FOREIGN
EXCHANGE RISK MANAGEMENT(Part 1)
1.
Risk
The is the possibility that something bad
will happen.
2.
Foreign exchange risk
This is the possibility that exchange
rates will move in an unexepected manner. You can either gain or lose from
unexpected movements.
For example, you paid for ACCA exam in
Pounds and you expect N50k to be removed from your account. When the alert came
in, you saw N40k. This means that you made a gain of N10k.
3.
Derivative
A deriv-ative is an instrument that DERIVES
its value from a specific price, interest rate, exchange rates or a basket of
prices, interest rates and exchange rates.
For example, you bought an option that
gives you the right to buy share in my company for N100/share. This option will
be valuable to you if my share price rises to N150 because you can shappaly buy
for N100 and sell for N150.
On the other hand, the option will have
no value to you if my share price falls to N90. It will not make sense to
exercise the option when you can buy for a lower price in the market.
4.
Initial Cost
Derivative may have a small/zero initial
cost. This is why firms used to exclude them from their SOFP before.
Now, IFRS requires them to be shown in
the financial statements even if their value is zero. This is because their
values are very fickle.
5.
Forward contract
i.
Intro
This is a
CONTRACT to buy/sell a specific amount
of a foreign currency for an exchange rate agreed now. It is a contract,
meaning that once you enter into it you can’t run away. You must fulfill your
promise.
ii.
Rate
A forward
fixes the exchange rate. This means that you will be 100% certain that that is
the rate that you will pay. This makes it easier to budget.
iii.
Spot rate
This is the
rate today. The forward rate is NOT an estimate of the future spot, but, it
shows whether the spot rate is expected to increase or decrease.
iv.
Bid rate and Offer rate
The rate is
the rate at which a bank will buy a foreign currency from you. Offer rate is
the rate at which a bank will sell a foreign currency to you.
The rate is
always the one that is best for the bank.
e.g $1= N250-N300
The bid rate
(rate the bank will buy $1 from you) is N250 because this is cheaper for the
bank.
The Offer
rate is N300 because the bank will make more money.
v.
Premium or Discount?
Forward rate
is quoted at a premium when it is lower than the spot rate.
It is quoted
at discount when it is higher than the spot rate.
e.g Spot rate for $1 is N250-300 and Forward rate
is N300-N350
The forward
rates are quoted at a discount because they are higher than the spot rate.
To buy a Dollar
now, you will pay N300(most favourable price to the bank). To buy a Dollar in the future, you will buy
it for N350. This means Naira is expected to depreciate because more Naira is
expected to be needed to buy a Dollar in the future.
vi.
Treatment of premium and discount
Normally, a
discount on the price of a good is lessed from it. The opposite is done for
foreign currency.
Spot
rate+Discount= Forward Rate
Spot
rate-Premium= Forward Rate.
vii.
Example
Spot rate is
N300-N350 for a Dollar
Forward rate
is N350-400 for a Dollar
Calculate
the amount you will pay for a Dollar if you enter into a forward contract to
buy a Dollar and the gain or loss if the spot rate moved to N200
Amount you
will buy the dollar for= N400
Gain or
loss= 400-200= N200 loss
The reason
it’s a loss is because buying a dollar
in the FOREX market way actually cheaper than the amount you were obliged to
pay under the forward contract.
6. Advantages
of forward contracts.
i.
They
make budgeting easier because they fix future foreign exchange rates.
ii.
Using
it to hedge usually leads to 100% hedge efficiency, i.e. no over-hedging and no
under-hedging
iii.
The have
a zero initial cost, i.e. nothing is paid to enter in to them.
iv.
They
can be used to hedge larger amounts when compared to exchange traded
derivatives
7.
Disadvantages of Forward contracts
i.
It may
be hard to negotiate good terms and conditions. This depends on your
negotiating skill.
ii.
They
must be fulfilled because there is a contractual obligation to do so.
iii.
The company
can not benefit from favourable foreign exchange rate movements because it must
buy/sell at the agreed rate.
iv.
Their
transaction cost is usually higher than currency future. More time will be
spent bargaining.
v.
There
is a risk that a party to the contract will not fulfill its obligations.
vi.
They
can not be sold in a market unsold exchange traded derivatives.
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8. .