Lecture 7: Measuring and Mannaging FX Exposure Flashcards
What are the two major types of FX risk exposures? Are there any further seperations within these exposures? What do each of these represent (what activites)?
Define translation exposure. Give one example if possible.
A change n EX rate will cause a change in the HC value of an accounting item.
e.g. An AUS company owns shares in a US company. The shares dont change value but the USD/AUD EX rate changes;
1 AUD = 0.85 USD to 1 AUD = 1 USD
The fall in AUD book value needs to be recogised in the accounts.
What effects do translation exposure have?
Define these effects.
May have these effects:
Informational Effect: interested parties may use accounting information to judge the health and value of the firm. Could effect confidence of users and impact economic interactions.
Managerial Behaviour: may effect loadd contracts based off accounting numbers, also compensation based off accounting profit.
Define transaction exposure. Provide an example if possible.
A change in the EX rate will cause gains/losses on transactions that are denominated in FC annd have already been entered into contractually (but not yet completed).
E.g. An AUS mining company has sold forward its production for the nnext 3 months of production at fixed USD amounts. The AUD depreciated against the USD in the next 3 months the revenue from production will be higher in AUD terms than expected while costs in AUD are likley to stay the same.
Define operating exposure. Give an example if possible.
A change in the EX rate will cause a change in the HC value of a future economic activity.
What is the first task in identifying FX exposure?
It is to know what the esposure is (i.e. need to identify cashflows for each** foreign currency in **each future time period)
*it is important to net off those that coincide.
What are the four main catagories of anticiparoty hedginng activites?
- Administrative Action (leads and lags): accelerate collection of FC recievables; delay payment of FC payables.
- Pricinng Decisions: Where possible; set import prices in FC and set export prices in HC.
- Use Financial Instruments: sell FC forward (=buy HC forward); buy a put option on FC.
- Balance Sheet Hedging: borrow FC
What is forward rate hedging?
If I have a commitment to recieve/pay FC in the future, then the hedge is to short/long a FC forward today.
What are three concerns of forward rate hadging?
- Are my competitors hedging too?
- Repeated FC cash flows
- How does inflation affect all this?
Explain the basis behind foward rate hedgings first concern ‘are my competitors hedging as well’?
The basis for this concern is that you want to hedge if your competitors are hedging and you don’t want to if they aren’t either.
Explain the basis of concern 2 (repeated forward rate hedging) in Forward rate hedging.
This concern is seperated into two parts:
- Protectig HC value of a given amount of FC.
- Protecting HC value of a sequence of FC recievables/payables.
Explain the basis for forward rate hedging’s 3rd concern (how does inflation affect it?).
The basis of this concern is that innflation rates between countires can vary greatly. This is largely unimportant to MNCs as although the inflation may differ it is not going to have a massive impact on the revenues/costs within each country.
Assuming PPP holds (long term) then the EX rates will reflect the innter-country differennces in inflation rates anyway.
*MNCs are in business for the long term.
What is balance sheet hedging?
Undertaking borrowing and/or lending transactions to achieve ann exchange rate hedge.
*construction of a home-made forward.
What is the main use of balance sheet hedging?
To borrow to hedge a foreign asset.
What is a hedging contingency? What is used to hedge a cotingency?
A contingency is where there is a potential future FX situatuion where a hedge may be needed. In this instance options are used to hedge the situation.
You need to pay a premium to purchase such insurance.
