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Finance > Module 14: Currency dividends > Flashcards

Module 14: Currency dividends Flashcards

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1
Q

Foreign exchange risk/currency risk

A

Risk that exchange rates will move in such a direction as to cost a company (or individual) money

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2
Q

Exchange rate

A

Price of one currency expressed in terms of another

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3
Q

Exchange rate risk: exporter vs importer

A

EXPORTER exposed to the risk that the DOMESTIC CURRENCY will STRENGTHEN against the foreign currency (receive less home currency from foreign sales)

IMPORTER subject to risk that the DOMESTIC CURRENCY will WEAKEN against the foreign currency (cost more in terms of their home currency)

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4
Q

Bid-offer rates

A

Banks will apply different exchange rates when buying (bid rate) and selling (ask rate) currency, and will MAKE A PROFIT on the difference (the spread)

Bid rate - bank will BUY the first currency (lower price)
Offer rate - bank will SELL the first currency quoted for the higher price

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5
Q

Golden rule

A

the company (importer or exporter) will always be offered the worst part of the bid-offer spread

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6
Q

Money market hedging

A

we can hedge against foreign currency exchange risk by exchanging our currency today when we know exactly what the exchange rate is

NB/ not a derivative

Hedging is all about reducing risk not making profits

Hedging is net or gross settlement

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7
Q

Hedging a foreign currency liability (an importer)

A

Company expecting to incur a cost in a foreign currency in the future (e.g. 3 months time) can put enough money into a foreign bank account now, at today’s exchange rate (the spot rate), so that it covers the payment due in the future

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8
Q

5 steps for hedging a foreign currency liability

A
  1. Identify that a company has a foreign currency liability
  2. Create a foreign currency asset by investing in a foreign currency TODAY
  3. Calculate how much to invest in the foreign currency (investing less than the transaction value today so it grows to be the transaction value at end of term)
  4. Translate at TODAYS exchange rate (KEY POINT - effectively accelerating transaction so that it is happening at today’s exchange rate)
  5. Borrow the REQUIRED amount in the UK today (which will incur interest during the term)
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9
Q

Hedging a foreign currency asset (I am an exporter)

A

Company expecting to receive revenue in a foreign currency in the future can BORROW MONEY in foreign currency now and convert this, at the spot rate, into its local currency. The foreign loan (plus interest) will be repaid by the future revenue

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10
Q

Steps for hedging a foreign currency asset:

A
  1. Identify that a company has a foreign currency ASSET
  2. Create a foreign currency liability by borrowing in a foreign currency TODAY
  3. Calculate how much to BORROW in the foreign currency (borrowing less than the transaction value so that it grows to be the transaction value at the end of the term)
  4. Translate at TODAYS exchange rate (money market hedge is in effect, accelerating the transaction so that it is happening at today’s exchange rate
  5. Invest in the UK today (which will grow and EARN INTEREST during the term)
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11
Q

Derivative

A

A financial instrument that derives its value from the behaviour of the price of an underlying asset

  • value depends on price of SOMETHING

e.g. entering a derivative transaction which gives a farmer the right to sell his potatoes at £5 a bag in 3 months time
if market price in 3 mths time is £4 => exercise your right to sell at £5 => gaining £1 more than selling in the spot market
If market price was £6 => better off selling in the spot market => derivative has no value

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12
Q

How are derivatives used?

