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Foreign Currency RiskPart 2

Mark Fielding-Pritchard

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3 Types of Risk

Transaction- the risk we don’t receive as much money as we expected or we have to pay more

Translation risk- The value of our balance sheet on translation to the operating currency falls- covenants

Economic risk- positive NPV projects become negative

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Transaction Risk

Forwards Futures Options Money Markets Swaps

}Covered in part 1

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Information

Marko is a UK company. Today is 1/1/16, Marko is due to receive US$937500

on 30/6/16 Biggo Bank is offering

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Biggo BankOffers to it’s clients on 1/1/16

Forward

Spot $/£ 1.7982- 1.8010

6 month forward $/£ 1.7835 - .1.7861

Options £62500

Calls Puts

March June March June

1.80 1.96 3 3.17 5.34

1.78 2.91 3.84 2.12 4.20

Futures £62500

March 1.7782

June 1.7492

Money Market Deposits $

3 Month 4- 6%

6 Month 4.4- 5.8%

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Options

Calls Puts US European OTC Premium payments

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Options

On 1 January set up hedge Pay premium on 1 January Close out on 30 June There will be exchange of currency on 30 June

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1 January Hedge

1. Calls or puts

2. Which month

3. How many

4. Premium cost

1) Marko will buy fx, exchange is in Chicago, so calls

2) June (even if September exists)

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Option Hedging Strategy

Strike Price Premium Cost Net

1.80 3 1.83

1.78 3.84 1.8184

So strike of 1.78 gives us the best price

Therefore we want ((937500/1.78)/62500))= 8Notice we round down with optionsPremium cost is 3.84c x 62500 x 8= $19200Payable on 1 January 19200/ 1.7982= £10677

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Options On 30 June the spot rate is $1.75 so we wouldn’t exercise the

options

937500/1.75= $535714 minus premium = £525037

If you were to exchange them

$ £

62500x 8 x 1.78 = 8900000 500000

937500- 890000= 47500/1.75 27143

Premium (10677)

Net Receipt 483534

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Money Market Hedge

Use bank accounts to create a liability if an asset exists or vice versa

We are due in 6 months to receive dollars. We take out a dollar loan, translate to cash now. Loan will be redeemed with dollars received in future

We are due in 6 months to pay dollars. Put on deposit dollars now

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Money Market Hedge Marko is due to receive US$937500 on 30/6/16

So we set up a liability. We borrow dollars now and translate those dollars to pounds on 1/1

We cannot borrow 937500 because the loan will be due interest over the next 6 months so we borrow net of interest

Money Market Deposits

3 Month 4- 6%

6 Month 4.4- 5.8%

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Money Market Hedge

We borrow at the 6 month rate of 5.8% Interest is quoted at annual nominal so interest rate = 2.9% Loan x 1.029 = 937500, therefore we borrow $911079 on 1

January That will grow to $937500 over 6 months 911079/1.8010 = £505874 This money is received on 1 January. Therefore it is part of

the technique that we recognise time value of money. Pound investing rate for 6 months is 2.4% Therefore we get 505874 x 1.024= £518015

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Summary How Many £s Do We Receive

Forward 524887

Future 535971

Option 525037

Money Market Hedge 518015