ACCA paper f9 financial management study materials F9FM session17 d08

INTEREST RATE RISK CURRENCY RISK RISK MANAGEMENT Ü Forecasting exchange rates Ü Types of exchange rate risk Ü External hedging of transaction risk Ü Types of interest rate risk Ü Ex

OVERVIEW

Objective

Ü To explain the causes of exchange rate fluctuations

Ü To apply hedging techniques for foreign currency risk

Ü To apply hedging techniques for interest rate risk

INTEREST RATE RISK

CURRENCY

RISK

RISK MANAGEMENT

Ü Forecasting exchange rates

Ü Types of exchange rate risk

Ü External hedging of

transaction risk

Ü Types of interest rate risk

Ü External hedging of interest

rate risk

1 FORECASTING EXCHANGE RATES

Ü The key models for forecasting future exchange rates focus either on inflation rate differences, or interest rate differences

Ü The relationships between these macro-economic variables can be summarised in the

“four-way equivalence model” shown below

Differences in

interest rates Expected difference in inflation rates

Interest rate

parity

Fisher effect

International Fisher effect Purchasing power party

Expectations theory

Difference between spot

and forward exchange

rate

Expected change

in spot exchange rate

Ü Spot exchange rate - the market exchange rate for buying/selling the currency for immediate delivery

Ü Forward exchange rate – the exchange rate for buying or selling the currency at a specific date in the future

1.1 Purchasing Power Parity (PPP)

Ü Absolute PPP states that the exchange rate simply reflects the different cost of living in

two countries For example if a representative basket of goods and services costs $1, 700

in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1

Ü While absolute PPP exchange rates may represent the long-run equilibrium rate

between two currencies, they are of limited practical use in financial management

Ü Financial managers are more interested in market exchange rates than theoretical rates

This is where relative PPP is useful

Relative PPP claims that changes in market exchange rates are caused by the rate of

Ü The formula for relative PPP is as follows:

s1 = s0 x ( )

(1 hbc)

h 1 +

+

where:

s1 = expected spot exchange rate after one year

s0 = today’s spot exchange rate

hc = foreign inflation rate (as a decimal)

hb = domestic inflation rate

Ü Spot rates should be put into the formula is the format:

Units of foreign currency/units of domestic currency

Example 1

Spot rate 1 January 19X6 = $1.90 per £1

Predicted inflation rates for 19X6:

Required:

What is the predicted exchange rate at 31 December 19X6?

Solution

1.2 Interest Rate Parity (IRP)

Ü IRP states that the forward exchange rate is based upon the spot rate and the interest rate differential between the two currencies:

Forward rate = spot rate × (1+overseas interest rate/1+ domestic interest rate)

Ü f0 = s0 x ( )

(1 ibc)

i 1 + +

where:

f0 = forward exchange rate

s0 = spot exchange rate

ic = overseas interest rate

ib = domestic interest rate

Example 2

If spot $ per £ = 1.78 and the dollar and sterling one year interest rates are

3.25% and 4.5% respectively, what is the one year forward exchange rate?

Solution

Ü If this theory did not hold it would be possible for investors to make a risk-free profit

using a process referred to as covered interest rate arbitrage

Ü Covered interest rate arbitrage = simultaneously borrowing domestic currency,

transferring it into foreign currency at the spot exchange rate, depositing the foreign currency, and signing a forward exchange contract to repatriate the foreign currency into domestic currency at a known forward exchange rate

1.3 Fisher effect

Ü Countries with a higher rate of inflation have higher nominal interest rates in order to offer the same real return as countries with low inflation

(1+i) = (1+r) (1+h)

Where i = nominal interest rate

r = real interest rate

h = inflation rate

1.4 International Fisher effect

Ü States that the spot exchange rate will change to offset interest rate differences between countries

Ü The calculations are basically as per Interest Rate Parity theory

1.5 Expectations theory

Ü Differences between forward and spot rates reflect the expected change in spot rates

1.6 Other factors influencing exchange rates

Ü Current and prospective government policies

Ü Balance of payments surpluses/deficits

Ü Actions of speculators

There are three types of exchange rate risk to consider – translation risk, economic risk and transaction risk

2.1 Translation risk

Ü This occurs where a parent company holds an overseas subsidiary

Ü In order to consolidate the subsidiary’s financial statements into the group accounts, they must first be translated into the reporting currency of the parent company The exact method for doing this depends on the relevant financial reporting standards

