Chapter 14

FOREIGN CURRENCY
RISK
The risk that exchange rate may move up and down in relation to other currencies. It will have a major impact
on the profitability of any company that buys or sells to other currencies.

TYPES OF FOREIGN CURRENCY RISK

There are three risks associated with foreign currency:

1. Transaction risk
2. Translation risk
3. Economic risk

Transaction risk

The risk of adverse exchange rate movements occurring in the course of normal international trading
transactions. This arises when prices of imports or exports are fixed in foreign currency terms and there is a
movement in the exchange rate between the date when the price is agreed and the date when the cash is paid or
received in settlement.

For example, a sale worth $3,000 when the exchange rate is $1.7820 per £ has an expected Sterling value of
£1,684. If the Dollar has depreciated against Sterling to $1.8500 per £ when the transaction is settled, the
Sterling receipt will have fallen to £1,622.

Transaction risk therefore affects cash flows so companies often choose to hedge or protect themselves against
transaction risk.

Translation risk

This is the risk that an organisation will make exchange losses when the accounting results of its foreign branches or
subsidiaries are translated into the home currency. Translation losses can result, for example, from restating the book values
of a foreign subsidiary’s asset at the exchange rate on the balance sheet date.

For example, an asset valued on the balance date at $14m and was acquired when the exchange rate was $1.7900 per £, one
year later, the exchange rate has moved to $1.8400 per £ and the balance sheet value of the asset has changed from £7.8m to
£7.61m, resulting in an unrealised (paper) loss of £0.21m.

Translation risk does not affect cash flows, so does not directly affect shareholder wealth. However, investors may be
influenced by the changing values of assets and liabilities so a company may choose to reduce translation risk through, for
example, matching currency of assets and liabilities. For example, an asset denominated in Euros would be financed by a
Euro loan.

Economic risk

This refers to the effect of exchange rate movements on the international competitiveness of a company. For example, a UK
company might use raw materials which are paid in $, but export its products mainly in the EU. A depreciation of the
sterling against the $ or an appreciation of the Sterling against other EU currencies will both erode the competitiveness of the
company. Economic exposure can be difficult to avoid, although diversification of the supplier and customer base across
different countries will reduce this kind of exposure to risk.

THE EXCHANGE RATE

The rate at which one country’s currency can be traded in exchange for another currency’s currency.

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Spot rates

This is a prevailing rate at a point in time (say today).

‘e.g. $: £1.9500

This means that the $ is expressed in terms of one pound (£), i.e. we express the first currency in terms of one of
the second.

Conversion rule ( ÷ and x ) ÷ 1st currency to calculate the 2nd

X 2nd currency to calculate the 1st

Spot rate with spread

The bank expects a margin to transact funds. As a result the rate is often expressed in terms of a bid/offer
spread. Remember the bank will always win!

Flow rule – when looking at the first currency

 Buy 1st currency low

 Sell 1st currency high

Question 1

Spot rate $: £ 1.9500 ± 0.0350

€: £ 1.2500 ± 0.0275

(a) A €300,000 receipt is transferred to our £ bank account.

(b) A £400,000 receipt is to be transferred into our $ bank account.
(c) A $250,000 payment is to be paid from our £ bank account.
(d) A £100,000 payment is to be paid from our € bank account.

Required:

What are the values of the transactions?

EXCHANGE RATE SYSTEMS

Exchange rates are a key measure for governments to attempt to control. They will have direct bearing on the
economic performance of the country.

Fixed (or pegged) rate systems

Where a currency is fixed in relation to the dominant world currency ($) or alternatively against a basket of
currencies (ERM).

The ‘peg’ may be changed from time to time to reflect the relative movement in the underlying value.

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This form of currency management is effective at giving a stable exchange platform for trade. It will however
lead to a parallel or unofficial market for currency if out of step with the perceived value and normally requires
strict exchange control to operate.

Floating rate systems

Where the exchange rate is allowed to be determined without any government intervention.

It is determined by supply and demand. This is rare; currency value is normally considered too important a
measure to be left solely to the market.

The market has a tendency to be volatile to the adverse effect of trade and wider government policy. This
volatility can adversely affect the ability to trade between currencies .

