Foreign Exchange risk

Question 1

Exchange rate spreads bank perspective

Answer 1

Bank buys high
Bank sells low

Question 2

Transaction risk

Answer 2

The change in exchange rate between the time a contract is entered and the date of settlement

E.g. US company enters an agreement when exchange rate is: £0.93=$1

Base currency USD depreciates to £0.89=$1 and therefore has to pay more

Question 3

Economic risk

Answer 3

Long term version of transaction risk.

If your home currency strengthens (OR COUNTER CURRENCY WEAKENS), to keep the same margin, you will need to raise your price, as the home currency is converted into a higher counter currency

Or if you keep the same selling price, you will make less profit

Question 4

Translation risk

Answer 4

Financial statements of subsidiaries translated into home currencies

If home currency depreciates (I have to use more home currency to buy the counter currency) then the value of that subsidiary lessens

Question 5

PPPT

Answer 5

Exchange rate depends on inflation rates: USED TO PREDICT future spot rate

Law of one price: identical goods must cost the same, the exchange rate simply moves
Country with a higher inflation will have a depreciating currency e.g:

Usual rate of $2=£1
If the rate moves (GBP weakens) to $1.5=£1, the US firm can now buy exports cheaper > demand for GBP rises > sterling exchange rate rises and strengthens until it reaches $2 again

Question 6

PPPT Visually

Answer 6

$3k at $1.50 buys $2k
US has 5% inflation, UK has 3% inflation
as US has higher inflation, the USD will weaken so that in 1 years time:
$3,150 must buy £2,060 at a weakened rate of $1.53

S1 = S0 * (1+hc)/(1+hb)

Question 7

IRPT

Answer 7

The currency with higher interest rates will be subject to depreciation
Therefore there is no benefit of using the interest of either currency

Question 8

IRPT Formula

Answer 8

S0 + (1+ic)/(1+ib)

If non annual periods (e.g. 2 means sq)

Question 9

IRPT Workthrough

Answer 9

E.g. GBP at 100k with 3% interest = 103k
Convert to USD, $123k, add US interest 5% = $130k, use IRPT formula divide = £103k

Question 10

Forward exchange contracts

Answer 10

Locked into the forward. Ignore any other rates.
With a spread, remember bank sells low, buys high. Company will make the less money.
Contractual commitment, no benefit to gain from the upside if currency depreciates

Question 11

Money market hedges - payments

Answer 11

1. Divide by the foreign currency DEPOSIT rate
2. Translate to HOME currency at a LOWER SPOT rate
3. Multiply by home currency BORROWING rate

Question 12

Money market hedge - receipt

Answer 12

1. Divide the receipt by the foreign currency BORROWING rate
2. Translate to HOME currency at SPOT rate - HIGHER of spread
3. Multiply by the home company DEPOSIT rate

Question 13

Difference between a hedge and a forward

Answer 13

Similar, but uses the money markets to lend or borrow

Question 14

Difference between Futures and Fowards

Answer 14

Again similar, company’s position is fixed by the rate of exchange in the contract and are binding
Differences:
Futures can be traded on exchange via the contract,
Futures take place in 3 monthly cycles
Standardises amounts
Always a bull and sell element of a future

Question 15

How Futures work

Answer 15

Company expects to receive US$, company bets the currency will depreciate, if it wins, it cancels out the loss, if it loses, US$ strengthens and cancels out the loss

Question 16

How Options work

Answer 16

Similar to forwards with one key difference:
It’s optional, can let it lapse if spot rate is more favourable or the company doesn’t need the FOREX.
Comes at a premium to purchase the option regardless of use.

PUT - Right to sell currency
Call - Right to buy currency

Question 17

Options how to

Answer 17

Call option, you’re buying the the currency. Call Lower
Put option - you’re selling the currency. Sell higher

Question 18

Comp perspective for FRA

Answer 18

Dep low borrow high