Ü In particular translating the statement of financial position of overseas subsidiaries can lead to significant translation gains/losses

Ü If the home currency has appreciated against the foreign currency, it is likely to produce a translation loss when converting the value of overseas net assets

Ü If the home currency has depreciated against the foreign currency, it is likely to produce

a translation gain when converting the value of overseas net assets

Ü Although such gains/losses can be significant in size, they do not represent actual cash

gains/losses for the group – they are simply caused by financial accounting methods for consolidating overseas subsidiaries

Ü As long as users of financial statements understand that translation differences do not represent cash flows, they should not affect the value of the group

Ü Therefore the financial manager should ensure that the nature of translation

gains/losses is clearly explained e.g in the annual report, at shareholder meetings

Ü However the financial manager does not need to hedge translation risk, because it is not

a cash flow

2.2 Economic risk

Ü Economic risk is the risk that cash flows will be affected by long-term exchange rate

movements

Ü As the value of a firm is the present value of its future cash flows, economic risk is a

significant issue for the financial manager Unfortunately it is difficult to hedge against

Ü For example, take a UK company which exports to the US and therefore has dollar export earnings Suppose that, over time, sterling becomes stronger against the dollar The sterling value of export earnings will fall, damaging the cash flow and the value of the company What can the company do to reduce this risk?

̌ Increase the dollar price of the exports – however this may not be practical,

particularly when exporting to a competitive market

̌ Diversify exports into other markets – in the hope that sterling will fall against some currencies while rising against the dollar

̌ Use hedging techniques such as forward contracts – however, in the long run this

will not give effective protection As sterling rises over time in the spot markets it

also rises in the forward markets – and the value of exports still falls

̌ Attempt to convert the cost base into dollars - for example by importing materials from the US or setting up operations in the US However these may not be practical options for many companies

Ü Note that economic risk can affect a company even if it does not export or import

Domestic producers may face tougher competition from overseas firms if the home currency appreciates Again there is no easy method of protecting against this

2.3 Transaction Risk

Ü Transaction risk is the short-term version of economic risk

Ü It is the risk that the exchange rate changes between the date of a specific export/import and the related receipt/payment of foreign currency

Ü Like economic risk this affects cash flows and hence affects the value of the firm It is therefore a significant issue for financial management

Ü Transaction risk can be effectively managed using both internal and external techniques

2.4 Internal management of exchange rate risk:

Ü Invoicing in the domestic currency – an exporter could denominate sales invoices in its domestic currency, effectively transferring the transaction risk to the customer

However this may lead to lost sales

Ü “Leading and lagging” - paying overseas suppliers earlier (“leading”) if the home

currency is expected to fall, or later (“lagging”) if the home currency is expected to appreciate

Ü Netting - where there are both sales and purchases in a foreign currency offset the

receivables and payables and only consider an external hedge on the net difference

Ü Matching - consider using foreign currency loans to finance overseas subsidiaries

Overseas earnings can be used to pay the loan interest and repay principal, reducing the net foreign currency cash flow exposed to risk upon repatriation to the parent company This may be effective as a longer-term hedge against economic risk

Ü Asset and Liability Management – if overseas subsidiaries borrow locally rather than receiving finance from the parent company this reduces the net assets of the subsidiary This can also be referred to as a “balance sheet hedge” and reduces exposure to

translation risk upon consolidation of the subsidiaries’ net assets into the group

accounts (although, as mentioned above, translation risk should not affect the value of the group)

3.1 Forward exchange contracts

Ü Forward contract – a legally binding agreement to buy or sell:

̌ a specified quantity

̌ of a specified currency

̌ on an agreed future date (“delivery date”)

̌ at an exchange rate fixed today

Ü Forward contracts are not traded but agreed between a company and a bank This means they are customised agreements which can match the exact requirements of the company regarding quantity and delivery date

Ü Forward contracts are not bought, they are entered into Therefore no premium needs to

be paid to set up a forward hedge (unlike options)

Ü Forward contracts do not require any margin to be posted i.e no deposit of cash is

required when setting up a forward hedge (unlike futures contracts) However there will usually be a small arrangement fee to set up a forward contract

Ü The major disadvantage of forward contracts is that physical delivery must occur i.e if a

company signs a forward contract to buy/sell foreign currency then it must physically exchange currency on the agreed date at the agreed rate, even if that rate has become unattractive compared to the spot rate

Ü Therefore forward contracts are not a flexible method of hedging

Example 3

Today is 1 January 19X1 A UK-based company is expecting dividend income

of $200,000 to be received from its US subsidiary on 31 March 19X1

Spot rate 1 January 19X1 ($ per £) = 1.5123–1.5245

Three month forward = 2.00–2.14 cents discount (c dis)

Required:

(a) How much sterling will be received if forward cover is taken out?