Managed or ‘dirty’ float

Where the market is allowed to determine the exchange rate but with government intervention to reduce the
adverse impacts of a freely floated rate.

The basic aim is to ‘damp’ the volatility by intervening or being prepared to intervene to maintain the value
within a ‘trading range’.

A government may further attempt to influence the ongoing value of the currency. If this is materially at odds
with the market’s perception of the value however it is rarely successful in the long run. Examples of this failing
include the pound falling out of the ERM or the collapse in the value of the Argentinean Peso.

The government may intervene by;

 Using reserves to buy or sell currency the government can artificially stimulate demand or supply and
keep the currency within a trading range reducing volatility.

 Using interest rates, by increasing the interest rate within the economy the government makes the
currency more attractive to investors in government debt and will attract speculative funds.

REASONS FOR EXCHANGE RATE MOVEMENTS

Balance of payments
The inflows and outflows from trade reflect demand for and supply for the home currency. If there is a consistent deficit or
surplus there will be a continuing excess supply or demand for the currency that would be reflected in weakness or strength
in the currency.

For major traded currencies this effect is relatively small.

Capital movements between currencies

Of far more importance for major currencies are the flows of speculative capital from one currency to another.
This makes the level of relative interest rates of critical importance for these currencies. An increase in the
interest rate of one currency will lead to a one-off increase of demand for that currency increasing its value.

It is difficult to predict future rates based on this measure.

Purchasing power parity theory (PPPT)

 Based on the law of one price in economic theory. This would suggest that the price of the same product is
the same in all currencies.

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 To extend the principle further this would suggest that a relative change in prices (inflation) would have a
direct effect on the exchange rate. If relative inflation is higher in one currency we would expect that
currency to fall. (depreciate).
 It is based on arbitrage – trade on margins to have a risk free return.

Problems:

1. Transaction costs
2. Tariffs and taxation
3. Local taste and disposable income.
4. Not all inflation relates to exported goods
5. Only a small proportion of trade relates to traded goods.

PPPT is an unbiased but poor predictor of future exchange rates.

Illustration
A product is currently being sold in the UK for £2,000 and in the US for $4,000. This would infer that the current exchange
rate is $: £ 2.0000.

What would we expect the exchange rate to be in one year if the inflation rates are 4% and 7% respectively?

Year UK US
0 £2,000 $4,000
Inflation x 1.04 x 1.07
1 £2,080 $4,280

The predicted exchange rate would be $4,280/£2,080 = $: £ 2.0577.

To calculate the impact of PPPT uses the following formula:

Future Current 1 + 1st currency inflation rate

Expected = spot x 1 + 2nd currency inflation rate
Spot raterate

Question 2
The current exchange rate is $: € 1.4000. Inflation rates for the two currency zones are as follows;
US ($) 4%
EU (€) 2%.

Required:
What is the predicted exchange rate in one year?

Interest rate parity theory (IRPT)

The theory that there is no gain relating to investing in government bonds in differing countries. Any benefit in
additional interest is eliminated by an adverse movement in exchange rates.

IRPT is an unbiased but poor predictor of future exchange rates.

Illustration
It is possible to invest £1m in short-dated government bonds in the UK at 6.08% or alternatively in the US
treasury bills at 9.14%. The current exchange rate is $: £ 2.000

Year UK US
0 £1 m x2= $2 m
Interest x 1.0608 x 1.0914
1 £1.0608m $2.1828m

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The predicted exchange rate would be $2.1828m / £1.0608m = $: £ 2.0577
Does it work?
In practice the relationship between interest and exchange rates is not perfect and certainly not simultaneous. It
is possible that the exchange rate does not move in line with interest rates for long periods only correct over a
short period of time.

Future Current 1 + 1st currency interest rate

Expected = spot x 1 + 2nd currency interest rate
Spot raterate

Question 3 (question 2 cont’d)

The current exchange rate is $: € 1.4000. Interest rates for the two currency zones are as follows;
US ($) 6.08%
EU (€) 4.04%

Required:
What is the predicted exchange rate in one year?

The international Fisher effect

The assumption that all currencies must offer the same real interest rate. This links PPPT to IRPT. It is based
upon the Fisher effect.

