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Exchange Rate Risk

Autor:   •  November 14, 2017  •  Course Note  •  461 Words (2 Pages)  •  9 Views

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Exchange rate risk

Transaction risk:

  • Accrues when:
    - purchasing/selling goods at previously agreed prices
    - borrowing/lending funds in foreign currencies
  • How much the income from individual transaction is affected by fluctuation of the rates

Economic risk:

  • Firm’s future of international earning affected by changes in exchange rates
  • Long term effect of changes in rates  different prices

Translation (Accounting) risk:

  • Impact of exchange rate changes on financial statements of a company
  • Concerned with present measurement of past events
  • Gains/losses are unrealized = paper losses

Hedging:
Operating hedge:

  • Cash management along a company through intracompany accounts

Possibilities:

  • Reduce cash to a minimum by purchasing inventories or other assets
  • Try to delay payments (extended trade credit)
  • Avoid giving extended trade credit
  • Borrow the local currency

Meaning in examples:

  • Cash netting of obligations among units (same currency)
  • The bigger the hedged amount the “cheaper” (per unit) it is to hedge

Financial hedge:

       Derivate securities:

  • Traded on spot market, prices set by forces of demand and supply
  • Can hedge risk, but can also give more risk

Forward contracts:

  • Agreement to trade at a specified price a specified quantity on a specified place on a specified date in the future
  • On maturity date the buyer takes delivery, the seller receive agreed payment
  • Amount will be paid regardless of the actual spot exchange rate on the date of maturity

 More flexible

Future contracts:

       Same as futures but:

  • Traded on organized exchanges
  • Highly standardized
  • Highly traded volumes  good liquidity
  • Can only be concluded for delivery in pre-specified months (usually 4years)
  • Guaranteed by stock exchanges

 lower risk, ease of trade

  • Short future hedge: selling a future contract, when you make delivery of an asset at a future date  minimize risk of a drop in price
  • Long future hedge: buying a future contract, used when buying an asset at a future date  minimize the risk of a increasing price

Swaps:

       Exchange one financial contract for another

  • Interest-rate swaps: convert an asset held at a floating rate of interest to a fixe rate and backward  Change of interest flows, no change of principal
  • Currency swaps: exchange debt obligations in different currencies, each agrees to pay the other’s interest obligation  Only cash-flow differences are paid, no exchange of principal

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