Ch 9 Flashcards

Question

Applicability of Interest Rate Parity Theory to determining forward rates

Answer 1

Primary limitation on applicability of this relationship is government intervention: CONTROLS ON CAPITAL MARKETS govt may limit range/type of mkts within their F/Svcs system CONTROLS ON CURRENCY TRADING e.g. limit on amount of currency that may be removed from country; use of "official" exchange rate which does not reflect "effective" rate mkt wishes to use GOVT INTERVENTION IN THE MARKET govt may attempt to control/manipulate the exch rate by buying/selling their own currency

Answer 2

The Intl Fisher Effect claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exch. Effect assumes that all countries will have same real interest rate, although nominal/money rates may differ due to expected inflation rates thus the interest rate differential between two countries should be equal to the expected inflation differential thus countries with higher expected inflation rates will have high nominal interest rates, and vice versa

Answer 3

examines the relationship between interest rates and inflation INFLATION = difference between real ROI (real interest) and nominal return (nominal interest rate) [1 + nominal] = [1 + real] \* [1 + inflation rate] e.g. UK interest 5.06%, inflation 3% Real interest rate = 1.0506/1.03 = 1.02 or 2% Thus the NOMINAL rate in a country must be sufficient to reward investors with a suitable REAL return (here 2%) plus an additnl return to allow for effects of inflation

Answer 4

The simultaneous purchase and sale of a security in different markets with the aim of making a risk-free profit through the exploitation of any price differences between the two markets Mainly used by speculators as a hedging tool Arbitrage differences are s/t - when other traders see commodity price differences they will exploit them and prices will converge - thus differences will vanish as equilibrium reached

Answer 5

Pure arbitrage = abritrage which is completely risk-free e.g. if EUR are available more cheaply in London than New York, arbitrageurs can make a risk-free profit by buying in London and selling in New York globalization of markets and proliferation of internet =\> pure arbitrage opportunities have all but dried up moreover, access to real-time market prices costs money, as done transaction fees - thus heavy heavy investment is req'd to make the above example practicable

Answer 6

fruit & veg stall at market customer asks for 1kg of apples you have none but know where to get them you ascertain customer WTP at GBP 1/kg and know a competitor supplier selling at 90p you make a profit of 10p if enough people ask for apples, the commpetitor will realize there is an increased demand for apples - which appear in short supply - and will increase price thus eliminating opportunity for arbtirage profits

Answer 7

Day-trader believes they can spot s/t speculative movements and benefit from them - re. exch rates: looks for a "cheap" currency and sells it quickly at a profit to someone needing it e.g. day trader thinks there is a difference in market for USD he can buy USD 2 for EUR 1.50 - he can buy EUR 1 for GBP 0.80 - he can sell USD 1.5 for GBP 1 - he has GBP 100k available convert GBP to EUR = 100k / 0.8 = EUR 125k convert EUR to USD = (EUR 125k / 1.5) \* 2 = USD 166,667 sell USD = USD 166.7k / 1.5 = GBP 111k thus GBP 11.1k risk-free profit

Answer 8

(1) identify risk exposures (2) quantify exposures (3) decide whether or not to hedge (4) implement and monitor hedging program

Answer 9

involves the reduction or elimination of financial risk by passing onto someone else – or internal hedging techniques which involve reducing risk by creating an offsetting position that has a tendency to cancel any risk

Answer 10

can provide certainty of CF which assists budgeting reduces risk - thus mgmt may be more inclined to undertake investment projects reduction in probability of bankruptcy mgrs often risk-averse since job is at risk - thus a company with hedging policy will be seen as a more attractive employer

Answer 11

sh/h have diversified their own portfolios - thus further hedging by business may harm sh/h interests tx costs associated with hedging can be significant lack of expertise within business, esp regarding use of derivative instruments complexity of a/c and tax issues associated with derivative use

Answer 12

A financial instrument whose value depends on the price of some other financial asset or underlying factor (e.g. oil, gold, interest rates, currencies)

Answer 13

HEDGING used a RM tool to reduce/eliminate financial risk SPECULATION used to make a profit from predicting mkt mvmts ARBITRAGE used to exploit s/t price differences between markets

