Chapter19 FXRisk

Premium Course Notes
[Session 11 & 12]
Chapter 19 Foreign Exchange Risk

SYLLABUS
1.
2.
3.
4.
5.
6.
Describe and discuss different types of foreign currency risk:

(a) translation risk
(b) transaction risk
(c) economic risk
Describe the causes of exchange rate fluctuations, including:
(a) balance of payments
(b) purchasing power parity theory
(c) interest rate parity theory
(d) four-way equivalence
Forecast exchange rates using:
(a) purchasing power parity
(b) interest rate parity
Discuss and apply traditional and basic methods of foreign currency risk management,
including:
(a) currency of invoice
(b) netting and matching
(c) leading and lagging
(d) forward exchange contracts
(e) money market hedge
(f) asset and liability management
Compare and evaluate traditional methods of foreign currency risk management.
Identify the main types of foreign currency derivatives used to hedge foreign currency
risk and explain how they are used in hedging. (No numerical questions will be set on
this topic.)
Prepared by Patrick Lui
P. 45
Copyright @ Kaplan Financial 2015
[Session 11 & 12]
F o re ig n
E xchange
R isk
E xchange
R a te
S y s te m s
T ypes of
F o re ig n C u rre n c y
R isk
C a u se s of
E x c h a n g e R a te
F lu c tu a tio n s
F o re ig n
C u rre n c y R isk
M anagem ent
F o re ig n
C u rre n c y
D e riv a tiv e s
1 . F ix e d
exchange
ra te
1 . T ra n s a c tio n s
ris k
1 . B a la n c e o f
p a y m e n ts
1 . H o m e c u rre n cy
2 . D o n o th in g
3 . L e a d in g &
la g g in g
1 . F u tu re s
2 . F 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 . C a p ita l
m o v e m e n ts
4 . N e ttin g &
m a tc h in g
2 . O p tio n s
3. M anaged
flo a tin g
e x c h a n g e r a te
3 . T ra n s la tio n
ris k
3 . S u p p ly a n d
dem and
5 . F o r w a rd
c o n tra c t
6 . M o n e y m a rk et
3. Sw aps
4 . P u rc h a s in g
p o w e r p a r ity
5 . I n t e re s t r a te
p a rity
6 . E x p e c ta tio n s
th e o ry
7 . In te rn a tio n a l
F is h e r
E ffe c t
P. 46
1.
1.1
[Session 11 & 12]
Exchange Rate Systems

Exchange Rate Systems
(a)
(b)
(c)
Fixed exchange rates This involves publishing the target parity against a
single currency (or a basket of currencies), and a commitment to use
monetary policy (interest rates) and official reserves of foreign exchange to
hold the actual spot rate within some trading band around this target.
(i)
Fixed against a single currency This is where a country fixes its
exchange rate against the currency of another countrys currency. More
than 50 countries fix their rates in this way, mostly against the US
dollar. Fixed rates are not permanently fixed and periodic revaluations
and devaluations occur when the economic fundamentals of the
country concerned strongly diverge (e.g. inflation rates).
(ii) Fixed against a basket of currencies Using 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. The basket is often
devised to reflect the major trading links of the country concerned.
Freely floating exchange rates (or clean float) A genuine free float would
involve leaving exchange rates entirely to the vagaries of supply and demand
on the foreign exchange markets, and neither intervening on the market using
official reserves of foreign exchange nor taking exchange rates into account
when making interest rate decisions. The Monetary Policy Committee of the
Bank of England clearly takes account of the external value 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.
Managed floating exchange rates (or dirty float) The central bank of
countries using a managed float will attempt to keep currency relationships
within a predetermined range of values (not usually publicly announced), and
will often intervene in the foreign exchange markets by buying or selling
their currency to remain within the range.
P. 47
2.
[Session 11 & 12]
Types of Foreign Currency Risk

(Pilot, Dec 09, Jun 13)
2.1
Currency risk
2.1.1
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).
2.2
Transaction risk
2.2.1
Transaction Risk
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.
It arises primarily on import and exports.
2.2.2
Example 1
A UK company, buy goods from Redland which cost 100,000 Reds (the local
currency). The goods are re-sold in the UK for 32,000. At the time of the import
purchases the exchange rate for Reds against sterling is 3.5650 3.5800.
Required:
(a)
(b)
What is the expected profit on the re-sale?

What would the actual profit be if the spot rate at the time when the currency
is received has moved to:
(i) 3.0800 3.0950
(ii) 4.0650 4.0800?
Ignore bank commission charges.
P. 48
[Session 11 & 12]
Solution:
(a)
The UK company must buy Reds to pay the supplier, and so the bank is
selling Reds. The expected profit is as follows.
Revenue from re-sale of goods

32,000,00
Less: Cost of 100,000 Reds in sterling ( 3.5650)
28,050.49
Expected profit
3,949.51
(b)(i) If the actual spot rate for the UK company to buy and the bank to sell the
Reds is 3.0800, the result is as follows.

32,000,00
32,467.53
Loss
(467.53)
(b)(ii) If the actual spot rate for the UK company to buy and the bank to sell the
Reds is 4.0650, the result is as follows.

32,000,00
24,600.25
Profit
7,399.75
This variation in the final sterling cost of the goods (and thus the profit) illustrated
the concept of transaction risk.
2.2.3
A firm decide to hedge take action to minimize the risk, if it is:

(a)
a material amount
(b)
over a material time period
(c)
thought likely exchange rates will change significantly.
2.2.4
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.
P. 49
2.3
[Session 11 & 12]
Economic risk
2.3.1
Economic Risk
Economic risk is the variation in the value of the business (i.e. the present value
of future cash flows) due to unexpected changes in exchange rates. It is the longterm version of transaction risk.
2.3.2
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,
although diversification of the supplier and customer base across different countries
will reduce this kind of exposure to risk.
2.4
Translation risk
2.4.1
Translation Risk
This is the risk that the organization 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 subsidiarys assets at the exchange rate on the statement of
financial position date.
Multiple Choice Questions

1.
Exporters Co is concerned that the cash received from overseas sales will not be as
expected due to exchange rate movements.
What type of risk is this?
A
B
C
D
Translation risk
Economic risk
Interest rate risk
Transaction risk
P. 50
2.
[Session 11 & 12]
There is a risk that the value of our foreign currency-denominated assets and
liabilities will change when we prepare our accounts.
To which risk does the above statement refer?
A
B
C
D
Translation risk
Economic risk
Transaction risk
Interest rate risk
(ACCA F9 Financial Management Pilot Paper 2014)
3.
The Causes of Exchange Rate Fluctuations
3.1
Balance of payments
3.1.1
Changes in exchange rates result from changes in the demand for and supply of the
currency. These changes may occur for a variety of reasons, e.g. due to changes in
international trade or capital flows between economies.
Balance of payments ( ) Since currencies are required to finance
international trade, changes in trade may lead to changes in exchange rates. In
principle:
(a)
demand for imports in the US represents a demand for foreign currency or a
supply of dollars.
(b)
overseas demand for US exports represents a demand for dollars or a supply of
the currency.
3.1.2
3.1.3
3.2
)
Thus a country with a current account deficit where imports exceed exports may
expect to see its exchange rate depreciate, since the supply of the currency (imports)
will exceed the demand for the currency (exports).
Capital movements
P. 51
[Session 11 & 12]
3.2.1
There are also capital movements between economies. These transactions are
effectively switching bank deposits from one currency to another. These flows are
now more important than the volume of trade in goods and services.
3.2.2
Thus supply/demand for a currency may reflect events on the capital account. Several
factors may lead to inflows or outflows of capital:
(a)
changes in interest rates: rising (falling) interest rates will attract a capital
inflow (outflow) and a demand (supply) for the currency
(b)
inflation: asset holders will not wish to hold financial assets in a currency
whose value is falling because of inflation.
3.3
Purchasing power parity theory (PPP) ( )

