Section C - Chapter 11-14 Flashcards
What are the types of Financial Risk
- Interest Rate Risk
- Credit Risk (credit rating or price of a good)
- Insurance
- Credit Control
- Factoring without recourse (do not have to buy back)
- FX
- Political - Although not directly a financial risk it has to do with Foriegn Direct Investment
How can a business assess the overseas Political risks before an FDI
- Evaluate the macro economics
- Balance of payments/inflation/FX/Unemployed
- Political Stability
- Religious and Cultural attitude
- Gov policy and attitude to FDI
- Advice from bank in said Country
What are some of the methids to reduce risks?
- Prior negotiation
- Structuring Investment (local suppliers)
- JV with local Org
- Obtaining contracts with Overseas Gov
- Using local financing
- Plans for eventual overseas buyout/ownership
What is Portfolio Theory?
When a business has a diverse portfolio globally such as trade or operate globally
- Production and Sales
- Suppliers and customers
- Financing
When you invoice in foriegn curency at one exchange rathe and 3 months later when it is settled a new exchange rate is used, where does the FX sit?
P&L in that period
Translation Risk on Unsettled Transactions
WHat is the treatment
Monetary Items - Re-translated at Year End rate (closing rate)
Non-Monetary Items - Not re-translated and left at historical cost
FX that arises sits on OCI until Subsidary is sold
What are some of the Political Risks that Governement actions can affect a business
- Confiscation/Expropriating
- Super Taxes
- Discriminations
- Restricted access to local borrowings
- Insist in JV or Resident Investor
Restirictions on
- Dividends
- Capital
- Rationing supply of foriegn currency (restrict residents from buying abroad)
- Price fixing
- % of local staff/components
- Import quotas - Limit amount sub can buy from foriegn parent
- Import Tarriffs - makes imports more expensive
What are the effects of increase in Interest Rates
- Inflation Falls
- DEPN of that currency
- Foriegn investment
- Assets Fall in value
What are the effects of rising inflation
- Distorts consumer behaviour
- Redistribute income - people on fixed income will be worse off as they will not have bargining power
- Wage Barginers/Unions - may ask for increase
- Undermins Biz confidence - uncertainity over future economic market
- Resdistrbutes Wealth - If IR is below Inflation then borrowers are ganing at the expense of lenders
What are the benefits of Post Complettion Audit
- Better decision making
- Greater accuracy using past lessons
- Improving control mechanisms
- Speedy modification should projects need it
- Increased ability to stop bad projects
- Highlights reasons for good and bad projects
Explain PPT and IRP
PPP - if one country and a higher inflation rate than another then their currency should fall in value
IRP - The difference between the spot rate and fwd rate can be predicted by the difference in IR in 2 countries - Company with higher IR will see the FWD rate for its currency fall
If the UK FWD Rate was no different that the current spot rate for USD but US had higher Interest Rates what would the outcome be
UK investors would invest in US to secure higher IR on deposits and suffer no FX when they exchange back at same FWD rate
UK Interest rates would rise and force up the spot rate for USD
What ways can a Gov override the IRP theory
- Gov FX Intervention - Manipulating the FX by buying or selling their currency
- Controls on currency trading - limits on inflo and outflow of currencies - or use of ‘offical FX rate’
- Controls on Financial markets - Gov may limit the range and type of markets within financial system
What are the benefits and arguemnts for hedging
Benefits
- Certainity over cashflows
- Risk is redcuded so may help risk adverse managers with investment
- reduction in probability of bankruptcy
Arguements
- S/h have already diverised their own portfolio
- Transactions costs can be high
- Do people have knowledge of Hedging
- Complexity of tax issues
What are the internal methods of currency risk exposure
- Matching/Netting (assets and liabilites/Payments and Receipts)
- Invoicing in home currency
- Leading/Lagging
- Countertrade - offset goods by each business
What are the features, benefits and disadvantages of FWD Contract
Features/Benfits
- Specific date/Price/Amount
- Binding contract
- Simple and low transaction costs
- Tailored for you/High street bank
Disadvnatages
- Counterparty risk
- You are selling something you do not have yet
- No upside potential
- Cannot be traded
- Inflexible
What are the Adv and DisAdv of MM Hedges
Adv
- No currency risk as exchange takes place today @ spot rate
- Low transaction costs
- Offer flexibility
DisAdv
- Complex
- Ability to get overseas loan may be difficult
What are the features of Futures
- Can be traded
- Small range of curriences
If we need to convert Eur to USD to pay US supplier then we need to SELL EUR Futures
What are Adv and DisAdv of Futures
Adv
- Offers effective ‘fixing’ exhange rate
- No transaction costs
- Tradeable
DisAdv
- Forigen currency market must be used for GBP futures
- Upfront Margins
- They are not for specific amount due to tick sizes
What are the 2 types of options?
