FOREIGN EXCHANGE RISK
Spot rate is the rate of exchange in currency for immediate delivery.
Forward rate： is an exchange rate set now for currencies to be exchanged at a future date.
Selling rate： also know as offer or ask price, is the rate that bank sells the currency.
Buying rate： also known as bid price, is the rate that bank buys the currency.
Depreciation and appreciation of a foreign currency
If a foreign currency depreciates it is simply worth less in our home currency
Eg. $1 = RMB 8 $1 = RMB 6 $ depreciate
Receipt - adverse movement - will receive less in your home currency.
Payment - favorable movement - will end up paying less in your home currency.
If a foreign currency appreciates it is simply worth more in our home currency
Eg. $1= RMB 6 $1 = RMB6.3 $ appreciate
Receipt – favorable movement - will receive more in your home currency.
Payment - adverse movement - will end up paying more in your home currency.
2 Types of currency risk
Translation Risk
This is the risk that the organisation will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the home currency. Translation losses can result, for example, from restating the book value of a foreign subsidiary's assets at the exchange rate on the statement of financial position date.
Note that this is purely a paper-based exercise - it is the translation not the conversion of real money from one currency to another.
Unless managers believe that the company‘s share price will fall as a result of showing a translation exposure loss in the company’s accounts, translation exposure will not normally be hedged. The company‘s share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.
Transaction Risk
Is the risk of an exchange rate changing between the transaction date and the subsequent settlement date i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component of treasury management.
Economic Risk
This refers to the effect of exchange rate movements on the international competitiveness of a company and refers to the effect on the present value of longer term cash flows.
For example, a UK company might use raw materials, which are priced in US dollars, but export its products mainly within the EU. A depreciation of sterling against the dollar or an appreciation of sterling against other EU currencies will both erode the competitiveness of the company.
Economic exposure can be difficult to avoid but a favored strategy is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.
3 The causes of exchange rate fluctuations
3.1 Currency supply and demand
Demand comes from individuals, firms and governments who want to buy a currency. Supply comes from those who want to sell it.
Supply and demand for currencies are in return influenced by:
① The rate of inflation, compared with the rate of inflation in other countries
② Interest rates, compared with interest rates in other countries
③ The balance of payments in goods and services
④ Transactions of a capital nature, such as inward or outward foreign investment
⑤ Sentiment of foreign exchange market participants regarding economic prospects
⑥ Speculation
⑦ Government policy on intervention to influence the exchange rate.
Balance of payment
Since currencies are required to finance international trade, change in trade may lead to changes in exchange rates. In principal:
·Demand for imports in the UK represents a demand for foreign currency or a supply of pounds.
·Oversea demand for UK exports represents a demand for pounds or a supply of the currency.
Thus a country with a home currency account deficit where imports exceed exports may expect to see its home currency depreciate, since the supply of the home currency （imports） will exceed the demand for the home currency （exports）.
Any factors which are likely to alter the state of the current account of the balance of payments may ultimately affect the exchange rate.
3.2 Purchasing power parity theory
PPPT claims that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country.
PPPT is based on the Law of One Price, i.e. identical goods must cost the same regardless of the currency in which they are sold.
Purchasing power theory can be used as our best predictor of future spot rates, however it suffers from the following major limitations:
1） The future inflation rates are only estimates.
2） The market is dominated by speculative transactions （98%） as opposed to trade transactions; therefore purchasing power theory breaks down.
3） Government intervention: Governments may manage exchange rates, thus defying the forces pressing towards PPPT.
In the real world, exchange rates move towards purchasing power parity only over long term. However the theory is sometimes used to predict future exchange rates in investment appraisal problems where forecasts of relative inflation rates are available.
1.3.3 Interest rate parity theory
The Interest Rate Parity theory claims that the difference between the spot and the forward exchange rates is equal to the differential between interest rates available in the two currencies
If you need to calculate the forward rate in one year's time.
If you need to estimate the forward rate, simply apply the following formula:
The IRPT may be useful in practice, however it suffers from the following limitations:
·Government controls on capital markets
·Government controls on currency trading
·Government intervenes in foreign exchange markets
1.3.4 Expectations theory
The expectations theory claims that the current forward rate is an unbiased predictor of the spot rate at that point in the future.
1.3.5 The International Fisher effect
The fisher effect looks at the relationship between interest rate and expected inflation rate.
（1+nominal rate）=（1+real rate） （1+inflation rate）
（1+i） = （1+r）（1+h）
The International Fisher Effect claims that the nominal interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange.
International Fisher Effect assumes that all countries will have the same real interest rate.
The currency of countries with relatively high interest rates is expected to depreciate against currencies with lower interest rate, because the higher interest rate are considered necessary to compensate for the anticipated currency depreciation.
