Foreign Currency Risk Part 2 Mark Fielding-Pritchard mefielding.com1.

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Foreign Currency Risk Part 2 Mark Fielding-Pritchard mefielding.com1

3 Types of Risk  Transaction- the risk we don’t receive as much money as we expected or we have to pay more  Translation risk- The value of our balance sheet on translation to the operating currency falls- covenants  Economic risk- positive NPV projects become negative mefielding.com2

Transaction Risk  Forwards  Futures  Options  Money Markets  Swaps mefielding.com3 } Covered in part 1

Information  Marko is a UK company.  Today is 1/1/16, Marko is due to receive US$ on 30/6/16  Biggo Bank is offering mefielding.com4

Biggo Bank mefielding.com5 Offers to it’s clients on 1/1/16 Forward Spot $/£ month forward $/£ Options £62500 CallsPuts MarchJuneMarchJune Futures £62500 March June Money Market Deposits $ 3 Month 4- 6% 6 Month %

Options  Calls  Puts  US  European  OTC  Premium payments mefielding.com6

Options  On 1 January set up hedge  Pay premium on 1 January  Close out on 30 June  There will be exchange of currency on 30 June mefielding.com7

1 January Hedge 1. Calls or puts 2. Which month 3. How many 4. Premium cost 1) Marko will buy fx, exchange is in Chicago, so calls 2) June (even if September exists) mefielding.com8

Option Hedging Strategy Strike PricePremium CostNet So strike of 1.78 gives us the best price mefielding.com9 Therefore we want ((937500/1.78)/62500))= 8 Notice we round down with options Premium cost is 3.84c x x 8= $19200 Payable on 1 January 19200/ = £10677

Options  On 30 June the spot rate is $1.75 so we wouldn’t exercise the options  /1.75= $ minus premium = £  If you were to exchange them mefielding.com10 $£ 62500x 8 x 1.78 = = 47500/ Premium(10677) Net Receipt483534

Money Market Hedge  Use bank accounts to create a liability if an asset exists or vice versa  We are due in 6 months to receive dollars. We take out a dollar loan, translate to cash now. Loan will be redeemed with dollars received in future  We are due in 6 months to pay dollars. Put on deposit dollars now mefielding.com11

Money Market Hedge  Marko is due to receive US$ on 30/6/16  So we set up a liability. We borrow dollars now and translate those dollars to pounds on 1/1  We cannot borrow because the loan will be due interest over the next 6 months so we borrow net of interest mefielding.com12 Money Market Deposits 3 Month 4- 6% 6 Month %

Money Market Hedge  We borrow at the 6 month rate of 5.8%  Interest is quoted at annual nominal so interest rate = 2.9%  Loan x = , therefore we borrow $ on 1 January  That will grow to $ over 6 months  / = £  This money is received on 1 January. Therefore it is part of the technique that we recognise time value of money.  Pound investing rate for 6 months is 2.4%  Therefore we get x 1.024= £ mefielding.com13

Summary How Many £s Do We Receive mefielding.com14 Forward Future Option Money Market Hedge518015