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ACCA F9 Chapter 13 Foreign exchange

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acca financial reporting (ACCA F7)

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Foreign Currency Risk

 Foreign Currency Risk refers to the risk that the exchange rate may move up or down in relation to other currencies.  It will have a major impact on the profitability of any company that has business transactions with foreign countries.

The Exchange Rate

Spot rate refers to the rate that is prevailing at the present point of time (say today). For example - $: GBP 1, this means that the dollar($) is expressed in terms of one pound.  Spot rate with spread refers to the margin to transact funds. As a result, the rate is often expressed in terms of a bid/offer spread. For example - $:GBP 1 - 1 or $:GBP 1 +/- 0.

Exchange Rate Systems

Exchange rates are a key measure for governments to attempt to control. They will have direct bearing on the economic performance of the country.

Fixed (or pegged) rate systems

 This refers to a system in which a currency is fixed in relation to the dominant world currency or against a basket of currencies.  The ‘peg’ may be changed from time to time to reflect the relative movement in underlying value.  This form of currency management is effective at giving a stable exchange platform for trade.  It will however lead to a parallel or unofficial market for currency if out of step with perceived value and normally requires strict exchange control to operate.

For example, the Indian Rupees (INR) is pegged to the US$ at a central rate of (say) 85 INR per 1 US$, with a ‘fluctuation band’ of +/- 2 per cent.

This means that the US$ to INR exchange rate must be with 2% of the central rate, and cannot drop below 82 INR per US $ or exceed more than 87 INR per US $.

Floating rate system

 It is a system in which the exchange rate is allowed to be determined without any government intervention.  It is determined by supply and demand in the market.  This is rare because currency value is normally considered too important a measure to be left solely to the market.  The market has a tendency to be volatile to the adverse effect of trade and wider government policy and this volatility can adversely affect the ability to trade between currencies.

For Example : In a floating exchange rate system, when the demand for a currency is low, its value decreases just as with any other product or service. But the result of a devalued currency is that imported goods seem more expensive to the people holding that currency. What used to require $5 to buy now requires $10. Because imported goods seem more expensive, people usually start buying more domestic goods, which tends to create jobs and stimulate/boost the economy in general.

However, the opposite is also true. When the currency becomes more valuable, imported items seem cheaper (what used to require $10 to buy now requires $5) and suddenly people want to buy fewer domestically produced items. This tends to increase unemployment and slow the economy in general.

Translation Risk

 Translation Risk refers to the risk associated with the reporting of foreign currency assets and liabilities within financial statements.  There is no cash flow impact of this type of risk.  However, the impact on the financial statements can be severe.  Translation risk may be hedged by matching the assets and liabilities within each country.  Any increase or decrease in value would cancel out on consolidation.

For example , a company is in possession of a facility located in Germany worth € million and the current dollar-to-euro exchange rate is 1:1, then the property would be reported as a $1 million asset. If the exchange rate changes and the dollar-to-euro ratio becomes 1:2, the asset would be reported as having a value of $500,000. This would appear as a $500,000 loss on financial statements, even though the company is in possession of the exact same asset it had before.

Economic Risk

 Economic risk refers to the long-term cash flow effects associated with asset investment in a foreign country or alternatively loans taken out or made in a foreign currency and the subsequent capital repayments.  Economic risk is more difficult to hedge given the longer term nature of the risk (over 10 or more years).  A simple technique would be to adopt a portfolio approach to investments by currency to spread the risk.

Example - Imagine a political party wins the general elections in a country where your oil & gas company, XYZ Inc. operates and has invested heavily.

After two years the party’s president and cabinet members start aiming the private sector, particularly foreign-owned companies.

One day the President of that country (who is from that political party) announces that the oil & gas industry will be nationalized. Your company is offered compensation which significantly undervalues its true worth.

The risk of losing that operation abroad due to nationalization has become a reality. Your company loses a lot of money and is unlikely to recoup its investment, even if you take the foreign government to international tribunals.

Companies that operate or operated in Venezuela have suffered similar problems, as well as a plummeting local currency and a raft of new anti-business legislation.

Transaction Risk

It refers to the risk associated with short-term cash flow transactions. This may include:

Commercial trade – this is normally reflected by the sale of goods in a foreign currency but with a delay in payment. The receipt will have an uncertain value in the home currency.  Borrowing or lending in another currency – subsequent cash flows relating to interest payments would be uncertain in the home currency.