(Pilot, Jun 11, Jun 12)
3.3.1
Purchasing Power Parity

PPP claims that the rate of exchange between two currencies depends on the
relative inflation rates within the respective countries. In equilibrium, identical
goods must cost the same, regardless of the currency in which they are sold.
PPP predicts that the country with the higher inflation will be subject to a
depreciation of its currency.
Formally, if you need to estimate the expected future spot rates, PPP can be
expressed in the following formula:
S1 1 hc
S 0 1 hb
Where: S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base country)
hc = Inflation rate in the other country (country currency).
3.3.2
Example 2
An item costs $3,000 in the US.
Assume that sterling and the US dollar are at PPP equilibrium, at the current spot
rate of $1.50/, i.e. the sterling price x current spot rate of $1.50 = dollar price.
The spot rate is the rate at which currency can be exchanged today.
P. 52
[Session 11 & 12]
The US market
Cost of item now
Estimated inflation
Cost in one year
$3,000
The UK market
$1.50
2,000
5%
3%
$3,150
2,060
The law of one price states that the item must always cost the same. Therefore in
one year:
$3,150 must equal 2,060, and also the expected future spot rate can be calculated:
$3,150 / 2,060 = $1.5291/
By formula:
S1
1 5%
1.50 1 3%
S1 $1.5291
3.3.3
Test your understanding 1

The dollar and sterling are currently trading at $1.72/.
Inflation in the US is expected to grow at 3% pa, but at 4% pa in the UK.
Predict the future spot rate in a years time.
Solution:
3.3.4
Case Study Big Mac Index

An amusing example of PPP is the Economists 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
P. 53
[Session 11 & 12]
compared with the actual exchange rates to decide which currencies are over and
under-valued.
3.3.5
3.3.6
3.4
PPP can be used as our best predictor of future spot rates; however it suffers from the
following major limitations:
(a)
the future inflation rates are only estimates
(b)
the market is dominated by speculative transactions (98%) as opposed to trade
transactions; therefore PPP breaks down
(c)
government intervention governments may manage exchange rates, thus
defying the forces pressing towards PPP.
However, it is likely that the PPP may be more useful for predicting long-run
changes in exchange rates since these are more likely to be determined by the
underlying competitiveness of economies, as measured by the model.
Interest rate parity theory (IRP) ( )
(Jun 11, Dec 14)
3.4.1
Interest Rate Parity (IRP)

The IRP 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.
IRP predicts that the country with the higher interest rate will see the forward
rate for its currency subject to a depreciation.
If you need to calculate the forward rate in one years time:
F0 1 ic
S 0 1 ib
Where: F0 = Forward rate
S0 = Current spot rate
ib = interest rate for base currency
ic = interest rate for counter currency
3.4.2
Example 3
UK investor invests in a one-year US bond with a 9.2% interest rate as this
compares well with similar risk UK bonds offering 7.12%. The current spot rate is
$1.5/.
When the investment matures and the dollars are converted into sterling, IRP states
P. 54
[Session 11 & 12]
that the investor will have achieved the same return as if the money had been
invested in UK government bonds.
In 1 year, 1.0712 million must equate to $1.638 million so what you gain in extra
interest, you lose on an adverse movement in exchange rates.
The forward rates moves to bring about interest rate parity amongst different
currencies:
$1.638 1.0712 = $1.5291
By formula:
F0
1 9 .2 %
1.5 1 7.12%
F0 $1.5291
3.4.3 The IRPT generally holds true in practice. There are no bargain interest rates to be had
on loans/deposits in one currency rather than another. However, it suffers from the
following limitations:
(a)
government controls on capital markets
(b)
controls on currency trading
(c)
intervention in foreign exchange markets.
3.4.4 The interest rate parity model shows that it may be possible to predict exchange rate
movements by referring to differences in nominal exchange rates. If the forward
exchange rate for sterling against the dollar was no higher than the spot rate but US
nominal interest rates were higher, the following would happen:
(a)
UK investors would shift funds to the US in order to secure the higher interest
P. 55
(b)
3.5
[Session 11 & 12]
rates, since they would suffer no exchange losses when they converted $ back
to .
the flow of capital from the UK to the US would raise UK interest rates and
force up the spot rate for the US$.
Expectations theory
3.5.2
(Jun 12)
The expectations theory claims that the current forward rate is an unbiased
predictor of the spot rate at that point in the future.
If a trader takes the view that the forward rate is lower than the expected future spot
price, there is an incentive to buy forward. The buying pressure on the forward rates
raises the price, until the forward price equals the market consensus view on the
expected future spot price.
3.6
The International Fisher Effect
3.5.1
3.6.1
The International Fisher Effect claims that the interest rate differentials between
two countries provide an unbiased predictor of future changes in the spot rate of
exchange.
3.6.2 The International Fisher Effect assumes that all countries will have the same real
interest rate, although nominal or money rates may differ due to expected inflation
rates. Thus the interest rate differential between two countries should be equal to
the expected inflation differential. Therefore, countries with higher expected
inflation rates will have higher nominal interest rates, and vice versa.
3.6.3 The currency of countries with relatively high interest rates is expected to
depreciate against currencies with lower interest rates, because the higher interest
rates are considered necessary to compensate for the anticipated currency
depreciation.
3.6.4 Given free movement of capital internationally, this idea suggests that the real rate of
return in different countries will equalize as a result of adjustments to spot exchange
rates. The International Fisher Effect can be expressed as:
1 ia 1 ha
1 ib 1 hb
Where: ia = the nominal interest rate in country a

ib = the nominal interest rate in country b
ha = the inflation rate in country a
hb = the inflation rate in country b
P. 56
[Session 11 & 12]
P. 57
3.7
[Session 11 & 12]
Four-way equivalence
3.7.1 The four theories can be pulled together to show the overall relationship between spot
rates, interest rates, inflation rates and the forward and expected future spot rates. As
shown above, these relationships can be used to forecast exchange rates.

