W5: managing financial risk - overseas trade

• exchange rate - rate at which one country's currency can be traded in exchange for another country's currency
• spot rate - exchange rate offered on a currency for immediate delivery of the currency
• forward rate - exchange rate for the exchange of currencies at a future date
• bid price = buying rate
• offer price = selling rate
• currency risk arises from the possible effects of future movements in an exchange rate
• transaction risk - risk of adverse exchange rate movements in the course of normal international trading transactions
• translation risk - risk that the firm will make exchange losses when the accounting results of its foreign branches are translated into the home currency
• economic risk - effect of exchange rate movements on the international competitiveness of a company
• factors to consider when hedging:

  • costs
  • exposure
  • attitude to risk
  • portfolio effect
  • shareholders
  • insolvency risk and cost of capital
• forward exchange contracts hedge against transaction exposures by allowing the importer/exporter to arrange for a bank to sell/buy a quantity of foreign currency for settlement in the future, at a exchange rate determined when the contract is made
• forward exchange contract is

  • an immediately binding contract
  • for the purchase/sale of a specified quantity of one currency in exchange for another
  • at a rate of exchange fixed when the contract is made
  • for performance (delivery and payment of currency) at a future date
• currency future - standardised exchange-traded contract to buy/sell a quantity of one currency in exchange for another, for notional delivery at a future date
• converting home currency → foreign currency:

  home currency * exchange rate
• converting foreign currency → home currency:

  foreign currency / exchange rate
• money market hedge - manufacturing a forward rate by using the spot exchange rate and money market lending or borrowing rate
• currency options - right, but not obligation, to buy or sell an amount of currency for an agreed exchange rate
• currency options reduce exposure to adverse currency movements but allows the holder to profit from favourable movements
• currency options are useful when:

  • there's uncertainty about foreign currency receipts or payments
  • protecting import/export of price-sensitive goods
  • company is allowed to publish the price lists for goods in a foreign currency