Fund Hedging Strategies For Foreign Exchange Rate Risk

FUND HEDGING STRATEGIES FOR FOREIGN EXCHANGE RISK - P a g e | 1 This Material is not available offline & online in any
form (Printed, Digital) except ACCASUPPORT.COM
TABLE OF CONTENTS
1 DIRECT VS INDIRECT QUOTE.5 1.1 1.2 2 DIRECT QUOTE.5 INDIRECT QUOTE...6
BUYING & SELLING RATE.6 2.1 2.2 DIRECT QUOTE.7 INDIRECT QUOTE7
AGREEMENT & SETTLEMENT DATE.7 3.1 3.2 AGREEMENT DATE...7 SETTLEMENT DATE...7
4 5
FOREIGN EXCHANGE RISK..8 TYPES OF FOREIGN EXCHANGE RISK8 5.1 5.2 5.3 6 6.1 6.2 6.3 6.4 TRANSACTION RISK..8 TRANSLATION RISK...10 ECONOMIC RISK..11 MANAGING FOREIGN EXCHANGE RISK...12 HEDGING..12 INVOICING IN HOME CURRENCY..13 MATCHING..13 BARTER TRADE.14
7 8 9
NETTING..15 LEAD & LAG PAYMENT..15 STEP BY STEP SOLUTION..16

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FUND HEDGING STRATEGIES FOR FOREIGN EXCHANGE RISK - P a g e | 2 This Material is not available offline & online in any form (Printed, Digital) except ACCASUPPORT.COM
10
SPOT & FORWARD RATE 16 10.1 SPOT RATE.16 10.2 FORWARD RATE.16
11 12 13
INFLATION RATE PARITY THEORY.17 INTEREST RATE PARITY THEORY18 FORWARD CONTRACT HEDGE.20 13.1 RECEIPT.20 13.2 PAYMENT.21 13.3 BENEFITS..23 13.4 LIMITATIONS.23
14
FUTURE CONTRACT HEDGE24 14.1 FUTURE MARKET...24 14.2 CONTRACT PRICE...24 14.3 CONTRACT SIZE...25 14.4 BASIS RISK25 14.5 TICK..25 14.6 AGREEMENT DATE.26 14.7 SETTLEMENT DATE.26 14.8 BENEFITS..27 14.9 LIMITATIONS.27
15
MONEY MARKET HEDGE.27 15.1 STEP BY STEP PROCESS..27 15.2 BENEFITS.33
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15.3 LIMITATIONS..33 16 CURRENCY OPTION..33 16.1 BENEFITS...35 16.2 LIMITATIONS..35 17 18 19 CURRENCY SWAP36 DERIVATIVE37 RELATED PRODUCTS39
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IMPORTANT!
Disclaimer This material is sold only through accasupport.com website. However, Clickbank.com is the credit card processing organization for collecting payments for this study material. This material is not available offline (shops, schools etc.) in any form such as DVDs, CDs, Printed books etc. Materials purchased from unauthorized source can be out of date and incomplete. In addition, you will not be able to receive free updates given to the buyers of original material. Demo version of this material is available free of cost, please take care, not to pay for demo version of this e-book to unauthorized sellers. Readers of this material will be solely responsible for the consequences of any decisions made in real life. Author & accasupport.com are not responsible to the readers of this material under any circumstances. Recommendations made of any kind are intelligent guesses to the best of authors knowledge. Names of individuals, organizations, countries, religions etc are used for educational purpose only. It is not intended to abuse, discriminate and heart anyone's feelings and dignity. Copyright Notice This material is subject to copyright protection law. Infringement of copyright law results in criminal liability (fine or imprisonment or both). Copyright infringement is effectively theft of intellectual property; therefore, it is unethical from social viewpoint and sinful act from religious viewpoint as well. Copyright 2012 Murtaza Lanewala. All rights reserved. Do You can make a backup copy of this material. You can use parts of this material provided you quote the appropriate reference to the author and material.
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Do Not You cannot publicly share this material in the form of hard copy or soft copy (physically and over the internet) for cash or for free. You cannot transform this material into other means of communication such as photocopy, video, audio etc. Unless needed for accessibility purpose or personal use. You cannot change the file format of this material or make it editable. You cannot resell this material unless you are selling the original copy purchased. You cannot use any part of this material in or with contents associated with violence, politics, religious and pornographic contents in any way.
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BENENFITS OF FUND HEDGING STRATEGIES FOR FOREIGN EXCHANGE RISK