3.
The spot exchange rate

A
B
C
D
is the rate today for exchanging one currency for another for immediate delivery
is the rate today for exchanging one currency for another at a specified future
date
is the rate today for exchanging one currency for another at a specific location on
a specified future date
is the rate today for exchanging one currency for another at a specific location for
immediate delivery
P. 58
4.
If the US dollar weakens against the pound sterling, will UK exporters and importers
suffer or benefit?
A
B
C
D
5.
[Session 11 & 12]
UK exporters to US
Benefit
Suffer
Benefit
Suffer
UK importers from US
Benefit
Suffer
Suffer
Benefit
Pechora Co is a German business that has purchased goods from a supplier, Kama Co,
which is based in the USA. Pechora Co has been invoiced in euros and payment is to
be made 30 days after the purchase. During this 30-day period, the euro strengthened
against the US$.
Assuming neither Pechora Co nor Kama Co hedge against currency risk, what would
be the currency gain or loss for each party as a result of this transaction?
A
B
C
D
6.
Pechora
No gain or loss
Gain
No gain or loss
Loss
Kama
Gain
No gain or loss
Loss
No gain or loss
Sirius plc is a UK business that has recently purchased machinery from a Bulgarian
exporter. The company has been invoiced in sterling and the terms of sale include
payment within sixty days. During this payment period, the sterling weakened
against the Bulgarian lev.
If neither Sirius plc nor the Bulgarian exporter hedge against foreign exchange risk,
what would be the foreign exchange gain or loss arising from this transaction for Sirius
plc and for the Bulgarian exporter?
A
B
C
Sirius plc
No gain or loss
Gain
No gain or loss
Bulgarian exporter
Gain
No gain or loss
Loss
P. 59
D
7.
[Session 11 & 12]
Loss
No gain or loss
The current euro / US dollar exchange rate is 1 : $2. ABC Co, a Eurozone company,
makes a $1,000 sale to a US customer on credit. By the time the customer pays, the
Euro has strengthened by 20%.
What will the Euro receipt be?
A
B
C
D
8.
416.67
2,400
600
400
The current spot rate for the Dollar /Euro is $/ 2.0000 +/- 0.003. The dollar is quoted
at a 0.2c premium for the forward rate.
What will a $2,000 receipt be translated to at the forward rate?
A
B
C
D
9.
4,002
999.5
998
4,008
The spot rate of exchange is 1 = $14400. Annual interest rates are 4% in the UK and
10% in the USA.
The three month forward rate of exchange should be:
A
B
C
D
10.
1 = $14616
1 = $15264
1 = $15231
1 = $14614.
The home currency of ACB Co is the dollar ($) and it trades with a company in a
foreign country whose home currency is the Dinar. The following information is
available:
Home country
Foreign country
P. 60
Spot rate
Interest rate
Inflation rate
[Session 11 & 12]
20.00 Dinar per $

3% per year
2% per year
7% per year
5% per year
What is the six-month forward exchange rate?

A
B
C
D
2039 Dinar per $

2030 Dinar per $
2059 Dinar per $
2078 Dinar per $
11.
The following exchange rates of sterling against the Singapore dollar have been
quoted in a financial newspaper:
Spot
Three months forward
1 = Singapore $23820
1 = Singapore $23540
The interest rate in Singapore is 6% per year for a three-month deposit or borrowing.
What is the annual interest rate for a three-month deposit or borrowing in the UK?
A
B
C
D
12.
271%
726%
871%
1083%
Interest rate parity theory generally holds true in practice. However it suffers from
several limitations.
Which of the following is not a limitation of interest rate parity theory?
A
B
C
D
Government controls on capital markets

Controls on currency trading
Intervention in foreign exchange markets
Future inflation rates are only estimates
P. 61
13.
What does purchasing power parity refers to?

A
B
C
D
14.
A situation where two businesses have equal available funds to spend.

Inflation in different locations is the same.
Prices are the same to different customers in an economy.
Exchange rate movements will absorb inflation differences.
Purchasing Power Parity Theory (PPP) refers to

A
B
C
D
15.
[Session 11 & 12]
The concept that the same goods should sell for the same price across countries
after exchange rates are taken into account
The concept that interest rates across countries will eventually be the same
The orderly relationship between spot and forward currency exchange rates and
the rates of interest between countries
The natural offsetting relationship provided by costs and revenues in similar
market environments
An Iraqi company is expecting to receive Indian rupees in one year's time. The spot
rate is 19.68 Iraqi dinar per 1 India rupee. The company could borrow in rupees at 10%
or in dinars at 15%.
What is the expected exchange rate in one year's time?
A
B
C
D
16.
18.82 Iraqi dinar = 1 Indian rupee

What is the impact of a fall in a countrys exchange rate?

1
2
Exports will be given a stimulus

The rate of domestic inflation will rise
P. 62
A
B
C
D
17.
[Session 11 & 12]
1 only
2 only
Both 1 and 2
Neither 1 nor 2

An investor plans to exchange $1,000 into euros now, invest the resulting euros for 12
months, and then exchange the euros back into dollars at the end of the 12-month
period. The spot exchange rate is 1415 per $1 and the euro interest rate is 2% per
year. The dollar interest rate is 18% per year.
Compared to making a dollar investment for 12 months, at what 12-month forward
exchange rate will the investor make neither a loss nor a gain?
A
B
C
D
1223 per $1
1412 per $1
1418 per $1
1439 per $1
(ACCA F9 Financial Management June 2015)
4.
Foreign Currency Risk Management
4.1
Foreign currency hedging
4.1.1
When currency risk is significant for a company, it should do something to either

eliminate it or reduce it. Taking measures to eliminate or reduce the risk is called
hedging the risk or hedging the exposure.
4.2
Deal in home currency
(Jun 14, Dec 14)

4.2.1 Insist all customers pay in your own home currency and pay for all imports in home
currency. This method:
(a)
transfer risk to the other party
(b)
may not be commercially acceptable.
4.3
Do nothing
4.3.1
In the long run, the company would win some, lose some. This method
P. 63
(a)
(b)
(c)
4.4
[Session 11 & 12]
works for small occasional transactions

saves in transaction costs
is dangerous.
Leading and lagging

(Dec 07, Dec 08, Jun 14)
4.4.1
Companies might try to use:

(a)
Lead payments payment in advance
(b)
Lagged payments delaying payments beyond their due date.
4.4.2 In order to take advantage of foreign exchange rate movements. With a lead
payments, paying in advance of the due date, there is a finance cost to consider. This
is the interest cost on the money used to make the payment, but early settlement
discounts may be available.
4.4.3 Leading and lagging are a form of speculation. In relation to foreign currency
settlements, additional benefits can be obtained by the use these techniques when
currency exchange rates are fluctuating (assuming one can forecast the changes.)
4.4.4 Leading would be beneficial to the payer if this currency were strengthening
against his own. Lagging would be appropriate for the payer if the currency were
weakening.
4.5
4.5.1
Matching ()
(Jun 14)
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 foreign exchange (forex) markets for the unmatched portion of the total
transactions.
Suppose that ABC Co has the following receipts and payments in three months time:
P. 64
[Session 11 & 12]
4.5.2
Netting only applies to transfers within a group of companies. Matching can be

used for both intra-group transactions and those involving third parties. The
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.
4.6
Netting ()
4.6.1
Unlike matching, netting is not technically a method of managing exchange risk.

