8/13/2019 ExAns-Ch19

1/16

Chapter 19 Foreign Exchange Risk

Answer Test your understanding 1

7035.1$

%41

%31

72.1

1

1

=

+

+=

S

S

Answer Test your understanding 2

The exporter will be selling his dollars to the bank and the bank buys high at 1.455.

The exporter will there!ore re"ei#e 400000 & 1.455 '27431.

(. 1

8/13/2019 ExAns-Ch19

2/16

Examination Stye !uestions

Answer 1

)a*

Transaction risk

1. This is the risk arising on short"term #oreign currency transactionsthat the actua

income or cost +ay be di##erent #rom the income or cost expected when the

transa"tion was agreed. ,or exa+ple a sale worth $10000 when the ex"hange rate is

$1.7- per ' has an expe"ted sterling #alue is $557. /! the dollar has depre"iated against

sterling to $1.4 per ' when the transa"tion is settled the sterling re"eipt will ha#e

!allen to $5435.

2. Transa"tion risk there!ore a##ects cash #ows and !or this reason most companies

choose to hedgeor prote"t the+sel#es against transaction risk.

$2 marks%

Transation risk

1. This risk arises on consoidation o# #inancia statementsprior to reporting !inan"ial

results and !or this reason is also known as a""ounting exposure. onsider an asset

worth 14 +illion a"uired when the ex"hange rate was 1.4 per $. ne year later

when !inan"ial state+ents are being prepared the ex"hange rate has +o#ed to 1.5 per $

and the balan"e sheet #alue o! the asset has "hanged !ro+ $10 +illion to $-.3 +illion

resulting an unrealised )paper* loss o! $0.7 +illion.

2. Translation risk does not in&o&e cash #ows and so does not directy a##ect

sharehoder weath. owe#er in&estor perception may 'e a##ected 'y the changing

&aues o# assets and ia'iities and so a "o+pany may choose to hedge transation

risk through !or exa+ple matching the currency o# assets and ia'iities)eg a euro

deno+inated asset !inan"ed by a eurodeno+inated loan*.

$2 marks%

Economic risk

1. Transaction risk is seen as the short"term mani#estation o# economic risk whi"h"ould be de#ined as the risk o# the present &aue o# a company(s expected #uture

cash #ows 'eing a##ected 'y exchange rate mo&ements o&er time.

2. /t is di##icut to measure economic risk although its e!!e"ts "an be des"ribed and it is

aso di##icut to hedgeagainst it.

$2 marks%

)b*

)iscussion o# purchasing power parity*

1. The aw o# one price suggests that identica goods seing in di##erent countries

(. 2

8/13/2019 ExAns-Ch19

3/16

shoud se at the same price and that exchange rates reate these identica &aues.

2. This leads on to purchasing power parity theory whi"h suggests that changes in

exchange rates o&er time must re#ect reati&e changes in in#ation 'etween two

countries.

3. /! pur"hasing power parity holds true the expe"ted spot rate )6!* "an be !ore"ast !ro+

the "urrent spot rate )60* by +ultiplying by the ratio o! expe"ted in!lation rates ))1 i !*8

)1 i9:** in the two "ounties being "onsidered. /n !or+ula !or+; 6 ! 60)1 i!*8 )1

i9:*.

$+ , marks%

)iscussion o# interest rate parity*

4. This relationship has been !ound to hold in the longerter+ rather than the shorterter+

and so tends to be used !or !ore"asting ex"hange rates se#eral years in the !uture rather

than !or periods o! less than one year. ,or shorter periods #orward rates can 'e

cacuated using interest rate parity theory whi"h suggests that changes in exchange

rates re#ect di##erences 'etween interest rates 'etween countries.

$1 2 marks%

)"*

Forward market e&auation

8/13/2019 ExAns-Ch19

4/16

expe"ted a!ter 3 +onths. $1 mark%

)e*

1. B currency #utures contractis a standardised contract!or the 'uying or seing o# a

speci#ied .uantity o! !oreign "urren"y. /t is traded on a #utures exchange and

settement takes pace in three"monthy cycesending in Car"h Dune 6epte+ber and

@e"e+ber ie a "o+pany "an buy or sell 6epte+ber !utures @e"e+ber !utures and so

on.

2. The price o! a "urren"y !utures "ontra"t is the exchange rate #or the currencies

speci#ied in the contract.

$1 2 marks%

3. Ehen a "urren"y !utures "ontra"t is bought or sold the 'uyer or seer is re.uired to

deposit a sum o# moneywith the ex"hange caed initia margin.