Fund Hedging Strategies for foreign exchange rate risk provides knowledge from zero. It assumes that reader has no prior financial background. It is suitable for small & medium sized entities and entrepreneurs wishing to manage foreign exchange risk. It explains when foreign exchange risk arises and the types of foreign exchange risk exposure. Foreign exchange risk affects all entities regardless of involvement in foreign trade. Foreign exchange risk management is complex concept. Therefore, it simplifies the complexity by providing real life examples and diagrams. It explains the pros & cons and circumstances in which each foreign exchange hedging strategy would be useful taking account of factors, such as cost of hedging, duration, effectiveness, risk, flexibility, availability of currency pair. Therefore, you can choose best strategy according to your circumstances and risk appetite. Foreign exchange rate movement can create huge losses. In practice, many companies went into liquidation due to foreign exchange risk exposure. Therefore, it is essential to spent some time and learn foreign exchange risks & strategies to reduce these risks. If you have not enough budget or want save fee to hire a hedging expert as sum of money at risk do not justify paying fee, then you can choose to do it yourself. However, even if you hire hedging expert, then you must have suitable knowledge to find suitable hedging expert, collaborate and review its work effectively. It is always advisable to obtain expert opinion, as foreign exchange movement is one of the key causes of business failure. It does NOT have any DRM protection to enforce copyrights. It is completely printable and allows sharing of foreign exchange risk organization wide. Persons involved in sales and purchase needs to be aware of foreign exchange risks to accept/reject customer orders, selection of suppliers, pricing, credit terms etc.
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1 Direct Vs Indirect Quote

Foreign exchange rates are quoted in pairs Example: Dollar to Pound, Franks to Yen, Rupees to Dinar etc. 1.1 Direct Quote A foreign exchange rate quoted as the home currency per unit of the foreign currency. In other words, one unit of foreign currency is measured in home currency. In Direct quote, exchange rate is represented by home currency symbol. In Direct quote, home currency is written prior to foreign currency and home currency symbol is written just before exchange rate. Example: If home currency is Rupees, then Rupees to Pound Sterling (Rs/) is expressed as Rs140/1. Generally, it is expressed as just Rs140. If home currency is Pound sterling, then Pound Sterling/Dollars (/$) is expressed as 1.556. In Direct Quote, exchange rate is multiplied by the foreign currency to convert foreign currency into home currency. Example: Suppose exchange rate of Rupees to Dollar is Rs140. If a Pakistani citizen pays ACCA fee 86, then he/she will calculate equivalent amount in home currency (Rs) as follows:
Direct quote is used when foreign currency is stronger than home currency. It eases calculating foreign exchange rate by avoiding decimal places. It is used mostly used in developing countries such as Pakistan and India.
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1.2 Indirect Quote A foreign exchange rate quoted as the foreign currency per unit of the home currency. In other words, one unit of home currency is measured in foreign currency. In Indirect quote, exchange rate is represented by opposite currency symbol. In Indirect quote, foreign currency is written prior to home currency and foreign currency symbol is written just before exchange rate. Example: If home currency is Pound Sterling, then Dollar to Pound Sterling ($/) is expressed as $1.555. In Indirect quote, exchange rate is divided by the foreign currency to convert foreign currency into home currency. Example: Suppose exchange rate of Pound Sterling to Dollar is 1.555. If a UK citizen pays CFA fees $786, then he/she will calculate equivalent amount in home currency as follows:
2 Buying & Selling Rate

Buying and selling rates are two different rates. Difference between buying and selling rate is known as spread. Spread represents the profit to the foreign exchange dealer (broker). They sell at profit and buy to cause you loss. Diagram:
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Buy
Higher rate
Sell
Direct
Spread
Profit
Indirect
Sell
Lower rate
Buy
2.1 Direct Quote In direct quote, buying rate is higher rate and selling rate is lower rate. 2.2 Indirect Quote In indirect quote, buying rate is lower rate and selling rate is higher rate. Remember whichever quote you use, you should select an exchange rate for buying and selling which is loss making to you and profitable to foreign exchange dealer. Because, foreign exchange dealer is trading for profit and if they are making profit, then you should definitely be losing money. Lower rate is written before the higher rate regardless of the type of quote in use. Example: Dollar to Pound Sterling rate is $1.554 $1.557
3 Agreement & Settlement Date

3.1 Agreement Date Agreement date is the date at which organization enters into contract. Example: Date at which organization commits for buying or selling of goods to foreign supplier or customer respectively. 3.2 Settlement Date Settlement date is the date at which organization expects to receive cash from foreign customer as per credit term offered or obliged to make payment to foreign suppliers.
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Example: If organization purchases goods on 1/1/2012 on 90 days credit period, then settlement date will be 30/3/2012.
4 Foreign Exchange Risk

