Premium Course Notes
[Session 11 & 12]
Chapter 19 Foreign Exchange Risk
SYLLABUS
1.
2.
3.
4.
5.
6.
Describe and discuss different types of foreign currency risk:
(a) translation risk
(b) transaction risk
(c) economic risk
Describe the causes of exchange rate fluctuations, including:
(a) balance of payments
(b) purchasing power parity theory
(c) interest rate parity theory
(d) four-way equivalence
Forecast exchange rates using:
(a) purchasing power parity
(b) interest rate parity
Discuss and apply traditional and basic methods of foreign currency risk management,
including:
(a) currency of invoice
(b) netting and matching
(c) leading and lagging
(d) forward exchange contracts
(e) money market hedge
(f) asset and liability management
Compare and evaluate traditional methods of foreign currency risk management.
Identify the main types of foreign currency derivatives used to hedge foreign currency
risk and explain how they are used in hedging. (No numerical questions will be set on
this topic.)
Prepared by Patrick Lui
P. 557
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Foreign
Exchange
Risk
Exchange
Rate
Systems
Types of
Foreign Currency
Risk
Causes of
Exchange Rate
Fluctuations
Foreign
Currency Risk
Management
Foreign
Currency
Derivatives
1. Fixed
exchange
rate
1. Transactions
risk
1. Balance of
payments
1. Home currency
2. Do nothing
3. Leading &
lagging
1. Futures
2. Freely
floating
exchange rate
2. Economic
risk
2. Capital
movements
4. Netting &
matching
2. Options
3. Managed
floating
exchange rate
3. Translation
risk
3. Supply and
demand
5. Forward
contract
6. Money market
3. Swaps
4. Purchasing
power parity
5. Interest rate
parity
6. Expectations
theory
7. International
Fisher
Effect
Prepared by Patrick Lui
P. 558
Copyright @ Kaplan Financial 2015
Premium Course Notes
1.
1.1
[Session 11 & 12]
Exchange Rate Systems
Exchange Rate Systems
(a)
Fixed exchange rates – This involves publishing the target parity against a
single currency (or a basket of currencies), and a commitment to use
monetary policy (interest rates) and official reserves of foreign exchange to
hold the actual spot rate within some trading band around this target.
(i)
Fixed against a single currency – This is where a country fixes its
exchange rate against the currency of another country’s currency. More
than 50 countries fix their rates in this way, mostly against the US
dollar. Fixed rates are not permanently fixed and periodic revaluations
and devaluations occur when the economic fundamentals of the
country concerned strongly diverge (e.g. inflation rates).
(ii)
(b)
Fixed against a basket of currencies – Using a basket of currencies is
aimed at fixing the exchange rate against a more stable currency base
than would occur with a single currency fix. The basket is often
devised to reflect the major trading links of the country concerned.
Freely floating exchange rates (or clean float) – A genuine free float would
involve leaving exchange rates entirely to the vagaries of supply and demand
on the foreign exchange markets, and neither intervening on the market using
official reserves of foreign exchange nor taking exchange rates into account
when making interest rate decisions. The Monetary Policy Committee of the
Bank of England clearly takes account of the external value of sterling in its
decision-making process, so that although the pound is no longer in a fixed
exchange rate system, it would not be correct to argue that it is on a
genuinely free float.
(c)
Managed floating exchange rates (or dirty float) – The central bank of
countries using a managed float will attempt to keep currency relationships
within a predetermined range of values (not usually publicly announced), and
will often intervene in the foreign exchange markets by buying or selling
their currency to remain within the range.
Prepared by Patrick Lui
P. 559
Copyright @ Kaplan Financial 2015
Premium Course Notes
2.
[Session 11 & 12]
Types of Foreign Currency Risk
(Pilot, Dec 09, Jun 13)
2.1
Currency risk
2.1.1 Currency risk occurs in three forms: transaction exposure (short-term), economic
exposure (effect on present value of longer term cash flows) and translation
exposure (book gains or losses).
2.2
2.2.1
Transaction risk
Transaction Risk
Transaction risk is the risk of an exchange rate changing between the transaction
date and the subsequent settlement date, i.e. it is the gain or loss arising on
conversion.
It arises primarily on import and exports.
2.2.2
Example 1
A UK company, buy goods from Redland which cost 100,000 Reds (the local
currency). The goods are re-sold in the UK for £32,000. At the time of the import
purchases the exchange rate for Reds against sterling is 3.5650 – 3.5800.
Required:
(a)
(b)
What is the expected profit on the re-sale?
What would the actual profit be if the spot rate at the time when the currency
is received has moved to:
(i) 3.0800 – 3.0950
(ii) 4.0650 – 4.0800?
Ignore bank commission charges.
Prepared by Patrick Lui
P. 560
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Solution:
(a)
The UK company must buy Reds to pay the supplier, and so the bank is
selling Reds. The expected profit is as follows.
£
Revenue from re-sale of goods
32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.5650)
28,050.49
Expected profit
3,949.51
(b)(i) If the actual spot rate for the UK company to buy and the bank to sell the
Reds is 3.0800, the result is as follows.
Revenue from re-sale of goods
Less: Cost of 100,000 Reds in sterling (÷ 3.0800)
£
32,000,00
32,467.53
Loss
(467.53)
(b)(ii) If the actual spot rate for the UK company to buy and the bank to sell the
Reds is 4.0650, the result is as follows.
£
Revenue from re-sale of goods
32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 4.0650)
24,600.25
Profit
7,399.75
This variation in the final sterling cost of the goods (and thus the profit) illustrated
the concept of transaction risk.
2.2.3 A firm decide to hedge – take action to minimize – the risk, if it is:
(a)
a material amount
(b)
over a material time period
(c)
thought likely exchange rates will change significantly.
2.2.4 As transaction risk has a potential impact on the cash flows of a company, most
companies choose to hedge against such exposure. Measuring and monitoring
transaction risk is normally an important component of treasury management.
Prepared by Patrick Lui
P. 561
Copyright @ Kaplan Financial 2015
Premium Course Notes
2.3
[Session 11 & 12]
Economic risk
2.3.1
Economic Risk
Economic risk is the variation in the value of the business (i.e. the present value
of future cash flows) due to unexpected changes in exchange rates. It is the
long-term version of transaction risk.
2.3.2 For example, a UK company might use raw materials which are priced in US dollars,
but export its products mainly within the EU. A depreciation of sterling against the
dollar or an appreciation of sterling against other EU currencies will both erode the
competitiveness of the company. Economic exposure can be difficult to avoid,
although diversification of the supplier and customer base across different countries
will reduce this kind of exposure to risk.
2.4
Translation risk
2.4.1
Translation Risk
This is the risk that the organization will make exchange losses when the
accounting results of its foreign branches or subsidiaries are translated into
the home currency. Translation losses can result, for example, from restating the
book value of a foreign subsidiary’s assets at the exchange rate on the statement of
financial position date.
Multiple Choice Questions
1.
Exporters Co is concerned that the cash received from overseas sales will not be as
expected due to exchange rate movements.
What type of risk is this?
A
B
C
D
Translation risk
Economic risk
Interest rate risk
Transaction risk
Prepared by Patrick Lui
P. 562
Copyright @ Kaplan Financial 2015
Premium Course Notes
2.
[Session 11 & 12]
‘There is a risk that the value of our foreign currency-denominated assets and
liabilities will change when we prepare our accounts.’
To which risk does the above statement refer?
A
B
C
D
Translation risk
Economic risk
Transaction risk
Interest rate risk
(ACCA F9 Financial Management Pilot Paper 2014)
3.
The Causes of Exchange Rate Fluctuations
3.1
Balance of payments
3.1.1 Changes in exchange rates result from changes in the demand for and supply of the
currency. These changes may occur for a variety of reasons, e.g. due to changes in
international trade or capital flows between economies.
3.1.2 Balance of payments (國際收支平衡) – Since currencies are required to finance
international trade, changes in trade may lead to changes in exchange rates. In
principle:
(a)
demand for imports in the US represents a demand for foreign currency or a
supply of dollars.
