AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

# E2b. Understanding Exchange Rates 3 / 13

### Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

i) The use of the forward exchange market and the creation of a money market hedge

### Understanding Exchange Rates

#### £ : \$1.5

Here £ = Base Currency; \$ = Counter Currency

#### £0.67:\$

Here \$ = Base Currency; £ = Counter currency

Normally the “foreign” currency is the counter currency

#### Banks BUY HIGH and SELL LOW

Here we are referring to the foreign / counter currency

#### If a company needs to make a foreign currency payment

• Banks SELL the foreign currency at the LOWER rate

#### If a company needs to make a foreign currency receipt

• Banks will BUY that foreign currency from them at the HIGHER rate

#### Translating Currencies

1. If you are given the counter currency:

DIVIDE the amount by the exchange rate

Eg A UK company has to pay \$1,500.
£ : \$1.5
Solution = \$1,500 / 1.5 = £1,000

2. If you are given the Base currency:

MULTIPLY the amount by the exchange rate

Eg A UK company has to pay £1,000 in \$.
£ : \$1.5
Solution = £1,000 x 1.5 = \$1,500

#### If £ is strong (strengthening, appreciate)

• UK exporters suffers because the \$ is weak and their revenues is in \$s.

• If the £ appreciates relative to the \$, the exchange rate falls:

it takes fewer £ to purchase \$1.

(\$1 = £1.5  → \$1= £1.4).

#### If £ is weak (weakening, depreciate, devalue)

• UK importers suffer because the \$ is strong and their costs are in \$s.

Translation risk
- NCA and CA value - decrease
- NCL and CL value - increase.

• For instance, if the £ depreciates relative to the \$, the exchange rate rises:

it takes more £ to purchase \$1.

(\$1= £1.5 → \$1= £1.7).