Lecture 5 Flashcards
What are the 3 types of Foreign Exchange Exposure?
- Foreign Exchange: Refers to the money of a foreign country; foreign currency bank balances, banknotes, checks and drafts.
- Foreign Exchange Transaction: An agreement between a buyer and a seller where one fixed amount of one currency is exchanged for another currency at a specified rate.
- Foreign Exchange Rate: The price of one currency expressed in terms of another currency.
Describe the spot market (3):
- The Spot Market involves an immediate purchase or sale of foreign exchange.
○ One can buy (long position) or sell (short position) foreign exchange.
○ A cash settlement is usually made within 2 business days.
Describe the Forward Market and provide the general circumstances that occur in the forward market (3)
The forward market involves contracting today, for a future purchase or sale of foreign exchange. It is often used to hedge exchange risk exposure or to speculate.
- Circumstances:
○ No money changes hands upon entering the contract today.
○ The Forward price is either at a premium (higher) or a discount (lower) than the spot price.
○ The Forward market has maturities of 1, 3, 6, 9, or 12 months readily available.
What are the 3 types of Foreign Currency Exposure?
- Transaction Exposure: Over the duration of the inception and settlement of the contract, the transaction exposure is where there is a potential change in the value of the financial positions due to unexpected changes in the exchange rate.
- Economic Exposure: This refers to the unanticipated changes in the exchange rates affecting the value of the firm.
- Translation Exposure: When an unanticipated change in the exchange rates affect the consolidated financial reports of a Multinational Corporation.
What are the 2 main techniques to Hedge Transaction Exposure?
- Financial Contracts: Forward contracts, money market instruments, options contracts, and other special cases.
- Operational Techniques: Choice of invoice currency, lead/lag strategy, and exposure netting.
What is the formula to calculate the Gains and Losses of a Currency Forward Contract?
Gain = (F - S{T}) x Initial Value
F = Forward Exchange Rate
S{T} = Spot Exchange Rate
Initial Value = The value specified at the beginning of the contract.
What decisions should a firm make based on the following conditions:
Spot Exchange Rate = Forward Exchange Rate
Spot Exchange Rate < Forward Exchange Rate
Spot Exchange Rate > Forward Exchange Rate
- Spot Exchange Rate = Forward Exchange Rate
—> If expected gains or losses are approximately zero, firms who are adverse to risk should hedge to eliminate exchange exposure. - Spot Exchange Rate < Forward Exchange Rate
—> Firms that expect a positive gain from forward hedging should incline to hedge. - Spot Exchange Rate > Forward Exchange Rate
—> Firm would be less inclined to hedge under this scenario.
What is Money Market Hedging for a companies receivables?
This is where a company would take a loan in the foreign country (in the foreign currency), then convert it in to the home country currency. It is important that:
—> Maturity Value of the Loan = Foreign Receivable
On the maturity date of the loan, the company would use their receivables to pay off the foreign loan.
This eliminates the exchange exposure.
Using Money Marketing Hedging, how can a company determine the size of the loan in the foreign currency?
This can be computed by calculating:
1. Size of Receivables
2. Duration until Receivables
3. Foreign Currency Interest Rate
Example:
Size of Receivables: GBP 10,000,000
Duration until receiving Receivables: 1 year
Foreign Currency Interest Rate: 9%
10,000,000 / 1.09 = 9,174,312
What is an Options Market Hedge?
Although both forward and money market hedges completely eliminate exchange risk exposure, this also means that companies that use these hedging techniques do not have the opportunity to benefit if the exchange risk can benefit the company.
Currency Options provide a flexible “Optional” hedge against exchange exposure.
—> A firm can either buy a foreign currency put (call) option to hedge its foreign currency receivables (payables).
What is cross-hedging?
Cross-hedging is where firms hedge a position in one asset by taking position in another asset.
This is common in developing countries where the currencies may be less liquid (Such as the Thai Bhat).
What is contingent exposure?
This is the risk due to uncertain situations in which a firm does not know if it will face exchange risk exposure in the future.
An example would be if a company is bidding towards a certain project in a foreign country. If the company wins the bid, say they receive 100 million in the foreign currency. Companies may need to hedge to reduce this risk. This kind of risk is dependent on the situation and circumstance— this is known as a contingent exposure.
How can companies hedge against Contingent Exposure?
Options Contracts can provide an effective hedge against Contingent Exposure. Hedging tools such as forward contracts may be very difficult and unfeasible to manage.
How can a company hedge through an Invoice Currency? (3)
- The company could send their invoice in their home currency to the customer. The exchange exposure has not disappeared, but rather been shifted to the customer.
- The company may negotiate an agreement with a certain amount of the total payment being split into invoices with multiple currencies. This means the exchange exposure is shared with both parties.
- The firm can diversify exchange exposure to some extant by using currency basket units as the invoice currency. (Such as the Special Drawing Rights (SDR)).
How does a company hedge through using the Lead and Lag strategy?
The lead and lag strategy reduces transaction exposure by paying or collecting foreign financial obligations based on the conditions of the currency. They can either pay/collect early (lead) or late (lag), however, there are external factors to these payments that may affect the feasibility of this method.
—> Such as, A company that decides to prepay a given amount, they may want or expect a discount for doing it early.
Lead/lag strategies are very effective in intrafirm payables and receivables among subsidiaries.
Define and explain exposure netting:
This is hedging the net exposure only in firms/subsidiaries that have both payable and receivables in foreign currencies.
- Firms that would like to aggressively utilize this approach, would do so to centralize the firms exchange exposure management function in one location.
- Many MNCs use a reinvoice center, a financial subsidiary, as a mechanism for centralizing exposure management functions.