A

Two ways:

  • to make money (speculating)
  • To reduce risk (hedging)
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13
Q

Forward contract

A

An agreement to either buy or sell a certain amount of money at a SET EXCHANGE RATE at a specified time in the future

Currency risk is removed - no matter what happens, the company will transact at the forward rate

Buying party has the long position and the seller has a short position

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14
Q

The forward market

A

Forward contracts are organised OTC
- transactions agreed over the telephone between two parties and NOT ON EXCHANGES => forward contracts can be TAILORED to individual company’s needs

  • some COUNTERPARTY RISK as performance of the parties is not guaranteed by an exchange
    To try and protect the parties from the risk, forward contracts are non-transferrable and in principle CANNOT BE CANCELLED (cancellation at a cost is sometimes possible)
  • as it is one-to-one agreement (normally between a company and a bank) the bank will likely require the company be quite large and have a strong trading history before a forward contract is granted
  • gross settlement
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15
Q

Quotation of forward rates

A

if the forward points are decreasing, subtract them from the spot rate to give the forward rate

If they are increasing => add them to the spot rate to give the forward rate

NB// forward points are quoted in pence ( or cents) whereas spot rates are quoted in £ (or $) => divide forward points by 100 before subtracting or adding to the spot rate

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16
Q

Futures contracts definition

A

A contract to purchase or sell a standard quantity of a commodity (currency) at an AGREED FUTURE DATE at a SPECIFIED PRICE

  • intended to FIX the OUTCOME of a HEDGE by entering a futures contract that is SEPARATE from the actual transaction => if you make a loss in the spot market you make a profit in the futures market and vice versa
  • net settlement
  • spot rate and future prices will be close together but not exactly the same & tend to move in a similar direction => unlike forward contracts (where exchange rate is fixed), you don’t know the precise end result when entering into a futures contract
17
Q

The Futures Market

A
  • Futures trade on organised EXCHANGES and have standardised terms to facilitate trading (major diff between forward contracts)
  • Trading on the exchange means that CLOSING OUT the position prior to maturity is EASIER than with a forward contract
  • closing out involves entering into an equal and opposite contract in the same underlying currency and future month which cancels out the original obligation to buy or sell the currency. => FLEXIBLE FOR THE USER
18
Q

Futures contract: Setting up a futures transaction: the three steps

A

Today:
If company is buying in a foreign currency in the future (importer) => enter into FUTURES CONTRACTS to BUY this foreign currency at a fixed rate
If a company will be selling in a foreign currency in the future (exporter) => enter into a FUTURES contract to SELL this foreign currency at a fixed rate

Step 1
Contracts should be due to be fulfilled on a standardised date AFTER the transaction

Step 2:
Complete the ACTUAL transaction on the SPOT MARKET

Step 3:
CLOSE OUT THE FUTURES CONTRACT by doing the opposite of what you did in Step 1
- if you entered futures market to buy => close out by entering future contracts to SELL the contract currency
- if you entered into futures contracts to sell => close out by entering into futures contracts to BUY the contract currency at a fixed rate

19
Q

Future contracts: Sell rate vs buy rate on contract currency

A

If sell rate for the contract currency > buy rate = PROFIT on future
If buy rate > sell rate => LOSS on future

20
Q

Future contracts: Hedge efficiency

A

evaluated by comparing profit (or loss) on the futures contract to the loss/(profit) on the spot market

21
Q

Future contracts: Contract currencies

A

Future contracts exist for a narrow range of currency pairs, one of which is normally the US dollar
In the exam, futures contract currencies may be in any major currency including the £
- exam will specify the currency of the contracts => pay attention to determine whether future contracts are being bought or sold

22
Q

Future contracts: Marking to market -

A

Since contracts in the futures markets are with the exchange, the outcome is GUARANTEED BY THE EXCHANGE and counterparty risk is reduced

  • exchange must have some method of ensuring that participants do not build up such losses that they are subsequently unable to pay => margin accounts
  • exchange demands an INITIAL MARGIN (deposit) which is put into a client’s margin account
    Each day any profit or loss on the client’s position (VARIATION MARGIN) is debited and credited to this account so losses are not allowed to build up
    Process of settling the gains and losses on future contracts at the end of the trading day = ‘marking to market’
    If losses are made that reduce the account below the MAINTENANCE MARGIN (min balance) the investor will be required to restore the margin account to its maintenance margin level
23
Q

