ACCA P4 Advanced Financial Management - 2010 - Study text

Подождите немного. Документ загружается.

Chapter 11: The money markets. The treasury function

stating the amount payable for the goods at a stated future date (the end of the

credit period for the importer). The bill of exchange is then signed (‘accepted’) by a

bank representing the importer, and on acceptance, it becomes an undertaking by

the bank to make the payment.

The accepted bill is returned to the exporter’s country. It may also be ‘confirmed’ by

a bank in the importer’s country. Confirmation is an additional guarantee of

payment. The confirming bank undertakes to pay the bill in the event that the

accepting bank does not.

A bill of exchange that has been accepted, or accepted and confirmed, can either:

 be held until its expiry date, when the accepting bank will make the payment on

behalf of the importer, or

 sold before the expiry date, in the discount market for bank bills. The exporter

can arrange for its bank to sell the bill in the discount market, in order to obtain

the (discounted) payment sooner.

5.3 Export factoring

Export factoring is the factoring of trade receivables, where the receivables are trade

debts for export sales. An exporter can enter into an agreement with an export

factoring organisation.

 The export factor issues invoices for the exporter, administers the exporter’s

export sales ledger and collects the payments from the foreign customers.

 The export factor provides credit insurance for ‘approved’ export sales. In ‘non-

recourse’ factoring, the factor accepts the risks of non-payment by the foreign

customers. The exporter is therefore not exposed to the risks of non-payment

and bad debts.

 The export factor provides an advance of money, typically about 80% of the

value of the unpaid invoices that the factor is responsible for collecting. The

balance of the money, less the factor’s fees and charges, is paid to the exporter

when the foreign customers eventually pay.

Export factoring therefore reduces the administrative tasks of the exporter

(invoicing, debt collection, book-keeping), provides credit insurance and also

provides short-term finance.

The export factor charges a fee for its administration services and for the credit

insurance, and charges interest on the money it advances to the exporter.

5.4 Forfaiting

Forfaiting is a method of financing exports, used in some countries in continental

Europe.

Forfaiting might be appropriate where payment for the exported goods will take

place over a period of several years. Typically, the exports are exports of capital

Paper P4: Advanced Financial Management

306 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

goods such as machinery, and payment will be made by the importer over the

economic life of the goods.

 The importer pays a proportion of the purchase price on delivery and agrees to

pay the rest in instalments at regular intervals over a period of several years.

 The importer issues a series of bills of exchange or promissory notes, to coincide

with the schedule of payments.

 The importer finds a bank that is willing to ‘avalise’ the bills or promissory

notes. Avalising means providing a guarantee of payment.

 The exporter arranges for a bank in its own country to act as forfaiter. The

forfaiting bank buys the promissory notes at a discount. The exporter therefore

receives payment (a discounted payment). The forfaiting bank will probably

hold the promissory notes or bills until their due date for payment, and then

receive the payment from the importer.

5.5 Countertrade

Countertrade is a method of arranging payment for exports when the buyer is in a

country where there are foreign exchange restrictions.

Countertrade involves receiving payment in other goods for which there is an

international market.

For example, an exporter might arrange to sell machinery to a company in a country

where there are foreign exchange restrictions, and payments in foreign currency for

imports are not permitted. The importer and exporter might therefore agree to

payment in another type of goods. These goods could be any type of goods, but they

must have a ready market. For example, in exchange for machinery, an importer

might arrange to pay in coffee beans. These could then be sold in the commodity

markets by the exporter, in order to obtain payment in cash.

Similarly an exporter of optical instruments to South America may agree to accept

payment in cashew nuts, which it will then arrange to sell on the international

markets.

Paper P4

Advanced Financial Management

CHAPTER

Foreign exchange risk and

currency risk management

Contents

1 Foreign exchange risk

2 The FX markets: spot rates

3 Forward FX contracts and forward rates

4 Hedging exposure to foreign exchange risk

5 Synthetic agreements for forward exchange

(SAFEs)

6 Money market hedge

Paper P4: Advanced Financial Management

308 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Foreign exchange risk

 The need for foreign exchange

 Currency transaction exposures

 Exchange rates and volatility

 Government measures to stabilise exchange rates

1 Foreign exchange risk

1.1 The need for foreign exchange

Many companies make foreign exchange transactions with their banks. The need for

foreign exchange arises from international trade and international investment.

