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CIMA P3 Course Notes

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CIMA P3 Course Notes


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Chapter 12 Currency hedging techniques

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1.

Hedging

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. There are 4 key techniques for hedging currency risk: Forwards Money market hedge Futures ptions

2.

Forwards

hat is a !orward contract"


A !orward contract or simply a forward is a non!standardised contract between two parties to buy or sell a fi"ed amount of foreign currency at a specified future time at a price agreed upon today. The forward price of such a contract is commonly contrasted with the spot price# which is the current e"change rate. The difference between the spot and the forward price is the forward premium or forward discount.

How a !orward contract wor#s


$eneric e%amp&e $uppose that %ob wants to buy a house a year from now. At the same time# suppose that Andy currently owns a &'((#((( house that he wishes to sell a year from now. %oth parties could enter into a forward contract with each other. $uppose that they both agree on the sale price in one year)s time of &'(4#(((. Andy and %ob have entered into a forward contract. %ob has now fi"ed the amount he will pay for this house# ensuring he never has to pay any more than &'(4#(((. This helps him to manage his cashflows and reduce his e"posure to fluctuations in the property market.

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Currency e%amp&e A similar situation works for currency forwards# where one party opens a forward contract to buy or sell a currency *for e"ample a contract to buy +uros, to e"pire-settle at a future date# as they do not wish to be e"posed to e"change rate-currency risk over a period of time. $ometimes# the buy forward is opened because the investor will actually need +uros at a future date such as to pay a debt owed that is denominated in +uros therefore avoiding the risk that they have to pay more due to unfavourable e"change rate movements. This is the typical use of forwards by accountants. .t is also possible that# the party opening a forward does so# not because they need +uros because they are hedging currency risk# but because they are speculating on the currency# e"pecting the e"change rate to move favourably to generate a gain on closing the contract. Forwards are popular# as they are simple and fle"ible. ther characteristics include: '. /egally binding contract *so it must be completed even .f the need for the foreign currency or amount changes, 0. 1ou set any date for e"ercising# but that date is set and agreed 2. Agree any amount required 4. %ank offers a forward e"change rate

Numerica& e%amp&e
The current forward price quoted for the 3-& in 4 months time is '.5 ! '.50. .f a 6$ company needs 3'm for a contract to be paid in 4 months. Firstly we need to work out which of the two values is spread is the relevant one here. 7emember 8 the bank always wins. ne rate would cost them &'.5m and the second &'.50m. The worst for the company and best for the bank is the second option# so that9s the relevant forward rate# and that9s the amount payable in 4 months time.

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3.

Money mar#et hedge

hat is a money mar#et hedge"


There are two types of money market hedge: Paying in a !oreign currency in the !uture The home currency is converted at the spot rate# and monies held in a foreign currency bank account until required for payment in the future. The e"change rate used was the rate now# and hence the risk of rates changing by the payment date is removed. 'ecei(ing money in a currency in the !uture A loan is taken out in a foreign currency# and that converted at the spot rate now. :hen the monies are received in the foreign currency they are used to pay off the foreign currency loan. Again note that the e"change rate used was the rate now# and hence the risk of rates changing by the receipt date is removed.

)%amp&e question
A%; plc will be required to make a &0m payment in < months time. The current e"change rate is 3' = &0. The e"change rate for the & is highly volatile. The company9s banks are willing to undertake a forward contract at a rate of 3' = &'.>. A 3 loan would incur rates of interest are '(? per annum# while a & deposit would secure a return of '2? per annum. ;ompare the costs of leading*paying now,# with using a future or money market hedge.

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)%amp&e *o&ution
Payment now 8 Amount payable = &0m 0 = 3'm

Forward rates 8 Amount payable = &0m '.> Money mar#et hedge

= 3'#(50#420m

A%; plc will +1, borrow money now in 3# convert this at the spot rate to & +2,. This will then earn interest for < months when the payment can be made +3,.The @effective cost9 of this +-, can then be calculated by applying the 3 interest rate to the amount borrowed. (1) Borrow 920, 245.50 and covert now to $ at 1 = $2 $ (2)Deposit 1,840, 491 into a $ account This grows at 13% for 8 months effective interest rate = 13% x 8 = 8.66% 12

NOW

Interest payable at 10% for 8 months = 6.66%

8 months

(4) After 8 months the effective amount due would be 981,595

(3) Make payment of $2m

Aote that to do the calculation you have to start with amount *2,# then work out amount *0,# then *', and then *4,. +ffective amount payable in < months is 3><'#5>5 Conc&usion The money market hedge is the lowest cost method of hedging the risk.

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-.