Disadvantage to future contracts

A

The maintenance margin (marking to market) has LIQUIDITY IMPLICATIONS for companies => often the reason why other derivative are preferable to future contracts

24
Q

Call options: Buyer of a call option

A

Buyer of a call option

  • right to buy an asset at an agreed (exercise) price
  • option is only exercised if the exercise price is lower than market price
  • premium will have to be paid
  • known as the LONG CALL

The loss the buyer is exposed to is limited to the premium paid, but unlimited gains

25
Q

Call options: Seller of a call option

A 
The seller (writer) of a call option, sells (to the buyer) the right to buy an asset at an agreed price 
- known as a SHORT CALL
  • maximum profit is premium paid by buyer, loss is unlimited
26
Q

Put options: Buyer of a put option

A

Buyer of a put option BUYS the rights to SELL the shares at an agreed exercise price = LONG PUT

  • premium is the maximum loss
27
Q

Put options: Seller of a put option

A

SOLD the right to the other party for them to sell an asset at an agreed price

  • premium is the maximum profit
28
Q

Black-Scholes model for pricing options

A

premium, or price, the purchaser of an option will pay is established by considering a number of factors

a) INTRINSIC VALUE, the difference between:
- the current value of the asset
- the exercise price of the option

b) TIME VALUE of the premium, reflecting the uncertainty surrounding the intrinsic value between now and the exercise date. Relevant factors:
- Variability in the value of the assets
- Time until expiry of the option
- Interest rates

29
Q

Currency options

A

Protect the buyer against adverse movements in exchange rates but give the buyer upside potential should exchange rates move in their favour

A company will either buy a LONG CALL or LONG PUT

Price set for the future transaction specified in the option contract is known as the EXERCISE PRICE or the STRIKE PRICE
Price paid by the buyer of an option is generally referred to as the OPTION PREMIUM

Date on which an option expires is referred to as the expiration or EXERCISE DATE

30
Q

OTC Options

A

options arranged directly with a bank

  • especially useful for currencies that are not regularly traded
  • OTC options can generally only be exercised at the expiry of the contract - often referred to as a EUROPEAN OPTION
31
Q

Options: Exchange traded

A

Currency options are also available on a number of option exchanges

  • exchanges are usually standardised contracts with standardised maturity dates
  • exchange traded options normally allow the holder to exercise the option AT ANY TIME up to the expiry date - described as American Style options. Gives the holder more flexibility. Options are exercised when they are in-the-money
32
Q

option contracts

A 
CALL = buy
PUT = sell
33
Q

Setting up an exchange traded options transaction: Three steps

A

Step 1:
Calculate the premium
Step 2:
Complete the ACTUAL transaction on the SPOT RATE
Step 3:
Decide whether to exercise the options contract (is the option in-the-money?)

34
Q

Currency swaps

A

An agreement between TWO COUNTERPARTIES which agree to SWAP THEIR LIABILITIES for loan repayments in different currencies over a period of time.

Usually organised by the bank to remove the need for counterparties to find each other and will underwrite the deal to remove default risk

Swaps tend to run for between 3 and 20 years

35
Q

Purpose of currency swaps

A

Borrowing in a foreign currency may allow a comp to benefit from UNUSUALLY LOW INTEREST RATES in certain countries.
It can also help manage EXCHANGE RISK by creating cash outflows in a foreign currency to match against cash inflows in that currency
However overseas debt finance can take a LONG TIME TO ORGANISE and can be EXPENSIVE TO OBTAIN

May be EASIER and CHEAPER for a comp to borrow in a currency that is easy and cheap to borrow in (often its domestic currency) and SWAP this (capital and interest) with another comp, which will borrow in the currency that Company A wants to obtain

Currency swaps are generally used by companies which are EXPANDING into foreign countries or which are looking to ACCESS LESS EXPENSIVE DEBT that is available in a foreign currency

Not suitable for hedging ST currency risk from importing or exporting

Finance (13 decks)

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