However, it is conveniently dealt with at this stage. The objective is simply to save
transactions 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, there is likely
to be inter-company indebtedness denominated in different currencies.
4.6.2
4.7
4.7.1
4.7.2
4.7.3
Forward exchange hedging ( )

(Pilot, Dec 07, Dec 08, Dec 09, Jun 11, Jun 12, Jun 13, Dec 14, Jun 15)
The spot market ( ) is where you can buy and sell a currency now
(immediate delivery), i.e. the spot rate of exchange.
The forward 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.
Forward Exchange Contracts
A forward exchange contract is:
(a)
An immediately firm and binding contract, e.g. between a bank and its
customer.
P. 65
(b)
(c)
(d)
4.7.4
[Session 11 & 12]
For the purchase or sale of a specified quantity of a stated foreign currency.

At a rate of exchange fixed at the time the contract is made.
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).
Example 4 Forward Contract

It is now 1 January and X Co will receive $10 million on 30 April.
It enters into a forward contract to sell this amount on the forward date at a rate of
$1.60/. On 30 April the company is guaranteed 6.25 million.
The risk has been completely removed.
4.7.5
Test your understanding 2

The current spot rate for US dollars against UK sterling is 1.4525 1.4535 $/ and
the one-month forward is quoted as 1.4550 1.4565.
A UK exporter expects to receive $400,000 in one month.
If a forward contract is used, how much will be received in sterling?
Solution:
4.7.6
Advantages and disadvantages:

Advantages
Disadvantages
Flexibility with regard to the

amount to be covered.
Relatively straightforward both to
comprehend and to organize.
4.8
Contractual commitment that must

be completed on the due date.
No opportunity to benefit from
favourable movements in exchange
rates.
Money market hedge
P. 66
[Session 11 & 12]
(Pilot, Dec 07, Dec 08, Dec 09, Jun 11, Jun 12, Jun 13, Jun 15)
4.8.1
Money Market Hedge

Money market hedge 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 favourable interest
rate movements.
(a)
Setting up a money market hedge for a foreign currency payment
4.8.2
Suppose a British company needs to pay a Swiss creditor in Swiss francs in three
months time. It does not have enough cash to pay now, but will have sufficient in three
months time. Instead of negotiating a forward contract, the company could:
Step 1:
Step 2:
Step 3:
Step 4:
4.8.3
Borrow the appropriate amount in pounds now

Convert the pounds to francs immediately
Put the francs on deposit in a Swiss franc bank account
When time comes to pay the company:
(a) pay the creditor out of the franc bank account
(b) repays the pound loan account
Example 5
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?
Solution:
The interest rates for 3 months are 2.15% to borrow in pounds and 2.5% to deposit
in kroners. The company needs to deposit enough kroners now so that the total
including interest will be Kr3,500,000 in three months time. This means
depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.
These kroners will cost 452,215 (spot rate 7.5509). The company must borrow this
amount and, with three months interest of 2.15%, will have to repay:
P. 67
[Session 11 & 12]
452,215 x (1 + 0.0215) = 461,938.

Thus, in three months, the Danish creditor will be paid out of the Danish bank
account and the company will effectively be paying 461,938 to satisfy this debt.
The effective forward rate which the company has manufactured is
3,500,000/461,938 = 7.5768. This effective forward rate shows the kroner at a
discount to the pound because the kroner interest rate is higher than the sterling
rate.
(b)
Setting up a money market hedge for a foreign currency receipt
4.8.4
A similar technique can be used to cover a foreign currency receipt from a debtor. To
manufacture a forward exchange rate, follow the steps below.
Step 1: Borrow the appropriate amount in foreign currency today
Step 2: Convert it immediately to home currency
Step 3: Place it on deposit in the home currency
Step 4: When the debtors cash is received:
(a) Repay the foreign currency loan
(b) Take the cash from the home currency deposit account
4.8.5
Example 6
A UK company is owed SFr 2,500,000 in three months time by a Swiss company.
The spot exchange rate is SFr/ 2.2498 2.2510. The company can deposit in
Sterling for 3 months at 8.00% per annum and can borrow Swiss Francs for 3
months at 7.00% per annum. What is the receipt in pounds with a money market
P. 68
[Session 11 & 12]
hedge and what effective forward rate would this represent?

Solution:
The interest rates for 3 months are 2.00% to deposit in pounds and 1.75% to borrow
in Swiss francs. The company needs to borrow SFr2,500,000/1.0175 =
SFr2,457,003 today. These Swiss francs will be converted to at 2,457,003/2.2510
= 1,091,516. The company must deposit this amount and, with three months
interest of 2.00%, will have earned
1,091,516 x (1 + 0.02) = 1,113,346
Thus, in three months, the loan will be paid out of the proceeds from the debtor and
the company will receive 1,113,346. The effective forward rate which the
company has manufactured is 2,500,000/1,113,346 = 2.2455. This effective
forward rate shows the Swiss franc at a premium to the pound because the
Swiss franc interest rate is lower than the sterling rate.
4.9
Choosing the hedging method
4.9.1
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.
When a company expects to receive or pay a sum of foreign currency in the next few
months, it can choose between using the forward exchange market and the money
market to hedge against the foreign exchange risk. Other methods may also be
possible, such as making lead payments. The cheapest method available is the one
4.9.2
P. 69
[Session 11 & 12]
that ought to be chosen.

4.9.3
Example 7
ABC Co has bought goods from a US supplier, and must pay $4,000,000 for them
in three months time. The companys finance director wishes to hedge against the
foreign exchange risk, and the three methods which the company usually considers
are:
(a) Using forward exchange contracts
(b) Using money market borrowing or lending
(c) Making lead payments
The following annual interest rates and exchange rates are currently available.
US dollar
Sterling
Deposit rate
Borrowing rate
Deposit rate
Borrowing rate
1 month
10.25
10.75
14.00
3 months
10.75
11.00
14.25
$/ exchange rate ($ = 1)
1.8625 1.8635
1.8565 1.8577
1.8455 1.8460
Spot
1 month forward
3 months forward
Which is the cheapest method for ABC Co? Ignore commission costs (the bank
charges for arranging a forward contract or a loan).
Solution:
The three choices must be compared on a similar basis, which means working out
the cost of each to ABC Co either now or in three months time. In the following
paragraphs, the cost to ABC Co now will be determined.
Choice 1: the forward exchange market
ABC Co must buy dollars in order to pay the US supplier. The exchange rate in a
forward exchange contract to buy $4,000,000 in three months time (bank sells) is
1.8445.
P. 70
[Session 11 & 12]
The cost of the $4,000,000 to ABC Co in three months time will be:
$4,000,000
= 2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that by
deferring payment for three months, we assume that the company needs to borrow
the money for the payment.
At an annual interest rate of 14.25% the rate for three months is 14.25/4 = 3.5625%.
The present cost of 2,168,609.38 in three months time is:
2,168,609.38 / 1.035625 = 2,094,010.26
Choice 2: the money markets
Using the money market involves
(a) Borrowing in the foreign currency, if the company will eventually receive the
currency
(b) Lending in the foreign currency, if the company will eventually pay the
currency. Here, ABC Co will pay $4,000,000 and so it would lend US
dollars.
It would lend enough US dollars for three months, so that the principal repaid in
three months time plus interest will amount to the payment due of $4,000,000.
(a) Since the US dollar deposit rate is 7%, the rate for three months is
approximately 7/4 = 1.75%.
(b) To earn $4,000,000 in three months time at 1.75% interest, ABC Co would
have to lend now:
$4,000,000
$3,931,203.93
1.0175
These dollars would have to be purchased now at the spot rate of $1.8625. The cost
would be:
$3,931,203.93
= 2,110,713,52
1.8625
By lending US dollars for three months, ABC Co is matching eventual receipts and
payments in US dollars, and so has hedged against foreign exchange risk.
P. 71
[Session 11 & 12]
Choice 3: lead payments

