Q 1 There are multiple ways through which the financial manager can mitigate foreign exchange related risks. These include: Forward Contract is a contract that compels one to purchase or sell a currency at a given fixed rate on a pre-defined future date. By connecting this date to the date of one’s currency payment/purchase, an individual in effect lock in the exchange rate an individual wants and mitigates the risk of future volatility…
Futures contracts can be transferred between parties. Futures have advantages similar to those mentioned for forwards. Currency Options involves a contract for a fee (premium + commission), sold by one party to another that provides the buyer the right, although not the obligation, to purchase or sell a specified amount of a single currency for a given amount in another at an agreed-on price within a given period of time or on an exact date. Its advantage is that it protect against downside risk in addition to allowing upside appreciation. Currency Swaps on the other hand is an agreement by two corporations to exchange specified amounts of currency currently and to reverse the exchange at a given point in the future. A currency swap might not incorporate an initial exchange, in which instance it would incorporate one or multiple payments during the swap’s life in addition to a final exchange. This option helps in minimizing the costs of foreign conversion while client is secured against exchange rate risk. Additionally, it costs nothing to enter into a swap. Back-to-Back Loans is a form of loan where two corporations in different nations borrow offsetting amounts in individual’s currency. The aim of this transaction is to hedge against fluctuations in the currencies. It key benefit is that it allows one to gain from approved spot limits. A Non-deliverable forward contract is a form of agreement between parties where one (an individual) is protected against undesirable rates in foreign exchange. Generally, it is a cash settled transaction and as such there are no real exchange of currencies at maturity. Essentially, a net payment is made by one of the parties to the other on basis of the contracted rate alongside the market rate at the day of settlement. It effectively involves hedging of expected foreign currency cash flows. Simply put, a contract rate is agreed up-front, alongside the fixing rate (and the corresponding fixing date). The contract rate is made use of in calculation of the amount payable on the nominated date of maturity. It is important to mention that an NDF may is useful in management of currency risks related to exportation and importation of goods, foreign currency purchase, conversion of foreign currency denominated dividends, or in settlement of other foreign currency contractual agreements. It is more particularly useful in instances where physical exchange is not necessary on the maturity date or in instances where a foreign central bank puts some limit to offshore access to its local cash niche. It should be put into use in instances where one has a genuine commercial necessity to manage currency risks linked to a particular pair of currency. Q2: The strike price of an equity option in popular plc is 380p and the premium was 24p per share. The current market price of a share in the company is 410p. The exercise date is still over one month away. Calculate the profit or loss on one contract to date for: A long call A long put A short call A short put If the market price of shares in popular rose explains how, and why, the premium would alter as a result for: i) a long call The profit made by the trader will increase. This is due to the fact ...
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