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).