Foreign Exchange and Hedging Strategies

Question 1

What is the foreign exchange market?

Answer 1

Where pairs of currencies can be bought and sold in exchange for one another i.e. £, $ and euros.

Question 2

What is a FX rate?

Answer 2

The number of foreign currency units per unit of the domestic currency.

i.e. if the US Dollar Sterling ($/£) rate is 1.6000 then $1.6 (foreign) is equivalent to £1 (domestic)

Question 3

How do you convert a domestic currency amount to the foreign currency?

Answer 3

Multiply by the FX rate.

i.e. £10,000 = £10,000 x 1.6 = $16,000.

Question 4

How do you convert a foreign currency amount to the domestic currency?

Answer 4

Divide by the fx rate.

i.e. $16,000 = 16,000/1.6 = £10,000

Question 5

What is the 7 types of terminology within a FX Rate structure? (slide 4).

Answer 5

1. Offer - the dealing rate when buying the domestic currency and selling the foreign currency.
2. Pm - the premium of the spot rate over the forward rate (in pips)
3. ds - the discount of the spot rate to the forward rate (in pips)
4. Bid - the dealing rate when selling the domestic currency and buying the foreign currency
5. £/$ - US Dollars (foreign) per UK Pound (domestic)
6. Spot - the rate for dealing today and settling today
7. Foward – the rate for dealing today but settling in the future

Question 6

How do you calculate forward rates? (slides 5-6)

Answer 6

1. deduct premiums (pm) from the spot rate

2. Then add discounts (ds) to the spot rate

Question 7

What are FX rates in the long term?

Answer 7

Determined by relative levels of national economic growth which will ultimately impact on Inflation rates; and Interest rates.

Question 8

What are Fx rates in the short term?

Answer 8

Volatile and Unpredictable

Question 9

What 3 types of foreign exchange risks are companies exposed to?

Answer 9

1. Economic risk - All companies
2. Translation risk - Companies which have overseas assets and/or liabilities.
3. Transaction risk - Companies which import and/or export.

Question 10

What is economic risk?

Answer 10

The risk that a significant and permanent FX rate movement will adversely and permanently affect a company’s competitive position

Question 11

What happens when the domestic currency is devalued? economic risk) (weakened)

Answer 11

Exporters benefit but importers suffer.

Question 12

What happens when the domestic currency is revalued? economic risk) (strengthened)

Answer 12

importers benefit but exporters suffer.

Question 13

What can economic risk NOT be?

Answer 13

Avoided even if the company trades purely in its domestic economy

Eliminated, only reduced by having a global spread of operations

Question 14

What types of companies does translation risk affect?

Answer 14

Companies with overseas assets and/or liabilities.

Question 15

What happens to these assets/liabilities when dealing with translation risk?

Answer 15

Have to be translated to the domestic currency at the spot rate prevailing at the financial year end (balance sheet date)

Question 16

Where does this translation risk arise from?

Answer 16

From FX rates moving between balance sheet dates and changing the net asset value of the company.

Question 17

How can translation risk be reduced?

Answer 17

By matching overseas assets and liabilities (i.e. borrowing overseas to fund overseas projects)

Question 18

Who does transACTION risk affect?

Answer 18

Importers and exporters taking/giving trade credit.

Question 19

How can transAction arise?

Answer 19

From the FX rate moving between the order date and the settlement date.

Order date - the date that the company agrees to buy/sell goods in a foreign currency; and

Settlement date - the date that the company pays for/is paid for goods in the foreign currency

Question 20

What types of fx rate movements are within the transACTION risk?

Answer 20

1. Adverse - real cash losses in the domestic currency (i.e. lower than expected sales revenues for exporters)
2. Favourable - real cash gains in the domestic currency (i.e. lower than expected costs for importers)

Question 21

How can you reduce transACTION risk?

Answer 21

Hedge it.

