Q3

Question 1

Advice on whether to hedge against FX movements (5)

Answer 1

1. Calculate spot rate
2. Summary of range of receipts
3. Which gives the highest?
4. How does current spot rate compare?
5. Management’s attitude to risk
6. Apply advantages/disadvantages of the various techniques

Question 2

Why will futures hedging not be 100% efficient? (2)

Answer 2

1. Basis risk - risk that hedge will not experience price changes in entirely opposite direction from hedged asset
2. Rounding of contracts - asset will be over-/under-hedged

Question 3

FX forward contract - Advantages (3)

Answer 3

1. Tailored to the company’s needs
2. Fixes future rate, eliminating downside risk exposure
3. Relatively straightforward to comprehend/organise

Question 4

FX forward contract - Disadvantages (3)

Answer 4

1. No secondary market
2. Contractual commitment
3. No upside potential

Question 5

Money market hedge - Advantages (3)

Answer 5

1. Tailored to the company’s needs
2. In the case of receipts, accelerates receiving home currency
3. No requirement for set forward rates

Question 6

Money market hedge - Disadvantages (3)

Answer 6

1. More complicated to organise than forwards
2. Can’t benefit from upside potential
3. No secondary market and may use up credit lines

Question 7

Currency futures - Advantage (1)

Answer 7

1. Secondary market

Question 8

Currency futures - Disadvantages (1)

Answer 8

1. Not tailored
2. Basis risk an issue
3. Requires a margin to be deposited at the exchange
4. Need for liquidity if margin calls are made

Question 9

OTC options - Advantage (1)

Answer 9

1. Allow co. to exploit upside potential and protect downside risk

Question 10

OTC options - Disadvantages (2)

Answer 10

1. Expensive

2. No secondary market