Lead payments should be considered when the currency of payment is expected to
strengthen over time, and is quoted forward at a premium on the foreign exchange
market. Here, the cost of a lead payment (paying $4,000,000 now) would be
$4,000,000 / 1.8625 = 2,147,651.01.
Summary
Forward exchange contract (cheapest)
Currency lending
Lead payment
2,094,010.26
2,110,713.52
2,147,651.01

18.
What is the purpose of hedging?

A
B
C
D
19.
What does the term matching refer to?

A
B
C
D
20.
To protect a profit already made from having undertaken a risky position

To make a profit by accepting risk
To reduce or eliminate exposure to risk
To reduce costs.
The coupling of two simple financial instruments to create a more complex one.
The mechanism whereby a company balances its foreign currency inflows and
outflows.
The adjustment of credit terms between companies
Contracts not yet offset by futures contracts or fulfilled by delivery.
ABC plc has to pay a Germany supplier 90,000 euros in three months time. The
companys finance director wishes to avoid exchange rate exposure, and is looking at
four options.
1.
Do nothing for three months and then buy euros at the spot rate
P. 72
2.
3.
4.
[Session 11 & 12]
Pay in full now, buying euros at todays spot rate

Buy euros now, put them on deposit for three months, and pay the debt with
these euro plus accumulated interest
Arrange a forward exchange contract to buy the euros in three months time
Which of these options would provide cover against the exchange rate exposure that
ABC plc would otherwise suffer?
A
B
C
D
21.
4 only
3 and 4 only
2, 3 and 4 only
1, 2,3 and 4
Consider the following statements concerning currency risk:

1.
2.
Leading and lagging is a method of hedging transaction exposure.

Matching receipts and payments is a method of hedging translation exposure.
Which of the above statements is/are true?

Statement 1
Statement 2
A
True
True
B
True
False
C
False
True
D
False
False
22.
A large multinational business wishes to manage its currency risk. It has been
suggested that:
1.
2.
Matching receipts and payments can be used to manage translation risk.

Matching assets and liabilities can be used to manage economic risk.
Which ONE of the following combinations (true/false) concerning the above

statements is correct?
P. 73
A
B
C
D
23.
Statement 1
True
True
False
False
[Session 11 & 12]
Statement 2
True
False
True
False
A business uses each of the hedging methods described below to protect against a
particular type of foreign exchange risk:
1.
2.
3.
Hedging method used

Matching receipts and payments
Matching assets and liabilities
Leading and lagging
Type of foreign exchange risk

Transaction risk
Economic risk
Translation risk
Which of the hedging methods described above are suitable for their intended
purpose?
A
B
C
D
24.
25.
1 and 2
1 and 3
1, 2 and 3
2 and 3
A forward exchange contract is

(1)
(2)
(3)
(4)
an immediately firm and binding contract

for the purchase or sale of a specified quantity of a stated foreign currency
at a rate of exchange fixed at the time the contract is made
for performance at a future time which is agreed when making the contract
A
B
C
D
(1) and (2) only

(1), (2) and (3) only
(2) and (3) only
All of the above
Consider the following hedging methods.

1.
International diversification of operations
P. 74
2.
3.
4.
[Session 11 & 12]

Leading and lagging
Forward exchange contracts
Which of the hedging methods above are suitable for hedging transaction exposure?
A
B
C
D
26.
1 and 2
1, 2 and 3
2 and 3
2, 3 and 4
The following methods may be used to hedge currency risk:

1.
2.
3.
4.
International diversification of operations;

Currency swaps;
Leading and lagging;
Forward exchange contracts.
Which TWO of the above can be used to hedge currency risk arising from economic
exposure?
A
B
C
D
27.
1 and 2
1 and 3
2 and 4
3 and 4
A business uses the hedging methods outlined below to protect itself against the
particular types of foreign exchange risk against which they are matched.
Hedging method
Forward exchange contracts
Buying or selling domestic currency
Type of risk
Transaction risk
Economic risk
Translation risk
Which one of the following combinations best describes the suitability of the three
hedging methods for their intended purpose?
P. 75
A
B
C
D
28.
29.
30.
[Session 11 & 12]
Suitability of hedging method for the type of risk identified

Forward exchange
Matching receipts and
Buying or selling in
contracts
payments
domestic currency
Yes
No
Yes
Yes
No
No
No
Yes
Yes
No
No
Yes
Which is true of forward contracts?

1
2
3
4
They fix the rate for a future transaction.

They are a binding contract.
They are flexible once agreed.
They are traded openly.
A
B
C
D
1, 2 and 4 only
1, 2, 3 and 4
1 and 2 only
2 only
In comparison to forward contracts, which of the following are true in the relation to
futures contracts?
1
2
3
4
They are more expensive.

They are only available in a small amount of currencies.
They are less flexible.
They are probably an imprecise match for the underlying transaction.
A
B
C
D
1, 2 and 4 only
2 and 4 only
1 and 3 only
1, 2, 3 and 4
A UK company expects to receive 200,000 in three months time for goods sold to a
German customer and wishes to hedge the currency risk by taking out a forward
contract. The following rates have been quoted:
P. 76
Euro per
[Session 11 & 12]
Spot rate
1.4925 1.4985
3 months forward
1.4890 1.4897
If the forward contract is taken out, what are the sterling receipts for the UK company?
A
B
C
D
31.
133,467
134,003
134,255
134,318
Polaris plc, a UK-based business, has recently exported antique furniture to a US

customer and is due to be paid $500,000 in three months time. To hedge against
foreign exchange risk, Polaris plc has entered into a forward contract to sell $500,000
in three months time. The relevant exchange rates are as follows:
Spot 1 = $15535 15595
Three months forward 030 025 cents premium
How much will Polaris plc receive in sterling at the end of three months?
A
B
C
D
32.
321,130
321,234
322,373
322,477
Gydan plc, a UK business, is due to receive 500,000 in four months time for goods
supplied to a French customer. The company has decided to use a money market hedge
to manage currency risk. The following information concerning borrowing rates is
available:
Country
France
UK
Borrowing rate per annum

9%
6%
The spot rate is 1 = 14490 14520

Using the money market approach, what is the sterling value of the amount that
P. 77
[Session 11 & 12]
Gydan Co will have to borrow now in order to match the receipt?

