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 Foreign Exchange Risk Management

1. Summary of Key Points

Foreign Exchange Risk Management

  • FX Risks: Arise due to currency fluctuations affecting payments and receipts.
  • Market Size: Daily FX trading volume is around $6.6 trillion (BIS, 2019), with the USD involved in 88% of transactions.
  • Market Participants:
    • Market Makers – Banks and financial institutions providing bid/offer quotes.
    • Market Takers – Businesses and corporations executing trades at quoted prices.
    • Central Banks – Influence currency value through market interventions.

FX Trading Methods

  • Telephone Dealing: Used by small businesses or for complex, high-value transactions.
  • Single-Bank FX Portals: Exclusive platforms for corporate clients to execute trades with one bank.
  • Multi-Bank Portals: Allow businesses to compare rates from different banks for better pricing.
  • Non-Bank Fintechs: Increasingly popular for FX transactions due to cost-effectiveness.

FX Instruments for Risk Management

  • Spot Rate: Immediate exchange of currencies at current market prices.
  • Forward Contract: Locking in a rate for a future exchange to hedge against fluctuations.
  • Currency Options: Right (but not obligation) to exchange currency at a pre-set rate.

Hedging Decisions

  • Businesses should hedge based on:
    • Risk Exposure – Large international transactions need risk mitigation.
    • Market Volatility – High fluctuation periods increase the need for hedging.
    • Cost Considerations – Some hedging strategies may be expensive.

2. Multiple-Choice Questions (MCQs)

1. Which of the following is the primary function of the foreign exchange market?

A) Facilitate international stock trading
B) Provide a marketplace for currency exchange
C) Regulate global trade agreements
D) Establish international lending rates

✅ Answer: B) Provide a marketplace for currency exchange

2. What is a key advantage of using a multi-bank FX portal?

A) It ensures businesses always get the lowest possible exchange rate
B) It allows businesses to compare quotes from multiple banks
C) It is only accessible to central banks and large corporations
D) It eliminates all foreign exchange risks

✅ Answer: B) It allows businesses to compare quotes from multiple banks

3. If a company wants to fix an exchange rate for a future transaction, which instrument should it use?

A) Spot contract
B) Forward contract
C) Swap agreement
D) Equity option

✅ Answer: B) Forward contract

4. What is the primary purpose of a central bank in the foreign exchange market?

A) To speculate for profit
B) To facilitate corporate transactions
C) To stabilize the national currency
D) To provide loans to businesses

✅ Answer: C) To stabilize the national currency

5. What is a major risk of foreign exchange transactions for businesses?

A) Increased employee turnover
B) Market interest rate fluctuations
C) Uncertain future cash flows due to currency fluctuations
D) Government taxation policies

✅ Answer: C) Uncertain future cash flows due to currency fluctuations

3. Practical Case Study on FX Risk Management

Scenario:

A UK-based company, TechImports Ltd, imports electronics from Japan and must make a payment of JPY 100 million in three months. The current GBP/JPY spot rate is 1 GBP = 150 JPY, but the company fears the yen might strengthen, increasing its cost in GBP.

Problem:

If the exchange rate moves to 1 GBP = 140 JPY in three months, the company will need more GBP to settle the payment.

Solution:

TechImports Ltd considers the following hedging strategies:

  1. Forward Contract – The company agrees with its bank to buy JPY 100 million at 1 GBP = 150 JPY in three months, locking in the rate.
  2. Currency Option – Buys an option to exchange GBP for JPY at 150 JPY per GBP, allowing flexibility in case the rate moves favorably.
  3. Natural Hedging – If TechImports Ltd also exports to Japan, it could use JPY revenues to pay for imports, reducing FX risk.

Outcome:

By hedging with a forward contract, TechImports Ltd avoids uncertainty and knows exactly how much GBP will be needed for the payment.

 

 

Foreign Exchange Risk Types

  1. Transaction Risk: When future cash flows in foreign currency fluctuate due to exchange rate movements.
  2. Translation Risk: When a company’s financial statements are affected by currency fluctuations.
  3. Economic Risk: Long-term risk affecting a company’s market position due to currency changes.