(b)
overseas demand for US exports represents a demand for dollars or a supply of
the currency.
(國際收支平衡是一個帳目，把一個國家與其他國家的交易記錄下來。這個記錄
主要是記下一些涉及金錢或有價值的經濟活動，好些沒有金錢的經濟活動，如甲
國有五萬人移民往乙國，這是不會記下的。)
3.1.3 Thus a country with a current account deficit where imports exceed exports may
expect to see its exchange rate depreciate, since the supply of the currency (imports)
will exceed the demand for the currency (exports).
3.2
Capital movements
3.2.1 There are also capital movements between economies. These transactions are
effectively switching bank deposits from one currency to another. These flows are
now more important than the volume of trade in goods and services.
Prepared by Patrick Lui
P. 563
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
3.2.2 Thus supply/demand for a currency may reflect events on the capital account. Several
factors may lead to inflows or outflows of capital:
3.3
(a)
changes in interest rates: rising (falling) interest rates will attract a capital
inflow (outflow) and a demand (supply) for the currency
(b)
inflation: asset holders will not wish to hold financial assets in a currency
whose value is falling because of inflation.
Purchasing power parity theory (PPP) (購買力平價學說)
(Pilot, Jun 11, Jun 12)
3.3.1
Purchasing Power Parity
PPP claims that the rate of exchange between two currencies depends on the
relative inflation rates within the respective countries. In equilibrium, identical
goods must cost the same, regardless of the currency in which they are sold.
PPP predicts that the country with the higher inflation will be subject to a
depreciation of its currency.
Formally, if you need to estimate the expected future spot rates, PPP can be
expressed in the following formula:
S1 1  hc

S 0 1  hb
Where: S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base country)
hc = Inflation rate in the other country (country currency).
3.3.2
Example 2
An item costs $3,000 in the US.
Assume that sterling and the US dollar are at PPP equilibrium, at the current spot
rate of $1.50/£, i.e. the sterling price x current spot rate of $1.50 = dollar price.
The spot rate is the rate at which currency can be exchanged today.
The US market
Cost of item now
Estimated inflation
Cost in one year
Prepared by Patrick Lui
$3,000
The UK market
$1.50
£2,000
5%
3%
$3,150
£2,060
P. 564
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
The law of one price states that the item must always cost the same. Therefore in
one year:
$3,150 must equal £2,060, and also the expected future spot rate can be calculated:
$3,150 / £2,060 = $1.5291/£
By formula:
S1
1  5%

1.50 1  3%
S1  $1.5291
3.3.3
Test your understanding 1
The dollar and sterling are currently trading at $1.72/£.
Inflation in the US is expected to grow at 3% pa, but at 4% pa in the UK.
Predict the future spot rate in a year’s time.
Solution:
3.3.4
Case Study – Big Mac Index
An amusing example of PPP is the Economist’s Big Mac Index. Under PPP
movements in countries’ exchange rates should in the long-term mean that the
prices of an identical basket of goods or services are equalized. The McDonalds
Big Mac represents this basket.
The index compares local Big Mac prices with the price of Big Macs in America.
This comparison is used to forecast what exchange rates should be, and this is then
compared with the actual exchange rates to decide which currencies are over and
under-valued.
3.3.5 PPP can be used as our best predictor of future spot rates; however it suffers from the
following major limitations:
(a)
the future inflation rates are only estimates
Prepared by Patrick Lui
P. 565
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
(b)
the market is dominated by speculative transactions (98%) as opposed to trade
(c)
transactions; therefore PPP breaks down
government intervention – governments may manage exchange rates, thus
defying the forces pressing towards PPP.
3.3.6 However, it is likely that the PPP may be more useful for predicting long-run
changes in exchange rates since these are more likely to be determined by the
underlying competitiveness of economies, as measured by the model.
3.4
Interest rate parity theory (IRP) (利率平價學說)
(Jun 11, Dec 14)
3.4.1
Interest Rate Parity (IRP)
The IRP claims that the difference between the spot and the forward exchange rates
is equal to the differential between interest rates available in the two currencies.
IRP predicts that the country with the higher interest rate will see the forward
rate for its currency subject to a depreciation.
If you need to calculate the forward rate in one year’s time:
F0 1  ic

S 0 1  ib
Where: F0 = Forward rate
S0 = Current spot rate
ib = interest rate for base currency
ic = interest rate for counter currency
3.4.2
Example 3
UK investor invests in a one-year US bond with a 9.2% interest rate as this
compares well with similar risk UK bonds offering 7.12%. The current spot rate is
$1.5/£.
When the investment matures and the dollars are converted into sterling, IRP states
that the investor will have achieved the same return as if the money had been
invested in UK government bonds.
Prepared by Patrick Lui
P. 566
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
In 1 year, £1.0712 million must equate to $1.638 million so what you gain in extra
interest, you lose on an adverse movement in exchange rates.
The forward rates moves to bring about interest rate parity amongst different
currencies:
$1.638 ÷ £1.0712 = $1.5291
By formula:
F0
1  9.2%

1.5 1  7.12%
F0  $1.5291
3.4.3 The IRPT generally holds true in practice. There are no bargain interest rates to be had
on loans/deposits in one currency rather than another. However, it suffers from the
following limitations:
(a)
government controls on capital markets
(b)
controls on currency trading
(c)
intervention in foreign exchange markets.
3.4.4 The interest rate parity model shows that it may be possible to predict exchange rate
movements by referring to differences in nominal exchange rates. If the forward
exchange rate for sterling against the dollar was no higher than the spot rate but US
nominal interest rates were higher, the following would happen:
(a)
UK investors would shift funds to the US in order to secure the higher interest
rates, since they would suffer no exchange losses when they converted $ back
to £.
(b)
the flow of capital from the UK to the US would raise UK interest rates and
force up the spot rate for the US$.
Prepared by Patrick Lui
P. 567
Copyright @ Kaplan Financial 2015
Premium Course Notes
3.5
[Session 11 & 12]
Expectations theory
(Jun 12)
3.5.1 The expectations theory claims that the current forward rate is an unbiased
predictor of the spot rate at that point in the future.
3.5.2 If a trader takes the view that the forward rate is lower than the expected future spot
price, there is an incentive to buy forward. The buying pressure on the forward rates
raises the price, until the forward price equals the market consensus view on the
expected future spot price.
3.6
The International Fisher Effect
3.6.1 The International Fisher Effect claims that the interest rate differentials between
two countries provide an unbiased predictor of future changes in the spot rate of
exchange.
3.6.2 The International Fisher Effect assumes that all countries will have the same real
interest rate, although nominal or money rates may differ due to expected inflation
rates. Thus the interest rate differential between two countries should be equal to
the expected inflation differential. Therefore, countries with higher expected
inflation rates will have higher nominal interest rates, and vice versa.
3.6.3 The currency of countries with relatively high interest rates is expected to
depreciate against currencies with lower interest rates, because the higher interest
rates are considered necessary to compensate for the anticipated currency
depreciation.
3.6.4 Given free movement of capital internationally, this idea suggests that the real rate of
return in different countries will equalize as a result of adjustments to spot exchange
rates. The International Fisher Effect can be expressed as:
1  ia 1  ha

1  ib 1  hb
Where: ia = the nominal interest rate in country a
ib = the nominal interest rate in country b
ha = the inflation rate in country a
hb = the inflation rate in country b
Prepared by Patrick Lui
P. 568
Copyright @ Kaplan Financial 2015
Premium Course Notes
3.7
[Session 11 & 12]
Four-way equivalence
3.7.1 The four theories can be pulled together to show the overall relationship between spot
rates, interest rates, inflation rates and the forward and expected future spot rates. As
shown above, these relationships can be used to forecast exchange rates.
Multiple Choice Questions
3.