1.3.6 Four-way equivalence
The four-way equivalence model states that in equilibrium, difference between forward and spot rates, differences in interest rates, expected differences in inflation rate and expected changes in spot rates are equal to one another.
（1） Inflation rates can be used to predict the future spot rate （PPPT）; if inflation rate is higher in country A then the currency A would be expected to devalue against the currency in country B, and
（2） Long-term interest rates can be used to predict the future spot rate （international Fisher effect）
（3） In other words, the theories are linked to each other.
1.4 Foreign currency risk management
1.4.1 The minor techniques
（1） Invoice in home currency
One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.
However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier. Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.
（2） Leading and lagging
>> Lead payments （payments in advance for goods purchased in a foreign currency）
>> Lagged payments （ delaying payments beyond their due date for goods purchased in a foreign currency）
If an importer （payment） expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.
If an exporter （receipt） expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.
（3） Matching receipts and payments
When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other. It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions. Suppose that ABC plc has the following receipts and payments in three months time:
（4） Matching assets and liabilities
A company that expects to receive a substantial amount of income in a foreign currency will be concerned that this currency may weaken. It can hedge against this possibility by borrowing in the foreign currency and using the foreign receipts to repay the loan.
For example, US dollar receivables can be hedged by taking out a US dollar overdraft. In the same way, US dollar trade payables can be matched against a US dollar bank account, which is used to pay the suppliers.
A company which has a long-term foreign investment, for example an overseas subsidiary, will similarly try to match its foreign assets （property, plant etc） by a long-term loan in the foreign currency.
（5） Netting
Unlike matching, netting is not technically a method of managing exchange risk. Its objective is simply to save transaction costs by netting off inter-company balances before arranging payment.
Many multinational groups of companies engage in intra-group trading. Where related companies located in different countries trade with one another. Netting is a process in which credit balances are netted off against debit balances so that only the reduced net amounts remain due to be paid by actual currency flows.
1.5 The major techniques
1.5.1 Forward Contracts
A forward contract fixes in advance the rate at which a specified quantity of currency will be bought and sold.
A forward exchange contract is defined as:
a.An immediately firm and binding contract, eg between a bank and its customer
b.For the purchase or sale of a specified quantity of a stated foreign currency
c.At a rate of exchange fixed at the time the contract is made
d.For performance （delivery of the currency and payment for it） at a future time which is agreed when making the contract. （This future time will be either a specified date, or any time between two specified dates.）
Spot Market: where you can buy and sell a currency now （immediate delivery） i.e. the spot rate of exchange.
Forward Market: where you can buy and sell a currency, at a fixed future date for a predetermined rate i.e. the forward rate of exchange.
A forward exchange rate may be higher or lower than the spot rate. When a currency is more expensive forward than spot, it is quoted forward ‘at a premium’ to the spot rate. When a currency is cheaper forward than spot, it is quoted forward ‘at a discount’ to the spot rate.
Example:
The spot rate SFr/￡ SFr1.4460 – SFr1.4560
The three months forward rate is Swiss franc at a discount to the spot rate SFr0.0220 - SFr0.0240
Forward rate: SFr 1.4680（1.4460+0.0220） – SFr 1.4800（1.4560+0.0240）
Assuming an UK exporter will received 30,000 Swiss franc in 3 months’ time, if forward contract is used, then the amount of sterling will be received: 30,000 / 1.48 = ￡20,270
Comment on forward contract/FRA
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Advantages: · The contract can be tailored to user’s exact requirement. · The trader will know in advanced how much money/interest will be received or paid. · Payment is not required until the contract is settled. |
Disadvantages: · The user may not be able to negotiate good term, the price/interest rate may depend on the size of the deal and how the user is rated. · Users have to bear the spread of the contract between the buying and selling price/deposit and loan interest rate. · Forward contract may not be available in the currencies that the customer requires. |
1.5.2 Money Market Hedges
If you are hedging a payment you buy the present value of foreign currency amount today at the spot rate. This results in an immediate payment in sterling. The foreign currency which you purchased is placed on deposit and accrues interest until the transaction date. Then the deposit is used to make the foreign currency payment.
Comments
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Advantage: Under the money market hedge we buy or sell the foreign currency today using the current spot rate, therefore the forex risk is eliminated. We do not have to worry about any future adverse movement because we use today's rate. |
Disadvantage: This approach has obvious cash flow implications which may prevent a company from using this method e.g. if a company has a considerable overdraft it may be impossible for it to borrow funds now. |
Example 1
A UK company has a payable of US $450,000 to a US company, in 3 months time. The company treasurer has determined the following:
Should a forward contract hedge or a money market hedge be undertaken?
