Risk management:

a. Foreign currency risk

b. Foreign or domestic interest rate

Currency hedging:

Exchange rate is price between 2 currencies.

- Spot rate is rate of the currency at today’s terms.

- Forward rate is rate of the currency in the future.

Quotation of the exchange rate: (Bank will buy high, sell low)

- Bank buying the currency is known as BID

- Bank selling the currency is known as OFFER

Currency exchange rate can be direct or indirect.

- Direct quote= amount of domestic currency against 1 unit of foreign currency (2850tugrugs/1$)
- Indirect quote= amount of foreign currency against 1 unit of domestic currency (1.39$/1pound)

In Indirect quote,

- On left-hand side, always bank selling rate

- On right-hand side, always bank buying rate

3 types of risk:

1. Transaction risk-occurs mostly due to exchange of currencies (export, import business)

2. Translation risk-risk of value of assets/liabilities in foreign currency is decreasing/increasing
while translating foreign currency accounts into domestic currency accounts in FSs. (no CF issue)
Hedging is done through matching of assets and liabilities in same currency.
3. Economic risk-Long-term movement in exchange rate damages the value of company due to
weakening of exchange rate as a result of prevailing economic conditions.
Risk factors:
- Inflation
- Interest rate (carry trade)
- Balance of trade
Best way to deal with economic risk is diversification.

Forecasting exchange rates:

2 techniques:
a. Interest rate parity is used for predicting forward rate. (contractual)
Difference in spot and forward rate is reflected by difference in interest rates.
b. Purchasing power parity is used for predicting future spot rate

Difference in future spot rate and current spot rate is reflected by the difference in inflation between 2
countries.

S1=S0*(1+hc)/(1+hb)
S1= future spot rate

S0=current spot rate

Hc=inflation in counter currency country

Hb=inflation in base currency country

Management of risk:
Hedging techniques are:
a. Do nothing (cost>benefit) Accept the risk as it is as exposure is too little. Firm is risk seeker
and firm is having wide range of portfolio.
b. Matching receipts and payments in the same currency and remaining amount which cannot
be matched should be hedged.
c. Invoice in the home currency, leads to lose competitiveness
d. Leading and lagging
Leading= accelerate the payment in belief that future foreign currency will become strong.
Lagging=delaying future payments in belief that future foreign currency will become weak.
e. Forward contract= Contract for buying and selling fixed amount of currency, determined
rate today at fixed future settlement date.
Forward rates can be quoted in premium or discount. Premium should be subtracted and
discount should be added back.
Forward contracts cannot be traded. It is only between you and a bank.
f. Money market hedging
It is used for short term to improve liquidity position by taking or depositing the money.
Company tries to take advantage of exchange rate movements.
- For exporters, risk is foreign currency depreciating. Should borrow money in foreign currency,
then convert borrowed foreign currency into domestic currency at spot rate, then deposit
domestic currency into domestic currency account. At the time of settlement, clear foreign
currency debt through foreign currency receipts. Withdraw domestic currency.
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