Factors Influencing Exchange Rates

  1. Interest Rate Differentials – Higher interest rates attract investment, strengthening a currency.
  2. Inflation Rates – Lower inflation leads to stronger currency value.
  3. Political Stability – Countries with stable economies attract foreign investment.
  4. Supply & Demand – High demand for a currency increases its value.
  5. Market Speculation – If investors expect a currency to strengthen, they buy more, driving up value.

Foreign Exchange Hedging Techniques

  1. Forwards: Lock in an exchange rate for a future transaction.
  2. Options: Buy the right (not obligation) to exchange at a fixed rate.
  3. Swaps: Exchange currencies for a fixed period and reverse at a later date.
  4. Money Market Hedge: Using loans and deposits to offset FX risk.
  5. Natural Hedging: Matching revenues and costs in the same currency.

2. Additional Multiple-Choice Questions (MCQs)

6. Which of the following is NOT a major factor influencing exchange rates?

A) Interest rates
B) Trade agreements
C) Inflation rates
D) Employee satisfaction levels

✅ Answer: D) Employee satisfaction levels

7. What type of FX risk arises when a company has foreign currency payables or receivables?

A) Economic risk
B) Translation risk
C) Transaction risk
D) Systemic risk

✅ Answer: C) Transaction risk

8. A company that exports goods from the UK to the US receives USD payments. What is the best way to hedge against a weakening USD?

A) Buy a forward contract to sell USD and buy GBP
B) Keep all earnings in USD and hope the rate improves
C) Invest in USD-based assets
D) Convert USD to GBP only at the time of payment

✅ Answer: A) Buy a forward contract to sell USD and buy GBP

9. Which FX instrument gives the buyer the right but not the obligation to buy or sell currency at a fixed rate?

A) Forward contract
B) Currency swap
C) Currency option
D) Spot contract

✅ Answer: C) Currency option

10. A company has a large payment due in 6 months in a foreign currency. What is the main disadvantage of using a forward contract?

A) It requires a deposit
B) It does not allow flexibility if the exchange rate moves favorably
C) It is illegal in most countries
D) It is only available for large multinational corporations

✅ Answer: B) It does not allow flexibility if the exchange rate moves favorably

3. Advanced Case Study on FX Risk Management

Scenario:

A German auto parts manufacturer, AutoTech GmbH, exports components to the US and receives payments in USD. A major US client has placed an order worth $5 million, payable in six months. The current exchange rate is 1 EUR = 1.10 USD, but AutoTech GmbH fears the EUR might strengthen, reducing its revenue in EUR.

Risk Analysis:

  • If the EUR/USD rate moves to 1 EUR = 1.20 USD, the company will receive fewer euros when converting the $5 million.
  • Revenue in EUR at different exchange rates:
    • At 1.10: $5M ÷ 1.10 = €4.55M
    • At 1.20: $5M ÷ 1.20 = €4.17M (Loss of €380,000!)

Hedging Strategies:

  1. Forward Contract
    • AutoTech GmbH enters into a forward contract to sell $5M at 1 EUR = 1.10 USD in six months.
    • Guaranteed revenue of €4.55M, eliminating risk.
    • Downside: No benefit if the EUR weakens.
  2. Currency Option
    • Buys an option to sell $5M at 1 EUR = 1.10 USD.
    • If the EUR strengthens, they can use the market rate instead of the contract.
    • Downside: Premium (cost) must be paid for the option.
  3. Natural Hedging
    • AutoTech GmbH also imports materials from the US and can use USD revenue to pay suppliers directly.
    • Reduces currency conversion costs and FX risk.

Outcome:

  • If EUR strengthens, the forward contract protects revenue.
  • If EUR weakens, an option gives flexibility to use the better rate.
  • If natural hedging is available, it can reduce reliance on financial hedging.

Key Learning:

  • Forward contracts provide certainty but limit flexibility.
  • Options offer flexibility but come at a cost.
  • Natural hedging is an effective, cost-free alternative if available.

4. Additional Exam-Style Questions

Short Answer Questions:

  1. Explain the difference between a forward contract and a currency option.
  2. Why might a company choose not to hedge its foreign exchange risk?
  3. What are the benefits of multi-bank FX portals over single-bank portals?
  4. How do central banks influence the foreign exchange market?
  5. What are the key risks associated with FX transactions via telephone dealing?

 

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