IFM 5

15 flashcards · Other · by Daniel F.

1. Foreign Exchange (FX) vs FX Transaction vs FX Rate

   Foreign Exchange (FX): Simply the money of another country. FX Transaction: An agreement to exchange a specific amount of one currency for another at a specific rate. FX Rate: The price of one currency in terms of another (e.g., $1.50 per £1).

2. Spot Market

   This is for immediate exchange. "Immediate" in FX markets usually means settlement in two business days. You can take a long position (buying a currency) or a short position (selling a currency).

3. Forward Market

   This is for future exchange. You enter into a contract today to buy or sell a currency at a specific future date for a price agreed upon today. No money changes hands when you enter the contract. It can be used to hedge (reduce risk) or to speculate (bet on future currency movements). The forward price is often different from the spot price. If it's higher, the currency is at a premium; if it's lower, it's at a discount.

4. types of risk from currency fluctuations (FX exposure)

   Transaction Exposure Economic Exposure Translation Exposure / Accounting Exposure

5. Transaction Exposure

   The risk that the value of a specific, contractual cash flow (like a receivable or a payable) will change due to unexpected changes in the exchange rate. The risk exists between the time a contract is signed and the time it is settled (paid).

6. Economic Exposure

   broader risk: It's the possibility that a firm's overall value (the present value of all its future cash flows) will be affected by exchange rate changes. relates to the firm's long-term competitive position, pricing strategy, and market share.

7. Translation Exposure / Accounting Exposure

   A purely accounting-based risk. It's the effect that exchange rate changes have on a company's consolidated financial statements when it combines the results of its foreign subsidiaries.

8. Hedging Transaction Exposure with Financial Contracts

   Hedging Foreign Currency Receivables Forward Market Hedge Money Market Hedge Options Market Hedge Hedging Foreign Currency Payables Forward Market Hedge Money Market Hedge Options Market Hedge Special Cases Cross-Hedging Contingent Exposure Recurrent Exposure

9. Hedging Foreign Currency Receivables / Payables: Forward Market Hedge

   US company will receive €10M is one year It enters a contract today to deliver €10 million in one year in exchange for a guaranteed amount of $ on the forward market at $X/€ Gains and Losses if future spot rate is more, gain if future spot rate is less, loss Home Currency Cost = (Foreign Payable Amount) x (Forward Rate) The decision to hedge is made before you know the future spot rate. A risk-averse firm will likely hedge to eliminate uncertainty, even if it means giving up potential gains. US…

10. Hedging Foreign Currency Receivables / Payables: Money Market Hedge

    US company will receive €10M is one year Get a loan that will equal €10M in one year at EUi interest rate borrow €10M/1+i immediately convert € to $ at spot rate $X/€ Invest dollars in the US for USi In one year Collect €10M receivable Use it to pay off loan + EU interest Collect the matured $ investment Home Currency Cost = (Dollars Needed Today) x (1 + i$) US company will have to pay €10M is one year Buy € now that will be €10M after one year (PV = 10M/(1+EURi)) Invest in EURi In one year Sel…

11. Hedging Foreign Currency Receivables / Payables: Options Market Hedge

    US company will receive €10M is one year buy a put option: gives you the right, but not the obligation, to sell the foreign currency at a pre-agreed "exercise price." Spend $X premium on the option (FV = $X*(USi+1)) If € weakens exercise the option to sell at exercise price if € strengthens let the option expire worthless, sell EUR on spot market Home Currency Cost = (Payable Amount x Expected Spot Rate / exercise rate) + (FV of Premium) US company will have to pay €10M is one year buy a call o…

12. Special hedging

    Cross-Hedging: Used for minor, illiquid currencies where direct hedges are unavailable. You hedge your position by using a financial contract in a highly correlated, liquid currency. Contingent Exposure: The risk of a cash flow that may or may not happen (e.g., bidding on a contract). A forward hedge is dangerous here. An option is the perfect tool because you can let it expire if you don't win the contract, losing only the premium. Recurrent Exposure: A continuous stream of payables or receiva…

13. Hedging with Operational / non-financial techniques Techniques

    Hedging through Invoice Currency: invoice in home currency or share the risk by invoicing 50% in one currency and 50% in the other Hedging via Lead and Lag If you expect a foreign currency to weaken, you want to lead (pay early) your payables in that currency and lag (collect late) your receivables. If you expect a foreign currency to strengthen, you want to lag your payables and lead your receivables. This is most effective between subsidiaries of the same MNC. Exposure Netting: An MNC with ma…

14. most popular hedging product used by corporations

    traditional forward contract typically use a combination of financial contracts and operational techniques to manage their overall exposure

15. Why Don't All Firms Hedge?

    Internal Diversification: The firm may believe it has a "natural hedge." If it sells products in many different countries and buys raw materials from many different countries, its various currency exposures might cancel each other out. For example, a weak euro might hurt sales revenue from Germany but help by making parts purchased from Italy cheaper. The firm might feel its net exposure is too small to worry about. Shareholder Diversification (A Finance Theory View): This argument, rooted in c…