 A company buying goods from another country might be required to pay in a

foreign currency, such as the domestic currency of the supplier. It must therefore

obtain the foreign currency to make the payment.

 A company selling goods abroad might price the goods in the buyer’s domestic

currency, or in another currency such as US dollars. When the customer pays in

the foreign currency, the company might sell the currency received in exchange

for its own domestic currency

 A company investing abroad might need to obtain foreign currency to acquire or

to make the investment.

If a company in Australia wants to buy goods from a supplier in Germany, and the

purchase price is in euros, the Australian company has to buy euros from its bank in

order to make the payment to the supplier.

Similarly, if a company in The UK sells goods to a customer in Africa, and the price

is paid in US dollars, the company will probably sell the dollars it has received to its

bank, in exchange for sterling. (Alternatively, the company could keep the dollars in

a US dollar bank account, if it has one.) The company in Africa would also need to

buy dollars from a bank in order to pay the UK supplier.

Many foreign currencies can be bought and sold freely in the foreign exchange

markets (FX markets), which are operated world-wide by banks. On the other hand,

some currencies do not have a liquid market, and foreign companies might be

reluctant to accept payment in those currencies.

1.2 Currency transaction exposures

Transactions in foreign currency give rise to currency transaction exposures.

Transaction exposures were explained in the earlier chapter in international

investment.

A transaction exposure occurs when a payment of a foreign currency is required at a

future date, or when a receipt of a payment in a foreign currency will occur at a

Chapter 12: Foreign exchange risk and currency risk management

future date. An exposure to risk occurs because the exchange rate could move

adversely between ‘now’ and the time that the currency payment or receipt

happens, with the result that either:

 it costs more to buy the foreign currency to make the currency payment, or

 there is less income when a currency payment is received and the currency is

converted into domestic currency by selling it to a bank.

Currency transaction exposures can be analysed according to when the currency

payment or receipt is expected to happen, and exposures can be measured in each

foreign currency. An exposure is simply:

 the amount of payments that will be made in the currency, and

 the amount of the currency that will be received.

If payments and receipts of the same currency are expected at the same time, the net

exposure is the difference between the expected receipt and the expected payment.

1.3 Exchange rates and volatility

When currencies can be bought and sold in the FX markets, banks quote exchange

rates at which they will deal. Exchange rates are quoted as a number of units of one

currency (the variable currency) in exchange for one unit of the other currency (the

base currency). For example, the sterling/US dollar exchange rate (GBP/USD)

might be 1.9150, meaning that each £1 can be exchanged for US$1.9150 in the

market.

Experience has shown that exchange rates can be very volatile. Volatility means that

exchange rates can move up or down by large amounts, within a fairly short period

of time. A notable example in recent years has been the euro/US dollar exchange

rate. Since the euro was created in 1999, when its value was about €1 = $1.20, the

exchange rate has ranged between about €1 = $0.80 to about €1 = $1.35. Exchange

rate volatility creates foreign exchange risk for anyone involved in buying, selling,

borrowing or investing foreign currency.

Example

A German company sells goods to a US buyer for US$330,000 when the exchange

rate is €1 = $1.1000. The US buyer is allowed three months’ credit, and when the

German company eventually receives the US dollars three months later, and

exchanges them for euros, the exchange rate has moved to €1 = $1.2000.

The original expectation would have been that the sale proceeds in euros would be

€300,000 ($330,000/1.1000). However, during the time that it was exposed to the

currency risk, the exchange rate has moved in an adverse direction, and the actual

receipts are only €275,000 ($330,000/1.2000). The ‘FX loss’ has been €25,000.

Conclusion

This example illustrates several points about currency risk.

