Forex Risk Management

Question 1

What are options and their different excerise times?

Answer 1

1) Right but not obligation to buy or sell an asset at a fixed price/ Strike Price.
2) Excercise times depends on US(available everytime), European(available at the end) and Bermuda (available every set period)

Question 2

Whats the process of setting up a normal option with a dealer/ party?

Answer 2

Buyer/ holder pays premium to a Seller writer whom will give the Buyer/ holder a put or call option.

Put: Right to sell (A stop loss to minimize downside risk)
Call: Right to buy (To increase upside potential)

Question 3

Steps to set up an Option?

Answer 3

1) Call or Put
2) Premium(if overdraft the PV)
3) Excercise or lapse
4) If TR: Excercise - Prem
If TP: Excercise + Prem

Question 4

Advantages vs Disadvantages of options

Answer 4

Advantages
1) Contigent commitment
2) Certain cashflows
3) OTC: Tailored
4) Exchange: Secondary Market
Disadvantages
1) Sunk Cost: Premium
2) OTC: No secondary market
3) Exchange: Not tailored

Question 5

What are cylinder/collar options, their advantages and disadvantages?

Answer 5

Options that give the holder the right but not obligation to both call and put, maximizing upside potential whilst minimizing downside risk.

Advantages
1) Low/no premium
2) Put/call rates to be tailored
3) American option: Open

Disadvantages
1) Opportunity Cost
2) Commiment still present

Question 6

Name 5 internal hedging techniques

Answer 6

1) Matching(debt factoring)
2) Portfolio Approach to forex rate risk(currencies of same movement)
3) Multilateral Netting(subsidiaries protecting subsidiaries)
4) Invoice currency(use of buying power/scale)
5) Lead(pay first) and lag(pay later)

Question 7

what are the benefits of hedging transaction exposure?

Answer 7

1) Reduces volatility of earnings & cash flows leading to stable profits and lower tax
2) Lower Risk=WACC(weighted average cost of capital) is lower which increases borrowing capacity.
3) Managers & employees won’t hold secondary jobs
4) Suppliers and customers prefer to deal with less risky firms

Question 8

What are the arguments to not hedge translation exposure?

Answer 8

1) No cash inflows or outflows from gains or losses.
2) Hedging is costly and would be unnecessary(Agency theory)
3) Oversea assets are strategic therefore investors may want the risk.
4) For large MNC, could be offset by subsidiaries
5) Build relationships

Question 9

What are ways to hedge Economic Exposure and overall problems with hedging.

Answer 9

Ways to:
1) Set up subsidiaries in those markets
2) Reduce prices
3) Diversify customers & suppliers
4) Improve product quality
Problems:
1) Difficult to forecast movements
2) Hard to know currency cost base for competitors & their hedging position.