Foreign Exchange and Interest rate risk Flashcards
What are the different types of risk and how can they arise?
Transaction risk - risk usually occurring over a relatively short period. Is the potential for change in the exchange rate between transaction and settlement dates.
Translation Risk - where translation in to base currency causes a distortion in the reported figures. I.e. when consolidating statements from different entities.
Economic risk - long term version of transaction risk. Variation in the value of a business due to exchange rate fluctuations.
How can the balance of payments impact fluctuations in exchange rates?
Balance of payments = imports vs Exports.
Imbalance here will impact supply or demand of currency.
Increased demand for imports = Supply of £ or demand for $
Increased demand for Exports = Supply of $ or demand for £
The exchange rate can also be impacted by capital movements between economies as a result of changes in interest rates or inflation.
What is Purchasing power parity (PPPT) and how does this impact exchange rates?
PPPT is basically the assumption that all currencies will retain their value relative to each other.
So if inflation in both markets is the same level exchange rates would also remain constant, however should there be differences in inflation the exchange rate will fluctuate in order to maintain parity.
The formula to forecast the expected future exchange rate uses:
- S0 - Current exchange (Spot rate)
- Hb - Base currency exchange rate
- Hc - Foreign currency exchange rate
NOTE - when looking at exchange rate the base currency is always shown as a single unit e.g. £1:$1.50 - base currency is GBP.
What is interest rate parity and how can this impact exchange rates?
IRPT orperates in almost the same way as PPPT, just it’s interest rates impacting the changes not inflation.
The formula is pretty much the same as for PPPT using base and foreign interest rates.
What is four way equivalence?
This links to the Money (Nominal) rate of interest being made up of two under laying parts, real interest rate and rate of inflation.
(1+i) = (1+r)(1+h)
Makes the assumption that all countries will have the same real interest rate (R) with money and inflation rates being the difference.
Not hugely accurate as other factors such as government intervention will impact exchange rates as well.
What is a business fundamentally trying to achieve when dealing with foreign exchange risk?
In relation to foreign exchange rate risk a business will be trying to:
- Minimise risk - reduce the potential for losses due to changes in exchange rates
- Build in certainty - being able to determine exact cash flows in base currency is of importance for planning and forecasting.
What methods or processes might a business employ as part of managing foreign exchange risk?
- Invoice in Base currency - this essentially removes/transfers all exchange risk to the buyer.
- Netting - where inter company sales and purchase transactions in the same foreign currency are due to occurr closely together, save transaction costs by making payments between companies.
- Matching - operate foreign currency bank accounts to receive and make payments in that currency.
- Leading/Lagging - essentially advancing or delaying payment or exchange of currency for payment.
What is a forward exchange contract and how is the outcome calculated?
Forward Exchange - essentially fixing a currency rate now for a future transaction.
This is a contract so the currency amount must be sold as agreed.
Remember when looking at exchange rate spreads - the Bank always wins.
So even if the rate moves the exchange rate to apply is the one agreed in the forward contract.
What is money market hedging and how does it work?
Hedging is essentially using the money markets to lend or borrow money achieving the same result as with a forward contract.
The home currency amount required is calculated in three steps:
- Borrow/lend foreign amount that will result in the payment value required at the future time. 1 + ForEx rate for time period)
- Translate this to base currency at the spot rate
- Multiply translated amount by 1 + Home currency rate for the period
In relation to foreign currency risk management what is meant by asset and liability management?
Asset and liability management is in its simplest form having assets and liabilities in the same currency with the same maturity period.
This essentially provides a form of offsetting for any exchange risk limiting it to the net balance of the two elements.
What approaches may be used when managing foreign currency risk?
- Dealing in home currency - eliminates risk, but may have commercial impact due to risk passing to customer.
- Doing nothing
- Leading/Lagging - based on an expected change in interest rates so could go very wrong.
- Matching receipts and payments - can be an issue if there is significant time between transactions.
What foreign currency derivatives may be used to hedge foreign currency risk?
- Forward Exchange Contracts - Fix currency price on future transaction. Flexible and straight forward. Contractual commitment, removes opportunity to benefit from movements in exchange rates.
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Futures - like a FC but:
- Can be traded
- Runs in 3 months cycles
- Standard amounts, can only be bought/sold in multiples.
- May result in exposure to basis risk.
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Options - Similar to forwards:
- May exercise if needed, if not let it lapse.
- Premium must be paid to purchase.
What is Gap exposure and gap analysis?
Gap analysis is used to identify the level of interest rate risk a company is exposed to.
Looks at assets and liabilities affected by changes in interest rates according to their maturity dates.
Negative gap - maturing liabilities > Maturing Assets at a certain date.
Positive gap - opposite of the above.
What is basis risk and when can it arise?
Basis risk may arise where the price of a futures contract does not exactly offset the fluctuations in the spot rate.
It may also arise where the contract value must be rounded to a whole denomination.
What is the structure of interest rates and the yield curve and how do they relate to each other?
Structure = the way that the return on a debt or bond will vary based on the term (duration).
A yield curve is a graphical analysis of this variation between yields and duration. The yield curve falls in to three types:
- Normal - Longer maturity = higher yield as a result of the increase in risk over time.
- Inverted - inverse of normal yield. May indicate a coming recession.
- Flat (Humped) - No variation in yield seen over differing terms, may also indicate change.
Consider how the attitude of the graph line changes along each axis, Steep = bigger difference.