4. /! osses are incurred as ex"hange rates and hen"e the pri"es o! "urren"y !utures

"ontra"ts "hange the 'uyer or seer may 'e caed on to deposit additiona #unds

)&ariation margin* with the ex"hange. ?ually pro#its are credited to the margin

account on a daiy 'asisas the "ontra"t is Fmarked to marketG.

$1 2 marks%

5. Cost currency #utures contracts are cosed out 'e#ore their settement dates 'y

undertaking the opposite transactionto the initial !utures transa"tion ie i! buying

"urren"y !utures was the initial transa"tion it is "losed out by selling "urren"y !utures. B

gain +ade on the !utures transa"tions will o!!set a loss +ade on the "urren"y +arkets

and #i"e #ersa.

$1 2 marks%

.

8/13/2019 ExAns-Ch19

5/16

ACCA 4arking Scheme

Answer 2

)a*

The o'5ecti&es o# working capita management are pro#ita'iity and i.uidity. The

o'5ecti&e o# pro#ita'iity supports the primary #inancia management o'5ecti&e whi"h is

sharehoder weath maximisation. The o'5ecti&e o# i.uidity ensures that "o+panies are

a'e to meet their ia'iities as they #a due and thus re+ain in business.

$1 mark%

owe#er #unds hed in the #orm o# cash do not earn a return while near"i.uid assets

su"h as shortter+ in#est+ents earn ony a sma return. Ceeting the o'5ecti&e o# i.uidity

withere!ore con#ict with the o'5ecti&e o# pro#ita'iity whi"h is +et by in&esting o&er the

onger termin order to achie&e higher returns.

6ood working capita management there!ore needs to achie&e a 'aance between theobHe"ti#es o! pro!itability and liuidity i! shareholder wealth is to be +axi+ised.

$2 marks%

)b*

ost o! "urrent ordering poli"y o! (:B o

rdering "ost 250 x )250008100000* 153 per year

Eeekly de+and 25000850 12500 units per week

onsu+ption during 2 weeks lead ti+e 12500 x 2 25000 units

Iu!!er sto"k reorder le#el less usage during lead ti+e 35000 = 25000 10000 units

B#erage sto"k held during the year 10000 )10000082* 0000 units

(. 5

8/13/2019 ExAns-Ch19

6/16

olding "ost 0000 x 0J50 30000 per year

Total "ost ordering "ost plus holding "ost 153 30000 3153 per year

$- marks%

?"ono+i" order uantity ))2 x 250 x 25000*80J5*182 25000 units

8/13/2019 ExAns-Ch19

7/16

re"ei#able to be settled "loser to the agreed date.

2. Assuming that the credit period o##ered 'y 8A Co is in ine with that o# its

competitors the "o+pany should deter+ine whether they too are su!!ering !ro+ si+ilar

di!!i"ulties with late payers. /! they are not (:B o should deter+ine in what way its

own ter+s di!!er !ro+ those o! its "o+petitors and "onsider whether o!!ering the sa+e

trade ter+s would ha#e an i+pa"t on its a""ounts re"ei#able. ,or exa+ple its

competitorsmay o##er a discount #or eary settementwhie 8A Co does notand

introdu"ing a dis"ount +ay a"hie#e the desired redu"tion in the a#erage a""ounts

re"ei#able period.

3. /! its competitors are experiencing a simiar accounts recei&a'e pro'em 8A Co

coud take the initiati&e 'y introducing more #a&oura'e eary settement termsand

perhaps generate in"reased business as well as redu"ing the a#erage a""ounts re"ei#able

period.

4. (:B o shoud aso in&estigate the e##iciency with which accounts recei&a'e are

managed. Bre state+ents sent regularly to "usto+ersL /s an aged a""ounts re"ei#able

analysis produ"ed at the end o! ea"h +onthL Bre outstanding a""ounts re"ei#able

"onta"ted regularly to en"ourage pay+entL /s "redit denied to any o#erdue a""ounts

seeking !urther businessL /s interest "harged on o#erdue a""ountsL These are all +atters

that "ould be in"luded by (:B o in a re#ised poli"y on a""ounts re"ei#able

+anage+ent.

$- + marks%

)d*

4oney market hedge

(:B o should pla"e su!!i"ient dollars on deposit now so that with a""u+ulated interest the

six+onth liability o! $250000 "an be +et. 6in"e the "o+pany has no surplus "ash at the

present ti+e the "ost o! these dollars +ust be +et by a shortter+ euro loan.