(b) How much sterling would be received if no forward cover is taken out and

the actual spot rate on 31 March 19X1 = 1.5247–1.5361?

Solution

3.2 Money Market Hedges

Ü Money market hedges involve either borrowing or investing foreign currency in order

to protect against transaction risk Whether to borrow or invest depends on whether the company is exporting or importing

Ü Suppose a UK company has dollar export earnings A money market hedge could be set

up as follows:

1 Today borrow dollars

2 Exchange these dollars into sterling, which can then be invested

3 Use the dollar export earnings to repay the dollar loan

Example 4

A UK-based company expects to receive $300,000 in 3 months

Spot rate ($ per £): 1.7820 ± 0.0002

One year sterling interest rates: 4.9%(borrowing) 4.6% (investing)

One year dollar interest rate: 5.4% (borrowing) 5.1% (investing)

Required:

Set up a money market hedge

Solution

3.3 Currency Options

Ü If a company wants a more flexible hedge it may consider buying a currency option

Ü Options are an example of derivatives – a financial instrument based upon an underlying

asset In the case of currency options the underlying asset is a currency

Ü The purchaser of a currency option has the right, but not the obligation, to buy or sell:

̌ a specified quantity

̌ of a specified currency

̌ on or before a specified date (expiry date)

̌ at an exchange rate agreed today (exercise price/strike price)

Ü The owner of the option can either:

̌ exercise their right or

̌ allow it to lapse i.e not exercise it

Ü However the owner of an option must pay for this flexibility The cost of an option is known as its premium

Ü Premiums are paid at the date the option is bought and are non-refundable

Ü A company may buy options on:

̌ a derivatives market, or

̌ directly from a bank – known as OTC (Over The Counter)

Ü A call option gives its owner the right to buy the underlying asset

Ü A put option gives its owner the right to sell the underlying asset

Ü European style options can only be exercised on the expiry date

Ü American style options can be exercised at any time until the expiry date

3.4 Currency Futures Contracts

Ü Futures are simply traded forward contracts

Ü Currency futures contracts are standardised contracts for the buying or selling of a specified quantity of a specified currency They are traded on a futures exchange and have various “delivery dates” e.g March, June, September and December

Ü A company can choose whether to buy or sell futures and can choose which delivery

Ü When a currency futures contract is bought or sold, the buyer or seller is required to

deposit a sum of money with the exchange, called initial margin If losses are incurred

(as exchange rates and hence the prices of currency futures contracts change), the buyer

or seller may be called on to deposit additional funds (variation margin) with the

exchange

Ü Any profits are credited to the margin account on a daily basis as the contract is

“marked to market”

Ü Although the definition of a futures contract is basically the same as a forward contact, there is a significant practical difference between hedging with forwards and futures:

̌ With forward contracts there is always physical delivery i.e a company that signs a

forward contract will physically buy or sell the underlying currency when the contract reaches its delivery date

̌ However most currency futures contracts are “closed out” before their delivery

dates The company simply executes the opposite transaction to the initial futures position e.g if buying currency futures was the initial transaction, it is later closed out by selling currency futures

Ü If a futures hedge is correctly performed any gain made on the futures transactions will offset a loss made on the spot currency markets (and vice versa)

Illustration 1

Today is 1 February A UK exporter expects to receive $300,000 in three

months’ time and is considering the use of sterling futures to protect against

transaction risk

The company is worried that sterling will appreciate, leading to a loss on the

spot market sale of dollars in 3 months

It therefore needs to set up a futures position that would produce a gain on a

rise in sterling

On 1 February it should buy sterling futures contracts It needs to hedge until 1

May and hence June contracts should be used (March contacts would only

hedge until the end of March)

On 1 May the company should:

Ü sell June sterling futures

Ü sell the $300,000 export receipts on the spot market

If sterling has risen against the dollar, there will be a gain on sterling futures

(bought sterling low, sold sterling high) to offset the loss on the spot market