The relative real interest rates should be the same due to the principle of supply and demand, if a country offers a
higher real interest rate investors will invest in that currency and push up the price of the currency bringing the
real rate back to the equilibrium.

The International Fisher effect has a strong theoretical basis but is a poor predictor of future exchange rates.

Remember the Fisher effect:

(1 + m) = (1 + r) (1 + i)

Illustration
(using values from previous illustrations for PPPT and IRPT)

Year PPPT IRPT

0 2.0000 2.0000
X 1.07/1.04 x 1.0914/1.0608
1 2.0577 2.0577
UK US
Real = 1.0608/1.04 – 1 = 1.0914/1.07 – 1 the reason for both PPP
Rate of IRP having the same
Return Prediction is because the
= 2% = 2% international Fisher effect
Holds true.

According to the international Fischer effect, interest rate differentials between countries provide an unbiased
predictor of future changes in spot rates. The currency of countries with relatively high interest rates is expected
to depreciate against currencies with lower interest rates, because the higher interest rates are considered
necessary to compensate for the anticipated currency depreciation. Given free movement of capital
internationally, this idea suggests that the real rate of return in different countries equalise as a result of
adjustments to spot exchange rates.

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Four-way equivalence

The four-way equivalence model states that in equilibrium , differences between forward and spot rates,
differences in interest rates, expected differences in inflation rates and expected changes in spot rates are equal
to one another.

Difference in interest rates Expected differences in

(Equals
inflation rates
Fisher effects)

(equals) (equals) international equals

Interest rate parity Fisher effects Purchasing power parity

Differences between Expected change in spot

forward and spot equals rates
(equals)

Expectations Theory

Question 4
The following interest and inflation rates are known for the dollar and the euro
Inflation rates Interest rates
US $ 4% 6.08%
Euro zone € 2% 4.04%

Required:
What are the predicted exchange rates in one year using:
(a) PPPT?
(b) IRPT?
Does it hold true?

HEDGING EXCHANGE RATE RISK

Hedging is the process of reducing or eliminating risk. It may be achieved by using internal or external
measures.

Internal measures have the advantage of being essential cost free but at the same time are unlikely to completely
eliminate the risk.

External measures involve a bank or financial market. They will incur cost but may totally eliminate the risk.

HEDGING QUESTIONS?
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1. Hedge or do nothing?
2. Internally or externally?
3. Obligation or option?
4. OTC or exchange traded derivatives?

PURPOSE OF HRDGING
The purpose of hedging an exposure to risk is to eliminate or reduce the possibility that actual events will turn
out worse than expected.

Internal hedging techniques

1.Invoice in own currency
Arrange for the contract and invoice to be in your currency. This will shift the exchange rate risk from you onto
the other party. Of course who bears the risk will be a matter of negotiation, along with the price and other
payment terms. If you are very keen to get the sale to a foreign customer you might have to invoice in their
currency.

2.Netting
If you owe your Japanese supplier ¥1m, and another Japanese company owes your Japanese subsidiary ¥1.1m,
then by netting off group currency flows your net exposure is only ¥0.1m. This will really only work effectively
when there are many sales and purchases in the foreign currency. It would not be feasible if the transactions
were separated by many months. Bilateral netting is where two companies in the same group co-operate as
explained above. Multilateral netting is where may companies in the group liaise within the group’s treasury
department to achieve netting where possible.

3.Matching
If you have a sales transaction with a foreign customer, and then a purchase transaction with another (but both
parties operate with the same currency), then this can be efficiently dealt with by opening a foreign currency
bank account. For example:
1 November: should receive US$2m from the US customer.
15 November: must pay US $ 1.9m to US supplier.

Deposit the US$2m in a US$ bank account and simply pay the supplier from that account. That leaves only
US$0.1m of exposure to currency fluctuations.

For matching to work well, either,

 Specific matches are spotted or
 There have to be many import and export transactions to give opportunity for matching.

4.Leading and lagging

If you are planning to go to Spain and you will the Euro will strengthen against your own currency, it might be
wise that you change your spending money into Euro now. That would be ‘leading’ because you are changing
your money in advance of when you really need to. If the Euro weakens, then you lose. But managing
transaction risk is not about maximising your income or minimising your expenditure. It is about knowing for
certain what the transaction will cost in your own currency.

