTION risk?

A
  1. Adverse - real cash losses in the domestic currency (i.e. lower than expected sales revenues for exporters)
  2. Favourable - real cash gains in the domestic currency (i.e. lower than expected costs for importers)
21
Q

How can you reduce transACTION risk?

A

Hedge it.

22
Q

How do you manage FX Transaction Risk? (slide 15)

A

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.

23
Q

What are the Internal strategies to TransACTIONrisk?

A
  1. Request settlement in domestic currency.

2. Matching and netting when a company is a regular importer and exporter.

24
Q

What happens when you request a settlement in domestic currency? (Internal strategy of transACTION risk).

A

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.

25
Q

Why do importer/ exporter companies match and net? (slide 16).

A

Match foreign currency receipt and payment dates
Net foreign currency receipts and payment amounts
Hedge net exposure

26
Q

How 4 markets can the FX transaction risk be hedged?

A
  1. Forward market (physical)
  2. Money market (physical)
  3. Currency futures market (derivative)
  4. Currency options market
    (derivative)
27
Q

What 5 hedging implications should companies consider when deciding their hedging strategy?

A
  1. Availability - can the exposure be hedged?
  2. Cost: Implicit (domestic currency payment / receipt)
    Explicit (hedge set-up costs)
  3. Flexibility - can the hedge be altered in the future if required?
  4. Efficiency - can a perfect hedge be achieved which exactly matches the exposure (amount and date)?
  5. Complexity - the pricing mechanisms in derivative markets are more complex than in physical markets
28
Q

How do importer companies set up when they are doing a money market hedge?

A

Borrow in domestic money market, buy foreign currency in the spot market and lend in foreign money market

29
Q

How do exporter companies set up when they are doing a money market hedge?

A

Lend in domestic money market, sell foreign currency in the spot market and borrow in foreign money market

30
Q

What is the 2 advantages if a money market hedge?

A
  1. Perfect hedge can be achieved to eliminate FX transaction risk
  2. Flexibility – can be unwound or rolled-forward easily
31
Q

What are the 2 disadvantages of a money market hedge/?

A
  1. Higher transaction costs than forwards

2. Need access to the foreign money market

32
Q

FORWARD VS MONEY MARKET HEDGE EXAMPLE (SLIDES 21 - 26)

A

must learn this john

33
Q

How do you set up hedges with currency futures?

A

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.

34
Q

What is the 3 advantages of hedging with currency FUTURES?

A
  1. Lowest cost derivative
  2. High market liquidity – can hedge large exposures quickly
  3. Flexible – can unwind or roll-forward in the market
35
Q

What is the 2 disadvantages of hedging with currency FUTURES?

A
  1. Currency futures only available for major currency pairs
  2. Futures only trade on exchanges so contracts have standardised size and thus may not be possible to achieve a perfect hedge
36
Q

How do you set up hedges with currency OPTIONS?

A
  1. 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)
  2. Close position (or exercise option) on the settlement date
37
Q

What is an advantage of hedging with currency OPTION?

A

Options cap rather than fix prices which means it protects against adverse FX rate movements; and
offers some benefit from favourable FX rate movements.

38
Q

What are the 3 disadvantages of hedges with a Currency OPTION?

A
  1. Most expensive hedging method
  2. Less liquidity than futures markets
  3. Complex pricing mechanism introduces additional risks
39
Q

What is the 3 upsides of hedging FX transACTION risk? (Hedging debate)

A
  1. Reduces the risk of corporate failure
  2. Reduces the volatility of cash flows
  3. Reduces the cost of capital; which should increase shareholder wealth on balance.

Corporate Finance Revision (10 decks)

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