The spot exchange rate
A
B
C
D
is the rate today for exchanging one currency for another for immediate delivery
is the rate today for exchanging one currency for another at a specified future
date
is the rate today for exchanging one currency for another at a specific location on
a specified future date
is the rate today for exchanging one currency for another at a specific location
for immediate delivery
Prepared by Patrick Lui
P. 569
Copyright @ Kaplan Financial 2015
Premium Course Notes
4.
[Session 11 & 12]
If the US dollar weakens against the pound sterling, will UK exporters and importers
suffer or benefit?
A
B
C
D
5.
UK exporters to US
Benefit
Suffer
Benefit
Suffer
UK importers from US
Benefit
Suffer
Suffer
Benefit
Pechora Co is a German business that has purchased goods from a supplier, Kama Co,
which is based in the USA. Pechora Co has been invoiced in euros and payment is to
be made 30 days after the purchase. During this 30-day period, the euro strengthened
against the US$.
Assuming neither Pechora Co nor Kama Co hedge against currency risk, what would
be the currency gain or loss for each party as a result of this transaction?
6.
A
B
Pechora
No gain or loss
Gain
Kama
Gain
No gain or loss
C
D
No gain or loss
Loss
Loss
No gain or loss
Sirius plc is a UK business that has recently purchased machinery from a Bulgarian
exporter. The company has been invoiced in £ sterling and the terms of sale include
payment within sixty days. During this payment period, the £ sterling weakened
against the Bulgarian lev.
If neither Sirius plc nor the Bulgarian exporter hedge against foreign exchange risk,
what would be the foreign exchange gain or loss arising from this transaction for
Sirius plc and for the Bulgarian exporter?
A
B
C
D
Sirius plc
No gain or loss
Gain
No gain or loss
Loss
Prepared by Patrick Lui
Bulgarian exporter
Gain
No gain or loss
Loss
No gain or loss
P. 570
Copyright @ Kaplan Financial 2015
Premium Course Notes
7.
[Session 11 & 12]
The current euro / US dollar exchange rate is €1 : $2. ABC Co, a Eurozone company,
makes a $1,000 sale to a US customer on credit. By the time the customer pays, the
Euro has strengthened by 20%.
What will the Euro receipt be?
A
B
C
D
8.
€416.67
€2,400
€600
€400
The current spot rate for the Dollar /Euro is $/€ 2.0000 +/- 0.003. The dollar is quoted
at a 0.2c premium for the forward rate.
What will a $2,000 receipt be translated to at the forward rate?
A
B
C
D
9.
€4,002
€999.5
€998
€4,008
The spot rate of exchange is £1 = $1·4400. Annual interest rates are 4% in the UK and
10% in the USA.
The three month forward rate of exchange should be:
A
B
C
D
10.
£1 = $1·4616
£1 = $1·5264
£1 = $1·5231
£1 = $1·4614.
The home currency of ACB Co is the dollar ($) and it trades with a company in a
foreign country whose home currency is the Dinar. The following information is
available:
Spot rate
Interest rate
Inflation rate
Prepared by Patrick Lui
Home country
20.00 Dinar per $
3% per year
2% per year
P. 571
Foreign country
7% per year
5% per year
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
What is the six-month forward exchange rate?
A
B
C
D
20·39 Dinar per $
20·30 Dinar per $
20·59 Dinar per $
20·78 Dinar per $
(ACCA F9 Financial Management Pilot Paper 2014)
11.
The following exchange rates of £ sterling against the Singapore dollar have been
quoted in a financial newspaper:
Spot
Three months’ forward
£1 = Singapore $2·3820
£1 = Singapore $2·3540
The interest rate in Singapore is 6% per year for a three-month deposit or borrowing.
What is the annual interest rate for a three-month deposit or borrowing in the UK?
12.
A
B
2·71%
7·26%
C
D
8·71%
10·83%
Interest rate parity theory generally holds true in practice. However it suffers from
several limitations.
Which of the following is not a limitation of interest rate parity theory?
A
B
Government controls on capital markets
Controls on currency trading
C
D
Intervention in foreign exchange markets
Future inflation rates are only estimates
Prepared by Patrick Lui
P. 572
Copyright @ Kaplan Financial 2015
Premium Course Notes
13.
What does purchasing power parity refers to?
A
B
C
D
14.
15.
[Session 11 & 12]
A situation where two businesses have equal available funds to spend.
Inflation in different locations is the same.
Prices are the same to different customers in an economy.
Exchange rate movements will absorb inflation differences.
Purchasing Power Parity Theory (PPP) refers to
A
The concept that the same goods should sell for the same price across countries
after exchange rates are taken into account
B
C
The concept that interest rates across countries will eventually be the same
The orderly relationship between spot and forward currency exchange rates and
the rates of interest between countries
D
The natural offsetting relationship provided by costs and revenues in similar
market environments
An Iraqi company is expecting to receive Indian rupees in one year's time. The spot
rate is 19.68 Iraqi dinar per 1 India rupee. The company could borrow in rupees at
10% or in dinars at 15%.
What is the expected exchange rate in one year's time?
A
B
C
D
16.
18.82 Iraqi dinar = 1 Indian rupee
20.58 Iraqi dinar = 1 Indian rupee
21.65 Iraqi dinar = 1 Indian rupee
22.63 Iraqi dinar = 1 Indian rupee
What is the impact of a fall in a country’s exchange rate?
1
2
Exports will be given a stimulus
The rate of domestic inflation will rise
A
B
C
D
1 only
2 only
Both 1 and 2
Neither 1 nor 2
(ACCA F9 Financial Management Pilot Paper 2014)
Prepared by Patrick Lui
P. 573
Copyright @ Kaplan Financial 2015
Premium Course Notes
17.
[Session 11 & 12]
An investor plans to exchange $1,000 into euros now, invest the resulting euros for 12
months, and then exchange the euros back into dollars at the end of the 12-month
period. The spot exchange rate is €1·415 per $1 and the euro interest rate is 2% per
year. The dollar interest rate is 1·8% per year.
Compared to making a dollar investment for 12 months, at what 12-month forward
exchange rate will the investor make neither a loss nor a gain?
A
B
C
€1·223 per $1
€1·412 per $1
€1·418 per $1
D
€1·439 per $1
(ACCA F9 Financial Management June 2015)
4.
Foreign Currency Risk Management
4.1
Foreign currency hedging
4.1.1 When currency risk is significant for a company, it should do something to either
eliminate it or reduce it. Taking measures to eliminate or reduce the risk is called
hedging the risk or hedging the exposure.
4.2
Deal in home currency
(Jun 14, Dec 14)
4.2.1 Insist all customers pay in your own home currency and pay for all imports in home
currency. This method:
(a)
transfer risk to the other party
(b)
may not be commercially acceptable.
4.3
Do nothing
4.3.1 In the long run, the company would “win some, lose some”. This method
(a)
works for small occasional transactions
(b)
saves in transaction costs
(c)
is dangerous.
Prepared by Patrick Lui
P. 574
Copyright @ Kaplan Financial 2015
Premium Course Notes
4.4
[Session 11 & 12]
Leading and lagging
(Dec 07, Dec 08, Jun 14)
4.4.1 Companies might try to use:
(a)
Lead payments – payment in advance
(b)
Lagged payments – delaying payments beyond their due date.
4.4.2 In order to take advantage of foreign exchange rate movements. With a lead
payments, paying in advance of the due date, there is a finance cost to consider. This
is the interest cost on the money used to make the payment, but early settlement
discounts may be available.
4.4.3 Leading and lagging are a form of speculation. In relation to foreign currency
settlements, additional benefits can be obtained by the use these techniques when
currency exchange rates are fluctuating (assuming one can forecast the changes.)
4.4.4 Leading would be beneficial to the payer if this currency were strengthening
against his own. Lagging would be appropriate for the payer if the currency were
weakening.
4.5
Matching (配對)
(Jun 14)
4.5.1 When a company has receipts and payments in the same foreign currency due at the
same time, it can simply match them against each other. It is then only necessary to
deal on the foreign exchange (forex) markets for the unmatched portion of the total
transactions.
