Foreign Currency Risk (2)

Question 1

What is a forward contract?

Answer 1

A contract with a bank fixing the exchange rate on a specific amount of FX receivable or payable at a future date at an exchange rate agreed now

Question 2

Another name for a forward contract

Answer 2

OTC contract

Question 3

What is the purpose of a forward contract?

Answer 3

Fix and exchange rate now for settlement of a transaction at a future date

Question 4

What does a forward contract remove?

Answer 4

Uncertainty at what exchange rate will be at their future date

Question 5

What is currency risk?

Answer 5

A two-way risk

Question 6

Why is a forward contract a two-way risk?

Answer 6

Company can hedge against the risk of an adverse movement in spot exchange up to date of settlement, but loses the opportunity to gain from a favourable movement in spot rate

Question 7

How are forward contracts arranged?

Answer 7

Directly with a bank and sometimes referred to as OTC

Question 8

Advantages of forward rates?

Answer 8

Simple

Low or zero up-front costs

Available for many currencies

Question 9

Disadvantages of forward rates

Answer 9

Fixed date

Unattractive rate

Counter-party risk

Question 10

What is a foreign currency receipt (export)

Answer 10

It is possible to manufacture a forward rate by using spot exchange rate and money market lending or borrowing

Question 11

How can exchange rate risk be eliminated when foreign currency revenue is expected (export)

Answer 11

Borrowing foreign currency today, converting funds into domestic at today’s spot rate

Using future revenue to repay foreign currency loan

Question 12

What is meant by money-market hedging?

Answer 12

Involves a short-term loan in a foreign currency

Question 13

First step in creating a money market hedge for a receipt?

Answer 13

identify loan repayment required in the future

Question 14

Second step in creating a money market hedge for a receipt?

Answer 14

Calculate amount that needs to be borrowed today in the foreign currency using interest rate provided

Question 15

Third step in creating a money market hedge for a receipt?

Answer 15

Covert this immediately to domestic (home) currency at the spot rate. Place this deposit in the home currency

Question 16

Fourth step in creating a money market hedge for a receipt?

Answer 16

Include interest earned on deposit in the home currency, using interest rate provided

Question 17

How can foreign currency payable eliminate exchange rate risk?

Answer 17

Withdrawing funds from domestic currency and putting them in on deposit in foreign currency

Using foreign funds to pay foreign currency expense in the future

Question 18

First step in creating a money market hedge for an expense?

Answer 18

Identify cash required to pay the foreign currency expense

Question 19

Second step in creating a money market hedge for an expense?

Answer 19

Using interest rate provided, calculat the amount that needs to be invested today in foreign currency

Question 20

Third step in creating a money market hedge for an expense?

Answer 20

Convert immediately to home currency at the spot rate

Question 21

Fourth step in creating a money market hedge for an expense?

Answer 21

Include cost of borrowing in domestic country to compare to a forward contract

Question 22

What is money market hedging unlikely to deliver?

Answer 22

A significantly different outcome from that delivered by a forward contract

Question 23

What may money market hedging likely improve?

Answer 23

If it is used by an exporter with a cash flow deficit (saved overdraft interest) or importer with a cash flow surplus (interest on cash flow surplus less than cost of borrowing)

Question 24

When money market hedging less than a forward contract?

Answer 24

Likely to be more time-consuming than a forward contract and could involve issue costs as borrowing is involved