RISK MANAGEMENT

Exchange Risks System

The following exchange risk system often applies:

Fixed Exchange Rate System

This is where a country decides to peg its exchange rate against one strong international currency or
a basket of international currencies. The exchange rate of the local currency is then determined by
the movement of the international currencies.

Floating Exchange Rate System

This is where a country decides to allow its exchange rate to be determined by demand and supply.

Managed Exchange Rate System

This is where a country initially allows its exchange rate to flow freely but the central bank intervenes
anytime the currency gets too strong or too weak.

FOREX RISKS

There are three (3) main types of foreign exchange risks:

1. Transaction Risk

This is the risk of adverse changes in exchange rates between transaction and settlement date.

2. Economic Risk

The long-term effect of exchange gains and losses on the market value of an entity is referred to as
Economic Risk.

3. Translation Risk

This is the effect of exchange gains and losses on the translation of a foreign subsidiary( ies) for
consolidation purposes.
Ways of Minimizing Risks

Managing Transaction Risk

i. Invoice in home currency

ii. The matching system can also be used where sales and purchases are made in the same
currency

iii. Hedging using derivatives

iv. Deciding to do nothing

v. Leading and lagging

Managing Economic Risk

The only way of minimizing this risk is to diversify into different geographical area.

Predicting future exchange rate

Exchange rates between two countries can be predicted using:

i) The Purchasing Power Parity Theory (“PPPT”) – This theory predicts exchange rates by using
the inflation differential between two countries. This theory advocates that the country with the
highest rate of inflation will see its currency depreciate. The PPPT predicts future exchange rates
using the formula below:

FR = Spot rate x 1 + If

1 + Ih

Where:

FR = Future exchange rate

Spot rate = Exchange rate now

If = Inflation of foreign country

Ih = Inflation of home country

i) The Interest Rate Parity Theory (“IRPT”) – This theory predicts future exchange rate by
using the interest rate differential between the two countries. The IRPT calculates future
exchange rate by using a similar formula to the PPPT.

FR = Spt rate x 1 + If

1 + Ih

Where:

FR = Future exchange rate

Spot rate = Exchange rate now

If = Interest rate of foreign country

Ih = Interest rate of home country

Example 48

The spot rate between the pound and the dollar is £1:$1.638. Inflation in the UK is 6% and 4% in the
USA. Calculate the exchange rate between the dollar and the pound in 4 month time.

Note: Interest rate and inflation rate are always quoted per annum.

Hedging using Derivatives

If the currency is dividing, banks buy high and sell low

If the currency is multiplying, banks buy low and sell high

Example 49

The exchange rate between the dollar and the pound is now $/£ 1.2342 – 1.2432. A UK company
wishes to purchase $250,000, calculate its equivalent in Pounds.

Example 50

Spot – $/€ = 1.1234 – 1.1342. A German company wishes to sell $120,000, find its Euro equivalent.

Example 51

Spot – $/SF = 0.9230 – 0.9342. A US company wishes to purchase SF125,000, calculate its equivalent
in dollars.
Example 52

Spot – €/$ = 1.2342 – 1.2422. A French company wishes to sell $80,000. Calculate its equivalent in
Euros.

Example 53

An Australian dollar per Euro is 0.2382 – 0.2532. An Australian company wishes to purchase 50,000
Euros, calculate its equivalent.

Hedging using Forward Contract

This is where an entity agrees to buy or sell a foreign currency in future at a pre-determined
exchange rate usually called forward rate.

Advantages

i. The amount to be paid or received is certain

ii. Initial cost is almost negligible

Disadvantages

i. It is a fixed contract that needs to be settled at all costs

ii. Forward contract exist in few currencies only i.e. Pounds (£), Dollars ($), SWF, Yen (¥),
and Euro (€)

iii. A loss can be made when compared with the open market
Example 54

Spot rate $/£ - 1.4328 – 1.4352

3 months forward $/£ - 1.4532 – 1.4568

6 months forward $/£ - 1.4592 – 1.4601

A UK company have undertaken the following transactions:

i. The company has obtained a loan from the USA. The nominal value of the loan is $5.5m
and carries an interest rate of 15% payable every six (6) months.

Note: If the payment is not in Pounds, then there is exposure which needs to be hedged.

ii. The UK company have invoiced an American company an amount of $420,000 receivable
in 3 months’ time.

iii. The UK company have also been invoiced by a French company by an amount of $30,000
payable in 6-months’ time. Required:

Show the amount to be received or paid by the UK company if it hedges using the forward contract.