Suppose that ABC Co has the following receipts and payments in three months time:
4.5.2 Netting only applies to transfers within a group of companies. Matching can be
used for both intra-group transactions and those involving third parties. The
Prepared by Patrick Lui
P. 575
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
company match the inflows and outflows in different currencies caused by trade, etc.,
so that it is only necessary to deal on the forex markets for the unmatched portion of
the total transactions.
4.6
Netting (沖抵)
4.6.1 Unlike matching, netting is not technically a method of managing exchange risk.
However, it is conveniently dealt with at this stage. The objective is simply to save
transactions costs by netting off inter-company balances before arranging payment.
4.6.2 Many multinational groups of companies engage in intra-group trading. Where
related companies located in different countries trade with one another, there is likely
to be inter-company indebtedness denominated in different currencies.
4.7
Forward exchange hedging (對沖)
(Pilot, Dec 07, Dec 08, Dec 09, Jun 11, Jun 12, Jun 13, Dec 14, Jun 15)
4.7.1 The spot market (現貨市場) is where you can buy and sell a currency now
(immediate delivery), i.e. the spot rate of exchange.
4.7.2 The forward market (遠期市場) is where you can buy and sell a currency, at a fixed
future date for a predetermined rate, i.e. the forward rate of exchange.
4.7.3
Forward Exchange Contracts
A forward exchange contract is:
(a)
An immediately firm and binding contract, e.g. between a bank and its
customer.
(b)
For the purchase or sale of a specified quantity of a stated foreign currency.
(c)
At a rate of exchange fixed at the time the contract is made.
(d)
For performance (delivery of the currency and payment for it) at a future
time which is agreed when making the contract (this future time will be
either a specified date, or any time between two specified dates).
4.7.4
Example 4 – Forward Contract
It is now 1 January and X Co will receive $10 million on 30 April.
It enters into a forward contract to sell this amount on the forward date at a rate of
$1.60/£. On 30 April the company is guaranteed £6.25 million.
The risk has been completely removed.
Prepared by Patrick Lui
P. 576
Copyright @ Kaplan Financial 2015
Premium Course Notes
4.7.5
[Session 11 & 12]
Test your understanding 2
The current spot rate for US dollars against UK sterling is 1.4525 – 1.4535 $/£ and
the one-month forward is quoted as 1.4550 – 1.4565.
A UK exporter expects to receive $400,000 in one month.
If a forward contract is used, how much will be received in sterling?
Solution:
4.7.6 Advantages and disadvantages:
Advantages


Disadvantages
Flexibility with regard to the 
amount to be covered.
Relatively straightforward both to 
comprehend and to organize.
Contractual commitment that must
be completed on the due date.
No opportunity to benefit from
favourable movements in exchange
rates.
4.8
4.8.1
Money market hedge
(Pilot, Dec 07, Dec 08, Dec 09, Jun 11, Jun 12, Jun 13, Jun 15)
Money Market Hedge
Money market hedge involves borrowing in one currency, converting the money
borrowed into another currency and putting the money on deposit until the
time the transaction is completed, hoping to take advantage of favourable interest
rate movements.
(a)
Setting up a money market hedge for a foreign currency payment
4.8.2 Suppose a British company needs to pay a Swiss creditor in Swiss francs in three
months time. It does not have enough cash to pay now, but will have sufficient in three
months time. Instead of negotiating a forward contract, the company could:
Step 1: Borrow the appropriate amount in pounds now
Step 2: Convert the pounds to francs immediately
Prepared by Patrick Lui
P. 577
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Step 3: Put the francs on deposit in a Swiss franc bank account
Step 4: When time comes to pay the company:
(a) pay the creditor out of the franc bank account
(b) repays the pound loan account
4.8.3
Example 5
A UK company owes a Danish creditor Kr3,500,000 in three months time. The spot
exchange rate is Kr/£ 7.5509 – 7.5548. The company can borrow in Sterling for 3
months at 8.60% per annum and can deposit kroners for 3 months at 10% per
annum. What is the cost in pounds with a money market hedge and what effective
forward rate would this represent?
Solution:
The interest rates for 3 months are 2.15% to borrow in pounds and 2.5% to deposit
in kroners. The company needs to deposit enough kroners now so that the total
including interest will be Kr3,500,000 in three months’ time. This means
depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.
These kroners will cost £452,215 (spot rate 7.5509). The company must borrow
this amount and, with three months interest of 2.15%, will have to repay:
£452,215 x (1 + 0.0215) = £461,938.
Thus, in three months, the Danish creditor will be paid out of the Danish bank
account and the company will effectively be paying £461,938 to satisfy this debt.
The effective forward rate which the company has manufactured is
3,500,000/461,938 = 7.5768. This effective forward rate shows the kroner at a
discount to the pound because the kroner interest rate is higher than the sterling
rate.
Prepared by Patrick Lui
P. 578
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
£
Now:
Convert
7.5509
Borrow
£452,215
Kr
Deposit
Kr3,414,634
Interest
paid: 2.15%
Interest
earned: 2.5%
3 months' time: £461,938
(b)
Kr3,500,000
Setting up a money market hedge for a foreign currency receipt
4.8.4 A similar technique can be used to cover a foreign currency receipt from a debtor. To
manufacture a forward exchange rate, follow the steps below.
Step 1: Borrow the appropriate amount in foreign currency today
Step 2: Convert it immediately to home currency
Step 3: Place it on deposit in the home currency
Step 4: When the debtor’s cash is received:
(a) Repay the foreign currency loan
(b)
4.8.5
Take the cash from the home currency deposit account
Example 6
A UK company is owed SFr 2,500,000 in three months time by a Swiss company.
The spot exchange rate is SFr/£ 2.2498 – 2.2510. The company can deposit in
Sterling for 3 months at 8.00% per annum and can borrow Swiss Francs for 3
months at 7.00% per annum. What is the receipt in pounds with a money market
hedge and what effective forward rate would this represent?
Solution:
The interest rates for 3 months are 2.00% to deposit in pounds and 1.75% to borrow
in Swiss francs. The company needs to borrow SFr2,500,000/1.0175 =
SFr2,457,003 today. These Swiss francs will be converted to £ at 2,457,003/2.2510
= £1,091,516. The company must deposit this amount and, with three months
interest of 2.00%, will have earned
£1,091,516 x (1 + 0.02) = £1,113,346
Prepared by Patrick Lui
P. 579
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Thus, in three months, the loan will be paid out of the proceeds from the debtor and
the company will receive £1,113,346. The effective forward rate which the
company has manufactured is 2,500,000/1,113,346 = 2.2455. This effective
forward rate shows the Swiss franc at a premium to the pound because the
Swiss franc interest rate is lower than the sterling rate.
S Fr
Now:
Convert
2.251
Borrow
SFr2,457,003
£
Deposit
£1,091,516
Interest
paid: 1.75%
Interest
earned: 2.0%
3 months' time:SFr2,500,000
4.9
£1,113,546
Choosing the hedging method
4.9.1 The choice between forward and money markets is generally made on the basis of
which method is cheaper, with other factors being of limited significance.
4.9.2 When a company expects to receive or pay a sum of foreign currency in the next few
months, it can choose between using the forward exchange market and the money
market to hedge against the foreign exchange risk. Other methods may also be
possible, such as making lead payments. The cheapest method available is the one
that ought to be chosen.
4.9.3
Example 7
ABC Co has bought goods from a US supplier, and must pay $4,000,000 for them
in three months time. The company’s finance director wishes to hedge against the
foreign exchange risk, and the three methods which the company usually considers
are:
(a)
(b)
(c)
Using forward exchange contracts
Using money market borrowing or lending
Making lead payments
The following annual interest rates and exchange rates are currently available.
Prepared by Patrick Lui
P. 580
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
US dollar
Sterling
Deposit rate
Borrowing rate
Deposit rate
Borrowing rate
%
%
%
%
1 month
7
10.25
10.75
14.00
3 months
7
10.75
11.00
14.25
$/£ exchange rate ($ = £1)
1.8625 – 1.8635
1.8565 – 1.8577
1.8455 – 1.8460
Spot
1 month forward
3 months forward
Which is the cheapest method for ABC Co? Ignore commission costs (the bank
charges for arranging a forward contract or a loan).