MONEY MARKET HEDGE:
①After three months, the company will pay $450,000, so now it needs to make a $ deposit for the payment in the future.
②It needs to put $444,444 on deposit now, so that the principal plus the interest earned will match the payment in three months time.
③The $444,444 needs ￡ 261,438 to exchange at current spot rate 1.7000.
④The ￡ 261,438 will be borrowed from bank for 3-month with repayment amount of ￡ 266,340.
Forward market hedge:
$450,000/ 1.6902 = ￡266,241
The final payment using money market hedge will be ￡ 266,340, using forward market hedge will be ￡266,241 which is less. So the forward market hedge is financially viable.
Example 1 continued
The company will receive US $900,000 in 6 month's time.
All other factors are the same.
Should a forward contract hedge or a money hedge be undertaken?
MONEY MARKET HEDGE:
①After six months, the company will receive $450,000, so now it needs to make a $loan against the receipts in the future.
②It needs to borrow $871,671 now, so that the principal plus the interest payable will match the receipts in six months time.
③The $871,671 could be exchanged to ￡ 511,544 at current spot rate1.7040.
④The ￡ 511,544 will be deposited in the bank for 6-month with final receipts amount of ￡ 526,890.
Forward market hedge:
$900,000/ 1.6809 = ￡535,427
The final receipts using money market hedge will be ￡ 526,890, using forward market hedge will be ￡535,427 which is more. So the forward market hedge is financially viable.
1.5.3 Currency Futures
A currency future is a standardized, market-traded contract to buy or sell a specified quantity of foreign currency.
Currency futures can be used to hedge currency risk in the same way as forward contracts. But futures are exchange-traded instruments whereas forward contracts are over the counter transactions. Differences as following:
| Currency futures | Forward contracts |
| Standard contracts | Bespoke contracts |
| Exchange traded | Traded over the counter |
| Flexible close out dates | Fixed date of settlement |
| Settled at the spot rate | Settled at the forward rate |
| Cheaper than forwards | Relatively high premium required |
The contract size is the fixed minimum quantity, and dealing on futures markets must be in a whole number of contracts.
A future’s price may be different from the spot price, and this difference is the basis.
Basis=Futures price-Spot price
One tick is the smallest measured movement in the contract price, 0.0001=1 tick
Note: you will not be expected to do future calculations in the exam but you could understand how they work.
A US company buys goods worth
720,000 from a German company payable in 30 days. The US company wants to hedge against the risk.Current spot is 0.915-$0.9221 per
1 and the futures rate is $0.9245 per 1.The standard size of a three-month futures contract is
125,000.In 30 days’ time the spot is $0.9345 - $0.9351 per
1.Closing futures price will be $0.9367 per
1.Evaluate the hedge.
1.5.3.1 Futures contract hedge
Step 1. Set up the hedge
Buy or Sell
We need to buy
or sell $.As the futures contract is in
, we need to buy futures.| Spot market: |
Selling |
Buying |
|
| Future markets | Sell future contracts | Buy future contracts |
b） Number of contracts
Number of contracts = Amount of $ / $ contract standard size
c）. Determine which month future to be bought
Future contracts are issued on a three-month cycle. The contracts mature （expire） at the end of March, June, September and December. It is normal to choose the first contract to expire after the conversion date.
e.g. Conversion on the 22nd February March contracts
Conversion on the 5th June June contracts
Step 2: Closing futures price
We’re told it will be 0.9367
Step 3: hedge outcome
a） Outcome in futures market
opening futures price 0.9245 （buy at low price）
Closing futures price 0.9367 （sell at high price）
Movement in ticks : 122 ticks profit
Futures profit/loss: 122ticks*$125,0000*6 contracts=$9,150
b） Net outcome
Spot market payment （720,000*0.9351） = $673,272
Futures market profit $（9,150）
Final payment $664,122
If the spot market makes a profit, the futures markets will suffer a loss and vice versa.
1.5.3.2 Objective of future
Target: To lock the company into the effective currency rate. To hedge both adverse and favorable interest rate movements.
However future hedges are normally imperfect i.e. the company pays or receives foreign currency close to the target figure but not the actual target figure.
Future are traded on margin
When a futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin.
If losses are incurred, the buyer or seller may be called on to deposit additional funds （variation margin） with the exchange. Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.