These transactions may be hedged relatively easily either using internal or external hedging tools.

Example - For example, a domestic company signs a contract with a foreign company. The contract states that the domestic company will ship 1, units of product to the foreign company and the foreign company will pay for the goods in 3 months with 100 units of foreign currency. Assume the current exchange rate is: 1 unit of domestic currency equals 1 unit of foreign currency. The money the foreign company will pay the domestic company is equal to 100 units of domestic currency. The domestic company, the one that is going to receive payment in a foreign currency, now has transaction exposure. The value of the contract is exposed to the risk of exchange rate fluctuations. The next day the exchange rate changes and then remains constant at the new exchange rate for 3 months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign currency has devalued against the domestic currency. Now the value of the 100 units of foreign currency that the

3. Purchasing Power Parity Theory (PPPT)

This theory is based on the law of one price, i. it suggests that the price of the same product is the same in all currencies. To extend the principle further this would suggest that a relative change in prices (inflation) would have a direct effect on the exchange rate. PPPT is an unbiased but poor predictor of future exchange rates.

For example : A loaf of bread in the US costs $2, and that in Indian Rupees is 90, but a loaf of bread in India costs around 10, that’s about 20 cents. This creates an arbitrage opportunity where people in India can stock up on bread and bring it to the US and sell it and make a nice profit. Purchasing Power Parity says that since they are the same goods, the purchasing power in the countries should be the same. This doesn’t mean the exchange rate should be equal to one; it means the ratio of price to exchange rate should be one. In this example, it implies that exchange rate should be $2 = 10, $1 = 5. So, the Rupee here is undervalued.

Problems of PPPT:

 Not all inflation relates to exported goods.  There are market imperfections such as taxation and tariffs that reduce the impact of PPPT.  Only a small proportion of trade relates to traded goods.

4. Interest Rate Parity Theory (IRPT)

The theory that there is a no sum gain relating to investing in government bonds in differing countries. Any benefit in additional interest is eliminated by an adverse movement in exchange rates. IRPT is an unbiased but poor predictor of future exchange rates.

Suppose mid-market USD/CAD spot exchange rate is 1 CAD and one year forward rate is 1 CAD. Also the risk-free interest rate is 4% for USD and 3% for CAD. Check whether interest rate parity exist between USD and CAD?

Solution:

Ratio of Forward to Spot = 1 = 0. 1.

Ratio of Returns = (1+3%) = 0. (1+4%)

Does it work?

In practice the relationship between interest and exchange rates is not perfect and certainly not simultaneous. It is possible that the exchange rate does not move in line with interest rates for long periods (research the ‘carry trade’) only to correct over a short period of time.

Current spot rate x 1+ i1st = forward rate in one year’s time. 1+ i2nd

5. The International Fisher Effect

This theory is based on the assumption that all currencies must offer the same real interest rate. This links PPPT to IRPT. It is based upon the Fisher effect. The relative real interest rates should be the same due to the principle of supply and demand, if a country offers a higher real interest rate investors will invest in that currency and push up the price of the currency, bringing the real rate back to equilibrium. The international Fisher effect has a strong theoretical basis but is a poor predictor of future exchange rates.

Remember the Fisher effect: (1+m) = (1+r) (1+i)

Example

Let’s take the examples of two currencies, the USD (the United States) and the CAD (the Canadian Dollar). The USD/CAD spot exchange rate is 1, and the interest rate of the United States is 5% while that of Canada is 6%.

Internal Hedging Techniques:

 Invoice in own currency:

By invoicing in own currency an entity do not suffer the risk of exchange rate movement. The risk does not disappear; instead it passes on to the other party. It is questionable whether the other party will be happy to accept this risk.

 Leading payment:

By paying early or encouraging a customer to pay early the risk relating to an individual transaction is reduced or eliminated. The earlier the cash flow, the lower the exposure to exchange rate movements.

 Matching or netting:

If a company makes a number of transactions in both directions it will be able to net off those transactions relating to the same dates. In this way, a company can materially reduce the overall exposure but is unlikely to eliminate it. In order to perform netting the company must have a foreign currency bank account in the appropriate country.

 Do nothing:

A compelling idea, the exchange rates will fluctuate up and own. It could be argued that since we win some and lose some then ignoring the risk would be the best option. As a result we save on hedging costs, the downside being that the exposure to exchange rates is present in the short-term.