Paper P4: Advanced Financial Management

310 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

 Currency risk arises from exposure to the consequences of a rise or fall in an

exchange rate. Here, the German company was exposed to the risk of a fall in the

value of the US dollar.

 An exposure lasts for a period of time. Here, the exposure lasts from when the

goods were sold on credit until the time that the customer eventually pays.

 Currency risk is a two-way risk, and exposure to risk can lead to either losses or

gain from movements in an exchange rate. In this example, the exchange rate

could have moved the other way. For example, if the exchange rate after three

months had been $1 = €1, the German company would have received €330,000,

which is €30,000 more than it would have expected at the time of the sale. There

would have been an ‘FX gain’ of €30,000.

1.4 Government measures to stabilise exchange rates

A government may try to stabilise the exchange rate for its currency. The purpose of

having an exchange rate policy would be to create stable economic conditions for

international trade. A stable exchange rate, with relatively little exchange rate

volatility, should help to promote growth in the country’s economy.

In the past, some governments were able to manage the exchange rate by dealing on

the foreign exchange markets, using their official reserves of foreign exchange to

either buy or sell domestic currency. By creating demand or supply for its currency

in the markets, the government would try to move the exchange rate up or down

against major currencies such as the dollar. However, the foreign exchange markets

are now so large that very few countries are in a position to manage the exchange

rate effectively in this way. (Countries such as China may be an exception.)

The most effective way for a government to manage its exchange rate today, if it

wished to do so, would be to increase or reduce domestic interest rates on its

currency. Raising or reducing interest rates should affect the demand for the

currency from investors. For example, raising the interest rate should attract more

investment into the currency, and by increasing demand for the currency, the

foreign exchange value of the currency should increase.

There are several exchange rate policies that a government might adopt. These

include:

 free floating (‘benign neglect’ of the exchange rate)

 managed floating of the currency

 a fixed exchange rate policy, with the exchange rate fixed against a major

currency or a basket of world currencies

 a fixed exchange rate backed by a currency board system.

Free floating

With a policy of free floating, the government does not have a policy about the

exchange rate. Instead, it allows the currency to find its own market value in the

foreign exchange markets.

Chapter 12: Foreign exchange risk and currency risk management

Managed floating

A policy of managed floating is to allow the currency to find its own level in the

foreign exchange markets, but within target limits. (Targets may be set for the

maximum and minimum exchange rate against, say, the US dollar or the euro.)

If the exchange rate threatens to go through the upper or lower target limit, the

government will act to try to keep it within the policy limits, probably by raising or

lowering interest rates.

Fixed exchange rate policy

A government might try to fix its exchange rate against:

 another currency, such as the US dollar, or

 a basket of other world currencies, for example the US dollar, euro and yen.

The ‘fixed rate’ policy will normally permit some limited variations in the exchange

rate.

For example, countries that wish to enter the eurozone in the European Community

are expected to link their currency to the value of the euro for a period of time

before they can be considered for ‘eurozone membership’.

There are problems with fixing an exchange rate against another currency.

 Economic conditions in the two countries must remain similar; otherwise there

will be too much pressure on the exchange rate to change. For example, the rate

of inflation in both countries must be similar over a long period of time.

 The country’s economy will be affected by any crisis in the economy of the other

country, or by an increase in the volatility of the other country’s currency.

Fixed exchange rate backed by a currency board

A currency board system is another fixed exchange rate system. The government

fixes its currency against the value of another currency (a ‘hard’ currency, such as

the US dollar). Any new issues of domestic currency have to be backed by an

amount of the ‘hard currency’ in the country’s official reserves.

For example, a country with a currency board system might fix the exchange rate at

4 local currency units (LCUs) to the US dollar. If the country wants to increase its

money supply (which will be necessary for economic growth), it will need to hold

reserves of one US dollar for every increase of 4 LCUs in the money supply.

This ‘backing’ of a hard currency should help to stabilise the exchange rate for the

country’s own currency, which in turn should help the country to achieve economic

stability.

Paper P4: Advanced Financial Management

A problem with a currency board system is that on occasions:

 it might result in a shortage of domestic money supply, because of an

insufficiency of the hard currency, or

 it might push up domestic interest rates (in order to attract more hard currency).

