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32 Cards in this Set
- Front
- Back
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Benefits of Currency Derivatives
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Achieve payoffs that would not be possible without derivatives
Hedge risks Make markets more efficient Reduce volatility of stock and earnings Reduce tax liabilities |
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Benefits of Currency Derivatives
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Achieve payoffs that would not be possible without derivatives
Hedge risks Make markets more efficient Reduce volatility of stock and earnings Reduce tax liabilities |
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Foreign Currency Future
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Alternative to a forward and specifies delivery at a pre specified price, quantity, and time
Traded on International monetary market at CMS and is similar to futures for cattle, lumber etc. Contracts are standardized and then traded on exchange (different then forward) |
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Foreign Currency Future
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Alternative to a forward and specifies delivery at a pre specified price, quantity, and time
Traded on International monetary market at CMS and is similar to futures for cattle, lumber etc. Contracts are standardized and then traded on exchange (different then forward) |
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Future vs. Forward contract
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Futures are standardized in size while forwards are customizable
Futures trade on exchange while forwards are traded between banks and firms Futures are marked to market on a daily basis Futures are rarely settled while forwards almost always are |
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Future vs. Forward contract
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Futures are standardized in size while forwards are customizable
Futures trade on exchange while forwards are traded between banks and firms Futures are marked to market on a daily basis Futures are rarely settled while forwards almost always are |
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Foreign currency Options
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Call-right to buy
Put-right to sell Buyer (holder) and seller (writer) Every options has 3 elements: strike price, premium (price of option), and spot exchange rate |
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Foreign currency Options
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Call-right to buy
Put-right to sell Buyer (holder) and seller (writer) Every options has 3 elements: strike price, premium (price of option), and spot exchange rate |
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How speculators profit
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Spot market-think currency will appreciate in future
Forward market-spot price at current date will differ from spot price at future date Options-extensive differences in risk patterns produced depending upon purchase or sale of put or call |
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Buyer of call option
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At all spot rates above strike price the buyer profits (less the premium)
Buyer would not exercise option below strike price because they could buy the currency for cheaper on the spot market |
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Writer of call
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What the buyer gains, the writer loses
Maximum writer can gain is limited to the premium Naked-not owning currency before writing option the loss is unlimited |
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Buyer of Put
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If strike price is above spot rate buyer will not exercise
Anything below spot rate, the buyer will make that difference Buyer cannot lose more than the premium paid up front |
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Writer of Put
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Any price below the exercise the writer will lose minus the premium
Anything above strike price and writer will at the maximum gain the premium |
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Largest interest rate risk
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Debt service
Holdings of interest sensitive securities (assets of firm so even more sensitive because it represents earnings) |
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Credit risk v. repricing risk
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Credit Risk-borrower's credit worthiness at time of renewing credit is reclassified by lender resulting in changed fees, interest rates, or denial of credit
Repricing Risk-risk of changes in interest rates charged at the time of of financial contracts rate is reset |
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Managing interest rate risk
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Deals with managing existing or anticipated cash flow exposures of firm
Firm must take a view on future interest rate moves before hedging BUT interest rate movements are more stable than FX movements |
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Ways of managing interest rate risk
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1. Refinancing
2. Forward rate agreements 3. Interest rate futures 4. Interest Rate swaps |
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Forward Rate Agreements
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Right to buy or sell interest rate payments on given principal
Seller pays buyer increased interest rate difference and vice versa Popular amongst nonfinancial firms because of their liquidity on the market Most common types are Eurodollar futures and US treasury bond futures |
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Swaps
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Agreement to swap or exchange series of future cash flows (normally floating rate interest payments)
Trading fixed rate for floating rate interest payments is an interest rate swap (largest financial derivative in world) Swapping currencies of debts service obligations is a currency swap |
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Foreign Exchange Exposure
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Measure of firm's profitability, net cash flow, and market value to change due to change in exchange rates
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Transaction, Translation, and Operating Exposure
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Transaction-Impact of settling outstanding obligations entered into before change in exchange rates (contractual obligations)
Translation- Changes in reported owner's equity due to exchange rate change Operating-Change in expected future cash flows or present value of firm due to exchange rate change (not contracted for yet) |
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Why hedge?
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Firms have cash flows that are subject to exchange rate, interest, and commodity price changes
Taking a position that will rise in value if underlying asset falls in value While hedging protects from a loss it also limits gains |
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Arguement for hedging
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Reduction in risk of future cash flows increases planning abiliity of management
Reduction in risk of future cash flows protects firms value from falling below a certain level (financial distress) Management knows firm better than shareholder and can protect itself better than an individual can against currency rate changes |
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Managing transaction exposure
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Managed by contractual, operating, and financial hedges
Contractual hedges use the money market, forward, and options markets Operating and financial-risk sharing agreements, leads and lags in payment terms, and swaps |
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Natural Hedge v. Financial hedge
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Natural-Offsetting operational cash flow (payable) arising from doing business
Financial-an offsetting debt obligation or interest rate swap |
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Uncovered Forward position
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Buyer does not have funds to cover forward now and is uncovered or open (taking chance on future spot rate)
Once funds are collected they are then covered |
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Money Market hedge
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Firm borrows in one currency and exchanges proceeds in another
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Attributes of Operating Exposure
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Requires forecasting all firm's individual transaction exposures
Operating exposure is far more important for long run health of business than transaction and translation exposure but is the most subjective Managing operating exposure falls on management because you must determine strategies Management must try to anticipate and influence effect of unexpected future exchange rate changes rather than hoping for the best Options for doing this include diversifying financing base and changing the firm's operating and financing policies Domestic firms cannot act like an MNE can when managing operational exposure |
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Integrated Foreign Entity vs. Self sustaining
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Integrated-operates as extension of partent company with CFs that are highly interrelated
Self sustaining-operates in local economic environment, independent from parent company |
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Functional Currency
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Dominant currency that firm uses in day to day operations
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Current rate Translation
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Current rate-Assets and liabilities are translated at current exchange rate and income statement items on days they were accrued
Translation gains or losses are recorded on Balance sheet under Cumulative translation adjustment Biggest advantage of current rate method is that losses do not pass through income statement which reduces variability of earnings |
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Temporal Rate Translation
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Specific assets are translated at exchange rates consistent with the timing of the item’s creation
Gains or losses are recored on income statement |
