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

2. 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

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

4. Information  Marko is a UK company.  Today is 1/1/16, Marko is due to receive US$937500 on 30/6/16  Biggo Bank is offering mefielding.com4

5. Biggo Bank mefielding.com5 Offers to it’s clients on 1/1/16 Forward Spot $/£ 1.7982- 1.8010 6 month forward $/£ 1.7835 -.1.7861 Options £62500 CallsPuts MarchJuneMarchJune 1.801.9633.175.34 1.782.913.842.124.20 Futures £62500 March 1.7782 June 1.7492 Money Market Deposits $ 3 Month 4- 6% 6 Month 4.4- 5.8%

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

7. 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

8. 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

9. Option Hedging Strategy Strike PricePremium CostNet 1.8031.83 1.783.841.8184 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 62500 x 8= $19200 Payable on 1 January 19200/ 1.7982= £10677

10. Options  On 30 June the spot rate is $1.75 so we wouldn’t exercise the options  937500/1.75= $535714 minus premium = £525037  If you were to exchange them mefielding.com10 $£ 62500x 8 x 1.78 = 8900000500000 937500- 890000= 47500/1.7527143 Premium(10677) Net Receipt483534

11. 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

12. Money Market Hedge  Marko is due to receive US$937500 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 937500 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 4.4- 5.8%

13. 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 1.029 = 937500, therefore we borrow $911079 on 1 January  That will grow to $937500 over 6 months  911079/1.8010 = £505874  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 505874 x 1.024= £518015 mefielding.com13

14. Summary How Many £s Do We Receive mefielding.com14 Forward524887 Future535971 Option525037 Money Market Hedge518015