Fm Article
Financial Management | March 2012
In association with
Notes
Study
Paper T4 (part b) The seven deadly sins of a case study p45
Paper P3 Foreign currency hedging
Many P3 students understand the principles behind foreign currency hedging techniques but struggle to demonstrate the calculations in an exam. Let’s get some practice on how to figure out those numbers By Christine Bligh, content specialist, Kaplan edging involves reducing or eliminating financial risk by passing that risk on to someone else. It can provide certainty of cash flows, which helps with budgeting, encourages management to undertake investment, reduces the possibility of financial collapse and makes for a more attractive company to risk-averse staff. Foreign currency hedging specifically tries to reduce the risk that arises from future movements in an exchange rate. This is a two-way risk since exchange rates can move adversely or favourably. Management generally hedges for adverse movements only, for example higher costs and reduced income. Foreign currency hedging is a topic that frequently worries CIMA P3 students. Many seem to understand the basic principles of the available hedging techniques. However, demonstrating the calculations in an exam, under pressure, can cause problems. In this article, each foreign currency hedging technique is demonstrated numerically to give students further practice. Then the conditions for the use of each technique are discussed. Throughout this article the following scenario will be used:
Imagine USB Inc, an American software house, is due to pay a UK supplier £1m in three months’ time. It is now 1 May. Relevant data from the foreign currency and money market is given below. Exchange rates quoted today are: $/£ Spot rate 0.5120 – 0.5152 One-month forward rate 0.5141 – 0.5171 Three-month forward rate 0.5171 – 0.5202 Interest rates (p.a.) are: UK US % 5 – 5.5 2 – 2.4
H
Futures market (£100,000 contracts, margins are $1,000 per contract)
In association with
Notes
Study
Paper T4 (part b) The seven deadly sins of a case study p45
Paper P3 Foreign currency hedging
Many P3 students understand the principles behind foreign currency hedging techniques but struggle to demonstrate the calculations in an exam. Let’s get some practice on how to figure out those numbers By Christine Bligh, content specialist, Kaplan edging involves reducing or eliminating financial risk by passing that risk on to someone else. It can provide certainty of cash flows, which helps with budgeting, encourages management to undertake investment, reduces the possibility of financial collapse and makes for a more attractive company to risk-averse staff. Foreign currency hedging specifically tries to reduce the risk that arises from future movements in an exchange rate. This is a two-way risk since exchange rates can move adversely or favourably. Management generally hedges for adverse movements only, for example higher costs and reduced income. Foreign currency hedging is a topic that frequently worries CIMA P3 students. Many seem to understand the basic principles of the available hedging techniques. However, demonstrating the calculations in an exam, under pressure, can cause problems. In this article, each foreign currency hedging technique is demonstrated numerically to give students further practice. Then the conditions for the use of each technique are discussed. Throughout this article the following scenario will be used:
Imagine USB Inc, an American software house, is due to pay a UK supplier £1m in three months’ time. It is now 1 May. Relevant data from the foreign currency and money market is given below. Exchange rates quoted today are: $/£ Spot rate 0.5120 – 0.5152 One-month forward rate 0.5141 – 0.5171 Three-month forward rate 0.5171 – 0.5202 Interest rates (p.a.) are: UK US % 5 – 5.5 2 – 2.4
H
Futures market (£100,000 contracts, margins are $1,000 per contract)