Foreign exchange risk Flashcards
What are the 3 types of foreign exchange risk?
Transaction
Translation
Economic
What is transaction risk?
Short term gain or loss that arises when cash is converted following the settlement of a transaction
What is translation risk?
Gain or loss that arises in financial statements when assets or liabilities are translated at the end of an accounting period. (accounting risk)
What is economic risk?
Long term impact of exchange rate changes on the value of a business
When does economic risk arise?
When a business trades with another country, but can also impact companies who do not.
In what way can a company that does not trade with other countries be impacted by economic risk?
Competition with other companies who can take advantage of favourable exchange rates
A currency is said to strengthen if it can buy…
more of another currency
A currency is said to weak if it can buy
less of another currency
A strengthening currency is a favourable risk for …
imports where payments need to be made in another currency
A strengthening currency is of an adverse risk for…
exports where receipts arise in another currency.
What are the two types of exchange rate?
Spot rate
Forward rate
What is a spot rate?
This is todays rate. The rate for immediate conversion of cash from one currency to another
What is a forward rate?
The rate at which currency can be bought or sold on a future date using the forward market.
What causes exchange rate fluctuations?
Purchasing Power Parity (PPPT) and Interest Rate Parity (IRPT)
What does the PPPT theory suggest?
The exchange rate between two currencies (long term) depends on the relative inflation rates in those two currencies.
In the purchasing power formula, S1 = S0 X (1+hc)/(1+hb), what is S1, S0, hc and hb
S1 = future expected spot rate S0 = spot rate today hc = counter currency inflation rate (Variable rate) hb= base currency inflation rate
What does the Interest rate Parity theory suggest?
The forward rate used in a forward exchange contract is based on interest rate differentials.
In the IRPT formula
F0= S0 X (1+ic)/(1+ib)
What do FO, S0, ic and ib mean?
F0 = Forward rate or future expected spot rate
S0= Spot rate today
ic = interest rate in counter currency
ib- interest rate in base currency
What is the four way equivalence theory?
Explain the two fisher effects and what this means.
The fisher effect- money rate of interest is made up of real rate of interest and a premium based on inflation..
The international fisher effect assumes that all countries will have the same real interest rate and therefore the difference in interest rates between the two will be equal to the difference in inflation rates between the two countries.
IF the above is true then the current forward rate is an unbiased predictor of the spot rate at that point in a future date ( the expectation theory) - PPPT and IRPT will be the same
What is the Bid-offer spread?
The profit made by a foreign exchange dealer when buying and selling currency.
List 6 techniques for managing currency risk practically (internally)
- Do nothing
- Invoice in home currency
- Matching
- Foreign bank accounts
- Leading and Lagging
- Matching Assets and Liabilities
How does invoicing in the home currency mitigate risk?
Transfers risk to the other party.
How does matching work?
Match receipts and payments in the same currency that arise at the same time.
How does using foreign bank accounts help manage currency risk?
Open accounts in the currency so that payments and receipts can be deposited and paid out in that currency that arise in future.
What is leading and lagging?
This is the bringing forward, or delaying of payment to make the most of favourable exchange rates
How does matching assets and liabilities help manage currency risk?
If a company owns assets in a foreign currency, they should borrow in that currency so that if the assets lose value, so does the liability.
What are 4 external techniques for managing currency risk?
- Forward exchange contracts
- Money market hedge
- Futures
- Options
What is a forward exchange contract?
A legally binding contract for the purchase or sale of a specified amount of foreign currency on a future date, at a rate of exchange fixed at the time the contract is made.
What are the advantages of a forward exchange contract?
- Fixes the rate and eliminates adverse exchange rate movements.
- Tailor made and flexible in terms of amount and hedged/settlement date.
- Simple and easy to arrange
What are the disadvantages of a forward exchange contract?
- Cannot take advantage of favourable exchange movements
2. Legally binding so if underlying transaction falls through you have to complete the exchange anyway
What are the steps to a Money Market Hedge payment?
1 - Borrow money in the home currency
2 - Convert the amount into foreign currency today
3 - Deposit the amount in a foreign currency bank
4. Make the payment out of the foreign currency bank account.
What are the steps to hedging a foreign currency receipt?
1- borrow money in foreign currency today
2 - Convert the borrowed amount into the home currency today
3- Put the amount on deposit
4 - When cash is received, use this to repay the foreign currency borrowing.
What are the advantages of a money market hedge?
- Fixed rate eliminates adverse exchnge rate movements
- Tailor made and flexible in terms of amount / settlement date.
- Some felixibility in terms of timing (if receipt is delayed then you could extend foreign currency loan and repay later (making it slightly better than a forward contract)
What are the disadvantages of a money market hedge?
- Cannot take advantage of favourable movements
2. Transaction costs for taking out, or depositing money.
What is a futures contract?
A type of derivative contract i.e is derived from the value of something else.
Are futures contracts binding?
Yes
How are futures similar to forward contracts?
It is a fixed rate, and it protects against adverse exchange rate movements but do not take advantage of favourable movements
Futures are standardised contracts. What does this mean/
They are only available in standard amounts eg multiples of £62,500. and can only be settled at the end of March, June, September and December.
How can futures be traded?
On the futures exchange
In terms of the date upon which they need to be used, which offers more flexibility? Futures or Forward contracts?
Forward Contracts
Does a future hedge give a perfect result in terms of amounts received and paid?
Not always
What is a currency option?
A derivative contract?
What is the difference between a future and an option?
An option gives the holder the right to buy or sell foreign currency at a specific exchange rate on a future date - but they are NOT obliged to do so, meaning they can allow the option to lapse.
What is the the key advantage of a currency option?
It allows the holder to protect against an adverse exchange risk whilst at the same time, take advantage of a favourable exchange movement.
What is the key disadvantage to a currency option?
It is very expenses as the holder must pay a premium , irrespective of whether the option is exercised or allowed to lapse.
