Understanding Exchange Rates

£ : $1.5
Here £ = Base Currency; $ = Counter Currency
£0.67:$
Here $ = Base Currency; £ = Counter currency
Normally the “foreign” currency is the counter currency
Banks BUY HIGH and SELL LOW
Here we are referring to the foreign / counter currency
If a company needs to make a foreign currency payment
 Banks SELL the foreign currency at the LOWER rate
If a company needs to make a foreign currency receipt
 Banks will BUY that foreign currency from them at the HIGHER rate
Translating Currencies
1. If you are given the counter currency:
DIVIDE the amount by the exchange rate
Eg A UK company has to pay $1,500.
£ : $1.5
Solution = $1,500 / 1.5 = £1,000
2. If you are given the Base currency:
MULTIPLY the amount by the exchange rate
Eg A UK company has to pay £1,000 in $.
£ : $1.5
Solution = £1,000 x 1.5 = $1,500
If £ is strong (strengthening, appreciate)
 UK exporters suffers because the $ is weak and their revenues is in $s.
 If the £ appreciates relative to the $, the exchange rate falls: 
it takes fewer £ to purchase $1. 
($1 = £1.5  → $1= £1.4).
If £ is weak (weakening, depreciate, devalue)
 UK importers suffer because the $ is strong and their costs are in $s.
Translation risk 
- NCA and CA value - decrease
- NCL and CL value - increase.
 For instance, if the £ depreciates relative to the $, the exchange rate rises: 
it takes more £ to purchase $1. 
($1= £1.5 → $1= £1.7).
Forward Rates
So, remember what we are looking at here are ways to negate the risk that, in the future, the exchange rates may
move against us
So we have bought or agreed a sale now in a foreign currency, but the cash won’t be paid (or received) until a
future date
With a forward rate we are simply agreeing a future rate now.
Therefore fixing yourself in against any possible future losses caused by movements in the real exchange rate
However - you also lose out if the actual exchange rate moves in your favour as you have fixed yourself in at a
forward rate already
Illustration
UK importer has to pay $1,000 in a months time
He takes the forward rate of $1.8-1.9:£
The bank then has agreed to SELL the dollars (counter currency) to the importer. 
Remember the bank SELLS LOW
The exchange rate would therefore be $1.8:£
So, the bank will give the exporter $1,000 in return for £555. 
The importer must pay £555
 NOTE 
If importer cannot fulfill the forward contract agreed (maybe because he didnt receive the goods) the
bank will sell the importer the currency and then buy it back again at the current spot rate.
This closes out the forward contract
Advantages of forward rate
1. Flexible
2. Straightforward
Disadvantages of forward rate
1. Contracted commitment (even if you haven’t received money)
2. Cannot benefit from favourable movements
Money Market Hedges - payment
The whole idea of a money market hedge is to take the exchange rate NOW even though the payment is in the
future.
By doing this we eliminate the future exchange risk (and possible benefits too of course)
So. the foreign payment is in the future, but we are going to get some foreign currency NOW to pay for it.
We do not need the full amount though, as we can put the foreign money into a foreign deposit account to earn
just enough interest to make the full payment when ready
We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the
foreign deposit rate
Now we know how much foreign currency we need NOW, we can convert that into home currency using the
spot rate
We now know how much home currency we need. This needs to be borrowed. So, the cost to us will eventually
be:
 Amount of home currency borrowed + interest on that until payment is made. 
(Obviously here we use the home borrowing rate)
Steps:
1. Calculate how much foreign currency needed (discount @ foreign deposit rate)
2. Convert that to home currency
3. Borrow that amount of home currency
4. The cost will be the amount borrowed plus interest on that (home currency borrowing rate)
Illustration
Let’s say we are a UK company and need to pay $100 in 1 year. 
UK borrowing rate is 8% and US deposit rate is 10%. 
Exchange rate now $2 - 2.2 :£
 Need to pay $100 in 1 year so we borrow 100 x 1/ 1.10 = 91
 Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay off the whole $100 at
the end
 Convert $91 dollars now. We need dollars, so bank SELLS us them. They always SELL LOW. So 91 /
2 = £45.5
 £45.5 is borrowed now. We will then have to pay interest on this in the UK for a year. 
So £45.5 x 1.08 = 49.14
£49.14 is the total cost to us
Money Market Hedge - Receipt
The whole idea of a money market hedge is to take the exchange rate NOW even though the receipt is in the
future.
