ACCA F9 Financial Management - 2010 - Study text

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Chapter 19: Foreign exchange risk

Example

The current exchange rate for British pound against the euro (€/£1) is 1.2115. The

forecast annual interest rate for the British pound is 5% in years 1 and 2 and 6% in

years 3 and 4.

The forecast annual interest rate for the euro is 2.5% in year 1 and 3% in each of

years 2 – 4.

Required

Use this data to estimate a spot rate (€/£1) at the end of each year for years 1 – 4.

Answer

The current exchange rate for British pound against the euro (€/£1) is 1.2115. The

exchange rate is quoted in terms of euros to £1, therefore the pound is the base

currency. Applying interest rate parity theory to predict future spot exchange rates:

Year Forecastrate

0 Actualrate 1.2115

1 1.2115×(1.025)/(1.05) 1.1827

2 1.2115×[(1.025)(1.03)]/(1.05)2 1.1601

3 1.2115×[(1.025)(1.03)2]/[(1.05)2(1.06)] 1.1273

4 1.2115×[(1.025)(1.03)3]/[(1.05)2)(1.06)2] 1.0954

Four-way equivalence

The term ‘four-way equivalence refers to four concepts that together provide a

consistent explanation of changes in foreign exchange rates, and a method of

predicting future ‘spot’ exchange rates. These four concepts are:

 purchasing power parity theory

 the Fisher effect (which together with PPP theory makes the international Fisher

effect)

 interest rate parity theory

 expectations theory.

Expectations theory is the theory that all relevant information is reflected in the

market rates of exchange; therefore forward exchange rate between a pair of

currencies reflect market expectations about what the spot rate will be in the future.

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Example

The currency of Country X is the dollar and the currency of Country Y is the franc.

The current spot exchange rate is $1 = 4.00 francs.

The one year nominal rate of interest on the dollar is 6.00%. Inflation over the course

of the next year in Country X is expected to be 5%.

The one year nominal rate of interest on the franc is 8.02%. Inflation over the course

of the next year in Country X is expected to be 7%.

This information can be used with four-way equivalence to make the following

predictions.

 Using purchasing power parity theory, we would predict that the spot rate in

one year’s time will be:

4.00 × (1.07/1.05) = 4.0762.

 The real return on investment in Country X for the next year is (1.06/1.05) – 1

0.95%. The real return in investment in Country Y for the same period is

(1.0802/1.07) – 1 = 0.95%.

 Using interest rate parity theory, we would predict that the exchange rate in one

year’s time will be:

4.00 × (1.0802/1.06) = 4.0762.

 The current one-year forward exchange rate will be $1 = 4.0762 francs, and this is

the expected spot rate in one year’s time.

Chapter 19: Foreign exchange risk

Hedging exposure to foreign exchange risk

 The purpose of hedging risk

 Methods of hedging exposures to foreign exchange risk

 Invoicing in the domestic currency

 Leading and lagging

 Matching

 Netting

 Forward contracts and hedging exposure to FX risk

 Introduction to money market hedging

5 Hedging exposure to foreign exchange risk

5.1 The purpose of hedging risk

The purpose of hedging an exposure to risk is to eliminate or reduce the possibility

that actual events will turn out worse than expected. The purpose of hedging an

exposure to currency risk is to remove (or reduce) the possibility that a future

transaction involving a foreign currency will have to be made at a less favourable

exchange rate than expected.

Exchange rates can move up or down, and spot rates could move favourably as well

as adversely. However, many companies prefer to hedge their currency risks by

fixing an exchange rate now for a future transaction, even if this means that it will

not be able to benefit from any favourable future movement in the exchange rate.

5.2 Methods of hedging exposures to foreign exchange risk

The most important methods of hedging exposures to currency risk, which you will

be expected to know for the examination, are:

 invoicing in the domestic currency

 leading and lagging

 matching receipts and expenditure (or matching assets and liabilities)

 netting balances

 forward exchange contracts

 creating a money market hedge

5.3 Invoicing in the domestic currency

One method of eliminating transaction risk is for an exporter to invoice the

customer in the domestic currency. This eliminates all of the transaction risk for the

exporter. This is a one-sided technique because

one of the parties to the transaction

will always have all the exchange rate risk

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Example

Suppose that an exporter in Singapore is selling goods on credit to a company in the

USA, and is willing to give three months’ credit. The exporter can avoid any

exposure to foreign exchange risk by negotiating the sales price in Singapore dollars.

