Chapter 19 Foreign Exchange Risk

1. 1.1 1.2 1.3 1.4 1. 1." 1.# 1.$ 1.( 1.1) 1.11 1.12 1.13 1.14 Objectives Describe different types of exchange rate systems. Explain the meaning and causes of translation risk, transaction risk and economic risk. Describe how the balance of payments can cause exchange rate fluctuations. Explain the impact of purchasing power parity on exchange rate fluctuations. !se purchasing power parity theory to forecast exchange rates. Explain the impact of interest rate parity on exchange rate fluctuations. !se interest rate parity theory to forecast exchange rates. Explain the principle of four%way e&ui'alence and the impact on exchange rate fluctuations. Discuss and apply netting, matching, leading and lagging as a form of foreign currency risk management. Define a forward exchange contract. *alculate the outcome of a forward exchange contract. Define money market hedging. *alculate the outcome of a money market hedge used by an importer and exporter. Define the main types of foreign currency deri'ates and explain how they can be used to hedge foreign currency risk.

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+ o re ig n E xchange - is k

E xchange - a te . y s te m s

/ ypes of + o re ig n * u rre n c y - isk

* au ses of E x c h a n g e - a te + lu c tu a tio n s

+ o re ig n * u rre n c y - is k , anagem ent

+ o re ig n * u rre n cy D e ri' a ti' e s

1 . + ix e d exchange ra te

1 . / ra n s a c tio n s ris k

1 . 0 a la n c e o f p a y m e n ts

1 . 3 o m e c u rre n cy 2 . D o n o th in g 3 . 4 e a d in g 5 la g g in g 4 . 6 e ttin g 5 m a tc h in g

1 . + u tu re s

2 . + r e e ly flo a tin g e x c h a n g e r a te

2 . E c o n o m ic ris k

2 . * a p ita l m o ' e m e n ts

2 . 7 p tio n s

3. , anaged flo a tin g e x c h a n g e r a te

3 . / ra n s la tio n ris k

3 . . u p p ly a n d dem and

. + o r w a rd c o n tra c t " . , o n e y m a rk et

3. .w aps

4 . 1 u rc h a s in g p o w e r p a r ity

. 2 n t e r e s t r a te p a rity

" . E x p e c ta tio n s th e o ry

# . 2n te rn a tio n a l + is h e r E ffe c t

2. 2.1

Exchange Rate Systems Exchange Rate Systems 8a9 Fixed exchange rates : /his in'ol'es publishing the target parity against a single currency 8or a basket of currencies9, and a commitment to use monetary policy 8interest rates9 and official reser'es of foreign exchange to hold the actual spot rate within some trading band around this target. Fixed against a sing y c!rrency : /his is where a country fixes its exchange rate against the currency of another country;s currency. ,ore than ) countries fix their rates in this way, mostly against the !. dollar. +ixed rates are not permanently fixed and periodic re'aluations and de'aluations occur when the economic fundamentals of the country concerned strongly di'erge 8e.g. inflation rates9. Fixed against a basket o" c!rrencies : !sing a basket of currencies is aimed at fixing the exchange rate against a more stable currency base than would occur with a single currency fix. /he basket is often de'ised to reflect the ma<or trading links of the country concerned. Free y " oating exchange rates #or c ean " oat$ : = genuine free float would in'ol'e lea'ing exchange rates entirely to the 'agaries of supply and demand on the foreign exchange markets, and neither inter'ening on the market using official reser'es of foreign exchange nor taking exchange rates into account when making interest rate decisions. /he ,onetary 1olicy *ommittee of the 0ank of England clearly takes account of the external 'alue of sterling in its decision% making process, so that although the pound is no longer in a fixed exchange rate system, it would not be correct to argue that it is on a genuinely free float. %anaged " oating exchange rates #or dirty " oat$ : /he central bank of countries using a managed float will attempt to keep currency relationships within a predetermined range of 'alues 8not usually publicly announced9, and will often inter'ene in the foreign exchange markets by buying or selling their currency to remain within the range.

8b9

8c9

8d9

8e9

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&. 3.1

'ypes o" Foreign C!rrency Risk C!rrency risk occurs in three forms> transaction expos!re 8short%term9, economic expos!re 8effect on present 'alue of longer term cash flows9 and trans ation expos!re 8book gains or losses9. 'ransaction risk 'ransaction Risk /ransaction risk is the risk o" an exchange rate changing between the transaction date and the s!bse)!ent sett ement date, i.e. it is the gain or loss arising on con'ersion. 2t arises primarily on import and exports.

#($ 3.2

3.3

Examp e 1 = !? company, buy goods from -edland which cost 1)),))) -eds 8the local currency9. /he goods are re%sold in the !? for @32,))). =t the time of the import purchases the exchange rate for -eds against sterling is 3. " ) : 3. $)). Re)!ired* 8a9 8b9 Ahat is the expected profit on the re%saleB Ahat would the actual profit be if the spot rate at the time when the currency is recei'ed has mo'ed to> 8i9 3.)$)) : 3.)( ) 8ii9 4.)" ) : 4.)$))B 2gnore bank commission charges.

