Lesson 5 Flashcards
Please list and outline the three types of foreign currency exposures
-Transaction exposure: Refers to the sensitivity of the value of future cash transaction to unexpected exchange rate fluctuations
-Economic exposure: This refers to the sensitivity of a firm’s present value of future cash flows to unexpected exchange rate fluctuations. I.e. long-term and indirect effect caused by exc. rate fluctuations. (How international competitiveness is affected by exc. rate)
Translation exposure: Refers to the degree to which a firm’s consolidated financial statements can be influenced by exchange rate fluctations - ‘on paper’ gains and losses
For translation exposure, outline the four translation methods
Current/Non-current method: -Current Rate: Current assets and liabilities
-Average rate: Most income statement items
-Historical rate: Non-current assets and liabilities and their associated income statement items
Monetary/non-monetary method:
-Current Rate: Monetary Balance sheet accounts
-Average Rate: Most income statement items
Historical Rate: Non-monetary balance sheet accounts and their associated income statement items
Temporal Method:
Current Rate: Monetary balance sheet accounts and accounts recorded at current value
Average Rate: Most inome statement items
Historical rate: Balance sheet accounts recorded at historical value and their associated income statement items
Current rate method:
All balance sheet accounts except for shareholders equity at current rate
Please describe the invoice currency strat. as a hedging strategy
Shift: The exporter quotes their price in their home currency rather than the importer’s.
Share: Here the currencies are divided equally. E.g. 50% EUR 50% USD
Diversify: When a global company invoices in different currencies dependent on the market to which they are selling
Lead/lag strategy
Lead:
-Collect receivables earlier in soft currencies (currencies expected to depreciate).
-Pay payables earlier in hard currencies (expected to appreciate)
Lag:
-Delay collecting receivables in hard currencies (expected to appreciate)
-Delay paying payables in soft currencies which are expected to depreciate
Netting strategy
Method involving offsetting payables and receivables in the same currency to reduce the volume of cross border transactions.
-Bilateral netting: When two companies or divisions within a company offset their receivables and payables with each other.
-Multilateral netting: When multiple companies or subsidiaries within a larger organization net out all their currency exposures across the group.
Money market hedge
Borrowing and lending in the foreign currency to lock in an exchange rate today for a future payable or receivable.
For a foreign currency payable - borrow in foreign currency. Invest in a domestic money market to earn interest until the payable is due.
Money market hedge example:
UK Company needs to pay a French company 1m EUR in 30 days. The 30 day int. rate is 0.5% in France. Spot exc. rate is 1.20EUR/GBP. How can the company manage this exposure?
Convert GBP to EUR at the spot exc. rate and invest the proceeds for 30 days.
1,000,000/1.05 = 995,025 EUR
Convert GBP to EUR and deposit in French bank to receive 1m EUR after 30 days.
995,025/1.20 = 829,188 GBP
What is a forward?
An agreement to buy or sell a currency at a fixed rate on a future date, often used to lock in an exchange rate.
What is an option?
A derivative that gives the holder the right but not the obligation to exchange currency at a specified rate on or before a certain date
Swaps
An agreement to exchange currencies between two parties for a set period and then revert back at a specified date, often used to manage longer term exposures
Exchange of int. rate payments in two different currencies. Ideal for managing a sequence of payables or receivables in foreign currency.
Forward hedge example:
A UK company needs to pay 1m EUR in 30 days. How does the company manage this exposure using a forward contract if the 30-day int. rate in the UK is 1.4%, the forward rate is 1.19EUR/GBP
In 30 days the company needs to have:
1m EUR, thus:
1,000,000/1.19 = 840,336 GBP
Therefore, amount needed now:
840,336/1.014 = 828,734 GBP
Please differentiate between the forward hedge and the money market hedge
They are equally as effective in managing transaction exposure.
If IR parity does not hold, forward premium or discount does not fully offset the int. rate differential between the two currencies; an arbitrage opp. exists.
Money market hedge and forward hedge will produce different results
Example: A British company needs to pay EUR 1million in 30 days, the 30-day interest rate is 0.5% for EUR and 0.8% for GBP, the spot and the forward exchange rates are €1.20/£ and €1.18/£, respectively. Which hedging method is preferred?
- Money market hedge: €1M/(€1.20/£*1.005) = £829,188
- Forward hedge: €1M/(€1.18/£*1.008) = £840,732
- The covered IRP implied forward rate is €1.196/£- it will take more GBP to buy EUR.
It is thus better to convert GBP into EUR now rather than later.
Please describe a currency call/put option
A currency call option provides the right but not obligation to buy a currency at a specified price (exercise price) within a given period of time. The option is execerised if the spot rate is higher than the exercise rate. We should buy call options to hedge payables.
A currency put option provides the right to sell a specified amount of a particular currency at a specified price within a period of time. We should buy put options to hedge receivables.
Company A has payables of $100,000 to be made 90 days from now. Assume there is a call option available with an exercise price of £0.62/$. The option premium is £0.03 per $1.
Assume the spot goes to £0.66/$, calculate the total price paid for the USD.
As the spot after 90 days is higher than the option price we should exercise the option and pay the 0.66 for the $.
Price will be 0.03100,000 + 0.62100,000 = £65,000
