Corporate Finance
Lecture 10: Currency risks
Joacim Broth 2024
Managing risks
• Some actors dislike risks, for example risk of an
asset losing value
• Some actors want risks, if they can earn money
• Risks can be transferred, at the right price
• Some type of risks are traded on financial
markets
– Currency risks
– Interest rate risks
– Price risks
Why are currency risks relevant?
• Take 5 minutes to discuss the effect of exchange
rate movements on a medium-sized exporting
company
– Short term
– Long term
• What can the company do to manage these
risks
– Short term
– Long term
FX –rates "foreign exchange rates"
• The price of one currency vs. another
• A complex relationship, for example:
FX
Difference in
Difference in
inflation/interest
growth in GDP
rates
Key factors influencing FX-rates
• Differences in growth of the economy
– A strong economy tends to get stronger currency
• Differences in interest rates (and inflation)
– Interest rate parity theory: the interest rate differential between two
countries is equal to the differential between the forward exchange
rate and the spot exchange rate
• Trade balance
– A trade deficit (imports>exports) leads to the country´s currency
reserves to diminish, must be funded by foreign debt. Decreased
demand for the currency weakens the currency
• Political stability
Key factors influencing FX-rates
explanation 1:2
The relationship between interest rates, inflation, and exchange rates, and how they influence each other in
international financial markets. :
Interest Rate Parity (IRP)
The interest rate parity theory states that the difference in interest rates between two countries is equal to the
difference between their forward and spot exchange rates. This means that currency markets and interest
rate markets are closely linked.
What this means in practice:
• Interest rate differential between countries: If country A has a higher interest rate than country B, the
currency of country A is expected to depreciate in the future to offset the higher returns.
• Forward and spot exchange rates:
• Spot rate: The current exchange rate for immediate transactions.
• Forward rate: The agreed-upon exchange rate for a transaction that will occur at a future date (e.g., three
months ahead).
• According to IRP, the difference between the forward and spot rates should reflect the difference in
interest rates between the countries.
Key factors influencing FX-rates:
explanation 2:2
Example:
• If the interest rate in Sweden is 4% and in the US it’s 2%, and the spot exchange rate for 1
USD is 10 SEK, the forward rate for 1 USD (one year ahead) will be higher in SEK to
reflect the interest rate differential. This ensures that investors cannot make risk-free profits
by moving money between countries with different interest rates.
The Role of Inflation
• Interest rates and inflation are often linked. Countries with higher inflation tend to have
higher interest rates to compensate for the erosion of purchasing power. The currency in
such countries is expected to weaken over time, which is reflected in the forward rate.
Summary:
• IRP establishes a relationship between interest rate differentials and exchange rates to
ensure that arbitrage (risk-free profits) is not possible.
• It helps explain why currencies tend to weaken or strengthen based on the interest rates
and inflation of the respective countries.
Interest rate parity explained
• Arbitrage = excessive risk-free return
– Interest rates in US = 2,0%
– Interest rates in EU = 1,0%
– EUR-USD FX = 1,10000
a) Take a 10.000 € loan, change to 11.000 $ and make a one-year deposit
b) Buy a currency forward that give a change that 11.000 $ will give back 10.250 € after one year.
c) Pay back the loan (10.000 €) and the interest (100 €) and you have a risk free return of 150 €
• Arbitrage cannot exist on working markets because all investors would run there! Demand
would change the prices
• To eliminate the arbitrage, the USD must weaken (forward rate lower than today
– Change 11.000 $ back to EUR at 1,08911 to get 10.100 €
– Pay back the loan and the interest and you are left with no return
– A risk free investment should give no return, as you did not tie up any money (no ”time-effect”)
Short-term currency risks
• Offers made in foreign currency
• Offers made in home currency to foreigners
• Trade receivables in currency
• Trade payables in currency
• Solutions to manage these?
Short-term currency risks 1:3
• Solutions to manage these?
We can e.g. handle short-term currency risks in the business world:
Currency Forwards: (binding contract in the exchange market that locks at exchange rates for
a currency on a future date.)
• Companies can use currency forwards to lock in a future exchange rate
for a specific transaction.
• This provides predictability over costs and revenues as they can fix the
exchange rate at the initiation of the deal.
Currency Options:
• Currency options give companies the right, but not the obligation, to buy
or sell currency at an agreed-upon rate before or at the expiration date.
• It provides flexibility, especially if currency rates move unexpectedly.
The company can choose to exercise the option if it's advantageous.
Short-term currency risks 2:3
• Solutions to manage these?
We can e.g. handle short-term currency risks in the business world:
Currency Swaps:
• Currency swaps involve two parties exchanging currencies for a specific
period and then reverting to their original positions.
• This can be used to reduce currency risks by converting one type of
currency exposure into another.
Centralized Cash and Currency Management:
• Companies can centralize their cash management to monitor and control
currency risks at the corporate level.
• By consolidating cash and monitoring currency transactions, the company
can effectively manage and minimize risks.
Short-term currency risks 3:3
• Solutions to manage these?
We can e.g. handle short-term currency risks in the business world:
Currency Clauses:
Companies can use currency clauses in their contracts to fix prices in advance
or include mechanisms to adjust prices based on currency rate changes.
Operational Efficiency and Working Capital Management:
Efficient working capital management, including optimizing inventory and credit
terms. Different payments forms and pre-payments, divided into different
payment rounds
…can reduce the need for rapid currency transactions, thereby reducing the
risks.
Long-term currency risks
• Pricing and competitiveness of exports
• Cost of imported raw materials
• Cost of foreign labour
• Long term debt or investments
• Solutions to manage these?
Long-term currency risks 1:4
Solutions to manage these?
Some methods used to handle long-term currency risks in the business world:
Currency Swaps:
• Currency swaps involve two parties exchanging currencies for a specific period and
then reverting to their original positions.
• This can be used to reduce currency risks by converting one type of currency
exposure into another.
Forward Contracts:
• Similar to short-term currency risks, companies can use forward contracts to lock in
future exchange rates for long-term business transactions.
• It provides predictability and protection against uncertainty regarding future exchange
rate movements.
Long-term currency risks 2:4
Solutions to manage these?
Currency Forward Options:
These are options that give the company the right to enter into a forward
contract at a later date, providing additional flexibility to manage long-term
risks.
Structured Financial Products:
Companies may consider using structured financial products, such as currency
swaps with different structures, to tailor to their specific risk profile and
business needs.
Long-term currency risks 3:4
Solutions to manage these?
Diversification of Business Units and Markets:
By diversifying business units and markets, companies can reduce vulnerability
to currency risks in a specific region or currency.
Inflation Adjustment and Pricing:
Companies may consider using inflation adjustments in their contracts and
pricing strategies to manage long-term currency risks.
Investment Strategy and Currency Matching:
Companies can structure their investment portfolios and financial commitments
to better match the currencies in which they expect to generate revenues.
Long-term currency risks 4:4
Solutions to manage these?
Managing long-term currency risks requires a careful analysis of the
company's exposure and a well-thought-out strategy that considers the
business model, markets, and financial goals.
And the use of diversified strategies can be crucial for the successful
management of long-term currency risks.
Conclusions
• Currency fluctuations can have a major impact
– On long-term profitability
– On individual deals/contracts
– On local value of receivables and debt in currency
• As a business manager you must have a view on
the expected changes
– Read the news!
– Speak to your bank
• Take action where appropriate to limit the currency
risk
• Next occasions 3th December
No lesson, time for work with assignments
2024-11-28
