Financial engineering, exchange rate risks, interest rate risks and the mitigating techniques are discussed under this topic.
1. Exchange rates
An exchange rate is the rate at which the currency of one country can be traded in exchange of the currency of another country. Every traded currency in fact has many exchange rates. There is an exchange rate with every other traded currency on the foreign exchange market. Foreign exchange dealers make their profit by buying currency for less than they sell it, and so there are really to exchange rates, a selling rate and a buying rate. Broadly speaking there are two ways in which currencies are bought and sold.
Forward – for delivery at a date in the future
Spot – for immediate delivery
The foreign exchange markets
The foreign exchange (or Forex) markets are worldwide, and are continuing to expand. The main dealers are banks. Banks buy currency from customers and sell currency to customers. International trade also involves foreign currency for either the buyer, the seller or both.
Foreign currency quotations
The price of foreign currency is normally quoted in terms of the local currency. The difference between the offer price and the bid price covering dealers’ costs and profit is called the spread.
Foreign exchange risk
The following different types of currency risk may be identified in financial management notes;
Transaction risk – this is the risk of adverse exchange rate movements occurring in the course of normal international trading transactions
Translation risk – this is the risk that the organization will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the home currency
Economic risk – this refers to the effect of exchange rate movements on the internationally competitiveness of the company.
Direct risk reduction methods
The forward exchange contract is perhaps the most important method of obtaining cover against risk. Another way of avoiding exchange risk is for an exporter to invoice his foreign customer in his domestic currency. Leads and lags are also methods of minimizing foreign exchange risks.
2. Interest rate Risk
Here we consider interest rate risk and some of the financial instruments which are now available for managing financial risk, including derivatives such as options. The risk of interest rate changes is however less significant in most cases than the risk of currency fluctuations.
Hedging interest rate risks
Alternative strategies that companies might adopt with respect to interest rate & currency exposure are discussed under this topic.
Forward rate agreements
Understanding the nature of FRAs and how their prices are quoted and evaluating the interest rate hedge using FRAs are the topics discussed in financial management notes.
Futures and contracts
Interest rate futures (short term & long term) and currency future contracts are discussed under this topic.
Various types of interest rate options including short term options, caps, collars and floors and the nature of currency options com under this topic.
Gap analysis of interest rate risk
This identifies the degree to which a firm is exposed to interest rate risk. Gap analysis is based on the principle of grouping together assets and liabilities which are sensitive to interest rate changes according to their maturity dates.
3. Financial Engineering
Financial engineering involves the creation of new financial instruments thru the existing instruments or innovation. Financial engineering makes use of various mathematical calculations and the new instruments created by the financial engineers may serve as a solution to a particular problem or situation.