By doing this, the US company has the exposure to currency risk for three months,

because it will need to buy Singapore dollars to make the payment. It is therefore

exposed to a rise in the value of the Singapore dollar against the US dollar.

If the Singapore exporter believed that the Singapore dollar was likely to fall in

value against the US dollar during the three month credit period, it might try to

negotiate a sales price instead in US dollars rather than Singapore dollars. If the

sales price is agreed in US dollars, the Singapore exporter would have the exposure

foreign exchange risk, but would expect to profit from this exposure rather than

make a loss (because it would expect the exchange rate to move in its favour over

the next three months).

5.4 Leading and lagging

Leading means making a payment early, before the end of the credit period

allowed. Lagging means making a payment as late as possible, possible by taking

longer credit than allowed.

Leading or lagging might be used by a company when it believes that the exchange

rate between two currencies will change significantly up or down during a credit

period.

 The purpose of leading is to pay early in a currency that is expected to increase

in value against the payer’s own currency during the credit period.

 The purpose of lagging is to delay payment as long as possible in a currency that

is expected to fall in value

Example

A company in the UK purchases goods from a supplier in Malaysia. The UK

company is required to pay in Malaysian dollars but has three months’ credit from

the supplier. When the goods are delivered ,the exchange rate is £1 = M$6.00

The UK company might have strong reasons for believing that the British pound

will fall in value against the Malaysian dollar over the next three months. If so,

delaying payment means that the eventual cost of the payment in pounds will

increase.

The UK company might therefore decide to make the payment immediately, so that

it is no longer exposed to the risk of a fall in the value of the pound against the M$.

Chapter 19: Foreign exchange risk

Example

A company in Japan has bought goods from a US supplier and payment in US

dollars is required after two months. The US dollar has recently been falling in value

against the Japanese yen and the depreciation of the dollar against the yen is

expected to continue for some time.

The Japanese company might therefore try to delay its payment to the US supplier

as long as possible, perhaps by taking longer credit than the two months allowed,

because if the dollar does fall in value, the eventual cost in yen of paying the US

supplier in dollars will be lower.

5.5 Netting and matching

Netting and matching can be applied to cash flows in a foreign currency or to assets

and liabilities denominated in a foreign currency.

 Netting means offsetting a payment against a receipt to get a net payment or a

net receipt. Netting can reduce a currency exposure to the net amount.

 Alternatively netting means offsetting a liability against an asset in the same

currency.

 Matching is similar ,except the receipt and payment are the same amount, or the

asset and liability are for the same amount. Matching reduces an exposure to

currency risk to 0.

Netting or matching cash flows

When a company expects to have future cash receipts in a foreign currency and

future cash payments in the same currency at about the same time, it can use the

receipts to make some or all of the payments. To the extent that future receipts

match future payments, the foreign exchange risk is eliminated. Movements in the

spot exchange rate will affect the receipts and payments equally. The loss from the

adverse movement affecting the cash receipts or payments will be offset by the gain

from the favourable movement affecting the cash payments or receipts.

Example

A UK company expects to receive US$400,000 in two months’ time and to make

payments of $600,000, also in two months. To hedge its currency exposures, the

company can match $400,000 of receipts and payments, leaving a net exposure of

just $200,000 in payments. This net exposure might be hedged with a forward

exchange contract.

Matching assets and liabilities

A company might also try to match assets and liabilities in the same currency, to

reduce exposures to foreign exchange risk.

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For example suppose that a UK company plans to make an investment in a business

operation in the USA. The investment would involve buying non-current assets in

US dollars. The company might finance the project by obtaining a US dollar loan.

The assets of the project and the financial liabilities would therefore be matched in

the same currency.