By doing this we eliminate the future exchange risk (and possible benefits too of course)
The foreign receipt is in the future, we are going to get eliminate rate risk by getting that foreign currency
NOW.
To do this we need to borrow it abroad.
We do not borrow the full amount though, as the receipt will pay off this loan plus interest.
We, therefore, calculate how much is needed now by taking the full amount and discounting it down at the
foreign borrowing rate
Now we know how much foreign currency we need NOW, we can convert that into home currency using the
spot rate.
Here the bank are buying foreign currency off us and so will BUY HIGH
We then take this home currency and put it on deposit at home
The eventual receipt is the amount converted plus the interest earned at home
Steps:
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)
2. Convert that to home currency
3. Deposit that amount of home currency
4. The receipt will be the amount converted plus interest on that (home currency deposit rate)
Illustration
Will receive $400,000 in 3 months
Exchange rate now: $1.8250 - 1.8361:£
Forward rates $1.8338 - 1.8452:£
Deposit rates (3 months) UK 4.5% annual US 4.2% annual
Borrowing rates (3 months) UK 5.75% US 5.1% annual
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate) 
Interest = 5.1% x 3/12 = 1.275%
$400,000 x 1/ 1.01275 = $394,964
2. Convert that to home currency
 
The UK company now needs to sell $394,964 from the bank. The bank will BUY HIGH
394,964 / 1.8361 = £215,110
3. Deposit that amount of home currency 
This amount will be deposited at home at 4.5% for 3/12 = 1.125% = 215,110 x 1.125% = £217,530
Currency Futures Contracts
What is this little baby all about then?
 It’s a standard contract for set amount of currency at a set date
 It is a market traded forward rate basically
*Calculations of how these work are required only for P4 exam (not F9)
Congrats guys. I passed both F6 and F7 this time. Thanks @aCOWtancy
Explanation
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, ie 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.
Advantages
1. Lower transaction costs than money market
2. They are tradeable and so do not need to always be closed out
Disadvantages
1. Cannot be tailored as they are standard contracts
2. Only available in a limited number of currencies
3. Still cannot take advantage of favourable movements in actual exchange rates (unlike in options…
next!)
Currency Futures - calculation
Typical available futures contracts are as follows:

Example - Extract from the exam June 11

Casasophia Co, based in a European country that uses the Euro (€) is due to receive the payment of US$20
million in four months.
Spot rate $ per €1:
US$1·3585–US$1·3618
Currency Futures (Contract size €125,000, Quotation: US$ per €1)
2-month expiry 1•3633
5-month expiry 1•3698
Required:
Advise Casasophia Co on an appropriate hedging strategy for the US$ income it is due to receive in four
months.
 Solution
For a US$ receipt, the five-month futures contracts (two-month is too short for the required hedge
period) need be bought.
The contract will be closed out in 4 months.
Predicted futures rate = 1•3698 – (1/3 x (1•3698 – 1•3633)) = 1•3676 (when the five-month contract is
closed out in four months’ time)
Why did I use 1/3?
Because the change between 2-month expiry and 5-month expiry is 3 months. Therefore 1 month
represents 1/3, and therefore we have deducted 1 month from 5-month expiry  option to get the
predicted rate in 4th month.
Expected receipt = US$20,000,000/1•3676 = €14,624,159
Number of contracts to be bought = €14,624,159/€125,000 = 117 contracts
 [OR: Futures lock-in rate may be estimated from the spot and five-month futures rate:
1•3698 – (1/5 x (1•3698 – 1•3618)) = 1•3682
Note:
Casasophia Co will have $20m and the bank will buy them from it. Therefore the bank BUYS HIGH
and therefore the spot rate $1.3618 per €1 is used.
US$20,000,000/1•3682 = €14,617,746
€14,617,746/€125,000 = 116•9 or 117 contracts (a slight over-hedge)]
Currency Swaps
What are they?
 The exchange of debt from one currency to another
 2 companies agree to exchange payments on different terms (eg different currency)
Advantages
1. Easy
2. Low transaction costs
3. Spread debt across different currencies
How to use them
Currency swaps are better for managing risk over a longer term (than currency futures or currency options)
A currency swap is an interest rate swap (between 2 companies) where the loans are in different currencies.