6ix+onth dollar deposit rate 3J582 1J75%

urrent spot selling rate 1J-- = 0J002 $1J-- per euro

6ix+onth euro borrowing rate J182 3J05%

@ollars deposited now 25000081J0175 $245700

ost o! these dollars at spot 24570081J-- 1230- euros

?uro #alue o! loan in six +onthsG ti+e 1230- x 1J0305 1250 euros

$- marks%

(. 7

8/13/2019 ExAns-Ch19

8/16

Forward market hedge

6ix +onths !orward selling rate 1J-7- = 0J004 $1J-75 per euro

?uro "ost using !orward +arket hedge 25000081J-75 1252 euros

$2 marks%

:ead payment

6in"e the dollar is appre"iating against the euro a lead pay+ent +ay be worthwhile.

?uro "ost now 25000081J-- 125251 euros

This "ost +ust be +et by a shortter+ loan at a six+onth interest rate o! 3J05%

?uro #alue o! loan in six +onthsG ti+e 125251 x 1J0305 12-071 euros

$2 marks%

E&auation o# hedges

The relati#e "osts o! the three hedges "an be "o+pared sin"e they ha#e been re!eren"ed to the

sa+e point in ti+e i.e. six +onths in the !uture. The most expensi&e hedge is the ead

payment while the cheapest is the #orward market hedge. 9sing the !orward +arket to

hedge the a""ount payable "urren"y risk "an there!ore be recommended. $1 mark%

ACCA 4arking Scheme

Answer -

)a*

1. 8ecking order theory suggeststhat "o+panies ha#e a pre!erred order in whi"h they

seek to raise #inance 'eginning with retained earnings. The ad#antages o! using

retained earnings are that issue "osts are a#oided by using the+ the de"ision to use

the+ "an be +ade without re!eren"e to a third party and using the+ does not bring

additional obligations to "onsider the needs o! !inan"e pro#iders.

(.

8/13/2019 ExAns-Ch19

9/16

2. n"e a#ailable retained earnings ha#e been allo"ated to appropriate uses within a

"o+pany its next pre!eren"e will be !or debt. ;ne reason!or "hoosing to !inan"e a new

in#est+ent by an issue o! debt !inan"e there!ore is that insu##icient retained earnings

are a&aia'e and the in#esting "o+pany pre#ers issuing de't #inance to issuing

e.uity #inance.

3. )e't #inance+ay also be pre#erredwhen a "o+pany has not yet reached its optima

capita structureand it is +ainly !inan"ed by euity whi"h is expensi#e "o+pared to

debt. /ssuing debt here will ead to a reduction in the

8/13/2019 ExAns-Ch19

10/16

+ade. $2 marks%

=ustration o# money market hedge

(eso deposit reuired -70008 1J05 -2-524 pesos

@ollar eui#alent at spot -2-5248 $154-21

@ollar "ost in one yearGs ti+e 154-21 x 1J04 $1111

$2 marks%

)"*)ii*

ost o! !orward +arket hedge -70008J07 $107-0

The !orward +arket hedge is slightly "heaper

$2 marks%

)d*

1. IoluHe re"ei#es peso in"o+e !ro+ its export sales and +akes annual pesodeno+inated

interest pay+ents to bondholders. /t "ould consider opening a peso account in the

o&erseas countryand using this as a natura hedgeagainst peso ex"hange rate risk.

$1 2 marks%

2. IoluHe o "ould "onsider using ead payments to sette #oreign currency ia'iities.

This would not be bene!i"ial as !ar as peso deno+inated liabilities are "on"erned as the

peso is depre"iating against the dollar. /t is inad#isable to lag pay+ents to !oreign

suppliers sin"e this would brea"h sales agree+ents and lead to loss o! goodwill.

,oreign "urren"y deri#ati#es a#ailable to IoluHe o "ould in"lude "urren"y !utures "urren"y

options and "urren"y swaps.

-> Currency #utures

urren"y !utures are standardised contracts !or the purchase or saeo! a speci#ied

.uantity o# a #oreign currency.

These "ontra"ts are setted on a .uartery cyce but a !utures position can 'e cosed

out any timeby undertaking the opposite transa"tion to the one that opened the !utures

position. urren"y !utures pro&ide a hedge that theoreticay eiminates 'oth upside and

downside risk 'y e##ecti&ey ocking the hoder into a gi&en exchange rate sin"e any

gains in the currency #utures+arket are o##set 'y exchange rate ossesin the cash

market and #i"e #ersa.

/n pra"ti"e howe#er mo&ements in the two markets are not per#ecty correatedand

'asis risk existsi# maturities are not per#ecty matched.