Cash flows from the project in US dollars could then be used to pay interest on the

loan and repay the loan principal. The company’s only exposure to foreign

exchange risk would then be the net cash flow surplus from the project.

Matching assets and liabilities to reduce translation exposure

A company with a foreign subsidiary might raise debt capital in the currency of the

subsidiary, so that when consolidated accounts are prepared for the group, the

assets of the subsidiary will be matched, at least partially, by the foreign currency

borrowings (liabilities). This will reduce exposure to translation risk, i.e. reduce the

reported gains or losses on consolidation.

Centralised cash management

In a large multinational company, a centralised treasury department might be given

the responsibility for cash management throughout the group, and might operate

centralised bank accounts in a number of currencies.

Each subsidiary in the group might be involved in foreign trade, making payments

or obtaining receipts in various currencies.

If all payments to a subsidiary are transferred to a central bank account, and if all

payments by a subsidiary are made with cash from a central bank account, the

group will be able to net its receipts and payments in all its trading currencies, and

in doing so reduce its net exposures to currency risk.

5.7 Forward contracts and hedging exposure to FX risk

Forward FX contracts can be used by companies to hedge an exposure to currency

risk. Currency risk will arise, for example, when a company expects to receive a

quantity of a foreign currency in several months’ time, which it will sell in exchange

for its own domestic currency. If it plans to sell the foreign currency in a spot

transaction, until it receives the currency it is exposed to the risk that the exchange

rate will move adversely and the currency will fall in value and be worth less than

its current value.

A forward exchange contract can be used to fix the exchange rate now for a future

payment or receipt in foreign currency. This removes the exposure to foreign

currency risk.

Although spot exchange rates can move favourably as well as adversely, many

companies engaged in international trade usually prefer to avoid exposure to

currency risk, and they make extensive use of forward exchange contracts.

Chapter 19: Foreign exchange risk

Example

A British company needs to pay a German supplier €80,000 in three months’ time. A

bank quotes the following forward rates for three months (€/£1): 1.7820 – 1.7830.

If the company arranges a forward contract to buy the euros in exchange for British

pounds, the forward rate will be 1.7820. This is the rate that is more favourable to

the bank, because it will receive more pounds in exchange for the euros. The cost to

the company of obtaining $80,000 in three months’ time is £44,893.38 (=

$80,000/1.7820).

For the company, an advantage of arranging this forward contract to buy the euros

is that:

 the company knows exactly how much it will have to pay in British pounds in

three months’ time, and

 this forward contract eliminates the risk of an adverse movement in the

exchange rate and allows the company to make financial plans (such as cash

budgets) with greater certainty.

However, having made a forward exchange agreement, the company has a

contractual obligation to carry out the terms of the agreement and buy the euros at

1.6820 at the settlement date. If the spot rate at this date is more favourable, say

1.7500, the company cannot choose to ignore the forward contract and buy euros at

the spot rate.

Hedging an exposure to currency risk with a forward contract gives protection

against adverse exchange rate movements, but prevents the company from taking

advantage of any favourable movement in the spot rate.

Example

A UK company enters into a service provision agreement with a US customer and

under the terms of the agreement it will receive payment of $2 million from the

customer in one year’s time. The UK company intends to hedge its exposure to

currency risk by arranging a forward exchange contract.

The spot rate for dollars against British pounds is 1.9800 ± 0.0010

The one-year forward rate is quoted as 1.9350 ± 0.0015.

What will be the receipts in British pounds in one year’s time if the currency risk

exposure is hedged with a forward contract?

Answer

The one-year forward rate is £1 = $1.9335 – 1.9365.

The company wants to sell dollars and buy sterling. The bank will apply the rate

that is more favourable to itself, which is 1.9365.

(At this rate, it will pay fewer pounds to the UK company than at a rate of 1.9335.)

The receipts in one year’s time will therefore be $2 million/1.9365 = £1,032,791.

Paper F9: Financial management

Limitations of forward exchange contracts

Although forward exchange contracts are used extensively by companies to hedge

exposures to currency risks, they have some limitations.

 It is not possible to arrange forward exchange contracts for some currencies,

because not all currencies are traded in the forward market. Some currencies

that are traded ‘spot’ cannot be traded forward.

