ACCA Financial Management

Spot exchange rate = market exchange rate for buying/selling currency NOW

Forward exchange rate = market exchange rate for buying/selling currency at a specific date in the future (pre-set exchange rate (NO FORECAST))

a theoretical exchange rate that allows you to buy the same amount of goods & services in another country

the rates of currency conversion that aim to equalise the purchasing power of different currencies by eliminating differences in price levels between countries.

takes into consideration the expected difference in inflation Rate & Expected Change in spot rates

Correclation between Interest raqte & inflation rate

the exchange rate simply reflects the different cost of living in two countries.

long-run equilibrium rate

For example, if a representative basket of goods and services costs $1,700 in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1.

the future spot exchange rate is based on the current spot rate (the purchasing power of one currency relative to another) and the inflation rate differential between the two currencies (in other words, relative price changes).

S₁ = Expected spot exchange rate after one year

S₀ = Today's spot exchange rate

h_c = Variable currency (“foreign”) inflation rate (as a decimal)

h_b = Base currency (“domestic”) inflation rate

the forward exchange rate is based on the spot rate and the interest rate differential between the two currencies:

F₀ = Forward exchange rate

S₀ = Spot exchange rate

i_c = Variable currency interest rate

i_b = Base currency interest rate

PPP predicts the future spot rate, whereas IRP predicts the forward rate. Check the definitions in s.1.2 if necessary.

a record of all monetary transactions between a country and the rest of the world

Includes Current Account & Capital Account

net amount a country earns if it is in surplus or spends if it is in deficit. Its main component is the balance of trade, which is net earnings on exports minus payments for imports.

net change in ownership of foreign assets. It includes the foreign exchange market operations of a nation's central bank and loans and investments between the country and the rest of the world.

1. Translation Risk = if a company has foreign denominated assets/liabilities or foreign subsidiaries
   1. due to being presented at closing rate in financial statements, the amounts can fluctuate and create FX gain/losses
   2. NOT real CF but only created due to accounting
2. Economic Risk
   1. Risk that CF will be affected by long-term exchange rate movements
      1. Value of company = PV of fututre CF
   2. affects international competitiveness (import/export) & local competitiveness (no export)
   3. difficult to hedged
3. Transaction Risk
   1. short-term version of economic risk
   2. risk that exchange rates change between contract dates of export/import and the receipt/payment of foreign currency

Certainty of receipts & payments

• Invoicing in Domestic Currency = customer has transaction risk
• Leading / lagging
  • Leading = convert domestic currency in foreign currency early, if domestic currency is expected to fall
  • Lagging = delaying conversion and paying suppliers late ("lagging"), if the domestic currency is expected to appreciate
    • only leading reduces exposure to risk.
• Netting of sales/receivables and purchases/payables in foreign currency to only have net exposure on the difference
• Matching of assets/liabilities using foreign currency loans to finance overseas subsidiaries
• Matching of receipts and payments using a foreign currency bank account
• asset & liiability management = overseas subsidiaries borrow locally instead of receiving fiinance from the parent

• Forward exchange conctract
• money market hedge
• Currency option
• currency futures contract

A forward contract is a legally binding agreement to buy or sell:

• a specified quantity;
• of a specified currency;
• on an agreed future date ("delivery date");
• at an exchange rate fixed today.

• not bought but entered into (for derivatives, no initial transaction)
• no margin required (e.g no cash deposit)
• not traded but agreements between company & counterparty

Important:

physical delivery must occur. So, a company signing a forward contract to buy/sell foreign currency must physically exchange currency on the agreed date at the agreed rate, even if that rate has become unattractive compared to the spot rat

Euro/$ - 1.2022 - 1.208

= sell $ at a rate of E/$ 1.2022

= buy $ at a rate of E/$ 1.208

= aa technique to lock in the value of a foreign currency transaction in terms of the organisation's domestic currency using a combination of investing, borrowing and a spot currency exchange.

Suppose a UK company has dollar export earnings. A money market hedge could be set up as follows:

1. Borrow dollars today at the company's fixed-rate dollar borrowing rate, for repayment when the dollar earnings are due to be received. The intention is that the dollar earnings will repay this dollar loan.
2. Exchange these dollars into sterling at the current spot rate.
3. Invest the sterling received at the company's fixed rate sterling investment rate, to mature on the date the dollar earnings are due

Derivative

The purchaser of a currency option has the right, but not the obligation, to buy or sell:

• a specified quantity;
• of a specified currency;
• on or before a specified date (expiry date);
• at an exchange rate agreed today (exercise price/strike price).