Foreign exchange risk is the risk that foreign exchange rate movement will affect profitability and stability. Ultimately, it will prevent an organization from achieving its objective of shareholders wealth maximization. Not-for-profit organization is also subject to foreign exchange risk, which will prevent an organization from providing particular services (education, health care, entertainment etc) to its members or society as whole.
5 Types of Foreign Exchange Risk

5.1 Transaction Risk Transaction risk is short-term risk rises due to particular transaction. It is the risk that foreign exchange rate will adversely affect organizational profitability. It arises due to following conditions being met, if any these conditions do not exist, then there will no transaction risk: Receipt and payment in foreign currency rather than home currency. Payment and receipt (settlement) date against purchase and sale is different from agreement date of goods or services. Increase in foreign exchange rate makes foreign purchases more costly. Movement in foreign exchange rates makes cost of purchases higher and lower. Cost of purchase for goods cannot be exactly known in home currency until settlement is made. It is due to timing difference between agreement date and settlement date. However, purchased goods are already being sold into market between those dates. If exchange rate moves adversely, then organization can do nothing to cover increased cost of purchase. Diagram:
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Net Loss Net profit $ Cost per unit Selling price Cost per unit Time Settled f t +1
Agreed
Exchange rate Movement
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Example: If a person situated in US has bought a pair of shoes for 30 on 90 days credit period. Suppose he/she sold his/her shoes for $37 in home market before settlement date. If exchange rate US to UK appreciates between these 90 days from $0.876 to $0.718 for buying, then at the last day of credit period, he/she will require $41.78 to pay 30 because of strengthening of dollar. ( )
However, at agreement date, he/she was required $34.24 to pay $30. ( )
Net foreign exchange transaction loss is $7.54, which turned his profit of $2.76 to loss of $4.78 because of exchange rate movement.
( ( (
) ) )
Similarly, increase in foreign exchange rate makes foreign sales less profitable. Period between which goods are sold and receipt is expected, foreign exchange movement can decrease the amount of money received in home currency. Significant foreign exchange losses can create liquidity problem and in extreme cases end up in liquidation. Fortunately, transaction risk can be controlled using appropriate Hedging techniques. 5.2 Translation Risk Translation risk does not involve cash flows.
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Investment (land and building) in foreign currency will result in lower amount in balance sheet prepared in home currency due to depreciation of foreign currency. Liability (Bank loans) in foreign currency will result in higher amount in balance sheet prepared in home currency due to appreciation of foreign currency. Transaction risk is long-term risk because it is subject to long-term investments & liabilities. Translation risk can affect key ratios such as profitability, gearing and investor ratios. Translation risk can result in violation of loan covenants about maximum gearing level, which should not be exceeded. Reduction in assets leads to reduction in equity resulting in higher gearing ratio. Moreover, organization may find difficulty raising finance as lenders evaluate credit risk by calculating gearing ratios. Similarly, transaction risk can result in reduction in share price and market capitalization of the organization due to reduction in equity. ROCE will also increase without any improve in performance of the organization. Managers will be wrongly rewarded, if ROCE is used for calculating profit related pay (PRP). Translation risk can be controlled by organization through careful planning and using matching principle. 5.3 Economic Risk Economic risk affects all the organizations regardless of involvement in foreign trade or investment. Increase in foreign exchange rate will make imported goods more costly in home currency terms. Organizations using imported raw material as an input to the goods or services provided by the organization is exposed to economic risk. Increase in the cost of raw materials to the organization will lead to increase in the cost of goods produced or services provided by the organization.
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Organization may have to raise selling price or reduce profit margin to remain competitive in the market against suppliers of imported goods from other foreign countries. Economic risk is beyond the control of the organization. Organization has to accept that risk. Government can control economic risk in the long term. However, in short term, it is uncontrollable even by government. Organization can use its economic power to influence the actions of government.
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Fund Hedging Strategies For Foreign Exchange Rate Risk

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FUND HEDGING STRATEGIES FOR FOREIGN EXCHANGE RISK - P a g e | 1 This Material is not available offline & online in any

form (Printed, Digital) except ACCASUPPORT.COM

NETTING..15 LEAD & LAG PAYMENT..15 STEP BY STEP SOLUTION..16

MONEY MARKET HEDGE.27 15.1 STEP BY STEP PROCESS..27 15.2 BENEFITS.33

BENENFITS OF FUND HEDGING STRATEGIES FOR FOREIGN EXCHANGE RISK

1 Direct Vs Indirect Quote

2 Buying & Selling Rate

3 Agreement & Settlement Date

4 Foreign Exchange Risk

5 Types of Foreign Exchange Risk

Exchange rate Movement

However, at agreement date, he/she was required $34.24 to pay $30. ( )

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