So !tion* 8a9 /he !? company must buy -eds to pay the supplier, and so the bank is selling -eds. /he expected profit is as follows. @ -e'enue from re%sale of goods 32,))),)) 4ess> *ost of 1)),))) -eds in sterling (C 3. " )9 2$,) ).4(
(#

Expected profit

3,(4(. 1

8b98i9 2f the actual spot rate for the !? company to buy and the bank to sell the -eds is 3.)$)), the result is as follows. @ -e'enue from re%sale of goods 32,))),)) 4ess> *ost of 1)),))) -eds in sterling (C 3.)$))9 32,4"#. 3 4oss 84"#. 39

8b98ii9 2f the actual spot rate for the !? company to buy and the bank to sell the -eds is 4.)" ), the result is as follows. @ -e'enue from re%sale of goods 32,))),)) 4ess> *ost of 1)),))) -eds in sterling (C 4.)" )9 24,")).2 1rofit #,3((.#

/his 'ariation in the final sterling cost of the goods 8and thus the profit9 illustrated the concept of transaction risk. 3.4 = firm decide to hedge : take action to minimiDe : the risk, if it is> 8a9 a material amount 8b9 o'er a material time period 8c9 thought likely exchange rates will change significantly. =s transaction risk has a potentia impact on the cash " o+s of a company, most companies choose to hedge against s!ch expos!re. ,easuring and monitoring transaction risk is normally an important component o" treas!ry management. Economic risk Economic Risk Economic risk is the variation in the va !e o" the b!siness 8i.e. the present 'alue of future cash flows9 due to !nexpected changes in exchange rates. 2t is the ong-term version o" transaction risk. 3.# +or example, a !? company might use raw materials which are priced in !.
($

3.

#,$ 3."

dollars, but export its products mainly within the E!. = depreciation of sterling against the dollar or an appreciation of sterling against other E! currencies will both erode the competiti'eness of the company. Economic exposure can be difficult to a'oid, although diversi"ication o" the s!pp ier and c!stomer base across different countries will reduce this kind of exposure to risk. #C$ 3.$ 'rans ation risk 'rans ation Risk /his is the risk that the organiDation will make exchange osses when the acco!nting res! ts o" its "oreign branches or s!bsidiaries are trans ated into the home c!rrency. /ranslation losses can result, for example, from restating the book 'alue of a foreign subsidiary;s assets at the exchange rate on the statement of financial position date. .. 4.1 'he Ca!ses o" Exchange Rate F !ct!ations *hanges in exchange rates result from changes in the demand for and supply of the currency. /hese changes may occur for a 'ariety of reasons, e.g. due to changes in international trade or capital flows between economies. ,a ance o" payments ( ) : .ince currencies are re&uired to finance international trade, changes in trade may lead to changes in exchange rates. 2n principle> 8a9 demand for imports in the !. represents a demand for foreign currency or a supply of dollars. 8b9 o'erseas demand for !. exports represents a demand for dollars or a supply of the currency. ( !"#$%&'()*+# ! &'(),-#./0123456) /hus a country with a c!rrent acco!nt de"icit where imports exceed exports may expect to see its exchange rate depreciate, since the supply of the currency 8imports9 will exceed the demand for the currency 8exports9. /here are also capita movements bet+een economies. /hese transactions are effecti'ely s+itching bank deposits "rom one c!rrency to another . /hese flows are now more important than the vo !me o" trade in goods and
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4.2

4.3

4.4

4.

ser'ices. /hus supplyEdemand for a currency may reflect e'ents on the capital account. .e'eral factors may lead to inflows or outflows of capital> 8a9 changes in interest rates> rising 8falling9 interest rates will attract a capital inflow 8outflow9 and a demand 8supply9 for the currency 8b9 in" ation> asset holders will not wish to hold financial assets in a currency whose 'alue is falling because of inflation. /!rchasing po+er parity theory #///$ (789$:; ) /!rchasing /o+er /arity 111 claims that the rate of exchange between two currencies depends on the re ative in" ation rates +ithin the respective co!ntries . 2n e&uilibrium, identica goods m!st cost the same, regardless of the currency in which they are sold. 111 predicts that the co!ntry with the higher in" ation will be sub<ect to a depreciation o" its c!rrency. +ormally, if you need to estimate the expected future spot rates, 111 can be expressed in the following formula> S1 1 + hc = S ) 1 + hb Ahere> .) F *urrent spot rate .1 F Expected future rate hb F 2nflation rate in country for which the spot is &uoted 8base country9 hc F 2nflation rate in the other country 8country currency9.

#($ 4."

4.#

Examp e 2 =n item costs G3,))) in the !.. =ssume that sterling and the !. dollar are at 111 e&uilibrium, at the current spot rate of G1. )E@, i.e. the sterling price x current spot rate of G1. ) F dollar price. /he spot rate is the rate at which currency can be exchanged today.
1))

/he !. market *ost of item now Estimated inflation *ost in one year G3,))) H G3,1 ) G1. )

/he !? market @2,))) 3H @2,)")

/he a+ o" one price states that the item m!st a +ays cost the same . /herefore in one year> G3,1 ) must e&ual @2,)"), and also the expected future spot rate can be calculated> G3,1 ) E @2,)") F G1. 2(1E@ 0y formula>
S1 1+ H = 1. ) 1 + 3H S1 = G1. 2(1

