For in-depth coverage and reading please refer to Chapters 19 of the 2013 ACCA F9 Financial

Management Emile Woolf Study Text

Currency Risk

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 Buy or Sell Currency - Illustration 1

You have an invoice to pay to a US business of $1250 and you are a UK business.

The rate offered by the bank is $:£ 1.2500 - 1.3500

How many £ will it take to pay the $125?

Solution

Bank sells low We want to buy $ with our £ and the bank will sell them to
us at the low rate of 1.2500

For a receipt use the rate We are making a payment so we use the rate on the left i.e.
on the right 1.2500

Cost of $ (Amount of $ / ($1250 / 1.25) = £1,000

FX Rate)

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 Buy or Sell Currency - Illustration 2

You have issued an invoice to a US customer of $2000 and you are a UK business.

The rate offered by the bank is $:£ 1.4500 - 1.5500

How many £ will you receive for the $2000?

Solution

Bank sells low We want to sell the $ we will receive. The bank will buy them
from us at the high rate of 1.5500

For a receipt use the This is a receipt so use the rate on the right of 1.5500
rate on the right

Value of $ (Amount of ($2000 / 1.55) = £1,290

$ / FX Rate)

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 Purchasing Power Parity Theory - Illustration 3

The current exchange rate is 2$ per £.

Inflation in the US is 6%.

Inflation in the UK is 8%.

What will the FX rate be in 1 years time?

Solution

Current Spot Rate 2

Inflation in Counter (US) 6%

Inflation in Base (UK) 8%

Forecast (Spot Rate Counter x (1 + Inf in Counter / 1 2 x ((1 + 0.06) / (1 + 0.08)) = 1.96
+ Inf in Base)

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 Interest Rate Parity Theory - Illustration 4

The current exchange rate is 2$ per £.

The interest rate in the US is 3%.

The interest rate in the UK is 2%.

What will the FX rate be in 1 years time?

Solution

Current Spot Rate 2

Interest rate in Counter (US) 3%

Interest rate in Base (UK) 2%

Forecast (Spot Rate Counter x (1 + Int in Counter / 1 2 x ((1 + 0.03) / (1 + 0.02)) = 2.02
+ Int in Base)

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 Forward Rate - Illustration 5

ABC Company has entered into a contract whereby they will receive $500,000 from a
US customer in 3 months.

ABC is a UK company.

A 3 month forward rate is available at $:£ 1.6000 +/- 0.0500.

Calculate the amount of £ ABC would receive under the forward contract.

Solution

A rate quoted at $:£ 1.6000 +/- 0.0500 is the same as saying $:£ 1.5500 - 1.6500

Rate to use (For a receipt use the one on the 1.6500

right)

Convert ($ amount / Forward rate) (500,000 / 1.6500) = £303,030

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 Money Market Hedge - Illustration 6

A UK business needs to pay $350,000 to a US supplier in 3 months time.

Exchange rate now: $:£ 1.6500 - 1.7000

Deposit rates UK 4% annual US 6% annual

Borrowing rates UK 5% annual US 6.5% annual

How much £ will the transaction cost using a money market hedge?

Solution

Step 1 - How much Foreign Currency?

Amount of $ to pay 350,000

We will deposit the money in the US where it will earn interest so that in 3 months we
have $350,000.

Deposit Rate in US per year 6%

Deposit Rate for 3 months (Annual rate x 6 x (3/12) = 1.5%

3/12)

Amount to deposit (Total $ discounted at 350,000 x (100 / 101.5) = $344,827

1.5%)

We will deposit $344,827 in the US where it will earn interest of 1.5% over the 3 months
making it worth $350,000 when the payment becomes due.

We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.

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 Step 2 - Convert using the Spot Rate

Amount to Transfer (Step 1) $344,827

We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.

Spot rate (We are making a payment) 1.6500

Convert ($ Amount / Spot Rate) (344,827 / 1.6500) = £208,986

Step 3 - Borrow the Home Currency

Amount to Borrow (Step 2) £208,986

We will have to pay interest on the amount we have borrowed for 3 months.

