Foreign exchange exposure

Question 1

What is a bilateral exchange rate?

Answer 1

Value of one currency expressed in terms of another (7.5 DKK/EUR).

Question 2

What is the trade weighted index?

Answer 2

Value of the currency expressed in terms of weighted average of a number of other currencies (basket of currencies).

The weight of the currencies in the basket depends on the trading activity.

Shows more accurately the current development of the currency (appreciation/depreciation) in comparison to the main trading partners.

Question 3

What is the nominal effective exchange rate index?

Answer 3

Weighted average of the value of the currency over time.

Basically just a different name for the trade weighted index.
The word nominal highligths that it is NOT taking PPP into consideration, just shows value development over time in comparison to some arbitrary base.

Question 4

What is the real effective exchange rate index?

Answer 4

Weighted average of the currency over time adjusted for PPP.

Question 5

What is a spot rate?

Answer 5

rate at which a currency can be purchased or sold in a spot transaction (= to be settled within the following 2 days)

Question 6

What is a forward rate?

Answer 6

an exchange rate quoted today for settlement at some future date (e.g. 3-months forward rate)

Question 7

Explain depreciation

Answer 7

Depreciation: a decrease in the exchange rate

Question 8

Explain appreciation

Answer 8

Appreciation: an increase in the exchange rate

Question 9

How does currency affect competitiveness?

Answer 9

It influences a firms through participation in GVC, foreign currency dominated debt, and change in domestic market conditions.

Question 10

How does currency affect competitiveness through participation in GVC?

Answer 10

If the firm export goods it will be positively affected by a depreciation of their currency, since their good become cheaper in other countries, increasing demand for their products.

If the firm import intermediaries a currency depreciation is bad, since intermediate input becomes more expensive, reducing their competiveness.

Question 11

How does currency affect foreign currency denominated debt?

Answer 11

MNEs sometimes fund their activities using foreign banks or foreign currencies.

If the home currency appreciates against the foreign currency denominated debt, it becomes less expensive to pay of debt, thus, it is good for the firm.

If the home currency depreciates, it becomes more expensive to pay of debt in the foreign currency, which is bad for the firm.

Question 12

How does currency affect change in domestic market conditions?

Answer 12

If two countries are trading with each other, then one countries product will become more competitive as their currency depreciates, because consumers from the other country needs less money to purchase their goods compared to home country goods.

I.e., USA selling to DK, US currency depriciates against the krone, making US dollars cheaper, inducing dnaish consumers to buy more US products than dansih products.

Question 13

What is Foreign direct exposure?

Answer 13

Foreign direct exposure is a measure of the potential change of a firm’s profitability, net cash flow and market value cause by a change in exchange rate.

Degree to which a company is potentially affected by a change in foreign exchange.

Question 14

What are the different types of foreign direct exposures?

Answer 14

accounting exposure and operating exposure (economic)

Question 15

Explain accounting exposure

Answer 15

Accounting exposure includes transaction exposure and translation exposure, which arise from contracts and accounts denominated in foreign currency

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.
- Changes in cash flows that result from existing contractual obligations.
- Can occur from upstream (receivables) and downstream activities (payables)

Translation exposure relates to the potential for changes in owner’s equity resulting from translating foreign currency financial statements of foreign subsidiaries into a single reporting currency for preparing consolidated financial statements.

Question 16

Explain economic exposure (operating)

Answer 16

Economic exposure (operating exposure) is the potential change in the present value of the firm resulting from change in the future operating cash flows of the firm caused by its changing global competitiveness as determined by exchange rates
It is related to changes in future cash flows caused by unexpected exchange rate changes, and it focuses on the potential impact of exchange rate changes on sales volume, prices, and costs.

Question 17

What is hedging?

Answer 17

Hedging means taking a position (an asset, a contract, a derivative) that counters the fall or rise in value of an existing position.

Hedging protects the owner of the existing asset from loss but eliminates any gain from an increase in the value of the asset hedged. Even the mildest forms that allow for some potential gains will take a “cut” – meaning hedging will always cost money.

Hedging these cash flows narrows the distribution of the cash flows about the mean of the distribution, which reduces risk.

Question 18

What are the benefits of hedging?

Answer 18

It reduces risk and improves the planning capability of the firm by allowing for more accurate prediction of future cash flows.

Avoid point of financial distress (minimum cash flow for the firm).

Information asymmetry between management of MNEs and shareholders – managers know the FX risk for the whole firm better than shareholders. Managers are in better positions than shareholders to know about exceptional exposures and therefore one-off hedging-opportunities.

Question 19

How do you measure transaction exposure?

Answer 19

Transaction exposure = gains and losses arising from the settlement of existing financial obligations stated in foreign currency

Question 20

How does transaction exposure arise?

Answer 20

Steam from purchasing/selling in foreign currency, borrowing/lending in foreign currency, being a party to an unperformed foreign exchange forward contract, or otherwise acquired assets or incurring liabilities in foreign currency.

Question 21

What is quotation exposure?

Answer 21

Time between quoting a price and reaching a contractual sale

Question 22

What is backlog exposure?

Answer 22

Time it takes to fill the order after contract is signed

Question 23

What is billing exposure

Answer 23

Time it takes to get paid in cash after accounts receivable is issued

Question 24

Why hedging?

Answer 24

MNEs have multiple cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices.
Hedging is a common technique used to manage exchange rate risk, which involves using financial instruments to offset the potential losses resulting from exchange rate fluctuations.

Question 25

What are some different types of hedging?

Answer 25

Different hedging strategies can be used, such as forward contracts, options, and swaps, depending on the specific needs and circumstances of the firm.

Question 26

What is currency risk?

Answer 26

Currency risk can be defined as the variance in expected cash flows arising from unexpected changes in exchange rates.

Question 27

What are the cons of hedging?

Answer 27

Shareholders are more capable of diversifying currency risk than is the management of the firm.

Currency hedging does not increase the expected cash flows of the firm.

Currency risk management consume firm resources and so reduces cash flow.

Management often conducts hedging activities that benefit management at the expense of the shareholders.

Managers cannot outguess the market.

Management’s motivation to reduce variability is sometimes for accounting reasons.

Hedging add cost.