Risk management - foreign currency

Question 1

what are exchange rate terms?

Answer 1

direct quote - how many units of domestic currency equal 1 unit of foreign.

indirect quote - how many units of foreign currency equal 1 unit of domestic

Question 2

What is foreign currency risk?

Answer 2

• risk of changes in an exchange rate.
• Two-way risk since changes can be favourable and adverse (importing / exporting)
• If i import from USA and pound is stronger, goods are cheaper from US.
• If i am an exporter, depreciation of the pound to dollar means i will get less for my goods.

Question 3

What does an appreciation mean?

Answer 3

An appreciation of the £ means you et more USD per GBP which is favourable for UK firm.

Question 4

What does depreciation mean?

Answer 4

A depreciation of the £ means you get fewer USD per GBP which is adverse for a UK firm.

Question 5

What is translation risk?

Answer 5

risk that the firm makes an exchange loss when accounting results are translated into the domestic currency.

Question 6

What is economic risk?

Answer 6

Refers to movements in the exchange rates on international competitiveness of a firm and concerns the impact of the present value of longer-term cash flows.

risk overtime that a nation’s currency will appreciate or depreciate relative to other currencies such that nation becomes more/less competitive

Question 7

What is transaction risk?

Answer 7

risk adverse movements in the exchange rates occurring in the normal course of international trading conditions.

as most international trade involves credit terms (several months to settle a transaction).

A lot of countries go off the managed floating exchange rate, UK does currently. The central bank will intervene if it moves in such a way that it will cause adverse relationship for the economy.

Question 8

Interest rate parity?

Answer 8

This predicts foreign exchange rates under the hypothesis, that the interest rates differential between two countries should offset the differences between the spot and the forward rate over the same period.

Question 9

What is purchasing power parity?

Answer 9

• exchange rate between 2 countries is the same in equilibrium when the purchasing power of the currency is the same in each.
• predicts movements in spot exchange rates over time vary according to relative price changes (e.g., inflation)
• PPP tends to occur in the long-term but can be used to predict future exchange rates in investment appraisal.

Question 10

Fisher and international Fisher effects?

Answer 10

• nations with high inflation rates generally have high nominal rates.
• High nominal rates ensure the required real rate of return by investors is met.
• IFE states the nominal interest rate differentials between two countries provides an unbiased predictor of changes in future spot rates.

Question 11

What are the methods of managing Exchange rate risk?

Answer 11

Currency of invoice
- invoice consumers in domestic currency (transfer any rate risks to overseas buyer/seller)

• negotiate exchange rate as part of contract
• firm may take on an exchange risk if there is a marketing advantage, able to offset payments to own suppliers if working in same foreign currency.

Question 12

Methods of managing exchange risks?

Answer 12

• matching receipts and payments, this is when bank accounts overseas permits firms to match receipts and payments in that currency
• matching assets and liabilities, firm expecting to receive substantial foreign currency income can hedge against the currency weakening by borrowing in the foreign currency and using receipts to pay the loan.

Leading - occurs when firms expect foreign currency to appreciate so they pay in advance of settlement.

laggings - when firms expect foreign currency to depreciate they delay payment.

netting - reduces transactions by netting credit balances with debit balances so net amounts are to be paid by the actual currency flows.

Question 13

What are forward exchange contracts?

Answer 13

Contract made now for the purchase/sale of a quantity of currency in exchange for another currency for a settlement in the future at a rate that is fixed in the contract.

arranged directly with the bank and are OTC contracts.

Question 14

what is money market hedging?

Answer 14

when you borrow in one currency and covert borrowed money to another currency and deposit (in an account that earns interest) until the time the transaction completes.

Question 15

Foreign currency payment

Answer 15

• borrow domestic currency now
• convert domestic currency to foreign currency at spot rate.
• deposit in overseas account
• at completion - pay supplier from oversees account and repay domestic loan

Question 16

Foreign currency receipt?

Answer 16

• borrow in foreign currency today
• covert to domestic currency at spot rate
• deposit in domestic account
• at completion - repay foreign loan, take cash out from domestic account.