Answer 14

MANAGING RELATIONSHIPS WITH BANKS investment of surplus cash, arrangements to allow cash deficits, hedging WORKING CAPITAL AND LIQUIDITY MANAGEMENT ensure sufficient (not excessive) daily cash available to fund inv, A/P and A/R LONG-TERM FUNDING MANAGEMENT cash for l/t investments e.g. NCA or mortgages/debentures CURRENCY MANAGEMENT multi currency implies internal and external hedging techniques, sourcing currencies, managing foreign currency bank accounts

Answer 15

Treasurer has capacity to make large gains or loss in short period of time - esp when trading in fin derivatives - thus careful role defintiion and monitoring key

Answer 16

Profit Center vs Cost Center Centralized vs Decentralized

Answer 17

Advantages of PROFIT CENTER approach - mkt rate charge to all business units, meaning operating costs are realistic - treasurer is motivated to provide svcs as efficiently and economically as possible Disadvantages of PROFIT CENTER approach - profit concept drives temptation to speculate and take excessive risk - mgmt time wasted on discussing internal charges for treasury activities - additional admin costs

Answer 18

RISKS associated with centralized - lack of motivation at sub level to manage cash, as any cash received is swept up to head office and managed at group level - risk that, should head office commit an error in treasury ops, entire group is in jeopardy RISKS associated with decentralized - one sub may pay large overdraft interest costs whereas another has cash balances on hand earning low interest rates - risk of not generating group profits that would be earned if group funds were actively managed by a profit-oriented treasury \> individual executives seeking to reduce costs

Answer 19

INTERNAL METHODS Invoicing in home currency leading / lagging Offsetting: matching / netting / pooling countertrade EXTERNAL METHODS netting centers forward contracts money market hedges currency futures / options / swaps

Answer 20

internal hedging often more effective for dealing with economic risk internal hedging often cheaper and simpler to understand external hedging more complex and thus requires more skilled staff in treasury depts

Answer 21

UK business sending and receiving invoices exclusively in GBP partly removes currency risk by transferring onto customer or supplier economic risk is not removed - b/c business value will still fall if overseas competition are "winning" with their overseas trade in foreign currencies PRACTICAL ISSUES: - cust/suppliers may not want to accept currency risk =\> won't trade with us - other parties may not accept same prices, will require discounts (sales) or premiums (purchases) - other ways exist of hedging risks which render risk of transacting in foreign currency acceptable

Answer 22

a way of trying to make gains on foreign currency payments leading = paying before due date // lagging = holding off as long as possible in both cases b/c of a strong view on future exch rate mvmts PROBLEMS - early payment costs us interest foregone on funds which have been disbursed early - payee not happy if payment may be overdue - especially if currency expected to fall - company required to speculate =\> risk of getting it wrong

Answer 23

Company has to pay a US supplier $100k Payment due in two months - but could be paid now or in three months Sterling expected to depreciate vs USD - meaning better to pay ASAP otherwise more of our currency required to make up 100k e.g. rate expected to go from GBP 1/$2 to GBP 1/$1.5, payment would go from GBP 50k to 66.7k

Answer 24

MATCHING matching assets/liabs in same currency e.g. financing foreign inv'ment with foreign loan - favorable rate changes on one would mean adverse on the other - thus exch risk reduced NETTING using foreign bank a/c and reducing risk by using foreign receipts to cover foreign payments - works best if dates line up at group level, can work such that one bus unit's payments are netted against another's receipts POOLING end-of-day cash sweep into central account (including overdrafts too) to maximize interest earned, minimize any bank charges although not hedging against FX, does avoid overdraft costs and enables more efficient use of surpluses best operated by a central treasury function POOLING

Answer 25

parties exchanging goods/svcs of equivalent value old fashioned bartering and avoids any type of currency exchange tax authorities do not like this – without cash changing hands, difficult to estblish value and thus sales tax payable risk of tax authority dispute + associated mgmt time =\> unpopular

Answer 26

Treasury mgmt technique used by large companies to manage their interco payment processes, usually involving many currencies can yield significant savings from reduced foreign exchange trading netting ctr collates batches of CF between a defined set of orgs and offsets them such that only a single CF to or from each company takes place to settle the net result cyclical basis - usually monthly - managed centrally by netting center several currencies involved - all CF converted into equivalent domestic amounts such that the org has only a single net position to settle objective is to reduce overall forex volume traded and thereby cut forex spread paid by the company (b/c direct billing in multicurrency implies excessive buying/selling of foreign currencies over and over)

