17. Risk Management

Question 1

What is the spot exchange rate?

Answer 1

This is the market exchange rate for buying/selling the currency for immediate delivery.

Question 2

What is the forward exchange rate?

Answer 2

This is the exchange rate for buying or selling the currency at a specific date in the future.

Question 3

Differentiate between absolute PPP and relative PPP.

Answer 3

Absolute PPP states that the exchange rate simply reflects the different cost of living in two countries.

Relative PPP states that the future spot exchange rate is based on the current spot rate (the purchasing power of one currency relative to another) and the inflation rate differential between the two currencies (in other words, relative price changes).

Question 4

What is the formula for relative PPP?

Answer 4

S₁ = S₀ * (1+h_c)/(1+h_b)

Where:
S₁ = expected spot exchange rate after one year

S₀ = today’s spot exchange rate

h_c = variable currency (“foreign”) inflation rate (as a decimal)

h_b = base currency (“domestic”) inflation rate

Question 5

What does the interest rate parity state? What is its formula?

Answer 5

The interest rate parity (IRP) states that the forward exchange rate is based on the spot rate and the interest rate differential between two currencies. It is calculated as:

F₀ = S₀ * (1+i_c)/(1+i_b)

Where:
F₀ = forward exchange rate

S₀ = spot exchange rate

i_c = variable currency (“foreign”) interest rate (as a decimal)

i_b = base currency (“domestic”) interest rate

Question 6

What is the difference between PPP and IRP?

Answer 6

PPP predicts the future spot rate whereas IRP predicts the forward rate.

Question 7

Outline the fisher effect and state its formula.

Answer 7

According to the Fisher Effect, countries with a higher inflation rate have higher nominal interest rates in order to offer the same real return as countries with low inflation.

(1+i) = (1+r)(1+h)

Where:
i = nominal interest rate
r = real interest rate
h = inflation rate

Question 8

Outline the international Fisher effect.

Answer 8

According to the international Fisher effect, the spot exchange rate will change to offset nominal interest rate differences between countries.

Question 9

Outline the Expectations Theory.

Answer 9

The forward rate is an unbiased estimate of the future spot rate. An unbiased estimate is not a forecast, since 50% of the time it will be too low and 50% of the time it will be too high.

Question 10

What is the balance of payments and what are its two principal parts?

Answer 10

The BOP accounts are a record of all monetary transactions between a country and the rest of the world. The two principal parts are:
- current account
- capital account

Question 11

Differentiate between the current account and the capital account in the BOP.

Answer 11

The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. Its main component is the balance of trade, which is net earnings on exports minus payments for imports.

The capital account records the net change in ownership of foreign assets and includes the foreign exchange market operations of a nation’s central bank, along with loans and investments between the country and the rest of the world.

Question 12

Any current account surplus (deficit) will be balanced by a capital account deficit (surplus) of equal size. Outline how a change in a nation’s currency’s value may correct current account surpluses/(deficits).

Answer 12

1. A rise in the value of a nation’s currency makes its exports less competitive and imports cheaper, with these effects tending to correct a current account surplus.
2. A fall in the value of a nation’s currency makes imports more expensive and increases the competitiveness of exports, and so helps to correct a deficit.

Question 13

What are the three types of exchange rate (foreign currency) risk?

Answer 13

1. Translation risk
2. Economic risk
3. Transaction risk

Question 14

Outline translation risk.

Answer 14

Translation risk occurs where a company has foreign denominated assets or liabilities or a foreign subsidiary or branches.

When these are presented at the closing rate in the SOFP of the company or parent, as exchange rates fluctuate, these amounts will change resulting in FX profits or losses.

If the domestic currency has appreciated/(depreciated) against the foreign currency, a translation loss(gain) is likely to arise.

Question 15

Translation gains or losses are not cash flows however, they still affect the value of a company. Why is this?

Answer 15

1. Debt covenants often use book values, so unless they are explicitly excluded from such values, foreign currency gains and losses may have real economic consequences if a debt covenant is breached.
2. Shareholders may attribute great importance to reported profits/losses, even where carefully explained.

Question 16

What are two ways companies may hedge against translation risk?

Answer 16

1. To hedge against a change in shareholders’ equity, the total value of foreign currency denominated assets should match that of foreign currency denominated liabilities.
2. To hedge against a change in the debt/equity ratio, the ratio of foreign currency debt/equity should be the same as the domestic company.

Question 17

What is economic risk?

Answer 17

Economic risk is the risk that cash flows will be affected by long-term FX movements.

It is difficult to hedge against but is somewhat helped by diversification of customer and supplier base across different countries.