It begins with an exchange of principal, although this may be a notional exchange rather than a physical
exchange.
During the life of the swap agreement, the companies pay each others’ foreign currency interest payments. At
the end of the swap, the initial exchange of principal is reversed.
Example
Consider a US company X with a subsidiary Y in France which owns vineyards. Assume a spot rate of $1 =
€0.7062. Suppose the parent company X wishes to raise a loan of €1.6 million for the purpose of buying another
French wine company. 
At the same time, the French subsidiary Y wishes to raise $1 million to pay for new up-to-date capital
equipment imported from the US. 
The US parent company X could borrow the $1 million and the French subsidiary Y could borrow the € 1.6
million, each effectively borrowing on the other's behalf. They would then swap currencies.
Currency Options
Features of Currency Options
A currency option gives its holder the right to:
Buy (Call option) the contracted currency or
Sell (Put option) the contracted currency
on or before a specified date, at a fixed rate of exchange (the strike rate for the option).
If the exchange rate moves against you - then take the option which is more favourable
If the exchange rate moves in your favour - then ignore the option (which would be adverse)... You can't lose!
Clearly, because of this, the option involves buying at a premium at the beginning
Thank you @aCOWtancy for the beautiful online course. I cleared the financial reporting exam on my first
attempt. Cheers!
Disadvantages
1. The premium
2. Must be paid up immediately
3. Not available in every currency
Advantages
1. Currency options do not need to be exercised if it is disadvantageous for the holder to do so.
2. Holders of currency options can take advantage of favourable exchange rate movements in the cash
market and allow their options to lapse. The initial fee paid for the options will still have been incurred,
however.
Options - calculations 
A right to sell (put options) or buy (call options) a currency at the exercise price in the future
Rules:
 If the movement in the exchange rate is favourable 
- don't exercise the option
- let it lapse
 If the movement is adverse
- exercise the option
Steps:
1. Do I want call or put options?
Will I buy (call options) or sell (put options) the BASE currency?
2. Choose expiry
3. Choose strike (exercise) price
4. How many contracts?
5. How much BASE currency do I receive (call options)/pay (put options)?
6. Calculate Premium
7. Amount not hedged
8. Choose whether to exercise
Example - Put options- Extract from the June 13 exam
Kenduri Co is based in the UK. It will have to pay $2,400,000 in 3 months.
Spot rate US$/£1:
1.5938-1.5962
Hedging using Forward: £1,500,375 payment
Required
Advise Kenduri Co on, and recommend, an appropriate hedging strategy for the US$ cash flows it is due to pay
in three month.
Currency options available to Kenduri Co
Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1
Exercise Call options Call options Put option
3-month expiry 6-month expiry 3-month e
1.60 1.55 2.25 2.08
Solution
1. Do I want call or put options?
BASE currency is £.
Kenduri Co will pay $2.4m in 3 months, therefore have to sell £ to buy $2.4m, therefore Kenduri Co
would purchase Sterling three-month put options to protect itself against a strengthening US$ to £.
2. Choose expiry
Kenduri Co will choose Put 3-month expiry options, because it will pay $2.4m in 3 months.
3. Choose strike (exercise) price
Exercise price: $1•60/£1
£ payment = 2,400,000/1•60 = £1,500,000
4. How many contracts?
£1,500,000 / £62,500 = 24 contracts
24 put options purchased
5. How much BASE currency do I pay (put options)?
£ payment = 2,400,000/1•60 = 1,500,000
6. Calculate Premium
Premium payable = 24 x 0•0208 x 62,500 = US$31,200
Premium in £ = 31,200/1•5938 = £19,576
Note:
Kenduri Co will pay the premium in US$31,200. Kenduri Co have to buy $ from the bank (the bank
will "sell LOW" $, therefore the Spot rate US$1.5938  is used.
7. Amount not hedged
All amount is hedged (refer to step 4)
8. Choose whether to exercise
Total payments = £1,500,000 + £19,576 = £1,519,576
£1,519,576 > £1,500,375 FWD, therefore use the Forward rate hedge.
Example- Call options - Extract from the June 11 exam
Casasophia Co, based in a European country that uses the Euro (€) is due to receive the final payment of US$20
million in four months.
Spot rate $ Per €1:
US$1·3585–US$1·3618
4-month forward $ Per €1:
US$1·3588–US$1·3623
Hedging using Forward contracts is €14,681,054.