External Hedging Techniques:

 Forward Contract:

Features: 1. An agreement with the bank to exchange currency for a specific amount at a future date. 2. It is an obligation that must be completed once entered into. 3. The transaction may take place over a limited range of dates if option dated. It is an over the counter (OTC) product which means that it is tailored to the specific value and date required. 4. The forward rate offers a perfect hedge because it is for the exact amount required by the transaction on the appropriate date and the future rate is known with certainty. 5. The underlying theory behind the setting of the future rate is IRPT.

Example of a Forward Contract

Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its financial institution to sell two million bushels of corn at a price of $4 per bushel in six months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

1. It is exactly $4 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed. 2. It is higher than the contract price, say $5 per bushel. The producer owes the institution $1 million, or the difference between the current spot price and the contracted rate of $4. 3. It is lower than the contract price, say $3 per bushel. The financial institution will pay the producer $1 million, or the difference between the contracted rate of $4 and the current spot price.

company could use a money market hedge to lock in the value of the euro relative to the dollar at the current rate so that, even if the dollar weakens relative to the euro in six months, the U. company knows exactly what the transaction cost is going to be in dollars and can budget accordingly. The money market hedge would be executed by:

Buying the current value of the foreign currency transaction amount at the spot rate.Placing the foreign currency purchased on deposit and receiving interest until payment is made.Using the deposit to make the foreign currency payment.

Advantages:  there is some flexibility with regard to the date at which the transaction takes place

 may be available in currencies for which a forward rate is not available

Disadvantages:

 complex in nature

 may be difficult to borrow/deposit in some currencies at a risk-free rate

 Other currency hedging techniques:

Currency Futures:

The ‘fixing’ of the exchange rate today for a future trade in a similar manner to the forward contract. The Future is an exchange traded instrument that can be bought or sold on an exchange (e. LIFFE).

The future is a standardized financial instrument in terms of amount and date. This may lead to a hedge that is less than perfect because the amount of the trade may differ.

The aim is to buy or sell the future in such a way as to compliment the underlying trade. Therefore we will have:

 A futures contract betting on the exchange rate rising or falling; and  An underlying transaction that may fall or rise in terms of the home currency.

The linking of the two cancels out the movement of the exchange rate and leads to the hedge.

For example - Assume a trader buys a Euro FX contract at 1 and then sells it at 1. That is a 20 tick profit, and each tick in that contract is worth $12. Therefore, the profit is $12 x 20, multiplied by the number of contracts the trader had bought. Each currency contract may have a different tick value. This can be checked on the exchange website (CME, for example).

Currency Options:

They may be exchange traded or OTC. Options have the benefit of being a one sided bet. You can protect the downside risk of the currency moving against you but still take advantage of the upside potential. The option writer therefore only has a downside risk (as we take the upside). The option writer needs compensating for this risk and is paid a premium over and above transaction cost.

Example

Let's say an investor is bullish on the euro and believes it will increase against the U. dollar. The investor purchases a currency call option on the euro with a strike price of $115, since currency prices are quoted as 100 times the exchange rate. When the investor purchases the contract, the spot rate of the euro is equivalent to $110. Assume the euro's spot price at the expiration date is $118. Consequently, the currency option is said to have expired in the money. Therefore, the investor's profit is $300, or (100 * ($118 - $115)), less the premium paid for the currency call option.

 Market segmentation.

 Liquidity preference

Investors prefer to be liquid over being illiquid. To encourage investment over the longer term the long-term debt must offer a higher return over short-term debt.

 Market expectations

If interest rates are expected to fall over time long-term rates will be lower than short-term rates. This would lead to an inverted yield curve.

 Market segmentation

Differing parts of the market (short-term vs long-term debt markets) may react to differing economic information meaning that the yield curve is not smooth but suffers discontinuities

Hedging Interest Rate Risk:

We may hedge interest rate risk over the short or the long-term:

Short term hedging Long-term hedging Forward rate agreements Swaps Interest rate guarantee Interest rate futures Interest rate options

Short-term measures:

 Forward rate agreements(FRA)

FRA refers to the fixing of the interest rate today in relation to a future short-term loan. It is an obligation that must be taken once entered into. It is OTC and tailored to a specific loan in terms of:

  1. Date
  2. Amount, and
  3. Term and offers a ‘perfect hedge’. The FRA is wholly separate to the underlying loan. It will give certainty as regards the interest paid but there is a downside risk that interest rates may fall and we have already fixed at a higher rate.