Answer 27

CURRENCIES which one used for invoicing? buyer's, seller's, another? CREDIT PERIOD ideally the same for all participants - some variations for those who are long or short of funds SETTLEMENT DATES timetable of the cycle must be known and followed, as should frequency of netting EXCHANGE RATES spot, or mid at 11am, or budgeted - needs agreeing - should be "arms length" to avoid tax issues CONFLICT RESOLUTION process for resolving disagreements so as not to slow down the process - may be complex to agree who owes what to whom MANAGEMENT internal or by the bank

Answer 28

Agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate most popular hedge for foreign currency tx risk - setting your rate in advance risk is taken by the bank who is better able to manage exposure - a proportion of their exposue will normally be avoided by writing forward contracts for opposite trades on the same day

Answer 29

binding commitment often quoted at discount ("dis") or premium ("prem") - "dis" meaning currency being quoted (USD) is expected to fall vs other currency (GBP), thus more USD req'd to purchase a single unit of GBP rule: add a fwd discount to spot "add:dis" // subtract a forward premium from spot

Answer 30

Simple, thus low tx costs purchased from high street bank fixed exchange rate tailored - thus flexible in terms of amount and time period

Answer 31

(1) Contractual Commitment Thus potential credit risk as org may be awaiting overseas customer payment and wishing to convert using the contract "option date" forward exchange contract can be arranged - gives companies a range of dates within which it can settle at the agreed rate - thus more flex (2) generaly inflexible - eliminates downside risk of adverse mvmt, but no upside potential / no participation in a favorable mvmt

Answer 32

Money Markets are for wholesale (large scale) lending and borrowing, or trading in s/t financial instruments many orgs able to borrow/deposit funds through their bank in the money markets instead of hedging currency exposure with a forward contract, company could use money markets to lend/borrow and achieve a similar result since foreward exch rates are derived from spot rates and money mkt interest rates (IRPT), end result should be similar in either method

Answer 33

Basic idea is to create assets and liabilities which "mirror" the future assets/liabilities RULE: money req'd for tx is exchanged at today's spot rate, is then deposited/borrowed on the money market to accrue at the amount req'd for the future tx NOTE: interest rates used for the depositing/borrowing - usually quoted per annum.

Answer 34

available for any length of borrowing/deposit period up to circa 1 year Two rates quoted: higher is that banks charge for loans, lower is on deposits e.g. 1-mo USD LIBOR 3.250 -- 3.1250 thus 3.25%/year if you wanted to borrow from them for exam purposes, assume that 1 month of interest = 3.25% / 12 = 0.271%

Answer 35

Basic idea = avoid future exch rate uncertainty by making the exch at today's spot rate Achieved by depositing/borrowing the foreign currency until the actual tx cash flows occur

Answer 36

ensure no currency risk b/c exch takes places today fairly low tx costs flexibility - especially if customer delays payment

Answer 37

complex may be difficult to get an overseas loan in case of foreign currency receipt

Answer 38

interest rate parity implies that money market hedge should give same result as forward contract CF implications may prevent company from using this method - if org has considerable overdraft, it may not be able to borrow funds right away

Answer 39

form of hedging very similar to use of forward contracts key difference is that, whereas forward contract requires a tailor-made instrument for the specific tx, futures are standardized for fixed amounts of money for a limited range of future dates

Answer 40

futures are derivatives contracts, thus can be traded on futures exchanges the "futures contract" which guarantees the price is separate from the tx thus easily tradable futures contracts usually denominated in USD - thus they are known as the "other" currency, e.g. the GBP1/USD future is known as GBP contracts example - Chicago Mercantile Exchange trades sterling futures contracts with standard size of GBP 62,500 and one can only purchase multiples of this amount - thus somewhat inflexible

