Chapter 23 - Foreign Exchange Risk Management Flashcards
What are the 3 types of risk
- Transaction risk - if I buy goods in USA for $2 to the pound, in 30 days when we pay the invoice the exchange rate will have changed and we could be paying a lot more or a lot less
- Translation (or accounting) risk - suppose I have a factory in America that costs me $100,000. When it comes to the SFP at the end of the year I need to convert the $100,000 to gbp because I’m a gbp company. Over the years the value of the factory will fluctuate each year with the FX. Therefore it’s the value of foreign assets in the SFP
- Economic risk - if sell goods abroad on credit, more risk of irrecoverable debt. Also risk in the sense of the political stability of the other country
What is the spot rate ?
The exchange rate on a given day
How are exchange rates quoted ?
If $/£ 1.6250 - 1.6310 then it’s $1.6250 to each £1
It is (like real life) quoted to 4 decimal places
The reason for 2 quotes, depends on which rate you are converting at, is it gbp to usd or usd to gbp, the difference is the profit the bank makes
How to know which rate to use on the exchange rate spread
Imagine we receive $100,000 from a US customer
The exchange rate is $/£ 1.6250 - 1.6310
- Because it is USD to GBP we divide the $100,000 to get the GBP value
- To know which rate to use, because it is the bank that makes the profit it is whichever rate gives the worse total for us
Because we are receiving money
$100,000 / 1.6310 = £61,312
$100,000/ 1.6250 = £61,538
The worst is 1.6310 and therefore that is the correct FX rate
4 Methods to use to help with the risk of exchange rates changing between now and the date we either pay or receive the foreign currency ?
- Invoice in home currency
- Leading and lagging - if we owe money in foreign currency with pay quickly (leading) or delay paying depending (lagging) on which way you expect the exchange rate to move
- Netting - if we pay and receive dollars then rather than converting the received dollars to gbp and then have to pay back in dollars, we would only convert the net amount, it is this amount that is at risk
- Matching - e.g company in UK and we have regular income in dollars, we are at risk each month, matching creates an expense in dollars, like maybe borrow money in USD so we have to pay interest in dollars or purchase raw materials for America so that if the foreign currency falls or rises it is offset by the expense falling or rising so cancels out
5 Methods to use to help with the risk of exchange rates changing between now and the date we either pay or receive the foreign currency ?
- Forward contracts - suppose I need to pay something in $100k in 1 months time rather than wait and see the exchange rate, you can ring the bank and they can give you fixed rate now and we can convert at that rate in a month. Therefore there is no risk because we know how much we are to pay. Downside is that we have to make to payment on that specific date regardless if we no longer need to pay it or need to pay it in 5 weeks rather than 4 as first thought etc
- Money market hedging - imagine we are due to receive $5m in 3 months time which we will then convert to our GBP value, how can we remove the risk. If we borrow $5m now at the spot rate we know of, so that we can convert now to GBP at spot also so there is no risk. So we get pounds now rather than 3 months, to make it comparable, we don’t take the pounds now, we deposit it for 3 months so we get interest. Effectively it’s the same as forward contracts. This was the way in the old times before forward rates were an option.
- Currency futures
- Currency options
- Currency swaps
How can the spread look different with future contracts
Often in newspapers, rather than quote the exact rates for the forward amounts they quote the difference.
E.g if the spot is $/£ 1.5326 - 1.5385 and 3 month forward is 0.62 - 0.51 c’p’m then the 3m forward exchange rates will be
$/£ 1.5264 - 1.5334
The reason we subtract remember is because c’p’m stands for “cent premium” as because it is a premium we pay more than therefore it is taken off to make the exchange rate worse for us in GBP
How to know if to add of subtract the forward exchange rate difference ?
If the letters after the forward rate is p’m this refers to “premium” which we subtract from the original spot number
If the letter after the forward rate is dis this refers to “discount” which we add from the original spot number
What does +- with future contracts ?