If the problem becomes too serious, the currency board system may break down. A

currency board system has worked well for Hong Kong (whose dollar has been

linked to the US dollar), but has not been so successful in other cases (such as

Argentina).

Chapter 12: Foreign exchange risk and currency risk management

The FX markets: spot rates

 Bid and offer rates

 Spot rates

 Quoting exchange rates

2 The FX markets: spot rates

You need to understand how currencies are bought and sold in the FX markets. This

section of the chapter explains the basic ‘rules’ for buying and selling currency.

2.1 Bid and offer prices

In an examination, you might be required to calculate the cash flows in a foreign

currency exchange transaction. If so, you might be given one figure for the current

exchange rate between two currencies. In practice, banks quote two rates: a bid rate and

an offer rate.

 The bid rate is the rate at which the bank will buy the base currency.

 The offer rate is the rate at which the bank will sell the base currency.

Most exchange rates are quoted to four decimal places.

It is easy to get confused about which exchange rate should be applied to a

particular transaction. The basic rule to remember is that the bank will use the rate

that is more favourable to itself and less favourable to the customer.

Example

A UK company needs $10,000 to pay a US supplier. The bank’s current rates for

sterling/US dollar (US$/£1) are 1.9850 – 1.9855.

The British pound is the base currency, since the rate is quoted as £1 = £X.

The company needs to buy US dollars in exchange for British pounds, in order to

pay the US supplier. The bank is selling dollars and receiving British pounds in

exchange. It will apply a rate of 1.9850 to the currency transaction with the

company, because 1.9850 will give it more British pounds than the rate of 1.9855.

The cost of buying the dollars is therefore £5,037.78 ($10,000/1.9850).

Example

The same UK company receives US$15,000 from a customer, and it wants to convert

these dollar receipts into British pounds. The exchange rate is 1.9850 – 1.9855.

The bank will buy dollars at 1.9855, and so the company will receive £7,554.77

(15,000/1.9855) in exchange for the dollars.

Paper P4: Advanced Financial Management

Taking this transaction and the previous example together, the UK company’s cash

flows in British pounds from the two transactions would be as follows:

Buy $10,000 at 1.9850: pay (5,037.78)

Sell $15,000 at 1.9855: receive 7,554.77

Net receipts 2,516.99

It would be more sensible for the company to pay the $10,000 to the US supplier out

of the $15,000 it receives from its customer. That would leave it needing to sell just

US$5,000 at 1.9855. The receipts in British pounds would then be £2,518.26

($5,000/1.9855).

Example

(a) A French company has received Aus$7,000 from a customer in Australia. The

current exchange rate for the euro and the Australian dollar (Aus$/€1) is

1.5230 – 1.5240.

How much will the company receive in euros for selling the Australian

dollars?

(b) An Australian company needs to buy €12,000 to pay a Spanish supplier. The

exchange rate is the same as above. How much will it cost the company to

obtain the euros that it needs?

Answer

(a) The bank is buying Australian dollars and selling euros. It will offer the rate

more favourable to itself, which is 1.5240. The company will receive $7,000/

1.5240 = €4,593.18.

(b) The Australian company needs to buy euros, and the bank will charge the rate

most favourable to itself. To buy €12,000, the Australian company will have to

pay 12,000 × 1.5240 = Aus$18,288.

2.2 Spot rates

In the FX markets, banks trade currencies both spot and forward. A spot transaction

is a transaction for the sale of one currency in exchange for another, for ‘immediate’

settlement. ‘Immediate’ settlement in practice usually means after two working

days, so that if a company makes a spot transaction with a bank on a Monday, the

actual exchange of currencies will happen on Wednesday, two working days later.

For the purpose of the examination, however, you can treat spot transactions as

transactions for immediate settlement.

Although currency can be bought and sold ‘spot’, spot transactions cannot be used

to ‘hedge’ a currency exposure and foreign exchange risk.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

Подождите немного. Документ загружается.