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what is interest rate parity

predicting FX rate based upon the difference between interest rates in two countries


what is purchasing power parity

predicting FX rate based upon differences between inflation rates in two countries


money market hedge- how do you hedge a future foreign currency payment

1) borrow an amount of home currency now

2) convert to foreign currency at spot

3) deposit foreign currency in foreign currency bank account now (earn interest)

4) use this deposit to make the foreign currency payment in the future


money market hedge- how do you hedge a future foreign currency receipt

1) borrow an amount of foreign currency now

2) convert to home currency at spot

3) deposit home currency in home currency bank account now

4) when the foreign receipt is received, use it to repay the foreign currency load


what is transaction risk

This is the risk arising on short-term foreign currency transactions that the actual income or cost may be different from the income or cost expected when the transaction was agreed.

. Transaction risk therefore affects cash flows and for this reason most companies choose to hedge or protect themselves against transaction risk.


what is translation risk

This risk arises on consolidation of financial statements prior to reporting financial results and for this reason is also known as accounting exposure.

Consider an asset worth €14 million, acquired when the exchange rate was €1.4 per $. One year later, when financial statements are being prepared, the exchange rate has moved to €1.5 per $ and the statement of financial position value of the asset has changed from $10 million to $9.3 million, resulting an unrealised (paper) loss of $0.7 million.

Translation risk does not involve cash flows and so does not directly affect shareholder wealth. However, investor perception may be affected by the changing values of assets and liabilities, and so a company may choose to hedge translation risk through, for example, matching the currency of assets and liabilities (e.g. a euro-denominated asset financed by a euro-denominated loan)


what is economic risk

Transaction risk is seen as the short-term manifestation of economic risk, which could be defined as the risk of the present value of a company’s expected future cash flows being affected by exchange rate movements over time. It is difficult to measure economic risk, although its effects can be described, and it is also difficult to hedge against it.


what are the different points you can look at when comparing the 3 different ypes of risk?

1) effect on cash flow (transaction affects CF, Economic affects future CF and translation doesn't)
2) short term (transaction risk) VS Long term (economic risk)
3) ability to hedge. Transacion can be hedged but economic risk is less easy to hedge- facr longer and more uncertainty as well as no real contorl as a company


what is a currency futures contract?

A currency futures contract is a standardised contract for the buying or selling of a specified quantity of foreign currency. It is traded on a futures exchange and settlement takes place in three-monthly cycles ending in March, June, September and December, i.e. a company can buy or sell September futures, December futures and so on.

The price of a currency futures contract is the exchange rate for the currencies specified in the contract.

When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may be called on to deposit additional funds (variation margin) with the exchange. Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market'

Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the initial futures transaction, i.e. if buying currency futures was the initial transaction, it is closed out by selling currency futures. A gain made on the futures transactions will offset a loss made on the currency markets and vice versa


give an example of futures

Nedwen Co expects to receive $300,000 in three months’ time and so is concerned that sterling may appreciate (strengthen) against the dollar, since this would result in a lower sterling receipt. The company can hedge the receipt using sterling futures contracts as follows. As Nedwen will be buying sterling in June with the dollars it receives from its customer, it will also want to sell June sterling futures contracts at the same time (or as close as possible) so that any movement in exchange rates is offset by the two opposite transactions. This means that Nedwen would have to buy the futures contracts now in order to be able to sell them in JunE


what is the fisher efect

Fishes effect Suggests that Money rate of interest = Real rate of interest + premium for inflation

International fisher effect assumes that all countries will have the same real interest rate and the difference is the inflation

If true, this means that the current forward rate is a predictor of the spot rate at a future point


What is expectations theory

ET is all about the long term and short term interest rates. the reason long term interest rates are higher than ST is because we expect that interest rates are going to increase in the future. That's why we also talk about the normal yield curve


What is basis

The difference between the price of a futures contract and the spot price on a given date is known a basis


Do banks allow Forward exchange contracts to lapse if they are not used by company

Forward contracts are binding and will not be allowed to lapse by the bank


when do you pay for currency options

Options are paid for when they are taken on. They may never be exercised


What is basis risk

Basis risk is the possibility that movements in the currency futures price and spot price will be different.

This risk goes by the term "basis risk," which refers to the chance that there may be an unpredicted mismatch between the price set on the futures contract and the actual cash price at the designated time.

It is one of the reasons for an imperfect currency futures hedge


what are practical/internal techniques for managing currency risk

Do nothing
Invoice in home currency
foreign bank accounts
leading and lagging
matching assets and liabilities