A
B
C
D
33.
315,920
335,015
334,323
337,601
A UK based company, which has no surplus cash, is due to pay Euro 2,125,000 to a
company in Germany in three months time and wants to hedge the payment using
money markets.
The current spot rate is Euro 1223012270 per sterling. The annual interest rates
available to the company in the UK and in Germany are as follows:
Country
UK
Germany
Borrow
5.72%
4.52%
Lend
3.64%
2.84%
What would it cost the company in UK if it hedges its Euro exposure?
A
B
C
D
34.
If the underlying transaction gives you _____________, denominated in a foreign

currency, the general principal behind a money market hedge states that you need an
equivalent liability in the money market to provide a hedge.
A
B
C
D
35.
1,786,190
1,780,367
1,749,953
1,744,248
a liability
an asset
a forward contract
a foreign bank account
A company whose home currency is the dollar ($) expects to receive 500,000 pesos in
six months time from a customer in a foreign country. The following interest rates and
P. 78
[Session 11 & 12]
exchange rates are available to the company:

Spot rate
Six-month forward rate
Borrowing interest rate

Deposit interest rate
15.00 peso per $

15.30 peso per $
Home country
4% per year
3% per year
Foreign country
8% per year
6% per year
Working to the nearest $100, what is the six-month dollar value of the expected receipt
using a money-market hedge?
A
B
C
D
$32,500
$33,700
$31,800
$31,900
(ACCA F9 Financial Management December 2014)
P. 79
[Session 11 & 12]
5.
Foreign Currency Derivatives
5.1
Currency futures
(Pilot, Dec 08, Dec 09)
5.1.1
Currency Futures
Currency futures are standardized contracts for the sale or purchase at a set
future date of a set quantity of currency.
Futures contracts are exchange-based instruments traded on a regulated exchange.
The buyer and seller of a contract do not transact with each other directly.
5.1.2
Example 8
A US company buys goods worth 720,000 from a German company payable in 30
days. The US company wants to hedge against the strengthening against the
dollar.
Current spot is 0.9215 0.9221 $/ and the futures rate is 0.9245 $/.
The standard size of a 3 month futures contract is 125,000.
In 30 days time the spot is 0.9345 0.9351 $/.
Closing futures price will be 0.9367.
Evaluate the hedge.
Solution:
1.
2.
We assume that the three month contract is the best available.

We need to buy or sell $. As the futures contract is in , we need to buy
futures.
3.
No. of contracts -
4.
Tick size minimum price movement x contract size = 0.0001 125,000 =

$12.50
Closing futures price we are told it will be 0.9367
Hedge outcome
Outcome in futures market
Opening futures price = 0.9245
Closing futures price = 0.9367
5.
6.
720,000
= 5.76, say 6 contracts
125,000
P. 80
[Session 11 & 12]
Movement in ticks = 122 ticks

Futures profit = 122 $12.50 6 contracts = $9,150
Net outcome
Spot market payment (720,000 0.9351 $/)
Futures market profit
$
673,272
(9,150)
664,122
5.1.3
Advantages and disadvantages of futures to hedge risks

Advantages
Disadvantages
(a) Transaction costs should be lower (a) The contracts cannot be tailored
than other hedging methods.
to the users exact requirements.
(b) Futures are tradeable on a (b) Hedge inefficiencies are caused by
secondary market so there is pricing
having to deal in a whole number
transparency.
of contracts and by basis risk.
(c) The exact date of receipt or (c) Only a limited number of
payment does not have to be
currencies are the subject of
known.
futures contracts.
(d) Unlike options, they do not allow a
company to take advantage of
favourable currency movements.
Basis risk the risk that the futures contract price may move by a different amount
from the price of the underlying currency or commodity.
5.2
Currency options
(Dec 08, Dec 09)
5.2.1
Currency Options
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.
5.2.2
Key Terms
(a)
Call option gives the purchaser a right, but not the obligation, to buy a
fixed amount of currency at a specified price at some time in the future.
P. 81
(b)
(c)
(d)
(e)
(f)
(g)
(h)
[Session 11 & 12]
The seller of the option, who receives the premium, is referred to as the
writer.
Put option gives the holder the right, but not the obligation, to sell a
specific amount of currency at a specified date at a fixed exercise price (or
strike price).
In-the-money option ( ) the underlying price is above the
strike price.
At-the-money option ( ) the underlying price is equal to the
option exercise price.
Out-of-the-money option ( ) the underlying price is below the
option exercise price.
American-style options can be exercised by the buyer at any time up to
the expiry date.
European-style options can only be exercised on a predetermined
future date.
5.2.3 Companies can choose whether to buy:

(a)
a tailor-made currency option from a bank, suited to the companys specific
needs. These are over-the-counter (OTC) or negotiated options, or
(b)
a standard option, in certain currencies only, from an options exchange. Such
options are traded or exchange-traded options.
5.2.4 A company can therefore:
(a)
Exercise the option if it is in its interests to do so.
(b)
Let it lapse if:
(i)
the spot rate is more favourable
(ii)
there is no longer a need to exchange currency.
5.3
Currency swap ( )
(Dec 08, Dec 09)
5.3.1
Currency Swap
A swap is a formal agreement whereby two organizations contractually agree to
exchange payments on different terms, e.g. in different currencies, or one at a
fixed rate and the other at a floating rate.
5.3.2
Example 9
Consider a UK company X with a subsidiary Y in France which owns vineyards.
Assume a spot rate of 1 = 1.6 Euros. Suppose the parent company X wishes to
P. 82
[Session 11 & 12]
raise a loan of 1.6 million Euros for the purpose of buying another French wine
company. At the same time, the French subsidiary Y wishes to raise 1 million to
pay new up-to-date capital equipment imported from the UK. The UK parent
company X could borrow the 1 million sterling and the French subsidiary Y could
borrow the 1.6 million Euros, each effectively borrowing on the others behalf.
They would then swap currencies.

36.
Which of the following is true?

A
B
C
D
37.
As the majority of futures contracts are never taken to delivery a futures contract
is not legally binding
The quantity in a futures contract is agreed between the buyer and seller
Delivery dates on futures contracts are specified by the futures exchange and not
by the buyer and seller
The margin requirement is a purchase cost of a future.
Consider the following two statements:

1.
2.
One form of hedging is where an investor buys shares in one market and sells
them immediately in another to profit from price differences between the two
markets.
One form of financial derivative is a preference share of a business.
Which one of the following combinations relating to the above statements is correct?
Statement 1
Statement 2
P. 83
A
B
C
D
38.
[Session 11 & 12]
True
True
False
False
True
False
True
False
Consider the following statements concerning derivatives.

1.
2.
Futures contracts may not be traded on an organised exchange

Forward contracts may be traded on an organised exchange
Which one of the following combinations (true/false) concerning the above statements
is correct?
A
B
C
D
39.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
Consider the following two statements concerning futures contracts.

1.
2.
A futures contract is negotiated between a buyer and seller and can be tailored to
the buyers particular requirements.
A futures contract can be traded on a futures exchange.
Which of the following combinations (true/false) is correct?
A
B
C
D
40.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
Consider the following statements concerning futures contracts.

