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Flashcards in Final Deck (75):
1

what is a hard currency

currency likliky to appreciate

2

Covariance

* measure of the degree to which the two variables move together
* positive: move together
* negative: move opposite

3

What is the home currency invoicing strategy

* invoice exports in strong currencies, imports in weak currenies
* can only “win” if not dealing with informed customers or suppliers

4

Managing transaction exposure

* forward contract
* price adjustment clauses
* currency options
* HC invoicing

5


How to account for inflation and exchange rate projection

1. convert each nominal foreign CF into nominal domestic, then discount using a rate that reflects domestic inflation + risk premium


2. discount each nominal foreign CF at rate reflects foreign inflation and apposite risk premium. su up foreign PV and convert to domestic using spot exchange rate
* THESE SHOULD BOTH PRODUCE THE SAME RESULT

6

when does transaction exposure occur

* from time of agreement to time of payment
* Fixed foreign currency inflows or outflows in the future
* Arises from possibility of exchange rate changes between transaction date and settlement date

7

Features of futures (Currency)

* Contract size standardized by amount of foreign currency
* transaction costs:commision
* Leverage is high
* Max price movements

8

International diversification

* Better risk-return trade off
* diversify across nations in different stages of the economic cycle
* international investments push out the efficient frontier

9

Currency risk sharing

* develop custom hedge contract
* Price adjustment clause
* share currency risk outside a neutral band
* neutral zone range in which risk is NOT shared

10

Steps in futures

1. initial margin
2. daily fluctuations flow to margin account
3. maintenance margin breached, margin call is issued

11

Differences between forwards and futures

* trading location
* trading hours
* regulation
* delivery date and frequency
* costs
* margins
* market value at origniation
* credit risk
* cash flows

12

What are the components of Economic exposure

Transaction exposure + operating exposure

13

Circumstance in which firms face economic exposure

1. enter purchase/sale agreement in foreign currency
2. selling or buying abroad or face domestic competition from imports

3. operating in foreign country where govt. taxes nominal rather than real income

14

What is transaction exposure

results from changes the in value of foreign currency contracts due to exchange rate changes

15

True cost of hedging

opportunity cost depends upon future spot rate at settlement

16

How to think about measuring translation exposure

* some assets held at historical rate (not exposed)
* some held at current : exposed
* Translation exposure = “exposed assets” - “exposed liabilities”

17

Options on currencies

* foreign (non-US currency) is asset, state prices in USD
* call : right to buy asset
* Put; right to sell asset

18

Economic impact of changes in foreign exchange

look at real, see if inflation has offset currency rate changes

19

Limits to international diversifiaction

* correlation between markets is time-varying
* correlation appears to increase during period of high vol
* markets move together during bear markets

20

Currency future

agreement to buy/sell a standard quantity of an available currency at a fixed exchange rate at a set delivery price

21

Basic translation methods

1. Current/non current
-only CA, CL, exposed
2. monetary/non monetary
-only monetary assets are exposed
3. temporal
-current costs are exposed, historical aren't
4. current rate
-all CA, CL exposed

22

Currency likely to depreciate

soft currency

23

Currency collars

* contract bought to protect against currency moves outside the neutral zone
* firm convert its foreign currency denominated receivable at zone forward rate

24

Which risk can be eliminated by diversification

non-systematic risk

25

Regression

INPUT

26

Why use derivatives

* income opportunities/speculation
* risk management
* Finanical Engineering

27

Political risks

* adjust either discount rate or CF, easier to do CF

28

3 options to manage translation exposure

* adjust fund flows
* forward contracts
* exposure netting

29

What is meant by increasing soft-currency liabilities

* devaluation likely
* tighten credit to reduce AR
* reduce level of cash
* increase LC borriwn
* delay AP
* sell weak currency forward
* SUMMARY: increase cash cycle

30

What is hedging currency exposure

* creating offsetting currency position

31

How to create a currency collar

* long put on FC, sell call on FC
* Long put to hedge downside
* short call to reduce cost of hedge

32

How to measure transaction exposure

* currency by currency
* equals difference between the contractually fixed future cash inflow and outflows in each currency

33

arises because exchange rate changes alter the value of future revenues and costs

Operating exposure

34

Currency swap

exchange of debt-service obligations denominated in one currency for the service on an agreed-upon principal amount of debt denominated in another currency

35

Cross -hedging

* use when forward contract not available
* futures/forward on related currency
* use regression

36

Impact depends on pricing flexibility

* price elasticity of demand
* product differentiation
* ability to shift produciton
* substitution on inputs

37

Accounting vs. economic exposure

* accounting: reflects past decisions of the firm
* economic: focus on future impact of exchange rate changes
* SHOULD FOCUS ON ECONOMIC: true CF expected to firm, max SH value