Question 18

Outline Transaction Risk.

Answer 18

Transaction risk is the short-term version of economic risk. It is the risk that the exchange rate changes between the contracting date of a specific export/import and the related receipt/payment of foreign currency.

Like economic risk, this affects cash flows and so affects the value of the company. It is therefore, a significant issue for financial management.

Transaction risk can be effectively managed using both internal and external hedging techniques.

Question 19

Outline 6 internal techniques that may be used to manage FX risk.

Answer 19

1. Invoicing in the company’s domestic currency which transfers the transaction risk to the customer. This may lead to lost sales.
2. Leading and lagging - eg converting domestic currency in to foreign currency earlier than you need to pay suppliers (leading) if the domestic currency is expected to fall, which may lead to a finance cost (although early settlement discounts may be available) or
   Delaying conversion and paying suppliers late (lagging) if the domestic currency is expected to appreciate (paying after agreed credit period is questionable).
   Only leading reduces risk exposure as uncertainty about the cost of paying the supplier is eliminated. Lagging does not reduce risk because domestic currency could depreciate and increase cost of settling the foreign currency liability (and cannot be delayed indefinitely).
3. Netting - is when there are both sales/receivables and purchases/payables in a foreign currency so the net exposure is only the difference between receivables and payables. Only effective if there are numerous transactions in the foreign currency and they occur relatively closely, but can result in a reduction in FX purchase costs and money transmission costs.
4. Matching of assets and liabilities - considers using foreign currency loans to finance overseas subsidiaries. Overseas earnings can be used to pay the loan interest and repay principal, reducing the net foreign currency cash flow exposed to risk in the event of repatriation to the parent. This may be effective as a longer-term hedge against economic risk.
5. Matching of receipts and payments - offsetting payments against receipts in a foreign currency bank account. There is no purchase or sale of the currency and so it does not matter if the currency strengthens or weakens. However, transactions should be close so not as to have funds sitting idle for months.
6. Asset and liability management (ALM) - overseas subsidiaries borrow locally rather than receiving finance from the parent. This reduces the net assets of the subsidiary. ALM may be referred to as a balance sheet hedge which reduces exposure to translation risk on consolidation of the subsidiaries net assets in the group accounts (although translation risk in theory should not affect the value of the group).

Question 20

What are five external hedges that may be used to manage transaction risk?

Answer 20

1. Forward FX contracts
2. Money market hedges
3. Currency options
4. Currency futures contracts
5. Currency swaps

Question 21

Outline forward exchange contracts.

Answer 21

A forward contract is a legally binding agreement to buy or sell:
- a specified quantity
- of a specified currency
- on an agreed future date (delivery date)
- at an exchange rate fixed today

Forward contracts are tailored exactly to requirements of company are therefore not traded.

They are not bought and no premiums need to be paid like an option.

They do not require margin to be posted (ie no cash deposit required unlike futures) but they dk have a small arrangement fee to set up the contract.

The disadvantage is that physical delivery must occur so company must exchange currency regardless of if FX rate becomes unfavourable. ie inflexible

Question 22

Outline a money market hedge.

Answer 22

This is a technique to lock in the value of a foreign currency transaction in terms of the organisation’s domestic currency using a combination of investing, borrowing and a spot currency exchange.

It effectively produces a home-made forward exchange rate. Resulting exchange rate is dependent on interest rate differential between two currencies.

Eg UK company exports in dollars. Hedge could be:
- borrow dollars today to be repaid when earnings are due.
- exchange borrowed dollars into sterling at current spot rate.
- invest sterling to mature on date dollar earnings are due.

Question 23

Outline currency options.

Answer 23

A more flexible hedge. Options are an example of derivatives (ie a financial instrument based on an underlying asset). The underlying asset here is a currency.

The purchaser of a currency optio. Has the right, but not the obligation, to buy or sell:
- a specified quantity
- of a specified currency
- on or before a specified date (expiry date)
- at an FX rate agreed today (exercise price/strike price).

The owner of the option can either:
- exercise their right or
- allow it to lapse (ie not exercise it)

The owner pays for this flexibility through a premium. Options are traded on the derivatives market or may be bought directly from a bank (OTC).

Question 24

Outline currency futures contracts.

Answer 24

Futures contract - a standardised contract between buyer and seller, in which the buyer has a binding obligation to buy a fixed amount (the contract size), at a fixed price (the futures price), on a fixed date (the delivery date), of some underlying asset via a recognised exchange.

Futures are simply exchange-traded forward contracts.

Currency futures contracts are standardised contracts for buying or selling of a specified quantity of a specified currency.