1.
2.
Futures contracts are tailor-made for the needs of the client

Futures contracts can be traded on a futures exchange
P. 84
3.
4.
[Session 11 & 12]
A short position on a futures contract can be closed by buying an equal number

of the contracts for the same settlement date.
A long position on a futures contract can be closed by buying an equal number of
contracts for the same settlement date.
Which two of the above statements are correct?

A
B
C
D
41.
1 and 3
1 and 4
2 and 3
2 and 4
Consider the following statements concerning financial options.

1.
2.
A European-style option gives the holder the right to exercise the option at any
time up to and including its expiry date.
An in-the-money option has a more favourable strike price for the option writer
than the current market price of the underlying item.
is correct?
A
B
C
D
42.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
Consider the following statements concerning options.

1.
2.
An out of-the-money call option has an intrinsic value of zero.

An American-style option can be exercised at any time up to, and including, the
expiry date.
Which one of the following combinations (true/false) relating to the above statements
is correct?
Statement 1
Statement 2
P. 85
A
B
C
D
43.
[Session 11 & 12]
True
True
False
False
True
False
True
False
The following statements have been made concerning options.

1.
2.
3.
4.
An out-of-the-money option has an intrinsic value of zero.

An American-style option can only be exercised on the expiry date of the option.
When an option is used to hedge currency risk, the option will be exercised only
if the market price of the underlying item is less favourable than the option strike
price.
An employee share option is a form of put option.
Which TWO of the above statements are correct?

A
B
C
D
44.
Which of the following measures will allow a UK company to enjoy the benefits of a
favourable change in exchange rates for their euro receivables contract while
protecting them from unfavourable exchange rate movements?
A
B
C
D
45.
1 and 2
1 and 3
2 and 4
3 and 4
A forward exchange contract

A put option for euros
A call option for euros
A money market hedge
The following European-style options are held at their expiry date by an investor:
1.
2.
A call option of 20,000 shares in Peterhouse plc with an exercise price of 860p.
The market price of the shares at the expiry date is 880p.
A put option of 600,000 in exchange for euros at a strike rate of 1 = 15. The
exchange rate at the expiry date is 1 = 145.
P. 86
[Session 11 & 12]
Which one of the above combinations (exercise/lapse) concerning the options should
be undertaken by the investor?
Option 1
Exercise
Exercise
Lapse
Lapse
A
B
C
D
46.
Option 2
Exercise
Lapse
Exercise
Lapse
Musat plc holds the following OTC options at their expiry date:
1.
2.
A put option on dollars at an exchange rate of 1 = $192. The exchange rate is

1 = $195 at the expiry date of the option.
A call option on 5,000 ordinary shares in Spitzer plc at an exercise price of 575p.
The share price is 562p at the expiry date of the option.
Which of the above options should be exercised and which should be allowed to lapse
at their expiry date?
Put option
Exercise
Lapse
Exercise
Lapse
A
B
C
D
47.
Call option
Exercise
Exercise
Lapse
Lapse
A US company has just purchased goods from a UK supplier for 500,000. Payment is
due in three months time and the US company wishes to hedge its exposure to
exchange rate risk. The following ways of dealing with the exchange rate risk have
been suggested:
1.
2.
3.
Buy sterling futures now and sell sterling futures in three months time
Buy sterling call options now.
Sell sterling futures now and buy sterling futures in three months time
P. 87
4.
[Session 11 & 12]
Buy sterling put options now
Which two of the above suggestions would provide a hedge against exchange rate
risk?
A
1 and 2
B
1 and 3
C
2 and 3
D
3 and 4
48.
A UK business expects to receive euros in five months time. Assume that the business
wishes to hedge against exchange rate risk.
Which one of the following methods should be employed?
A
B
C
D
49.
Take out a forward contract to sell euros in five months time

Take out a forward contract to buy euros in five months time
Buy euros now at the prevailing spot rate
Take out a call option on euros.
A company based in Farland (with the Splot as its currency) is expecting its US
customer to pay $1,000,000 in 3 months time and wants to hedge this transaction
using currency options.
What is the option they require?
50.
1
2
3
4
A Splot put option purchased in America

A US dollar put option purchased in Farland
A Splot call option purchased in America
A US dollar call option purchased in Farland.
A
B
C
D
2 or 3 only
2 only
1 or 4 only
4 only
A UK company has just provided a service to a US company for $750,000. Settlement

is due in two months time and the UK company wants to hedge the risk of a fall in the
P. 88
[Session 11 & 12]
value of the US dollar over the next two months. The following methods of hedging
this risk have been suggested:
1.
2.
3.
4.
Buy sterling put options now

Buy sterling futures now
Buy sterling call options now
Sell sterling futures now
Which two of the above suggestions would provide a hedge against the exchange rate
risk?
A
B
C
D
51.
1 and 3
1 and 4
2 and 3
2 and 4
Wetterstein Inc, a US-based company, expects to receive 800,000 in two months time
for consultancy services provided to the Spanish government. It wishes to be certain of
the amount to be received and will use the derivatives market to achieve this.
Which one of the following actions should the company take NOW to hedge the risk?
A
B
C
D
52.
Buy euro futures

Buy US dollar options
Sell euro futures
Sell US dollar futures
Three derivatives that may be used to manage financial risk are as follows:
1. Futures contracts
2. Forward contracts
3. Swaps
Which of the above may be traded on an organised exchange?
A
1 only
P. 89
B
C
D
53.
[Session 11 & 12]
1 and 2
2 only
2 and 3
Consider the following statements concerning currency risk hedges:

1.
2.
A currency swap may be used to hedge for a longer period than that offered by
forward exchange contracts.
A futures contract can be customised to fit the particular needs of the client.
is correct?
A
B
C
D
54.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
Which of the following statements is correct?

A
B
C
D
Once purchased, currency futures have a range of close-out dates

Currency swaps can be used to hedge exchange rate risk over longer periods than
the forward market
Banks will allow forward exchange contracts to lapse if they are not used by a
company
Currency options are paid for when they are exercised
(ACCA F9 Financial Management December 2014)
P. 90
[Session 11 & 12]
Examination Style Questions

Question 1 Types of foreign currency risk, PPP, IRP, forward contract, money market
and futures
Nedwen Co is a UK-based company which has the following expected transactions.
One month:
One month:
Three months:
Expected receipt of $240,000

Expected payment of $140,000
Expected receipts of $300,000
The finance manager has collected the following information:

Spot rate ($ per ):
One month forward rate ($ per ):
Three months forward rate ($ per ):
1.7820 0.0002
1.7829 0.0003
1.7846 0.0004
Money market rates for Nedwen Co:
One year sterling interest rate:

One year dollar interest rate
Borrowing
4.9%
5.4%
Deposit
4.6%
5.1%
Assume that it is now 1 April