4.$

'est yo!r !nderstanding 1 /he dollar and sterling are currently trading at G1.#2E@. 2nflation in the !. is expected to grow at 3H pa, but at 4H pa in the !?. 1redict the future spot rate in a year;s time. So !tion*

4.(

Case St!dy 0 ,ig %ac 1ndex =n amusing example of 111 is the Economist;s 0ig ,ac 2ndex. !nder 111 mo'ements in countries; exchange rates should in the long%term mean that the prices of an identical basket of goods or ser'ices are e&ualiDed. /he ,cDonalds 0ig ,ac represents this basket. /he index compares local 0ig ,ac prices with the price of 0ig ,acs in =merica. /his comparison is used to forecast what exchange rates should
1)1

be, and this is then compared with the actual exchange rates to decide which currencies are o'er and under%'alued. 4.1) 111 can be used as our best predictor of future spot ratesI howe'er it suffers from the following ma<or limitations> 8a9 the future inflation rates are only estimates 8b9 the market is dominated by speculati'e transactions 8($H9 as opposed to trade transactionsI therefore 111 breaks down 8c9 go'ernment inter'ention : go'ernments may manage exchange rates, thus defying the forces pressing towards 111. 3owe'er, it is likely that the 111 may be more !se"! "or predicting ongr!n changes in exchange rates since these are more likely to be determined by the underlying competiti'eness of economies, as measured by the model. 1nterest rate parity theory #1R/$ (<=$:; ) 1nterest Rate /arity #1R/$ /he 2-1 claims that the difference between the spot and the forward exchange rates is e&ual to the differential between interest rates a'ailable in the two currencies. 2-1 predicts that the country with the higher interest rate will see the "or+ard rate for its currency sub<ect to a depreciation. 2f you need to calculate the forward rate in one year;s time> F) 1 + ic = S ) 1 + ib Ahere> +) F +orward rate .) F *urrent spot rate ic F interest rate for base currency ib F interest rate for counter currency 4.13 Examp e & !? in'estor in'ests in a one%year !. bond with a (.2H interest rate as this compares well with similar risk !? bonds offering #.12H. /he current spot rate is H1. E@.

4.11

#,$ 4.12

1)2

Ahen the in'estment matures and the dollars are con'erted into sterling, 2-1 states that the in'estor will ha'e achie'ed the same return as if the money had been in'ested in !? go'ernment bonds.

2n 1 year, @1.)#12 million must e&uate to G1."3$ million so what you gain in extra interest, you lose on an ad'erse mo'ement in exchange rates. /he forward rates mo'es to bring about interest rate parity amongst different currencies> G1."3$ C @1.)#12 F G1. 2(1 0y formula>
F) 1 + ( .2 H = 1. 1 + #.12H F) = G1. 2(1

4.14

4.1

/he 2-1/ generally holds true in practice. /here are no bargain interest rates to be had on loansEdeposits in one currency rather than another. 3owe'er, it suffers from the following limitations> 8a9 go'ernment controls on capital markets 8b9 controls on currency trading 8c9 inter'ention in foreign exchange markets. /he interest rate parity model shows that it may be possible to predict exchange rate mo'ements by referring to differences in nominal exchange rates. 2f the forward exchange rate for sterling against the dollar was no higher than the spot rate but !. nominal interest rates were higher, the following
1)3

would happen> 8a9 !? in'estors would shift funds to the !. in order to secure the higher interest rates, since they would suffer no exchange losses when they con'erted G back to @. 8b9 the flow of capital from the !? to the !. would raise !? interest rates and force up the spot rate for the !.G. #C$ 4.1" 4.1# Expectations theory /he expectations theory claims that the c!rrent "or+ard rate is an !nbiased predictor o" the spot rate at that point in the "!t!re. 2f a trader takes the 'iew that the forward rate is lower than the expected future spot price, there is an incenti'e to buy forward. /he buying pressure on the forward rates raises the price, until the forward price e&uals the market consensus 'iew on the expected future spot price. 'he 1nternationa Fisher E""ect /he 2nternational +isher Effect claims that the interest rate differentials between two countries pro'ide an unbiased predictor of future changes in the spot rate of exchange. /he 2nternational +isher Effect assumes that all countries will ha'e the same real interest rate, although nominal or money rates may differ due to expected inflation rates. /hus the interest rate differential between two countries should be e&ual to the expected inflation differential. /herefore, countries with higher expected inflation rates will ha'e higher nominal interest rates, and 'ice 'ersa. /he c!rrency of countries with re ative y high interest rates is expected to depreciate against currencies with lower interest rates, beca!se the higher interest rates are considered necessary to compensate "or the anticipated c!rrency depreciation. Ji'en free mo'ement of capital internationally, this idea suggests that the real rate of return in different countries will e&ualiDe as a result of ad<ustments to spot exchange rates. /he 2nternational +isher Effect can be expressed as>
1 + i a 1 + ha = 1 + ib 1 + hb

#2$ 4.1$

4.1(

4.2)

4.21

Ahere> ia F the nominal interest rate in country a ib F the nominal interest rate in country b
1)4

ha F the inflation rate in country a hb F the inflation rate in country b

#E$ 4.22

Fo!r-+ay e)!iva ence /he four theories can be pulled together to show the o'erall relationship between spot rates, interest rates, inflation rates and the forward and expected future spot rates. =s shown abo'e, these relationships can be used to forecast exchange rates.

