1 & 2 same as Sept 2019

3(a) effective foreign exchange risk strategies to execute to minimize the adverse effect of foreign
exchange fluctuations on the profit of their business

- Forward contract
Forward contract is a legal binding agreement where one counterparties agrees to deliver
specified amount of one currency in exchange of another currency to be delivered at a specific
future date (normally up to one year) at a “lock in” rate. It allows market participants to hedge
their forward currency exposure risk (either using “fixed delivery” forwards or forward option
delivery contract).It can be open or closed, and allows businesses to hedge against unfavourable
currency movements. It is, however, a firm commitment that cannot be cancelled. For example,
for your American company, this means you can know in advance how much U.S. dollars you will
receive for future payments in foreign currency. For example, you could sign a forward contract
with a local bank for a payment in Japanese yen that you'll receive in six months. You agree on
an exchange rate of 115 yen per dollar, so either if the exchange rate goes up to 125 or down to
105, you will receive the same amount of dollars at 115 yen per dollar.

- Currency swap
A currency swap is a cash flow management tool that is quite popular with businesses that have
foreign currency inflows and outflows at different or unexpected dates. A currency swap is a
transaction in which two parties agree to exchange a fixed amount of one currency for another.
A first exchange of the two currencies occurs at the initiation of the swap contract. Typically, this
first exchange is often based on prevailing spot exchange rates at the time. This initial exchange
is then reversed at the end of the swap contract period. Since the amounts exchanged in both
periods are exactly the same, exchange rate risk is eliminated. For illustration,

MISC (Malaysia company), with operations in Matsushita (Japanese firm) with operations in
Japan wishes to expand its warehousing Malaysia wants to expand its facilities in
facilities in Yokohama. The cost of the Malaysia. The estimated cost of the expansion
expansion will be 100 million ¥en. Its banker in is RM10 million. Matsushita’s banker in
Japan, The Bank of Tokyo is willing to provide Malaysia, Maybank is willing to provide a
the financing on the following terms: RM10 million loan on the following terms:
Principal Amount= ¥en 100 million Principal Amount= RM10 million
Loan Tenor = 5 years Loan Tenor = 5 years
Interest = fixed 5%; (¥en 5 million) Interest = fixed 8%; (RM800,000)
To avoid these problems both MISC and Matsushita could take the foreign currency loans they
are being offered and then enter into a currency swap in order to overcome the exchange rate
risk. To see how the swap can be structured; assume that the spot exchange rate between the
¥en and the Ringgit is 10 ¥en per Ringgit. To lock-in the prevailing exchange and avoid currency
risk on both the principal and interest payments over the next 5 years, they can undertake the
swap as follows. MISC takes the loan principal of 100 million ¥en from Bank of Tokyo and
forwards it to Matsushita, which in turn gives MISC the RM10 million it received from Maybank.
These principal amounts are reversed at the end of the 5th year. In addition, at the end of each
 year, MISC gives RM800,000 being 8% interest on RM10 million to Matsushita which in turn
gives ¥en 5 million as (5%) interest on the ¥en loan. Each company simply passes on the
payments received to their respective banks as fulfillment of their obligation

- Option
A currency option may be defined as a contract between two parties (buyer and seller) whereby
the buyer of the option has the right but not the obligation, to buy or sell a specified currency at
a specified exchange rate, at or before a specified date, from the seller of the option. While the
buyer of option enjoys a right but not obligation, the seller of the option nevertheless has an
obligation in the event the buyer exercises the given right. An option is a bit like insurance that a
buyer takes out against unfavourable currency movements, and as with insurance policies, the
option buyer must pay a premium. A call option protects importers against potential currency
appreciation, while the put option protects exporters against currency depreciation. In hedging
using options, calls are used if the risk is an upward trend in price and puts are used if the risk in
a downward trend in price. In our Bumiways example, since the risk is a depreciation of Rupees,
Bumiways would need to buy put options on Rupees. If Rupees were to actually depreciate by
the time Bumiways receives its Rupee revenue then Bumiways would exercise its right and
exchange its Rupees at the higher exercise rate. If however Rupees were to appreciate instead,
Bumiways would just let the contract expire and exchange its Rupees in the spot market for the
higher exchange rate. Therefore the options market allows traders to enjoy unlimited
favourable movements while limiting losses.

