Hedging Techniques

Question 1

Purchasing power parity theory

Answer 1

It seems that foreign currency exchange rate between two countries will be influenced by respective inflation rates.

If inflation is lower in one country than another customer will seek by goods in that country where they can get more for their money.

This means demand for the currency will increase (supply and demand) resulting in the currency strengthening.

Countries with higher inflation will always see their currency weakem against countries with lower inflation

Question 2

Leading and lagging

Answer 2

Monitor day exchange rates and pay when favourable.

Advantages – can get more favourable rate.

Disadvantages – pressure on working capital cycle and potential bad reaction for late payments

Question 3

Methods for mitigating for an exchange risk

Answer 3

Leading and lagging

Options

Futures

Bank account in foreign currency

Multi lateral netting

Matching

Negotiation

Question 4

Options

Answer 4

A derivative financial instrument that gives the user the right, but not the obligation, to exchange money at a predetermined rate and date

Advantages – allow to the upside risk on currency translation.

Disadvantages - is more expensive (pay premium)

Question 5

Negotiation

Answer 5

Share any transaction losses.

How high is our purchasing power?

Question 6

Bank account in foreign currency

Answer 6

Move money into this account when exchange rates are more favourable and pay liabilities from it

Advantages – able to take advantage of upside risk.

Disadvantages – translation risk (will be on the balance sheet) and bank fees

Question 7

Multi lateral netting

Answer 7

Takes a more holistic approach to foreign exchange risk, netting losses in some countries against others.

Works when businesses operate across a large number of countries.

Question 8

Matching

Answer 8

Matching revenues already generated in the country with payables and matching them off, effectively bypassing the conversion which gives rise to the translation risk

Question 9

Futures

Answer 9

A financial derivative. A binding agreement to purchase of foreign currency on specified date and rate in the future.

Advantages – mitigate the downside risk.

Disadvantages – cannot benefit from upside risk.

Question 10

Hedging techniques

Answer 10

Generally involve the use of financial instruments known as derivatives

With derivatives you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.