The owner of the option can either:

• exercise their right; or
• allow it to lapse (i.e. not exercise it).

However, the owner of an option must pay for this flexibility. The cost of an option is known as its premium.

Call = Owner can buy the underlying asset

Put = owner can sell the underlying asset

European–style options can only be exercised on the expiry date.

American–style options can be exercised at any time until (i.e. on or before) the expiry date.

a standardised contract between buyer and seller, in which the buyer has a binding obligation to buy a fixed amount (the contract size) at a fixed price (the futures price) on a specified date (the delivery date) of some underlying asset via a recognised exchang

Contract & Contract size are standardyzed!!!

raded on a futures exchange and have various "delivery dates" (e.g. March, June, September and December).

A company can choose:

• whether to buy or sell futures; and
• which delivery date to use.

The difference between the futures price and the spot exchange rate is known as the basis in the futures contract. he basis in a futures contract will naturally amortise to zero by the contract's delivery date.

"closed out" before delivery.

no guarantee that the basis in the futures contract will be amortised at a linear rate. Therefore, the result of a futures hedge cannot be known in advance. This is known as basis risk

agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency.

difference between the amounts of interest-sensitive assets and liabilities (i.e. their market prices are vulnerable to changes in interest rates).

1. Negative gap − when rate-sensitive liabilities are greater than rate-sensitive assets.
2. Positive gap − when rate-sensitive assets are greater than rate-sensitive liabilities = when rates rise, a bank’s profits or revenues will likely rise. .

a risk if the variable interest rates are determined on different bases. For example, variable rates may be referenced to different benchmarks

• Smoothing = maintaining an appropriate balance between fixed-rate and floating-rate borrowings or deposits
• Matching = common interest rate for assets and liabilities

Forward rate agreements (FRAs) allow companies to fix, in advance, either a future borrowing rate or a future deposit rate, based on a notional principal amount over a given period.

FRAs are cash-settled, in advance at the start of the FRA term, based on the present value of the difference on settlement date between:

• the fixed contract rate; and
• the reference interest rate (e.g. SOFR).

A company plans to borrow $20m in three months for six months and wishes to pay 7% interest no matter what happens to interest rates during the next three months.

It can enter into an FRA with the bank at an agreed rate of 7% on a notional principal amount of $20m, starting in three months and lasting for six months. This is known as a 3-9 FRA because it begins in 3 months and ends after 9 months.

• If actual interest rates are higher than 7% in three months, the bank pays the company the difference between 7% and the actual rate (i.e. cash settlement is made at the start of the FRA period). The compensation would be calculated as the present value of the interest rate difference on a $20m six-month loan (discounted at the actual interest rate).
• If actual interest rates are lower than 7%, the company pays the bank the difference.

A futures contract gives the owner the right to earn interest or obligation to pay interest:

• Selling a future creates an obligation to borrow money/obligation to pay interest;
• Buying a future creates an obligation to deposit money/right to receive interest.

Interest rate futures are priced at 100 minus the implied interest rate. Therefore, if interest rates rise, the price of interest rate futures falls.

Consider, for example, a futures contract that allows lenders and borrowers to receive or pay interest at 6%, the current market interest rate. Suppose the market rate rises to 8%. Lenders will now find the futures contract less attractive because they could earn 8% at the market rate but only 6% under the futures contract. So the price of the contract must fall.

If a company wishes to hedge against rising interest rates it should use futures as follows:

• Sell interest rate futures today;
• Wait for interest rates to rise;
• If interest rates do rise, the price of futures must fall;
• "Close out" the futures position by buying the same contracts that were originally sold.

Interest Rate Cap = if the reference interest rate rises above a predetermined level, the financial institution pays the difference to the company based on an agreed notional principal and period. = cap on interest rate paid

Interest Rate Collar = this combination of a cap and a floor keeps an interest rate between an upper and a lower limit.

Interest Rate floor = if the reference interest rate falls below a predetermined level, the financial institution pays the difference to the company.

P = I / kd

kd = pre-tax cost of debt

kd(1-t) = post tax cost of debt

IRR of the (PF) cash flows associated with that source.

IRR of the after-tax cash flows:

short-term unsecured debt.Investors can trade it on the secondary market