- Currency future
A currency futures contract is an agreement between two parties (buyer and seller) to buy or
sell a particular currency at a future date, at a particular exchange rate that is fixed or agreed
upon today. This sounds a lot like the forward contract. In fact the futures contract is similar to
the forward contract but is much more liquid because currency futures are used to hedge
exchange rate risk because they trade on an exchange and need only a small amount of upfront
margin. For example, Bumiways sold Rupee futures at the rate RM0.10 per Rupee. Hence the
size of the contract is RM1,000,000. Now say that Rupee depreciates to RM0.07 per Rupee, the
very thing Bumiways was afraid of. Bumiways would then close the futures contract by buying
back the contract at this new rate. Note that in essence Bumiways basically bought the contract
for RM0.07 and sold it for RM0.10. This would give a futures profit of RM300,000 [(RM0.10-
RM0.07) x 10,000,000]. However in the spot market Bumiways gets only RM700,000 when it
exchanges the 10,000,000 Rupees contract value at RM0.07. The total cash flow however, is
RM1,000,000 (RM700,000 from spot and RM300,000 profit from futures).

(b) (i) in conservative corporation, after the management has established its overall risk management
objectives, the corporation will proactively in a serious of steps to manage its foreign exchange risk.
Identify and explain briefly 2 steps taken by these corporations (not sure)

- Measure and manage your exposure to currency risk

This should include the risk exposure before a deal, purchase or transaction is agreed upon and the
actual risk that exists after a completed transaction. When you have a sense of pre- and post-transaction
risk, you will be able to decide on your needed level of hedging. Transaction risks are the simplest
currency risk to measure and manage. These occur because of timing differences between a contractual
commitment and actual cash flows. For example, if a business manufactures a product in China and sells
it in Denmark for a price set in Danish krona and the payment terms allow the buyer to pay days or
weeks later, the business’s cash flow will be exposed to currency fluctuations while it waits for
settlement. Transaction risks can be hedged with financial instruments, including currency futures,
swaps, or options.

- Hedge your currency risk

Hedging means that you use financial instruments, such as currency or FX forwards, to lock in
the currency rate so that it remains the same over a specified period of time.

(ii) 5 hedging techniques that businesses often apply within its organization to manage their foreign
exchange risk exposure

- 4 get from part a

- FX swap
- Interest rate swap
Interest rate swaps (IRS) are the exchange of one set of cash flows for another. Because they
trade over the counter (OTC), the contracts are between two or more parties according to their
desired specifications and can be customized in many different ways. Swaps are often utilized if
a company can borrow money easily at one type of interest rate but prefers a different type.
There are three different types of interest rate swaps such as fixed-to-floating, floating-to-fixed,
and float-to-float. With IRS, it can hedge against rising or falling interest rates. For example,
suppose that PepsiCo needs to raise $75 million to acquire a competitor. In the U.S., they may
be able to borrow the money with a 3.5% interest rate, but outside of the U.S., they may be able
to borrow at just 3.2%. The catch is that they would need to issue the bond in a foreign
currency, which is subject to fluctuation based on the home country's interest rates. PepsiCo
could enter into an interest rate swap for the duration of the bond. Under the terms of the
agreement, PepsiCo would pay the counterparty a 3.2% interest rate over the life of the bond.
The company would then swap $75 million for the agreed upon exchange rate when the bond
matures and avoid any exposure to exchange-rate fluctuations.

4 (a) (i)

(ii)

(iii)

(b) (i) Transaction is Monday 8 December 2018; the value date is Tuesday 9 December 2018. The fund is
required for 1 day, so deal is considered tomorrow next fund (T/N). Thus, the mature date will be on
Wednesday 10 December 2018.
Principle: HKD20,000,000
Interest: HKD20,000,000 x 4.25% x 1/365 = HKD2328.77
Repayment: HKD20,000,000+ HKD2328.77 = HKD20,002,238.77
(ii) Transaction is Monday 8 December 2018; the value date is Tuesday 10 December 2018. The fund is
required for 1 week, so deal is considered one week fund spot. Thus, the mature date will be on Tuesday
17 December 2018.