Solution:
The three choices must be compared on a similar basis, which means working out
the cost of each to ABC Co either now or in three months time. In the following
paragraphs, the cost to ABC Co now will be determined.
Choice 1: the forward exchange market
ABC Co must buy dollars in order to pay the US supplier. The exchange rate in a
forward exchange contract to buy $4,000,000 in three months time (bank sells) is
1.8445.
The cost of the $4,000,000 to ABC Co in three months time will be:
$4,000,000
= £2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that by
deferring payment for three months, we assume that the company needs to borrow
the money for the payment.
At an annual interest rate of 14.25% the rate for three months is 14.25/4 =
3.5625%. The present cost of £2,168,609.38 in three months time is:
£2,168,609.38 / 1.035625 = £2,094,010.26
Prepared by Patrick Lui
P. 581
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Choice 2: the money markets
Using the money market involves
(a) Borrowing in the foreign currency, if the company will eventually receive the
currency
(b) Lending in the foreign currency, if the company will eventually pay the
currency. Here, ABC Co will pay $4,000,000 and so it would lend US
dollars.
It would lend enough US dollars for three months, so that the principal repaid in
three months time plus interest will amount to the payment due of $4,000,000.
(a) Since the US dollar deposit rate is 7%, the rate for three months is
approximately 7/4 = 1.75%.
(b)
To earn $4,000,000 in three months time at 1.75% interest, ABC Co would
have to lend now:
$4,000,000
 $3,931,203.93
1.0175
These dollars would have to be purchased now at the spot rate of $1.8625. The cost
would be:
$3,931,203.93
= £2,110,713,52
1.8625
By lending US dollars for three months, ABC Co is matching eventual receipts and
payments in US dollars, and so has hedged against foreign exchange risk.
Choice 3: lead payments
Lead payments should be considered when the currency of payment is expected to
strengthen over time, and is quoted forward at a premium on the foreign exchange
market. Here, the cost of a lead payment (paying $4,000,000 now) would be
$4,000,000 / 1.8625 = £2,147,651.01.
Summary
Forward exchange contract (cheapest)
Currency lending
Lead payment
Prepared by Patrick Lui
P. 582
£
2,094,010.26
2,110,713.52
2,147,651.01
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Multiple Choice Questions
18.
What is the purpose of hedging?
A
B
C
D
19.
20.
To protect a profit already made from having undertaken a risky position
To make a profit by accepting risk
To reduce or eliminate exposure to risk
To reduce costs.
What does the term ‘matching’ refer to?
A
B
The coupling of two simple financial instruments to create a more complex one.
The mechanism whereby a company balances its foreign currency inflows and
outflows.
C
D
The adjustment of credit terms between companies
Contracts not yet offset by futures contracts or fulfilled by delivery.
ABC plc has to pay a Germany supplier 90,000 euros in three months’ time. The
company’s finance director wishes to avoid exchange rate exposure, and is looking at
four options.
1.
2.
3.
4.
Do nothing for three months and then buy euros at the spot rate
Pay in full now, buying euros at today’s spot rate
Buy euros now, put them on deposit for three months, and pay the debt with
these euro plus accumulated interest
Arrange a forward exchange contract to buy the euros in three months’ time
Which of these options would provide cover against the exchange rate exposure that
ABC plc would otherwise suffer?
A
B
C
D
4 only
3 and 4 only
2, 3 and 4 only
1, 2,3 and 4
Prepared by Patrick Lui
P. 583
Copyright @ Kaplan Financial 2015
Premium Course Notes
21.
[Session 11 & 12]
Consider the following statements concerning currency risk:
1.
2.
Leading and lagging is a method of hedging transaction exposure.
Matching receipts and payments is a method of hedging translation exposure.
Which of the above statements is/are true?
A
B
C
D
22.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
A large multinational business wishes to manage its currency risk. It has been
suggested that:
1.
2.
Matching receipts and payments can be used to manage translation risk.
Matching assets and liabilities can be used to manage economic risk.
Which ONE of the following combinations (true/false) concerning the above
statements is correct?
A
B
C
D
23.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
A business uses each of the hedging methods described below to protect against a
particular type of foreign exchange risk:
1.
2.
3.
Hedging method used
Matching receipts and payments
Matching assets and liabilities
Leading and lagging
Type of foreign exchange risk
Transaction risk
Economic risk
Translation risk
Which of the hedging methods described above are suitable for their intended
purpose?
Prepared by Patrick Lui
P. 584
Copyright @ Kaplan Financial 2015
Premium Course Notes
24.
25.
A
1 and 2
B
C
D
1 and 3
1, 2 and 3
2 and 3
[Session 11 & 12]
A forward exchange contract is
(1)
(2)
(3)
(4)
an immediately firm and binding contract
for the purchase or sale of a specified quantity of a stated foreign currency
at a rate of exchange fixed at the time the contract is made
for performance at a future time which is agreed when making the contract
A
B
(1) and (2) only
(1), (2) and (3) only
C
D
(2) and (3) only
All of the above
Consider the following hedging methods.
1.
International diversification of operations
2.
3.
4.
Matching receipts and payments
Leading and lagging
Forward exchange contracts
Which of the hedging methods above are suitable for hedging transaction exposure?
A
B
C
D
26.
1 and 2
1, 2 and 3
2 and 3
2, 3 and 4
The following methods may be used to hedge currency risk:
1.
2.
3.
4.
International diversification of operations;
Currency swaps;
Leading and lagging;
Forward exchange contracts.
Prepared by Patrick Lui
P. 585
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Which TWO of the above can be used to hedge currency risk arising from economic
exposure?
A
B
C
D
27.
1 and 2
1 and 3
2 and 4
3 and 4
A business uses the hedging methods outlined below to protect itself against the
particular types of foreign exchange risk against which they are matched.
Hedging method
Forward exchange contracts
Matching receipts and payments
Type of risk
Transaction risk
Economic risk
Buying or selling domestic currency
Translation risk
Which one of the following combinations best describes the suitability of the three
hedging methods for their intended purpose?
Suitability of hedging method for the type of risk identified
A
B
C
D
28.
Forward exchange
contracts
Yes
Yes
No
No
Matching receipts and
payments
No
No
Yes
No
Buying or selling in
domestic currency
Yes
No
Yes
Yes
Which is true of forward contracts?
1
They fix the rate for a future transaction.
2
3
4
They are a binding contract.
They are flexible once agreed.
They are traded openly.
A
B
C
D
1, 2 and 4 only
1, 2, 3 and 4
1 and 2 only
2 only
Prepared by Patrick Lui
P. 586
Copyright @ Kaplan Financial 2015
Premium Course Notes
29.
30.
[Session 11 & 12]
In comparison to forward contracts, which of the following are true in the relation to
futures contracts?
1
2
3
4
They are more expensive.
They are only available in a small amount of currencies.
They are less flexible.
They are probably an imprecise match for the underlying transaction.
A
B
1, 2 and 4 only
2 and 4 only
C
D
1 and 3 only
1, 2, 3 and 4
A UK company expects to receive €200,000 in three months’ time for goods sold to a
German customer and wishes to hedge the currency risk by taking out a forward
contract. The following rates have been quoted:
Euro per £
Spot rate
1.4925 – 1.4985
3 months forward
1.4890 – 1.4897
If the forward contract is taken out, what are the sterling receipts for the UK company?
A
B
C
D
31.
£133,467
£134,003
£134,255
£134,318
Polaris plc, a UK-based business, has recently exported antique furniture to a US
customer and is due to be paid $500,000 in three months’ time. To hedge against
foreign exchange risk, Polaris plc has entered into a forward contract to sell $500,000
in three months’ time. The relevant exchange rates are as follows:
Spot £1 = $1·5535 – 1·5595
Three months’ forward 0·30 – 0·25 cents premium
How much will Polaris plc receive in £ sterling at the end of three months?
