Case 9 Flashcards
What is exposure?
Is the risk that a company faces when involved in international trade, that the currency exchange rate will change after a company has already entered into financial obligations.
What is volatility?
The degree to which a certain currency fluctuates within a certain period of time.
What are the 3 types of currency risks? Explain them
The three types of currency risks are Transaction risk, economic risk, and accounting risk.
Transaction risk: The exchange rate risk associated with the time delay between entering into a contract and settling it.
Economic risk: Due to exchange rate changes operating cost will raise making the product uncompetitive, thus eroding profitability.
Accounting risk: the effect of unexpected changes in exchange rates on company assets, liabilities, and long-term solvency
What are the 3 different types of hedging strategies? Explain what they do, advantages and disadvantages.
The three types of hedging strategies are: Do nothing, forward contract, and currency options
Do nothing: Is actually do nothing, do not adopt forward contract or currency options in the international contract.
Advantages: An appreciation of the currency can lead to profit
Disadvantages: a depreciation of the currency can lead to losses.
Forward contract: Two companies enter into an agreement to exchange one currency for another currency at a specific date and at a specific exchange rate.
The advantage is that this strategy is the most secure between the three because the company will know for sure how much it will receive in the future, independent of depreciation of the currency. The disadvantage is that if the currency appreciates the company cannot have extra gains.
Currency options is a financial instrument that companies use to hedge international currency transactions. There are two types of currency strategy and they are called pull and call options.
Advantages: The transaction is hedged, however, there is a possibility to obtain gain if the currency appreciates. Disadvantages: more complex, high cost.
Explain the pull option
An option contract giving the owner the right to sell, a specific amount of underling security at a specific price within a specific date.
Explain the call option
An option contract giving the owner the right to buy, a specific amount of underling security at a specified date
What is strike price?
Is a fixed price that an owner of an option can buy or sell an underling commodity or security.
What is the forward price?
Is a price in the future, agreed to the forward contract
What is spot price?
It is the price of the day.