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Advantages: · Futures are tradeable and can be bought and sold on a secondary market so there is price transparency, determined by the market. · Transaction costs are generally lower than for forward contracts. · The exact date of payment or receipts of the currency does not have to be known, because future contract does not have to be closed out until the actual cash receipts or payment is made. |
Disadvantages: · The contracts can not be tailored to the user’s exact requirement. · The futures hedge is imperfect due to: >>Basis risk- the future rate （as defined by the future prices） moves approximately but not precisely in line with the cash market rate. >>Have to round to whole contracts · Future contract may not be available in the currencies that the customer requires. |
1.5.4 Currency Options
· A currency option is a right of an option holder to buy （call） or sell （put） a quantity of one currency in exchange for another, at a specified rate on or before a future expiry date.
· The right will only be exercised to protect against an adverse movement i.e. the worst-case scenario.
· Buying a currency option involves paying a premium, which is a cost of using an option, thus more expensive than the forward contracts and futures.
· A European option can only be exercised on the expiry date whilst an American option can be exercised at any time up to the expiry date.
· A company can choose whether to buy:
– A tailor-made currency option from a bank, suited to the company’s specific need. They are over the counter （OTC） options; or
– A standard option, in certain currencies only, from an option exchange. Such options are traded or exchange traded options.
For example, a company may buy a currency call option, giving it the right to buy
6,000,000 in 2 months’ time in exchange for dollars at an exercise rate of 1.5000 per $. Buying the euros at this rate would cost $4,000,000.（a） If the spot exchange rate at the exercise rate is
1.60, the option holder will let the option lapse and will buy the euros at the spot rate for $3,750,000.（b） If the spot exchange rate at the exercise rate is
1.40, the option holder will exercise the option and will buy the euros at the exercise rate of 1.50 , cost $4,000,000. （Buying at the spot rate would cost $4,285,714）|
Advantages ①Protect against adverse movements and allow you to take advantage of favorable movements. ②They are a useful hedge when the company is unsure whether a future foreign exchange risk will occur, for example when tendering for a contract. ③They provide an effective currency hedge. Especially when foreign exchange markets are volatile. |
Disadvantages: ①The cost of the premium. The premium is relatively expensive and payable whether the option is exercised or not. ②Options must be paid for as soon as they are bought. ③Tailor-made options lack flexibility ④Exchange trade options are only available in a small number of currencies. |
1.5.5 Currency SWAP
·A swap is a formal agreement whereby two organizations contractually agree to exchange payments on different terms, eg in different currencies.
·Currency swaps effectively involve the exchange of debt from one currency to another.
·It provide hedge against exchange rate movement for longer period than forward market, and can be means of obtaining finance form new countries.
·In practice, most currency swaps are conducted between banks and their customers.
For example:
Step 1.
Edted, a UK company, wishes to invest in Germany. It borrows ￡20m from its bank and pays interest at 5%. To invest in Germany, the ￡20m will be converted into euros at a spot rate of ￡1= ?1.30. The earnings from the German investment will be in euros, but Edted will have to pay interest on the swap. Gordonbear, a company in the euro currency zone but plans to invest ?6m in UK, faces the similar problem.
Edted arranges to swap the ￡20m for ?6m with Gordonbear, thus the counterparty in this transaction. Interest of 6% is payable on the ?6m. Edted can use the ?6m it receives to invest in Germany and Gordonbear can use the ￡20m to invest in UK.
Step 2. Each year when interest is due:
（a） Edted receives from its German investment cash remittances of ?.56m （?6m *6%）
（b） Edted passes this ?.56m to Gordonbear so that Gordonbear can settle its interest liability.
（c） Gordonbear passes to Edted ￡1m （￡20m*5%）.
（d） Edted settles its interest liability of ￡1m with its lender.
Step 3. At the end of the useful life of the investment the original payments are reversed with Edted paying back the ?6m it originally received and receiving back from Gordonbear the ￡20m . Edted uses the ￡20m to repay the loan it originally received from its UK lender.
Benefits of currency swaps
·Easy to arrange and flexible （any size and reversible）
·Transaction costs are low, only amounting to legal fees.
·Obtain the required currency without suffering exchange risk.
·Access to debt finance in another country and obtain a lower interest rates.
·Restructuring the currency base of the company’s liabilities
2.INTEREST RATE RISK
2.1 INTEREST RATE EXPOSUE
Interest rate risk refers to the risk of an adverse movement in interest rates and thus a reduction in the company's net cash flow.
GAP EXPOSURE
A negative gap occurs when a firm has a larger amount of interest-sensitive liabilities maturing at a certain time or in a certain period than it has interest-sensitive assets maturing at the same time. The difference between the two amounts indicates the net exposure.
Positive gap occurs if the amount of interest-sensitive assets maturing at a particular time exceeds the amount of interest-sensitive liabilities maturing at the same time.
With a negative gap, the company faces exposure if interest rates rise by the time of maturity.
With a positive gap, the company will lose out if interest rates fall by maturity.
Adverse Interest Rate Movements
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