Topic 17: Currency risk management Flashcards
What are the different types of exchange risk?
Transaction Risk - The difference between transactions entered and transactions settled.
Translation risk - When the exchange rate affects the value of an asset, liability and profit. This is accounting risk.
Economic risk - The long term impact of exchange rate change of the value of business - A business Competitiveness
What is strengthening and weekening of currencies? and which is more favourable to imports and exports?
Strengthening is when we can buy more of another currency.
Weakening is when we can buy less of another currency.
Strengthening is better for imports when purchases in another currency and weakening is better when being paid from another currency.
What is a spot rate?
Todays rate of exchange.
What is a forward rate?
A future exchange rate
What is the bid-off spread?
A bank will offer two deals when enquirying about a currency and the lower rate is when we are selling to the in exchange for our currency and the higher rate is for when we are buying another currency. This is how they make money.
SELL BASE LOW, BUY BASE HIGH!
What causes the exchange rate to change?
Balance of payments - The difference between exports and imports.
Demand for imports increases = Increase demand for foreign currency = supply of £ will increase
Demand for exports increases = Increase supply of foreign currency = increased demand of £.
When there is a deficit (more import than exports) supply of home currency will excess demand which cause home currency to weaken and the opposite for surplus.
What is purchasing power parity?
It suggest that exchange rates is affected by the two countries relative inflations, The currency with the higher inflation inflation is expected to weaken against the other lower currency.
What are the terms for the purchasing power parity formula?
S1 = Expected future rate
S2 = Current spot rate
hc = inflation rate of counter country (Foriegn)
hb = inflation rate of base currency (Home)
What are the terms for the interest rate parity?
Same as purchase power parity but interest instead of inflation.
S1 = Future rate
S2 = Current spot rate
hc = interest rate of counter country (Foriegn)
hb = interest rate of base currency (Home)
What is the international Fisher effect?
It assumes that all currencies have the same real interest rates so the difference in interest rates is the money interest rate which is the difference in inflation.
What are the internal techniquies for managing currency risk?
Do nothing - Expect the risk if its low.
Invoice in home currency - Risk is transferred to other party
Matching - Net off receipts and payments in the same currency. if we are paid in a currency, use that money to pay payments to that currency, Negates risk
Foreign Bank account - Same as matching but its done for you.
Leading and Lagging - Leading is bring forward a receiptand lagging is delaying a receipt to get a more favourable exchange rate.
What are the external techniquies for managing transaction currency risk.
Forward exchange contracts
Money market hedge
Derivatives - Future Contracts & Currency options
What is a forward exchange contract? and what are the advantages and disadvantages?
They are legally binding contracts to buy or sell a specific amount of currency on a future date at an exchange rate that is fixed now. Gives certianty of future cahsflows and its the perfect hedge as it eliminates risk.
Advantages -
Fixed rate = eliminates risk
Easy to arrange
Disadvantages -
Legally binding - cant back out.
Can’t take advantage of better exchange rate
What is a money market hedge? Explain the difference between payment and receipt and what are the advantages and disadvantages of money market hedging?
It is a way of fixing the exchange rate without a contract as the company will borrow the amount needed to pay or to be paid to them in the foreign currency.
With payments - We will borrow the money now and convert at the spot rate and place the funds in a foreign deposit account, where it will wait to be paid to the supplier.
With receipts - We borrow the amount to be paid in forgien currency, convert at the spot rate and deposit in our home account and the customer repay the loan when payment is received.
Advantages:
Fixed rate eliminates adverse risk.
Flexible
Tailor made - flexible with amount and time.
Disadvantages:
May lose out to more favourable exchange rate.
Transaction costs / bank interest / Deposit charge / dealers fees.
What are the two types of derivatives? and what are the characteristics of each?
Future Contracts:
They are standardised (Standard currencies and Standard date e.g end of Mar, Jun, Sep, Dec.
They can be traded on a future exchange (Buying or selling the contract) so you dont need to hold onto them until settlement.
Price is the exchange rate.
Currency Options Contracts:
Two Types:
Call options = gives the right to buy the currency
Put option = gives the right to sell the currency of the contract.