Answer 41

STEP 1: THREE KEY QUESTIONS do we initially buy or sell futures? (if we want to buy GBP, buy a GBP contract) which expiry date should we choose? (3-month settlement cycle, usually the one after required conversion date is used) how many contracts? STEP 2: CONTRACT EXCHANGE pay the initial MARGIN then wait for tx/settlement date margin = initial deposit to the exchange which is returned when position is closed STEP 3: CLOSING OUT on contract expiry the trading position is automatically reversed, any P/L is computed and cleared and underlying commodity retained by the trader margin refunded by exchange value of tx calculated using spot rate on tx date most futures are closed out before settlement dates by undertaking the opposite tx on initial futures tx - i.e. if buying currency futures was initial tx, closed out by selling currency futures

Answer 42

Hedging or speculating on the movement of the exchange rate on the futures market effectively a future is a bet - if an org expected a USD receipt in 3 months, it will lose if USD depreciated vs GBP - the futures contract lets the org "bet" the USD will depreciate - if it does, the win on the bet cancels out the loss on the tx - if the USD strengthens, the gain on the tx covers the loss on the bet

Answer 43

Initial Margin - paid to exchange when futures contract is bought / sold If losses are incurred, buyer/seller may be required to deposit additional "variation margin" with the exchange Similarly, profits credited to the margin account on daily basis as the contract is "marked to market"

Answer 44

today is Oct 15, an org needs to convert EUR into USD to pay USD12m on Nov 20 December Euro Futures = contract size EUR200k, prices given in USD per EUR, tick size USD 0.0001 / USD 20 per contract Oct 15 spot rate 1.3300, futures price 1.3350 Nov 20 spot rate 1.3190, futures price 1.3240 STEP ONE - three questions buy or sell – need to sell EUR to buy USD, thus SELL FUTURES now which expiry – Nov 20 – thus choose December futures how many – to cover 12m/1.3350 = EUR 8.99m / 0.2m (per contract) = 45 contracts STEP TWO - contract sell 45 December futures at futures price of EUR1 / USD 1.3350 STEP 3 - close position and calculate P/L Initially sell at 1.3350 close out buy at 1.3240 difference is USD 0.011 per EUR 1 thus total profit = 0.011 \* 45 \* 200,000 = USD 99,000 tx at spot rate on Nov 20 = USD 12m less 99k profit = USD 11.901m at spot rate EUR1/USD1.3190 = EUR 9,022,744

Answer 45

the minimum price mvmt for a contract e.g. sterling futures of GBP 62,500 are priced at exch rate in USD and tick size is USD 0.0001 thus if price changes from USD 1.7105 to USD 1.7120, increase is 0.0015 or 15 ticks every one tick mvmt in price has the same money value for futures trading e.g. 1 tick of mvmt in the contract above costs 62,500 \* 0.0001 = USD 6.25

Answer 46

the current futures price varies from current "cash market" price re. currency futures, current mkt price of currency future and current spot rate will be different, will only start to converge when the final settlement date for futures contract aproaches - this is known as the "basis" at final settlement date of contract, future prices and market price of underlying item ought to be the same; otherwise speculators would make an instant profit trading between the two most futures positions closed out before contract reaches settlement date - thus there will be an inevitable differences in futures price at close-out and current spot market price of underlying item - thus "there will still be some basis" b/c basis exists, an estimate can be made when a hedge is created with futures about what the size of the basis will be when the futures position is closed

Answer 47

February, UK org wishes to hedge currency exposure arising from USD payment that will have to be made in May current spot exch rate is USD 1.5670 and current June futures price is USD 1.5530 - thus basis of 140 pts in Feb if we assumed basis will decline from 140 to 0 in June, we can predict a 3/4 fall of 105 points by May when payment is due

Answer 48

The risk that when a hedge is constructed, the size of the basis when the futures position is closed out is different from the expectation of what the basis ought to be (from when the hedge was created) thus if initial spot was GBP 1 : USD 1.5670 an June futures price was USD 1.5530 – but rate falls to USD 1.5500 – the pound has fallen in value more than expected thus a higher payment will be req'd to settle the US obligation

Answer 49

offer an effective "fixing" of exchange rate no tx costs tradable instruments

Answer 50

foreign futures market must be used for GBP futures require up front margin payments not usually for the precise tailored amounts required

Answer 51

The right - but not obligation - to buy or sell a currency at an exercise price on a future date Favorable mvmt = company allows option to lapse to take advantage of favorable mvmt Adverse mvmt = option is exercised to protect against adverse mvmt

