Foreign Exchange Risk

Chapter 19 Foreign Exchange Risk

1.         Objectives

1.1       Describe different types of exchange rate systems.
1.2       Explain the meaning and causes of translation risk, transaction risk and economic risk.
1.3       Describe how the balance of payments can cause exchange rate fluctuations.
1.4       Explain the impact of purchasing power parity on exchange rate fluctuations.
1.5       Use purchasing power parity theory to forecast exchange rates.
1.6       Explain the impact of interest rate parity on exchange rate fluctuations.
1.7       Use interest rate parity theory to forecast exchange rates.
1.8       Explain the principle of four-way equivalence and the impact on exchange rate fluctuations.
1.9      Discuss and apply netting, matching, leading and lagging as a form of foreign currency risk management.
1.10     Define a forward exchange contract.
1.11     Calculate the outcome of a forward exchange contract.
1.12     Define money market hedging.
1.13     Calculate the outcome of a money market hedge used by an importer and exporter.
1.14     Define the main types of foreign currency derivates and explain how they can be used to hedge foreign currency risk.

2.         Exchange Rate Systems

2.1

Exchange Rate Systems

(a)      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. (b)      Fixed against a singly currency – This is where a country fixes its exchange rate against the currency of another country’s 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). (c)      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. (d)      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. (e)      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.

3.         Types of Foreign Currency Risk

3.1       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).

(A)       Transaction risk

3.2	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.

3.3

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)      What is the expected profit on the re-sale? (b)      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. 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.   £ Revenue from re-sale of goods 32,000,00 Less: Cost of 100,000 Reds in sterling (÷ 3.0800) 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.   £ Revenue from re-sale of goods 32,000,00 Less: Cost of 100,000 Reds in sterling (÷ 4.0650) 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.

3.4       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.

3.5       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.

(B)       Economic risk

3.6	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 long-term version of transaction risk.

3.7       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.

(C)       Translation risk

3.8	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 subsidiary’s assets at the exchange rate on the statement of financial position date.

4.         The Causes of Exchange Rate Fluctuations

4.1       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.
4.2       Balance of payments (國際收支平衡) – 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.
(國際收支平衡是一個帳目，把一個國家與其他國家的交易記錄下來。這個記錄主要是記下一些涉及金錢或有價值的經濟活動，好些沒有金錢的經濟活動，如甲國有五萬人移民往乙國，這是不會記下的。)
4.3       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).
4.4       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.
4.5       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.

(A)       Purchasing power parity theory (PPP) (購買力平價學說)

4.6

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: 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).

4.7

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.   The US market   The UK market Cost of item now $3,000 $1.50 £2,000 Estimated inflation 5%   3% Cost in one year $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:

4.8	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 year’s time.

Solution:

4.9

Case Study – Big Mac Index

An amusing example of PPP is the Economist’s Big Mac Index. Under PPP movements in countries’ exchange rates should in the long-term mean that the prices of an identical basket of goods or services are equalized. The McDonalds Big Mac represents this basket. The index compares local Big Mac prices with the price of Big Macs in America. This comparison is used to forecast what exchange rates should be, and this is then compared with the actual exchange rates to decide which currencies are over and under-valued.

4.10     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.
4.11     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.

(B)       Interest rate parity theory (IRP) (利率平價學說)

4.12

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 year’s time: Where: F0 = Forward rate S0 = Current spot rate ic = interest rate for base currency ib = interest rate for counter currency

4.13

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 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:

4.14     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.
4.15     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 rates, since they would suffer no exchange losses when they converted $ back to £.
(b)       the flow of capital from the UK to the US would raise UK interest rates and force up the spot rate for the US$.

(C)       Expectations theory

4.16     The expectations theory claims that the current forward rate is an unbiased predictor of the spot rate at that point in the future.
4.17     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.

(D)       The International Fisher Effect

4.18     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.
4.19     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.
4.20     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.
4.21     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:

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

 

(E)       Four-way equivalence

4.22     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.

5.         Foreign Currency Risk Management

5.1       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.

(A)       Deal in home currency

5.2       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.

 

(B)       Do nothing

5.3       In the long run, the company would “win some, lose some”. This method
(a)        works for small occasional transactions
(b)       saves in transaction costs
(c)        is dangerous.

(C)       Leading and lagging

5.4       Companies might try to use:
(a)        Lead payments – payment in advance
(b)       Lagged payments – delaying payments beyond their due date.
5.5       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.
5.6       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.)
5.7       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.

