Currency risk? Flashcards
(10 cards)
What are the types of currency risk?
Translation, transaction, and economic exposure.
What is transaction exposure in currency risk?
It is the risk of exchange rate fluctuations affecting the value of actual transactions that have already been agreed upon but not yet settled.
🔹 Example:
A US firm agrees to pay €1 million to a German supplier in 3 months. If the euro strengthens, the dollar cost increases.
🔹 Hedging method:
Use of forward contracts to lock in exchange rates.
What is translation (accounting) exposure?
It is the risk arising from converting the financial statements of foreign subsidiaries into the parent company’s reporting currency.
🔹 Example:
A UK-based company with a US subsidiary must consolidate US dollar-denominated assets into GBP. A falling USD reduces reported assets and equity.
🔹 Impact:
This affects the balance sheet and reported earnings, even though no cash flow occurs.
What is economic exposure in currency risk?
It reflects the long-term impact of exchange rate movements on a firm’s future cash flows and market value—even if no foreign transactions are currently planned.
🔹 Example:
A Canadian manufacturer competing with US firms may be impacted if the USD weakens, making US goods cheaper and more competitive.
🔹 Management strategy:
Can include operational restructuring like relocating production or adjusting sourcing strategies.
What does the Interest Rate Parity (IRP) theory explain?
IRP states that the difference between interest rates of two countries is equal to the difference between the forward and spot exchange rates of their currencies. This ensures no arbitrage opportunities in the currency markets.
What is the definition of Covered IRP?
CIRP holds when the return on domestic deposits equals the return on foreign deposits once exchange rate risk is hedged using a forward contract.
Formula:
F = S* (1+interest rate home/1+interest rate foreign)
F - Forward Rate
S - Spot Rate
What is an example of covered interest arbitrage?
UK investor: 90-day interest rate = 4%
US investor: 90-day interest rate = 2%
Spot rate: $1.60/£
Forward rate (90-day): $1.60/£
Since both interest and forward rates align, there’s no arbitrage—IRP holds.
What is Uncovered Interest Rate Parity?
UIRP states that the expected appreciation/depreciation of a currency offsets the interest rate differential—without using forward contracts.
Why is interest rate parity important in finance?
Prevents arbitrage in FX and capital markets
Guides multinational firms on hedging and investment choices
Determines forward exchange rates
Links monetary policy with currency markets
What can cause IRP to not hold?
Transaction costs
Political risk
Capital controls or taxes
Credit/default risk
Market segmentation
Even small deviations are usually temporary due to arbitrage.