Required
Advise Casasophia Co on, and recommend, an appropriate hedging strategy.
 Exercise price     Calls 2-month expiry Calls  5-month expiry Put
1.36 2.35 2.80 2.4
Solution
1. Do I want call or put options?
BASE currency is EUR.
Casasophia Co will receive $20m in 4 months and then will convert them to EUR (buy EUR), therefore
Casasophia Co would purchase Euro call options to protect itself against a weakening Dollar to the
Euro.
2. Choose expiry
Casasophia Co will choose Call 5-month expiry options, because it will receive $20m in 4 months. The
2-month expiry is too short.
3. Choose strike (exercise) price
Exercise Price: $1•36/€1
€ receipts =$ 20,000,000/($1•36/€1) = €14,705,882
4. How many contracts?
€14,705,882 / €125,000 =  117•6 contracts
117 call options purchased
5. How much BASE currency do I receive?
€ receipts = 117 x €125,000 = €14,625,000
6. Calculate Premium
Premium payable = 117 x 0•0280 x 125,000 = US$409,500
Premium in € = 409,500/1•3585 = €301,435
Note:
Casasophia Co will pay the premium in US$409,500. Casasophia Co have to buy $ from the bank (the
bank will "sell LOW" $, therefore the Spot rate US$1·3585 is used.
7. Amount not hedged
Amount not hedged = US$20,000,000 – (117 x €125,000 x 1•36) = US$110,000
Use forwards to hedge amount not hedged = US$110,000/1•3623 (the banks "buy high")= €80,746
8. Choose whether to exercise
Total receipts = 14,625,000 Receipt– 301,435 Premium + 80,746 FWD = €14,404,311
€14,404,311 < €14,681,054 FWD contract, therefore choose badge using the forward contract.
Netting

Netting is setting the debtors and creditors in the group resulting in the net amount either paid or received.
There are two types of netting:
1. Bilateral Netting
In the case of bilateral netting, only two companies are involved. 
The lower balance is netted against the higher balance and the difference is the amount remaining to be
paid.
2. Multilateral Netting
Multilateral netting is a more complex procedure in which the debts of more than two group companies
are netted off against each other.
Example - June 2013 extract
Kenduri Co is considering whether or not to manage the foreign exchange exposure using multilateral netting
from the UK, with the Sterling Pound (£) as the base currency. 
If multilateral netting is undertaken, spot mid-rates would be used.
The following cash flows are due in three months between Kenduri Co and three of its subsidiary companies. 
The subsidiary companies are Lakama Co, based in the United States (currency US$), Jaia Co, based in Canada
(currency CAD) and Gochiso Co, based in Japan (currency JPY).
Owed by Owed to Amo
Kenduri Co Lakama Co US$
Kenduri Co Jaia Co CAD
Gochiso Co Jaia Co CAD
Gochiso Co Lakama Co US$
Jaia Co Lakama Co US$
Jaia Co Kenduri Co CAD
Lakama Co Gochiso Co JPY
Lakama Co Kenduri Co US$
Exchange rates available to Kenduri Co
US$/£1 CAD/£1
spot 1.5938-1.5962 1.5690-1.5710
Required:
Calculate the impact of undertaking multilateral netting by Kenduri Co and its three subsidiary companies for
the cash flows due in three months.
Solution
Based on spot mid-rates: US$1·5950/£1; CAD1·5700/£1; JPY132·75/£1

Multilateral netting involves minimising the number of transactions taking place through each country’s banks.
This would limit the fees that these banks would receive for undertaking the transactions.
It disadvantages may include:
 The central treasury may have difficulties in exercising control that the procedure demands.
 Subsidiary company’s result may be distorted if the base currency is weaken in the sustained period.
Matching
This is the use of receipts in a particular currency to match payment in that same currency.
Wherever possible, a company that expects to make payments and have receipts in the same foreign currency
should plan to of set it payments against its receipts in that currency.
Since the company is offsetting foreign payment and receipt in the same currency, it does not matter whether
that currency strengthens or weakens against the company’s domestic currency because there will be no
purchase or sale of the currency.
The process of matching is made simply by having a foreign currency account, whereby receipts and payments
in the currency are credited and debited to the account respectively.
Probably, the only exchange risk will be limited to conversion of the net account balance into the domestic
currency.
This account can be opened in the domestic country or as a deposit account in oversees country.