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Topic H
Risk
management
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PART H-19
Foreign currency risk
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Topic list
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Study guide
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Study guide
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Exam guide
• This is an important chapter. You need to
have a good understanding of various
hedging methods, and be able to
determine in a given situation what
exposure needs hedging and how best to
do it.
• Pilot Paper question 2 requires a good
working knowledge of exchange rate
topics.
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Foreign currency risk
•
•
•
•
Foreign currency risk
Causes of exchange rate fluctuations
Foreign currency risk management
Derivatives
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Exchange rates
Key terms
• An exchange rate is the rate at which one
country's currency can be traded in exchange for
another country's currency.
• The spot rate is the exchange or interest rate
currently offered on a particular currency or
security. The spot rate is the rate of exchange in
currency for immediate delivery.
• The forward rate is an exchange rate set now for
currencies to be exchanged at a future date.
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Question
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Foreign currency risk
Fast forward
Currency risk occurs in three forms:
transaction exposure (short-term),
economic exposure (effect on present
value of longer term cash flows) and
translation exposure (book gains or
losses).
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Question
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The causes of exchange rate
fluctuations
Fast forward
Factors influencing the exchange rate
include the comparative rates of inflation in
different countries (purchasing power
parity), comparative interest rates in
different countries (interest rate parity), the
underlying balance of payments,
speculation and government policy on
managing or fixing exchange rates.
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The causes of exchange rate
fluctuations
•
•
•
•
•
•
Supply and demand for currencies are in turn influenced
by:
The rate of inflation, compared with the rate of inflation in
other countries
Interest rates, compared with interest rates in other
countries
The balance of payments
Sentiment of foreign exchange market participants
regarding economic prospects
Speculation
Government policy on intervention to influence the
exchange rate
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Interest rate parity
Key term
Interest rate parity is a method of
predicting foreign exchange rates based
on the hypothesis that the difference
between the interest rates in the two
countries should offset the difference
between the spot rates and the forward
foreign exchange rates over the same
period.
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Formula
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Example: interest rate parity
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Example: Interest rate parity
A Canadian company is expecting to receive
Kuwaiti dinars in one year's time. The spot rate
is Canadian dollar/dinar 5.4670. The company
could borrow in dinars at 9% or in Canadian
dollars at 14%. There is no forward rate for one
year's time. Predict what the exchange rate is
likely to be in one year.
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Purchasing power parity
Key term
Purchasing power parity theory states that
the exchange rate between two currencies
is the same in equilibrium when the
purchasing power of currency is the same
in each country.
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Formula
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Example: Purchasing power
parity
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Case study
• An amusing example of purchasing power parity is the
Economist's Big Mac index. Under PPP movements in
countries' exchange rates should in the long-term mean
that the prices of an identical basket of goods or services
are equalized. The McDonalds Big Mac represents this
basket.
• The index compares local Big Mac prices with the price
of Big Macs in America. This comparison is used to
forecast what exchange rates should be, and this is then
compared with the actual exchange rates to decide
which currencies are over and under-valued.
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The Fisher effect
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Formula
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Four-way equivalence
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Foreign currency risk
management
Fast forward
Basic methods of hedging risk include
matching receipts and payments, invoicing
in own currency, and leading and lagging
the times that cash is received and paid.
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Foreign currency risk
management
• (a) Firstly, a business may wish to reduce risks to which
it is exposed to acceptable levels. What is an acceptable
level of risk may depend upon various factors, including
the scale of operations of the business and the degree to
which its proprietors or shareholders are risk-averse.
• (b) Secondly, a business may wish to avoid particular
kinds of risks. For example, a business may be averse to
taking risks with exchange rates. The reasons may
include the fact that the risks are simply too great for the
business to bear, for example if exchange rate
movements could easily bankrupt the business.
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Currency of invoice
• (a) There is the possible marketing advantage by
proposing to invoice in the buyer's own currency, when
there is competition for the sales contract.
• (b) The exporter may also be able to offset payments to
his own suppliers in a particular foreign currency against
receipts in that currency.
