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Chapter 19. Foreign currency risk. Contents. 1. Exchange rates. Foreign currency risk. 2. 3. The causes of exchange rate fluctuations. Foreign currency risk management. 4. 5. Foreign currency derivatives. Exchange rates. Exchange rate :.
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Chapter 19 Foreign currency risk
Contents 1 Exchange rates Foreign currency risk 2 3 The causes of exchange rate fluctuations Foreign currency risk management 4 5 Foreign currency derivatives
Exchange rates • Exchange rate: • Exchange rate: is the rate at which one country's currency can be traded in exchange for another country's currency. • There are two ways in which exchange rates are quoted: A direct quotation: domestic currency is quoted per unit of the foreign currency An indirect quotation: foreign currency is quoted per unit of the domestic currency, this is the way exchange rates are quoted in UK. • Spot rates: the rate at which the currency can be exchanged immediately; • Forward rates: the rate at which the currency can be exchanged at some specified future date. • Spot rates: • Forward rates:
Translation risk Foreign currency 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 subsidiary’s assets at the exchange rate on the balance sheet date.
Foreign currency risk Translation risk: changes of the value of assets and liabilities in the financial accounts
Foreign currency risk Economic risk: the impact on the values of a business-the PV of future CF of unexpected exchange rate changes.
Economic risk Foreign currency risk This refers to the effect of exchange rate movements on the international competitiveness of a company and refers to the effect on the present value of longer term cash flows. 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.
Foreign currency risk • Transaction risk: is the risk of adverse exchange rate movements occurring in the course of normal international trading transactions. This arises when the prices of imports or exports are fixed in foreign currency terms and there is movement in the exchange rate between the date when the price is agreed and the date when the cash is paid or received in settlement.
Exchange rates • Speculation • The underlying balance of payments • Government policy on managing or fixing exchange rates Exchange rates • Comparative rates of inflation in different countries (Purchasing power parity, PPP,) • Comparative interest rates in different countries (Interest rate parity,)
Exchange rates Interest rate parity —The difference between spot and forward rates reflects differences in interest rates. —The principle of interest rate parity links the foreign exchange markets and the international money markets. Purchasing power parity —Purchasing power parity theory predicts that the exchange value of foreign currency depends on the relative purchasing power of each currency in its own country and that spot exchange rates will vary over time according to relative price changes.
PPP theory Inflation rate differences Exchange rate movements High interest rates due to high inflation High interest rates predict a decline in the exchange rate IRP theory Interest rate differences Forward rates Four way equivalence
Foreign currency risk management • Foreign exchange risk currency of invoice matching receipts and payments matching assets and liabilities leading and lagging netting forward exchange contracts money market hedging
Managing transaction risk–internal methods Matching Invoice in £s Leading $ revenue Netting Lagging
Exchange rates • Netting Netting is a process in which credit balances are netted off against debit balances so tat only the reduced net amounts remain due to be paid by actual currency flows. • Close-out of forward contracts The bank arranges for the customer to perform his part of the forward exchange contract by either selling or buying the ‘missing’ currency at the spot rate. These arrangements are known as closing out a forward exchange contract.
Ad/Disad money market hedging • Advantages of money market hedging – May be cheaper if an exporter with a cash flow deficit or an importer with a cash flow surplus • Disadvantages – More time consuming than a forward contract and normally no cheaper
Foreign currency derivatives • Currency future —Currency futures are standardized contracts for the sale or purchase at a set future date of a set quantity of currency. —Currency futureare not nearly as common as forward contracts, and their market is much smaller. —A currency future is a standardized contract to buy or sell a specified quantity of foreign currency.
Foreign currency derivatives • Currency options Currency options protect against adverse exchange rate movements while allowing the investor to take advantage of favourable exchange rate movements. They are particularly useful in situations where the cash flow is not certain to occur(eg when tendering for overseas contracts). 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.
Foreign currency derivatives • Currency swaps —Currency swaps effectively involve the exchange of debt from one currency to another. —Currency swaps can provide a hedge against exchange rate movements for longer periods than the forward market, and can be a means of obtaining finance from new countries.