Principle: SGD15,000,000
Interest: SGD15,000,000 x 3.2% x 7/365 = SGD9205.48
Repayment: SGD15,000,000 + SGD9205.48 = SGD15,009,205.48

(iii) Transaction is Monday 8 December 2018; the value date is Friday 15 December 2018. The fund is
required for 1 day, but since it is Friday, so deal is considered weekend fund. Thus, the mature date will
be on Monday 18 December 2018.

Principle: USD30,000,000
Interest: USD30,000,000 x 3.0% x 3/360 =USD7500
Repayment: USD30,000,000 + USD7500 = USD30,007,500

5(a) 3 objectives of BNM intervention pure floating exchange rate system

- Promoting stability of the exchange rate

Bank Negara Malaysia will monitor the exchange rate against a currency basket to ensure that
the exchange rate remains close to its fair value. Changes in the international and regional
financial and economic environment have made it important for Malaysia to have a stable
exchange rate against its major trading partners, in particular, the regional countries.
Consequently, the stability of the ringgit exchange rate against the regional currencies will
become increasingly important. Such stability can best be achieved by maintaining the value of
the ringgit against a trade-weighted index of Malaysia’s major trading partners.

- maintaining orderly foreign exchange and financial market conditions

With floating exchange rate system , ringgit is referenced against a basket comprising the
currencies of the country’s major trade partners and is allowed to move according to market
forces. Since then, the focus of central bank intervention has been limited to maintaining
orderly foreign exchange market conditions with a view to avoiding extreme movements in the
ringgit exchange rate that could destabilise the real economy. Since the floating of the ringgit,
the approach to foreign exchange intervention has further evolved, in line with the
development of the Malaysian foreign exchange market and as market participants have
become better equipped to manage their own foreign exchange risks.
 - flexibility to adjust to international economic and financial developments.
With this, it will continue to facilitate the transformation of the economy as we advance
towards being a high-income nation

- Greater insulation from other countries’ economic problems:

Under a fixed exchange rate regime, countries export their macroeconomic problems to other
countries. Suppose that the inflation rate in the U.S. is rising relative to that of the Euro-zone.
Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for
European goods, which then increases the Euro-zone’s price level. Under a floating exchange
rate system, however, countries are more insulated from other countries’ macroeconomic
problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for
European goods.

- No need for international management of exchange rates:

Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require
an international manager such as the International Monetary Fund to look over current account
imbalances. Under the floating system, if a country has large current account deficits, its
currency depreciates.

- No need for frequent central bank intervention

Central banks frequently must intervene in foreign exchange markets under the fixed exchange
rate regime to protect the gold parity, but such is not the case under the floating regime. Here
there’s no parity to uphold.

(b) 2 method that BNM execute to achieve its desired objectives

- Direct intervention

With respect to direct intervention, which is also the focus of this study, official intervention in foreign
exchange market involves purchases or sales of foreign currencies, usually in the spot market, with the
intention to move the exchange rate of the domestic currency relative to foreign currencies. When
authorities purchase foreign currency with domestic currency, they increase commercial bank reserves
and domestic money balances, with the intended effect of depreciating domestic currency. When the
authorities sell foreign currency, they reduce commercial bank reserves and hence domestic money
balance, with the intended effect of appreciating the domestic currency.

- indirect intervention (open market operations)

 For example, buying or selling domestic treasury bonds. Purchases (sales) of foreign currency

on the Forex will raise (lower) the domestic money supply and cause a secondary indirect

effect upon the exchange rate.