- Call Option - to buy the underlying currency
- Put Option - to sell the underlying currency
- Due to receive EUR from client but your functional currency is USD.
- Sell EUR Future or buy PUT option on EUR Futures
What are the Adv and DisAdv of currency options
Adv
- Perfect hedge as no downside
- Can lapse if future transaction does not take place
- Many choices of strike price and dates
Dis Adv
- Premium paid, regardless
- GBP currency options only available in foriegn markets
What are the characteristics of an ‘over the counter option’ compared to a exchange traded
OTC
- Customised to meet customer needs
- Settlement at maturity
- Potential to benefit from favourable FX
ETO
- easier to liquidate as open market
What are the Internal and External ways of managing IR risk
Internal
- SMoothing
- Matching
- Netting
External
- FRA’s
- IRG
- IR Futures
- IR Options
- IR Swaps
Explain OTC and Exchange Traded instruments and Fixing and Insurance Instruments
Fixing Intruments lock a company into a IR providing certainty over cashflow
- OTC = FRA
- ETI = IR Futures
Insurance instruments allow a company to benefit from the upside and protect from downside of IR movements
- OTC = IRG (aka, caps and floor options)
- ETI = IR Options
What is the process of buying or sellind an FRA
Borrowing - You will BUY an FRA from the bank to ‘fix’ cashflow expense
Deposits - You will SELL an FRA to bank to ‘fix’ cashflow income
What are the features of an FRA
- Short term
- Usually over £1m
- Secures cashflow
What are the features of a IRG Options
- Insurance against downside
- OTC directly with bank
- Maximum maturity of 1yr
- More expensive than FRA
They are basically and FRA just with an option
Borrowers will wish to hedge against IR rise by?
Selling a future now and then buying a future on the day that the IR is fixed
Using IR Options (aka IRG - Not traded) when would you CALL or PUT an option
A C/o wishing to borrow funds in future would BUY an FRA from bank so would need a IRG with a CALL option
A C/o wishing to lend in future would SELL an FRA to bank so would need an IRG with a PUT option
IR Swaps - whats the movements
Move from Variable to Fixed therefore
- Pay bank the ASK rate (higher)
- Receive LIBOR
Move from Fixed to Variable
- Pay bank LIBOR
- Receive Bid (lower
What are the Adv and DisAdv of IR Swaps
Adv
- Managing Fixed and Floating rate without changing borrowing
- Take Adv of IR movements
- Hedge against variations
Borrow in the rate that you have COMPARATIVE ADVANTAGE
Identify loan with biggest difference and borrow that way
FRA =
- IR derivitaive
- Available for any amount
- Redeemable any date
- Payment on settlement
- Traded OTC
Futures are for specific amounts
Options require premiums to be paid upfront
Swaps do not require payment on settlement
FRA are the Interest Rate equivilant to FWD Exchange contracts
Foriegn investment financed by local investment can help with?
- Translation risk (assets and Liabilites
- Transaction risk
- Reduce risk of assets being confiscated
What is counter trade
Exchanging goods or services of similar service
What are the 2 basic principles of Black-Scholes Model and 5 Variables
2 Princilples
- Intrinsic value of Option
- Time value of option
5 Variables
- Spot price of underlying asset
- Variability of price of underlying asset
- Time to maturity
- Risk-Free interest rate
What are the benefits and drawback of using Certainty Equivilants
Benfits
- By using Risk free rate you don’t double count risk
- Simple way of brining risk into investment
- Decion maker reduces cashflows to make a worst case scenario NPV
Drawback
- Subjective