(D)       Matching (配對)

5.8       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:

5.9       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.

(E)       Netting (沖抵)

5.10     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.
5.11     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.

(F)       Trading in currencies

5.12     The foreign exchange market or forex market is an international market in national currencies. It is highly competitive and virtually no difference exists between the prices in one market (e.g. New York) and another (e.g. London).
5.13     Banks dealing in foreign currency quote two prices for an exchange rate:
(a)        a lower bid price
(b)       a higher offer/ask price.
For example, a dealer might quote a price for US$/£ of 1.4325 – 1.4330.

•     The lower rate, 1.4325, is the rate at which the dealer will sell the variable currency (US$) in exchange for the base currency (sterling).
•     The higher rate, 1.4330, is the rate at which the dealer will buy the variable currency (US$) in exchange for the base currency (sterling).

5.14

Example 4

Suppose that the US$ rate per £ is quoted as 1.4325 – 1.4330. If the company wants to buy $100,000 in exchange for sterling (so that the bank will be selling dollars): If we used the lower rate of 1.4325, the bank would sell them for £69,808. If we used the higher rate of 1.4330, the bank would sell them for £69,784. Clearly the bank would be better off selling them at the lower rate. Rule: Bank sells lower. If a company wants to sell $200,000 in exchange for sterling (so the bank would be buy dollars): If we used the lower rate of 1.4325, the bank would buy them for £139,616. If we used the higher rate of 1.4330, the bank would buy them for £139,567. The bank will make more money buy at the higher rate. Rule: Bank buys high.

(G)       Forward exchange hedging (對沖)

5.15     The spot market (現貨市場) is where you can buy and sell a currency now (immediate delivery), i.e. the spot rate of exchange.
5.16     The forward market (遠期市場) 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.

5.17

Forward Exchange Contracts

A forward exchange contract is: (a)        An immediately firm and binding contract, e.g. between a bank and its customer. (b)        For the purchase or sale of a specified quantity of a stated foreign currency. (c)        At a rate of exchange fixed at the time the contract is made. (d)        For performance (delivery of the currency and payment for it) at a future time which is agreed when making the contract (this future time will be either a specified date, or any time between two specified dates).

5.18	Example 5 – 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.

5.19	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:

 

5.20     Advantages and disadvantages:

Advantages	Disadvantages
Flexibility with regard to the amount to be covered. Relatively straightforward both to comprehend and to organize.	Contractual commitment that must be completed on the due date. No opportunity to benefit from favourable movements in exchange rates.

 

(H)       Money market hedge

5.21	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

5.22     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:    Borrow the appropriate amount in pounds now
Step 2:    Convert the pounds to francs immediately
Step 3:    Put the francs on deposit in a Swiss franc bank account
Step 4:    When time comes to pay the company:
(a)     pay the creditor out of the franc bank account
(b)     repays the pound loan account

5.23

Example 6

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: £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

5.24     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 debtor’s cash is received:
(a)     Repay the foreign currency loan
(b)     Take the cash from the home currency deposit account

5.25

Example 7

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 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.

(I)        Choosing the hedging method

5.26     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.
5.27     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 that ought to be chosen.

5.28

Example 8

ABC Co has bought goods from a US supplier, and must pay $4,000,000 for them in three months time. The company’s 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 7 10.25 10.75 14.00 3 months 7 10.75 11.00 14.25   $/£ exchange rate ($ = £1) Spot 1.8625 – 1.8635 1 month forward 1.8565 – 1.8577 3 months forward 1.8455 – 1.8460 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. The cost of the $4,000,000 to ABC Co in three months time will be:  = £2,168,609.38 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: These dollars would have to be purchased now at the spot rate of $1.8625. The cost would be:  = £2,110,713,52 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. 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) 2,094,010.26 Currency lending 2,110,713.52 Lead payment 2,147,651.01

 

6.         Foreign Currency Derivatives

(A)      Currency futures

6.1	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.