3. .1

Foreign C!rrency Risk %anagement Ahen currency risk is significant for a company, it should do something to either eliminate it or reduce it. /aking measures to eliminate or reduce the risk is called hedging the risk or hedging the expos!re. 2ea in home c!rrency 2nsist all customers pay in your own home currency and pay for all imports in home currency. /his method>
1)

#($ .2

8a9 8b9

transfer risk to the other party may not be commercially acceptable.

#,$ .3

2o nothing 2n the long run, the company would Kwin some, lose someL. /his method 8a9 works for small occasional transactions 8b9 sa'es in transaction costs 8c9 is dangerous. 4eading and agging *ompanies might try to use> 8a9 4ead payments : payment in ad'ance 8b9 4agged payments : delaying payments beyond their due date. 2n order to take ad'antage of foreign exchange rate mo'ements. Aith a ead payments, paying in ad'ance of the due date, there is a "inance cost to consider. /his is the interest cost on the money !sed to make the payment , b!t ear y sett ement disco!nts may be avai ab e. 4eading and lagging are a form of spec! ation. 2n relation to foreign currency settlements, additional benefits can be obtained by the use these techni&ues when currency exchange rates are fluctuating 8assuming one can forecast the changes.9 4eading would be bene"icia to the payer if this c!rrency +ere strengthening against his o+n. 4agging would be appropriate for the payer if the c!rrency +ere +eakening. %atching #>? $ Ahen a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other. 2t is then only necessary to deal on the foreign exchange 8forex9 markets for the unmatched portion of the total transactions. .uppose that =0* *o has the following receipts and payments in three months time>
1)"

#C$ .4

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#2$ .$

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6etting only applies to transfers within a group of companies. ,atching can be used for both intra%group transactions and those in'ol'ing third parties. /he company match the inflows and outflows in different currencies caused by trade, etc., so that it is only necessary to deal on the forex markets for the unmatched portion of the total transactions. 5etting #@A $ !nlike matching, netting is not technically a method of managing exchange risk. 3owe'er, it is con'eniently dealt with at this stage. /he ob<ecti'e is simply to save transactions costs by netting o"" inter-company ba ances before arranging payment. ,any m! tinationa gro!ps of companies engage in intra-gro!p trading. Ahere related companies located in different countries trade with one another, there is likely to be inter%company indebtedness denominated in different currencies. 'rading in c!rrencies /he foreign exchange market or forex market is an international market in national currencies. 2t is highly competiti'e and 'irtually no difference exists between the prices in one market 8e.g. 6ew Mork9 and another 8e.g. 4ondon9. 0anks dealing in foreign currency &uote two prices for an exchange rate>
1)#

#E$ .1)

.11

#F$ .12

.13

8a9 a lower bid price 8b9 a higher offerEask price. +or example, a dealer might &uote a price for !.GE@ of 1.432 : 1.433). /he lower rate, 1.432 , is the rate at which the dealer will sell the 'ariable currency 8!.G9 in exchange for the base currency 8sterling9. /he higher rate, 1.433), is the rate at which the dealer will buy the 'ariable currency 8!.G9 in exchange for the base currency 8sterling9. .14 Examp e . .uppose that the !.G rate per @ is &uoted as 1.432 : 1.433). 2f the company wants to buy G1)),))) in exchange for sterling 8so that the bank will be selling dollars9> 2f we used the lower rate of 1.432 , the bank would sell them for @"(,$)$. 2f we used the higher rate of 1.433), the bank would sell them for @"(,#$4. *learly the bank would be better off selling them at the lower rate. R! e* ,ank se s o+er. 2f a company wants to sell G2)),))) in exchange for sterling 8so the bank would be buy dollars9> 2f we used the lower rate of 1.432 , the bank would buy them for @13(,"1". 2f we used the higher rate of 1.433), the bank would buy them for @13(, "#. /he bank will make more money buy at the higher rate. R! e* ,ank b!ys high.

1)$

#6$ .1 .1"

For+ard exchange hedging ( ) /he spot market ( ) is where you can b!y and se a c!rrency no+ 8immediate deli'ery9, i.e. the spot rate of exchange. /he "or+ard market ( ) is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward rate of exchange. For+ard Exchange Contracts = forward exchange contract is> 8a9 =n immediately firm and binding contract, e.g. between a bank and its customer. 8b9 +or the purchase or sale of a specified &uantity of a stated foreign currency. 8c9 =t a rate of exchange fixed at the time the contract is made. 8d9 +or performance 8deli'ery of the currency and payment for it9 at a future time which is agreed when making the contract 8this future time will be either a specified date, or any time between two specified dates9.