 There is a limit to time horizon for forward contracts. For the major currencies,

such as the US dollar, the euro and the British pound, forward contracts with

other major currencies can be arranged with a settlement date of up to one year

forward. For other exchange rates, forward contracts might only be possible

with a settlement date of several months. Forward contracts cannot therefore be

used to hedge long-term exposures to currency risk.

5.8 Introduction to money market hedging

A money market hedge is an alternative to hedging with a forward contract, using

the international money markets rather than the forward exchange market. Money

market hedges are slightly complex, and so are described separately in the next

section.

Chapter 19: Foreign exchange risk

Money market hedging

 Definition

 Constructing a hedge for a future currency receipt

 Constructing a hedge for a future currency payment

6 Money market hedging

6.1 Definition

A money market hedge is another method of creating a hedge against an exposure

to currency risk. Instead of hedging with a forward exchange contract, a company

can create a hedge by borrowing or lending short-term in the international money

markets, to fix an effective exchange rate ‘now’ for a future currency transaction.

A slightly different arrangement is needed for a money market hedge for an

exposure arising from:

 a future receipt in a foreign currency

 a future payment in a foreign currency.

6.2 Constructing a hedge for a future currency receipt

A company might expect to receive an amount of foreign currency at a future date,

which it intends to exchange into its domestic currency. It wants to hedge its

exposure to currency risk.

 To create a money market hedge, it should borrow an amount of the currency

immediately, for repayment at the same time that the future currency income

will be received. The future income in the foreign currency will be used to repay

the loan with interest. The amount borrowed should therefore, together with the

accumulated interest for the borrowing period, equal the amount of the future

currency income.

 Having borrowed the quantity of currency, the company should exchange it

immediately (spot) for its domestic currency.

 The domestic currency obtained in this way can be used in the company’s

business. However, for examination purposes, you might be expected to assume

that the domestic currency will be invested or deposited for the same period as

the currency loan.

 At the end of the loan period, when the company uses its currency income to

repay the currency loan, the deposit plus accumulated interest is an equivalent

amount in domestic currency. This can be used to calculate an effective forward

interest rate for the hedge of the currency exposure.

Paper F9: Financial management

A numerical example might help to clarify this technique:

Example

A UK company expects to receive a payment of US$800,000 in three months’ time. It

wants to hedge this exposure to currency risk using a money market hedge.

Spot three-month interest rates currently available in the money markets are:

Deposits

Borrowing

US dollar 4.125%

4.250%

British pound 6.500%

6.625%

The spot exchange rate (US/£1) is 1.9770 – 1.9780.

Step 1

The UK company will be receiving US dollars in three months’ time. It should

therefore borrow US dollars for three months. The borrowing rate will be 4.25% (the

higher of the two quoted rates). This is an annual rate, and in answering an

examination question, you should calculate the rate for the interest period as an

appropriate fraction of the annual rate. Here, the interest for three months will be

4.25% × 3/12 = 1.0625% or 0.010625.

The borrowed dollars plus accumulated interest after three months needs to be

$800,000, therefore the amount of dollars borrowed should be:

Final amount

1+ interest rate for the period

()

$800,000

1.010625

= $791,589

Step 2

The company should sell the borrowed $791,589 in exchange for British pounds. The

appropriate spot rate is 1.9780. The company will receive £400,197.

We now assume that this will be placed on deposit for three months. The interest

rate on deposits for sterling is 6.500%. This is an annual rate, and the interest for

three months is assumed to be 6.5% × 3/12 = 1.625% or 0.01625.

After three months, the deposit plus accumulated interest will be £400,197 × 1.01625

= £406,700.

Step 3

At the end of three months, the company will receive US$800,000. Its three-month

loan will mature, and the $800,000 is used to pay back the loan plus interest. The

company has £406,700 from its deposit (its short-term investment in British pounds).

The money market hedge has therefore fixed an effective exchange rate for the

dollar receipts, which is calculated as $800,000/£406,700. This gives an effective

three-month forward rate of £1 = $1.9671.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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