F9 - RISK MANAGEMENT

State the Purchasing Power Parity theory (PPP)

Purchasing power parity theory states that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country.

Explain the Fisher effect

higher nominal interest rates serve to allow investors to obtain a high enough real rate of return where inflation is relatively high.

What is translation risk?

is the risk that the organisation will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the home currency.

What is currency risk?

Currency risk is the risk of changes in an exchange rate or in the foreign exchange value of a currency. It is a two-way risk.

What is leading and lagging?

In order to take advantage of foreign exchange rate movements, companies might try to use: + Lead payments (payments in advance for goods purchased in a foreign currency) + Lagged payments (delaying payments beyond their due date for goods purchased in a foreign currency)

State the Interest rate parity (IRP)

Interest rate parity is a method of predicting foreign exchange rates based on the hypothesis that the difference between the interest rates in the two countries should offset the difference between the spot rates and the forward foreign exchange rates over the same period.

What factors exert influences on exchange rate?

Interest rates Inflation rates Balance of payments Market sentiment/speculation Government policy

State the liquidity preference theory

Liquidity preference means investors prefer having cash now to deferring the use of the cash by lending it or investing it. Investors also prefer having cash sooner to having cash later. They therefore want compensation in the form of a higher return for being unable to use their cash now. The required return increases with the length of time for which the cash is unavailable. Because of this, long-term interest rates, such as bond yields, tend to be higher than short-term yields, and the yield curve slopes upward.

What are methods to manage currency risk?

+ Matching receipts and payments + Invoicing in own currency + Leading and lagging + Netting

What are structures of interest rate? (Why interest rate differ in different markets and market segments?)

+ Risk: higher risk borrowers pay higher rates on their borrowing for as a compensation for lends' taking risk + The need of making a profit on re-lending of financial intermediaries. + The size of loan +Different type of financial asset + The duration of the lending (regarding the term structure of interest rate)

What are the causes of interest rate fluctuations?

+ Structure of interest rate + Yield curve + Changing economic

State expectation theory

Expectations theory states that interest rates reflect expectations of future changes in interest rates. If interest rates are expected to rise in the future, the yield curve will slope upwards. When interest rates are expected to fall, short-term rates may be higher than long-term rates, and the yield curve downward sloping. Thus, the shape of the yield curve gives an indication about how interest rates are expected to move in the future.

State the market segmentation theory

The market segmentation theory of interest rates suggests that the slope of the yield curve will reflect conditions in different segments of the market. This theory holds that the major investors are confined to a particular segment of the market and will not switch segment even if the forecast of likely future interests rates changes.

Explain the relationship between exchange rate and interest rate

The relationship between the exchange rate and interest rate could be explained by the interest rate parity. Interest rate parity is a method of predicting foreign exchange rates based on the hypothesis that the difference between the interest rates in the two countries should offset the difference between the spot rates and the forward foreign exchange rates over the same period. The forward rate can be found by multiplying the spot rate by the ratio of the two interest rates. The country with the higher nominal interest rate is forecast to have its currency weaken against the currency of the country with the lower interest rate.

Explain the relationship between exchange rate and inflation rate

The relationship between the exchange rate and the inflation is explained by the purchasing power parity. Purchasing power parity theory states that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country. Purchasing power parity theory predicts that the exchange value of foreign currency depends on the relative purchasing power of each currency in its own country and that spot exchange rates will vary over time according to relative price changes. The country with the higher rate of inflation is forecast to have its currency weaken against the currency of the country with the lower rate of inflation. Purchasing power parity holds in the longer term, not in the short term and therefore can be used to provide long-term forecasts of exchange rate movements.

What is the term structure of interest rate?

The term structure of interest rates refers to the way in which the yield on a security varies according to the term of the borrowing.

Why interest rate on a debt security or loan may differ for different maturities?

Theories: + Liquidity preference theory + Expectation theory + Market segmentation theory + Government policy

Explain the method of matching receipts and payments

plan to offset its payments against its receipts in the currency.

What is the currency option?

Currency options protect against adverse exchange rate movements while allowing the investor to take advantage of favorable exchange rate movements.

List all types of currency risks.

Currency risk occurs in three forms: transaction exposure (short-term), economic exposure (effect on present value of longer term cash flows) and translation exposure (book gains or losses).

Explain the relationship between the expected future spot rate and the current forward exchange rate

Expectations theory states that there is an equilibrium between relative inflation rates and relative interest rates, so the expected spot rate and the current forward rate would be the same. Realistically, purchasing power parity tends to hold true in the longer term, so is used to forecast exchange rates a number of years into the future. Short-term differences are not unusual.

What factors influences interest rate?

Need for a real return Inflation Uncertainty about future rates of inflation Liquidity preference Balance of payment Monetary policies

What is forward rate?

being an exchange rate set for currencies to be exchanged at a specified future date.

What is spot rate?

being the exchange rate currently offered on a particular currency

What is netting?

being the process in which credit balances are netted off against debit balances so that only the reduced net amounts remain due to be paid by actual currency flows.

What is transaction risk?

being the risk of adverse exchange rate movements between the date the price is agreed and the date cash is received/paid, arising during normal international trade.

What is economic risk?

being the risk that the present value of a company's future cash flows might be reduced by adverse exchange rate movements.