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Financial Management > Hedging > Flashcards

Hedging Flashcards

1
Q

What is a forward?

A

A binding agreement to buy or sell (borrow or lend) something in the future at an agreed price today.

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2
Q

What are futures?

A

Forward contracts that have been standardised (in terms of delivery date and quantity)

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3
Q

How can a business be exposed to interest rate risk?

A

It pays variable (fixed) interest on debt so has a risk that interest goes up (down).
It receives variable (fixed) interest on debt so has a risk interest rates go down (up)

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4
Q

Advantages of a forward contract (interest rate)

A

Tailored arrangements
100% effective hedge

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5
Q

Disadvantages of a forward contract (interest rate)

A

Only available for large amounts
Only available for periods less than 12m
Can’t benefit from upside risk

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6
Q

How do you calculate the cost of a loan (borrow) using a forward rate agreement?

A

Calculate the interest on the loan and then add/subtract the gain/loss of the forward contract

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7
Q

What are the 5 steps in calculating the cost of a futures contract (interest rate risk)?

A

Step 1: What is our interest rate risk so should we buy or sell interest rate futures?
Step 2: Calculate no. contracts needed to offset loan
Step 3: Calculate gain/loss futures
Step 4: Calculate actual interest paid on the actual loan
Step 5: Calculate the net amount and effective interest rate

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8
Q

Advantages of a futures contract (interest rate)

A

Lower cost than forwards
Can hedge large amounts

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9
Q

Disadvantages of a futures contract (interest rate)

A

Futures movement may not be the same as actual market (basis risk)
Contracts are standardised so can’t hedge exact amount of loan (contract risk)

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10
Q

What are trade options?

A

An option to buy or sell an interest rate future/a set foreign currency rate

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11
Q

How is a premium calculated?

A

Option premium x no. contracts x contract size x 3/12 months

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12
Q

Advantages of options for an interest rate future

A

Can benefit from upside risk as don’t as don’t have to exercise option
OTC are flexible with tailored amounts, maturity dates etc.

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13
Q

Disadvantages of a futures contract for foreign exchange.

A

Expensive (option premium)
Traded options are for standardised futures contracts so can’t hedge exact amount of loan (contract risk)
Futures movement may not be the same as actual market (basis risk)

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14
Q

What are swaps?

A

If one company is paying fixed, the other is paying variable, and they both want the opposite then they can agree to swap interest payments with one another.
They still retain liability for their individual loans and just pa the interest to each other

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15
Q

What are the steps when showing how a swap deal could be beneficial to two companies?

A

Step 1: Is there a potential gain?
Step 2: What should the result be if the gain is split?
Step 3: What are the cash flows to get that result?

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16
Q

Advantages of swaps

A

Less arrangement fees compared with taking out a new loan
Possible for both parties to save interest
Tailored arrangements

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17
Q

Disadvantages of swaps

A

Counterparty may not pay
Actual interest rates may change which changes value of the swap

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18
Q

List four ways a business could be exposed to a foreign exchange risk

A
  • Future payments in forex to international suppliers (transaction risk)
  • Future receipts in forex from international customers (transaction risk)
  • Loss of international competitiveness due to exchange rates moving unfavourably (economic risk)
  • International operations loss value when translated back to company’s reporting currency for financial statements (translation risk)
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19
Q

What is the spot rate?

A

The rate available to buy and sell currency now

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20
Q

How do you calculate a forward rate for foreign exchange?

A

Agreed price / Spot rate, less arrangement fee
- a discount is added to the spot rate
- a premium is subtracted from the spot rate
- if receipt, use spot rate on the right

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21
Q

What is Interest Rate Parity (IRP)?

A

It predicts the forward rate based on interest rates.
If interest rates move higher in one country, investors will want to invest in that country to earn higher interest and then convert back to their home currency later

22
Q

How do you calculate the forward rate using Interest Rate Parity (IRP)?

A

Average spot rate x (1+foreign interest rate)/(1+domestic interest rate)

23
Q

What is Purchasing Power Parity (PPP)?

A

It predicts the forward rate based on inflation rates
If inflation rates move lower in one country, customers will want to buy from that country to obtain a lower price.

24
Q

How do you calculate the forward rate using Purchasing Power Parity (PPP)?

A

Average spot rate x (1+foreign inflation rate)/(1+domestic inflation rate)

25
Q

Advantages of forward rate for foreign exchange

A

Tailored arrangements
Not complex

26
Q

Disadvantages of forward rate for foreign exchange

A

Arrangement fees add to cost
Can’t benefit from upside risk
No secondary market

27
Q

What are the 5 steps in calculating the cost of a futures contract (foreign exchange risk)?

