The term exchange rate risk is used to define the possibility that, because of fluctuation currency values, companies dealing in more than one currency may end up with more or less of a profit. In the Bruce Company's case, a fluctuation of 1.45733 Euros per Sterling denotes a negative exchange rate risk. Put more simply, the Bruce Company must pay the French company a total sum of 4.48 million Euros in four equal installments of 1.12 million Euros. Because the Sterling is currently stronger than the Euro, Bruce Company will loose money during four separate transactions in which their stronger currency is converted to the weaker currency.
Thus, Bruce Company must determine a way to hedge against the exchange rate risk, or take out another investment specifically to reduce or eliminate this risk. One way to hedge against this risk is allowing the sterling to accrue interest in a money market account. Because interest in a British account is and will continue to be greater than that of a French account, a simple rate of return calculation will show that the British account will yield higher profit For instance, consider one payment of 1.12 million Euros kept in a British Money Market account for three months.
________ = 768, 529
ROR= 768, 529 ( .25 + 4.59375 )
If, on the other hand, the Euros were kept in a French Money Market account for three months, the following results would occur:
ROR= 1.12 million (.25 + 2.75000)
It is obvious, therefore, that using British Money Market transactions is especially advantageous in this type of scenario. The extra money accumulated in the account may compensate for, or at least soften, the blow of exchange rate risk, depending on the floating rates at the time. There is a significant risk involved in long term Money Market account investment, however, in that they too are subject to fluctuating exchange rates. If exchange rates vary drastically in while interest is accruing, lower interest rates might, in the he end, have generated more capital once the money is exchanged for the original currency.
1Interest Rate Risk
When the Bruce Company took out its loan, its choice of a fixed interest rate was an attempt to avoid great interest rate risk, as interest rates were rising. Now that the financial advisor and others believe that the interest rate is falling, howerver, and interest rate swap is beginning to look beneficial. A company uses an interest rate swap when it exchanges its interest rate for that of another party. By swapping interest rates, companies allow themselves some freedom from climbing interest rates. In order to determine whether or not an interest rate swap is beneficial, however, the zero-coupon bonds calculations must be performed.
If interest is compounded annually, using the rate of returns formula, interest rates for zero-coupon bonds are as followes:
One Year Two Years Three Years Four Years
4.675= (1+ i) 4.