- One of the main objectives of central banks is to promote and maintain monetary and financial
stability as it contributes to a healthy economy and sustainable growth. Bank Negara Malaysia
discharges the responsibility for promoting a sound and efficient Malaysian financial system by
preserving the soundness of financial institutions and the robustness of the financial infrastructure to
withstand adverse economic cycles and shocks, thereby preventing inordinate disruptions to the
intermediation process and maintaining confidence in the financial system. This is primarily achieved
through the regulation and supervision of the licensed financial institutions, by ensuring the continued
reliability of major payment and settlement systems, and actively contributing to the development of
efficient financial markets

- Malaysia’s interventions were relatively effective in moderating excessive exchange rate volatility by
providing two-way flows. But during times of low global volatility, as in January 2007, interventions were
on a more limited scale than elsewhere in the Asia-Pacific region. This seems to suggest, at least in
Malaysia’s case, that higher reserves volatility is associated with lower exchange rate volatility.

- Improving the management of foreign exchange volatility by continuing efforts to enhance

resilience. Capital flows to EMEs are likely to increase in the future, with net capital inflows most
probable over the medium to long term given the balance of push and pull factors. In this regard, the
central bank is making continued efforts to enhance its capacity in managing volatile capital flows

- Managing the challenges of foreign exchange intervention

Two of the key challenges in managing the accumulation of reserves from intervention operations relate
to the currency mismatch in the central bank’s assets and liabilities as well as the rising differential
between interest rates in the advanced economies and emerging economies. First, the central bank’s
balance sheet may experience significant volatility from foreign exchange translation gains or losses due
to the mismatch between its foreign currency assets and its local currency liabilities. A strengthening
local currency may lead to negative capital on the balance sheet as foreign currency-denominated assets
are revalued downwards due to currency movements. Second, carrying costs can arise from the growing
differential between the interest returns of advanced and emerging economies. This is especially the
case for emerging Asian economies into which US dollar-denominated funds flow from advanced
economies, in search of higher yields. Without the capacity to invest in assets with a lower credit quality
or instruments of greater complexity, the cost of the central bank’s interventions would normally be
higher than the returns from its investments.

- Wide range of monetary instruments has allowed effective and flexible liquidity management
In addition to cost considerations, a further challenge following an intervention is the need to
manage liquidity creation or withdrawal and hence the impact on monetary conditions. In this
respect, effective and flexible liquidity management has benefited from advances in Malaysia’s
financial market development and a broadening range of instruments. Traditional liquidity
management instruments such as direct borrowing and reserve requirements are now
accompanied by the use of repo operations, BNM bills and FX swaps. Direct borrowings and
 BNM bills are potent instruments for the management of excess liquidity as they are subject to
flexible issuance limits 6 and issuance tenure. BNM bills have additional advantages in managing
duration and liquidity risks. The wide range of monetary instruments has enabled the efficient
sterilisation of liquidity, thus avoiding overly expansionary monetary conditions. The
effectiveness of the central bank’s sterilisation operations can be seen by the stability of the
monetary base even in the course of intervention operations. At the same time, interest rates in
the interbank market have remained stable without experiencing downward pressure from
excess liquidity

(c) effect of intervention floating exchange rate system on money supply and interest rates and action to
overcome
- In Expansionary Monetary Policy corresponds to a increase in the money supply. With larger money
supply will lowers market interest rates, making it less expensive for consumers to borrow.
- Contractionary monetary policy corresponds to a decrease in the money supply. With smaller money
supplies tend to raise market interest rates, making it pricier for consumers to take out a loan.

- The action to overcome is the Fed can influence the money supply by modifying reserve
requirements, which generally refers to the amount of funds banks must hold against
deposits in bank accounts. By lowering the reserve requirements, banks are able to loan
more money, which increases the overall supply of money in the economy. Conversely,
by raising the banks' reserve requirements, the Fed is able to decrease the size of the
money supply. Besides, the Fed can affect the money supply by conducting open market
operations, which affects the federal funds rate. In open operations, the Fed buys and
sells government securities in the open market. If the Fed wants to increase the money
supply, it buys government bonds. This supplies the securities dealers who sell the
bonds with cash, increasing the overall money supply. Conversely, if the Fed wants to
decrease the money supply, it sells bonds from its account, thus taking in cash and
removing money from the economic system.