Prepared by Patrick Lui
P. 587
Copyright @ Kaplan Financial 2015
Premium Course Notes
32.
A
£321,130
B
C
D
£321,234
£322,373
£322,477
[Session 11 & 12]
Gydan plc, a UK business, is due to receive €500,000 in four months’ time for goods
supplied to a French customer. The company has decided to use a money market hedge
to manage currency risk. The following information concerning borrowing rates is
available:
Country
France
UK
Borrowing rate per annum
9%
6%
The spot rate is £1 = €1·4490 – 1·4520
Using the money market approach, what is the £ sterling value of the amount that
Gydan Co will have to borrow now in order to match the receipt?
33.
A
£315,920
B
C
D
£335,015
£334,323
£337,601
A UK based company, which has no surplus cash, is due to pay Euro 2,125,000 to a
company in Germany in three months time and wants to hedge the payment using
money markets.
The current spot rate is Euro 1·2230–1·2270 per £ sterling. The annual interest rates
available to the company in the UK and in Germany are as follows:
Country
UK
Germany
Borrow
5.72%
4.52%
Lend
3.64%
2.84%
What would it cost the company in UK£ if it hedges its Euro exposure?
Prepared by Patrick Lui
P. 588
Copyright @ Kaplan Financial 2015
Premium Course Notes
34.
35.
A
£1,786,190
B
C
D
£1,780,367
£1,749,953
£1,744,248
[Session 11 & 12]
If the underlying transaction gives you _____________, denominated in a foreign
currency, the general principal behind a money market hedge states that you need an
equivalent liability in the money market to provide a hedge.
A
B
a liability
an asset
C
D
a forward contract
a foreign bank account
A company whose home currency is the dollar ($) expects to receive 500,000 pesos in
six months’ time from a customer in a foreign country. The following interest rates and
exchange rates are available to the company:
Spot rate
Six-month forward rate
Borrowing interest rate
Deposit interest rate
15.00 peso per $
15.30 peso per $
Home country
4% per year
3% per year
Foreign country
8% per year
6% per year
Working to the nearest $100, what is the six-month dollar value of the expected receipt
using a money-market hedge?
A
$32,500
B
C
D
$33,700
$31,800
$31,900
(ACCA F9 Financial Management December 2014)
Prepared by Patrick Lui
P. 589
Copyright @ Kaplan Financial 2015
Premium Course Notes
5.
Foreign Currency Derivatives
5.1
Currency futures
[Session 11 & 12]
(Pilot, Dec 08, Dec 09)
5.1.1
Currency Futures
Currency futures are standardized contracts for the sale or purchase at a set
future date of a set quantity of currency.
Futures contracts are exchange-based instruments traded on a regulated
exchange. The buyer and seller of a contract do not transact with each other
directly.
5.1.2
Example 8
A US company buys goods worth €720,000 from a German company payable in 30
days. The US company wants to hedge against the € strengthening against the
dollar.
Current spot is 0.9215 – 0.9221 $/€ and the € futures rate is 0.9245 $/€.
The standard size of a 3 month € futures contract is €125,000.
In 30 days time the spot is 0.9345 – 0.9351 $/€.
Closing futures price will be 0.9367.
Evaluate the hedge.
Solution:
1.
2.
3.
4.
5.
6.
We assume that the three month contract is the best available.
We need to buy € or sell $. As the futures contract is in €, we need to buy
futures.
720,000
No. of contracts = 5.76, say 6 contracts
125,000
Tick size – minimum price movement x contract size = 0.0001 × 125,000 =
$12.50
Closing futures price – we are told it will be 0.9367
Hedge outcome
Outcome in futures market
Opening futures price = 0.9245
Closing futures price = 0.9367
Prepared by Patrick Lui
P. 590
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Movement in ticks = 122 ticks
Futures profit = 122 × $12.50 × 6 contracts = $9,150
Net outcome
Spot market payment (720,000 × 0.9351 $/€)
Futures market profit
$
673,272
(9,150)
664,122
5.1.3 Advantages and disadvantages of futures to hedge risks
Advantages
Disadvantages
(a) Transaction costs should be lower (a) The contracts cannot be tailored
than other hedging methods.
to the user’s exact requirements.
(b) Futures are tradeable on a (b) Hedge inefficiencies are caused by
secondary market so there is pricing
having to deal in a whole number
transparency.
of contracts and by basis risk.
(c) The exact date of receipt or (c) Only a limited number of
payment does not have to be
currencies are the subject of
futures contracts.
known.
(d) Unlike options, they do not allow a
company to take advantage of
favourable currency movements.
Basis risk – the risk that the futures contract price may move by a different amount
from the price of the underlying currency or commodity.
5.2
Currency options
(Dec 08, Dec 09)
5.2.1
Currency Options
A currency option is a right of an option holder to buy (call) or sell (put) foreign
currency at a specific exchange rate at a future date.
5.2.2
Key Terms
(a)
(b)
Call option – gives the purchaser a right, but not the obligation, to buy a
fixed amount of currency at a specified price at some time in the future.
The seller of the option, who receives the premium, is referred to as the
writer.
Prepared by Patrick Lui
P. 591
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
(c)
Put option – gives the holder the right, but not the obligation, to sell a
(d)
specific amount of currency at a specified date at a fixed exercise price (or
strike price).
In-the-money option (價內期權) – the underlying price is above the
(e)
strike price.
At-the-money option (等價期權) – the underlying price is equal to the
(f)
option exercise price.
Out-of-the-money option (價外期權) – the underlying price is below the
(g)
(h)
option exercise price.
American-style options – can be exercised by the buyer at any time up to
the expiry date.
European-style options – can only be exercised on a predetermined
future date.
5.2.3 Companies can choose whether to buy:
(a)
a tailor-made currency option from a bank, suited to the company’s specific
needs. These are over-the-counter (OTC) or negotiated options, or
(b)
a standard option, in certain currencies only, from an options exchange. Such
options are traded or exchange-traded options.
5.2.4 A company can therefore:
(a)
(b)
5.3
Exercise the option if it is in its interests to do so.
Let it lapse if:
(i)
the spot rate is more favourable
(ii)
there is no longer a need to exchange currency.
Currency swap (貨幣互換)
(Dec 08, Dec 09)
5.3.1
Currency Swap
A swap is a formal agreement whereby two organizations contractually agree to
exchange payments on different terms, e.g. in different currencies, or one at a
fixed rate and the other at a floating rate.
5.3.2
Example 9
Consider a UK company X with a subsidiary Y in France which owns vineyards.
Assume a spot rate of £1 = 1.6 Euros. Suppose the parent company X wishes to
raise a loan of 1.6 million Euros for the purpose of buying another French wine
company. At the same time, the French subsidiary Y wishes to raise £1 million to
pay new up-to-date capital equipment imported from the UK. The UK parent
Prepared by Patrick Lui
P. 592
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
company X could borrow the £1 million sterling and the French subsidiary Y could
borrow the 1.6 million Euros, each effectively borrowing on the other’s behalf.
They would then swap currencies.
£1 million
UK
Company X
France
Subsidiary Y
€1.6 million
Borrow
£1 million
Borrow
€1.6 million
Bank
Bank
Multiple Choice Questions
36.
Which of the following is true?
A
As the majority of futures contracts are never taken to delivery a futures contract
is not legally binding
B
C
The quantity in a futures contract is agreed between the buyer and seller
Delivery dates on futures contracts are specified by the futures exchange and not
by the buyer and seller
The margin requirement is a purchase cost of a future.
D
37.
Consider the following two statements:
1.
One form of hedging is where an investor buys shares in one market and sells
them immediately in another to profit from price differences between the two
markets.
2.
One form of financial derivative is a preference share of a business.
Which one of the following combinations relating to the above statements is correct?
A
B
C
D
Statement 1
True
True
False
False
Prepared by Patrick Lui
Statement 2
True
False
True
False
P. 593
Copyright @ Kaplan Financial 2015
Premium Course Notes
38.