Required:
(a)
(b)
(c)
(d)
(e)
Discuss the differences between transaction risk, translation risk and economic risk.
(6 marks)
Explain how inflation rates can be used to forecast exchange rates.
(6 marks)
Calculate the expected sterling receipts in one month and in three months using the
forward market.
(3 marks)
Calculate 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.
(5 marks)
Discuss how sterling currency futures contracts could be used to hedge the three-month
dollar receipt.
(5 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper 2006 Q2)
P. 91
[Session 11 & 12]
Question 2 Objectives of working capital management, EOQ, receivables management,

forward contract, money market hedge and lead payment
PKA Co is a European company that sells goods solely within Europe. The recently-appointed
financial manager of PKA Co has been investigating the working capital management of the
company and has gathered the following information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units.
Forecast demand to meet production requirements during the next year is 625,000 units. The
cost of placing and processing an order is 250, while the cost of holding a unit in stores is
050 per unit per year. Both costs are expected to be constant during the next year. Orders are
received two weeks after being placed with the supplier. You should assume a 50-week year
and that demand is constant throughout the year.
Accounts receivable management
Domestic customers are allowed 30 days credit, but the financial statements of PKA Co show
that the average accounts receivable period in the last financial year was 75 days. The
financial manager also noted that bad debts as a percentage of sales, which are all on credit,
increased in the last financial year from 5% to 8%.
Accounts payable management
PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in
six months time. The financial manager is concerned that the cost of these supplies may rise
in euro terms and has decided to hedge the currency risk of this account payable. The
following information has been provided by the companys bank:
Spot rate ($ per ):
Six months forward rate ($ per ):
1.998 0.002
1.979 0.004
Money market rates available to PKA Co:

One year euro interest rate:
One year dollar interest rate
Borrowing
6.1%
4.0%
Deposit
5.4%
3.5%
Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.
Required:
P. 92
(a)
(b)
(c)
(d)
[Session 11 & 12]
Identify the objectives of working capital management and discuss the conflict that may
arise between them.
(3 marks)
Calculate the cost of the current ordering policy and determine the saving that could be
made by using the economic order quantity model.
(7 marks)
Discuss ways in which PKA Co could improve the management of domestic accounts
receivable.
(7 marks)
Evaluate whether a money market hedge, a forward market hedge or a lead payment
should be used to hedge the foreign account payable.
(8 marks)
(25 marks)
(ACCA F9 Financial Management December 2007 Q4)
Question 3 Pecking order theory, market value of bond, forward contract, money
market hedge and foreign currency derivatives
Three years ago Boluje Co built a factory in its home country costing $32 million. To finance
the construction of the factory, Boluje Co issued peso-denominated bonds in a foreign country
whose currency is the peso. Interest rates at the time in the foreign country were historically
low. The foreign bond issue raised 16 million pesos and the exchange rate at the time was
500 pesos/$.
Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each
year of 61%. The bonds will be redeemed in five years time at par. The current cost of debt
of peso-denominated bonds of similar risk is 7%.
In addition to domestic sales, Boluje Co exports goods to the foreign country and receives
payment for export sales in pesos. Approximately 40% of production is exported to the
foreign country.
The spot exchange rate is 600 pesos/$ and the 12-month forward exchange rate is 607 pesos/
$. Boluje Co can borrow money on a short-term basis at 4% per year in its home currency and
it can deposit money at 5% per year in the foreign country where the foreign bonds were
issued. Taxation may be ignored in all calculation parts of this question.
Required:
(a)
Briefly explain the reasons why a company may choose to finance a new investment by
an issue of debt finance.
(7 marks)
P. 93
(b)
(c)
(d)
[Session 11 & 12]
Calculate the current total market value (in pesos) of the foreign bonds used to finance
the building of the new factory.
(4 marks)
Assume that Boluje Co has no surplus cash at the present time:
(i) Explain and illustrate how a money market hedge could protect Boluje Co against
exchange rate risk in relation to the dollar cost of the interest payment to be made
in one years time on its foreign bonds.
(4 marks)
(ii) Compare the relative costs of a money market hedge and a forward market hedge.
(2 marks)
Describe other methods, including derivatives, that Boluje Co could use to hedge
against exchange rate risk.
(8 marks)
(Total 25 marks)
Question 4 Rights issue, EPS, shareholders wealth, transaction risk, translation risk,
forward contracts and money market hedge
NG Co has exported products to Europe for several years and has an established market
presence there. It now plans to increase its market share through investing in a storage,
packing and distribution network. The investment will cost 13 million and is to be financed
by equal amounts of equity and debt. The return in euros before interest and taxation on the
total amount invested is forecast to be 20% per year.
The debt finance will be provided by a 65 million bond issue on a large European stock
market. The interest rate on the bond issue is 8% per year, with interest being payable in euros
on a six-monthly basis.
The equity finance will be raised in dollars by a rights issue in the home country of NG Co.
Issue costs for the rights issue will be $312,000. The rights issue price will be at a 17%
discount to the current share price. The current share price of NG Co is $400 per share and
the market capitalisation of the company is $100 million.
NG Co pays taxation in its home country at a rate of 30% per year. The currency of its home
country is the dollar. The current price/earnings ratio of the company, which is not expected to
change as a result of the proposed investment, is 10 times.
The spot exchange rate is 13000 /$. All European customers pay on a credit basis in euros.
Required:
P. 94
(a)
(b)
(c)
(d)
[Session 11 & 12]
Calculate the theoretical ex rights price per share after the rights issue.
(4 marks)
Evaluate the effect of the European investment on:
(i) the earnings per share of NG Co; and
(ii) the wealth of the shareholders of NG Co.
Assume that the current spot rate and earnings from existing operations are both
constant.
(9 marks)
Explain the difference between transaction risk and translation risk, illustrating your
answer using the information provided.
(4 marks)
The six-month forward rate is 12876 /$ and the twelve-month forward rate is 12752
/$. NG Co can earn 28% per year on short-term euro deposits and can borrow shortterm in dollars at 53% per year.
Identify and briefly discuss exchange rate hedging methods that could be used by NG
Co. Provide calculations that illustrate TWO of the hedging methods that you have
identified.
(8 marks)
(Total 25 marks)
Question 5 IRP, PPP and foreign currency risk management

ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several
years ago when peso interest rates were relatively cheap compared to dollar interest rates.
Economic difficulties have now increased peso interest rates while dollar interest rates have
remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months time.
The following information is available.
Spot rate:
Six month forward rate
Per $
pesos 12.500 pesos 12.582
pesos 12.805 pesos 12.889
Interest rates that can be used by ZPS Co:

Borrow
Peso interest rates
10.0% per year
Dollar interest rates
4.5% per year
Deposit
7.5% per year
3.5% per year
Required:
P. 95
(a)
(b)
[Session 11 & 12]
Explain briefly the relationships between;

(i) exchange rates and interest rates;
(ii) exchange rates and inflation rates.
(5 marks)
Calculate whether a forward market hedge or a money market hedge should be used to
hedge the interest payment of 5 million pesos in six months time. Assume that ZPS Co
would need to borrow any cash it uses in hedging exchange rate risk.
(6 marks)
(ACCA F9 Financial Management June 2011 Q4a)
P. 96

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