Lagging is delaying the transaction in anticipation that the Euro currency is going to weaken. This does not
reduce any risk. If the Euro strengthens then your travel will turn out to be expensive. Lagging does not reduce
risks because you still do not know your costs.

5. Do nothing.
A compelling idea, the exchange rates will fluctuate up and down. It could be argued that since you will win
some and lose some then ignoring the risk would be the best option.

As a result you save on hedging costs, the down side being that the exposure to exchange rates is present in the
short-term.

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EXTERNAL HEDGING TECHNIQUES

2 forms
1. Bank
 Forward contracts
 Money markets

2. Derivatives
 Currency futures
 Options

Forward exchange contracts

A forward exchange contract is a binding agreement to sell (deliver) or buy an agreed amount of currency at a
specified time in the future at an agreed exchange rate (forward rate).

Features
1. An agreement with the bank to exchange currency for a specified amount at a future date (fix the rate
today for a future transaction).
2. It is an obligation that must be completed once entered into.
3. The transaction may take place over a limited range of dates if option dated. It is an over the counter
(OTC) product which means that it is tailored to the specific value and date required.
4. The forward rate offers a perfect hedge because it is for the exact amount required by the transaction on
the appropriate date and the future rate is known with certainty.
5. Based on the interest rate parity (IRP)

Illustration
The current spot rate is $:£ 2.1132 ± 0.0046. The company is expecting to receive $400,000 in three months.
The forward is quoted at a discount of 0.32 – 0.36 in cents in three months.

Forward rule
The forward rate may be given as an adjustment to the prevailing spot rate, if so:
Add a discount, subtract a premium
$ $
Spot rate 2.1086 2.1178
Add discount 0.0032 0.0036
Forward rate 2.1118 2.1214

Receipt in £ = $400,000/2.1214 = £188,555.

Change £100 to Euro, €1.2022 or €1.2028

Which rate will the bank give you!

You will always be given the exchange rate which leaves you less well off. So here, you will be given a rate of;

1.2022 If you are changing from £ to € now.

Once you have decided which direction one rate is for, the other rate is used when converting the other way.
€ to £ £ to €
Spot €/£ 1.2028 1.2022
Three months forward rate €/£ 1.2026 1.2014

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Example
You are a manufacturer in Italy, exporting to the UK. You have agreed that the sale is worth £500,000, to be
received in three months, and wish to hedge against currency movements.

In three months you will want to change £ to € and you can enter a binding agreement with a bank that in three
months you will deliver £500,000 and that the bank will give you £500,000 x 1.2014 = €600,700 in return. That
rate and the number of Euros you will receive, is now guaranteed irrespective of what the spot rate is at that
time. If the £ had strengthened against the € (say to €/£ = 1.50) you might feel aggravated as you could have
then received €750,000, but income maximisation is not the point of hedging: its point is to provide certainty
and you can now put €600,700 into your cash flow forecast with confidence.

What happens if the sale falls through after arranging the contract?
The bank will expect you to fulfil the commitment, and so what you might have to do is to get enough € to buy
£500,000 using the spot rate, use this to meet your forward contract, receiving €600,700 back. This process is
known as ‘closing out’ and you could win or lose on it depending on the spot rate at the time.

Premiums and discounts

Forward rates are derived from,
1. Spot rates
2. Interest rate differences.

When the interest rate on the variable currency is lower than the interest rate on the fixed currency, the forward
rate will be lower than the spot rate. The variable currency will be worth more forward than spot, and the
forward rate is at a premium to the spot rate.

When the interest rate on the variable currency is higher than the interest rate on the fixed currency, the forward
rate will be higher than the spot rate. The variable currency will be less forward than spot, and the forward rate
is at a discount to the spot rate.

The premium/ discount is shown in points of a price, so that 240 – 231 means 0.0240 – 0.0231.

If you are given spot rates and premium or discount for the forward rate, you should apply the following rule:

 Subtract a premium from the spot rate to derive the forward rate.
 Add a discount to the spot rate to derive the forward rate.

The interest rate on the variable Higher Lower
currency is:
The forward rate is quoted forward Discount to the spot rate (dis) Premium to the spot rate (pm)
at a:
Subtract the premium from the
Rule for obtaining the forward rate. Add the discount to the spot rate. spot rate.