Answer 52

they carry a COST - b/c options limit downside risk but allow holder to benefit from upside risk, the writer of the option will charge a non-refundable premium for writing the option

Answer 53

CALL OPTION gives the holder the right to buy the underlying currency PUT OPTION gives the holder the right to sell

Answer 54

Using attached table The option to buy a contract with an expiry date of September and a strike price of EUR 1 = USD 1.17 would cost 1.55/euro as a premium If the contract was EUR 125k =\> premium of USD 1,937.50 Or an option to sell in June at strike price of EUR 1 = USD 1.15 would cost 0.64 cents per euro as commission =\> USD 800

Answer 55

STEP ONE: FOUR KEY QUESTIONS - call or put? - which expiry date? - what strike price? - how many contracts? STEP TWO Contact exchange, pay up-front premium, then await tx/settlement date STEP THREE on tx date, compare option price with spot rate and determine whether to exercise or allow to lapse STEP FOUR Calculate the net CF - if the number of contracts need rounding, some exchange at prevailing spot rate will be req'd even if option is exercised

Answer 56

strike price for an option may be \< or \> than current mkt price e.g. call option may give right to buy GBP at GBP 1 / USD 1.79 -- spot rate may be higher, lower, or bang on if exercise price for an option is more favorable to the option holder than the current "spot" rate = "in-the-money" option if less favorable = "out-of-the-money" if the same = "at-the-money" an option will only ever be exercised if "in-the-money" BEAR IN MIND - this relates to EXERCISE PRICE (thus at the "end" of the contract) - an option may start out-of-the-money and move in - although it may also stay out

Answer 57

offer the perfect hedge - downside risk covered, can participate in upside potential many choices of strike price, dates, premia option can be allowed to lapse if the future transaction does not arise

Answer 58

traded sterling currency options are only available in foreign markets high up-front premium costs (non-refundable)

Answer 59

setting premium level for options requires complex models - these are also used to calculate FV of an option at given date (for fin rptg) Black-Scholes model is the most common option pricing model used basic principle is that the market value (or price) of a call option consists of two elements: - intrinsic value of the option - time value of the option between these two elements there are five variables affecting the price of a call option

Answer 60

ELEMENT ONE: INTRINSIC VALUE OF OPTION difference between current price of underlying asset and option strike (exercise) price -- for the market value of a call option to rise, one/both of the following variables must change: (1) current price of underlying asset must increase (2) strike price must fall - thus increasing likelihood that option is exercised - which has some worth ELEMENT TWO: TIME VALUE reflects the uncertainty surrounding the intrinsic value, impacted by three variables: (1) st dev in daily value of underlying asset - more variability means higher chance of option "in-the-money" and thus will be exercised (2) time period until expiry - longer time means more likely increase in asset value, thus option is exercised (3) risk free interest rates - a call option means purchase can be deferred - thus owning a call option is more valuable with higher interest rates, since money left in the bank generates a higher return

Answer 61

the basic form is widely used by traders in option markets to give an estimate of option values - there are several limitations: - assumes that the risk-free interest rate is known and constant throughout the life of the option - st dev of returns from underlying security must be accurately estimated and must be constant throughout asset life - in practice st dev will vary depending on the period over which it is calculated; the model is unfortunately very sensitive to its value - assumes no tx costs of taxation effects involved in buying/selling option or underlying item

Answer 62

e. g. interest rate options, options for other assets/liabilities e. g. a company may wish to buy an option to purchase a factory currently under construction company may pay a premium to the builder entitling them to first option to buy (not comitment) if the council then changes planning guidelines and prevents further development in the area, the option becomes very valuable since no other companies can build new factories - thus the option could be sold on at a profit (if the builder allows it)

Answer 63

Cross-currency swap - allows a company to swap a currency it currently holds for a different currency for a fixed period, then same back at the same rate at the end of the period counterparty is usually a bank two elements: (1) exchange of principals in different currencies, which are swapped back at the original spot rate (2) exchange of interest rates - timing of these depends on the individual contract

Answer 64

Some risks better covered by internal methods, others by external - key is matching a suitable hedging method to the specific risk consider options beyond financial instruments e.g. UK company exporting to the US could suffer if USD weakens - could hedge by matching USD revenues with USD costs - ideally by importing materials priced in USD -- rather than going for a limited-term external hedging instrument