MODULE 3 Flashcards
is the conversion of one currency into another at a specific rate known as the ___. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and
demand.
Foreign exchange (Forex or FX) / FOREIGN EXCHANGE RATE
is a decentralized and over-the-counter market where all currency exchange trades occur. It is the largest (in terms of trading volume) and the most liquid market in the world.
one of the most accessible financial markets.
The Foreign Exchange Market
is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be
equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country.
The interest rate parity (IRP)
refers to the state in which no-arbitrage is satisfied without the use of a forward contract.
IRP, the expected exchange rate adjusts so that
IRP holds. This concept is a part of the expected spot exchange rate determination.
Uncovered Interest Rate Parity
refers to the state in which no-arbitrage is satisfied with
the use of a forward contract.
investors would be indifferent as to
whether to invest in their home country interest rate or the foreign country interest rate
since the forward exchange rate is holding the currencies in equilibrium. This concept is part of theforward exchange rate determination.
Covered Interest Rate Parity
This theory states that the
exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels.
is a tool used to make multilateral comparisons between the national incomes and living standards of different countries.
Purchasing Power Parity (PPP)
is measured by the price of a specified basket of goods and services.
purchasing power
measures deviation from the condition of parity between two countries and
represents the total number of the baskets of goods and services that a single unit of a country’s currency can buy.
PPP ratio
is the risk incurred due to the fluctuations in exchange rates before the contract is settled.
Transaction exposure
Financial Techniques for Managing Transaction Exposure
- FORWARD CONTRACTS
- FUTURE CONTRACTS
- MONEY MARKET HEDGE
- OPTIONS
Operational Techniques for Managing Transaction Exposure
- RISK SHIFTING
- CURENCY RISK SHARING
- LEADING AND LAGGING
- REINVOICING CENTERS
If a firm is required to pay a specific amount of foreign currency in the future, it can enter into a contract that fixes the price for the foreign currency for a future date. This eliminates the chances of suffering due to currency fluctuations.
Forward Contracts
are similar to ‘forward contracts. However, futures contracts have standardized and limited maturity dates, initial collateral and contract sizes.
Futures Contracts
the forward price is equal to current spot price multiplied by the ratio of the currency’s riskless returns. This also creates the finance for the foreign currency transaction.
Money Market Hedge
involve an upfront fee and do not oblige the owner to trade currencies at a specified price, time period and quantity.
options contracts
The firm can completely avoid transaction exposure by not involving itself in foreign exchange at all. All the transactions can be conducted in the home currency. However,
this is not possible for all types of businesses.
Risk Shifting
The two parties involved in the deal can have the understanding to share the transaction risk.
Currency Risk Sharing
involve manipulating currency cash flows in accordance with the
fluctuations.
Leading and Lagging
Paying off liabilities when the currency is appreciating IS KNOWN AS –
LEADING
While collecting receivables when the currency is at a low value in called ___
LAGGING
is a single third-party subsidiary used to conduct all intra-company
trades.
carry out transactions in domestic currency, thereby
bearing the losses from the transaction exposures.
Reinvoicing Centers
refers to an effect caused on a company’s cash flows due to unexpected currency rate fluctuations. Economic
exposures are long-term in nature and have a substantial impact on a company’s market value.
Economic exposure, also known as operating exposure
The following are the operational strategies which can be used to alleviate the risk of
economic exposure:
A. Diversifying Production Facilities and Markets for Products
B. Sourcing Flexibility
C. Diversifying Financing
The following are the currency risk mitigation strategies which can be used to alleviate
the risk of economic exposure:
A. Matching Currency Flows
B. Currency Risk-Sharing Agreements
C. Back-to-Back Loans
D. Currency Swaps
