Managing financial risk: Overseas trade

Question 1

What 10 risks should be considered if companies wish to trade abroad?

Answer 1

• Physical risk
• Import restrictions
• Government stability
• Liquidity risk
• Economic stability
• special Taxes
• Currency risk
• Credit risk
• Regulations for foreign companies
• Remittance restrictions

Question 2

Method for calculating sterling receipt when using a forward contract

Answer 2

1. Higher spot rate plus higher forward rate discount.
2. Value in foreign currency divided by answer from Step 1.
3. Less cost of forward contract.

Question 3

Method for calculating sterling receipt when using a money market hedge

Answer 3

1. Receive value in foreign currency.
2. Accrue interest - Prorate foreign currency borrowing interest rate.
3. Take out a loan - Value in foreign currency divided by 1 + accrued interest.
4. Convert at spot rate - Divide by higher spot rate.
5. Earn interest - Prorate sterling lending interest rate.
6. Lend in sterling - Multiply answers from Step 4 and Step 5.

Question 4

Method for exchanging traded currency options

Answer 4

1. Choose a strike price with a better rate than the current spot rate.
2. Calculate the number of contracts.
3. Decide whether the company needs to buy or sell currency.
4. Calculate the premium for the strike price.
5. Calculate the value of currency the company will be buying or selling.
6. Decide if the futures position should be exercised.
7. Add total profit if exercising.
8. Less premium.
9. Total cost.

Question 5

Advantage of hedging forex risk with forwards

Answer 5

Tailored.

Question 6

Disadvantage of hedging forex risk with forwards

Answer 6

No secondary market.

Question 7

2 disadvantages of hedging forex risk with money market hedges

Answer 7

• More difficult to arrange than a forward contract.

- Might use up the firm’s credit lines.

Question 8

Disadvantage of hedging forex risk with OTC currency options

Answer 8

No secondary market.

Question 9

What should always be mentioned in hedging decision questions?

Answer 9

Attitude to risk.

Question 10

2 key problems for using cryptocurrencies for international transactions

Answer 10

1. Exchangeability: Cryptocurrency exchanges are only likely to exchange Bitcoins for a narrow range of major currencies. This appears to be less of a problem for companies trading in countries using these currencies.
2. Price volatility: Cryptocurrency exchange rates are extremely volatile with prices moving significantly each day. However, companies can choose to hedge this risk using OTC agreements such as forward contracts (if these are available) and also using derivative agreements such as futures. However, in both cases there is the possibility that the rate quoted by the markets is unattractive.

Question 11

Advise a company on whether to accept payments from customers in Bitcoin.

Answer 11

Unless the company can hedge the risk of the Bitcoin price moving against it, it is not recommended that the company accepts payment in Bitcoins. Attitude to
risk can also be mentioned.

Question 12

Define interest rate parity

Answer 12

Theory that claims the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies.

Question 13

How does interest rate parity theory relate to forwards?

Answer 13

Used by banks to calculate the forward rate quoted on a currency.

Question 14

Formula for interest rate parity

Answer 14

current spot rate x (1 + If) / (1 + Iuk) = forward rate

If = foreign currency interest rate for the period
Iuk = UK interest rate for the period

Question 15

How to calculate interest premium / discount using interest rate parity theory

Answer 15

average forward rate less average spot rate = discount / premium