Money Market Hedging

Hedging Receipts

Step 1: Borrow the present value of the overseas currency to be received using the borrowing rate of
that currency as a discount factor (principal – interest)
Step 2: Sell the present value of the amount borrowed back to the bank and collect local currency

Step 3: Deposit the local currency into a local currency account and collect interest over the period

Hedging Payments

Step 1: Calculate the present value of the overseas currency needed to make the payment using the
deposit rate of the overseas currency as a discount factor

Step 2: Purchase the present value of the overseas currency now using a loan in the local currency

Step 3: The amount borrowed to purchase the foreign currency plus interest will be the total
amount to settle the payment

Note: Loan + interest will be the amount incurred in settling the overseas currency

Example 55

Spot rate $/£ - 1.4328 – 1.4352

3 months forward $/£ - 1.4532 – 1.4568

6 months forward $/£ - 1.4592 – 1.4601

Money market rates UK£ - 5% - 8%

US$ - 7% - 10%

Note: The smaller percentage relates to when deposits are made and the higher percentage relates
to when borrowing – as banks would always want to benefit

A UK company have undertaken the following transactions:

i. The company has obtained a loan from the USA. The nominal value of the loan is $5.5m
and carries an interest rate of 15% payable every six (6) months.

Note: If the payment is not in Pounds, then there is exposure which needs to be hedged.

ii. The UK company have invoiced an American company an amount of $420,000 receivable
in 3 months’ time.

iii. The UK company have also been invoiced by a French company by an amount of $30,000
payable in 6-months’ time. Required:

Show the amount to be received or paid by the UK company if it hedges using the forward contract.
OBJECTIVES

1. 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. Translation risk

B. Economic risk

C. Transaction risk

D. Interest rate risk

2. The home currency of ACB is the dollar ($) and it trades with a company in a foreign country
whose home currency is the Dinar. The following information is available.

Home country Foreign country

Spot rate 20.00 Dinar per $

Interest rate 3% per year 7% per year

Inflation rate 2% per year 5% per year

What is the six-month forward exchange rate?

A. 20.39 Dinar per $

B. 20.30 Dinar per $

C. 20.59 Dinar per $

D. 20. 78 Dinar per $

3. What is the impact of a fall in a country’s exchange rate?

i. Export will be given a stimulus

ii. The rate of domestic inflation will rise

A. I

B. II

C. I, II

D. Neither I nor II
Interest Rate Risk

The Yield Curve

The yield curve shows the relationship between the return that a debt holder would seek and the
maturity of the investment.

Normal Yield Curve: The normal yield curve slopes upwards indicating that the return that an
investor would seek increases with increase maturity period.
The longer the money is held, the riskier it becomes so investors would demand a higher return.

Return

Maturity

Inverted Yield Curve: This is a yield curve which slopes downwards indicating that an investor
would seek a higher return in the short-term than in the long-term. This usually happens in periods
of recession.
Investors demand higher return in short term than in the longer term.

Return

Maturity

The Flat Yield Curve: This shows that an investor’s required rate of return in the short term and
long term are almost the same. This usually occurs when an economy is returning from recession.

Return

Maturity
Theories explaining the shape of the Yield Curve

1. Liquidity Preference Theory

This theory advocates that the yield curve slopes upwards because an investor would be denied of
cash over a long period of time and hence require a higher/bigger return to compensate for the
opportunities lost in investing somewhere else.

2. Expectation Theory

This theory advocates that an investor will seek a higher rate of return with time due to the
expectation of an increase in inflation with time. The higher return is to compensate for the increase
in inflation.

3. Market Segmentation Theory

This theory argues that the shape of the yield curve will depend on the segment in which the investor
deals. An investor can either operate in the short or long term market and the characteristics of each
market are different. This will result in the shape of the yield curve being different in each market.

Hedging of Interest Rate Risk

Forward Rate Agreements (FRAs)

An FRA allows an entity to convert a variable rate into a fixed rate.

Example 56

D. Plc wishes to borrow $8.5m in 4-months time over a 3-months period. D Plc can only borrow at a
variable rate and wish to hedge this exposure using FRAs. The follow FRAs are available:

3v7 - 6% - 8%

4v7 - 7% - 9%

4v6 - 8% - 10%

Illustrate the outcome of the hedge if:

i. Actual market interest is 11%

ii. Actual market interest is 6%

OBJECTIVES
 1. In relation to hedging interest rate risk, which of the following statements is correct?

A. The flexible nature of interest rate futures means that they can always be matched with a
specific interest rate exposure.

B. Interest rate options carry an obligation to the holder to complete the contact at maturity

C. Forward rate agreements are the interest rate equivalent of forwards exchange contracts

D. Matching is where a balance is maintained between fixed rate and floating rate debt.

Efficient market hypostases

This a theory that talks about the nature of information used by investors with respect to the
purchase of shares in the stock market. The nature of information determining the value of shares in
a stock market ranks stock market in to three categories

i. weak form: This is a stock market that its share price is determine by information that
are publicly available to all investors

ii. Semi-strong: This is a stock market that its share price is determining by publicly
available information and information that have just be made available

iii. Strong form: This is a stock market that its share price is determining by information that
are publicly available, just be made available and information which the public have not
been made aware (insider information)

If a stock market is weak, an investor can easily predict the movement of share price and hence
makes gains if the investor is aware of information that have just be made available and insider
information.

If the market is semi-strong efficient an investor can only make a gain using information if the
investor is aware of insider information

if the market is strongly efficient, an investor cannot use information to make a gain.