.1#

.1$

Examp e 3 0 For+ard Contract 2t is now 1 Nanuary and O *o will recei'e G1) million on 3) =pril. 2t enters into a forward contract to sell this amount on the forward date at a rate of G1.")E@. 7n 3) =pril the company is guaranteed @".2 million. /he risk has been completely remo'ed.
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'est yo!r !nderstanding 2 /he current spot rate for !. dollars against !? sterling is 1.4 2 : 1.4 3 GE@ and the one%month forward is &uoted as 1.4 ) : 1.4 " . = !? exporter expects to recei'e G4)),))) in one month. 2f a forward contract is used, how much will be recei'ed in sterlingB So !tion*

.2)

=d'antages and disad'antages> =d'antages +lexibility with regard to the amount to be co'ered. -elati'ely straightforward both to comprehend and to organiDe. Disad'antages *ontractual commitment that must be completed on the due date. 6o opportunity to benefit from fa'ourable mo'ements in exchange rates.

#7$ .21

%oney market hedge %oney %arket 7edge ,oney market hedge invo ves borro+ing in one c!rrency, converting the money borro+ed into another c!rrency and p!tting the money on deposit !nti the time the transaction is comp eted , hoping to take ad'antage of fa'ourable interest rate mo'ements.

(a) .22

Setting up a money market hedge for a foreign currency payment .uppose a 0ritish company needs to pay a .wiss creditor in .wiss francs in three months time. 2t does not ha'e enough cash to pay now, but will ha'e sufficient in three months time. 2nstead of negotiating a forward contract, the
11)

company could> .tep 1> .tep 2> .tep 3> .tep 4> 0orrow the appropriate amount in pounds now *on'ert the pounds to francs immediately 1ut the francs on deposit in a .wiss franc bank account Ahen time comes to pay the company> 8a9 pay the creditor out of the franc bank account 8b9 repays the pound loan account

.23

Examp e 8 = !? company owes a Danish creditor ?r3, )),))) in three months time. /he spot exchange rate is ?rE@ #. )( : #. 4$. /he company can borrow in .terling for 3 months at $.")H per annum and can deposit kroners for 3 months at 1)H per annum. Ahat is the cost in pounds with a money market hedge and what effecti'e forward rate would this representB So !tion* /he interest rates for 3 months are 2.1 H to borrow in pounds and 2. H to deposit in kroners. /he company needs to deposit enough kroners now so that the total including interest will be ?r3, )),))) in three months; time. /his means depositing> ?r3, )),)))E81 P ).)2 9 F ?r3,414,"34. /hese kroners will cost @4 2,21 8spot rate #. )(9. /he company must borrow this amount and, with three months interest of 2.1 H, will ha'e to repay> @4 2,21 x 81 P ).)21 9 F @4"1,(3$. /hus, in three months, the Danish creditor will be paid out of the Danish bank account and the company will effecti'ely be paying @4"1,(3$ to satisfy this debt. /he effecti'e forward rate which the company has manufactured is 3, )),)))E4"1,(3$ F #. #"$. /his e""ective "or+ard rate shows the kroner at a disco!nt to the pound beca!se the kroner interest rate is higher than the sterling rate.
111

@ 6ow> 0orrow @4 2,21

*on'ert #. )(

?r Deposit ?r3,414,"34

2nterest paid> 2.1 H

2nterest earned> 2. H

3 monthsQ time> @4"1,(3$ (b) .24

?r3, )),)))

Setting up a money market hedge for a foreign currency receipt = similar techni&ue can be used to co'er a foreign currency receipt from a debtor. /o manufacture a forward exchange rate, follow the steps below. .tep 1> 0orrow the appropriate amount in foreign currency today .tep 2> *on'ert it immediately to home currency .tep 3> 1lace it on deposit in the home currency .tep 4> Ahen the debtor;s cash is recei'ed> 8a9 -epay the foreign currency loan 8b9 /ake the cash from the home currency deposit account Examp e 9 = !? company is owed .+r 2, )),))) in three months time by a .wiss company. /he spot exchange rate is .+rE@ 2.24($ : 2.2 1). /he company can deposit in .terling for 3 months at $.))H per annum and can borrow .wiss +rancs for 3 months at #.))H per annum. Ahat is the receipt in pounds with a money market hedge and what effecti'e forward rate would this representB So !tion* /he interest rates for 3 months are 2.))H to deposit in pounds and 1.# H to borrow in .wiss francs. /he company needs to borrow .+r2, )),)))E1.)1# F .+r2,4 #,))3 today. /hese .wiss francs will be con'erted to @ at 2,4 #,))3E2.2 1) F @1,)(1, 1". /he company must deposit this amount
112

.2

and, with three months interest of 2.))H, will ha'e earned @1,)(1, 1" x 81 P ).)29 F @1,113,34" /hus, in three months, the loan will be paid out of the proceeds from the debtor and the company will recei'e @1,113,34". /he effecti'e forward rate which the company has manufactured is 2, )),)))E1,113,34" F 2.24 . /his e""ective "or+ard rate shows the S+iss "ranc at a premi!m to the pound beca!se the S+iss "ranc interest rate is o+er than the sterling rate.
. +r 6ow> 0orrow .+r2,4 #,))3 *on'ert 2.2 1 @ Deposit @1,)(1, 1"

2nterest paid> 1.# H

2nterest earned> 2.)H

3 monthsQ time>.+r2, )),)))

@1,113, 4"

#1$ .2"