[Session 11 & 12]
Consider the following statements concerning derivatives.
1.
2.
Futures contracts may not be traded on an organised exchange
Forward contracts may be traded on an organised exchange
Which one of the following combinations (true/false) concerning the above statements
is correct?
39.
A
Statement 1
True
Statement 2
True
B
C
D
True
False
False
False
True
False
Consider the following two statements concerning futures contracts.
1.
2.
A futures contract is negotiated between a buyer and seller and can be tailored to
the buyer’s particular requirements.
A futures contract can be traded on a futures exchange.
Which of the following combinations (true/false) is correct?
A
B
C
D
40.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
Consider the following statements concerning futures contracts.
1.
2.
3.
4.
Futures contracts are tailor-made for the needs of the client
Futures contracts can be traded on a futures exchange
A short position on a futures contract can be closed by buying an equal number
of the contracts for the same settlement date.
A long position on a futures contract can be closed by buying an equal number of
contracts for the same settlement date.
Prepared by Patrick Lui
P. 594
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Which two of the above statements are correct?
A
B
C
D
41.
1 and 3
1 and 4
2 and 3
2 and 4
Consider the following statements concerning financial options.
1.
A European-style option gives the holder the right to exercise the option at any
time up to and including its expiry date.
2.
An in-the-money option has a more favourable strike price for the option writer
than the current market price of the underlying item.
Which one of the following combinations (true/false) concerning the above statements
is correct?
42.
A
B
Statement 1
True
True
Statement 2
True
False
C
D
False
False
True
False
Consider the following statements concerning options.
1.
2.
An out of-the-money call option has an intrinsic value of zero.
An American-style option can be exercised at any time up to, and including, the
expiry date.
Which one of the following combinations (true/false) relating to the above statements
is correct?
A
B
C
D
Statement 1
True
True
False
False
Prepared by Patrick Lui
Statement 2
True
False
True
False
P. 595
Copyright @ Kaplan Financial 2015
Premium Course Notes
43.
[Session 11 & 12]
The following statements have been made concerning options.
1.
2.
3.
4.
An out-of-the-money option has an intrinsic value of zero.
An American-style option can only be exercised on the expiry date of the option.
When an option is used to hedge currency risk, the option will be exercised only
if the market price of the underlying item is less favourable than the option strike
price.
An employee share option is a form of put option.
Which TWO of the above statements are correct?
44.
A
B
C
1 and 2
1 and 3
2 and 4
D
3 and 4
Which of the following measures will allow a UK company to enjoy the benefits of a
favourable change in exchange rates for their euro receivables contract while
protecting them from unfavourable exchange rate movements?
A
B
C
D
45.
A forward exchange contract
A put option for euros
A call option for euros
A money market hedge
The following European-style options are held at their expiry date by an investor:
1.
2.
A call option of 20,000 shares in Peterhouse plc with an exercise price of 860p.
The market price of the shares at the expiry date is 880p.
A put option of £600,000 in exchange for euros at a strike rate of £1 = €1·5. The
exchange rate at the expiry date is £1 = €1·45.
Which one of the above combinations (exercise/lapse) concerning the options should
be undertaken by the investor?
Prepared by Patrick Lui
P. 596
Copyright @ Kaplan Financial 2015
Premium Course Notes
Option 1
Exercise
Exercise
Lapse
Lapse
A
B
C
D
46.
[Session 11 & 12]
Option 2
Exercise
Lapse
Exercise
Lapse
Musat plc holds the following OTC options at their expiry date:
1.
2.
A put option on dollars at an exchange rate of £1 = $1·92. The exchange rate is
£1 = $1·95 at the expiry date of the option.
A call option on 5,000 ordinary shares in Spitzer plc at an exercise price of 575p.
The share price is 562p at the expiry date of the option.
Which of the above options should be exercised and which should be allowed to lapse
at their expiry date?
47.
A
B
C
Put option
Exercise
Lapse
Exercise
Call option
Exercise
Exercise
Lapse
D
Lapse
Lapse
A US company has just purchased goods from a UK supplier for £500,000. Payment is
due in three months’ time and the US company wishes to hedge its exposure to
exchange rate risk. The following ways of dealing with the exchange rate risk have
been suggested:
1.
2.
3.
Buy sterling futures now and sell sterling futures in three months’ time
Buy sterling call options now.
Sell sterling futures now and buy sterling futures in three months’ time
4.
Buy sterling put options now
Which two of the above suggestions would provide a hedge against exchange rate
risk?
A
1 and 2
B
1 and 3
C
2 and 3
D
3 and 4
Prepared by Patrick Lui
P. 597
Copyright @ Kaplan Financial 2015
Premium Course Notes
48.
[Session 11 & 12]
A UK business expects to receive euros in five months’ time. Assume that the business
wishes to hedge against exchange rate risk.
Which one of the following methods should be employed?
A
B
C
D
49.
Take out a forward contract to sell euros in five months’ time
Take out a forward contract to buy euros in five months’ time
Buy euros now at the prevailing spot rate
Take out a call option on euros.
A company based in Farland (with the Splot as its currency) is expecting its US
customer to pay $1,000,000 in 3 month’s time and wants to hedge this transaction
using currency options.
What is the option they require?
50.
1
2
3
A Splot put option purchased in America
A US dollar put option purchased in Farland
A Splot call option purchased in America
4
A US dollar call option purchased in Farland.
A
B
C
D
2 or 3 only
2 only
1 or 4 only
4 only
A UK company has just provided a service to a US company for $750,000. Settlement
is due in two months’ time and the UK company wants to hedge the risk of a fall in the
value of the US dollar over the next two months. The following methods of hedging
this risk have been suggested:
1.
2.
3.
4.
Buy sterling put options now
Buy sterling futures now
Buy sterling call options now
Sell sterling futures now
Prepared by Patrick Lui
P. 598
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Which two of the above suggestions would provide a hedge against the exchange rate
risk?
A
B
C
D
51.
1 and 3
1 and 4
2 and 3
2 and 4
Wetterstein Inc, a US-based company, expects to receive €800,000 in two months’
time for consultancy services provided to the Spanish government. It wishes to be
certain of the amount to be received and will use the derivatives market to achieve
this.
Which one of the following actions should the company take NOW to hedge the risk?
A
B
C
D
52.
Buy euro futures
Buy US dollar options
Sell euro futures
Sell US dollar futures
Three derivatives that may be used to manage financial risk are as follows:
1. Futures contracts
2. Forward contracts
3. Swaps
Which of the above may be traded on an organised exchange?
A
B
1 only
1 and 2
C
D
2 only
2 and 3
Prepared by Patrick Lui
P. 599
Copyright @ Kaplan Financial 2015
Premium Course Notes
53.
[Session 11 & 12]
Consider the following statements concerning currency risk hedges:
1.
2.
A currency swap may be used to hedge for a longer period than that offered by
forward exchange contracts.
A futures contract can be customised to fit the particular needs of the client.
Which one of the following combinations (true/false) concerning the above statements
is correct?
54.
A
Statement 1
True
Statement 2
True
B
C
D
True
False
False
False
True
False
Which of the following statements is correct?
A
B
Once purchased, currency futures have a range of close-out dates
Currency swaps can be used to hedge exchange rate risk over longer periods than
the forward market
C
Banks will allow forward exchange contracts to lapse if they are not used by a
company
Currency options are paid for when they are exercised
(ACCA F9 Financial Management December 2014)
D
Prepared by Patrick Lui
P. 600
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Examination Style Questions
Question 1 – Types of foreign currency risk, PPP, IRP, forward contract, money market
and futures
Nedwen Co is a UK-based company which has the following expected transactions.
One month:
One month:
Three months:
Expected receipt of $240,000
Expected payment of $140,000
Expected receipts of $300,000
The finance manager has collected the following information:
Spot rate ($ per £):
One month forward rate ($ per £):
1.7820 ± 0.0002
1.7829 ± 0.0003
Three months forward rate ($ per £):
1.7846 ± 0.0004
Money market rates for Nedwen Co:
One year sterling interest rate:
One year dollar interest rate
Borrowing
4.9%
5.4%
Deposit
4.6%
5.1%
Assume that it is now 1 April
Required:
(a)
(b)
(c)
(d)
(e)
Discuss the differences between transaction risk, translation risk and economic risk.