Borrowing Rate per year in UK 5%

Borrowing Rate for 3 months (Annual Rate (5 x 3/12) = 1.25%

x 3/12)

Total Cost of transaction

Amount transferred to US £208,986

Interest on borrowings in UK (£ amount x 3 (208,986 x 1.25%) = £2,612

month UK borrowing rate)

Total Cost (Amount transferred + interest (208,986 + 2,612) = £211,589

incurred)

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 Money Market Hedge Illustration 7

A UK business will receive $350,000 from a US supplier in 3 months time.

Exchange rate now: $:£ 1.6500 - 1.7000

Deposit rates UK 4% annual US 6% annual

Borrowing rates UK 5% annual US 6.5% annual

How much £ will the business receive using a money market hedge?

Solution

Step 1 - How much foreign currency?

Amount of $ to receive 350,000

We will borrow the money in the US now and transfer it home.

Borrowing Rate in US per year 6.5%

Borrowing Rate for 3 months (Annual rate 6.5 x (3/12) = 1.625%

x 3/12)

Amount to borrow (Total $ discounted at 350,000 x (100 / 101.625) = $344,403

1.625%)

We will borrow $344,403 in the US where it will earn interest of 1.625% over the 3
months making it worth $350,000 when the receipt becomes due.

We will pay off the loan in the US when we receive the $350,000 in 3 months.

We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.

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 Step 2 - Convert into home currency using spot rate.

Amount to Transfer (Step 1) $344,403

We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.

Spot rate (We are receiving the foreign 1.7000

currency)

Convert ($ Amount / Spot Rate) (344,403 / 1.7000) = £202,590

Step 3 - Place the money on deposit in the UK

Amount to Deposit (Step 2) £202,590

We will receive interest on the money we deposit.

Deposit Rate per year in UK 4

Deposit Rate for 3 months (Annual Rate x (4 x 3/12) = 1%

3/12)

Total Receipt

Amount transferred to UK £202,590

Interest on deposit in UK (£ Amount x 3 (202,590 x 1%) = £2,026

month UK borrowing rate)

Total Receipt (Amount transferred + interest (202,590 + 2,026) = £204,616

received)

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 Test Your Knowledge

Multiple Choice Questions

1. The home currency of ACB Co is the dollar ($) and it trades with a company in a foreign
country whose home currency is the Dinar. The following information is available:

Home Country Foreign Country

Spot Rate 20.00 Dinar per $

Interest Rate 3% per year 7% per year

Inflation Rate 2% per year 5% per year

What is the six-month forward exchange rate?

A 20·39 Dinar per $

B 20·30 Dinar per $
C 20·59 Dinar per $
D 20·78 Dinar per $

Answer A

Using interest rate parity, six-month forward rate

= 20·00 x (1·07/1·03)0·5 = 20·39 Dinar per

$

2. What is the impact of a fall in a country’s exchange rate?

1 Exports will be given a stimulus

2 The rate of domestic inflation will rise

A 1 only
B 2 only
C Both1 and 2
D Neither 1 nor 2

Answer C

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 3. The date is 31 January 2014 and Avecas Co. has entered into a contract whereby they
will receive $300,000 from a US customer on 01 April 2014. Avecas Co. is a UK company.

The following forward rates are available:

2 Month Rate $:£ 1.6000 +/- 0.0500.

3 Month Rate $:£ 1.5000 +/- 0.0500.
6 Month Rate $:£ 1.4000 +/- 0.0500.

What amount in £ will Avecas Co. receive under the appropriate forward contract to the
nearest £.?

A. £181,818
B. £193,548
C. £206,897
D. £495,000

Answer A

4. Hilasys Co. is a UK business that needs to pay $250,000 to a US supplier in 3 months

time. The spot rate now is: $:£ 1.6500 - 1.7000. Deposit rates in the UK are 5% annual
and in the US are 7% annual. Borrowing rates in the UK are 3% annual and in the US are
4.5% annual.

What will the transaction cost Hilasys Co. to the nearest £ using a money market hedge?