A

Step 1: What is our exchange rate risk so should we buy or sell futures?
Step 2: Calculate the no. contracts needed to offset actual payment
Step 3: Calculate gain/loss on futures
Step 4: Calculate actual £ payment/receipt in the spot market
Step 5: Calculate the net amount

28
Q

Advantages of a futures contract for foreign exchange.

A

Secondary market for futures
Lower transaction costs
Don’t need to know exact date of payment/receipt

29
Q

Disadvantages of a futures contract for foreign exchange.

A

Can’t benefit from upside risk
Not available in every currency
Standardised futures contracts so can’t hedge exact amount
Futures movement may not be the same as actual market (basis risk)

30
Q

Advantages of options for a set foreign currency rate

A

Can benefit from upside risk as don’t have to exercise option
OTC are flexible with amounts, maturity dates
Secondary market for traded options

31
Q

Disadvantages of options for a set foreign currency rate

A

Expensive (option premium)
Traded options not available in every currency
Traded options are for standardised contracts so can’t hedge exact amount (contract risk)

32
Q

How can a money market hedge be used when paying a foreign supplier?

A
  • Buy the present value of the foreign currency amount today at the spot rate
  • the foreign currency purchased is placed on deposit and accrues interest until
    the transaction date
  • the deposit is then used to make the foreign currency payment.
33
Q

How can a money market hedge be used when receiving a payment from a foreign customer?

A
  • borrow the present value of the foreign currency
    amount today
  • the foreign loan accrues interest until the transaction date
  • the loan is then repaid with the foreign currency receipt
34
Q

Advantages of a money market hedge

A

No arrangement fee like forward
Secondary market
Could use surplus funds
For a receipt, received funds earlier

35
Q

Disadvantages of a money market hedge

A

Difficult to arrange
Used up credit facility/increase gearing
Complex for management to implement
Interest rates/FX rates may change

36
Q

Points to make if asked on decision to hedge

A
  • Risk attitude of directors: not hedging offers upside and downside risk
  • Exposure: if amounts are immaterial then not worth hedging
  • Costs: hedging is expensive and time consuming
  • Uncertainty: difficult to forecast without knowing exact amounts
37
Q

What is economic risk?

A

Loss of international competitiveness due to exchange rates moving unfavourably causing cost of inputs to increase, value of revenue to fall

38
Q

How can you hedge economic risk?

A

Diversifying production and sales operations worldwide
Adjusting selling prices for FX movements

39
Q

What is translation risk?

A

International operations lose value when revenue and assets translated back to company’s reporting currency for financial statements

40
Q

How can you hedge translation risk?

A

Finance international operations with international debt

41
Q

What is Cryptocurrency risk?

A

Risk that value of Crypto will change
Can be used to make payment between overseas business

42
Q

What is a Crypto forward?

A

Buy or sell Crpyto in the future at a fixed exchange rate

43
Q

What is a Crypto future?

A

Standardised contracts to buy or sell a notional amount of Crypto
Futures market will move with actual market

44
Q

What are the 5 steps in calculating the cost of a futures contract (Cryptocurrency risk)?

A

Step 1: What is our risk so should we buy or sell futures?
Step 2: Calculate the no. contracts needed to offset actual payment
Step 3: Calculate gain/loss on futures
Step 4: Calculate actual £ payment/receipt in the spot market
Step 5: Calculate the net amount

45
Q

Advantages of Cryptocurrency futures

A

Removes currency risk
Can convert Crypto to £ when rates favourable

46
Q

Disadvantages of Cryptocurrency futures

A

Can only exchange for limited currencies
Value is very volatile

47
Q

What is Equity Investment Risk?

A

Risk that the investment may fall in value (a decline in the share price)
A company may invest in other companies in order to earn a return

48
Q

What are Equity Investment futures?

A

Standardised contracts to buy or sell a notional amount of shares
Futures market will move with actual market
Transactions costs lower than buying actual shares

49
Q

What are the 5 steps in calculating the cost of a futures contract (Equity Investment risk)?

A

Step 1: What is our risk so should we buy or sell futures?
Step 2: Calculate the no. contracts needed to offset share price movement
Step 3: Calculate gain/loss on futures
Step 4: Calculate actual loss due to share price fall
Step 5: Calculate the net amount

50
Q
A

Financial Management (6 decks)

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