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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 39
CURRENCY RISKS
We shall take care of following topics in this hand out:
Future payment situation ­ hedging
Currency futures ­ features
CF ­ future payment in FCY
Money Market Hedge ­ future FCY payment scenario
A similar approach will be taken to create the hedge when a firm is expecting to pay in FCY in future. In
this scenario, a hedge can be created by exchanging local currency for FCY now using spot rates and putting
the currency on deposit until the future payment is to be made. The amount borrowed and the interest
earned on the deposit should be equal to the FCY. If it is not the case then it will not be a clean hedge. The
cash flows are fixed because the cost in local currency is the cost of buying FCY on spot rates that was put
under a deposit.
Mechanism:
Step 1: determine the FCY (assume US $) amount to be put to a deposit that will grow exactly to equalize
the future payment in dollars. You need to calculate this using the available spot rates and interest rate on
dollar deposit.
Step 2: in order to deposit dollars in interest bearing account, the company will buy dollars at spot rates.
Step 3: the company will borrow local currency for the period of hedge.
These steps will ensure that the hedge created a definite cash flow regardless of exchange rate or interest
rate fluctuations. The exchange rate has been fixed.
Currency Futures:
A currency future is a standard contract between buyer and seller in which the buyer has a binding
obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying security.
Fixed amount = contract size
Fixed date = delivery date
Fixed price = future price
Futures are forward contracts traded on future and option exchanges. There are several such exchanges
around the world and although some trade in similar forward contracts, as a general rule each exchange
specializes in its own future contracts. This means that if a company wants of trade in future contracts it has
to go to exchange where those contracts are traded.
Futures are only traded on exchanges using standardized contracts. Each future contract is in particular item
having identical specification. For example, every sterling contract has same specification.
Settlement of future contracts is made at predetermined times during a year. These are usually in March,
June, September and December each year. This means, for example, that sterling future contracts are traded
on the exchange for settlement in these months.
Futures are traded at a price agreed between the buyer and the seller. This price reflects the price of the item
traded by the contract.
Most of the futures do not run to their final settlement date. These contracts may be cash settled or physical
delivery settled. With cash settlement, there is payment in cash from one party to the other. With physical
delivery, the underlying item is delivered by one party to other.
When a trader buys future, this represents taking a long position in futures. Such a trader having a long
position can close his position at any time before the settlement date by selling the same number of
contracts.
On the other side, when a trader is selling futures then it represent his or her short position. It is possible to
sell future even you don't have them. A trader who is in short position can close her position by buying the
same number of future before the final settlement date.
Ticks:
A tick is the minimum price movement of a contract. For example, the movement in US$ / PKR rate from
60.1501 to 60.1505, means the rate has risen four ticks. Every tick movement in price has same money
value. For example, sterling/us$ contract standard size is sterling 62,500/-. The price is in us$ and tick size
is $ 0.0001, which means each tick value is $ 6.25. If a trader is holding a long position and price of future
increases, then there's profit and fall in value represents loss. If trader is holding is short position, rise in
future value represent a loss, fall in price profit.
Like forward contracts, currency futures have also two-scenario: receipt of FCY and payment involving
FCY.
133
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Corporate Finance ­FIN 622
VU
Currency Market Hedging ­ FCY payment in future:
A company might have an exposure to a future payment in a foreign currency. It can hedge the exposure by
arranging to buy the currency forward using futures.
When the payment is actual made, the currency to make the payment should be purchase spot. The futures
position should be closed. If there is a gain on the future position, this might be used to make some of the
payment.
Example ­ currency futures ­
Scenario - future payment in FCY
A Pak company bought goods for $ 900,000/- in December and needs to settle in May. Due to the
sensitivity of exchange rate of $/PKR the company intends to hedge this transaction exposure with
currency futures. The spot rate when the goods were purchased was us$ 1 = PKR 60.1559. The $/PKR
May futures contract is currently priced at us $ 1 = PKR 60.1585.
Assuming that the spot rate when goods are paid is US$ 1 = PKR 60. 2171 and June futures is priced at us$
60.2201.
How can company hedge this transaction with currency future?
US $
900,000.00
SPOT RATE DECEMBER
PKR
60.1559
FCY FUTURE - DEC
PKR
60.1585
SPOT RATE JUNE
PKR
60.2171
FCY FUTURE - JUNE
PKR
60.2201
BUY IN DECEMBER AND WILL SELL IN
JUNE.
PKR/$
US$
PKR
DECEMBER - FCY FUTURES PURCHASED
60.1585
900,000.00
54,142,650.00
IN MAY - WHEN PAYMENT WILL BE MADE
IN US $
60.2201
900,000.00
54,198,090.00
GAIN ON SALE OF FCY
CONTRACTS
55,440.00
MAY
- NEED TO BUY US $ AT SPOT RATES TO
60.2171
900,000.00
54,195,390.00
MAKE PAYMENT
LESS: PROFIT / GAIN ON FCY
FUTURES
(55,440.00)
NET COST
54,139,950.00
EFFECTIVE EXCHANGE RATE
54,139,950.00
900,000.00
60.1555
134
Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk