Things to learn in this chapler] Bosics of Rick Management Basic Hedging Methods Forword Contracts Money Mor Ket Hed ping Derivatives Forecasting exchange rate movements Managing other rieks. )_Exenende Exchanoe Beek: The rate at which one county’: currenty can be treded in exchenge for another county currenty. Eychange Rale RISK management jwhich fs sometimes referred to as hedging. 4 : Three categories of Rick transaction translation & economic Tigges In the exam, the domestic currengy Is. Normally. dollars. & Foreign currency (a Ih pesos, + ent basics + Trensachion Rick The rick that a transaction in a foreign curreny -fs recorded St one rate and then settled at a different rete because of a change in the exchange rate. Arices due +o the Hming between entering info the transaction and the settlement of transaction: cen also arise when there is recetvables or poyarles from Foreign county. Ey: A company Is makrno Interest payments ona foreign eorrened loan (or ls vecelving interest). $ strong (Home curreny) 4 leag (Hone Correnyy) Exporiers toce if the $ T Strong| [Importers lose If the d rs wwe becuse the pesolforeion curiency)ie | PRO the peso (forelgn curren) Weak and thelr rvevenve Is 8 strong and tneir cocls in_pesv. are IN pesos:sect Rate ) The exchange rete currently offerecl on & currency ‘for immedi- ate delve. K Exports Gexport sales create revenue ing forelon currency (€9 pesos) | this will normally converted by @ company into dollars (the clomestic currency) at the spor rate aveileble: when money receta), Epa — . : elves 208 (Sells. pesos TO buy dollars Imports G costs that sre payable, in a foreign currency will require & company: fo séll dollars cclomestic currenwy) to bY the. forei Qn. - currenyy required, for the, transaction’ at thes pot rte avai tape. Importer \ Pays invoreas Tn pesas 5 sed Sell's' dollars to buy , pesod : , | Fe_Spreads vv F - a A spread chows the different rates at whith benx\ will transact with an exporter and an importer. D Questions may. provide spot rate a8 a spread eg: £7600 -1.900° pesds per dollar. f it ‘ - ayy. bIn order to make a profit, 8 \bank cells. dollars Cdomestic curren) to an exporter af &\ high Price. (1-80) Pesos and buy doller from importer at a. low price (1-76 pesos) and make ; a profit on c¢preadd. t Exam Fows -Point sag rf in dovbt es to which part of the spread TO use, rem- ember that @ company will always be offered the worse rate so bank generates profit on the: transaction:corn ee TL! cre Melhods i I by 4 company to eliminate d4ransaction risk or to reduce it to an acceptable (imi: ly Lilustrated below tora company with dollar as (ts domestic currency end with vaareing FSS (foreipn Currency). ——RATEHTN — Wherever possible’, a company the expects to mae payments & Have reweipls in same, foreign Curreny! Shovid plan te offset tts my nts apelnst its receipt Fa “Trvoice in domestic a Adoiters) Agreeing with costemers to pay iP heme cur end pay all Imports tn hone curren). Transfer risk to other porty 4 Leading Tf you Know the currency will Strerigth in future you tends to Pay earlier ond vice versa if recelpt Netting A ‘process in which Credit balan ces ore netted off ageing debit balances 80 that onl the redvee| net amis vemain dit. to ‘be by actual currenyy flows. Lagoing Tt goo eas thé currency wi depreciate in futwe you, tends to Pay later and vice versa if receipt] 3) Managing transaction Risk- forward conheds It ig a Contract’ with the bank (also called over the counter or OTC contrac) fixing the exchange rat€ one specific amount of foreign currenyy recelvable. or payable at future clata at an exchange rate agreed now. purpose is to fix an exchange sate now for settlement of 8 transaction at a future date At the same time it loses the opportunity fo gain from a fevour- eue movement tn the spot rate « can be used for severe] months ahead or for one yer Bhead byt cannot be used for long term. > Forward cpntracts ave arranged directly with @ bank Advantaga are simple, low or zero up-front cost, avellable for mani currencies. Drsadvantaoes ore tixed date, unattractive rate, covnler- pry yiSE) Instead of hedging a curreny expos ith @ forward contract, a company covld use the money markets +0 lend or borrows and achleve~ a similar sesvit- Use of the short-term money markets 40 borrow or deposit fund This gives the company the Spportunty hr exchanye currency today at fhe Prevaileng spot Yate. where forelon currency Revenve ré expected ,exchange rate riSK cen be eliminated by: ; ; @ borrowing in the foreion currency today , converting these © funds into’ dollars (domestic Coren at today’s spot tate (80 there Is M0. exchange rate risk). ‘ 8) using the -futvie revenve Cin foi on. qurreng) to repay the Forelgn currency loan. Because this Involves @ ghort-term loan, in @ foreign curren, it is ‘called mongy- market hedging ' To create a money market hedoe -for a recelpt follow steps beloy Step i: Telentify the ‘loan vepayment required in future (Expected Revenue) , ' GeP2: Using the interest rete provided ;caleviate the amt (Pv) thst needs to be borrowed today in. foreign, currengy. iv Step&:' Convert this immediately ‘to ‘clomestic .Chome). currenc at the spot rate. Place this’ onideposit in the home currenty: . . ‘ 4. Include the ‘nterat rete earned: on the depasit in the home. curren susing the inierest rate provided -(forword ant Aer recelving from Foreign comrengy, Repay the Joan in retgn Clonee Ben i NOTE: The deposit and borrowing fate will normaly. be given as annua) rates and will! have to be adjusted for the fime period in the question, > -A PureiyN LUTeEnty Paysble LEY AM yur wihele foreign currency expenses are clue, Money market hed Qi- hg cen eliminate exchange rate risk by: a) withdrawing funds from your local bank tn domestic currenty (eg doltars) and petting them on deposit in a foreign currency bank Ale today (So no exchange rate risk) ») Using these funds Cplus Expectecl Spot Rete So> current pot Rate h > Infleton in ‘foreign county hp= base county inf letion iii) Interest Rates JIN the (ono term two counties of cimiler risk should offer Similar rates of refurn to international investors so eny differen ces in interest rates chouidl reflect ‘differences in inflation. > High rates of inflation In a foreign. currency weeken Its exchange tele So hioh interest retes are acsociated with weakening currencies Tis is sometimes called internationa) Fisher effect In the “short-run banks use interest sates to calevlate forward exchange rates; this is Interest rate parity theogy Formulas Fy = Sy x_(U4ic) (441d : ‘where, y= Forward Rate b= base county So: Current Spot Rete c= Foreign county So, if interest rater ore relatively high in. One county, then thet county will experience @ fall In value of its currenty. . iv) Four-wa, vivalence : Links together interes? rete and inflation rate theories. Inflation rates asn be used to predtet the future Spot Rate (pppt Long: term interest rates ceh also be used to piedict future spot Rate (LPT). Linkage of these theories. have been Shown tn the diagram.che pn fur power parity theoyy Tnflstion sete) High infation= fan) a ex-1af@ [Forecast chanoes difference in exchanoe rates 7 “ Hioh interest Hrgh tone ~term interest,“ rates “due to high rafet pedicle © decline, ¢ inflation: In exchange rate,“ ‘Interest rate}, ditterences Interest rate parity theogy Forwards rates fe ictsee oy ‘un biased, indiator} of - spot rate @ Managing _other_Risks TORIES AOS )) Translation ISK i The risk that the domestic cureny value “of foreign Correng assets fall ,or value of forelon currengy (vebilities yiseg. Unlike transaction risk, this 1s not a Cashflow pout it ts sti 2 worry for some companies becsuse of it posentieal” Profit r chs ¢ ante affects companies with foreign subsidiaries . Tf subsidiary ts In a county whose currency weakens ,the ee assets | will be less valuable tn esse consolidated Gtatemenh: A ie) that -has assets in Q@ foreron currency. can mata these assets with Vabilitel (eo debt finale) en conve forelgn evner a Economic RISK Eronomic risk avises when changes 1h exchange rales stfect the demand for a company's product or services, the cost of (ts inputs, or its competitive posiffon in the market. For example, #3 company sources raw materials from oversea and the domartic curren shengthens ,the cost Of Those mater tals will’ (ndiedse which could reduce the companys profitabitt + Companies that are exposed +o economic rick may use hedging Strategies Such as diversifying thelr opeiations across different fons » veg