FM Flashcards
(31 cards)
What is operating risk exposure primarily affected by?
A firm’s ability to adjust its cost structure and raise prices of products/services.
How can a company measure economic exposure, according to Shapiro’s approach?
By assessing the correlation between variations in the dollar value of cash flows and variations in the nominal exchange rate through regression analysis.
In the regression equation for measuring economic exposure, what does the foreign exchange beta coefficient (b) indicate?
It measures the sensitivity of dollar cash flows to exchange rate changes; a higher value indicates greater exposure.
What do a larger ‘t’ value and a higher R-squared value imply in the context of the regression equation for economic exposure?
A larger ‘t’ value implies a higher level of confidence in the beta coefficient, and a higher R-squared indicates a greater fraction of cash flow variability explained by exchange rate variations.
What is foreign exchange risk?
The possibility of loss to a business unit due to unfavorable movement in foreign exchange rates.
What is Foreign Exchange Risk Management (FERM)?
The process through which finance managers try to eliminate/reduce the adverse impact of unfavorable changes in the foreign exchange rates to a tolerable level.
What are the four major external techniques of Foreign Exchange Risk Management (FERM)?
Forward contracts, currency futures, currency options, and swaps.
What is a forward exchange contract?
An agreement to buy or sell foreign currency in exchange for home currency at a specific future date at a predetermined exchange conversion rate.
What are the key specifications in a typical forward contract?
Contract amount, forward exchange rate, parties to the contract, specified date of delivery, name of foreign currencies involved, and terms and conditions for cancellation.
What is a futures contract?
A standardized agreement to buy or sell a pre-specified amount of foreign currency in the futures market at some specified future date.
How do futures contracts differ from forward contracts?
Futures contracts are standardized, traded on an organized exchange with a clearing house, more liquid, require guarantee deposits/margins, and have reduced default risk.
What is a currency option?
A financial instrument that provides its holder a right but no obligation to buy or sell a pre-specified amount of a foreign currency at a pre-determined rate in the future.
What is a call option?
The holder has the right to buy a specific currency at a specific price on a specific maturity date or within a specified period of time, but is under no obligation to buy.
What is a put option?
The holder has the right, but no obligation, to sell a specified amount of currency at a pre-fixed price on or up to a specified date.
What are swaps in the context of foreign exchange risk management?
Exchange of debt obligations (interest and/or principal payments) between two parties, including interest swaps and currency swaps.
What are interest swaps?
Exchange of interest obligations between two parties.
What are currency swaps?
Two parties agree to pay each other’s debt obligations denominated in different currencies.
How can money market operations be used to hedge foreign exchange risk?
By borrowing home currency, buying the required foreign currency in the spot market, and investing it in forex money markets to yield interest in the desired foreign currency.
What is ‘leading’ in the context of internal hedging techniques?
Collecting from foreign currency debtors expeditiously before they are due (when the home currency is expected to strengthen) and paying foreign currency creditors before their due date.
What is ‘lagging’ in the context of internal hedging techniques?
Delaying receipts from foreign currency receivables whose currencies are likely to appreciate and delaying payments of foreign currency payables whose currencies are likely to depreciate.
How does invoicing/billing in the desired currency hedge foreign exchange risk?
By ensuring the firm knows the precise amount it will receive from sales or pay for purchases in its home currency.
How do indexation clauses hedge foreign exchange risk?
By adjusting prices in contracts to account for adverse movements in exchange rates, shifting the risk to one party or sharing it between parties.
How does shifting the manufacturing base hedge foreign exchange risk?
By locating production in a country where there are substantial sales, creating a built-in hedge as costs and revenues are in the same currency.
What is netting, and what are its types?
Settling foreign currency receivables and payments on a net balance basis, including bilateral (two parties) and multilateral (more than two parties) netting.