(6 marks)
Explain how inflation rates can be used to forecast exchange rates.
(6 marks)
Calculate the expected sterling receipts in one month and in three months using the
forward market.
(3 marks)
Calculate the expected sterling receipts in three months using a money-market hedge
and recommend whether a forward market hedge or a money market hedge should be
used.
(5 marks)
Discuss how sterling currency futures contracts could be used to hedge the three-month
dollar receipt.
(5 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper 2006 Q2)
Prepared by Patrick Lui
P. 601
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
Question 2 – Objectives of working capital management, EOQ, receivables management,
forward contract, money market hedge and lead payment
PKA Co is a European company that sells goods solely within Europe. The recently-appointed
financial manager of PKA Co has been investigating the working capital management of the
company and has gathered the following information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units.
Forecast demand to meet production requirements during the next year is 625,000 units. The
cost of placing and processing an order is €250, while the cost of holding a unit in stores is
€0·50 per unit per year. Both costs are expected to be constant during the next year. Orders
are received two weeks after being placed with the supplier. You should assume a 50-week
year and that demand is constant throughout the year.
Accounts receivable management
Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show
that the average accounts receivable period in the last financial year was 75 days. The
financial manager also noted that bad debts as a percentage of sales, which are all on credit,
increased in the last financial year from 5% to 8%.
Accounts payable management
PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in
six months’ time. The financial manager is concerned that the cost of these supplies may rise
in euro terms and has decided to hedge the currency risk of this account payable. The
following information has been provided by the company’s bank:
Spot rate ($ per €):
Six months forward rate ($ per €):
1.998 ± 0.002
1.979 ± 0.004
Money market rates available to PKA Co:
One year euro interest rate:
One year dollar interest rate
Borrowing
6.1%
4.0%
Deposit
5.4%
3.5%
Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.
Required:
Prepared by Patrick Lui
P. 602
Copyright @ Kaplan Financial 2015
Premium Course Notes
(a)
(b)
(c)
(d)
[Session 11 & 12]
Identify the objectives of working capital management and discuss the conflict that may
arise between them.
(3 marks)
Calculate the cost of the current ordering policy and determine the saving that could be
made by using the economic order quantity model.
(7 marks)
Discuss ways in which PKA Co could improve the management of domestic accounts
receivable.
(7 marks)
Evaluate whether a money market hedge, a forward market hedge or a lead payment
should be used to hedge the foreign account payable.
(8 marks)
(25 marks)
(ACCA F9 Financial Management December 2007 Q4)
Question 3 – Pecking order theory, market value of bond, forward contract, money
market hedge and foreign currency derivatives
Three years ago Boluje Co built a factory in its home country costing $3·2 million. To finance
the construction of the factory, Boluje Co issued peso-denominated bonds in a foreign country
whose currency is the peso. Interest rates at the time in the foreign country were historically
low. The foreign bond issue raised 16 million pesos and the exchange rate at the time was
5·00 pesos/$.
Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each
year of 6·1%. The bonds will be redeemed in five years’ time at par. The current cost of debt
of peso-denominated bonds of similar risk is 7%.
In addition to domestic sales, Boluje Co exports goods to the foreign country and receives
payment for export sales in pesos. Approximately 40% of production is exported to the
foreign country.
The spot exchange rate is 6·00 pesos/$ and the 12-month forward exchange rate is 6·07
pesos/$. Boluje Co can borrow money on a short-term basis at 4% per year in its home
currency and it can deposit money at 5% per year in the foreign country where the foreign
bonds were issued. Taxation may be ignored in all calculation parts of this question.
Required:
(a)
Briefly explain the reasons why a company may choose to finance a new investment by
an issue of debt finance.
(7 marks)
Prepared by Patrick Lui
P. 603
Copyright @ Kaplan Financial 2015
Premium Course Notes
(b)
(c)
(d)
[Session 11 & 12]
Calculate the current total market value (in pesos) of the foreign bonds used to finance
the building of the new factory.
(4 marks)
Assume that Boluje Co has no surplus cash at the present time:
(i) Explain and illustrate how a money market hedge could protect Boluje Co against
exchange rate risk in relation to the dollar cost of the interest payment to be made
in one year’s time on its foreign bonds.
(4 marks)
(ii) Compare the relative costs of a money market hedge and a forward market hedge.
(2 marks)
Describe other methods, including derivatives, that Boluje Co could use to hedge
against exchange rate risk.
(8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2008 Q4)
Question 4 – Rights issue, EPS, shareholders’ wealth, transaction risk, translation risk,
forward contracts and money market hedge
NG Co has exported products to Europe for several years and has an established market
presence there. It now plans to increase its market share through investing in a storage,
packing and distribution network. The investment will cost €13 million and is to be financed
by equal amounts of equity and debt. The return in euros before interest and taxation on the
total amount invested is forecast to be 20% per year.
The debt finance will be provided by a €6·5 million bond issue on a large European stock
market. The interest rate on the bond issue is 8% per year, with interest being payable in euros
on a six-monthly basis.
The equity finance will be raised in dollars by a rights issue in the home country of NG Co.
Issue costs for the rights issue will be $312,000. The rights issue price will be at a 17%
discount to the current share price. The current share price of NG Co is $4·00 per share and
the market capitalisation of the company is $100 million.
NG Co pays taxation in its home country at a rate of 30% per year. The currency of its home
country is the dollar. The current price/earnings ratio of the company, which is not expected to
change as a result of the proposed investment, is 10 times.
The spot exchange rate is 1·3000 €/$. All European customers pay on a credit basis in euros.
Required:
Prepared by Patrick Lui
P. 604
Copyright @ Kaplan Financial 2015
Premium Course Notes
[Session 11 & 12]
(a)
Calculate the theoretical ex rights price per share after the rights issue.
(b)
Evaluate the effect of the European investment on:
(i) the earnings per share of NG Co; and
(ii) the wealth of the shareholders of NG Co.
Assume that the current spot rate and earnings from existing operations are both
constant.
(9 marks)
Explain the difference between transaction risk and translation risk, illustrating your
answer using the information provided.
(4 marks)
The six-month forward rate is 1·2876 €/$ and the twelve-month forward rate is 1·2752
€/$. NG Co can earn 2·8% per year on short-term euro deposits and can borrow
short-term in dollars at 5·3% per year.
(c)
(d)
(4 marks)
Identify and briefly discuss exchange rate hedging methods that could be used by NG
Co. Provide calculations that illustrate TWO of the hedging methods that you have
identified.
(8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2009 Q3)
Question 5 – IRP, PPP and foreign currency risk management
ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several
years ago when peso interest rates were relatively cheap compared to dollar interest rates.
Economic difficulties have now increased peso interest rates while dollar interest rates have
remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months’ time.
The following information is available.
Spot rate:
Six month forward rate
Per $
pesos 12.500 – pesos 12.582
pesos 12.805 – pesos 12.889
Interest rates that can be used by ZPS Co:
Peso interest rates
Dollar interest rates
Borrow
10.0% per year
4.5% per year
Deposit
7.5% per year
3.5% per year
Required:
Prepared by Patrick Lui
P. 605
Copyright @ Kaplan Financial 2015
Premium Course Notes
(a)
(b)
[Session 11 & 12]
Explain briefly the relationships between;
(i) exchange rates and interest rates;
(ii) exchange rates and inflation rates.
(5 marks)
Calculate whether a forward market hedge or a money market hedge should be used to
hedge the interest payment of 5 million pesos in six months’ time. Assume that ZPS Co
would need to borrow any cash it uses in hedging exchange rate risk.
(6 marks)
(ACCA F9 Financial Management June 2011 Q4a)
Prepared by Patrick Lui
P. 606
Copyright @ Kaplan Financial 2015