• (c) By arranging to sell goods to customers in a foreign
currency, a UK exporter might be able to obtain a loan in
that currency at a lower rate of interest than in the UK,
and at the same time obtain cover against exchange
risks by arranging to repay the loan out of the proceeds
from the sales in that currency.
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Leading and lagging
• Lead payments (payments in advance)
• Lagged payments (delaying payments
beyond their due date)
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Netting
Key term
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.
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Example: Netting
A and B are respectively UK and US based
subsidiaries of a Swiss based holding company.
At 31 March 20X5, A owed B SFr300,000 and B
owed A SFr220,000. Netting can reduce the
value of the intercompany debts: the two
intercompany balances are set against each
other, leaving a net debt owed by A to B of SFr
80,000 (SFr300,000 - 220,000).
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Forward exchange contracts
Fast forward
A forward contract specifies in advance the
rate at which a specified quantity of
currency will be bought and sold.
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Forward exchange contracts
Key term
A forward exchange contract is:
• (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.)
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Example: Forward exchange
contracts 1
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Example: Forward exchange
contracts 2
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Money market hedging
Fast forward
Money market hedging involves borrowing
in one currency, converting the money
borrowed into another currency and
putting the money on deposit until the time
the transaction is completed, hoping to
take advantage of favorable interest rate
movements.
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Setting up a money market hedge
for a foreign currency payment
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Example: Money market hedge
A UK company owes a Danish creditor
Kr3,500,000 in three months time. The spot
exchange rate is Kr/￡ 7.5509 – 7.5548. The
company can borrow in Sterling for 3 months at
8.60% per annum and can deposit kroners for 3
months at 10% per annum. What is the cost in
pounds with a money market hedge and what
effective forward rate would this represent?
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Choosing between a forward contract
and a money market hedge
Fast forward
The choice between forward and money
markets is generally made on the basis of
which method is cheaper, with other
factors being of limited significance.
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Example: Choosing the cheapest
method
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Choice 1: the forward exchange
market
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Choice 2: the money markets
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Choice 3: lead payments
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Foreign currency derivatives
Fast forward
Foreign currency derivatives can be used
to hedge foreign currency risk. Futures
contracts, options and swaps are types of
derivative.
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Currency futures
Fast forward
A currency future is a standardized
contract to buy or sell a specified quantity
of foreign currency.
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Currency futures
Key term
A currency future is a standardised
contract to buy or sell a specified quantity
of foreign currency.
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futures contract
Exam focus point
You will not be expected to do futures
calculations in the exam but the following
example will help you to understand how
they work.
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Example: futures contract
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Currency options
Fast forward
Currency options protect against adverse
exchange rate movements while allowing the
investor to take advantage of favourable
exchange rate movements. They are particularly
useful in situations where the cash flow is not
certain to occur (eg when tendering for overseas
contracts).
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Currency options
Key term
A currency option is a right of an option
holder to buy (call) or sell (put) foreign
currency at a specific exchange rate at a
future date.
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Currency swaps
Fast forward
Currency swaps effectively involve the
exchange of debt from one currency to
another. Currency swaps can provide a
hedge against exchange rate movements
for longer periods than the forward market,
and can be a means of obtaining finance
from new countries.
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Currency swaps
Key term
A swap is a formal agreement whereby
two organisations contractually agree to
exchange payments on different terms, eg
in different currencies, or one at a fixed
rate and the other at a floating rate' .
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Example: Currency swap
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Chapter roundup
Text book : P346
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Quick Quiz
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Answers to Quick Quiz
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PART H-20
Interest rate risk
江西财经大学会计学院
Topic list
江西财经大学会计学院
Study guide
江西财经大学会计学院
Exam guide
The material in this chapter will be
examined almost entirely as a discussion
question and it is important you
understand and can explain the
terminology.
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Interest rate risk
• Interest rate risk
• Risk management
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Interest rates
Fast forward
• The pattern of interest rates on financial
assets is influenced by the risk of the
assets, the duration of the lending, and the
size of the loan.