A. £181,818
B. £245,700
C. £148,909
D. £150,026

Answer D

Amount of $ to pay 250,000

Deposit Rate in US per year 7%

Deposit Rate for 3 months (Annual rate x 3/12) 7 x (3/12) = 1.75%

Amount to deposit (Total $ discounted at 1.75%) 250,000 x (100 / 101.75) = $245,700

Convert at Spot Rate ($245,700 / 1.65) £148,909

Borrow at home (Annual rate x 3/12) 3 x (3/12) = 0.75%

Total Cost (£148,909 x 1.0075) £150,026

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 5. Varys Co is a UK business that will receive $500,000 from a US supplier in 3 months
time. The spot rate now is: $:£ 1.6500 - 1.7000. Deposit rates in the UK are 5% annual
and in the US are 6.5% annual. Borrowing rates in the UK are 3% annual and in the US
are 4% annual

How much to the nearest £ will the Varys receive using a money market hedge?

A. £256,732
B. £294,846
C. £291,206
D. £495,050

Answer B

Amount of $ to receive 500,000

Borrowing Rate in US per year 4%

Borrowing Rate for 3 months (Annual rate x

4 x (3/12) = 1%
3/12)

Amount to Borrow (Total $ discounted at 1%) 500,000 x (100 / 101) = $495,050

Convert at Spot Rate ($495,050 / 1.7) £291,206

Deposit at home (Annual rate x 3/12) 5 x (3/12) = 1.25%

Total Cost (£291,206 x 1.0125) £294,846

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 Short Form Questions

1. $/£ 1.35 - 1.45 which currency is the counter currency?

The dollar.

Remember this as the base is always on the right or that this is dollars (plural) to
the pound (singular).

2. UK company receiving $500. Spot rate is $/£ 1.35 - 1.45. How many £ will the company
receive?

500 / 1.45 = £344

For a receipt of foreign currency use the rate on the right.

3. UK inflation is 5%, US inflation is 2%. The spot rate is $/£ 1.35. What will the FX rate be
in one year’s time?

Future rate = spot rate x (1 + inf in the counter) / (1 + inf in the base)

Future rate = 1.35 x (1.02 / 1.05) = 1.31

4. What are the internal methods of hedging currency risk?

Invoicing in the home currency.

Leading - paying up front.
Lagging - paying when the rate is favourable.
Offsetting receipts & payments in a foreign bank account.

5. What are the disadvantages of a forward contract?

Contractual commitment that you cannot renege upon.

Can’t take advantage of favourable movements in the currency.

6. How many £ will a company receive if they take a forward contract at a rate of $/£ 1.55
+/- 0.05 for an amount of $400,000?

Rate to use: 1.55 + 0.05 = 1.6

$400,000 / 1.6 = £250,000

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 7. How does a money market hedge eliminate the foreign currency risk?

The transfer is made today at the spot rate so no more exposure to the risk.

8. A UK company is going to pay $400,000 to a US supplier in 3 months time. The UK

deposit rate is 4.5% and the borrowing rate is 5.5%. The US deposit rate is 5.5% and
the borrowing rate is 6.5%. The spot rate is $/£ 1.5 +/- 0.025. Calculate the cost of the
payment if the company uses a money market hedge?

Step 1 - How much Foreign Currency?

Amount of $ to pay 400,000

We will deposit the money in the US where it will earn interest so that in 3 months we
have $350,000.

Deposit Rate in US per year 5.5%

Deposit Rate for 3 months (Annual rate x 5.5 x (3/12) = 1.375%

3/12)

Amount to deposit (Total $ discounted at 400,000 x (100 / 101.375) = $394,575

1.375%)

We will deposit $394,575 in the US where it will earn interest of 1.375% over the 3
months making it worth $400,000 when the payment becomes due.

We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.

Step 2 - Convert using the Spot Rate

Amount to Transfer (Step 1) $394,575

We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.

Spot rate (We are making a payment) 1.475

Convert ($ Amount / Spot Rate) (394,575 / 1.475) = £267,508

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 Step 3 - Borrow the Home Currency

Amount to Borrow (Step 2) £267,508

We will have to pay interest on the amount we have borrowed for 3 months.

