Examples of Exchange rate risk in the following topics:
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- First, the company has an exchange rate risk.
- Second, the company eliminates the exchange rate risk and pays $5 million.
- First, the company has an exchange rate risk.
- Second, the company eliminated the exchange rate risk, and it will pay $41,666.67.
- It has two sources of variation: Fluctuations in the exchange rate and the sensitivity of the asset's price to changes in the exchange rate.
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- We usually write an exchange rate as Equation 1.
- Exchange rates can fluctuate over time.
- Exchange rate can also move in the other direction.
- Fluctuating exchange rates leads to the exchange rate risk, which can financially harm international banks, investors, and businessmen.
- What would happen if the exchange rate varies?
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- International investors, buying foreign bonds, can experience a currency exchange rate risk, an interest-rate risk, a borrower default, and/or a country risk.
- An investor experiences an exchange rate risk because a country's exchange rates are constantly fluctuating, changing an investment's value.
- Consequently, the interest rate is comprised of the risk-free interest rate and risk premium.
- Consequently, a country's risk differs from a currency exchange rate risk.
- A country's risk could be zero, but that country has a large currency exchange risk.
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- Bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
- Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise.
- Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.
- If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", the interest rate risk could become a real problem.
- As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
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- As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency.
- A firm has economic exposure / long-term exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations.
- Such exchange rate adjustments can severely affect the firm's position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value.
- A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good.
- A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements.
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- Firms are subjected to currency risk, called exposure.
- Transaction exposure comes from the risk of transactions denominated in different currencies.
- Exchange rate alters future sales, prices, and costs.
- Keeping them straight, economic exposure is how a change in an exchange rate influences a company's finances over time, while transaction exposure is a change in exchange rates impact current assets and liabilities.
- Thus, companies could gain profit from favorable changes in the exchange rates.
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- Then, students learn the supply and demand analysis to predict changes in a currency's exchange rate because a country's income, inflation, interest rates, etc.influence exchange rates.
- They calculate the cross rate to determine the exchange rate for these currencies.
- For example, the Mexican peso to U.S. dollar exchange rate is well established, while the peso-euro exchange rate is not.
- Since the exchange rates differ, then arbitrage exists, and we can profit from the exchange rate differences.
- It does not matter which exchange rates we calculate the cross rate from.
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- Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk.
- Banks experience an interest-rate risk, when changes in the interest rates cause the banks' profit to fluctuate.
- If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
- For example, a variable interest rate mortgage is an adjustable-rate mortgage (ARM).
- Banks could buy futures and options to protect themselves from changing interest rates and exchange rate.
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- Spot & forward rates are settlement prices of spot & forward contracts; cross rates are the exchange rate between two unofficial currencies.
- where F is the forward price to be paid at time, Tex is the exponential function (used for calculating compounding interests), r is the risk-free interest rate, q is the cost-of-carry, S0 is the spot price of the asset (i.e., what it would sell for at time 0), Di is a dividend which is guaranteed to be paid at time ti where 0< ti< T.
- A cross rate is the currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in.
- For example, if an exchange rate between the euro and the Japanese yen was quoted in an American newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is the standard currency of the U.S.
- However, if the exchange rate between the euro and the U.S. dollar were quoted in that same newspaper, it would not be considered a cross rate because the quote involves the U.S. official currency.
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- Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.
- The greater the risk is, the higher the market interest rate will get.
- Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.
- However, economists generally agree that the interest rates yielded by any investment take into account: the risk-free cost of capital, inflationary expectations, the level of risk in the investment, and the costs of the transaction.
- where in is the nominal interest rate on a given investment, ir is the risk-free return to capital, pe = inflationary expectations, i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.