Foreign exchange rates Flashcards
Types of Foreign Exchange Exposure
Translation risk, transaction exposure, economic exposure.
External Techniques for Managing Foreign Exchange Risk
-Forward contracts
-options contracts
-swaps
-foreign currency loans
Internal Techniques for Managing Foreign Exchange Risk
Invoicing in home currency, leading and lagging, natural hedging.
Factors that determine exchange rates.
Interest rate differentials, inflation rates, economic growth, political stability, and trade balance.
Transaction risk?
-arises from exchange rate changes on signed contracts for goods/services
-receivables/payables in foreign currency, exchange fluctuations can impact CF’a
Translation risk?
-arises when a firms foreign currency assets/liabilities need to be consolidated into FS
-fluctuating risks can effect their reporting value
Economic risk?
-reflects long-term effect of exchange rate changes on firms MV
-encompasses how fluctuations can impact a firms competitiveness and future CF’s
Forward contracts
An agreement to buy or sell an asset at a predetermined price on a future date. Tailored to the parties involved.
options contracts
A contract giving the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a set price before a specific date.
swaps
A contract where two parties exchange cash flows based on different financial variables, like interest rates or currencies, to manage risk.
foreign currency loans
Loans issued in a currency other than the borrower’s home currency, which expose the borrower to exchange rate risk.
Invoicing in home currency
This is the practice of billing clients in the currency of the seller’s home country. It reduces exchange rate risk for the seller but may expose the buyer to currency risk if they need to convert their funds.
leading and lagging,
These strategies involve adjusting the timing of cash flows based on expected currency movements. “Leading” refers to accelerating payments in a foreign currency if it’s expected to strengthen, while “lagging” means delaying them if the currency is expected to weaken.
natural hedging
This strategy involves minimizing currency risk by balancing cash inflows and outflows in the same foreign currency. For example, a company generating revenue in a foreign currency will aim to match its expenses in that same currency, thereby reducing exposure to exchange rate fluctuations.