Question 5
A US corporation is looking to hedge its foreign exchange. The current spot rate is $:€ 1.6578 ± 0.0032. The
company is expecting to pay €350,000 in one month. The forward is quoted at a premium of 0.13 – 0.11 in cents
in one month.

Required:
What is the value of the payment in $s?

Advantages of forward exchange contracts

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 Flexibility with regard to the amount to be covered, should lead to a perfect hedge in terms of amount and
date.

 Relatively straight forward both to comprehend and to organise.

Disadvantages of forward exchange contracts

 Contractual commitment that must be completed on the due date, if the underlying transaction is in anyway
doubtful, this may be a problem.

 The rate is fixed with no opportunity to benefit from favourable movements in exchange rates.

Forward rates
 Banks are able to quote exchange rates because of the money markets – (short-term borrowing and lending
markets).

 Forward exchange rates are different from spot rates.

Reason
 Interest rate differences between the two currencies.

A forward rate can be higher or lower than the spot rate, depending on whether the interest on the variable
currency is higher or lower than the interest rate on the base currency.

Example

Current spot rates US $/£1 is 1.8000

Interest rate on the £ is 6% p.a.
Interest rate on the $ is 4% p.a.
(1 + interest rate on the variable currency)
One year forward rate = spot rate x (1 + interest rate on the base currency)

= 1.8000 x (1.04/1.06) = 1.7660.

Money market hedge

The use of short-term money markets to borrow or deposit funds. This gives the company the opportunity to
exchange currency today at the prevailing spot rate.

steps
1. Borrow – borrow funds in the currency in which you need the money.
2. Translate – exchange the funds today avoiding exposure to fluctuations in the rate.
3. Deposit – deposit the funds in the currency in which you eventually want the funds until such time as you
will need them.

Example:
 UK company exports to the US and in three months are due to receive US$2m.
 You could suffer no risk if that US$2m could be used then to settle a US$2m liability.
 That would be matching the currency inflow and outflow. However, you do not have a US$2m to settle
then, so create one that can soak up the US $.

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 You can create a US$ liability by borrowing US $ now and then repaying that in three months with the US$
receipt. So the plan is:

Interest on the US$ loan will accrue for three months.

Borrow US$ US$2m

Now liability

Convert at
Spot rate

£ available now US$2m from

Customer

 To work out how many US$ is needed to be borrowed now, you need to know US$ interest rates. For
example, the US$ three months interest rate might be quoted as:

o 0.54% - 0.66%

Note: The rates are always quoted as annualised rates.

o One rate is what you would earn in interest if the money was on deposit
o And the other is the rate you would pay on the loan.
o You will always be charged more than you earn.

On the US$ loan we will be charged 0.66% p.a. for three months and the loan has to grow to become US$2m in
that time.

So if x is borrowed now and three months interest is added,

X (1 + 0.66/4) = 2,000,000
1.00165x = 2,000,000
X = $1,996,705
This can be changed now from US$ to £ at the current spot rate, say US$: £ 1.4701 to give £1,358,210.

This amount of Sterling is certain we have it now and it does not matter what happens to the exchange rate in
the future.

Ticking away in the background , is the US$ loan which will amount to US$2m in three months and which can
then be paid by the US$2m we hope to receive from the customer. This is the hedging process finished because
exchange rate risk has been eliminated.

Advantages
 We have our money now rather than having to wait for three months for it.
o We can use it
o We can deposit it for three months in a Sterling deposit account.

This raises an important issue when we come to compare amounts received under forward contracts and money
market hedges.

So if the Sterling 3 months deposit rate were 1.2%, then planning £1,358,210 on deposit for three months would
result in £1,358,210 x ( 1 + 1.2%)/4 = £1,362,285. It is this amount that should be compared to any proceeds
under a forward contract.

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If a foreign currency has to be paid in the future, then what the company can do is to change money into
sufficient foreign currency now and place it on deposit so that it will grow to become the required amount by the
right time. Because the money is changed now at the spot rate, the translation is immune from future changes in
the exchange rates.

Advantages of money market hedge

 There is some flexibility regarding the date at which the transaction takes place.
 May be available in currencies for which a forward rate is not available.

