Hedging - Exchange Rates

Question 1

Define transaction risk

Answer 1

Risk of adverse exchange rate movements occurring in the course of normal international trading transactions.
Occurs when there is movement in the exchange rate between the date when the price is agreed and the date when the cash is paid (received).

Question 2

4 ways of hedging against transaction risk

Answer 2

1. Forward exchange contracts
2. Money market funds
3. Futures market
4. Options market

Question 3

Elements of a forward exchange contract

Answer 3

1. firm and binding contract
2. For purchase/sale of a specified quantity of a stated foreign currency
3. At a rate of exchange fixed at the time the contract is made
4. For performance at a future time which is agreed when making the contract
5. Bank will make the customer fulfil the contract, meaning the customer is exposed to currency transaction risk if the counterparty defaults

Question 4

If a forward rate is quoted at a discount, this is …. to the spot rate

Answer 4

Added

Question 5

If a forward rate is quoted at a premium, this is …. to the spot rate

Answer 5

Deducted

Question 6

What does interest rate parity theory state

Answer 6

The difference between the spot and forward rate can be predicted by the difference in interest rate between the two countries

Question 7

Formula for the relationship between the spot rate and forward rate

Answer 7

Fwd rate = Spot x ((1+ if) / (1+iuk))

if = foreign interest rate
iuk = domestic interest rate

Question 8

Define purchasing power parity

Answer 8

Theory that in the long, exchange rates between currencies will tend to reflect the relative purchasing power of each country.

Question 9

Steps to set up a Money Market Hedge for a foreign currency payment

Answer 9

1. Borrow the appropriate amount in the home currency now
2. Convert the money borrowed to the currency of payment.
3. Put the money on deposit in the foreign currency to accrue interest.
4. Settle the liability using the deposit (plus interest)

Question 10

Steps to set up a Money Market Hedge for a foreign currency receipt

Answer 10

1. Borrow the appropriate amount in the foreign currency now
2. Convert it immediately to home currency.
3. Place it on deposit in the home currency.
4. When customer cash is received, the company repays the foreign currency loan and takes the cash from the home currency deposit account.