Borrowing Rate per year in UK 5.5%

Borrowing Rate for 3 months (Annual Rate (5.5 x 3/12) = 1.375%

x 3/12)

Total Cost of
transaction

Amount transferred to US £267,508

Interest on borrowings in UK (£ amount x 3 (267,508 x 1.375%) = £3,678

month UK borrowing rate)

Total Cost (Amount transferred + interest (267,508 + 3,678) = £271,186

incurred)

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For in-depth coverage and reading please refer to Chapters 20 of the 2013 ACCA F9 Financial
Management Emile Woolf Study Text

Interest Rate Risk

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 Test Your Knowledge

Multiple Choice Questions

1. In relation to hedging interest rate risk, which of the following statements is correct?

A. The flexible nature of interest rate futures means that they can always be matched with
a specific interest rate exposure
B. Interest rate options carry an obligation to the holder to complete the contract at
maturity
C. Forward rate agreements are the interest rate equivalent of forward exchange contracts
D. Matching is where a balance is maintained between fixed rate and floating rate debt

Answer C

2. Which of the following are disadvantages of using an interest rate swap to hedge
interest rate risk?

1. There is a risk that one of the parties fails to pay their side of the swap.
2. It is a reversible agreement.
3. The decision to move into the swap may be the wrong decision as interest rates may
change unexpectedly.
4. The transactions costs can be very high.

A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1 and 4 only

Answer B

3. Which of the following statements are correct in reference to using an ‘over the counter’
interest rate option to manage interest rate risk?

A. It constitutes an contract with a bank to secure a specific interest rate no matter what
happens.
B. It is an agreement with a bank that ensures that the company can take advantage of
low rates, but secure against high rates.
C. It is an exchange traded contract that can be closed out at any time.
D. It enables the company to swap from a fixed interest rate to a floating rate or vice-versa.

Answer B

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 4. In relation to hedging interest rate risk, which of the following statements is correct?

A. The flexible nature of interest rate futures means that they can always be matched with
a specific interest rate exposure
B. Interest rate options carry an obligation to the holder to complete the contract at
maturity
C. Forward rate agreements are the interest rate equivalent of money market hedging of
foreign exchange risk
D. Smoothing is where a balance is maintained between fixed rate and floating rate debt

Answer D

5. Which of the following statements about the yield curve is correct?

1. In normal circumstances the curve is upward sloping.

2. Liquidity preference theory explains the yield curve on the basis that investors generally
prefer cash.
3. Expectations theory explains the yield curve as the market generally expects interest
rates to be lower in the future.
4. The yield curve can be used to predict interest rates.

A 1, 2 and 3 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 4 only

Answer D

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 Short Form Questions

1. What internal methods may a firm use to manage interest rate risk?

Smoothing.
Matching.
Netting.

2. What is an FRA?

A forward rate agreement. Effectively this is a forward interest rate agreed with a
bank.

3. Why might a firm use an interest rate option to manage interest rate risk?

It means that they can take advantage of low rates, but secure against high rates.

4. What is an Interest Rate Swap?

Sn arrangement organised through a bank whereby two parties swap interest rate
commitments.

5. What are the disadvantages of an interest rate swap?

There is a risk that one of the parties fails to pay their side of the swap.
It is a binding agreement.
The decision to move into the swap may be the wrong decision as interest rates
may change unexpectedly.
The transactions can be complex.

6. What does a Yield Curve plot?

Interest rates against the length of time or term of the debt.

7. In what way does a Yield Curve slope?

In normal circumstances the curve is upward sloping.

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 8. What are the three ways in which theorists have sought to explain the slope of the
yield curve?

Expectations theory states that if debt is to be held for longer terms it is more
likely that it won’t get paid back so higher interest rates are demanded to
compensate so as the term gets longer the interest rate rises = upward sloping
curve.

Liquidity preference theory states that because investors prefer cash, if they
are going to tie capital up by lending it out for the longer term they will
demand higher interest rates to compensate = upward sloping curve.

Market segmentation theory suggests that different investors have different

requirements based on their own circumstances and that long term investors
want higher yields leading to the upward sloping curve.

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