Hedging Flashcards
(22 cards)
What is purchasing power parity
It claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries
Higher inflation = depreciation in currency
How to estimate future spot rates with PPP
Current spot rate * 1+foreign inflation/1+uk inflation
What is interest rate parity theory
It claims that the difference between the spot and future exchange rates is equal to the differential between interest rates available in two currencies
How to estimate future spot rates with IRP
Current spot rate * 1+foreign interest rate/1+uk interest rate
Risks of overseas trade
Physical risk
Trade risk
Liquidity risk
Credit risk
Types of financial risk
Transaction risk
Economic risk
Translation risk
What is transaction risk
The risk that the exchange rate will change between date of contract and date of settlement
What is economic risk
Value of the business will be affected by long run changes in exchange rates
What is translation risk
Reported performance will be affected by exchange rate movements
How to manage economic risk
Diversify internationally
How to manage transaction risk
Invoice in sterling
Leading and lagging
Matching assets and liabilities
Foreign currency bank accounts
Forward advantages
Tailor made, any product any time
Avoid downside
Forward disadvantages
No upside
Binding agreement, must go ahead
Futures advantage
Contract and transaction seperate
Avoid downside
Futures disadvantage
No upside
Standard size contracts, not tailor made, can be imperfect
Option advantage
Don’t have to exercise
Flexibility
Avoid downside and benefit from upside
Option disadvantage
Expensive
FRA 5-8 meaning
Forward rate agreement starting in 5 months for 3 months
FRA priced at 3.2 - 2.6
Borrow 3.2%
Deposit 2.6%
Advantage of swaps
Can run for 30 years
Transaction costs cheaper
Hedge against adverse movement
Disadvantage of swaps
Counterparty risk
Market risk
Transparency risk