6.2

Example 9

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.       We assume that the three month contract is the best available. 2.       We need to buy € or sell $. As the futures contract is in €, we need to buy futures. 3.       No. of contracts -  = 5.76, say 6 contracts 4.       Tick size – minimum price movement x contract size = 0.0001 x 125,000 = $12.50 5.       Closing futures price – we are told it will be 0.9367 6.       Hedge outcome Outcome in futures market Opening futures price = 0.9245 Closing futures price = 0.9367 Movement in ticks = 122 ticks Futures profit = 122 x $12.50 x 6 contracts = $9,150 Net outcome   $ Spot market payment (720,000 x 0.9351 $/€ 673,272 Futures market profit (9,150)   664,122

 

6.3       Advantages and disadvantages of futures to hedge risks

Advantages	Disadvantages
(a)   Transaction costs should be lower than other hedging methods. (b)   Futures are tradeable on a secondary market so there is pricing transparency. (c)   The exact date of receipt or payment does not have to be known.	(a)    The contracts cannot be tailored to the user’s exact requirements. (b)    Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk. (c)    Only a limited number of currencies are the subject of 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.

 

(B)       Currency options

6.4	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.

6.5

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. (b)     The seller of the option, who receives the premium, is referred to as the writer. (c)      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). (d)     In-the-money option (價內期權) – the underlying price is above the strike price. (e)      At-the-money option (等價期權) – the underlying price is equal to the option exercise price. (f)      Out-of-the-money option (價外期權) – the underlying price is below the option exercise price. (g)     American-style options – can be exercised by the buyer at any time up to the expiry date. (h)     European-style options – can only be exercised on a predetermined future date.

6.6       Companies can choose whether to buy:
(a)        a tailor-made currency option from a bank, suited to the company’s 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.
6.7       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.

(C)       Currency swap (貨幣互換)

6.8	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.

6.9

Example 10

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 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 other’s behalf. They would then swap currencies.

Examination Style Questions

Question 1
Nedwen Co is a UK-based company which has the following expected transactions.

One month:            Expected receipt of $240,000
One month:            Expected payment of $140,000
Three months:        Expected receipts of $300,000

The finance manager has collected the following information:

Spot rate ($ per £):	1.7820 ± 0.0002
One month forward rate ($ per £):	1.7829 ± 0.0003
Three months forward rate ($ per £):	1.7846 ± 0.0004

Money market rates for Nedwen Co:

	Borrowing	Deposit
One year sterling interest rate:	4.9%	4.6%
One year dollar interest rate	5.4%	5.1%

Assume that it is now 1 April

Required:

(a)     Discuss the differences between transaction risk, translation risk and economic risk.          (6 marks)
(b)     Explain how inflation rates can be used to forecast exchange rates.       (6 marks)
(c)     Calculate the expected sterling receipts in one month and in three months using the forward market.                                                                                                                  (3 marks)
(d)     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)
(e)     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)

Question 2
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 €0·50 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 company’s bank:

Spot rate ($ per €):	1.998 ± 0.002
Six months forward rate ($ per €):	1.979 ± 0.004

Money market rates available to PKA Co:

	Borrowing	Deposit
One year euro interest rate:	6.1%	5.4%
One year dollar interest rate	4.0%	3.5%

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

Required:

(a)     Identify the objectives of working capital management and discuss the conflict that may arise between them.                                                                                                         (3 marks)
(b)     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)
(c)     Discuss ways in which PKA Co could improve the management of domestic accounts receivable.                                                                                                                  (7 marks)
(d)     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
Three years ago Boluje Co built a factory in its home country costing $3·2 million. To finance the construction of the factory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates at the time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchange rate at the time was 5·00 pesos/$.

Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6·1%. 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 6·00 pesos/$ and the 12-month forward exchange rate is 6·07 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)
(b)     Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of the new factory.                                                                                              (4 marks)
(c)     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 year’s time on its foreign bonds.                                                                                              (4 marks)
(ii)     Compare the relative costs of a money market hedge and a forward market hedge.   (2 marks)
(d)     Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk.                                                                                                           (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2008 Q4)

Question 4
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 €6·5 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 $4·00 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 1·3000 €/$. All European customers pay on a credit basis in euros.

 

Required:

(a)     Calculate the theoretical ex rights price per share after the rights issue.
(4 marks)
(b)     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)
(c)     Explain the difference between transaction risk and translation risk, illustrating your answer using the information provided.                                                                               (4 marks)
(d)     The six-month forward rate is 1·2876 €/$ and the twelve-month forward rate is 1·2752 €/$. NG Co can earn 2·8% per year on short-term euro deposits and can borrow short-term in dollars at 5·3% 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)
(ACCA F9 Financial Management December 2009 Q3)