FOREX
Currency quotes
Spot rate
Forward rate
Bid: Ask rate
Quotes
Direct
Indirect
Rate determine today for settlement in the future
Factors that influence exchange rates
Hedging
Money market
Forward exchange contracts (FEC)
Foreign exchange option contracts
Currency risk
Other risks
Dealer risk
risk that dealer does not perform as expected
Counterparty risk
risk that counterparty defaulting in future
Categories of currency risk
Economic risk
the performance of a country’s currency relative to other currencies has a direct impact on how competitive an enterprise will be in the international market
Translation risk
comes from translating foreign currency into local currency or vase versa
Transaction risk
Results from adverse changes in exchange rates between date of entering transaction & date paid
Currency risk or foreign exchange rate risk is the potential losses for an enterprise due to adverse movements in the foreign exchange rates when it’s involved in international transactions
Foreign supplier perspective – enterprise functional currency depreciates or weakens
Foreign customer perspective – SA currency strengthens or appreciates
Rate which apply to immediate delivery of the specified amount
Bid rate
Ask rate
Price bank pay for the currency
Price bank sell currency to a client
number of units of local currency for 1 unit in foreign currency ( always multiply)
number of foreign currency for 1 unit local currency (always divide)
Bank buys low and sell high
Average rate
Cross rate
Also known as mid rate
Average spot rate for a period
currency exchange rate between two currencies when neither are the official currencies of the country in which the exchange rate quote is given
@ premium
Can be quoted at a premium or discount to spot rate
Indicates that the base currency is expected to increase in value
@ discount
Indicates that base currency is expected to loss value
Exchange rate is lower than currently
Exchange rate is higher than currently
Calculate premium or discount
(Forward rate-spot rate)/(spot rate ) x 360/days x 100 = premium or discount
Interest rates
Inflation rate
Exports
Intervention by central bank
Imports
Speculative transactions
Investors sentiment
Local economic conditions
Buy & sell currency to make profit
Link to political risk
Basic forms of hedging
Currency of invoice
Leading & lagging
Netting
Local exporter
Local importer
Invoice foreign sales in Rand & not in foreign currency
Ask foreign suppliers to invoice in Rand rather than foreign currency
Leading
Lagging
Pay foreign creditors earlier than credit terms - thus reducing transaction risk
Delaying a foreign payment if it's expected that local currency will strengthen
Inter-company transactions
Amount owing by divisions in a group is matched against amount owing to the different divisions
This reduce currency risk
Making use of short term borrowing & investment facilities
Process for foreign payment
Day 1
Borrow funds locally
Invest foreign currency in foreign deposit account
Convert into foreign currency (ask rate)
On cash-flow settlement date
Pay foreign creditor using amount invested in that country
Process for foreign receipt
Day 1
On cash-flow settlement date
Convert into local currency (bid rate)
Invest rand amount locally in a local investment account
Borrow funds in country from which foreign receipt come
Receive foreign amount and repay foreign borrowing
Advantages
Disadvantages
Removes uncertainty as to what the rate will be
Cost (premium) incurred in using FEC
If rate is less than FEC on settlement date - must still use FEC
Calculate FEC cost
If rate given just use it as is
If rate not given calc
FEC rate = spot rate (on entering date) + FEC premium
If premium is an annual premium - pro rata equivalent used
Foreign exchange futures contract
Standardized contract which allows parties to buy/sell fixed amount of foreign currency @ fixed rate in future
Contracts must be bought or sold by an investor
Trade in the derivative market
specify the price in one currency at which another currency can be bought or sold at a future date
Main attributes
Option to sell - Put option
Option to buy = Call option
Gives holder the right to exercise not obligation
Date on which option may be exercised is the strike or exercise date
Before option used - has to be bought
Over-the-counter (OTC) options vs. trade options
OTC options is a customized option created specifically for the party wanting it
Traded options - Standarised size, specified period & only written for selected currencies
OTC option brings flexibility, but a premium must be paid. The premium will be higher than that incurred in purchasing traded options