Currency !utures

hat is a currency !uture"


A currency future is a futures contract to e"change one currency for another at a specified date in the future at a price *e"change rate, that is fi"ed on the purchase date. They differ from forwards in that the contracts are standardised amounts *e.g. 3'05#((( is typical, which are traded on currency e"changes Typically# one of the currencies is the 6$ dollar. The price of a future is then in terms of 6$ dollars per unit of other currency. .f you hold a contract at the end of the last trading day# actual payments are made in each currency. Bowever# most contracts are closed out before that. .nvestors can close out the contract at any time prior to the contract)s delivery date by selling it on the market. .nvestors use these futures contracts to hedge against foreign e"change risk. .f an investor will receive a cashflow denominated in a foreign currency on some future date# that investor can lock in the current e"change rate by entering into an offsetting currency futures position that e"pires on the date of the cashflow. Further notes on how futures work: '. ;ontrolled by an e"change *in 6$, 8 gives security 0. Ceposit required by e"change from both parties *in a client9s margin account, 2. Drofits and losses in the margin account are adEusted daily 4. Futures are always a standard siFe i.e. G40#5(( 5. Maturity dates are fi"ed at end of March# Hune# $eptember and Cecember

Futures Ca&cu&ation
A 6I company has to pay &04(#((( on 2'st May. The current spot rate is &'.>-G. Futures are sold in contract siFes of G40#5(( and the current price of a future to the end of Hune is &'.>0((-G. n 2' May# the spot rate and the futures rate on that date are both &'.<-G. To do futures questions you can always follow the same standard steps which are as follows:

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Civide the total amount *&04(#(((, by the current futures price *&'.>0, to get the G amount needed 8 G'05#((( Therefore 0 contracts of G40#5(( are needed. *tep 2 . Are you /uying or se&&ing !utures" 6se the following rule: 0we 1 or 2 . 3uying 1 or 2 !utures 0wed 1 or 2 4 *e&&ing 1 or 2 !utures 0we 5 . *e&&ing 1 or 2 !utures 0wed 5 4 3uying 1 or 2 !utures .n this case the company owes & so is selling futures.

*tep 3 . C&ose out the contract +31 May, 6se the following rule: *e&&ing !utures6 opening price 4 c&osing price 3uying !utures6 c&osing price . opening price Bere we are selling futures *step 0, so take the opening price 8 closing price: pening price ;losing price Drofit-*loss, &'.>0(( &*'.<(((, &(.'0((

which is positive so is a profit

Total profit = 0 contracts " G40#5(( " &(.'0 = &'5#((( profit *tep - 7nderta#e the spot mar#et transaction +31 May, Total needed &04(#((( /ess profit from future *&'5#(((, 3a&ance at spot rate+1.8, 5229:;;; In 2 this is 229:;;;<1.8 = 2129:;;;

*add on if step 2 is a loss,

9.

Currency options

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hat is a currency option"


A currency option gives the owner the right /ut not the o/&igation to e"change money denominated in one currency into another currency at a pre!agreed e"change rate on a specified date. The key is to note that there is no o/&igation to undertake the option# which gives much more fle"ibility to the purchaser than a forward as they can pull out of the deal if e"change rates move favourably. f course# this increases risk to the bank and so options are more e"pensive. A premium is the fee paid when an option is taken out.

)%amp&e
For e"ample a G-& contract could give the owner the right to sell G'#(((#((( and buy &0#(((#((( on Cecember 2'. .n this case the pre!agreed e"change rate# or stri#e price# is &0 per G' and the notiona& amounts are G'#(((#((( and &0#(((#(((. n the e"ercise date *2' Cecember,# if the spot rate is higher than 0# the option is lapsed# as it is better to take the spot rate. .f the rate is lower than 0 on Cecember 2' *say at '.>,# meaning that the dollar is stronger and the pound is weaker# then the option is e"ercised# allowing the owner to sell G at 0 and immediately buy it back in the spot market at '.># making a profit of: *0 8 '.>, " '#(((#((( = &'((#(((

.f they immediately convert the profit into G this amounts to '((#(((-'.>((( = G50#42'.5< foreign!e"change option.

3&ac#4*cho&es options pricing mode&


The %lack8$choles model provides a formula which can be used to price options. Many empirical tests have shown the %lack8$choles price is Jfairly closeK to the observed prices 1ou do not need to know the model for the e"am# but should know that the options price depends on the following factors: >he current price *e.g. current e"change rate, 8 sets the underlying value of the option

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>he stri#e price o! the option 8 the more favourable the price to the buyer the more e"pensive the option will be as the more likely the seller will have to pay out >he annua&ised ris#4!ree interest rate 8 like a present value calculationL future returns need to be discounted to present value to find the current price ?o&ati&ity 8 the greater the volatility the higher the risk to the seller so the higher the price >ime unti& e%piry 8 the longer into the future# the longer the period to be discounted and the greater the chance of a change in value of the underlying asset.

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*trategic Moc# )%ams . )3: F3 and P3 %ased around the &atest Preseen 0 full mocks are available for each strategic subEect Fu&& mar#ing and detai&ed !eed/ac# Full mock marking Cetailed and personalised feedback to focus on helping to pass the e"ams Persona& coaching on your moc# e%am 'hr personal coaching session with your marker Dersonalised feedback and guidance +"am technique and technical review *trategic and Financia& ana&ysis o! the Pre4seen *trategic ana&ysis ! all key business strategy models in +2 Financia& ana&ysis 8 based around the F2 syllabus 'is# ana&ysis 8 based around the D2 syllabus 2( page strategic report Full video analysis of how all key models apply to the unseen Mideo introduction to all the key models Persona& Coaching Courses Dersonal coaching to get you through the e"am >uition Course 8 Dersonalised tuition to give you the required syllabus knowledge 8 tailored to your needs 'e(ision Course ! Dractise past e"am questions with personal feedback on your technical weaknesses and e"am approach and technique 'esit Course 8 .dentifying weaknesses from past attempts and providing personalised guidance and study guides to get you through the e"am

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