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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
Advantages of forward rate for foreign exchange
Tailored arrangements Not complex
26
Disadvantages of forward rate for foreign exchange
Arrangement fees add to cost Can't benefit from upside risk No secondary market
27
What are the 5 steps in calculating the cost of a futures contract (foreign exchange risk)?
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
Advantages of a futures contract for foreign exchange.
Secondary market for futures Lower transaction costs Don't need to know exact date of payment/receipt
29
Disadvantages of a futures contract for foreign exchange.
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
Advantages of options for a set foreign currency rate
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
Disadvantages of options for a set foreign currency rate
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
How can a money market hedge be used when paying a foreign supplier?
- 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
How can a money market hedge be used when receiving a payment from a foreign customer?
- 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
Advantages of a money market hedge
No arrangement fee like forward Secondary market Could use surplus funds For a receipt, received funds earlier
35
Disadvantages of a money market hedge
Difficult to arrange Used up credit facility/increase gearing Complex for management to implement Interest rates/FX rates may change
36
Points to make if asked on decision to hedge
- 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
What is economic risk?
Loss of international competitiveness due to exchange rates moving unfavourably causing cost of inputs to increase, value of revenue to fall
38
How can you hedge economic risk?
Diversifying production and sales operations worldwide Adjusting selling prices for FX movements
39
What is translation risk?
International operations lose value when revenue and assets translated back to company's reporting currency for financial statements
40
How can you hedge translation risk?
Finance international operations with international debt
41
What is Cryptocurrency risk?
Risk that value of Crypto will change Can be used to make payment between overseas business
42
What is a Crypto forward?
Buy or sell Crpyto in the future at a fixed exchange rate
43
What is a Crypto future?
Standardised contracts to buy or sell a notional amount of Crypto Futures market will move with actual market
44
What are the 5 steps in calculating the cost of a futures contract (Cryptocurrency risk)?
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
Advantages of Cryptocurrency futures
Removes currency risk Can convert Crypto to £ when rates favourable
46
Disadvantages of Cryptocurrency futures
Can only exchange for limited currencies Value is very volatile
47
What is Equity Investment Risk?
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
What are Equity Investment futures?
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
What are the 5 steps in calculating the cost of a futures contract (Equity Investment risk)?
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

Financial Management (6 decks)

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