Choosing the hedging method /he choice between forward and money markets is generally made on the basis of which method is cheaper, with other factors being of limited significance. Ahen a company expects to recei'e or pay a sum of foreign currency in the next few months, it can choose between using the "or+ard exchange market and the money market to hedge against the foreign exchange risk. 7ther methods may also be possible, such as making ead payments. /he cheapest method a'ailable is the one that ought to be chosen. Examp e : =0* *o has bought goods from a !. supplier, and must pay G4,))),))) for them in three months time. /he company;s finance director wishes to hedge against the foreign exchange risk, and the three methods which the company usually considers are>
113

.2#

.2$

8a9 8b9 8c9

!sing "or+ard exchange contracts !sing money market borro+ing or ending ,aking ead payments

/he following annual interest rates and exchange rates are currently a'ailable.
!. dollar Deposit rate H 1 month 3 months # # 0orrowing rate H 1).2 1).# H 1).# 11.)) .terling Deposit rate 0orrowing rate H 14.)) 14.2

.pot 1 month forward 3 months forward

GE@ exchange rate 8G F @19 1.$"2 : 1.$"3 1.$ " : 1.$ ## 1.$4 : 1.$4")

Ahich is the cheapest method for =0* *oB 2gnore commission costs 8the bank charges for arranging a forward contract or a loan9. So !tion* /he three choices must be compared on a similar basis, which means working out the cost of each to =0* *o either now or in three months time. 2n the following paragraphs, the cost to =0* *o now will be determined. Choice 1* the "or+ard exchange market =0* *o must buy dollars in order to pay the !. supplier. /he exchange rate in a forward exchange contract to buy G4,))),))) in three months time 8bank sells9 is 1.$44 . /he cost of the G4,))),))) to =0* *o in three months time will be>
G4,))),))) F @2,1"$,")(.3$ 1.$44

/his is the cost in three months. /o work out the cost now, we could say that
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by deferring payment for three months, we assume that the company needs to borrow the money for the payment. =t an annual interest rate of 14.2 H the rate for three months is 14.2 E4 F 3. "2 H. /he present cost of @2,1"$,")(.3$ in three months time is> @2,1"$,")(.3$ E 1.)3 "2 F @2,)(4,)1).2" Choice 2* the money markets !sing the money market in'ol'es 8a9 0orrowing in the foreign currency, if the company will e'entually recei'e the currency 8b9 4ending in the foreign currency, if the company will e'entually pay the currency. 3ere, =0* *o will pay G4,))),))) and so it would lend !. dollars. 2t would lend enough !. dollars for three months, so that the principal repaid in three months time plus interest will amount to the payment due of G4,))),))). 8a9 .ince the !. dollar deposit rate is #H, the rate for three months is approximately #E4 F 1.# H. 8b9 /o earn G4,))),))) in three months time at 1.# H interest, =0* *o would ha'e to lend now>
G4,))),))) = G3,(31,2)3.(3 1.)1#

/hese dollars would ha'e to be purchased now at the spot rate of G1.$"2 . /he cost would be>
G3,(31,2)3.(3 F @2,11),#13, 2 1.$"2

0y lending !. dollars for three months, =0* *o is matching e'entual receipts and payments in !. dollars, and so has hedged against foreign exchange risk. Choice &* ead payments 4ead payments should be considered when the currency of payment is
11

expected to strengthen o'er time, and is &uoted forward at a premium on the foreign exchange market. 3ere, the cost of a lead payment 8paying G4,))),))) now9 would be G4,))),))) E 1.$"2 F @2,14#," 1.)1.

S!mmary +orward exchange contract 8cheapest9 *urrency lending 4ead payment @ 2,)(4,)1).2" 2,11),#13. 2 2,14#," 1.)1

8. #($ ".1

Foreign C!rrency 2erivatives C!rrency "!t!res C!rrency F!t!res *urrency futures are standardi;ed contracts for the sale or purchase at a set "!t!re date of a set )!antity o" c!rrency. +utures contracts are exchange-based instr!ments traded on a regulated exchange. /he buyer and seller of a contract do not transact with each other directly.

".2

Examp e 9 = !. company buys goods worth R#2),))) from a Jerman company payable in 3) days. /he !. company wants to hedge against the R strengthening against the dollar. *urrent spot is ).(21 : ).(221 GER and the R futures rate is ).(24 GER. /he standard siDe of a 3 month R futures contract is R12 ,))). 2n 3) days time the spot is ).(34 : ).(3 1 GER. *losing futures price will be ).(3"#. E'aluate the hedge. So !tion*
11"

1. 2.

Ae assume that the three month contract is the best a'ailable. Ae need to buy R or sell G. =s the futures contract is in R, we need to buy futures. 6o. of contracts %
#2),))) F .#", say " contracts 12 ,)))

3. 4. . ".

