Question

URGENT WILL RATE IMMEDIATELY, please explain all concepts thoroughly and simplefied if possible

Where applicable, you may use the information you were given and/or results you have found in Exercises 1, 2, and 3.

A part of Flexfix’s global strategy, is to get access to foreign investment capital. The CFO believes that a global investor base will create positive synergies for the company’s futuregrowth.

1 In 200 words or less, explain what foreign exchange risk is, and what the exposure in this context would be for a foreign investor who owns Flexfix bonds.

2 In 200 words or less, explain how a foreign investor could hedge the relevant foreign exchange risk off-balance sheet.

3 In 200 words or less, explain how a foreign investor could hedge the relevant foreign exchange risk on-balance sheet.

Answer 1

1. Foreign Exchange Risk is a risk which arises from change in value of two currencies. It is also known as currency risk. In this case, investor will invest in Flexfix bonds where the currency f investment is different frm the investor's home currency. Any change in the currency valuation affects the investment value. Hence in this case, there will be a huge impact of currency valuation apart frmthe performance of bond. However, there can be positive aspects for investor if the currency movement is in his favour.

2. Foreign exchange risk can be hedged off balance sheet using forward contracts. It enables the company to reduce or eliminate it's foreign exchange risk. Off Balance Sheet transactions lead to contingent future cash flows. Since forward contracts are negotiated over the counter, the counterparties have maximum flexibility to set the term of contract.

3. There are two ways of hedging on balance sheet foreign exchange risk. Currency Swaps or Currency Options.

Currency swaps is an agreement between two parties to exchange series of cash flows denominated in one currency, over pre determined period.

Currency options gives buying party the right but not the obligation to exchange sum of one currency for an agreed sum of other.

These transactions are fully disclosed in balancesheet which may lead to additional disclosure costs to hedging on balancesheet. Also, these transactions result in upfront cash flows.