Risk Management
What you must understand
Distinguish transaction, translation and economic exposure to exchange rates, and the tools for each: forward contracts, money market hedges, currency futures, options and swaps. Know interest rate risk tools: forward rate agreements, interest rate futures, options on futures and swaps, and be able to compute a hedge using the appropriate tick value and basis. Understand the mechanics of the yield curve and the difference between hedging and speculation. Candidates should also cover credit risk, liquidity risk and the use of derivatives for hedging versus their misuse.
Traps in questions
- Mixing up the direction of a futures hedge: if you are receiving foreign currency, you sell futures; if paying, you buy.
- Forgetting basis risk and the need to estimate the basis at the close-out date.
- Using the spot rate rather than the forward rate in a money market hedge - the money market hedge replicates the forward.
- Confusing transaction exposure (contracted cash flows) with economic exposure (long-run competitiveness).
- Ignoring the premium cost of options when comparing with forwards.
Worked rule of thumb
For a money market hedge on a foreign currency receivable: borrow the foreign currency now, convert at spot, invest the home currency until receipt. For a payable: invest the foreign currency now, convert at spot, borrow home currency. This locks in a rate equivalent to the forward.
Example
A £1m receivable in dollars in three months. Borrow dollars now at the foreign rate, sell at spot for sterling, deposit at the home rate. The effective forward rate equals spot × (1 + home rate)/(1 + foreign rate) - compare this with the quoted forward to decide which hedge is cheaper.