For example if the question asks
2m forward $/£ 1.6550 +/- 0.0020 then this means the higher rate is + 0.0020 and the lower rate is - 0.0020 therefore the range is;
$/£ 1.6530 - 1.6570
How to work out money market hedging
Q. Carl co is due to receive $5m in 3 months time
Spot is $/£ 1.5384 - 1.5426
Current interest rates are;
USD - 5.2% - 5.8%
GBP - 3.6% - 3.9%
Step 1
Firstly we want to borrow USD now so we take the 5.8% US, remember it is higher because it’s worse for us. Also the 5.8% is p.a so @ 3 months it’s 5.8 * 3/12 = 1.45%
How many dollars can we afford to borrow as we need to factor in the interest so that in 3 months time we repay back exactly $5m therefore we borrow;
$5m / 1.0145 = $4,928,536
Step 2
We then convert into pounds at the worst rate for us is it;
$4,928,536 / 1.5384 = $3,203,677
Or
$4,928,536 / 1.5426 = $3,194,954
The worst for us is 3,194,954 as that’s what we are receiving now
Step 3
We can either take the £3.2m now or to make it comparable to 3 months from now @ the worst UK interest rate options for us as bank benefits therefore it’s
£3,194,954 x (3.6% x 3/12) = £28,755
Therefore the overall has grown to £3,223,709.
Step 4
So in 3 months time we receive money from the customer of $5m that will go straight to repaying the $5m borrowing
Also, the pound deposit matures so we receive the £3,223,709 so the end result is just like using the forward rate.
How to do money market hedging when we are paying rather than receiving
Same idea as previous with receiving. Let’s imagine Carl co is due to pay $8m in 3 months day. Therefore we want to buy dollars now. So I’ll borrow £ now for 3 months, convert to dollars now and therefore deposit the dollars for 3 months and use the matured borrowings to pay customer in 3 months time
Here though we have to work backwards as we don’t know how many £s to borrow until we know how much $ we have to put on deposit because we are having to pay at the end rather than wait to receive.
Step 1
Imagine we need $8m in 3 months time, we divide by the interest rate we will receive (let’s imagine it’s 1.016%) therefore we need to deposit $7,874,016 to get the $8m in 3 months time to pay customer
Step 2
We now need to get $7.8m now so we convert today to £
Step 3
Now we have the pounds for today at £4,860,204 we need to borrow it for 3 months at the worst UK interest rate (so bank can make profits so therefore the higher of two amounts), let’s say it’s 9.9% pa therefore it’s 2.475% for 3 months so we need to borrow
£4,860,204 x 2.475% = £120,290 (interest) + £4,860,204 = £4,980,494
Therefore in 3 months time,
- $ deposit matures and we pay $8.0m to supplier
- We repay the £4,980,494 to the bank
Therefore the equivalent forward rate would be 8m / 4.980494 = 1.6063.
That is why it’s easy to get a forward rate as this is what the bank does in the background
What are currencies futures
Similar to future contracts however they give you a rate now to use of a future date but they are on set dates. For example 31st June, 31st July etc rather than giving us a date we request like with future contracts.
Very restricted as rarely case we need it for the date they are offering.
In practice few people use futures in this way but instead people use futures to buy and sell on the stock exchange. Imagine at the end of march the rate is 1.6000 but you reckon it will be better than this then you can trade it.
Imagine it is start of December and the future rate is on 31st, I can buy $1 billion worth of futures if I want because I can sell them when they expect the money at end of December and it is only the difference that I receive or have to pay out so you can buy as many as you want and not have to buy them there and then like with normal stocks
What are options ?
An option is the right to covert at a fixed rate on a future date. Similar to futures but rather than being forced to convert we have the rights to either exercise the right or to convert at spot.
We wait til the rate of transaction
With this is seems you can only win, sounds too good to be true. The downside is that you have to pay for the option, it’s call the “premium”. We pay it whether or not we exercise it.
What are currency swaps
Suppose we are a company in the UK and we set up subsidiary in the US and we need to borrow money. It makes sense to borrow money in dollars if we are setting up in dollars but we don’t have credit rating in the US and we are a UK company.
So rather than paying the higher interest rate in USA because we are known why not find a company in the US that wants to borrow pounds.
So why don’t we do this. I’ll borrow in pounds because I can get a better interest rate because the UK know me, the US do the same with dollars and then we swap.
I then pay the dollar interest rate (the other companies interest) and visa versa
To find the other company is usually done via a bank
