WEEK 4 - The Parities Flashcards
What is Foreign Exchange Risk?
The risk that the value of a future receipt or obligation will change due
to a change in foreign exchange rates.
What are the three types of Foreign Exchange Risk?
- Transaction Exposure
- Translation Exposure
- Economic Exposure
What is Transaction Exposure?
The risk that the cost of a transaction, or the proceeds from a transaction, in terms of the domestic currency, may change due to
changes in exchange rates.
What is Translation Exposure?
Foreign exchange risk that results from the conversion of the value of a firm’s foreign-currency denominated assets and liabilities into a
common currency value.
What is Economic Exposure?
The risk that changes in exchange values might alter a firm’s present value of the future income streams.
What is Hedging?
Used to reduce/eliminate risk exposure
What is Covered Exposure?
A foreign exchange risk that has been completely eliminated with a
hedging instrument.
What is the early 2010’s example of Hedging?
- > Early 2010’s US kept depreciating against yen, profits of Toyota and Honda reduced
- > This generated large increases in dollar price of vehicles exported from JP to US and export revenues drop
- > So, Japanese automakers began ramping up production of automobiles in US
- > Both production costs and revenues would be denominated in $
- > Provided natural hedge for JP automakers
- > To address source of foreign exchange risks, automakers turned to financial instruments
What is a Forward Exchange Mkt? (ONE OF THE INSTRUMENTS)
A market for contracts that ensure the future delivery of a foreign currency at a specified exchange rate.
-> Most forward trades in amount of $1mil+ and occur between large commercial banks
What is a long position in the Forward Exchange Mkt?
An obligation to purchase a financial instrument at a given price and at a
specific time
What is a short position in the forward exchange mkt?
An obligation to sell a financial instrument at a given price and at a
specific time.
How can forward contracts be used to hedge?
Guarantees a rate of exchange at a future date
How else can firms experience transaction exposure and how can they solve it?
- > Transaction exposures resulting from foreign-curency-denominated payments they’ll receive in the future
- > In this situation firms have long positions, because they will receive amounts denominated in foreign currencies in future
- > To solve, firms could purchase forward contracts enabling them to sell foreign currencies at guaranteed exchange rates
What drives forward exchange rates?
-> Mkt forces of supply and demand
SEE GRAPH IN NOTES
How is the forward rate a predictor of the future spot rate?
- > Forward exchange rate reflects supply and demand for a currency of future delivery
- > Therefore, possible that forward rate provide info on the future spot exchange rate
When can it be said a currency is trading at a forward premium?
If the forward exchange rate is greater than spot exchange rate, a
currency is said to trade at a forward premium.
When can it be said a currency is trading at a forward discount?
if the forward exchange rate of a currency is less than the spot exchange rate, the currency is said to trade at a forward discount
What is the equation for the forward premium or discount?
Stated in standardised manner and expressed in annual terms
FP = Fn - S/S x 12/N x 100
Where:
Fn = Forward Rate
S = Spot Rate
N = Number of month of the forward contract
What is the definition of the forward premium or discount?
The difference between the
forward exchange rate and the spot exchange rate, expressed as a percentage of the spot exchange rate.
In what conditions would an equilibrium hold in a premium or discount?
If traders share same expectation, then difference between forward premium and expected appreciation elminated, equilibrium would hold:
(Fn - S)/S = (Fne -S)/S
What is Interest parity?
IDK