Disadvantages of money market hedge

 Complex
 May be difficult to borrow/deposit in some currencies at a risk-free rate.

Question 6
Arbeloa is a UK company trading extensively in the US. The current exchange rate is $:£ 1.9750 ±
0.003

We wish to do the following transactions:

$ receipt of $500,000 in one month.

$ payment of $300,000 in three months.

The money markets provides the following interest rates for the next year (p.a)
UK US
Loan rate 6.0% 7.5%
Deposit rate 4.0% 5.0%

Forward rates
1 month discount 0.0012 – 0.0017
3 months discount 0.0034 – 0.0038

Required:
Calculate the £ receipt and payments using both money markets and forward markets.

OTHER CURRENCY HEDGING TECHNIQUES

FOREIGN CURRENCY DERIVATIVES

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Financial instruments whose value derives from the value of something else like an exchange rate e.g. futures
and options.

Currency futures
A currency future is standardised, market traded contract to buy or sell a specified quantity of foreign
currency.

Differences between currency futures and forward contracts

Currency futures Forward contracts

Standard contracts Bespoke contracts

Traded on the open market (futures exchange) Traded over the counter

Contract price in US dollars Contract price in any currency offered by the bank

Flexible close out dates Fixed date settlement

Underlying transactions take place at the spot rate. The Underlying transactions take place at the forward
difference between spot rate and futures rate is settled rate
between the two parties

Cheaper than forwards Relatively high premium required

A future market is an exchange –traded market for the purchase or sale of a standard quantity of an underlying
item such as currencies, commodities or shares, for settlement at a future date at an agreed price.

The contract size is the fixed minimum quantity of commodity which can be bought or sold using a future
contract. In general, dealing on futures markets must be in a whole number of contracts.

The contract price is the price at which the futures contract can be bought or sold. For all currency futures the
contract price is in US dollars. The contract price is the figure which is traded on the futures exchange. It
changes continuously and is the basis for computing gains or losses.

The settlement date (or delivery date, or expiry date) is the date when the trading on a particular futures
contract stops and all accounts are settled. On the international Monetary Market (IMM), the settlement dates of
all currency futures are at the end of March, June, September and December.

A futures price may be different from the spot price, and this difference is the basis.
Basis = Spot price – Future price
One tick is the smallest measured movement in the contract price. For currency futures this is the movement in
the fourth decimal place.

Market traders will compute gains or losses on their futures positions by reference to the number of ticks by
which the contract price has moved.

Question 7
A US company buys goods worth €720,000 from a German company payable in 30days. The US company
wants to hedge against the € strengthening against the dollar.

Current spot is $0.9215 - $0.9221 per €1and the € futures rate is $0.9245 per €1.

The standard size of a 3 month € futures contract is €125,000.

In 30 days time the spot is $0.9345 - $0.9351 per €1.

Closing futures price will be $0.9367 per €1.

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Required:
Evaluate the hedge.

Advantages of futures
a) Transaction costs should be lower than other hedging methods
b) Futures are tradable and can be bought or sold on a secondary market so the is pricing transparency,
unlike forward contracts where prices are set by financial institutions.

c) The exact date of receipt or payment of the currency does not have to be known, because the futures
contract does not have to be closed out until the actual cash receipt or payment is made.

Disadvantages of futures
a) The contracts cannot be tailored to the user’s exact requirements.
b) Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk (the
risk that the futures contract may move by a different amount from the price of the underlying currency or
commodity).

c) Only a limited number of currencies are the subject of futures contracts (although the number of
currencies is growing, especially with the rapid development of Asian economies)

d) Unlike options, they do not allow a company to take advantage of favoured currency movements.

Currency options
A currency option is a right of an option holder to buy (call) or to sell (put) a quantity of one currency in
exchange for another, at a specific exchange rate (the exercise rate, exercise price or strike price) on or before a
future expiry date. If the buyer exercises the option, the option seller must sell or buy at this rate. If an option is
not exercised, it lapses at the expiry date.

The exercise price for the option may be the same as the current spot rate, or it may be more favourable or less
favourable to the option holder than the current spot rate.

