F9 Financial Management

2 Designed to give you the knowledge and application of: Section H: Risk Management H1. The nature and type of risk and approaches to risk management H2. Causes of exchange rate differences and interest rate fluctuations H3. Hedging techniques for foreign currency risk H4. Hedging techniques for interest rate risk

3  Different types of currency risk: [2] i. Translation risk ii. Transaction risk iii. Economic risk  Types of interest rate risk: [1] i. gap exposure ii. basis risk Learning Outcomes H1: Courses of exchange rate differences and interest rate fluctuations

4 Direct quote An exchange rate in terms of the number of units of home currency required to purchase one unit of foreign currency For example $1 = £0.504 means that one dollar can be exchanged for £ This quote is a direct quote for a party in the UK. Exchange rate The price of one currency expressed in terms of another currency. For example, a rate of Rupees 46 per US$ means that to buy one US$, 46 Indian Rupees are required. Indirect quote The price in terms of how many units of foreign currency can be bought with one unit of home currency For example, the quote £1 = $ is an indirect quote for a party in the UK Direct and indirect quotes are reciprocals of each other Types of foreign currency risk: translation risk, transaction risk, economic risk

5 Used in the New York and other foreign exchange markets Direct quote Indirect quote Used in the London foreign exchange market Direct quoteIndirect quote Buy Sell Buy LowHigh Low Rules for trading using direct and indirect quote Direct & Indirect Quote Continued …

6 Spot market rate The rate the bank quotes for immediate delivery The difference between the bid price and the offer price. The offer price is always higher than the bid price, as dealers make profits by buying at the bid price and selling at the offer price Bid offer spread Offer price (ask price) The rate at which the bank or the FOREX dealer is prepared to sell (ask) foreign currency to its clients in exchange for local currency. Therefore, it is the selling rate or offer rate at which foreign currency can be purchased from the dealer Bid price The rate at which the bank or the FOREX dealer is prepared to buy the foreign currency in exchange for the domestic currency. It is also known as the buying rate Continued …

7 Example If a UK bank quotes the spot rates (indirect) for dollar / Sterling as follows: Foreign exchange rates$/£ Spot – In this case, the quoting bank will buy one sterling pound at $ and sell one sterling pound at $ Example A foreign exchange dealer quotes dollar at $ – per Sterling. The bid price is $ and the offer price is $ The bid offer spread is $ Example

8 Forward exchange rate The rate agreed for foreign currency transaction at a later date. N = number of months for which the forward contract has been made Forward at par When forward rate = spot rate When forward rate > spot rate Forward at premium Forward exchange rate Continued …

9 Direct currency quote Premium Added to buying and selling spot exchange rates to ascertain forward rates Indirect currency quote Premium Deducted from buying and selling spot exchange rates to ascertain forward rates Forward at discount When forward rate < spot rate N = number of months for which the forward contract has been made Continued … Arbitrage In the context of foreign currency markets, arbitrage means buying foreign currency (at a lower rate) in one market and selling it (at a higher rate) in another market, thereby making profit without risk

10 Add: Premium Less: Discount Spot rate Buy / sell Forward rate Buy / Sell Indirect currency quote Discount Added to buying and selling exchange rates in order to ascertain forward rates Direct currency quote Discount Deducted from buying and selling exchange rates in order to ascertain forward rates Forward rate and spot rate Continued …

11 Type of quoteConditionsMeans that the currency is trading at Direct quoteSpot > Forward Spot < Forward Discount Premium Indirect quoteSpot > Forward Spot < Forward Premium Discount Example The following quotes are given in various currencies Foreign exchange rates$/£ Spot – months forward – Advise whether the forward currency is trading at a discount or premium to the spot rate. Answer The quotes given are indirect quotes from a UK point of view. Therefore, the pound is currently trading at a premium of 3.30% against its forward value. Direct and Indirect quotes

12 Example A foreign subsidiary has investments worth €5m. The exchange rate at the beginning of the year is €1.50 per £ but by the end of the year there has been an appreciation in the Euro and the resulting exchange rate is €1.43 per £. Therefore, the value of investments that were £3.33m (€5m/1.50) at the beginning of the year are now £3.50m (€5m/1.43) at the end of the year, giving rise to a translation gain of £0.17m. Translation risk  Refers to the possibility of accounting loss that could occur, as a result of the conversion of the value of assets and liabilities which are denominated in foreign currency, due to movements in exchange rate.  Entities which deal with foreign countries are subject to this risk.  This risk is also known as ‘accounting risk’.  Translation risk is a function of the accounting treatment of foreign assets and liabilities at the year end, and does not give any real gain or loss outcome for the company. Foreign currency risk

13 Example A UK company sells goods worth €1,000 to a customer based in Germany and gives 2 months’ credit. At the current spot rate of 1₤ = €1.456, the company expects to receive 1000/1.456 = £687. The German company takes 2 months’ credit and, by the end of the 2 months, the rate has changed to 1₤ = € The UK company will now receive only £673 (1,000/1.486). Transaction risk  Occurs due to adverse changes in exchange rates before the transaction is settled  Companies engaged in foreign currency transactions are exposed to this kind of risk  Companies expect either to pay or to receive amounts of foreign currency in the future as a result of either sale or purchases of goods or services Transaction risk

14 Example A company, Bricks Ltd, operates only in the US. Its domestic competitor, Cox Ltd, imports raw material from the UK. If the domestic currency i.e. dollar appreciates against the pound, the competitor, Cox Ltd, will be required to pay less to purchase the same quantity of material as before. This will put Cox Ltd in a more advantageous position; and the company operating only in the domestic market, Bricks Ltd, will lose its competitive edge. Economic risk  Economic risk is general in nature and independent of whether the company operates in an international market or not. That means even if a company buys and sells all its goods and services in the domestic market it is exposed to economic risk.  Long-term movement in exchange rates puts the company at a competitive disadvantage.  Economic risk cannot be avoided like translation risk and transaction risk, which can be reduced or eliminated by avoiding foreign currency transactions and overseas operations Economic risk

15 The impact on an institution’s financial condition if it is exposed to negative movements in interest rates. This risk can either be translated as an increase of interest payments to be made against attracted funds, or a reduction in income received from allocated funds. Interest rate risk Change in market interest rates Adversely affects the company’s financial condition Immediately has an impact on the company’s earnings Has an impact on a bank’s financial condition, by affecting its net interest income Types of interest rate risk: gap exposure, basis risk

16 Floating interest ratesFixed interest rates prove to be favourable when interest rates are rising in a falling interest rate scenario, companies that have fixed interest debt will pay higher interest thereby reducing the profitability of their operations prove to be favourable when interest rates are falling in a rising interest rate scenario, companies that have floating interest debt will pay higher interest thereby reducing the profitability of their operations For a borrowing company For a depositing company rise in interest rates will be favourable to a company with floating interest rates fall in interest rates will be favourable to a company with fixed interest rate Types of interest rates risk

17 Types of interest rates risk Continued …

18 Basis risk Arises when floating interest rate of assets and liabilities is based on different benchmarks Interest rate risk Gap exposure Arises due to gap between interest rate revision timings of assets and liabilities Continued …

19 Recap  Different types of currency risk: [2] i. Transition risk ii. Transaction risk iii. Economic risk  Types of interest rate risk: [1] i. gap exposure ii. basis risk