/ick siDe : minimum price mo'ement x contract siDe F ).)))1 x 12 ,))) F G12. ) *losing futures price : we are told it will be ).(3"# 3edge outcome 7utcome in futures market 7pening futures price F ).(24 *losing futures price F ).(3"# ,o'ement in ticks F 122 ticks +utures profit F 122 x G12. ) x " contracts F G(,1 ) 6et outcome .pot market payment 8#2),))) x ).(3 1 GER +utures market profit G "#3,2#2 8(,1 )9 ""4,122

".3

=d'antages and disad'antages of futures to hedge risks (dvantages 2isadvantages

8a9 'ransaction costs should be 8a9 /he contracts cannot be o+er than other hedging tai ored to the user;s exact methods. re&uirements. 8b9 +utures are tradeab e on a 8b9 7edge ine""iciencies are caused secondary market so there is by ha'ing to deal in a +ho e pricing transparency. n!mber o" contracts and by 8c9 /he exact date o" receipt or basis risk. payment does not have to be 8c9 7nly a imited n!mber o" kno+n. c!rrencies are the sub<ect of futures contracts. 8d9 !nlike options, they do not
11#

a o+ a company to take advantage of "avo!rab e c!rrency movements. 0asis risk : the risk that the futures contract price may mo'e by a different amount from the price of the underlying currency or commodity.

#,$ ".4

C!rrency options C!rrency Options = currency option is a right of an option holder to b!y #ca $ or se #p!t$ foreign currency at a specific exchange rate at a future date.

".

<ey 'erms 8a9 Ca option : gi'es the purchaser a right, but not the ob igation, to b!y a fixed amount of currency at a specified price at some time in the future. /he seller of the option, who recei'es the premium, is referred to as the +riter. /!t option : gi'es the holder the right, but not the ob igation, to se a specific amount of currency at a specified date at a fixed exercise price #or strike price$. 1n-the-money option ( ) : the !nder ying price is above the strike price. (t-the-money option ( ) : the !nder ying price is e)!a to the option exercise price. O!t-o"-the-money option ( ) : the !nder ying price is be o+ the option exercise price. (merican-sty e options : can be exercised by the buyer at any time up to the expiry date. E!ropean-sty e options : can on y be exercised on a predetermined "!t!re date.

8b9 8c9

8d9 8e9 8f9 8g9 8h9

"."

*ompanies can choose whether to buy> 8a9 a tai or-made currency option from a bank, suited to the company;s
11$

".#

specific needs. /hese are over-the-co!nter 87/*9 or negotiated options, or 8b9 a standard option, in certain currencies only, from an options exchange. .uch options are traded or exchange-traded options. = company can therefore> 8a9 Exercise the option if it is in its interests to do so. 8b9 4et it apse if> 8i9 the spot rate is more fa'ourable 8ii9 there is no longer a need to exchange currency. C!rrency s+ap ( ) C!rrency S+ap = swap is a "orma agreement whereby two organiDations contractually agree to exchange payments on di""erent terms, e.g. in different currencies, or one at a fixed rate and the other at a floating rate.

#C$ ".$

".(

Examp e 1= *onsider a !? company O with a subsidiary M in +rance which owns 'ineyards. =ssume a spot rate of @1 F 1." Euros. .uppose the parent company O wishes to raise a loan of 1." million Euros for the purpose of buying another +rench wine company. =t the same time, the +rench subsidiary M wishes to raise @1 million to pay new up%to%date capital e&uipment imported from the !?. /he !? parent company O could borrow the @1 million sterling and the +rench subsidiary M could borrow the 1." million Euros, each effecti'ely borrowing on the other;s behalf. /hey would then swap currencies.
@1 million !? *ompany O R1." million 0orrow @1 million 0orrow R1." million +rance .ubsidiary M

0ank
11(

0ank

12)

Examination Sty e >!estions >!estion 1 6edwen *o is a !?%based company which has the following expected transactions. 7ne month> 7ne month> /hree months> Expected receipt of G24),))) Expected payment of G14),))) Expected receipts of G3)),)))

/he finance manager has collected the following information> .pot rate 8G per @9> 7ne month forward rate 8G per @9> /hree months forward rate 8G per @9> ,oney market rates for 6edwen *o> ,orro+ing 4.(H .4H 2eposit 4."H .1H 1.#$2) S ).)))2 1.#$2( S ).)))3 1.#$4" S ).)))4

7ne year sterling interest rate> 7ne year dollar interest rate =ssume that it is now 1 =pril Re)!ired* 8a9 8b9 8c9 8d9

8e9

Discuss the differences between transaction risk, translation risk and economic risk. 8" marks9 Explain how inflation rates can be used to forecast exchange rates. 8" marks9 *alculate the expected sterling receipts in one month and in three months using the forward market. 83 marks9 *alculate the expected sterling receipts in three months using a money%market hedge and recommend whether a forward market hedge or a money market hedge should be used. 8 marks9 Discuss how sterling currency futures contracts could be used to hedge the three%month dollar receipt. 8 marks9 8/otal 2 marks9 8=**= +( +inancial ,anagement 1ilot 1aper 2))" T29
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>!estion 2 1?= *o is a European company that sells goods solely within Europe. /he recently% appointed financial manager of 1?= *o has been in'estigating the working capital management of the company and has gathered the following information> 1nventory management /he current policy is to order 1)),))) units when the in'entory le'el falls to 3 ,))) units. +orecast demand to meet production re&uirements during the next year is "2 ,))) units. /he cost of placing and processing an order is R2 ), while the cost of holding a unit in stores is R)U ) per unit per year. 0oth costs are expected to be constant during the next year. 7rders are recei'ed two weeks after being placed with the supplier. Mou should assume a )%week year and that demand is constant throughout the year. (cco!nts receivab e management Domestic customers are allowed 3) days; credit, but the financial statements of 1?= *o show that the a'erage accounts recei'able period in the last financial year was # days. /he financial manager also noted that bad debts as a percentage of sales, which are all on credit, increased in the last financial year from H to $H. (cco!nts payab e management 1?= *o has used a foreign supplier for the first time and must pay G2 ),))) to the supplier in six months; time. /he financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge the currency risk of this account payable. /he following information has been pro'ided by the company;s bank> .pot rate 8G per R9> .ix months forward rate 8G per R9> ,oney market rates a'ailable to 1?= *o> 7ne year euro interest rate> 7ne year dollar interest rate ,orro+ing ".1H 4.)H 2eposit .4H 3. H 1.(($ S ).))2 1.(#( S ).))4