Companies can choose whether to buy:

a) A tailor-made currency option from a bank, suited to the company’s specific needs. These are over-the-
counter (OTC) or negotiated options; or

b) A standard option, in certain currencies only, from an options exchange. Such options are traded or
exchange-traded options.

Because of the flexibility offered by the currency options – the holder can exercise the option at any point, or
choose to sell the option – it allows the holder to enjoy the upside without the risk of suffering the downside.

However, buying a currency option involves paying a premium to the option seller. The option premium is a
cost of using an option. It is the most the buyer of the option can lose by hedging an exposure to the currency
risk with an option: this maximum loss occurs if the option is not exercised, but is allowed to lapse.

The purposes of currency options

The purpose of currency options is to reduce or eliminate exposure to currency risk, and they are particularly
useful for companies in the following situations:

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a) Where there is uncertainty about foreign currency receipts or payments, either in timing or amount.
Should the foreign exchange transaction not materialise, the option can be sold on the market (if it has any
value) or exercised if this would make a profit.

b) To support the tender of an overseas contract by a company, priced in a foreign currency. The option
would be to sell the currency earned from the contract. If the company does not win the contract, it can let
the option lapse. In this situation, an option would be preferable to a binding forward contract, because it
does not know whether or not it will need to sell any currency.

c) To allow the publication of price lists for its goods in a foreign currency. A company can arrange a
number of currency options to sell a quantity of the foreign currency in exchange for its domestic currency,
covering the time period for which the price list remains valid.

Drawbacks of currency options

 They have a cost (the ‘option premium’). The cost depends on the expected volatility of the exchange rate,
the choice of the exercise rate and the length of time to the expiry date for the option

 Options must be paid for as soon as they are bought

 Tailor-made options (arranged over the counter with a bank) lack negotiability
 Traded options are not available in every currency
Currency swaps
A swap is a formal agreement whereby two organisations contractually agree to exchange payments on different
terms, eg in different currencies or one at a fixed rate and the other at a floating rate.

In a currency swap, the parties agree to swap equivalent amounts of currency for a period. This effectively
involves the exchange of debt from one currency to another. Liability on the main debt (the principal) is not
transferred and the parties are liable to a counterparty: if the other party defaults on the agreement to pay
interest, the original borrower remains liable to the lender.

Benefits of currency swaps

a) Swaps are easy to arrange and are flexible since they can be arranged in any size.
b) Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be
paid.

c) The parties can obtain the currency they require without subjecting themselves to the uncertainties of
the spot foreign exchange markets.

d) The company can gain access to debt finance in another country and currency where it is little known,
consequently has a poor credit rating, than in its home country. It can therefore take advantage of lower
interest rates than it could obtain if it arranged the currency loan itself.

e) Currency swaps may be used to restructure the currency base of the company’s liabilities. This may be
important where the company is trading overseas and is receiving revenues in foreign currencies, but its
borrowings are denominated in the currency of its home country. Currency swaps therefore provide a means
of reducing exchange rate exposure.

f) A currency swap could be used to absorb excess liquidity in one currency which is not needed
immediately, to create funds in another where there is need.

Question 8
Liverpool Co is a UK-based company which has the following expected transactions.

One month: Expected receipts of $40,000

One month: Expected payments of $140,000
Three months: Expected receipts of $300,000

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The finance manager has collected the following information:

Spot rate ($ per £): 1.7820 ± 0.0002

One month forward rate ($ per £): 1.7829 ± 0.0003
Three months forward rate ($ per £): 1.7846 ± 0.0004

Money market rates for Liverpool Co:

Borrowing Deposit
One year sterling interest rate: 4.9% 4.6%
One year dollar interest rate: 5.4% 5.1%

Assume that it is now 1 April.

Required:
(a) Discuss the differences between transaction risk, translation risk and economic risk.
(6 marks)
(b) Explain how inflation rates can be used to forecast exchange rates.
(6 marks)
(c) Calculate the expected sterling receipts in one month and in three months using the forward market.
(3 marks)

(d) Calculate the expected sterling receipts in three months using a money-market hedge and recommend whether a
forward market hedge or a money-market hedge should be used.
(5 marks)
(e) Discuss how sterling currency futures contracts could be used to hedge the three month dollar receipt.
(5 marks)
(25 marks)

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