38

Variance

a measure of the degree to which a variable deviates from its average

39

3 steps approach to simplify project evaluation

* estimate project cf from the project’s standpoint
* forecast the amount, timing and form of transfers to parents, taxes etc
* consider indirect benefits and costs

40

Selective hedging

* hedging only when a currency change is expected, going unhedged otherwise
* not much different from speculation

41

increase in the real value of a currency

* tax on exports
* subsidy on imports

42

Key questions to ask in identifying economic exposure

* Where is the company selling?
* Who are the company’s key competitors?
* How sensitive is demand to price?
* Where is the company producing?
* Where are the company’s inputs coming from?
* How are the company’s inputs and outputs priced?

43

Advantages of international investing

1.offers more opportunities
2. diversification (side benifit of 1 )

44

What is translation exposure

arises when reporting and consolidating financial statements requires conversion from local to home currency

45

Why to we care about foreign currency accounting

CF is basis for valuation

46

Systematic risk:

* risk present in all investment opportunities
* cannot be eliminated

47

How can a domestic company with no accounting exposure be exposed to currency risk?

eg. skiing in aspen

48

Basic hedging strategy for reducing translation expsoure

* increase hard currency asset
* decrease soft currency assets
* increase soft currency libaility
* decrease hard currency liability

49

Hedging methods

* Forward market hedge
* Money market hedge
* Risk shifting
* Pricing decisions
* Exposure netting
* Currency risk sharing
* Currency collars
* Cross-hedging
* Foreign currency options

50

Foreign currency options

* good for when quantity of FX is uncertain
* call option valuable when offered to buy a foreign asset at fixed price (limit downside to premium if bid is rejected)
* put: insure profit margin
* hedge anticipated sales or purchase
* hard to chard in FC
* protect margins in HC

51

Money market hedge

* Simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow
* “Homemade” forward contract

52

Risk shifting

* home currency invoicing
* zero sum game
* common for global businesses

53

Methods of international investing

* ADR
* GDR
* ETF
* Internationally diversified MFs
* MNCs
* Bonds

54

Foreign Exchange Exposure

– the degree to which a company is affected by exchange rate changes

55

Important aspects of hedging

* degree of centralization
* responsibility for developing and implementing the hedging strategy

56

Option value

* intrinsic + time value
* affected by volatility of exchange rate, time to expiration and interest rate differential
* when domestic r > foreign r, calls higher, puts lower

57

production management options

* input mix (shop the world)
* shift production among plants
* plant location
* raising productivity

58

Pricing decisions

* general rule on credit sales overseas
* conver foreign price to home price using forward, not spot rate
* use weighted average w. multiple payments

59

Example: Bombardier to receive NFr 50M from Norden Airlines in 6 months: Borrow PV(NFr 50M), NFr → C$, lend C$

This is an example of a money market hedge

60

Quoting futures and forwards

1.Future
* American ($/FC)
2.Forward
* Euro (FC/$)

61

Salient difference between futures, forwards and options

Futures/forwards must take delivery,

-options have no obligation

62

What is the objective a hedge

* reduce/ eliminate vol of CF as a result of exchange rate changes
* not a profit centre
* should be evaluated as a purchase of insurance

63

Total risk

= systematic + nonsystematic

64

If international fischer effect holds

firms face no exposure on foreign currency denominated transactions

65

How to manage exposure

hedge

66

Factors that can distort the base for incremental cf

* Cannibalization
* Sales creation
* Opportunity cost
* Transfer pricing
* Fees and royalties
* Getting the base case right
* Accounting for intangible benefits

67

What is a forward market hedge

* Consists of offsetting a receivable (or payable) in a foreign currency using a forward contract:
* eliminate downside risk at expense of upside potential

68

Three types of exposure

1. Translation
2. Transaction
3. Operating

69

Higher the price elasticity of demand

* more currency risk the firm faces by product substituion
* eg. lower end of car market in the US

70

When and how does Exposure netting work

* offset positively correlated currencies, (offset long with short)
* Offset negatively correlate currencies with another short

71

disadvantages of futures

* limited number of currencies
* rigid contract size (eliminated from emicro)
* create CF problems
* limited delivery date (not really an issue, explain why )

72

Option price influenced by interest rates

if domestic > foreign, calls are higher, puts a

73

what affects the price of a currency option

* volatility of exchange rate
* time to expiration
* interest rate differential between 2 currencies

74

put call parity

(St / 1+rf) + P - x/(1+rh) = C

75

Convert then discount method

((0.9 x 1.03 ) - (0.65x1.3) x 0.27 x 1.03/1.3) / (1.05x1.03) -1 -0.03