Module 14 Flashcards
Foreign exchange risk
Risk that exchange rates will move in such a direction as to cost a company
Bid rate
Buying
Ask rate
Selling
Spread
Difference between bid and ask
Reason exchange rates move
Purchasing power parity (PPP) theory
Money market hedging
Exchange our currency today when we know exactly what the exchange rate is. (Not a derivative)
Who hedges a foreign currency liability
Importers
Hedging a foreign currency liability > Step 1
Identify that a company has a foreign currency liability
Hedging a foreign currency liability > Step 2
Create a foreign currency asset by investing in a foreign currency today
Hedging a foreign currency liability > Step 3
Calculate how much to invest in the foreign currency
Hedging a foreign currency liability > Step 4
Translate at today’s exchange rate
Hedging a foreign currency liability > Step 5
Borrow the required amount in the UK today (which will incur interest during the term)
Who hedges a foreign currency asset
Exporters
Hedging a foreign currency asset > Step 1
Identify that the company has a foreign currency asset
Hedging a foreign currency asset > Step 2
Create a foreign currency liability by borrowing in a foreign currency
Hedging a foreign currency asset > Step 3
Calculate how much to borrow in the foreign currency
Hedging a foreign currency asset > Step 4
Translate at today’s exchange rate
Hedging a foreign currency asset > Step 5
Invest in the UK today (which will grow and earn interest during the term)
Derivative
Financial instrument that derives its value from the behaviour of the price of an underlying asset
Two ways derivatives are used
- To make money (speculating)
- To reduce risk (hedging)
Four types of derivatives
- Forwards
- Futures
- Options
- Swaps
Forward contract
Agreement to buy or sell a certain amount of money at a set exchange rate at a specified time in the future
Forward contract - currency risk
Removed as the exchange rate is fixed
Forward contracts traded
Over the counter (not on exchange)
Forward contracts settlement
Gross settlement (one cashflow)