Let’s take an example to understand how payments in an FRA are calculated:

Consider a 3×6 FRA on a notional principle amount of $1million. The FRA rate is 6%. The FRA settlement date is after 3 months (90 days) and the settlement is based on a 90 day LIBOR.

Assume that on the settlement date, the actual 90-day LIBOR is 8%. This means that the long is able to borrow at a rate of 6% under the FRA, which is 2% less than the market rate. This is a saving of:

= 1,000,000 * 2% *90/360 = $5,

This is the interest that the long would save by using the FRA. Since the settlement is happening today, the payment will be equal to the present value of these savings. The discount rate will be the current LIBOR rate.

FRA Payment = $5,000/(1+0)^(90/360) = $4,904.

 Interest rate guarantee(IRG)

IRG is similar to a FRA but an option rather than an obligation. In the event that interest rates move against the company (eg rise in the event of a loan) the option would be exercised. If the rates move in our favor then the option is allowed to lapse.

There is a premium to pay to compensate the IRG writer for accepting the downside risk.

Similar to an IRG but exchange traded, the option gives protection against the downside for the payment of a premium.

Long-Term Hedging - Swaps:

A company will borrow either using a variable or a fixed rate. If it wishes to change its borrowing type it could redeem its present debt and re-issue in the appropriate form. There are risks and costs involved in doing so.

A swap allows the company to change the exposure (fixed to variable or vice versa) without having to redeem existing debt.

For example - Imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1% (or 130 basis points). Also assume that LIBOR is at 2% and ABC management is anxious about an interest rate rise.

The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR plus 1% on a notional principal of $1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.

Below are two scenarios for this interest rate swap: 1) LIBOR rises 0% per year; and 2) LIBOR rises 0% per year.

Scenario 1

If LIBOR rises by 0% per year, Company ABC's total interest payments to its bond holders over the five-year period amount to $225,000. Let's break down the calculation:

In this scenario, ABC did well because its interest rate was fixed at 5% through the swap. ABC paid $15,000 less than it would have with the variable rate. XYZ's

forecast was incorrect, and the company lost $15,000 through the swap because rates rose faster than it had expected.

Scenario 2

In the second scenario, LIBOR rises by 0% per year:

In this case, ABC would have been better off by not engaging in the swap because interest rates rose slowly. XYZ profited $35,000 by engaging in the swap because its forecast was correct.

To prepare a swap we need the following steps:

 Identify a counter-party, either another company or bank willing to be the ‘other side’ of the transaction. If we want to swap fixed for variable they will want the opposite.  Agree the terms of the swap to ensure that at the outset both parties are in a neutral position.  On a regular basis (perhaps annually) transfer net amounts between the parties to reflect any movement in the prevailing exchange rates.

Advantages of swaps:

 Allows a change in interest rate exposure at relatively low cost and risk.  May allow access to a debt type that is otherwise unavailable to the company.  May reduce the overall cost of financing in certain circumstances.

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ACCA F9 Chapter 13 Foreign exchange

Module: acca financial reporting (ACCA F7)

54 Documents
Students shared 54 documents in this course

University: Association of Chartered Certified Accountants

Was this document helpful?
Foreign Currency Risk
Foreign Currency Risk refers to the risk that the exchange rate may move
up or down in relation to other currencies.
It will have a major impact on the profitability of any company that has
business transactions with foreign countries.
The Exchange Rate
Spot rate refers to the rate that is prevailing at the present point of time
(say today). For example - $: GBP 1.9500, this means that the dollar($) is
expressed in terms of one pound.
Spot rate with spread refers to the margin to transact funds. As a result,
the rate is often expressed in terms of a bid/offer spread. For example -
$:GBP 1.9150 - 1.9850 or $:GBP 1.9500 +/- 0.0350
Exchange Rate Systems
Exchange rates are a key measure for governments to attempt to control. They
will have direct bearing on the economic performance of the country.
Fixed (or pegged) rate systems
This refers to a system in which a currency is fixed in relation to the
dominant world currency or against a basket of currencies.
The ‘peg’ may be changed from time to time to reflect the relative
movement in underlying value.
This form of currency management is effective at giving a stable exchange
platform for trade.
It will however lead to a parallel or unofficial market for currency if out of
step with perceived value and normally requires strict exchange control to
operate.

Students also viewed

Related documents