=ssume that it is now 1 December and that 1?= *o has no surplus cash at the present time.
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Re)!ired* 8a9 8b9 8c9 8d9 2dentify the ob<ecti'es of working capital management and discuss the conflict that may arise between them. 83 marks9 *alculate the cost of the current ordering policy and determine the sa'ing that could be made by using the economic order &uantity model. 8# marks9 Discuss ways in which 1?= *o could impro'e the management of domestic accounts recei'able. 8# marks9 E'aluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedge the foreign account payable. 8$ marks9 82 marks9 8=**= +( +inancial ,anagement December 2))# T49

>!estion & /hree years ago 0olu<e *o built a factory in its home country costing G3U2 million. /o finance the construction of the factory, 0olu<e *o issued peso%denominated bonds in a foreign country whose currency is the peso. 2nterest rates at the time in the foreign country were historically low. /he foreign bond issue raised 1" million pesos and the exchange rate at the time was U)) pesosEG. Each foreign bond has a par 'alue of )) pesos and pays interest in pesos at the end of each year of "U1H. /he bonds will be redeemed in fi'e years; time at par. /he current cost of debt of peso%denominated bonds of similar risk is #H. 2n addition to domestic sales, 0olu<e *o exports goods to the foreign country and recei'es payment for export sales in pesos. =pproximately 4)H of production is exported to the foreign country. /he spot exchange rate is "U)) pesosEG and the 12%month forward exchange rate is "U)# pesosEG. 0olu<e *o can borrow money on a short%term basis at 4H per year in its home currency and it can deposit money at H per year in the foreign country where the foreign bonds were issued. /axation may be ignored in all calculation parts of this &uestion. Re)!ired* 8a9 0riefly explain the reasons why a company may choose to finance a new in'estment by an issue of debt finance. 8# marks9
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8b9 8c9

8d9

*alculate the current total market 'alue 8in pesos9 of the foreign bonds used to finance the building of the new factory. 84 marks9 =ssume that 0olu<e *o has no surplus cash at the present time> 8i9 Explain and illustrate how a money market hedge could protect 0olu<e *o against exchange rate risk in relation to the dollar cost of the interest payment to be made in one year;s time on its foreign bonds. 84 marks9 8ii9 *ompare the relati'e costs of a money market hedge and a forward market hedge. 82 marks9 Describe other methods, including deri'ati'es, that 0olu<e *o could use to hedge against exchange rate risk. 8$ marks9 8/otal 2 marks9 8=**= +( +inancial ,anagement December 2))$ T49

>!estion . 6J *o has exported products to Europe for se'eral years and has an established market presence there. 2t now plans to increase its market share through in'esting in a storage, packing and distribution network. /he in'estment will cost R13 million and is to be financed by e&ual amounts of e&uity and debt. /he return in euros before interest and taxation on the total amount in'ested is forecast to be 2)H per year. /he debt finance will be pro'ided by a R"U million bond issue on a large European stock market. /he interest rate on the bond issue is $H per year, with interest being payable in euros on a six%monthly basis. /he e&uity finance will be raised in dollars by a rights issue in the home country of 6J *o. 2ssue costs for the rights issue will be G312,))). /he rights issue price will be at a 1#H discount to the current share price. /he current share price of 6J *o is G4U)) per share and the market capitalisation of the company is G1)) million. 6J *o pays taxation in its home country at a rate of 3)H per year. /he currency of its home country is the dollar. /he current priceEearnings ratio of the company, which is not expected to change as a result of the proposed in'estment, is 1) times. /he spot exchange rate is 1U3))) REG. =ll European customers pay on a credit basis in euros.

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Re)!ired* 8a9 8b9 *alculate the theoretical ex rights price per share after the rights issue. 84 marks9 E'aluate the effect of the European in'estment on> 8i9 the earnings per share of 6J *oI and 8ii9 the wealth of the shareholders of 6J *o. =ssume that the current spot rate and earnings from existing operations are both constant. 8( marks9 Explain the difference between transaction risk and translation risk, illustrating your answer using the information pro'ided. 84 marks9 /he six%month forward rate is 1U2$#" REG and the twel'e%month forward rate is 1U2# 2 REG. 6J *o can earn 2U$H per year on short%term euro deposits and can borrow short%term in dollars at U3H per year. 2dentify and briefly discuss exchange rate hedging methods that could be used by 6J *o. 1ro'ide calculations that illustrate /A7 of the hedging methods that you ha'e identified. 8$ marks9 8/otal 2 marks9 8=**= +( +inancial ,anagement December 2))( T39

8c9 8d9

12