Hedging Interest Rate Risk Using Forward Rate Agreement (FRA) These arrangements effectively allow a business to borrow or deposit funds as though it had agreed a rate which will apply for a period of time. The period could, for example start in three months’ time and last for nine months after that. Such an FRA would be termed a 3
Continue reading Hedging Interest Rate Risk Using Asset and Liability Management This relates to the periods or durations for which loans (liabilities) and deposits (assets) last. The issues raised are not confined to variable rate arrangements because a company can face difficulties where amounts subject to fixed interest rates or earnings mature at different times. Say, for example, that a company borrows
Continue reading Hedging Interest Rate Risk Using Matching When taking out a loan or depositing money, businesses will often have a choice of variable or fixed rates of interest. Variable rates are sometimes known as floating rates and they are usually set with reference to a benchmark such as LIBOR, the London Interbank Offered Rate. For example, variable rate might be set
Continue reading Hedging Interest Rate using Smoothing When taking out a loan or depositing money, businesses will often have a choice of variable or fixed rates of interest. Variable rates are sometimes known as floating rates and they are usually set with reference to a benchmark such as LIBOR, the London Interbank Offered Rate. For example, variable rate might be set at
Continue reading Hedging foreign currency loan using currency swap A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate. During the length of the swap
Continue reading Hedging Exchange Rate | Currency risk using Options Options are radically different. They give the holder the right, but not the obligation, to buy or sell a given amount of currency at a fixed exchange rate (the exercise price) in the future (if you remember, forward contracts were binding). The right to sell a currency at a set rate is
Continue reading Hedging Exchange Rate | Currency risk using Currency futures Simply think of these as items you can buy and sell on the futures market and whose price will closely follow the exchange rate. Let’s say that a US exporter is expecting to receive €5m in three months’ time and that the current exchange rate is US$/€1.24. Assume that this rate
Continue reading Hedging Exchange Rate | Currency risk using Money market hedging Let’s say that you were a UK manufacturer exporting to the US and in three months you are due to receive US$2m. You would suffer no currency risk if that US$2m could be used then to settle a US$2m liability; that would be matching the currency inflow and outflow. However,
Continue reading Hedging Exchange Rate | Currency risk using Forward exchange contracts A forward exchange contract is a binding agreement to sell (deliver) or buy an agreed amount of currency at a specified time in the future at an agreed exchange rate (the forward rate). In practice there are various ways in which the relationship between a current exchange rate (spot rate)
Continue reading Hedging Exchange Rate | Currency risk using Leading and lagging Let’s imagine you are planning to go to Spain and you believe that the euro will strengthen against your own currency. It might be wise for you to change your spending money into euros now. That would be ‘leading’ because you are changing your money in advance of when you
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