Chapter 20 Interest rate risk
Contents Interest rates 1 Interest rate risk 2 3 The causes of Interest rate fluctuations Interest rate risk management 4 Interest rate derivatives 5
Interest rate risk Higher costs on existing loans Higher costs on planned loans Basis risk Gap exposure
Interest rate risk • Interest rates: are effectively the “prices” governing lending and borrowing. • Interest rates risk relates to the sensitivity of profit and cash flows to changes in interest rates. • Gap exposure – a negative gap: larger interest-sensitive liabilities than assets – a positive gap: larger interest-sensitive assets than liabilities • Basis risk: two floating rates not using the same basis
The causes of interest rate fluctuations • The structure of interest rates – risk – need to make a profit on re-lending – size of the loan or deposit – different types of financial asset – the duration of the lending – expectations theory – market segmentation theory – government policy
The causes of interest rate fluctuations • The general level of interest rates – need for a real return – inflation – uncertainty about future rates of inflation – liquidity preference of investors and the demand for borrowing – balance of payments – monetary policy – interest rates abroad
The causes of interest rate fluctuations • The term structure of interest rates – refers to the way in which the yield on a security varies according to the term of the borrowing, that is the length of time until the debt will be repaid as shown by the yield curve. • Why the yield curve normally be upward sloping – compensate for money tied up for a longer time – compensate for greater risk
The yield curve % yield Normal yield curve Years
Interest rate risk management • Interest rate risk can be managed using internal hedging in the form of asset and liability management, matching and smoothing or using external hedging instruments such as forward rate agreements and derivatives. • Matching and smoothing – matching is where liabilities and assets with a common interest rate are matched – smoothing is where a company keeps a balance between its fixed rate and floating rate borrowing • Forward rate agreements – forward rate agreements hedge risk by fixing the interest rate on future borrowing
Interest rate derivatives • Interest rate derivatives Interest rate futures can be used to hedge against interest rate changes between the current date and the date at which the interest rate on the lending or borrowing is set. Borrowing sell futures to hedge against interest rate rises; lenders buy futures to hedge against interest rate falls.
Interest rate derivatives • Future contracts Most LIFFE(London international financial futures and options exchange) futures contracts involve interest rates(interest rate futures), and these offer a means of hedging against the risk of interest rate movements. Such contracts are effectively a gamble on whether interest rates will rise or fall. Like other futures contracts, interest rate futures offer a way in which speculators can ‘bet’ on market movements just as they offer others who are more risk-averse a way of hedging risks.
Interest rate derivatives • Interest rate options Interest rate options allow an organisation to limit its exposure to adverse interest rate movements, while allowing it to take advantage of favourable interest rate movements. An interest rate option grants the buyer of it the right, but not the obligation, to deal at an agreed interest rate(strike rate) at a future maturity date. On the date of expiry of the option, the buyer must decide whether or not to exercise the right.
Interest rate derivatives • Interest Rate Cap Caps set a ceiling to the interest rate; a floor sets a lower limit. A collar is the simultaneous purchase of a cap and floor. Various cap and collar agreements are possible. • An interest rate cap is an option which sets an interest rate ceiling. • (b) A floor is an option which sets a lower limit to interest rates. • (c) Using a ‘collar’ arrangement, the borrower can buy an interest rate cap and at the same time sell an interest rate floor. This limits the cost for the company as it receives a premium for the option it’s sold.
Interest rate derivatives • Interest Rate Cap, collars and floors The cost of a collar is lower than for buying an option alone. However, the borrowing company forgoes the benefit of movements in interest rates below the floor limit in exchange for this cost reduction and an investing company forgoes the benefit of movements in interest rates above the cap level. A zero cost collar can even be negotiated sometimes, if the premium paid for buying the cap equals the premium received for selling the floor.
Interest rate derivatives • Interest Rate Swaps Interest rate swaps are where two parties agree to exchange interest rate payment. Interest rate swaps can act as a means of switching from paying one type of interest to another, raising less expensive loans and securing better deposit rates. A fixed to floating rate currency swap is a combination of a currency and interest rate swap. Interest rate swap is an agreement whereby the parties to the agreement exchange interest rate commitments.