Question 22

How do you manage FX Transaction Risk? (slide 15)

Answer 22

On the day that a company receives an export order or places an import order it can either take no action and accept the FX transaction risk or

Take action to reduce/eliminate the FX transaction risk by employing Internal strategies; and/or External hedging strategies.

Question 23

What are the Internal strategies to TransACTIONrisk?

Answer 23

1. Request settlement in domestic currency.

2. Matching and netting when a company is a regular importer and exporter.

Question 24

What happens when you request a settlement in domestic currency? (Internal strategy of transACTION risk).

Answer 24

Transfers all FX transaction risk to customer / supplier as there are no transaction costs; BUT it’s only possible if there is high bargaining power. This is because you may not be able to agree a fair exchange rate.

Question 25

Why do importer/ exporter companies match and net? (slide 16).

Answer 25

Match foreign currency receipt and payment dates Net foreign currency receipts and payment amounts Hedge net exposure

Question 26

How 4 markets can the FX transaction risk be hedged?

Answer 26

1. Forward market (physical) 2. Money market (physical) 3. Currency futures market (derivative) 4. Currency options market (derivative)

Question 27

What 5 hedging implications should companies consider when deciding their hedging strategy?

Answer 27

1. Availability - can the exposure be hedged? 2. Cost: Implicit (domestic currency payment / receipt) Explicit (hedge set-up costs) 3. Flexibility - can the hedge be altered in the future if required? 4. Efficiency - can a perfect hedge be achieved which exactly matches the exposure (amount and date)? 5. Complexity - the pricing mechanisms in derivative markets are more complex than in physical markets

Question 28

How do importer companies set up when they are doing a money market hedge?

Answer 28

Borrow in domestic money market, buy foreign currency in the spot market and lend in foreign money market

Question 29

How do exporter companies set up when they are doing a money market hedge?

Answer 29

Lend in domestic money market, sell foreign currency in the spot market and borrow in foreign money market

Question 30

What is the 2 advantages if a money market hedge?

Answer 30

1. Perfect hedge can be achieved to eliminate FX transaction risk 2. Flexibility – can be unwound or rolled-forward easily

Question 31

What are the 2 disadvantages of a money market hedge/?

Answer 31

1. Higher transaction costs than forwards | 2. Need access to the foreign money market

Question 32

FORWARD VS MONEY MARKET HEDGE EXAMPLE (SLIDES 21 - 26)

Answer 32

must learn this john

Question 33

How do you set up hedges with currency futures?

Answer 33

Buy or sell one or more currency future contracts on order date and close position on settlement date - If the FX rate movement is adverse then gain in value of the futures position will offset the underlying currency losses and vice versa.

Question 34

What is the 3 advantages of hedging with currency FUTURES?

Answer 34

1. Lowest cost derivative 2. High market liquidity – can hedge large exposures quickly 3. Flexible – can unwind or roll-forward in the market

Question 35

What is the 2 disadvantages of hedging with currency FUTURES?

Answer 35

1. Currency futures only available for major currency pairs 2. Futures only trade on exchanges so contracts have standardised size and thus may not be possible to achieve a perfect hedge

Question 36

How do you set up hedges with currency OPTIONS?

Answer 36

1. Buy or sell one or more currency options on the order date either: on exchange (cheaper but only certain pairs and hedge efficiency issues) or over-the-counter (More expensive but any pair and perfect hedge possible) 2. Close position (or exercise option) on the settlement date

Question 37

What is an advantage of hedging with currency OPTION?

Answer 37

Options cap rather than fix prices which means it protects against adverse FX rate movements; and offers some benefit from favourable FX rate movements.

Question 38

What are the 3 disadvantages of hedges with a Currency OPTION?

Answer 38

1. Most expensive hedging method 2. Less liquidity than futures markets 3. Complex pricing mechanism introduces additional risks

Question 39

What is the 3 upsides of hedging FX transACTION risk? (Hedging debate)

Answer 39

1. Reduces the risk of corporate failure 2. Reduces the volatility of cash flows 3. Reduces the cost of capital; which should increase shareholder wealth on balance.