=mper#ect hedges"an also arisei! the standardised si?eo! "urren"y !utures does not

match the exchange rate exposureo! the hedging "o+pany.

=nitia margin must 'e pro&ided when a "urren"y !utures position is opened and

(. 10

8/13/2019 ExAns-Ch19

11/16

&ariation margin+ay also be subseuently reuired.

IoluHe o "ould use "urren"y !utures to hedge both its regular !oreign "urren"y re"eipts

and its annual interest pay+ent.

+> Currency options

urren"y options gi&e hoders the right 'ut not the o'igation to 'uy or se #oreign

currency.

;&er"the"counter )T* "urren"y options are taiored to indi&idua cient needs

while exchange"traded currency options are standardised in the sa+e way as

"urren"y !utures in ter+s o! ex"hange rate a+ount o! "urren"y exer"ise date and

settle+ent "y"le.

Bn ad&antage o# currency optionso#er "urren"y !utures is that "urren"y options do

not need to 'e exercisedi! it is disad&antageous #or the hoderto do so.

olders o! "urren"y options can take ad&antage o# #a&oura'e exchange rate

mo&ementsin the "ash +arket and aow their options to apse.

The initia #ee paid!or the options will still ha#e been in"urred howe#er.

,> Currency swaps

urren"y swaps are appropriate !or hedging exchange rate risk o&er a onger period

o# timethan "urren"y !utures or "urren"y options.

B currency swap is an interest rate swap where the debt positions o! the

"ounterparties and the asso"iated interest pay+ents are in di!!erent "urren"ies.

B "urren"y swap 'egins with an exchange o# principa although this may 'e a

notiona exchangerather than a physi"al ex"hange.

@uring the li!e o! the swap agree+ent the counterparties undertake to ser&ice each

others( #oreign currency interest payments. Bt the end o! the swap the initial

ex"hange o! prin"ipal is re#ersed.

(. 11

8/13/2019 ExAns-Ch19

12/16

ACCA 4arking Scheme

Answer +

)a*

B+ount o! euity !inan"e to be in#ested in euros 13+82 J5 +illion

B+ount o! euity to be in#ested in dollars J5+81J3000 $5 +illion $1 mark%

The a+ount o! euity !inan"e to be raised in dollars 5+ 0J312+ $5J312+

>ights issue pri"e 4J00 x 0J3 $3J32 per share $1 mark%

8/13/2019 ExAns-Ch19

13/16

/n"rease in pro!it be!ore tax 100

Taxation 1.+ x 0.3 40

/n"rease in pro!it a!ter tax 1120

urrent pro!it a!ter tax 100+810 10000>e#ised pro!it a!ter tax 11120 $2%

Blternati#ely using euros;

000

/n"rease in pro!it be!ore interest and tax 13+ x 0.2 200

/n"rease in interest .5+ x 0.0 520

/n"rease in pro!it be!ore tax 200

Taxation 2.0+ x 0.3 24

/n"rease in pro!it a!ter tax 145

$000

/n"rease in dollar pro!it a!ter tax 1.45+81.300 1120

urrent pro!it a!ter tax 100+810 10000

>e#ised pro!it a!ter tax 11120

>e#ised ?(6 100 x 11J12+82J+ 41J "ents8share $1 mark%

)b*)ii*

?!!e"t on shareholder wealth

?xpe"ted share pri"e using (?> +ethod )41J x 10*8100 $4J1 per share $1 mark%

Comment on e##ect on sharehoder weath

This should be "o+pared to the theoreti"al ex rights pri"e per share in order to e#aluate any

"hange in shareholder wealth.

The in#est+ent produ"es a "apital gain o! 22 "ents per share )$4J1 = $3J-*

/n the absen"e o! any in!or+ation about di#idend pay+ents it appears that the in#est+ent

will in"rease the wealth o! shareholders.

$1 - marks%

)"*

Transaction risk

Transa"tion risk is ex"hange rate risk that arises as a resut o# short"term transactions.

Ie"ause it is short ter+ in nature it has a direct e##ect on cash #ows whi"h "an either

in"rease or de"rease depending on the mo&ement in exchange rates 'e#ore the settement

(. 13

8/13/2019 ExAns-Ch19

14/16

dates o# indi&idua short"term transactions.

$1 2 marks%

8/13/2019 ExAns-Ch19

15/16

interest pay+ent would be $203-0 )2000081J2752*.

$1 2 marks%

4oney market hedge

Bn alternati#e to an ,? is a +oney +arket hedge.

8/13/2019 ExAns-Ch19

16/16

ACCA 4arking Scheme

(. 1