The price of a currency futures contract represents the forward FX rate for the currencies specified in the contract.

The difference between the futures price and the spot FX rate is known as the basis in the futures contract.

The basis in a futures contract will naturally amortise to zero by the contract’s delivery date.

When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin.

If losses are incurred, the buyer or seller may be called to deposit additional funds with the exchange (variation margin) and any profits are credited to the margin account on a daily basis as the contract is marked to market.

Question 25

What are 3 differences between forward and futures contracts?

Answer 25

1. With forward contracts there is always physical delivery ie the underlying currency will be bought/sold when the contract reaches its delivery date).
2. However, most currency futures contracts are closed out before their delivery dates. The company simply executes the opposite transaction to the initial futures position (eg if initially buying the currency futures it is closed out by selling currency futures).
3. There is no guarantee that the basis in the futures contract will have amortised at a linear rate. The result of a futures hedge cannot therefore be known for sure in advance. This is known as basis risk.

Question 26

What are currency swaps?

Answer 26

An agreement between two parts to exchange principal and/or interest payments in different currencies over a stated time period.

Currency swaps can eliminate transaction risk on foreign currency loans as follows:
- on commencement of the swap - an exchange of agreed principal amounts, usually at the prevailing spot rate.
- over the life of the swap - an exchange of interest payments.
- at the end of the swap - a re-exchange of principals, usually at the original spot rate (thereby removing foreign currency risk).

Question 27

Outline two situations where a company may be concerned about rising interest rates.

Answer 27

1. If the company has a significant proportion of of floating (ie variable) interest rate debt, as this obviously leads to lower profits. However, higher interest expense also leads to a higher financial risk (ie more volatile future profits). An extreme interest rate rise could even cause financial distress risk (ie bankruptcy).
2. If a significant amount of surplus cash has been invested in fixed interest rate securities eg government bonds.

Question 28

Outline two situations in which a company may be concerned about failing interest rates.

Answer 28

1. If it has a specific proportion of fixed interest rate debt and therefore does not or participate in the benefits of falling rates (unlike its competitors, for example).
2. If it holds significant floating rate investments (eg money market investments)

Question 29

What is gap exposure? How can basis risk arise in matching assets and liabilities?

Answer 29

Gap exposure is the difference between the amounts of interest-sensitive assets and liabilities (ie their market prices are vulnerable me to changes in interest rates).

An organisation’s gap exposure can be identified through “gap analysis” by grouping together interest-sensitive assets and liabilities according to their maturity dates. Two different types of gaps may occur:

• negative gap - arises when the amount of liabilities maturing at a certain time exceeds the assets maturing at the same time. This results in a net exposure if interest rates rise by the time of maturity.
• positive gap - arises when the amount of assets maturing at a certain time exceeds the amount of interest-sensitive liabilities maturing at the same time. In this situation, the organisation will suffer a loss if interest rates fall by maturity.

Note:
Even if a company has matched its assets and liabilities with a variable rate of interest, there may still be e a risk if the variable interest rates are determined on different bases. Eg variable rates referenced to different benchmarks (eg one is linked to secured overnight financing rate (SOFR) and the other to the sterling overnight index average (SONIA).

This is an example of basis risk.

Question 30

Outline two internal techniques to hedge against interest rate risk.

Answer 30

1. Smoothing - involves maintaining an appropriate balance between fixed-rate and floating-rate borrowings or deposits.
2. Matching - this aims to have a common interest rate for both assets and liabilities (eg both linked to variable rates).

Question 31

List 3 external techniques a company may use to hedge against interest rate risk.

Answer 31

1. Forward rate agreements (FRAs)
2. Interest rate futures (IRFs)
3. Interest rate options
4. Interest rate swaps

Question 32

Outline forward rate agreements (FRAs).

Answer 32

A FRA is an agreement by a bank to enter into a notional loan or accept a notional deposit from a customer for a specified period of time. The contract is settled based on the difference between the interest rate agreed when the contract is signed and the rate prevailing when the notional loan/deposit is deemed to start.

FRAs allow companies to fix, in advance, either a future borrowing rate or a future deposit rate, based on a notional principal amount, over a given period.

FRAs are cash-settled, in advance at the start of the FRA term, based on the PV of the difference in settlement date between:
- the fixed contract rate
- the reference interest rate eg SOFR

The FRA can be with the same institution as the loan or deposit or an entirely different one.

Other features of FRAs include:
- the maximum maturity period for an FRA is usually about two years.
- customised agreement is reached with a bank (ie OTC).
- no premium is paid for the FRA and no margin needs to be posted.

A 3-6 FRA starts borrowing in 3 months and ends after 6 months.