• There is a trade-off between risk and
return. Investors in riskier assets expect to
be compensated for the risk
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Interest rate risk
Fast forward
Interest rate risk is faced by companies
with floating and fixed rate debt. It can
arise from gap exposure and basis risk.
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Basis risk
Key term
LIBOR or the London Inter-Bank Offered
Rate is the rate of interest applying to
wholesale money market lending between
London banks.
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The causes of interest rate
fluctuations
Fast forward
The causes of interest rate fluctuations
include the structure of interest rates and
yield curves and changing economic
factors.
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The causes of interest rate
fluctuations
• (a) Risk
• (b) The need to make a profit on re-lending
• (c) The size of the loan
• (d) Different types of financial asset
• (e) The duration of the lending
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The causes of interest rate
fluctuations
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The causes of interest rate
fluctuations
• (f) Expectations theory
• (g) The market segmentation theory
• (h) Government policy
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The general level of interest
rates
• (a) Need for a real return
• (b) Inflation
• (c) Uncertainty about future rates of inflation
• (d) Liquidity preference of investors and the
demand for borrowing
• (e) Balance of payments
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The general level of interest
rates
• (f) Monetary policy
• (g) Interest rates abroad
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Interest rate risk management
Fast forward
Interest rate risk can be managed using
internal hedging in the form of asset and
liability management, matching and
smoothing or using external hedging
instruments such as forward rate
agreements and derivatives.
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Interest rate risk management
Key term
• Matching is where liabilities and assets
with a common interest rate are matched.
• Smoothing is where a company keeps a
balance between its fixed rate and floating
rate borrowing.
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Forward rate agreements (FRAs)
Fast forward
Forward rate agreements hedge risk by
fixing the interest rate on future borrowing.
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Example: Forward rate
agreement
It is 30 June. Lynn plc will need a ￡10 million 6 month
fixed rate loan from 1 October. Lynn wants to hedge
using an FRA. The relevant FRA rate is 6% on 30 June.
• (a) State what FRA is required.
• (b) What is the result of the FRA and the effective loan
rate if the 6 month FRA benchmark rate has moved to
(i) 5%
(ii) 9%
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Interest rate derivatives
Fast forward
Interest rate futures can be used to hedge
against interest rate changes between the
current date and the date at which the
interest rate on the lending or borrowing is
set. Borrowers sell futures to hedge
against interest rate rises; lenders buy
futures to hedge against interest rate falls.
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Interest rate options
Fast forward
Interest rate options allow an organisation
to limit its exposure to adverse interest
rate movements, while allowing it to take
advantage of favourable interest rate
movements.
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Interest rate options
Key term
An interest rate option grants the buyer of
it the right, but not the obligation, to deal at
an agreed interest rate (strike rate) at a
future maturity date. On the date of expiry
of the option, the buyer must decide
whether or not to exercise the right.
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Interest rate caps, collars and
floors
Fast forward
Caps set a ceiling to the interest rate; a
floor sets a lower limit. A collar is the
simultaneous purchase of a cap and floor.
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Interest rate caps, collars and
floors
Key term
• (a) An interest rate cap is an option which sets
an interest rate ceiling.
• (b) A floor is an option which sets a lower limit to
interest rates.
• (c) Using a 'collar' arrangement, the borrower
can buy an interest rate cap and at the same
time sell an interest rate floor. This limits the cost
for the company as it receives a premium for the
option it's sold.
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Interest rate swaps
Fast forward
Interest rate swaps are where two parties agree
to exchange interest rate payments. Interest rate
swaps can act as a means of switching from
paying one type of interest to another, raising
less expensive loans and securing better deposit
rates. A fixed to floating rate currency swap is a
combination of a currency and interest rate swap.
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Interest rate swaps
Key term
Interest rate swap is an agreement
whereby the parties to the agreement
exchange interest rate commitments.
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Interest rate swaps
Exam focus point
If you have to discuss which instrument
should be used to hedge interest rate risk,
consider cost, flexibility, expectations and
ability to benefit from favourable interest
rate movements.
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Chapter Roundup
Text book : P358
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Quick Quiz
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Answers to Quick Quiz
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Revision P52-57
Risk management
51-57
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