Currency risk

▪ Currency risk is the exchange gain or loss that arises as a result of the
movements in exchange rates.
▪ An exchange rate is the price of one currency quoted against another
currency.
▪ The rate can be directly quoted or indirectly quoted
▪ A direct quote shows the amount of local currency per 1 unit of
foreign currency. The quoted currency is the local currency.
▪ The indirect quote shows the amount of foreign currency per unit of
local currency. The quoted currency is the foreign currency.
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▪ The direct quote is the inverse of the indirect quote.
 Direct Vs indirect quote
▪ When converting currency, the dealer (bank) buys at a lower price
and sells at a higher price (dealer receives more and pays less).
▪ When converting currencies, if the amount to be converted is of the
same currency as the exchange rate, you convert by dividing. If
different, you convert by multiplying.
▪ In short, same currencies, divide; Different currencies multiply.

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Spot exchange vs Forward rates
▪ A spot exchange rate is the exchange rate that is applicable for
immediate transaction and settlement.
▪ The forward exchange rate is the rate applied for immediate
transaction but delivery and settlement are for a specific future
date e.g. 1 month forward, 3 months forward etc.
▪ Forward exchange rates are used to lock into the price in order to
reduce the currency risk on transactions.
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Factors affecting exchange rates
▪ Balance of payment support: The interaction between imports and
exports can cause a surplus or a deficit in the country’s current
account which can subsequently affect the exchange rate.
▪ A surplus implies that there were more exports than imports
which tends to favour the local currency due to the increase in
forex in the market.
▪ A deficit means the country had more imports than exports which
negatively affects the domestic currency.
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 Factors affecting exchange rates
▪ Expectation theory or speculation:
▪ The actions and expectation of the players in the foreign exchange
market is likely to influence or predict what the future exchange
rate will be such that a currency can trade at a forward premium
or forward discount.

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Factors affecting exchange rates
▪ Interest rate parity (IRP):
▪ The difference in interest rates between two countries can be
explained by the differences in the exchange rates.
▪ Thus interest rate differential can be used to predict the future
exchange rate as:
𝒏
(𝟏+𝒒𝒖𝒐𝒕𝒆𝒅 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕)
▪ Forward exchange rate = spot rate x 𝒏
𝟏+𝒃𝒂𝒔𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕

where: Quoted currency is the variable currency.

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n is the period of time in years.

Practice question 1
▪ The spot exchange rate K16.14/US$. The interest rate in Zambia
is 7% per year while the US interest rate is 3% per year.
▪ Determine the following forward exchange rates:
a) 3-months forward rate.
b) 6-months forward rate.
c) 12-months forward rate.

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Practice question
𝒏
(𝟏+𝒒𝒖𝒐𝒕𝒆𝒅 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕)
▪ Forward exchange rate = spot rate x 𝒏
𝟏+𝒃𝒂𝒔𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕

▪ 3-months forward rate = K16.14 * (1.07(3/12)) = K16.29

(3/12)
(1.03 )
▪ 6-months forward rate = K16.14 * (1.07(6/12)) = K16.45
(1.03(6/12))
▪ 12-months forward rate = K16.14 * (1.07(12/12)) = K16.77
(1.03(/12))
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Practice question 2
𝒏
(𝟏+𝒒𝒖𝒐𝒕𝒆𝒅 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕)
▪ Forward exchange rate = spot rate x 𝒏
𝟏+𝒃𝒂𝒔𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕

▪ The spot exchange rate between kwacha and sterling pound is

K21.035 per £1. The interest rate in the UK is 2.5% per annum,
interest rate in Europe is 4% per year while the Zambian interest
rate currently stands 9% per year.
▪ Required
▪ Calculate the 6-months and the 1-year forward rates.
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 Factors affecting exchange rates
▪ Purchasing power parity (PPP):
▪ The difference in inflation rates between two countries can be
explained by the differences in the exchange rates.
▪ Thus inflation rate differential can be used to predict the future
exchange rate as:
𝒏
(𝟏+𝒒𝒖𝒐𝒕𝒆𝒅 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏)
▪ Forward exchange rate = spot rate x 𝒏
𝟏+𝒃𝒂𝒔𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏

where: Quoted currency is the variable currency.

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n is the period of time in years.

 Types of currency risk
▪ Transaction risk: Exchange gain/losses that arises as a result of
movement in exchange rates between transaction date and
settlement date.
▪ Translation risk: Exchange gain/losses that arises due to the need to
consolidate company accounts that involves foreign interest (assets
and or liabilities)
▪ Economic risk: loss of value or international competitiveness of a
local business due to adverse movements in exchange rates over
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 Internal hedging methods
▪ Home currency invoicing: Hedger can invoice its customers in its
home currency or request to be invoiced in its home currency.
▪ Matching receipts and payments: Maintaining foreign currency
accounts so that receipts in one currency are matched with
payments in the same currency.
▪ Leading and lagging: Speeding up collection/payments as well as
delaying receipts or payments in order to take advantage of
existing or anticipated favourable exchange rates. 12